The enforcement of shareholder agreements within the framework of Russia’s legal system has been the subject of considerable discussion. The issue arises from the confluence of (1) shareholders’ desire to strike, by contract, a particular balance of power in company management matters and (2) the lack of clear and predictable regulation of the resulting agreement under Russian law. This article attempts to lay out several of the most important obstacles to the enforcement of shareholder agreements.
The following issues are considered in detail below: (i) the ability of a disgruntled part to a shareholder agreement to challenge decisions which violate the terms of that agreement; (ii) judicial enforcement of the parties' respective obligations under a shareholder agreement; (iii) the availability of specific performance under a shareholder agreement; (iv) mandatory norms and shareholder agreements; and (v) governing law for shareholder agreements.
While shareholder agreements are widely considered a valuable tool for harmonizing shareholder interests, their use in Russia is potentially compromised by endemic concerns over their effective enforcement by courts. Among the most common types of shareholder agreements are those dealing with voting and the transfer of shares. Such agreements typically require shareholders to vote in a specified way on a particular matter presented at shareholder meetings and/or set forth certain requirements attending the sale or transfer of a company's shares.
Let us examine a prototypical case. In creating a company, two institutional shareholders enter into an agreement providing that the board of directors will consist of three representatives of one shareholder (holding, say, 70 percent of the shares of the company) and two representatives of the other shareholder (holding the remaining 30 percent). The two shareholders also adopt a company charter whose norms are, by necessity, identical to those set forth in the Law on Joint Stock Companies (the “JSC Law”). However, at one of the company’s subsequent general meetings of shareholders, the majority shareholder attempts to elect only its own candidates to the board and refuses to vote for the candidates of the minority shareholder.
Under Article 48.4 of the JSC Law, the board of directors of a company is elected by a simple majority of shareholder votes. Accordingly, the candidates nominated and supported by the majority shareholder will be deemed elected in the present case, pursuant to the requirements of the JSC law (and the conforming provisions of the company’s charter).
The question that arises in this situation is whether the minority shareholder will be able to protect its interests by obtaining judicial enforcement of the shareholders’ agreement. Unfortunately, there is, as yet, no clear answer to this question under current Russian law.
Discussion regarding judicial enforcement of the shareholder agreement naturally requires consideration of the form any such relief might take. Two mechanisms are potentially available to the minority shareholder and are discussed in detail below. They are (a) judicial annulment of the general meeting of shareholders' decision electing the board of directors; and (b) obtaining a court order directing the majority shareholder to appoint the candidates of the minority shareholder as directors – i.e., to specifically perform his obligation.
Annulling Decisions Made at the General Meeting of Shareholders
The grounds for invalidating decisions made at a general meeting of shareholders are set forth in Article 49.7 of the JSC Law, which provides:
“A shareholder shall have the right to bring action in court to challenge a decision made at a general meeting of shareholders in violation of this Federal Law, other laws of the Russian Federation, the charter of the company, in the event he was not present at the general meeting of shareholders or voted against the adoption of such decision, and such decision violates his rights and lawful interests.” (Emphasis added.)
Thus, a decision made at a shareholders’ meeting may only be invalidated if it directly contradicts the JSC Law, some other law of the Russian Federation, or the bylaws of the company. In our example, the decision of the general meeting made in disregard of the shareholder agreement (pursuant to which two representatives of the minority shareholder should have been elected to the board of directors) clearly does not violate the JSC Law (or any other law) or the company’s charter. Moreover, the JSC Law does not specify a breach of a shareholder agreement as grounds for invalidating a decision of the general meeting. Nor are such grounds contemplated by the Joint Decree of the Plenum of the Supreme Court of the Russian Federation and the High Arbitration Court of the Russian Federation No. 4/8 “On Certain Issues Relating to the Application of the Federal Law ‘On Joint Stock Companies,’” which clarifies for the lower courts the practical aspects of application of the JSC Law. Accordingly, it is unlikely that the decision of the general meeting violating the shareholder agreement could be annulled or set aside in our example.
Specific Performance of the Shareholder Agreement
The fact that it might be impossible to have such decision of the general meeting invalidated does not mean that there are no other potential avenues to protect the interests of the minority shareholder. Having a duly executed agreement, the latter may seek specific performance of the agreement through the courts.
The basic provisions relating to specific performance of obligations are set forth in Article 396 of the Civil Code. That article provides:
“1. The payment of a penalty and damages in the event of inadequate performance of an obligation will not release the debtor from specifically performing the obligation, unless otherwise provided by law or contract.
2. The payment of damages in the event of a failure to perform an obligation and the payment of a penalty for such failure to perform will release the debtor from specifically performing the obligation, unless otherwise provided by law or contract.” (Emphasis added.)
