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Consortium for Economic Policy Researchand Advice WCER Canadian Association Institute Working Academy International of Universities of Economy Center of National Development and Colleges in Transition for Economic Economy Agency of Canada Reform The institution of bankruptcy:

development, problems, areas of reforming Moscow 2005 UDC 658.16 +347.736 BBC 65.290 93+67.404 T44 The institution of bankruptcy: development, problems, areas of reforming. .: IET, 2005. P. 281.

Agency CIP RSL Authors: Radygin A.D. (Team Leader), Gontmakher A.E., Kuzyk M.G., Mezheraups I.V., Swain H., Simachiov Yu. V., Shmeleva N.A., Entov R. M.

The research focuses on the analysis of the emergence of the institution of bankruptcy (insolvency) in Russia. More specifically, it centers on studying the evaluation of its legal base, specific purposes of its use in the national transition economy, motives and objects of application of the given procedures and development of the respective country-specific recommendations. While analyzing theoretical approaches to the problem of bankruptcy, the authors focus on market financial regulation mechanisms, forms and options of bankruptcy procedures, as well as evaluation of first results of application of the new, 20022004, Russian law. In parallel with the analysis of the Canadian experiences in the area of corporate bankruptcy, the authors consider economic fundamentals of bankruptcy and provide a review of the contemporary legal and law enforcement systems in this particular area.

JEL Classification: G33, G38, P2, P31 Editors: Moldavsky A., Serianova S.

Page setting: V. Yudichev The research and the publication were undertaken in the framework of CEPRA (Consortium for Economic Policy, Research and Advice) project funded by the Canadian Agency for International Development (CIDA).

ISBN 5 93255 162 3 5, Gazetny per., Moscow,103918 Russia Tel. (095) 229 6736, Fax (095) 203 E MAIL info@iet.ru, WEB Site http://www.iet.ru Content Introduction..............................................................................Chapter 1. The problems of bankruptcy:

theoretic approaches............................................................. 1.1. Market mechanisms for financial regulation and their boundaries......................................... 1.2. The forms of bankruptcy: liquidation or reorganization............................................................ 1.3. Choices of bankruptcy procedures.............................. Chapter 2. Main legal phases in the development of the institution of insolvency in contemporary Russia......... 2.1. Traditional models and specific features of the economy in transition.............................................. 2.2. A general estimation of the provisions of the 3rd Law on bankruptcy............................................ 2.3. The formation of a subordinate legal base and regulation of the powers of the bodies of state authority during the period of the new Law being in force............................. 2.4. Prospects for the modification of bankruptcy legislation................................................... Chapter 3. Bankruptcy issues in regional legislations.......... Chapter 4. The economic aspects of the formation of the institution of bankruptcy and the dynamics of cases............................ 4.1. The specific economic and institutional conditions for applying bankruptcy procedures.................................................. 4.2. The financial aspects of the activity of large industrial enterprises in the context of their potential insolvency............................................. 4.3. The main trends in applying bankruptcy procedures during 19982002........................................ 4.4. The 3rd Law on bankruptcy: the first results of its application in 2003....................................... Chapter 5. The practice of applying bankruptcy procedures for control takeover and property redistribution.................................................. Chapter 6. The institution of bankruptcy commissioners in contemporary Russia............................... 6.1. Main Principles........................................................ 6.2.Regulation of the activity of bankruptcy commissioners: phases of development........................... Chapter 7. Canadian corporate bankruptcy:

law and public policy............................................................ 7.1. Background: economics of bankruptcy...................... 7.2. The Canadian system............................................... 7.3. Legislative reform of the Canadian Acts..................... 7.4. The example of Air Canada....................................... 7.5. Matters of special interest in Russia........................... Annex A: The ten acts of bankruptcy........................... Annex B: Powers and liabilities of trustees under the BIA........................................... Annex C: Statutory priorities in business insolvencies............................................................. Conclusion............................................................................ Bibliography......................................................................... Introduction Theoretically, the legal norms designed to regulate insolvency of en terprises may imply the achievement of the following goals: at the mac rolevel to decrease the levels of economic risks in the economy through liquidating inefficient enterprises, redistributing industrial as sets in favor of efficient ones, and developing a competitive environ ment; at the microlevel to protect creditors rights, ensure financial discipline, improve the safety of credit circulation, reorganize enter prises, which includes financial restructuring; to improve the quality of corporate governance, redistribute property in favor of efficient own ers, replace inadequately qualified managers, and implement rational management systems at enterprises.

At the same time, the effectuation of bankruptcy procedures always implies certain losses to creditors, debtors, and the State. Foreign countries with developed economies are no exception in this respect.

The possibilities for applying bankruptcy procedures in order to reform businesses and to replace inefficient owners are quite limited, their basic goal being that of liquidating inefficient production, redistributing unreasonably utilized assets, and lowering economic risks in the econ omy; that is, bankruptcy procedures may serve a creative purpose pri marily at the macrolevel.

The experience of foreign developed countries has not provided us with sufficient grounds for a firm belief that regulation of insolvency is to be effectuated only with the creditors priority in mind; there do exist examples demonstrating that insolvency is primarily orientated toward protecting the interests of the debtor or the State. It all depends on the specific economic policy of a given state and is largely associated with the scope of its state owned sector and the standpoints as to the ne cessity of its presence.

