The Constitutional Court of the Russian Federation adopted a resolution designed to stop the practice of “administrative closing” of firms without the payment of debts to creditors

Business received the ability to “liquidate debts” in 2005, when Paragraph 2 of Article 21.1 became part of the law on the state registration of legal entities. This amendment gave the tax authority the right to exclude a company from Unified State Register of Legal Entities (USRLE) through administrative procedure. Qualifying companies were those that had not reported to the tax authorities for 12 months. The focus of amendment was evident: “clean” the registry of legal entities of the nonfunctioning businesses “hanging” in the registry. The provision applied to companies which did not have debts, which represented a minority. Yet, exclusion from the registry could release a company from all liabilities. As a result, the courts were jammed with an avalanche of bankruptcy cases involving inactive companies, and the purpose of the new law melted.

On 20 December 2006, the Supreme Arbitration Court of the Russian Federation (SAC) adopted Resolution No. 67, which clarified its position on the possibility of a company’s exclusion from USRLE. It stated that bankruptcy only should take place in cases when the tax authority can demonstrate a high probability of detection of the debtor’s property or proof that the debtor’s executives were somehow liable.

The result of this development of jurisprudence was the phenomenon of “disappearances” of nonperforming businesses, which had both debts and assets. For example, the tax authorities, by mistake, included a major tour operator, Coral Travel, and OAO MMZ Mayak, more than 63 percent of which the state owned, on the list of non-performing firms. The absurdity was apparent in yet another way. The law allows firms to “disappear” legally from under the noses of creditors who were trying to find firms’ assets in bankruptcy proceedings or to prosecute their executives. Extrajudicial exception from the USRLE became a solution for debtors who wished to transfer assets and for those wishing to carry out corporate raiding and asset seizure. By excluding a company from the state register, at least for a time, the raiders blocked the legal capacity of the organization. Fortunately, the raiding based on the USRLE was not widespread.

It was Paragraph 2, Article 21.1 of the law on registration of legal entities that become the subject of the constitutional scrutiny. As part of a complaint of Otdelservis, the Constitutional Court found that the applicant had confirmed in court the right to file a claim against a debtor and to initiate proceedings to force it into bankruptcy. Nevertheless, due to the fact that the debtor represented an invalid organization, it was not on the register. This fact terminated the bankruptcy proceedings. Otdelservis applied to the Constitutional Court, referring to the contradiction between Article 46 of the Constitution and Paragraph 2 of Art. 21.1 of the law on registration of legal entities.

The Constitutional Court took the position that the administrative procedure for excluding a company from the register is unconstitutional when it coincides and “superimposes” on the bankruptcy procedure. The Constitutional Court, therefore, gave absolute priority to the bankruptcy procedure, noting that it creates “the necessary conditions both for the measures to overcome the insolvency of the debtor and to satisfy the claims of all creditors.”

Lawyers already appreciate the significance of this resolution. In fact, the Constitutional Court has eliminated one of the obvious ways to legitimize “liquidation with debts.” We believe that the legislature will heed the opinion of the Constitutional Court and draft appropriate measures to amend the regulatory acts.

The problem of debt evasion, tied with the use of one-day firms, has reached an incredible scale. More than ten years of experience since the introduction of “administrative closing” showed that “cleaning” the registry and bankruptcy are ineffective ways to combat companies running their business only “on paper.” The situation requires a systematic approach, rather than symptomatic treatment. It is necessary to regulate the business environment and create the conditions under which the very possibility of creating fictitious companies is impossible.