Fatal Flaws in Financing Personal Bankruptcy: The Curious Case of Russia in Comparative Context.

• Author: Kilborn, Jason J.

The first four years of operation of the new Russian personal bankruptcy procedure reveal a troubling flaw common to such new regimes: While the law on the books suggests a permissive and effective relief delivery procedure, the law in action has seen the vast majority of debtors barred from accessing that relief due to explicit and implicit financing burdens. Those few debtors admitted to the procedure in the first few years have proceeded relatively quickly to a discharge, which is good news. The bad news reveals an ironic fatal flaw: most intended debtor-beneficiaries are too cash-poor to seek bankruptcy relief. Debtors must bear the substantial unofficial market costs of private professional guidance, as well as the official statutory costs of a trustee to administer the case. Unlike in other world personal bankruptcy systems, these trustees are privately regulated in Russia and have frequently simply refused to take on low-value cases, even for debtors able to pay the official fee. Comparative exploration of this problem reveals surprising parallels with system structure, trustee regulation, and debtor-access financing challenges in Europe and North America. Solutions to these problems implemented in Europe, the US, and particularly in Canada may well work for Russia and other countries launching new personal bankruptcy regimes, but these problems and potential solutions need to be carefully considered to avoid setting up such systems for failure.

Tatyana lived with her young son on the border between Europe and Asia in the central-Russian city of Chelyabinsk. (1) Her 200-square-foot, one-bedroom apartment and her small civil service salary were sufficient to support the pair until Tatyana's son became seriously ill. To finance her son's expensive medication, Tatyana turned to the new but rapidly expanding Russian consumer credit market, (2) opening her first of several credit cards and personal loans in 2007.

After struggling to keep up with minimum payments for eight years, Tatyana realized that the interest rate and payment structure for these loans was designed to prevent her from ever escaping from the pit of debt into which she had dug herself. Consequently, when one of her banks suddenly raised the interest rate on several of her loans and imposed a new annual charge not described in the original loan agreement, Tatyana suffered her first default in May 2015 and by July had to stop paying entirely on her largest balance. A nightmare of angry phone calls and later personal visits from debt collectors ensued, compelling Tatyana to consider declaring herself bankrupt on her debt of 1.2 million rubles ($48,000 PPP (3)).

Coincidentally, Tatyana had been hearing on television and in the newspapers about a new law in Russia offering relief for overindebted individuals like herself, so after the law went into effect on October 1, 2015, she consulted with an attorney, who advised her to start collecting the documentation necessary to apply for bankruptcy relief. Tatyana's lawyer filed her papers with the court on October 27, 2015, she had her first hearing on the case on December 7, where the court immediately opened liquidation proceedings (bypassing any restructuring attempt in light of Tatyana's large debt and small salary). While she had to pay nearly 30,000 rubles (more than a month's salary) for the services of the trustee and duplicate announcements of her case in print and electronic media, the investment paid off when on August 4, 2016, the court declared Tatyana's case closed and discharged her remaining debt. "All I needed from bankruptcy was peace, and I obtained it," she concluded.

Tatyana thus became one of the first individuals to breathe a sigh of relief upon completion of the new Russian personal bankruptcy procedure. After an extended period of discussion, development, controversy, and compromise, the new provisions of the Russian bankruptcy law offering relief to "physical persons" (individuals) came into force on October 1, 2015. (4) I described the long legal and economic backstory of this new regime shortly after its adoption, (5) and with the benefit of four years of operation, we can now evaluate how the system is functioning.

Many debtors have experienced the joyful relief that Tatyana described, though not nearly as many as lawmakers had hoped. The vulnerable financial state of many debtors has, ironically, prevented them from seeking and/or obtaining relief. This failure is a function of the access burdens the system places on debtors, which are in turn a function of legislative choices as to how to structure and finance the delivery of this new public beneficence. Early experience with the new Russian procedure thus amplifies crucial lessons already learned in other systems about the hidden challenges of running and funding a personal debt relief process, especially the key challenge of compensating the administrators of this service while controlling access costs for needy debtors.