The role of bankruptcy as a means of exerting pressure on corpora tions CEOs in a market economy is well known and has been de scribed in all of its aspects (both positive and negative) in the vast litera ture existing on this subject. The threat of a corporations bankruptcy as a result of its CEOs erroneous policy on the markets (and as the ex treme variant the taking of control by its creditors) is usually regarded as the most important external instrument of corporate governance. An obvious expected result of applying this mechanism (irrespective of the faults and merits of specific country based models be they pro creditor or pro debtor) must the rehabilitation of finances and improved efficiency of a corporation which has been subjected to such proce dures.

At the same time, those specific objective limitations that character ize the situations existing in Russia and some other countries with tran sition economies and impede an efficient mass scale application of this mechanism are also very well known:

an unfavorable financial situation experienced by a considerable number of newly created corporations;

the traditions of soft budget constraints;

the preservation of a substantial number of corporations with the States participation;

the lack of an appropriate and highly qualified executive and judicial infrastructure;

social and political barriers hampering the implementation of genu ine bankruptcy procedures in respect to loss making corporations, especially in the instances of very large enterprises or those form ing company towns;

numerous technical difficulties associated with objective estimation of the financial status of potential bankrupts;

corruption and other criminal aspects of the problem, including those associated with property redistribution.

National legislation on bankruptcy is oriented towards a developed market economy, where the percentage of the economic subjects in respect to which it might be necessary to apply bankruptcy procedures is relatively small. However, the economic situation in Russia is funda mentally different. There exist, in fact, no doubts as to the necessity to create a well developed institution of bankruptcy in Russia, and almost no doubts as to its positive influence already being felt in the sphere of small and medium size business. The main object of criticism in Russia has now become the practice of bankruptcies of large enterprises.

Throughout the 1990s, the institution of bankruptcy in Russia was being applied either as a method for property redistribution (seizure, retention, privatization), or as a highly selective method of exerting po litical and economic pressure on enterprises by the State. A paradoxical situation could be thus observed: those enterprises that had a sufficient stability resource were being involved in bankruptcy procedures (due to the existence of a situation that favored the seizure of control over them by their competitors), while hopeless enterprises were avoiding this procedure (because there were no likely candidates willing to seize them, and the chances of recovering debts during the procedure of bankruptcy were slim).

While the institution of bankruptcy in the years 19921998 was more resembling an imitation of itself, the second law (adopted in 1998) dis torted the situation still further, by making the institution of bankruptcy, instead of a method for ensuring financial discipline, an instrument for property redistribution and asset withdrawal. This had a direct bearing on tax payments. According to the Federal Service for Financial Reha bilitation and Bankruptcy1, every fifth bankruptcy had certain character istics of premeditated criminal actions (in particular, bankruptcy as a way of writing off debts). It should be admitted that the State, in its turn, also sometimes resorts to the threat of bankruptcy as an instrument of exerting pressure upon an enterprise in order to make it pay its tax debts, or for other purposes, including non economic ones.

As a result, although the Russian Law On insolvency (bankruptcy), while being in force during 19982002, was formally quite progressive from the point of view of international practice, and implied that there existed a certain balance of debtors and creditors interests, the prac tical application of its norms became one of the most notorious exam ples of discrimination against some of the process participants (the owners of an enterprise, or various creditors, including the State, de pending on a specific situation).

Quite obviously, it was necessary, on the one hand, to ensure the protection of creditors rights during the process of an enterprises bankruptcy, and on the other, to protect the debtor from simplified pro cedures of a hostile takeover of control (or of a part of its assets) being applied to it within the framework of bankruptcy procedures.

Since September 1993, there existed in Russia the Federal Administration for Insolvency (Bankruptcy) (FAIB) at the RF State Committee for State Property; in March 1997 the Federal Service for Insolvency and Financial Rehabilitation of Russia (FSIFR) was created, which in June 1999 was transformed into the Federal Service for Financial Rehabilitation and Bankruptcy of Russia (FSFRB). From March 2004, the FSFRBs functions have been distributed among several State bodies.

Throughout the whole period of the 2nd Law on bankruptcy (now abolished) being in force, attempts were being made to somehow cor rect its provisions. During the discussion of the draft new (3rd) Law on bankruptcy, all the parties recognized the importance of finding solu tions to the following problems pertaining to insolvency regulation:

violation of the rights of the debtor enterprise and its owners, no possibilities for the latter to rehabilitate the enterprise under the creditors control;

insufficient protection of the rights of secured creditors;

very limited rights of the State as the creditor in respect to manda tory payments, the need to further specify the procedures for the States participation as a creditor in bankruptcy procedures;

the problem of a conflict of interests among empowered State bod ies, the legitimacy and consequences of the suggested extended powers;

the widespread practice of applying bankruptcy procedures in or der to seize (or intercept) the management of an enterprise and to withdraw the most attractive assets in the interests of some of the creditors;

undeveloped mechanisms for enforcing the responsibility of bank ruptcy commissioners;

the need to specify the status of self regulating organizations of bankruptcy commissioners, the terms of membership therein, and guarantee funds;

the lack of reasonable special mechanisms for the effectuation of bankruptcy of enterprises belonging to the military industrial com plex and natural monopolies;

the need to consider the feasibility of preventing the arbitrage court (which bears no responsibility) from making any decisions concern ing the candidacy and qualifications of a bankruptcy commissioner, or decisions (or the approving of decisions) concerning an enter prises assets;

the need to discuss the issue concerning the elimination, in princi ple, of the procedures of external administration and financial rehabilitation.

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