The difference between paragraphs 1 and 2 of Article 396 is the degree of completion of the debtor’s performance of a specific obligation at the time of breach. In the event of “inadequate performance” of the obligation (i.e., malfeasance), the debtor, notwithstanding payment of a penalty or damages, must properly complete its performance (paragraph 1). In contrast, in the event of a “failure to perform” the obligation (i.e., misfeasance), the debtor may limit its performance to the payment of damages and/or monetary penalties (paragraph 2).
The failure of the majority shareholder to vote for the nominees of the minority shareholders is likely to constitute a complete breach of the shareholder agreement and cannot be deemed to constitute “inadequate performance” of his obligation. However, regardless of whether the breach constitutes “inadequate performance” or a “failure to perform,” each of the two provisions of Article 396 allow shareholders to include in their agreements an express covenant to specifically perform a particular obligation (in our case, to vote in a specified manner).
One would expect this explicit mention of the possibility of specific performance in the Civil Code to be conclusive on the issue of judicial enforcement of shareholder agreements, such that in the event that “the agreement provides otherwise” – i.e., that by the terms of their agreement the parties cannot refuse to specifically perform their obligations – neither party will be able to avoid specific performance simply by the payment of damages or monetary penalties.
However, assuming that a court, consistent with the terms of the contract, would issue an order directing specific performance of an obligation to appoint a minority shareholder’s representatives to the board of directors, it is nevertheless unclear what form the remedy of specific performance could take. This is because, unlike in some other jurisdictions, courts in Russia are only authorized to provide those forms of remedy expressly permitted by law. As Russian legislation does not explicitly authorize courts to compel a breaching party to vote in a certain way, it is unlikely that the court would order the majority shareholder to actually vote in accordance with the shareholder agreement. The question then is whether the court can eliminate the middle step, and directly appoint the minority candidates as directors by its own order.
A similar remedy is expressly contemplated by Article 445.4 of the Civil Code and Article 130 of the Code of Arbitration Procedure, for example, in those cases involving “orders to compel to enter into an agreement.” In granting specific performance in certain cases involving obligations to enter into an agreement, the court can declare that there is an agreement between the parties and specify the conditions under which the parties must execute that agreement. However, on the other hand, Russian law does not expressly contemplate the possibility of appointment by court order of a particular candidate to the board of directors as a valid form of specific performance of an obligation arising under a shareholder agreement. Given thefactthatthereare,asyet,nojudicialprecedentsonthisissue, it is hard to predict exactly what decision a court would make in such a situation. However, itseemsunlikelythatacourt (havingnospecificauthoritytodosoundercurrent legislation) would appoint the minority shareholder candidate as member of the board of directors by its own court order.
Thus, the existence of a duty to specifically perform contractual obligations, on the one hand, and the lack of an effective enforcement mechanism, on the other, create uncertainty as to the enforceability of shareholder agreements relating to voting.
The problem of enforceability of shareholder agreements is further complicated by other issues. For example, the relationship between the provisions of a shareholder agreement and applicable mandatory norms of the JSC Law remains an open question. Moreover, there are problems as to the enforceability of the parties' choice of foreign law as the governing law of a shareholder agreement.
Shareholder Agreements and Mandatory Norms of the JSC Law
The issue is whether a shareholder agreement can lawfully establish procedures (in particular relating to management and voting) that differ from those prescribed by the JSC Law for such matters. For example, can an agreement lawfully provide that the number of votes, or seats on the board of directors, will not be determined based on the number of shares held by the shareholders or the results of a shareholder vote (as in our example)? Can the shareholders lawfully change by agreement the powers and duties of the chief executive officer or the board of directors, or provide for shareholder voting requirements (i.e., the minimum number of shareholder votes required for the transaction of business) that are more stringent than those set forth by the JSC Law? Within the existing regulatory framework, a Russian court might well reach the conclusion that the answers to these questions should be in the negative, on the grounds that the very nature of a mandatory norm does not permit any deviations from its requirements by the intended objects of the regulation.
In connection with the problem at hand, it is worthwhile to look at the changes to the process of decision-making at the general meetings of shareholders brought about by the new edition of the JSC Law (effective January 1, 2002). The old version of paragraph 2 of Article 49 of the JSC Law required that action taken at a meeting of shareholders be authorized by a simple majority of votes, unless the JSC Law itself or the company’s charter sets forth a higher voting requirement. The new edition of Article 49, on the other hand, does not provide for the possibility of increasing voting requirements by charter provision and thus permits changes in the number of votes required to take a particular shareholder action only if such changes are expressly authorized by the JSC Law. It follows from this rule that any shareholder agreement setting forth a higher voting requirement will unenforceable as it contradicts a mandatory norm of the JSC Law.
The same logic would seem to apply to the issue of allocation of positions on the board of directors of a company. The JSC Law establishes certain procedures for nominating candidates for director positions and for voting for such candidates. Accordingly, the provisions of any shareholder agreement purporting to change these procedures may be held to contradict the JSC Law.
Thus, the majority shareholder in our example may have a very strong argument that could allow him to disregard his obligations under the shareholder agreement. Since the agreement changes the procedures prescribed by the JSC Law, it may be held unenforceable for failing to comply with mandatory rules of law.