Part I describes the first few years of operation of the new Russian personal bankruptcy procedure. It reveals a fundamental flaw in applying the traditional high-value business bankruptcy model of private trustees to the new and very different low-value personal bankruptcy process. The funding challenges of this approach are not new, so Part II explores the various ways that countries in Europe and North America have met those challenges over the past 40 years. Discovering surprising parallels between the Russian model and the personal bankruptcy structures adopted in the United States and especially Canada, this discussion points the way toward effective reform of the Russian procedure; i.e., minimizing needless formality and formalism and finding a way to mandate crucially important private participation in the administration of thousands of low-value cases.

1. THE NEW RUSSIAN PERSONAL BANKRUPTCY REGIME: THE INAUGURAL YEARS

   A brief overview of the new Russian personal insolvency procedure will orient this discussion. Individual debtors and their creditors can file bankruptcy petitions (with a thick sheaf of supporting documents) in the arbitrazh (commercial) court for the region of the debtor's residence. (6) The petition must identify a self-regulatory organization (SRO) of bankruptcy trustees from whose membership the case trustee (in this context called a "financial administrator") will be chosen and confirmed by the court to administer the case. (7) If the petition is complete and a case opened, and the documents sufficiently confirm the debtor's insolvency, the court has essentially two options for opening proceedings: Debtors with income sufficient to make credible compromise offers to their creditors (with a maximum term of three years) can be routed to a restructuring plan negotiation procedure, or debtors can be declared bankrupt immediately and routed to a liquidation procedure. (8) In the latter case, the financial administrator takes control of, catalogues, values, and liquidates the debtor's non-exempt assets and distributes the net proceeds among creditors. The debtor's income received during the at least six-month pendency of the liquidation procedure also forms part of the estate, with only the poverty-level "subsistence minimum" income delivered to the debtor by the trustee. (9) Upon the completion of this process, the debtor is discharged from most unpaid debts. (10)

   Several of the finer details of this process, especially related to access financing, will be discussed below, but this overview sets the stage for an initial evaluation. I predicted that the ultimate success or failure of the new system depended on one crucial factor: institutional capacity. (11) Three institutions stood out as playing potentially significant roles: (1) the arbitrazh (commercial) courts, (2) financial administrators appointed by the courts as trustees in each case, and (3) private lawyers or other advisors retained by debtors to guide debtors into and through the process. (12) It turns out the first two official institutions have pushed in generally opposite directions, with the courts more or less facilitating smooth operation and liberal delivery of relief, and financial administrators standing as a huge roadblock in the way of progress. The reasons for this state of affairs are unique to the Russian approach to funding and formalism in the administration of personal insolvency cases, revealing important lessons when viewed in comparative context.

   1. RISING BUT SMALL FILINGS, PUBLIC INFORMATION CAMPAIGNS RAISE AWARENESS

      The new Russian personal insolvency procedure emerged against the backdrop of a "huge accumulated demand" of overindebtedness in need of alleviation. (13) Bank of Russia officials estimated that by mid-2019, debt service consumed nearly 45% of consumer borrowers' income. (14) In some regions, the burden is much greater. (15) The total number of individuals, both consumers and entrepreneurs, intended to fall within the ambit of the new procedure has been estimated between 670,000 and nearly 770,000, based on credit bureau data. (16) This includes all individuals with total debts exceeding 500,000 rubles (about $20,000 PPP) and a default on any one debt persisting for 90 days or longer. (17) When the new law was formally proposed in 2012, court administrators expressed fears of administrative breakdown in the wake of a tidal wave of over 200,000 petitions for relief in each of the first three years of the new procedure. (18)

      Much to the relief of court administrators, but to the consternation of policymakers, not even 10% of these significantly distressed debtors have sought (or were pushed into (19)) bankruptcy in any of the first few years of the new procedure. The number of petitions has risen slowly but steadily, increasing as jurisprudential and administrative kinks have been worked out and information campaigns have spread awareness of the new dispensation. (20)...