Russia: Balancing risk and reward

Author: | Published: 1 Oct 2011
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The Russian Government has been enthusiastic over the last few years in its welcoming of foreign capital and economic expertise. Indeed, President Medvedev's ambitious modernisation programme, aimed at creating a diversified and competitive economy that is not reliant on revenues from Russia's oil and gas exports, may help to significantly improve the country's investment climate in order to attract foreign investors.

The Government has, in particular, highlighted the automobile, pharmaceuticals, housing, construction and agriculture industries as priorities, and has embarked on a number of ambitious projects, including the advanced technology and innovations incubator in Skolkovo and the international financial centre in Moscow. The reality, however, is that successful investment projects are typically dependent on direct political support. Administrative obstacles, corruption, undeveloped legislation and an unpredictable court system are the primary reasons for Russia's generally questionable reputation as a destination for foreign direct investment. A recent court-sanctioned armed raid on BP's Moscow offices attests to the problems faced by foreign investor in the country.

On the other hand, Russia's sovereign debt is amongst the lowest in the world, its export and fiscal revenues are high and inflation is moderate. Russia's enormous natural resources, vast domestic market, low corporate and flat personal tax rates, and well-educated human resources have been key drivers in attracting foreign direct investment to the country in the past. Moreover, top government officials appear generally to understand that Russia has to clear the administrative and legal obstacles that hinder direct investment, to simplify the business environment in which companies operate and to enhance competition.

Based on that understanding, in March 2011 President Medvedev set out 10 measures to improve the investment climate in Russia, which were welcomed by the investment community and some of which have already been actively implemented. Among others, Medvedev proposed to:

(i) decrease the rate of social payroll charges;

(ii) establish a special investment ombudsman in each federal district whose job will be to assist companies in carrying out private investment projects, and help them in their dealings with the executive authorities;

(iii) make public a timetable for privatising large government shareholdings over the next three years and replace ministers and deputy prime ministers with independent directors on the boards of the major state companies;

(iv) pass the necessary laws to ascertain that minority shareholders in public companies are granted access to information on these companies' performance;

(v) establish a Russian direct investment fund that will be a co-investor for foreign investment funds and large companies launching investment projects that are important for Russia's economy (the fund would not be managed by the state and would typically have a share in all investment projects of between 10% and 25%);

(vi) submit a draft law to parliament which would narrow the scope of competence of the commission which oversees transactions in so-called strategic sectors of the Russian economy; and

(vii) improve the quality of services consumed by the investment community (such as travel, immigration and postal services).

Another trend which was recently announced by President Medvedev and which may provide significant opportunities for investors, is the programme to reduce state ownership in the economy through the privatisation of Russian companies.

Structuring investments

According to the Law on Foreign Investment in the Russian Federation (the Foreign Investment Law), foreign investments and investors are treated no less favourably than Russian investors and the legal regime governing their right to invest and to receive profits from such investments is no less favourable than the legal regime applicable to domestic investments, subject to any exceptions that may be set forth in federal laws and that are aimed at protecting the basics of the Russian constitutional system, morality, health and rights of persons or in order to ensure State security and defence.

The following investments are recognised as foreign direct investments under the Foreign Investment Law:

(i) the acquisition by a foreign investor of not less than a 10% interest in the charter capital of a commercial company incorporated or being incorporated in Russia in accordance with its civil law;

(ii) capital investment in fixed assets of a branch of a foreign legal entity which is being created in Russia; and

(iii) financial leasing activity by a foreign investor in the capacity of a lessor regarding certain high value machinery.

Only foreign direct investments, subject to certain thresholds, can qualify as a priority investment project. Such projects must be approved by the Government, which may grant guarantees and privileges on the federal or local level.

Foreign investors are allowed to make investments in Russia in any forms that are not prohibited by law. Generally, foreign direct investment in Russia can be conducted either by forming (or purchasing an interest in) a Russian legal entity or by establishing a branch of a non-Russian company in Russia (without forming a separate legal entity). There is a variety of business structures that may be used by investors to form a wholly-owned subsidiary or create a joint venture with Russian partners.

