Foreign Arbitral Awards in Russia — Public Policy Issue

Foreign Arbitral Awards in Russia — Public Policy Issue

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International arbitration is a highly popular instrument of the dispute resolution, and, therefore, the actual recovery of debts is a matter of high importance. Meanwhile, creditors often face problems in the process of recognition and enforcement of foreign arbitral awards in Russia. Statistics for 2020 shows that 87 of 244 claims submitted to Russian courts were dismissed (35.6%). This means that each third claimant cannot count on receiving the funds in reality.

One of the most popular but the least foreseeable reason for the refusal in recognition and enforcement of foreign arbitral awards is a contradiction to public policy of the Russian Federation.

Pursuant to the Russian Supreme Commercial Court clarifications, public policy means fundamental law principles of the highest degree of mandatory nature, generality, special social and public importance. Breaching public policy may infringe on the sovereignty or safety of the state, affect interests of large social groups or violate constitutional rights and liberties of individuals and companies.

Public policy is a vague category. The key problem of Russian courts is an overbroad interpretation of the term of ‘public policy’ when it comes to particular cases.

In this current overview, we examine the most remarkable legal cases of 2019-2020 concerning public policy. This will help to evaluate the prospects of enforceability of arbitral awards beforehand, sometimes even at a stage of entering into contractual arrangements.

Based on the review of recent cases, we arrived at a conclusion that the real risks arise if the following signs are present:

  1. Public element in the debtor’s corporate structure posing potential risks of budget funds recovery

When reviewing applications for recognition and enforcement of foreign arbitral awards, courts frequently examine corporate structures of debtors. If a court finds that the ultimate beneficiary of the debtor is the Russian Federation, then it will most likely dismiss the application since it will consider that the execution of the award may cause damage to the state budget resulting from withdrawal of funds to the account of a foreign company.

For instance, there was a case, where a Ukrainian state-owned company applied for recognition and enforcement of an arbitral award of the International Commercial Arbitration Court at the Chamber of Commerce and Industry of Ukraine rendered due to breach of a contract for supply of products. The products were a component of rocket and space equipment designed for military use and required a license for their export. The debtor did not obtain the license. Neither did it provide the required goods and documents.

The commercial court refused to recognize and enforce the decision and pointed out two circumstances:

  • the arbitrators had not examined the special supply procedure, the special terms and conditions of the contract and the fact that the performance of the debtor’s obligations was dependent on permits from the Russian Federation;
  • the arbitrators did not take into account the special type of military products and the licensable procedure for their export.

Despite the fact that the courts did not explain in what manner the fulfillment of the award contradicted public policy, it follows from court ruling that the contradiction consisted in:

  • the structure of the corporate governance of the debtor and the claimant: the ultimate beneficiary of the debtor was the Russian Federation (30%) represented by the Federal Agency for State Property Management (Rosimushchestvo), and of the claimant — Ukraine represented by the State Space Agency of Ukraine. Therefore, the fulfilment of the award had an indirect impact on budget funds;
  • the type of the documentation. The documentation is referred to a list of types of products, free sales of which are prohibited and are regulated by the Resolution of the Russian Government. Enforcement of an arbitral award is associated with observation of compulsory rules of Russian legislation pertaining to national security.

In another case, an English company was seeking recognition and enforcement of the LCIA award pertaining to which debts under a share purchase agreement were levied on Russian joint-stock company Rosshelf.

A Russian court refused to recognize and enforce the award. The court considered that the defendant was a shareholder of a number of enterprises being members of a state corporation group of companies, thus, the enforcement proceedings might have resulted in levying the execution on the shares and participation interest of such companies. The enforcement of the ruling might cause harm to the budget of the Russian Federation because of withdrawal of funds to the accounts of foreign entities, for which reason the general principles of law (principles of good faith and prohibition on abuse of right) could be violated.

  1. Threat to the principle of legality

The principle of legality of a judicial act, which includes, in broad sense, legality, relevance, proper substantiation and finality of a judicial act, constitutes a fundamental principle of Russian law, since only such a judicial act establishes legal certainty of matters in controversy and determines mutual rights and obligations of the parties involved.

The principle of legality is broadly construed by state courts. The most common cases of its violation include:

  • Absence of legal certainty in relationship of the parties

In one case, a German company (the seller) and a Russian company (the buyer) entered into a contract for manufacturing and supply of sawmill equipment. Russian law governed the contract.

According to the contract, the seller’s duty to supply the goods arises only after the buyer has made three advance payments. The buyer failed to make the third advance payment, and the seller filed a claim with the Court of Arbitration of the Hamburg Chamber of Commerce for recovery of the advance payment and interest. The court satisfied the claims in full.

However, the Russian commercial court refused to recognize and enforce the award since it violated the principle of legality. The court believes that the principle of legality, in broad sense, includes the finality of a judicial act and legal certainty in relationship of the parties pertaining to the matter of controversy. The award does not comply with this principle, because it does not solve de facto the conflict of the parties.

