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Insolvency of the developer: issues and mysteries

Taking part in share participation construction (as well as in plain construction) of property is one of the most common ways of acquisition of dwelling. Purchasing a ready dwelling both on first sale and resale markets is way more expensive. Economizing, however, brings along the risks which perhaps nowadays are the most significant ones in civil turnover involving natural persons.

The number of the so-called “deceived co-owners” is beyond any thinkable limit. Nevertheless, the craving for a deserved dwelling in this life continues to push people to become part of the sad hopeful majority of the “deceived co-owners”. This is what they call the persons who have invested into the construction of their dwelling but have not received it as a result of the fraud or the insolvency of the developer. The first attempt of the law-makers in order to protect the deceived co-owners was by means of giving them special protective tools to secure their interests and so they have enforced the Federal Law “On share participation construction”. This law, however, did not cover all the deceived co-owners and their interests to the full extend.

Firstly, many citizens did not enter into such an agreement, yielding to persuasion and pressure from the dishonest developers, instead they entered into other agreements and took part in suspicious arrangements that were designed to circumvent the agreement on share participation construction.

Secondly, even co-owners who did enter into the agreement on share participation construction got into a tight corner in case the developer that failed to fulfil its liabilities went into insolvency. The problem is that until recently an insolvent company could only be brought up with monetary claims. But most of the deceived co-owners were interested in acquisition of property rather than in return of their investment as the funds they had paid inevitably lost their value throughout the years of construction.

As from 15th of August 2011 the insolvency of the developers who attract investments of natural persons into construction of dwelling is regulated by the statutory requirements. Chapter IX of the Federal Law dated 26th October 2002 no. N127-FL “On Insolvency (bankruptcy)” provides for a separate clause (Clause 7 “Insolvency of developers”) that contains 15 articles. The amendments are enforced by the Federal Law dated 12 th July 2011 no. 210-FL and they provide for priority in the security interest of natural persons who have invested in construction of their dwelling. From there on in case of the insolvency of the developer one can not only have monetary claims against him but also enforce the transfer of title of the dwelling irrespective of whether the construction has been completed or not. In the latter event the category of the deceived co-owners received an opportunity to set up construction cooperative society of a new type – in order to complete the dwelling which was started by the developer.

Therefore, we shall further substitute an offensive term “deceived co-owners” with a more positive one – “construction participant”.

Unfortunately, when enforcing the mentioned amendments the law-makers have shown an inappropriate haste and Clause 7 Chapter IX of the Insolvency Act came out raw and contradictory. No wonder that after half year the clause was in force there was not a single comment or explanation from the authorities or the courts. What is more, the arbitration courts are extremely reluctant to apply the Insolvency procedure for developers, and in cases where it had been applied they do everything to delay the insolvency process simply because they do not know how to act. The receivers are in the similar position.

In this article we do not seek to interpret a vague logic of the law-makers, but we will analyse the main issues of the Insolvency of developers’ procedure and will speak in detail about the inconsistencies and the white spots of this matter.

Initiating the procedure of the developer’s insolvency

Usually the trouble starts from the beginning. The problem is that in the course of the ordinary insolvency process a single register of creditors is formed which includes only cash claims since other claims in the ordinary insolvency cannot be brought up. The competing creditors (as well as the authorities) having cash claims not related to the payment of salaries or remedies for damages take the third place in the priority list of this register. That means that their claims shall be repaid from the assets remaining after the payment of unpaid salaries and any outstanding damages. The provisions of Clause 7 Chapter IX of the Insolvency Law (hereinafter - Clause 7) provide the formation two creditors’ registers within one single insolvency process: the first one is the register of the claims of the construction participants to transfer to them the title for their dwellings. This register shall contain the details of the specific premises that the developer is obliged to transfer to the construction participant but has not done so. The second register includes the cash claims of both construction participants and the competing creditors and the authorized bodies. However, in this registry the cash claims of the construction participants take the third place and the claims of the competing creditors and of the authorized bodies take the fourth one.

It is seemingly clear that it is the construction participant who is interested most in the initiation of insolvency proceedings of the debtor developer. Nevertheless, it is for the construction participants that the initiation of insolvency proceedings of the debtor developer is extremely difficult. The law provides for the two options to initiate of insolvency proceedings of the debtor developer.

  • Primary initiation – where the procedure is initiated by the competing creditor or the authorized body (the Federal Tax Authority Inspection) by applying to the court with the request to declare the debtor insolvent. If such application confirms that the debtor is a developer, the arbitration court shall indicate that for the debtor’s insolvency the regulations of Clause 7 for the decision on declaring the debtor insolvent shall apply.

