The Bankruptcy Legislation of the Republic of Kazakhstan: an Echo of the Past OR a Road to the Future?

Khalida Azhigulova, MJur (Oxon)

Supervisor: Philip R. Wood, BA (Cape Town), MA (Oxon), Hon LLD (Lund), Solicitor of the Supreme Court (UK)

Oxford University, UK, 2008

1. Introduction

The evolution of economic relations requires a respective reform of the underlying legislation, which is comprised of various financial regulations covering a wide range of issues. One of such issues is bankruptcy which is an inevitable phenomenon of any economy. The insolvency law is regarded as one of the most important elements of the financial law and is often called a root of the financial and commercial law due to its tremendous consequences for the economy, which depending on a policy may be as beneficial, as disastrous. That’s why bankruptcy is the most crucial indicator of the attitudes of a legal system in its commercial aspects. It is the insolvency law which reveals most of the major disparities between legal systems in their financial law.

The purpose of this article is to carry out a comparative analysis of the bankruptcy legislation of Kazakhstan in the light of modern rescue laws existing in major financial legal systems; this analysis will subsequently allow us to determine the extent of the development of Kazakhstani legislation and its ability to respond effectively to current changes in financial and commercial relations; in other words, we will be able to answer a question whether the bankruptcy legislation is an outdated echo of the past with no place in the context of modern economic relations or, despite its current state, it still leads to the future enabling us to build a strong and competitive economy. It is worth mentioning that this analysis is quite topical due to the fact that the Parliament of the Republic of Kazakhstan is currently considering amendments to bankruptcy legislation. These amendments basically concern mechanisms of rehabilitation of insolvent companies, and administrative and criminal liability for violation of the bankruptcy legislation. The article in its turn may offer some additional points for consideration, which if were adopted could contribute to overall efficiency of the bankruptcy legislation.

2. Classification of financial legal systems

Internationally financial legal systems are allocated among common law and civil jurisdictions, the former subdivides into American common law and English common law groups, whereas the latter is further divided into Roman-Germanic (e.g. Germany, the Netherlands, Russia) and Napoleonic groups (e.g. France, Belgium, states of Latin America and North Africa).

By and large, the classification of jurisdictions is based on five criteria which essentially reflect basic attitudes to credit and insolvency in various legal groups[1]. There are other possible criteria which may be used to allocate jurisdictions, but these five have proven to be the most decisive in terms of financial law. Different attitudes taken within these criteria further reflect whether the financial regime is pro-debtor or pro-creditor.

These chosen indicators are:

• The availability of insolvency set-off and netting. Set-off and netting are relevant whenever the counterparties have mutual claims. They are used in commercial and financial law, including ordinary trade, insurance, land leases, constructions and commercial agencies, as well as financial contracts, such as bank deposits. They are fundamental for payment and securities settlement and derivatives.

This criterion involves an acute collision of policies: insolvency set-off pays the creditor, its absence pays the debtor.

• The availability and scope of security interests. Security interests are widely encountered in modern credit economies, e.g. corporate working capital finance provided by house commercial banks; project finance, property finance; acquisition finance, securitizations; finance of ships, aircraft; trade finance; and collateral settlement and clearing systems for derivatives.

This indicator is a guide to attitudes to credit and to whether the insolvency hierarchy should be flat or laddered.

• The availability of the commercial trust. A trust is a type of a deal that is largely attributable to common law jurisdictions. In substance, it involves the holding by an intermediary of title to property for the benefit of the real owner but so that the property is immune from the personal creditors of the intermediary. In English common law the institute of a trust was developed in relation to succession and family property, but these private uses – both gifts – are totally dwarfed by trusteeship in the commercial and financial spheres. A bailment of goods is essentially a trust. The trust, in a wider sense, arises whenever there is a need for an intermediary, or manager, or agent for sale of property. Trusteeship is essential for global custodianship and settlement systems and involves intermediaries holding title to investments for the benefit of ultimate investors; it is extremely useful for trustees of security interests and trustees of bondholders, amongst many other cases. The examples of trust in financial markets: Depositary Trust Corporation in the US which via the nominee Cede & Co holds investments of around a half of world GDP; and Euroclear in Belgium which holds investments exceeding the GDP of the entire European Union.
• The marketability of contracts, receivables and claims. This marketability affects all transactions involving the transfer of contract claims. Particular examples are factoring of trade receivables, security interests over bulk claims, loan transfers and securitizations. The key criterion is whether the notice to the debtor is necessary for the validity of the transfer if the transferor becomes insolvent.

