Streamlining of the Legal Status of Members of the Board of Directors of a Sole or Collegial Executive Body of an Economic Society

Back

In the State Duma on approval there is a governmental draft law on bringing to civil liability members of administration of economic societies. Among main provisions of the document there is subsidiary liability of company’s chief executives for material losses caused by shareholders or participants owing to violation of their rights related to placement of issuable securities of the society or violation of terms and procedure of dividend payment. A chief executive of the society is considered to be guilty if in the course of exercise of his rights and fulfillment of duties he acted irrationally and (or) unscrupulously. Will the law become “working” under the stated criteria of irrational and unscrupulous behavior?

Author: Diana Poletaeva – Head of the Corporate law department of the legal firm “Chastnoe Pravo”

Perhaps, the main disputable moment of the draft law is introduction of presumption of guilt of the society’s chief executives.

Apparently such a step was dictated by the authors’ aspiration to make the mechanism of legal protection of the society and its investors effective against senior managers’ abuses, because on the basis of current norms, which are rather abstract and estimating, effective prevention and reclamation of violated rights are hindered.

However, in this form the draft law allows for significant disbalance of interests of a conditionally strong (management) and a conditionally weak (shareholders, participants, and – according to the old tradition of abstract lawmaking – “other persons”) parties. Thus, not willing to give any warrants to investors, for some reason the authors of the project in advance declare chief executives of the society irrational and unscrupulous, guilty of negative results of the society’s activity.

In pratice, such legislative approach can give way to corporate blackmail: any person from the open list (for example, see item 1 of article 71 of the draft law) who thinks that the society has suffered losses (by which, as we know, they mean not only real damage but also loss of profit) can apply with a claim of their judicial compensation. Besides, the person initiating the dispute does not have to prove irrationality and/ or unscrupulousness of chief executives of the society, and is not restricted in economic expenses on proceedings (according to suggested changes in part 4 of article 225.8 of the RF Arbitration Procedural Code they can be assigned to the society itself – providing that there is a declaration of actions in its interests; the only exception can be chicanery established by the court).

Chief executives themselves will have to prove presence of grounds for exemption from liability, using rather doubtful criteria, and such proving should follow a peculiar pattern – by means of refutation of circumstances:

Proving “irrationality”, namely: the fact that the decision was made without taking into account available information; that before it was taken no actions were performed to get information necessary for the decision to be made, which are usually performed under similar conditions (also a rather conditional, estimating supposition);

Proving “unscrupulousness”, which expressed itself: in “conflict of interests” (the essence of which has not been revealed yet, except special cases); in actual (or presumed) knowledge about the fact that the decision made with account of his vote does not serve the society’s interests; in holdout from or nonfulfillment of his duties without good reason; in violation of legislative requirements or the society’s Charter by this decision.

Many aspects remain vague from the text of the draft law, for example: what should be understood by recording available information?; what information (content, volume) can be regarded as necessary to make a decision in a certain case and which circumstances can be regarded as similar ones?; what should be the grounds of the knowledge that the decision does not serve the society’s interests (if we talk about possible risks and not about a clearly illegal transaction)?

Following the authors’ logic one can make a conclusion that before a chief executive of the society makes a decision, he is delivered information in the form of two ready versions. The first version has 100% possible economically successful result (and only his own “irrationality” and/ or “unscrupulousness” prevent him from signing this decision). The second version has evident violations of law requirements and the society’s Charter, it apparantely entails losses (and again, only his own “irrationality” and/ or “unscrupulousness” make him sign this decision).

It is noteworthy that according to the presumption the authors present, for bringing to liability either criteria of irrationality or unscrupulousness are enough. And there are several such criteria. Does it mean that lack of refuting proofs for at least one of the listed criteria will entail the manager’s responsibility? There is no answer.

It seems that chief executives can only appeal to the fact that they usually make decisions in situations of entrepreneurial risk, and in this relation, economic losses are inevitable for the society and investors.

But in this case the legislator eliminated a possibility of any indulgence: the provision of item 3 of artcile 71 of the law on joint stock companies, existing in the current edition of the law: “In determining the grounds and amount of liability an ordinary course of business and other circumstances relevant to the case should be taken into account”, mysteriously disappears in the draft law. 

It seems that according to the old tradition, we shall follow the way of special clarifications, providing additional work to higher courts, and before that – we shall rely on moral certainty and a reasonable approach of judges considering disputes. And their task will not be easy, because when the “letter” of the law is difficult to understand, one can only rely on its “spirit”.

Author: Ilya Bogdanov – Head lawyer of the legal company Tenzor Consulting Group

 

The Government of the Russian Federation introduced a draft law N 394587-5 to the State Duma. It is dedicated to streamlining of the legal status of members of the Board of directors and members of a sole or collegial executive body of an economic society.

The draft law provides for amendments to the legislation on securities market, to the Labour and Arbitration Procedural Code and to federal laws on joint stock companies and limited liability companies. Among these amendments the following ones should be pointed out: detailed fixation of the legal position of members of an executive body of an economic society, payment for judicial expenses by a legal person regardless of results of the case consideration, fixation of relations of a limited liability company with its executive member in a civil contract, liability insurance of members of an executive body of an economic society.

However, the key point of this volumnious document is the provision according to which chief executives of the society (members of an executive body) bear subsidiary responsibility with the society before shareholders and owners of other issuable securities of the society for losses caused due to their actions. The chief executive of the society is considered guilty if in exercising his rights and duties he acted irrationally and (or) unscrupulously. Notions of “rationality” and “scrupulousness” have been present in the legislation quite a long time, but their clear definition has not been stated in the civil legislation. These legal innovations are an attempt to work out in detail provisions of item 3 of article 53 of the RF Civil Code, which presuppose that a person acting on behalf of an economic society must act scrupulously and rationally in the interests of the legal person he represents.