Governing Law for Shareholder Agreements
If a shareholder agreement is governed by foreign law, the issue of such agreement’s compliance with mandatory norms of Russian law may appear to be of a lesser magnitude. However, even in such cases, certain problems may arise.
First, enforcement of a decision of a foreign arbitral tribunal against a Russian shareholder (in the event the shareholder breaching the shareholder agreement is a Russian entity) is possible only through a Russian court. The relevant court, however, may decline to enforce the provisions of a shareholder agreement, even if the agreement is governed by foreign law, if it concludes that the agreement contradicts Russia’s public order.
Also worth mentioning is Article 1202 of Part III of the Civil Code (effective March 1, 2002), which introduces a concept of “personal law of a legal entity.” The personal law of a legal entity is the law of the country in which the legal entity was formed. Pursuant to paragraph 2(7) of Article 1202, the personal law of a legal entity governs, in particular, its “internal affairs, including the relationships of the legal entity with its members.” Since company management is principally a question of the company’s relationships with its members, shareholder agreements of a Russian company are likely to be governed by Russian law.
The same conclusion follows from Article 1210 of the Civil Code, regulating the general procedures for choosing applicable law by the parties to an agreement. Under paragraph 5 of Article 1210, “if it follows from the totality of the circumstances, as they existed at the time the applicable law was chosen, that the contract is actually connected with only one country, then the parties’ choice of the law of another country may not affect the application of mandatory norms of the country with which the contract is actually connected.” Although the meaning of the term “actually connected” remains unclear, it is likely that a court applying this provision will conclude that agreements among the shareholders of a Russian company are “actually connected” with Russia, rather than any other country, and therefore should be governed by Russian law. However, another conclusion is also possible -- that the above provisions of Article 1210 do not apply to shareholder agreements to begin with, because the Russian company whose shareholders have entered into the shareholder agreement is not itself a party to the agreement.
Moreover, pursuant to Article 5 of the Law “On Entering into Effect Part III of the Civil Code of the Russian Federation,” “Part III of the Code shall apply to civil law relations arising after it comes into effect.” Thus, even in the case of a most conservative interpretation of the provisions in question – i.e., prohibiting a party choice of foreign law in shareholder agreements – whether these provisions are applicable to agreements that were entered into before Part III of the Civil Code became effective remains an open question. Even if the shareholder agreement was entered into before March 1, 2002, the court may still come to the conclusion that the provisions of Part III of the Civil Code should apply to legal relations that arise under the agreement after that date.
In addition, if the provisions of the agreement involve issues relating to the creation of the company, subjecting such provisions to foreign law will directly contradict Article 1214 of the Civil Code. Under Article 1214, contracts for the formation of a legal entity must be governed by the law of the country in which the legal entity is to be formed.
As the above-mentioned norms, which regulate possible application of foreign law by parties to an agreement, entered into force on 1 March 2002 (as did the whole Part III of the Civil Code), there is as yet no legal practice of their application. Itislikelythatcourtswillhavethefinalsayonthequestionofgoverninglaw. Until then, there is a substantial risk that the parties' choice of foreign law as the governing law of a shareholder agreement may be unlawful.
From a practical point of view, as a measure to help achieve the performance of shareholder agreements, a provision may be included in the shareholder agreement for severe stipulated damages for failure to perform the obligations under the agreement. While specific performance of provisions relating, for example, to voting at a shareholders’ meeting may be difficult to obtain from Russian courts, it may be much easier to obtain an order directing the breaching party to pay high liquidated damages for the non-performance (or inadequate performance) of its obligations.
However, the introduction of heightened contractual liability for non-performance may not be a completely reliable solution to the problem. It is quite possible that the court may conclude that such a provision is invalid because it contradicts mandatory norms of the JSC Law, as discussed above.
Unfortunately, there is no watertight-dependable solution to the discussed problem of electing minority shareholder candidates to the board of directors via shareholder agreements. The only safe action for a minority shareholder in this situation would be the introduction into the charter of provisions providing for election of members of the board of directors by cumulative vote. Such a scenario, however, is only possible when the minority shareholder is present at the moment of the company’s foundation, when it is capable of exchanging its participation for certain favorable provisions in the charter. Having become a shareholder after creation of the company, there are no guarantees that it can introduce a cumulative voting procedure.
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The issues discussed above illustrate the fact that enforcement of shareholders’ agreements is not well tested as completely as they apply to Russian joint stock companies. Unfortunately, there are no specific provisions regulating such agreements (except for agreements for the formation of a company) in either the JSC Law or the Civil Code. Within the existing legal framework, judicial enforcement of such agreements in general, and obtaining specific performance of the obligations arising under such agreements in particular, are very uncertain. In time, and in the absence of new legislation, the existing gaps in the law will hopefully be filled by judicial practice, so as to bring about a resolution of the issue of enforceability of shareholder agreements.