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Senior Associate, Kinstellar
Senior Associate, Kinstellar
Recent Trends of Corporate Disputes in Ukraine Point Towards Increasing Investor Confidence
Ukraine has made considerable progress in recent years in the reform of its corporate legislation, particularly by stepping up the protection of companies and shareholders. Domestic courts play a central role in this process. They appear inclined to enforce claims for damages against fraudulent directors and, at the same time, to preserve contracts concluded in good faith. Additionally, the courts will soon scrutinise novel legal issues regarding shareholders’ agreements, as the first disputes over this instrument are coming into play.
Disputes with Dishonest Directors: Et tu, Brute?
Court disputes involving dishonest business practices by management have increased in number lately. They feature transactions with affiliates, contracts signed without approvals, and forged documents. Companies and shareholders frequently discover improper dealings only when the consequences are not easy to reverse. In this respect, Ukrainian law offers several legal remedies.
As a starting point, shareholders cannot sue directors for damages merely because a company has suffered losses. This is because Ukraine recognises the “no reflective loss” rule, as the Supreme Court of Ukraine confirmed on 8 October 2019 in case No. 916/2084/17. The rule explains that a shareholder does not suffer a personal loss because the shares remain unaffected directly by wrongdoing. Therefore, it is only for the company to bring a claim.
What if the director or other shareholders are opposed to the company initiating litigation? The Supreme Court shed some light on
3 December 2019 in case No. 904/10956/16. A shareholder, acting independently or together with fellow shareholders, can convene an Extraordinary General Meeting to appoint a loyal director and instruct them to sue those involved in the wrongdoing.
In contrast, minority shareholders often do not have sufficient leverage. Therefore, Ukrainian law allows certain shareholders to bring a derivative claim on behalf of the company. A shareholder whose stake in a company exceeds 10% can sue the director for a breach of their duties to recover company’s losses. Importantly, any sum recovered goes to the company, and not to the claimant shareholder.
The company can bring a claim against an errant director if it has suffered a loss. It must show that the loss resulted from a breach of the director’s duties. Historically, Ukrainian law recognised only the duty of a director to act within their powers. A breach of this duty occurs when a director exceeds their authority, fails to obtain corporate approvals, or submits false information to receive such approvals.
However, on 26 November 2019, the Supreme Court confirmed in case No. 910/20261/16 that a director also has fiduciary duties, which form a relationship of trust between the director and the company. Accordingly, directors are additionally required to act in the best interests of the company, to exercise skill and care, and to avoid conflicts of interest. A breach of fiduciary duties may give the company the right to claim damages from the director.
On the other hand, the director may not have sufficient assets to pay compensation. This makes it difficult, if not impossible, for shareholders to restore the status quo. In this case, the company may try to return assets from fraudulent third parties by initiating litigation to invalidate contracts of the company.
Claims for Invalidation of Contracts: A New Hope
Dishonest directors commonly misuse contracts to divert assets from a company. These contracts are usually signed without the approvals that are often required for transactions exceeding a certain amount or concerning valuable assets. When these transactions become known, companies can, and usually do, ask the court to invalidate such contracts. The invalidation results in the parties being restored to the position that existed before the conclusion of the contracts.
These claims, however, are not very successful in practice. As the Supreme Court put it on 24 December 2019 in case No. 910/12786/18, the mere fact that a director signs a contract outside their powers is not sufficient to invalidate a contract. That powers of a director have limitations is an internal company matter and, therefore, is not necessarily known to a third party. For this reason, the company must prove that the third party knew, or could have known, that the director did not have powers to sign the contract.
On the other hand, the Supreme Court recently took a progressive step towards the effective protection of defrauded companies. Article 232 of the Civil Code of Ukraine permits the invalidation of a contract when the contract results from a conspiracy between a “representative of one party” and another party. This remedy was for years not effective in practice because courts did not include management into the notion of a “representative of one party”.
However, on 22 October 2019 in case No. 911/2129/17, the Supreme Court finally extended Article 232 of the Civil Code to company directors, declared the contracts to be invalid on the basis of a conspiracy between the director and other parties, and ordered the defendant companies to return the assets in question to the claimant company.
Shareholders’ Agreements: Forewarned is Forearmed
The reality of the Ukrainian market has long been that parties conclude shareholders’ agreements by choosing a foreign governing law. Ukrainian legislation used to offer market players little room to regulate the relationship between shareholders as they wished. Recent reforms to the rules governing shareholders’ agreements may well shift market practice towards choosing Ukrainian law for such contracts, at least for small and medium-size M&A transactions and joint ventures.
Domestic businesses and foreign investors can now regulate such aspects as share transfers, corporate governance, deadlock resolution, etc., with shareholders’ agreements governed by Ukrainian law. Nevertheless, this should be done with the utmost caution, at least until courts develop consistent practice on enforcement of shareholders’ agreements.
Although consistent court practice in this area is still to come, certain legal issues are currently unfolding in court disputes. For example, in case No. 916/1444/19 a court of first instance had to decide under which circumstances a shareholders’ agreement can be declared invalid due to misrepresentation.
The court made a valuable point, namely that a shareholders’ agreement can be grounds for the transfer of shares even if the agreement does not involve the sale and purchase of shares. This is an important first step in the enforcement of shareholders’ agreements because Ukrainian law allows parties to freely decide how the transfer of shares should occur.
Many questions, however, remain unanswered. What happens if one party breaches the obligation to transfer shares under the shareholders’ agreement? Should an affected shareholder ask the court to order the breaching party to make this transfer? Alternatively, should the affected shareholder seek invalidation of a contract under which the breaching party transferred shares to a third party?
Considering the recent approach of the Supreme Court, courts would invalidate contracts with third parties only in exceptional circumstances. The affected shareholder would need to prove that the third party knew, or could have known, that the contract was concluded in breach of the shareholders’ agreement. Hence, the challenged contract is likely to be preserved unless there is a conspiracy between the breaching shareholder and the third party.
To avoid these difficulties, parties might want to include a liquidated damages clause in their shareholders’ agreement. This clause would enable the affected shareholder to claim damages in a predetermined amount or calculated in the manner stated in the shareholders’ agreement.
Recent developments in Ukrainian corporate litigation will certainly be of interest for existing and potential investors in the Ukrainian economy. Domestic courts are successfully enforcing the legal instruments recently introduced in Ukrainian law. Disputes involving claims for damages from company management or for invalidation of non-arm’s length contracts firmly exemplify this point. While it remains to be seen how higher courts will approach shareholders’ agreements, the pilot test seems to be reassuring.