The authority (the Federal Tax Authority), however, can not have an interest in the insolvency of the debtor developer. The authorized body always has exclusively monetary claims against the debtor. The same can be said about the competing creditors – as the definition stands it is merely a creditor who has the monetary claims against the debtor. In this case, the individuals, having monetary claims rather than the claim to transfer the title for the premises, have no interest at all in the insolvency of the debtor developer. Not only that it further complicates the time consuming insolvency procedure, furthermore the insolvency as per Clause 7 ranks the clear-cut cash creditors at a disadvantage with the construction participants. If the insolvency proceedings of the debtor developer are initiated, cash claims of the competing creditors who are not construction participant of the third place of debt repayment, in which they would fall under ordinary bankruptcy, are automatically moved to the fourth place. This means that their claims would be met only after the cash claims of the construction participant are satisfied.

Thus, neither of the two is interested in initiating the insolvency proceedings against the debtor developer – neither the competing creditors that are not construction participants, nor the competent authorities who are even less interested in that.

In contrast, the construction participants are interested in the insolvency of the debtor under the regulations of Clause 7, not under other regulations as in this case they leave all the "clean money" creditors behind by placing them in the fourth place of bankruptcy priority.

However, the only persons who are authorized to apply to the court for insolvency of the debtor are only the competing creditor or the authorized body, the cash claims of which are proven by the court’s decision that has already come in force. Therefore, the only persons who can make an application to declare the debtor insolvent are the ones who in fact are not interested in the debtor becoming insolvent in his capacity of the developer. Alternatively, a construction participant must first take to the court his cash claims against the debtor (something he may be not so interested in), wait until the decision comes into its legal force, then apply to the court for insolvency o the debtor and this is only for the purpose of application of the rules of Clause 7 of the Insolvency Law in the bankruptcy proceedings.

In this case, it remains unclear what is deemed to be the information that the debtor is a developer. Should this information be supported by any specific evidence? Should the court to assess these data and evidence, or take them for granted? In other words, it is not clear whether the court having seen in the application for bankruptcy an indication that the debtor is a developer is to verify that the validity of this information.

  • Secondary initiation - where the information that the debtor is a developer becomes known to the arbitration court after the initiation of the insolvency proceedings, the arbitration court shall make a decision on the application of the regulations of Clause 7 for the debtor’s insolvency, the court can do so either upon its own initiative or upon the application of a person who takes part in the insolvency.

Let us assume a situation where the primary initiation did not take place, i.e. the debtor or the creditor who have applied to the court to sue on the debtor's bankruptcy did not indicate that the regulations of Clause 7 shall apply. Let us assume that the applicant simply not interested in it because he has no claims for the transfer of title of the premises, and instead he has some monetary claims. In this case, however, there are other creditors of the debtor, who have invested money in this construction undertaken by this debtor. How can these construction participants initiate the proceedings of the insolvency of the developer.

Since the persons are nor involved into the case of insolvency, such construction participants are not authorized to make a request that the rules of Clause 7 should apply. By virtue of Art. 34 of the Insolvency Law, the persons taking part in a bankruptcy case are: the debtor, the official receiver, competing creditors, the competent authorities, a person providing security for financial recovery. As can be seen, a construction participant is not one of those involved in the insolvency case. Even if we assume that the law-maker had in mind the equality of the construction participant and the competing creditor (a lender of monetary obligation), then even the competing creditor becomes a person participating in a bankruptcy case only on receipt in the prescribed manner of a demand to include him in the register of creditors.

The demand for inclusion in the register of creditors, in its turn, in accordance with Article 71 of the Insolvency Law is possible within 30 days of the publication on the enforcement of the monitoring procedure on the debtor.

Thus, prior to the date of the publication on the enforcement of the monitoring procedure on the debtor the construction participants cannot make motions on the application of Clause 7. And after the date of publication such motion will be available only to the construction participants who have applied to be included in the register of creditors and thus have acquired the status of a person involved in the insolvency case.

In other words, in order to acquire the status of a person involved in the case, the construction participant must have monetary claims against the debtor. But the construction participants always have monetary claims against the debtor - this follows from the definition of the construction participant.

Therefore, secondary initiation of the insolvency procedure is available only to the construction participant whose application for inclusion in the register of creditors has been processed by the Court.

As a result we face a rather illogical pattern - in order to file a petition and bring up the case for insolvency of the debtor particularly in his capacity of the developer, a construction participant should first be listed in the process as an ordinary cash creditor, even though he does not intend to request the repayment. However, the construction participant needs to claim that only in order to be able to “get into” the insolvency proceedings and to request for Clause 7 on insolvency to be applied i.e. to initiate the insolvency of the developer.

