Securing Russia's future: a plea for reform in Russian secured transactions law.

• Author: Kilborn, Jason J.

After many turbulent years of uneasy transition to a market economy, Russia is finally "open for business."(1) Nonetheless, the transitional period remains far from over, and Russian enterprises are still starved for capital that they desperately need for retooling to convert from military to consumer production, for acquiring new equipment to replace old and worn machinery, and for undertaking new and lucrative projects. While Russian financial institutions may provide significant funding, their reserves are limited; they could not hope to finance independently the multitude of existing and potential enterprises within the expansive Russian territory. Therefore, much of the financing for the continuing development of Russian business has and will come from Western sources.(2)

The Russian legislature recently has taken a great stride toward further enticing Western investment by adopting a new and greatly enhanced Civil Code. There, nested within a fairly detailed section on the law of obligations,(3) lies a subsection on various methods of securing the performance of obligations, including an expanded and sophisticated section on "pledge."(4)

For any pledge system to function effectively, enticing lenders to part with their capital temporarily, the system must allow secured creditors(5) to feel reasonably assured that they will be able ultimately to regain their investments. Although secured creditors wish to avoid foreclosure and satisfaction from the collateral as much as debtors do,(6) they must have confidence that the system will provide them an acceptable means of realizing a return if eventually they are forced to foreclose on the collateral to avoid a loss.

While the new provisions on pledge have the potential to assure lenders of the security of their investments, and thus to stimulate greater flow of capital into Russian enterprises, several shortcomings might inhibit the effective achievement of the goals underlying these provisions. This Note focuses on one crucial birth defect of the fledgling Civil Code: it limits the mechanisms available to secured creditors for realizing on collateral following foreclosure by requiring that the collateral be sold at public auction.(7) This limitation might seriously undermine creditor comfort with the personal property security system in Russia. Lack of creditor confidence in the ability to cover the potential losses of debtor default with the collateral securing loans likely will produce one of two unpleasant results: either a dearth of available loan funds will arise as creditors refuse to risk their capital, or lenders will begrudgingly provide loans only at exorbitant rates of interest, which will stifle all but the boldest of potential debtors.8 In either case the progress of Russian enterprise will be greatly slowed or halted.

This Note argues that the current Russian law governing the realization of repossessed collateral is potentially harmful to both secured creditors and debtors alike, and it therefore proposes amendments that would benefit both parties.(9) Part I briefly examines the antecedent of the present Russian pledge law and describes the restrictions imposed by the current law. Part II looks to the pledge regimes of several European legal systems to explain and challenge the Russian approach. This Part also criticizes the Russian restriction based on the development of North American secured transactions law. Finally, Part II proposes several possible alternatives for broadening the options available to creditors for satisfying the obligations owed to them following foreclosure.

1. A Brief History and the Current State of the Law

   This Part first touches briefly on the wholly insufficient attention given to pledge law during the Soviet period, then it examines the greatly improved, yet still slightly deficient, system of secured transactions in present-day Russia.

   When it became apparent that secured lending would have to play a prominent role in the development of a rich new Russian market economy, Russian legislators likely built upon the base constructed by their predecessors.(10) During the Soviet period of a command economy, elaborate provisions for securing the repayment of debts were unnecessary because both the providers and the major consumers of credit belonged to the state. State banks made generous loans on extremely favorable terms to government enterprises. If an enterprise defaulted on its loans, the government had simply transferred funds from one pocket to another, it was of little import where the money eventually happened to accumulate. This attitude was reflected in the skeletal provisions on pledge in the old Soviet Civil Code, and no separate law existed to expand on this miserly treatment.(11) The few "hopelessly rudimentary"(12) provisions on pledge in the Soviet Civil Code grossly failed to provide the necessary legal framework for a practicable system of secured transactions in a Russia that at the beginning of the 1990s entered into a period of intense political, social, and commercial transformation.

   The fall of the Soviet Union in December of 1991 violently diverted the attention of Russian lawmakers from political dogma to the pragmatic concerns of free-market economics. Russian legislators quickly remedied many of the inadequacies of the secured transactions provisions of the old Soviet Civil Code by enacting two new laws governing the use of personal property security. One law, the Law on Pledge,(13) is devoted entirely to the subject, and the new, more business-oriented Russian Civil Code(14) contains a section on pledge among its provisions on contractual obligations.(15)

   These laws have tremendous potential to revolutionize the practice of securing obligations in Russia by providing greater stability and predictability to security in a broad range of tangible and intangible property rights.(16) Debtors are now free to secure their obligations with inventory,(17) the "separable and inseparable proceeds" of the original collateral,(18) as well as after-acquired property and property rights.(19) Whole enterprises can also serve as collateral, in which case the security interest extends to the entirety of the property and property rights belonging to that enterprise.(20) Moreover, the new law explicitly presumes that the debtor will remain in possession of these various forms of collateral, thus recognizing the greater convenience and efficiency of such "nonpossessory" security arrangements.(21) The new laws have also expanded the range of securable obligations to include those arising after conclusion of the security agreement.(22) Finally, both the Law on Pledge and the Civil Code are replete with opportunities for the debtor and the secured creditor to avoid the ready-made suppletive rules in the laws and to mold their agreement in a way that suits their particular preferences.(23) Such expanded and clarified treatment of the interests involved in secured transactions seems to pave the way toward the implementation of modern finance techniques in Russia.(24)

   Yet the ultimate achievement of a warm financial climate may remain farther away than anxious lenders might think. Stifling restrictions imposed at the final stage of the secured transactions continuum have the potential to undermine severely the effectiveness of the many laudable advances described above. The entire complex process of negotiating, creating, and registering a security agreement is conducted on the premise that if the debtor defaults on her obligation, during the crucial last throes of the transaction the secured creditor may resort to the collateral to mitigate, and ideally eliminate, the loss.(25) At this pivotal point, however, the Russian Civil Code confines the parties to realizing on the collateral only through sale at public auction.(26)

   The Code directs that the sale be conducted in accordance with procedural legislation, which leads the ill-fated secured creditor to the archaic Russian Civil Procedural Code.(27) The Procedural Code directs that a court officer shall conduct the auction and that the collateral be turned over to her for sale between five days and one month after foreclosure.(28) The court officer is responsible for publicizing the auction and for notifying the secured creditor - who can bid on the collateral - of the time and place of the auction.(29)

   If certain procedural irregularities occur during or after the sale, the auction is declared void,(30) and the secured creditor receives her first chance to retain the collateral in partial satisfaction of the obligation. Unfortunately for the debtor, the secured creditor takes the collateral not in the sense of "strict foreclosure,"(31) but rather by crediting the initial bidding price to the remaining unpaid amount of the secured obligation and pursuing a deficiency remedy for the remainder.(32). Moreover, the secured creditor can bide her time, refuse the collateral, and await a repeat auction.(33) If the auction is declared void a second time, the secured creditor can appropriate the twice-spumed collateral and credit the debtor for an amount "no more than ten percent less than the initial sale price of the collateral at repeat auction."(34) If the secured creditor fails to take the collateral and credit the debtor, the security agreement terminates.(35) If, on the other hand, the collateral produces a return at auction in excess of the obligation, the secured creditor is obligated to return the excess to the debtor,(36) although any surplus return is, as one prominent commentator has observed, but a "glittering mirage."(37) The "grim reality" is an inadequate return on the collateral and a deficiency demand by the secured creditor.(38)

2. Possible Rationales for and Critical Analysis of the

   Limitation to Public Sale

   Due to the lack of readily accessible legislative history in Russia,(39) one can only speculate about the motivations of the Russian...