This indicator reflects the attitudes to the publicity needed for transfers of property effective on insolvency (sales, security interests, trusts). The publicity principle of enormous importance in transactions and the proposition that a party can only have a property interest on insolvency if it is published has had a major effect on legal systems.

• The availability of tracing delinquent money (through transformations and mixtures) on the insolvency of the final holder, e.g. the recovery of money by virtue of a claim for embezzlement, mistake or misappropriation of assets by a director or another fiduciary. Many of these are unjust enrichment claims or simple money laundering.

The real strength of mentioned indicators is tested mainly on insolvency. Indeed, security interests are a protection against insolvency and are irrelevant if counterparties can pay. Set-off is not greatly important between solvent parties, but is crucial on insolvency. A trust which fails on the insolvency of the trustee is of little value because the real owner is expropriated to pay the creditors of the trustee. Insolvency is the destroyer and it is at this point when the law has to make a crucial choice between colliding principles and answer the fundamental question: who should be protected, the debtor or the creditor, more precisely, the creditors of a debtor or the creditors of a creditor?

If we apply the chosen five criteria to present legal groups, generally, it can be said that the traditional Napoleonic systems are negative on all of them, while the Anglo-American systems are positive on all of them. Roman-Germanic systems are positive on insolvency set-off, and debt transfer without notice to the debtor, and their attitude towards availability of security interests is somewhere in the middle. But there is no place for trust and delinquent money tracing in this group. However, one should always bear in mind that this classification represents only a broad generalization, and certain traditional legal systems provide for carve-out statutes for major financial institutions which envisage a more flexible regime and thus an overall strict regime may allow for pro-creditor treatment in case of sophisticated financial corporations, such as investment banks[2].

3. The stage of development of Kazakhstani bankruptcy legislation

Generally speaking, the development of financial legal system may be divided into 3 stages[3]: the 1^st stage represents the period when there is no separate insolvency statute, although there may be certain provisions within major miscellaneous statutes, for instance, in civil codes. The 2^nd is represented by the situation when there is a separate statute that deals with the insolvency, but it is underdeveloped, lacks determination on many crucial points, and as such represents a sort of a skeletal statute. The 3d stage is characterized by advanced rescue statutes which can be distinguished by their flexible rehabilitation provisions; these statutes reflect the attitude of a legal system on all five indicators what allows to allocate the jurisdiction in a proper group.

Overall, nearly all world’s major economies and a large number of other states have adopted modern low-entry corporate insolvency (rescue) statutes over the past 25 years. The trend of these statutes has been almost uniformly in the direction of increased protection of the corporate debtor. Yet the enhanced protection that these laws give to debtors varies significantly from mild to quite strict, with many gradations in between. The key criteria include degree to which these laws prejudice the security interests, set-off, contract and lease cancellations. Other factors include the impact of preference avoidance, the power of the debtor’s management to stay in place, control of new money trumping existing creditors and the role of the court in modifying a reorganization plan. Moreover, many jurisdictions are strengthening creditor protections in respect of financial institutions, especially security interest, set-off and the trust (China, Japan, France). There is a tendency to exclude insolvent banks from the operation of bankruptcy freezes and preference rules what allows contract and property rights not to be disrupted by an insolvency proceeding. Such privileged treatment of financial institutions is driven by the fact that societies are most prejudiced by the collapse of the financial debtors, such as banks, insurance companies, etc., whose predominant creditors are other banks as well. But in the final account, the bank is only an intermediary, and real creditors in interest are often the depositors, who are mainly represented by ordinary people. The pro-creditor policy of bank insolvency laws, therefore, allows to mitigate the credit risk borne by general population and, in the long run, to avoid the collapse of a national financial system by excising the defaulting bank.

Now let’s proceed on the analysis of the bankruptcy legislation of the Republic of Kazakhstan. After the dissolution of the USSR, Kazakhstan had to create its own legal system; as regards to financial legal system, it had to be invented practically from nothing. Eventually, the legal system acquired certain features that allowed to allocate it within the Roman-Germanic group. However, from the perspective of international financial law, the financial legal system of Kazakhstan does not fall squarely into the Roman-Germanic group and will be considered a new jurisdiction until its attitude is expressed on some of the crucial indicators attributable to this legal group. That’s why we should analyze whether the present state of the insolvency legislation of Kazakhstan fits into this group by reference not only to its form but also its substance; and what stage of development it mainly reflects.