Thus, the launch of the insolvency of the developer proceedings under the regulations of Clause 7 starts with the court accepting an application for the bankruptcy of the debtor that contains a reference to the application of Clause 7; or, in an already existing bankruptcy case with making a separate decision on the application of Clause 7 to the bankruptcy of the debtor.

There is more to it, though. The further the case goes the worse it gets. Let us assume that the monitoring proceedings have been enforced on the debtor. The register of creditors has been formed as per an ordinary bankruptcy. After a certain time, within the 30 day period, one of the competing creditors whose application to be included in the register of creditors has been processed, suddenly files a motion to apply Clause 7. A question arises - should the court in such case decide to enforce the monitoring procedures against the developer? The insolvency law seems not to provide for such cases. It can not enforce two monitoring procedures against one debtor at the same time. This suggests that the court is limited to determining the application of Clause 7 in the monitoring procedures already enforced against the debtor.

But here again is some lack of clarity. The creditor gets the status of a competing creditor only from the moment when his claims are entered into the register. If, that having been done, he still puts the application for bankruptcy of the developer, his claims against the creditor must be entered into another register - the register of claims for the transfer of the dwelling. It is then not clear what to do with the claims already included in the register of creditors. After all, the same creditor can not simultaneously claim a refund of the money paid for a dwelling and a transfer of the title of the dwelling into his name.

But if the monitoring procedure has been already enforced and the register of creditors has been formed, the creditors' claims to money not related to the cost of dwellings fall into third place, and if the procedure of insolvency of the developer has been enforced, the same claims shall apply to the fourth place. It turns out that the register of creditors must be formed anew. Of course, before the 30 day formation period ends, the register does not actually exist. But the court after considering each creditor’s application to be included in the register, shall make a determination which indicates that the creditor’s claims have been confirmed and have to be included in a particular queue of the creditors. If the order of the claims changes something needs to be done to the already executed determinations.

From the viewpoint of the procedures, the court has the authority to cancel its own definitions to include competing creditors in the third place in the register of creditors. This can make only by a higher instance arbitration court. The law contains no indication as to whether such a determination be appealed. Therefore, one should proceed from the general rule that the decisions of an arbitration court adopted under a bankruptcy case, but not provided for by the Arbitration Procedure of the Russian Federation, and for which it is not established that they are subject to appeal, may be appealed under the appellate procedure, within fourteen days from the date of their adoption.

But the competing creditor will hardly apply voluntarily for an appeal with a request to transfer them from the third place of creditors in the fourth one. The procedure deadlock occurs.

Insolvency procedures for developers may vary

An important question to which Clause 7 Chapter IX of the Insolvency Law gives no straight answer - is the question of which construction participant may be considered as the construction participant for the purposes of Clause 7. it follows from the definitions in pp. 2-3 Part 1 of Article 201.1 of the Insolvency Law that a construction participant is an individual, a legal entity, the Russian Federation, a subject of the Russian Federation or a municipality, having monetary claims or claims to transfer the title of ownership to the dwelling against the developer.

Further, the claim to transfer the title of ownership to the dwelling means the claim of the construction participant to transfer into his name for good and valuable consideration and agreement the ownership title for a dwelling (an apartment or a room) in an apartment house which at the time of raising funds and (or) other property of the construction participant is not put into operation (hereinafter - the agreement for the transfer of the ownership title for a dwelling).

Due to the fact that the definition clearly states that a construction participant must have a claim to transfer to him the ownership title of the dwelling in an apartment house, the question arises whether a construction participant can be a person who has invested in the construction of a dwelling other than an apartment house. According to the law, it is not possible. On the other hand, there are people who invest in the construction of houses, cottages, townhouses, etc. in such cases the investments are larger than the construction of apartments and the deceived co-owners are many.

A unique answer to this question was suggested by the chairman of the insolvency committee of one of the arbitration courts at a seminar on the problems of the insolvency of developers. He stated that in his opinion, one should follow from the fact whether the investment of funds was made in the primary residence or not. If the person is going to live in it permanently all year round, he may be deemed to be a construction participant and if it builds a cottage, he is not the one.

This approach is confusing, even if you omit its clear contradiction to the law. How can one determine what the use of a house that is not built yet would be? In our opinion, a person who invested his money in the construction of individual dwelling can not be considered as a construction participant for the purposes of Clause 7 of the Insolvency Law and the procedure for insolvency of the developer can not be applied to the developer of such a house or a residential complex. Thus, the differentiating feature will not be the permanent residence, but whether such a house has common property.