According to the Civil Code of the Russian Federation, commercial legal entities may be created in the form of, among others, business partnerships and companies. The business forms which are used by foreign investors are typically joint-stock companies (public or private) and limited liability companies.

Formation of a joint-stock company or a limited liability company requires the adoption of a charter and the capitalisation of the company. The minimum charter capital of a limited liability company is RUB10,000 (approximately $350) and of a joint-stock company RUB100,000. However, proposed amendments to the Civil Code would introduce significantly higher levels of minimum charter capital. It is yet to be seen what such levels would be as these and certain other proposed amendments to the Civil Code have been heavily criticised by practitioners and business community.

A company must be registered with the state registration authority, which is the local tax inspectorate at the place of location of the company's executive body. The registration of a company usually takes between 15 and 30 days. The newly created company is granted a main state registration number and a taxpayer's identification number. The state registration is confirmed by a certificate of state registration issued by the tax inspectorate.

Simultaneously with the state registration, tax registration and registration with various funds (such as the Pension Fund) is conducted by the same authority. Following the state registration, shares in a joint-stock company must be registered with the Federal Financial Markets Service or its department. The charter capital of a limited liability company is divided into participation interests, rather than stock.

Information on the state registration of a legal entity is incorporated in the Unified State Register of Legal Entities and Entrepreneurs and is partially publicly available on the web page of the Federal Tax Service on the internet.

According to the Civil Code, commercial companies can engage in any types of activities that are not prohibited by law. Some activities require obtaining of an operational licence (as discussed below) or participation in a self-regulatory organisation.

The predominant approach to structuring a business by foreign investors in Russia is to use a non-Russian company formed in an offshore jurisdiction as a holding vehicle for the entire corporate structure. There are two primary reasons for this: (i) greater tax advantages, and (ii) use of developed and predictable corporate governance rules to govern the relationship between the foreign investor and its Russian partners.

Until 2009, the evolving Russian corporate law failed to recognise one of the most important instruments used by foreign direct investors, namely shareholders agreements. Now, Russian law allows shareholders in both private and public joint-stock companies and participants in limited liability companies to enter into shareholders (participants) agreements. However, there are still many ambiguities in the law and uncertainties in its interpretation. Many important questions still remain unanswered, including whether Russian courts will recognise and enforce a foreign arbitral award rendered based on a shareholders agreement governed by a law other than Russian law, and whether Russian courts will enforce remedies provided in a shareholders agreement. Another important issue is that a shareholders agreement cannot create a set of corporate governance rules which compete with the charter of a company and contradict mandatory rules of applicable Russian law.

Bilateral investment treaties

To promote foreign investment, Russia has signed and ratified a number of bilateral investment treaties (BITs). Diligent investors structure their holdings in Russia so that they might gain protection from such a BIT. Such protection can be seen as a way to potentially have a robust discussion with Russian officials. Sometimes, a mere reference to the intent to use BIT protection could help to resist threats of Russian Government bodies (such as, for example, a threat to withdraw a licence).

Many BITs give investors a direct right of action against the State and the right to bring claims in international arbitration outside Russia which is obviously less subject to manipulation by the Russian Government. Although tax planning objectives usually prevail, some investors will structure their deals so that they obtain access to the investment protection remedies available through a BIT. Such structuring should occur at the time the deal is discussed and should be coordinated with tax planning.

Foreign arbitral awards are in principle enforceable in Russia under the 1958 New York Convention on Recognition and Enforcement of Foreign Arbitral Awards. In general, they are more enforceable than court judgments rendered outside Russia.

National security

The Law on the Procedure of Foreign Investment in Business Entities Having Strategic Importance for the Defense of the Country and the Security of the State (Strategic Industries Law) specifies 42 sectors/types of economic activity that are deemed to be of strategic importance for defence and national security.

Foreign investment proposals are reviewed by reference to national defence and security interests by the Strategic Investment Government Commission, headed by the Prime Minister. The Commission's prior approval is required for the acquisition of control over a target company operating in any of the relevant sectors, with "control" stated to include acquiring (directly or indirectly) more than 50% of the voting shares, obtaining more than 50% of the seats on its board or other management body, acquiring the right to appoint its chief executive officer, or otherwise determining the target's operations through a management or similar agreement.