The bankruptcy legislation comprises the Bankruptcy Law. The first bankruptcy law of the Republic of Kazakhstan was passed in 1992, and contained very rudimentary rehabilitation provision – broadly a court-supervised work-out[4]. This law was replaced by the Bankruptcy Decree 1995[5], which had the force of a law, and the latter in its turn was superseded by Bankruptcy Law 1997 with the last amendments adopted in 2008[6]. Further, the provisions on bankruptcy of banks are located in the Banks and Banking Activity Act 1995 with lat amendments adopted in 2008[7]. Finally, the Civil Code 1995 contains general provisions on bankruptcy[8].

Comparative analysis of the bankruptcy legislation vis-à-vis financial legal systems:

The following features of the bankruptcy law of the Republic of Kazakhstan tend to allocate it into the Roman-Germanic group of jurisdictions:

1) Marketability of contracts: the notice to the debtor on the transfer (assignment) of a debt is not necessary[9], though a new creditor (assignee) bears the risk of negative consequences entailed by non-notified assignment.

2) Security interest: the enforcement of security is largely stayed on insolvency; generally, the collateral is included into bankrupt’s estate, and is trumped by insolvency costs, post-commencement claims, and claims on behalf of preferential creditors (tort victims, employees)[10]. However, financial carve-outs allow for the protection of secured creditors on insolvency of banks[11] (considered below).

3) Commercial trust: generally there is no universal trust, however, commercial trust is introduced by financial carve-outs (considered below).

4) Money tracing: absent.

On the other hand, the general absence of insolvency set-off, save for the case when debtor and creditor coincide in one entity[12], demonstrates incompleteness of the legal reform in the field of bankruptcy legislation; and it is due to this reason that the allocation of the Kazakhstani financial jurisdiction into the Roman-Germanic group may raise doubts from international financial law perspective.

Comparative analysis of the bankruptcy legislation vis-à-vis modern rescue statutes:

In comparison with modern rescue statutes the current bankruptcy legislation contains the following progressive provisions:

1) Availability of financial carve-outs whereby the bankrupt’s estate excludes:

1. a) collateral on mortgage receivables;
2. b) securities held in trust for pension funds, investment funds and other financial companies[13];

2) Availability of preference rules that allow to cancel contracts whereby the debtor could have dissipated the assets in a suspect period, which would be otherwise available to pay out its creditors[14]. However, securitization transactions are explicitly excluded from the scope of the article, what is directed to securing transactions between financial institutions.

3) Debtor is permitted to cancel those transactions that may lead to its losses[15]: this provision reflects a pro-debtor policy because it allows to make more assets available to pay out debtor’s creditors on insolvency, but at the same time it may prejudice 3d parties that were dealing with a debtor in good faith prior to its insolvency. In order to mitigate adverse consequences of a bona fide counterparty, it has a right to claim damages for rescission of a contract.

4) It is possible to avoid liquidation of a company by settlement agreement[16]. However the application of this provision is unnecessarily limited only to rehabilitation measures, and the procedural aspects of its feasibility are quite obscure and underdeveloped[17].

Among the disadvantages of the bankruptcy legislation the following ones may be mentioned:

• The insolvency set-off is generally unavailable. The only exception may be when a debtor and a creditor coincide in the same entity. Otherwise, the set-off of mutual claims can be performed only in accordance with the bankruptcy priority order[18]. Insolvency set-off is vital in relationships between large financial institutions, since it enables a bank-creditor to reduce its exposure and protect its own creditors, including other banks. Due to interdependence of banks and major financial institutions, the presence of insolvency set-off minimizes a risk of collapse of the whole financial system.

2) The bankruptcy legislation is silent whether a creditor can cancel the contract in case of insolvency of its debtor. This gives rise to uncertainty in cases when a creditor has already fulfilled its contractual obligations prior to the insolvency of the debtor, e.g. delivered goods or made a payment, but the insolvent debtor has not. The availability of contract cancellation favours the creditor because it allows to diminish creditor’s exposure; equally its absence favours the debtor. The Civil Code allows for contract cancellation when a debtor is declared to be a bankrupt by a court judgment[19]. But is it possible to cancel a contract at the commencement of insolvency proceedings or even earlier, when the first signs of insolvency come to the surface, i.e. in presence of a three month default, what might be indicative of a de facto insolvency? In practice it may be that the contract cancellation is allowed at the commencement of insolvency proceedings unless explicitly stayed or frozen by legislation. This proposition needs further clarification in statutory provisions.