According to Article 16 of the Housing Code of the Russian Federation the residential dwelling shall include:
  • A residential house, a part of a residential house;
  • an apartment, a part of an apartment;
  • a room.

A residential house is a specific individual building which consists of the rooms, as well as of auxiliary facilities, designed to meet the household and other needs of the residents associated with life in this building.

An apartment is a structurally separate promises in an apartment building, providing direct access to the common areas in the house, and consisting of one or several rooms, as well as the auxiliary facilities, designed to meet the household and other needs of the residents associated with life in that the separate premises.

A room is a part of a residential house or a flat designed to be used as a place of primary residence of the residents in a house or apartment.

As the above definitions show the difference of a house from an apartment in an apartment building is that there are no common areas in an individual house, while in an apartment house such common areas are a must. The owners of the apartments in the apartment building automatically acquire a share in the ownership of the common property of the house.

However, such a criterion is not universal. An apartment house is deemed to be a house with more than one flat. However, the usual country house belonging to the common ownership of two families does in fact have the common property (a roof, an attic, a basement). The same can be said of the townhouses or semi-detached houses. Here separate houses connected by one or more common walls. Often, they connect to a dozen of these individual houses or blocks. Often, they have a common roof, communications and the land. It seems that in such cases, the decision whether to refer such houses to multi-family homes is up to the court based on the specific project.

Special procedures for the insolvency of the developer

Formation of the registers of the creditors’ claims and the construction participants’ claims within the insolvency procedure of the developer has its peculiar features.

Firstly, a construction participant should identify - what claims he seeks to satisfy in the course of insolvency. The matter is that a construction participant, unlike other creditors, always has two claims against the debtor. The first claim is money, for damages caused by the breach of contract on the part of the developer. The second one is the claim for the transfer of the ownership title for the premises. Declaring of both claims simultaneously is not permitted by the law. Thus, the participant must make a choice as to in what register his claims should be entered (i.e. the monetary claims register or the register of the transfer of premises). The modern case law of the arbitration courts is based on the inadmissibility of the subsequent transition from one register to the other.

If the participant chooses the refund of his funds, the register of creditors will be updated with the amount being the sum total of the funds the participant had paid to the developer up to the termination of the contract and the amount of the actual damages, as the difference between the value of the dwelling (determined on the date of termination of the agreement providing for the transfer of residential premises), which has to be transferred to participant and the amount paid before the termination of this contract, and (or) the value of the property transferred to the developer (determined by the contract providing for the transfer of the residential premises).

In this exceeding the cash paid until the termination of the contract which provides for the transfer of premises, and (or) the value of the transferred property to the developer over the cost of the dwelling (determined as of the date of termination of this agreement), which is to be transferred to construction participant, can not constitute the reason for reducing the amount of monetary claims of the participant or cause other negative consequences for the construction participant.

The claims for the transfer of ownership title of the residential premises are submitted and reviewed in accordance with Articles 71 and 100 of the Insolvency Law, that is, in the same manner as the cash claims.

In this case the arbitration court shall be provided with the evidence confirming the full or partial payment made by the construction participant in order to fulfil its responsibilities to the developer under the contract providing for the transfer of the dwelling.

It is unclear whether this provision is given a meaning that a person who has entered into an agreement on the transfer of the residential premises but having not paid for it in whole or in part, may not be considered as having claims for the transfer of the dwelling. The law does not provide guidance on this issue, and the case law by the arbitration has not been formed yet.

The claim for the transfer of ownership title that has been justified by the arbitration court shall be entered into the register of the transfer of residential premises.

From that moment the construction participants interested in the claims for the transfer of premises are entitled to take part in the creditors’ meetings and to have a number of votes determined by the agreement. Their voting right is based on the amount paid by the construction participant to the developer as per the agreement which provides for the transfer of premises, and (or) the value of the property that has been transferred to the developer.

The following details are included in the register of claims for the transfer of premises:
  • the amount paid by the construction participant to the developer as per the agreement which provides for the transfer of premises and (or) the value of the property that has been transferred to the developer indicated in roubles
  • the size of the outstanding liabilities indicated in roubles of the construction participant against the developer as per the agreement which provides for the transfer of premises (including the value of the property, as stated in the agreement, which has not been transferred yet);
  • the details of the residential premises (including the square meters) that is the subject of the agreement which provides for the transfer thereof, as well as the details identifying the object of construction as per this agreement.