In cases where a target has multiple minority shareholders, the acquisition of any voting interest below 50% also requires prior approval, if the acquisition would give the foreign acquirer de facto control over the target. The above thresholds are reduced to 10% if the target company is involved in geological research and/or exploration and development of certain natural resources deposits "of federal significance".

If the acquirer is a foreign state or an international organisation or a legal entity controlled by a foreign state or an international organisation, then the threshold at which prior approval is required is reduced to the level of a blocking stake (25% plus one share). Such threshold is further reduced to 5% of the voting shares if the target company is involved in geological research and/or exploration and development of natural resources deposits of federal significance. The acquisition of control over a target "strategic" company by such an acquirer is not permitted at all.

A foreign investor intending to acquire shares (or participation interests) or which has acquired shares as a result of a share capital increase in a Russian strategic company is responsible for making a filing. A filing pursuant to the Strategic Industries Law must be made by a foreign state or an international organisation (or a legal entity controlled by a foreign state or an international organisation) even if the target is not a strategic company.

A filing under the Strategic Industries Law is made through the Federal Antimonopoly Service (FAS) but the decision is taken by the Strategic Investment Government Commission. The Strategic Industries Law and the related amendments to other federal laws (in particular, the Subsoil Law) were adopted in May 2008, on the verge of the financial crisis and have been generally viewed as a significant additional obstacle to the flow of foreign investment into Russia.

However, the Strategic Industries Law has not been significantly changed since its introduction, despite the numerous statements made by government officials that the regime needs significant liberalisation, especially in relation to the development of natural resources.

Merger control

According to merger control rules incorporated in the Law on Protection of Competition, any direct or indirect acquisition of shares in a Russian company, any merger or joining of commercial organisations or formation of new commercial organisations capitalised with shares or assets of another commercial organisation may be subject to FAS clearance. Clearance will be required if the intended acquisition would result in the acquirer's ownership interest increasing above 25%, 50% or 75% of the voting shares in a joint stock company; or above one-third, a half or two-thirds of the participation interest in a limited liability company.

It is important to note that the concept of "acquisition of shares" is very broadly interpreted by the FAS and includes the granting of general proxies (providing for the right to vote shares without prior instructions of the shareholder), the entering into of management agreements, and shareholders agreements which provide for the right of one shareholder to vote shares or to direct other shareholders how to their vote shares.

Licensing

In May 2011, the new Law on Licensing of Certain Types of Activities (Licensing Law) was adopted. The Licensing Law will, in November 2011, replace the current law on the same subject and amend the list of activities that are subject to licensing. There are very few activities for which the licensing requirement has been abolished.

However, the Licensing Law does incorporate a number of novelties. In particular, it establishes an exhaustive list of objectives of licensing (such as prevention of damage to the rights, interests, lives and health of citizens and the environment, objects of cultural heritage, security and safety of the state) and prohibits the introduction of other licensing activities other than those provided in the Licensing Law. It introduces the principle of unlimited term of a licence and unified rules for the application, review and granting of licences.

A licence is personal and cannot be generally transferred except in certain limited cases of corporate reorganisations. A licence must be re-registered in the event of certain corporate changes (such as, for example, change of name or address, or transformation into a new form of a legal entity) and is valid over the entire territory of the Russian Federation.

The Licensing Law sets forth an exhaustive list of 49 activities that are subject to licensing and also lists those activities that are not governed by the Licensing Law but are subject to other federal laws. Any company whose activities are subject to licensing should be vigilant of the changes that are to be introduced by the Licensing Law.

Immoveable property

According to the Civil Code, immoveable property, and practically any transaction involving it, requires state registration. Registration of a new property takes about 45 days; registration of a transaction takes about 30 days (the term may be extended in case there is information at the registration authority of a title dispute or the registration authority has questions).

The main source of state registrations is the Unified State Register of Rights to Immoveable Property and Transactions with It. Its content is partially publicly available upon written request filed in person or on the web page of the Federal State Registration Service, Cadastre and Cartography on the internet. The system of this state registration has significantly improved over the last few years, and measures have been undertaken to unify and combine databases of land, buildings and constructions and related rights and encumbrances.