• The existing Bankruptcy Law does not expressly allow for private work-outs, which are distinct from a procedure of out-of court rehabilitation or voluntary liquidation proceedings under the supervision of a state regulator[20]. Private reorganization enables a debtor to satisfy claims of its creditors without public coverage in court proceedings or, at least, without knowing of state organs. Public knowledge may at times be unnecessary because it can cause damage to the reputation and image of a company and lead to loss of confidence by creditors. Moreover, the Bankruptcy Law sets a compulsory duty of directors to petition if there is a risk of insolvency of a company what further complicates the possibility of out-of-court reorganization[21].

4. Conclusion

The current bankruptcy legislation of the Republic of Kazakhstan broadly reflects a pro-debtor policy by the absence of insolvency set-off, ineffectiveness of security interest on the commencement of insolvency proceedings, the scope of preference rules and possibility of contract cancellation by the debtor and not its creditor. However the availability of financial carve-outs, which protect the assets held in trust and over which a security interest has been granted for the benefit of creditors in case of debtor’s default, reflects a pro-creditor policy in respect of financial institutions, such as banks, pension and investment funds, what is in line with modern insolvency statutes.

Nevertheless, the bankruptcy legislation still falls short of a few standards of modern insolvency laws, and it is for this reason that it may be regarded to be on the 2^nd stage of development. In order for it to move forward to the 3d stage of advanced rescue laws, the introduction of provisions covering the following issues should be considered:

• Availability of recourse to private work-outs;
• Availability of insolvency set-off and netting for financial institutions;
• Availability and conditions of contract cancellation by creditors.

Returning to the main question of the article, the current bankruptcy legislation of the Republic of Kazakhstan reflects most of the contemporary developments of international financial law, and therefore is definitely not an echo of the past. It is a road… Yet, not a smooth one, with some bumps that cause inconvenience to both drivers and passengers. The suggestions made in this article may serve as necessary repairs that will improve our ‘road’, making it more efficient. Efficient bankruptcy regime in its turn is a key element of any competitive economy; and proposed modifications will successfully contribute to furthering the prosperity and stability of Kazakhstani economy and the welfare of the people as a whole.

[1] Philip R Wood, ‘Principles of International Insolvency’, 2^nd ed., Sweet & Maxwell Ltd, London, 2007, pp. 75-78

[2] Philip R Wood, ‘Maps of World Financial Law’, 6^th ed., Sweet & Maxwell ltd., London, 2007, p. 63

[3] See supra note 1, at 24, 30

[4] The Law on Bankruptcy № 1125-XII dated 14 January 1992

[5] The Decree of the President of the Republic of Kazakhstan, effective as Law, on Bankruptcy № 2173 dated 31 August 1995

[6] The Law on Bankruptcy № 67-I dated 21 January 1997, as amended of 5 July 2008 , hereinafter the “Bankruptcy Law”

[7] The Law on Banks and Banking Activity № 2444 dated 31 August 1995, as amended of 20 November 2008, hereinafter the “Banks and Banking Activity Law”

[8] Civil Code of the Republic of Kazakhstan 1994, Articles 52-57

[9] Ibid., Art. 339(3)

[10] See supra note 6, Art. 75

[11] See supra note 7, Art. 74-1, Ibid., Art. 74(4)

[12] See supra note 7, Art. 73

[13] Ibid., Art. 74

[14] See supra note 6, Art. 6

[15] Ibid. Art. 7

[16] Ibid. Art. 44

[17] See: Iliyasova K. M. ‘Problems of conclusion of settlement agreement in bankruptcy proceedings under the legislation of the Republic of Kazakhstan’ (“Проблемы заключения мирового соглашения в процедурах банкротства по законодательству Республики Казахстан”). Retrieved March 10, 1997, from http://zakon.kz/our/news/news.asp?id=30146475

[18] See supra note 12, Art. 73

[19] See supra note 8, Art. 404

[20] See supra note 6, Art. 1(4, 6)

[21] Ibid., Art. 17