The draft laws contain both innovations in the form of norms supplementing the regulation of a number of institutions in the area of corporate law and provisions aimed at legislative consolidation of mechanisms used by participants in civil turnover by virtue of the principle of freedom of contract.
Mechanisms of tag-along and drag-along
The tag-along and the drag-along mechanisms are widely used on the market when negotiating terms and conditions of corporate agreements.Tag-along means the right of a party to a corporate agreement to join the sale of shares (participation interest) in favour of a third party on the same terms and conditions as the exiting participant that negotiated such transaction with the third party. Drag-along, in turn, denotes the right of one of the participants, when selling its shares (participation interest) to a third party, to demand the accession of another participant to such sale of shares (participation interest).
Despite the absence of direct regulation of these mechanisms in Russian legislation, such terms are included in corporate agreements subject to Russian law due to the principle of freedom of contractArticle 421 of the Civil Code of the Russian Federation. From a legal perspective, there are currently two options for including these formulations in corporate agreements:
- by formulating a contractual obligation based on the interpretation of clause 1 of article 67.2 of the Russian Civil Code, according to which the participants of a business company may stipulate in a corporate agreement obligations to acquire or dispose of shares (participation interest) at a certain price or upon the occurrence of certain circumstances or to refrain from disposing of shares (participation interest) until certain circumstances occur (“Contract Structure”).
The Contract Structure is usually more understandable and familiar to commercial teams (in particularly those business participants who interact with shareholder agreements where the applicable law is English law); or - by utilising the structures of an option to conclude the agreementArticle 429.2 of the Civil Code of the Russian Federation and an option agreementArticle 429.3. of the Civil Code of the Russian Federation (“Option Structure”).
The use of the abovementioned varieties of Option Structures for such cases creates a more “cumbersome” legal structure. However, depending on the wording and terms developed, such structuring may provide for a more automatic procedure for exercising these rights (without the involvement of the obligated party).
Draft Law No. 1 directly proposes providing for an Option Structure for the mechanisms of tag-along and drag-along by stipulating in the LLC Law and the JSC Law an indication of the possibility to include in the corporate agreement the relevant provisions regarding an option agreement on the sale and purchase of participation interest (shares) and/or an option to conclude an agreement on the sale and purchase of participation interest (shares).
Assessing the possible consequences of this innovation, we note that the regulation at the legislative level of contractual constructions already used in practice is both a positive and negative trend:
- on the one hand, participants in civil turnover and courts will be able to safely apply the relevant norms without relying only on the “vague” principle of freedom of contract, which in Russian judicial practice is often subject to significant restrictions;
- on the other hand, direct legislative regulation of only one legal option for structuring tag-along and drag-along mechanisms, in particular through the Option Construction, may result in weaker legal protection for the Contract Structure.
Separately, we note that for corporate agreements containing provisions on conditions for exercising the options, Draft Law No. 1 provides for the possibility of specifying in such agreements a person confirming the occurrence of such conditions, as well as the procedure for confirming their occurrence. Such person can be, for example, an appraiser who will confirm that the net asset value of the business company has reached a certain level, if the relevant circumstance is a “trigger” for the option to be triggered.
Irrevocable power of attorney
An irrevocable power of attorney is a power of attorney that cannot be revoked prior to its expiration or may be revoked (i) in cases expressly stipulated in such power of attorney; (ii) upon abuse by the representative of his/her authority; or (iii) upon the occurrence of circumstances clearly indicating that such abuse is likely to occurParagraph 1 and paragraph 2 of clause 1 of article 188.1 of the Civil Code of the Russian Federation.Such power of attorney may be issued for the purpose of performing or securing an obligation if such obligation is related to the performance of business activitiesParagraph 1 of clause 1 of article 188.1 of the Civil Code of the Russian Federation. The question of whether relations from a corporate agreement are related to entrepreneurial activity is controversial. At the moment, neither at the level of law nor at the level of court practice is there an unambiguous answer to the question of the possibility of issuing an irrevocable power of attorney for the purpose of performing or securing the performance of obligations under a corporate agreement, the parties to which are individuals who do not have the status of an individual entrepreneur.
Notwithstanding the above, in practice the irrevocable power of attorney, due to its convenience, is actively used for the purposes of ensuring the exercise of rights provided for in corporate agreements: irrevocable powers of attorney are used for the automatic implementation of contractual provisions, including option structures, voting at general meetings, and interactions with third parties.
Draft Law No. 2 resolves the debate regarding the possibility of using an irrevocable power of attorney for the automatic exercise of option constructions and proposes including in article 188.1 of the Civil Code of the Russian Federation a provision on the admissibility of using an irrevocable power of attorney to secure the performance of an obligation related to the “exercise of corporate rights in accordance with a corporate agreement”.
Nevertheless, the Draft Laws do not address the problem of terminating (revoking) an irrevocable power of attorney. We remind you that, by virtue of the current regulation, such a power of attorney may in any case be revoked after the termination of the obligation for the performance or enforcement of which it was issued, as well as at any time in the event of the representative’s abuse of his/her powers, and in the event of circumstances clearly indicating that such abuse is likely to occurParagraph 1 of clause 1 of article 188.1 of the Civil Code of the Russian Federation.