On the basis of the completed registers, once the procedures for the priority of the competing creditors are finalized, the monetary claims of the creditors and the claims for the transfer of the residential premises are satisfied in the following priority:

On the monetary claims:
  • firstly, the payments are made to the claims of individuals against whom the debtor is liable for damages made to their health and life, the payment are made by capitalization of the respective instalments and the compensation for the damages;
  • secondly, payments are made towards the salaries and the annual leave of the individuals who have been working or are currently working under the employment contract and the royalties to the owners of the IP rights;
  • thirdly, the payments are made to the construction participants against their monetary claims;
  • fourthly, the remaining creditors are repaid.

The manner of meeting the claims for the transfer of the residential premises can vary; it mainly depends on the financial capacity rather than on the wishes of the construction participants.

In case a developer has property, construction of which has not been completed yet, the general meeting of the construction participants can decide to transfer the ownership rights over this unfinished property and the plot to the construction cooperative society or another special purpose cooperative society set up by such individuals (hereinafter called the transfer of the unfinished property). In case such decision is taken the receiver applies to the court with the respective motion.

Such transfer, however, is possible only under a number of conditions, the primary condition being that the property that will remain with the debtor after the transfer of the unfinished property shall suffice to cover the repayment of the current liabilities and the claims of the creditors of the first and the second place. Otherwise, the construction participants shall have to contribute some funds on the deposit account of the arbitration court which amount would cover the margin between the current liabilities and the claims of the first place and second place creditors and the cost of the developer’s assets, but it should not exceed twenty per cent of the cost of the rights the developer has over the unfinished property and the plot.

These funds shall be contributed by the construction participants in proportion to the size of their claim unless otherwise provided at the meeting of the construction participants. In the case provided for by this paragraph, the claims of the construction participants and (or) third parties are entered into the register of the claims of creditors as per their size and priority as well as the claims of the first and second place creditors repaid by the construction participants and (or) the third parties.

As far as the repayment of the current liabilities is concerned, the claims of the construction participants and (or) third parties are to be repaid by the developer in the same manner and with the same priority as the repaid claims of the creditors on current liabilities.

Where upon completion of the apartment house the number of apartment will not be enough to meet the claims of all the construction participants, the transfer of the unfinished property shall be possible only provided that certain participants give up their interest in the residential premises so that the said house shall have enough apartments to meet the claims of the remaining participants.

Interestingly, in case a developer has several unfinished properties, a separate construction cooperative society or another special purpose cooperative society shall be set up in relation to each object, at the same time a decision at the meeting of the construction participants is made and the ruling of the arbitration court is made regarding all such premises collectively . It is however not clear what should be done where there are individuals who wish to set up a construction cooperative society for one unfinished house and nobody is willing to do so for the other house. Should the law be interpreted literally, in such a case the court shall refuse the setting up of the cooperative society and the transfer of the unfinished premises and the plot. Furthermore, this regulation creates an absurd situation regarding detached houses, townhouse communities. As a rule all the houses in the community belong to the same developer and one house may have only two or three apartments. In this case it will be required to set up several dozens of cooperative societies with two-three members each.

The claims of the construction participants can also be satisfied by transferring to them the ownership right for the residential premises. A happy ending, however, is possible only if the developer has an apartment house which has been completed. Besides, the developer must have a permission to start the operation of the apartment house the construction of which has been completed and such permission should be received in accordance with the town planning regulations. Moreover, as the case is with the transfer of the unfinished premises, the assets remaining with the debtor after the premises have been transferred should suffice the repayment of the current liabilities and the claims of the creditors of the first and second place. If not, the participants shall have to contribute to the deposit account of the arbitration court some funds which amount would cover the margin between the current liabilities and the claims of the first place and second place creditors and the cost of the developer’s assets, but it should not exceed twenty per cent of the cost of the rights the developer has over the unfinished property and the plot.

In case where the meeting of the construction participants fails to make a decision to apply to the arbitration court with the motion to transfer the unfinished premises or the residential premises in an apartment house the construction of which has been completed, the participants shall be entitled to apply to the arbitration court which is handling the insolvency case with the claims to be included into the register of creditors.

The regulation of Clause 7 Chapter IX of the Insolvency Law can be viewed as the law-makers’ attempt to integrate urgently the patters for satisfying the monetary claims into the Insolvency law which has never permitted such an option. This amendment seems to have been caused by the political need. However, the haste of the new regulations and insufficient study of significantly complex patterns resulted in a large number of issues and the lack of any comments from the Committee of the Supreme Arbitration Court of the Russian Federation. We dare believe that a wide range of cases on insolvency of developers will allow the courts to acquire experience in the nearest future and the Committee of the Supreme Arbitration Court of the Russian Federation will be able to interpret the issues covered by this article.