At the moment they remain an estimating category which is determined by parties to relations and judicial practice.

At the moment the criterion of rationality is defined through evaluation of knowledge on some object or process. For example, the notion of rational certainty, which is “a general approach related to the process of accumulation of audit evidence necessary and sufficient for an auditor to form an opinion on lack of significant distortions in financial (accounting) statements, considered as a whole”. (The RF Government regulation of September 23, 2002 N 696 On Approval of Federal Rules (Standards) of Auditor’s Activity).   

The notion of unscrupulousness was defined as any actions of economic entities aimed at acquisition of benefits of entrepreneurial activity, which contradict provisions of the current legislation, customary business practice, requirements of decency, rationality and fairness and can cause or have caused damage to other economic entities-competitors or damage their business reputation (article 18 “Comment to the Federal law of July 9, 1999 N 160-FZ On Foreign Investments in the Russian Federation”(S.N.Bratanovsky, A.B. Smushkin)).

In the new edition of article 71 of the Federal law On Joint Stock Companies it has been suggested to fill this gap. The criterion of rationality is defined through recording of all information a person has, and the criterion of scrupulousness is defined with account of interests of an economic society and compliance with the legislation.

Thus, general practice of definition of different notions is suggested by means of fixation present theoretical developments in the law. The draft law provides no fundamentally new mechanisms and definitions. So, it can be assumed that in implementation of these criteria a high role of their evaluation in the course of their practical application will remain.

Interpretation of rationality provided in the draft law does not exempt the court and other participants from evaluation of the fact of presence of necessary information and its completeness, as well as determination of actions necessary to obtain it. This situation will require significant efforts on the part of courts related to forming of corresponding practice.

The definition of “scrupulousness” is more disputable. Inclusion in the definition such criteria as non-compliance of a decision with the legislation and presence of a conflict of interests gives rise to some concern. These criteria have already been present in the legislation as separate grounds to recognise a chief executive’s actions invalid and requiring compensation. As a result there may be a conflict of grounds in applying to the court with a claim to compensate damage. Besides, in the definition of unscrupulousness such a notion as “the society’s interests” is used, and it is not interpreted by the legislation either. Are the society’s interests restricted by charter’s aims or are some other estimating categories involved in this notion? The legislator has not determined this.

As a result the scheme of defining unscrupulousness and irrationality of actions of a member of an executive body of an economic society suggested in the draft law is extremely unfinished and creates a great number of questions. Its implementation in practice will significantly complicate activity of economic societies and courts. Besides, the draft law provides only 10 days to enter into force, and it is too little for such large-scale changes.

Author: Sergey Kovalev – Executive partner of the legal group PRINCIPIUM, Assistant Professor of the civil and labour laws of RFUR, Lawyer, International Arbiter of ICAC under the EAC, PhD in Law.        

First of all, it is necessary to point out that in the current Law On Joint Stock Companies the structure of civil liability of members of executive bodies of a society is established. Cases and grounds for this liability are provided in article 71.

According to provisions of the named article, as a general rule, members of executive bodies of a society are liable jointly and severally for damages caused to the society by their faulty actions. Moreover, the Law provides for “a special case” of bringing members of executive bodies to liability for damages caused to the society or shareholders as a result of faulty violation of the procedure of shares acquisition of an open joint stock company (paragragh 2, item 2, article 71 of the Law).

According current provisions the following persons have the right to claim compensation for damages:

A society or a shareholder/ shareholders which own in total no less than 1 per cent of issued ordinary shares – for the benefit of the society;

A society or a shareholder – for the benefit of the shareholder (the society) in case of violation of the procedure of acquisition of shares of an open joint stock company by members of executive bodies (“a special case”). 

In fact, changes suggested in the draft law introduce a new structure of liability of members of executive bodies, particularly, of a sole executive body.

In the opinion of developers of such a construction of civil liability, it should protect, first of all, interests of shareholders (participants) as the most vulnerable part, and not interests of a society on the whole.

Considered innovations in terms of legal empowerment of shareholders (participants) on protection of their own interests and levy of damages have relation to the following cases:

Violation of the procedure and terms of dividend payment to shareholders;

Violation of shareholders’ (participants’) rights related to placement of issuable securities of the society.

Regulation of these two situations is not accidental. The most frequent violations and abuse on the part of members of executive bodies are connected precisely to these cases.

Developers of the draft law suggest introduction of a subsidiary liability of a chief executive in addition to current joint liability of members of executive bodies. According to special grounds for shareholders it will be an additional guarantee that if any damage is caused to them their claims will be satisfied.

But, like any other innovation the considered draft law has clearly weak points together with some positive moments. 

In particluar, qualification of a chief executive’s actions as faulty depends directly on the fact if he acted rationally and (or) scrupulously or not.

If in performing his duties a chief executive acted irrationally and (or) unscrupulously, he is considered guilty of causing damage to shareholders (participants) if there is a causation.

What criteria of “rationality” – “irrationality”, “scrupulousness” – “unscrupulousness” mean, developers have not interpreted again.

Thus, the draft law maintains continuity with provisions of the curent Law, in terms of use of similar vague formulations, weakening the structure of civil liability and leaving wide opportunities for judicial discretion.

How effectively it will be realised in practice – only time will show.

09 November 2010
"