Contesting resolutions of meetings
Under the current regulation, a breach of a corporate agreement may constitute a ground for invalidating a resolution adopted by a body of a business company upon a claim of a party to such agreement, provided that at the time the relevant resolution is adopted by the body of the business company all participants of the business entity were parties to the corporate agreementClause 6 of article 67.2 of the Civil Code of the Russian Federation.Under the Draft Laws, it is proposed that if all participants (or shareholders) are parties to the corporate agreement, then a breach by a party to the corporate agreement of its obligation to vote at a general meeting in a certain way may constitute a ground not only for invalidating the vote cast by the breaching party, but also for the court recognising the breaching party to have voted in a certain way in accordance with the corporate agreement. Therefore, the breaching party’s will is replaced with a court judgement based on the pre-agreed terms of the corporate agreement between the parties.
In addition, the Draft Laws also address the issue of what happens to a meeting resolution if a party to the corporate agreement, to which not all participants of the company are parties, voted in a manner inconsistent with the corporate agreement. In such case, in accordance with the Draft Laws, a meeting resolution may be invalidated at the claim of a party to the corporate agreement if the following conditions are met simultaneously:
- such possibility is provided for by the company’s charter;
- all participants of the company knew or should have known about the content of the corporate agreement prior to the adoption of the resolution of the general meeting; and
- the breach of the terms of the corporate agreement has affected the quorum or the number of votes needed for the adoption of the contested resolution.
Despite the presumed difficulty of proving the occurrence of the circumstances set out in points 1 to 3 above, the new rules for contesting resolutions of general meetings bring the corporate agreement closer in legal effect to a charter, even where not all participants of the company have agreed to its terms. In this connection, the question remains open as to the validity of applying the consequences of a breach of a corporate agreement to participants (or shareholders) who, although aware of the content of such agreement, are not parties to it and/or cannot influence the breaching party’s behaviour.
Limiting the possibility of reducing the contractual penalty
A contractual penalty is a measure of liability often provided for in practice for breaching certain provisions of corporate agreements. The contractual penalty compels the parties to timely and fully perform their obligations under the agreement.Regrettably, previously it was not uncommon in practice for the freedom of contract principle to be restricted by court and for the penalty amount initially agreed by the parties to be reduced by a court decision rendered upon a claim of the party obliged to pay the penalty. This paralysed the mechanism and made it less attractive for the parties of civil turnover, especially when the penalty, taking into account its agreed amount, was intertwined with the commercial component of the agreement. As part of the reform of the Civil Code of the Russian Federation, Federal Law No. 42-FZ of 8 March 2015 “On Making Amendments to Part One of the Civil Code of the Russian Federation”, the disposition of the abovementioned rule has significantly changed. For instance, clause 2 of article 333 of the Civil Code of the Russian Federation has been enacted which limits the ability of courts to unreasonably reduce the amounts of penalties.
Currently, there is practically no prevailing practice of courts reducing the amounts of penalties provided under the corporate agreement, even where the parties to the corporate agreement are individuals who are not individual entrepreneurs. Nevertheless, theoretically, it is still possible to reduce the penalty amount, which creates additional legal risks for participants of corporate legal relations. Therefore, today it is quite logical that the business community and lawmakers are interested in a more sustainable limitation of courts reducing penalties.
The Draft Laws are aimed, inter alia, at solving this problem by including in the JSC Law and the LLC Law rules limiting the possibility of reducing the penalty. In particular, it is proposed to provide that, as a rule, the penalty may not be reduced except where (1) the conditions of article 333 of the Civil Code of the Russian Federation are met; and (2) the party to the corporate agreement requesting the reduction of the penalty has proved that the recovery of the penalty in the amount stipulated in the corporate agreement may result in the other party receiving a greater benefit than it would have received if the party to the corporate agreement requesting the reduction of the penalty had not breached the corporate agreement. At the same time, the party to the corporate agreement that carries out business activities and requests a reduction of the penalty amount must also prove that it is not to blame for breaching the shareholders’ agreement.
Application of amendments
Draft Law No. 1 provides that the provisions of the LLC Law and the JSC Law apply, inter alia, to corporate agreements concluded prior to the entry into force of Draft Law No. 1, i.e., primarily to the already existing tag-along and drag-along mechanisms and previously issued irrevocable powers of attorney. At the same time, the retrospective nature of the amendments does not apply, among other things, to the provisions limiting the possibility of reducing the penalty and the new rules regarding challenging resolutions of general meetings.It should be noted that, as a rule, the provisions of legal acts are only applicable prospectively (i.e., only apply to future legal relations). The application of the legal rules to legal relations which arose before their entry into force may further create difficulties in realising the tag-along right or drag-along right on the basis of some other structure (e.g., Contractual Structure) than that provided in the Draft Laws, despite the absence of an express prohibition to that effect.
Since the Draft Laws have not been introduced by the Russian Government to the State Duma of the Russian Federation and, therefore, have not been considered under the relevant procedures, they may be changed significantly in the future. Bearing this in mind, on the one hand, it does not currently make sense to use the wording provided under the Draft Laws when negotiating corporate agreements which contain tag-along or drag-along provisions. On the other hand, in our view, it would be advisable to include in corporate agreements certain general provisions on the validity of the direction of the will of the parties, including if the amendments envisaged by the Draft Laws come into force after the parties sign corporate agreements.
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We will follow the further development of the Draft Laws and keep you informed.
