Subsidiary Liability of Beneficiaries

Holding business beneficiaries subsidiarily liable, including in cases of asset stripping. For creditors of an insolvent company, the question of holding the true beneficiary subsidiarily liable is highly significant. Owners, key shareholders, and major participants are frequently the persons actually controlling the entity, while the executive body plays a far smaller role in management. In many cases the company's director is an employee under a labour contract whose powers are materially constrained by the will of the business owners.

Why target beneficiaries rather than directors

When a company loses solvency and "falls" into bankruptcy, holding the director subsidiarily liable is often less effective than pursuing the owners and beneficiaries. Beneficiaries plainly exert enormous influence over the company's economic activity, since its effective strategy brings them profit. Yet in most cases these "grey cardinals" remain in the shadows.

Under current legislation, holding a participant subsidiarily liable is considerably harder than holding a director liable. Technically, proving a causal link between a participant's actions and the debtor's insolvency is almost impossible — unless that person simultaneously played a role in the executive apparatus.

A shift in case law

Case law on this question has produced diametrically opposed decisions, but a trend can be traced. Earlier, holding a founder liable was considered mainly in relation to municipal authorities that drove municipal unitary enterprises into bankruptcy by withdrawing property needed for their operations. Until 2015, claims against such authorities were granted where clear bad faith was evident.

More recently the practice changed sharply for that category: courts stopped finding a causal link between municipal authorities' actions and the insolvency of enterprises under their control. In relation to private business, however, courts reach the opposite conclusions.

The landmark ruling

Consider a significant judicial act — the Supreme Court Ruling of 21 April 2016 in case No. А33-1677/2013.

The insolvency officer sought to hold both the former director and the founder — a legal entity — subsidiarily liable. The application was granted and upheld on appeal. The cassation court considered the necessary circumstances insufficiently examined and remitted the case; on rehearing, only the director was held liable, and the claim against the participant was refused.

The Supreme Court disagreed. It found that the debtor had been founded by a company in which the debtor's director had also long served as director. Moreover, during the relevant period the founder held a 100% stake. The court held this sufficient to identify that entity as a controlling person. Persuasive too was the fact that, through a particular scheme of financial operations, the debtor's funds ultimately ended up in the founder's accounts — negatively affecting the debtor's financial condition. The court concluded that this mechanism was nothing other than asset stripping. In addition, the sole participant had withdrawn property from the debtor, preventing it from continuing its production and business activity.

The court's key conclusions

• The founder had hardly been guided by the debtor's interests in its actions.

• The lower courts had wrongly placed on the creditors the burden of proving grounds for subsidiary liability, whereas the founder itself had taken a passive stance — failing to disclose the circumstances of the financial operations of unclear origin and purpose, or to give any convincing reasons for withdrawing the debtor's assets. Such conduct, the court held, indicates a refusal to rebut the circumstances put forward by other participants.

• The court rejected the lower courts' view that insolvency is inherently identical to bankruptcy. Loss of the ability to meet monetary obligations does not necessarily arise simultaneously with insolvency itself; therefore, withdrawing property in a situation of existing financial difficulty could materially have provoked the debtor's bankruptcy.

The contested acts were set aside and the case remitted for rehearing.

What this means for international creditors

For foreign creditors, this line of authority is important: Russian courts will look through nominal directors to the real owners where assets have been diverted and where the controlling person stays passive and fails to explain suspicious transactions. The burden of proof can shift onto the beneficiary. Success turns on identifying the controlling person, tracing the flow of funds, and demonstrating that asset withdrawal contributed to insolvency.

Related materials

• Piercing the corporate veil

• Bankruptcy of legal entities