Employees’ fraud via a fly-by-night company in Russia
February 2015 | SPECIAL REPORT: CORPORATE FRAUD & CORRUPTION
Financier Worldwide Magazine
This article concerns ways to protect a company’s interests in case of employee fraud via a fly-by-night company, which is quite typical for Russian business.
Consider the following scenario: some chief employees of a company (Company) create a new company (Fly-by-night Company) through affiliated people in order to provide some services to the Company. The same employees present the Fly-by-night Company to the CEO of the Company as a very good service provider and persuade him to hire it. At the same time, they do not disclose that the Fly-by-night Company is controlled by them, that it does not render any services itself but acts instead as an intermediary and that its fees are considerably higher than average market fees.
In contrast to interested party transactions and CEO fraud, there are no direct regulations or well-established court practices on such employee fraud, despite the fact that this type of offence is widespread.
We suggest four key solutions to protect the Company’s interests in this case. While each of these solutions may be sufficient in themselves, we recommend using combinations thereof in complex cases.
Solution 1: Internal investigation including interviews of the Company’s employees acting in bad faith and beneficiaries of the Fly-by-night Company. The Company should first find out the exact amount of its damages, the scope and roles of its employees in the fraud, and other relevant circumstances. The Company should also collect evidence of affiliations with the Fly-by-night Company. In our experience, involvement of independent forensic experts and law firms with relevant expertise is the best option for handling the investigation and, for example, for obtaining written statements by individuals acting in bad faith and relevant video records.
As a result, the Company will: (i) obtain grounds for holding negotiations with persons involved regarding the risk of criminal liability and recovery of damages; or (ii) use the collected evidence and information in further proceedings if the involved persons acting in bad faith successfully resist pressure in negotiations.
Solution 2: Attempts to initiate a criminal investigation and the Company’s subsequent claim within the framework of the criminal court trial. The Company’s statement to the police in relation to the fraud or misuse of competence (articles 159 and 201 of the Russian Criminal Code) may lead to the start of a criminal investigation and subsequent court trial. The decision to open a criminal case is at the police’s discretion, but the Company has a right to appeal the refusal by the police and ask for additional examination of its statement.
As a result, the Company will: (i) obtain additional arguments and evidence with which to hold negotiations with the involved persons regarding the risk of criminal liability and recovery of damages if the criminal investigation has begun; or (ii) file a claim on recovery of damages against the involved individuals within the framework of the criminal proceedings if the criminal court trial has begun; or (iii) at least make reference to the facts discovered by the criminal investigator and reflected in the police’s acts and decisions in the subsequent litigation, even if these facts are not sufficient to open a criminal case.
Solution 3: Civil litigation against the Fly-by-night Company in a commercial court. Usually the Fly-by-night Company is a direct recipient of the Company’s money and a party to the relevant agreement, which means that it is quite reasonable to file a claim against the Fly-by-night Company providing it has assets to pay under a court judgment. Sometimes a claim against the Fly-by-night Company is reasonable even in the absence of any assets; for instance, to invalidate the unfair agreement binding the Company, or to be used as a counter-claim to defend the Company against the initial claim brought by the Fly-by-night Company seeking payment for their services.
Solution 4: Civil litigation against the involved individuals in the court of general jurisdiction. This solution may be useful if all assets have been transferred from the Fly-by-night Company to its beneficiaries and, therefore, judgment on a separate claim against this company is unenforceable. However, taking into account the heavy burden of proof in such cases and the policy of Russian courts of general jurisdiction on protection of individuals, it is reasonable to use this solution as a last option with the support of all possible evidence (including the judgment of the state commercial court against the Fly-by-night Company).
Tricky issues relating to litigation against the Fly-by-night Company
As far as litigation against the Fly-by-night Company is the principal option in complex cases, and due to the limited scope of the present article, we will examine some tricky issues only in relation to this particular option.
Issue 1: Subject-matter of the claim. The Company has a right to challenge the whole contract or its provision on the services price only, but generally we recommend the second option because of the burden of proof issues and the similar value of these options for a recovery claim. However, it may be reasonable to challenge the whole contract if it provides an obligation (not a right only) of the Company to use a certain amount of services for an extended period of time and restrictions on a unilateral termination of the contract.
Along with challenging the contract, the Company should claim for recovery of money. If the services under the Contract were actually performed, it is reasonable to ask the Court to recover the overestimated part of the service price. The Company should carefully reflect the legal nature of its monetary claim. The practice of claiming recovery money as a ‘consequence of invalidity of void transactions’ (in other words, as a ‘restitution’) which is common in Russia, is not applicable in this case because it would require services to be returned to the Fly-by-night Company, which is impossible (in contrast to return of goods, money, etc.) and would lead to the Company losing the case. This is one of the reasons why similar fraud schemes are usually based on services (not sale and purchase) contracts. If the Company claims for recovery of the money as an unjust enrichment, it would strongly mitigate the abovementioned risk.
Issue 2: Legal grounds for challenging the transaction. The best option is to use two separate grounds to challenge the transaction: (i) a special ground established by art. 178, 179 of the Russian Civil Code, which covers misrepresentation of the Company’s CEO or other senior management by the Company’s employees and by a Fly-by-night Company; and (ii) a general ground established by art. 10 of the Russian Civil Code, which covers a bad faith ‘misuse of rights’ by the Fly-by-night Company. This concept is aimed at protecting good faith interests in the absence of the direct legal provisions on a particular issue, and has been intensively developed in Russian court practice for the five last years.
Issue 3: Burden of proof and relevant evidence. The Company should prove three points. Firstly, that the particular employees of the Company are (or were) affiliated with the Fly-by-night Company. Most of the relevant evidence should be collected during the internal investigation and forensic searches, but some missing documents regarding family and labour relations, which are protected by data privacy laws, may be retrieved by the Court on the basis of the Company’s motion from the authorised government bodies. Secondly, that the market price of the performed services was considerably less than their contractual price. Generally, there are three types of relevant evidence: (i) a valuator’s report on the services market price; (ii) former contracts of the Company for similar services; and (iii) proposals received by the Company to enter into similar contracts prior or after the contract date. The final point to prove is that its CEO or other managers were misrepresented by the employees acting in bad faith and by the Fly-by-night Company with regard to absence of connections between them and to the overpriced cost of services, which could be proved by correspondence, witness statements, and local conflict of interest regulations of the Company. Ultimately, conflict of interest does not in itself predetermine the case, but it allocates the burden of proof of good faith and absence of misuse of rights to the Fly-by-night Company.
Maxim Kulkov is counsel at Freshfields Bruckhaus Deringer. He can be contacted on +7 985 769 3776 or by email: email@example.com.
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Freshfields Bruckhaus Deringer