Originally, the seller claimed for a part of the third advance payment only, and the court satisfied this very claim. Hence, there was a situation where the seller, without receiving a full amount of the third advance payment, still had no counter-duty to supply the goods, and the parties still experienced confusion and uncertainty. Therefore, the arbitral award breaches the principle of legality and cannot be enforced in Russia.

  • Violation of pari passu principle in foreign bankruptcy proceeding

The principle of equal treatment of unsecured creditors is a fundamental principle of Russian insolvency legislation. Enforcement of an award should not result in preferential satisfaction of claims of one of the creditors.

In a recent case, a Swiss bank (the creditor) provided a loan to a Swiss company (the debtor). Two Russian companies, the debtors’ subsidiaries, were the guarantors under the loan agreement. Since the debtor has not fulfilled his obligations, the creditor filed a claim with the LCIA claiming the debt jointly from Russian entities. Meanwhile, the Swiss court started bankruptcy proceedings against the debtor. The LCIA satisfied a claim, and the creditor applied to the Russian commercial court for recognition and enforcement of the arbitral award.

The application was denied due to a breach of the pari passu principle – when the creditor filed it with the Russian court, the bankruptcy proceedings had already been initiated against the debtor under the Swiss law. The Swiss court introduced a moratorium on debt collection, and any significant payments from guarantors required the debtor’s consent. In the bankruptcy process, the debtor would not give such consent, since it would violate the fundamental principle of equal treatment of creditors.

The Russian court pointed out that the protection of the third party interests that are guarded by law, including the cases involving insolvent debtors, is a vital function of justice and, therefore, an element of public policy of the state. The enforcement of the award will entail forced preferential satisfaction of the claims of one of the creditors, which is unacceptable. Superior courts supported the position.

  • Dispute between a major shareholder and a controlled entity

In one of the cases, the court established that the creditor claiming for a recognition and enforcement of the LCIA award in Russian bankruptcy proceedings was the debtor’s major shareholder. The court treated this kind of relationship as intercompany relationship. In such cases, where a controlling entity fully determines the actions of a controlled entity, specifically, by means of binding instructions, enforcement of a foreign arbitral award contradicts the sense and the objectives of the legal process and justice. All the settlements between such entities should be conducted by means of corporate decisions and not through legal action.

Summing it up, the court ruled that the recognition and enforcement of the LCIA award was in breach of both general legal principles (the principle of legality, good faith and prohibition of abuse of rights) and special principles of law, including the provisions of corporate disputes, and, therefore, it contradicted public policy of Russia.

  1. Disproportional liability applied against the debtor

The Russian Supreme Commercial Court outlined the general approach – recognition and enforcement of foreign awards prescribing for recovery of liquidated damages contradict public policy, in particular, if the following conditions are met:

  • the amount of the damages is so abnormally high that it is many times exceeds the amount which the parties could reasonably foresee while signing the contract;
  • while approving the amount of the damages, there were obvious signs of abuse of freedom of contract (by using weak negotiation capacity of the debtor, violation of public interests and third party interests, etc.).

If the court states that the parties have agreed on the amount of damages as equal participants in the deal, and the amount of damages corresponds to the effect of relevant breach, the seriousness of the breach of contractual obligations and the time of their non-fulfillment, then the court will satisfy the claim for recognition and enforcement of the foreign arbitral award.

As such, the court shall refuse in recognition and enforcement of the arbitral award only in exceptional cases.

In a recent case a Latvian company (the seller) and a Russian company (the buyer) entered into a master agreement for cooperation in manufacturing, promoting and selling a medical product. The Latvian side violated the provision on exclusivity of selling the product in Russia. As a result, the Chamber of Commerce and Industry of the Russian Federation (the ICAC at the RF CCI) imposed a EUR 2.5 mln fine and arbitration fees on the Latvian company under legal action taken by the Russian company. The size of the fine was 131 times as high as the losses incurred.

Overturning the arbitral award, the court found that the tribunal recovered an extremely high amount of fine in contravention of the fundamental principle of Russian law – the principle of proportionality of civil liability which, in general, cannot be aimed at creditor’s enrichment and serves to compensate the creditor for its potential losses and restore the rights that have been infringed.

The award does not comply with the principle of legal certainty and does not establish the balance of rights of conflicting parties, and the fulfillment of the award would entail violation of fundamental principles of Russian law.

In conclusion, it should be noted that the key problem of Russian courts consists in not only extended interpretation of the public policy clause but also general unpredictable nature of approaches to its application. Court practice shows that Russian courts quite often refer to violation of public policy while they do not reveal its content in terms of each specific case. This varying practice prevents from enforcement of foreign arbitral awards, reduces the efficiency of justice and interest to Russian jurisdiction in general. 

By Anastasia Cheredova, Head of Special Projects, and Daria Ovchinnikova, Associate of Special Projects group, VEGAS LEX