Labour law

Employment relations are governed primarily by the Labour Code of the Russian Federation, which applies to all employment relations if the working place is Russia. In terms of minimum guarantees or benefits provided to employees, the Labour Code prevails over the terms of an individual employment contract or an internal company employment policy. It is aimed at protecting employees and renders it very difficult to terminate underperforming employees.

Even in cases of disciplinary violations, an employer should document the violation extremely carefully in order to support the termination of employment in court should a dismissed employee file a claim. A significant incentive for employees in Russia to terminate employment with a settlement agreement is the so-called labour book, which records all previous employments and grounds for termination. Labour books must be provided to each subsequent employer.

Subject to certain limited exceptions, to work in Russia foreign employees must have an individual work permit. Employers have the right to employ non-Russian citizens only if they hold permits to employ foreign personnel. Such permits are generally subject to quotas and must be applied for well in advance (before May 1 of the previous calendar year). Employment of foreign personnel without a permit may result in significant penalties. The term of such permits is typically one year and they are usually related to a specific region. The rules applicable to highly qualified foreign personnel are less strict.

Settlement of disputes

Disputes with participation of foreign investors may be settled in the state arbitration courts (the state commercial courts – the word 'arbitration' in the name of these courts is historical and should not be confused with true arbitration) or in international commercial arbitration. Russia has implemented the Law on International Commercial Arbitration which is based on the UNCITRAL Model Law and under which any disputes of a commercial nature that involve a foreign party or commercial disputes where at least one party is a Russian company with foreign investments may be referred to international commercial arbitration.

An arbitration agreement is mandatory for referral of disputes to international commercial arbitration and it must be in writing. There are certain exceptions, including for example, insolvency proceedings, disputes about registration, reorganisation or liquidation of companies, disputes between companies and their shareholders, and competition issues.

An arbitral award rendered by a tribunal in Russia may be set aside by the state arbitration court. Enforcement of foreign arbitral awards is conducted through state arbitration courts.

Risk factors

Alleged corruption within government and, in particular, law enforcement bodies and the lack of an accountable, competent and reliable court system are the main problems that Russia faces in attempting to secure increased levels of foreign direct investment. Some businesses and individuals do not trust the government and law enforcers, and generally view them not as protective, but as dangerous factors.

Small and mid-sized businesses are unable to oppose extortion by government officers. Some achievements have been made recently in making Russian arbitration courts (courts for commercial disputes) more transparent and accountable and the Government appears to be taking some steps to take measures against corruption.

Rules limiting various audits and investigations of businesses have been introduced, and an attempted reform of the Russian militia into a contemporary police force has been launched. Russia still has to go a long way to transform, however.

The political uncertainly in Russia associated with the upcoming presidential elections in March 2012 appears to be one of the main risk factors and the reasons for persistent capital outflow. With the announcement of the presidential candidates, the related political risk should be reduced.

About the author

Natalya Morozova is the managing partner of Vinson & Elkins’ Moscow office. She has extensive experience in complex international mergers and acquisitions, private equity investments, securities transactions and other corporate and project development transactions, with a principal focus on the energy/natural resources sector. Her practice has also involved many of the high-profile issues shaping Russia’s corporate environment in recent years including protection of minority shareholders, creating joint ventures and structuring corporate relationships between Russian and non-Russian shareholders.

Morozova is recognised as a leading lawyer by several well-known legal publications.

Contact information

Natalya Morozova
Vinson & Elkins

Lesnaya Plaza
4th Lesnoy Pereulok, 4
4th Floor
125047 Moscow Russia
T:  +7.495.544.5800
F:  +7.495.544.5801
E: nmorozova@velaw.com
W: www.velaw.com

About the author

DmRob Patterson formerly served as co-managing partner in Vinson & Elkins’ Moscow office, and is primarily an energy transactional lawyer, with a broad practice that includes cross-border mergers and acquisitions and the development and financing of international energy and infrastructure projects. In addition to his extensive knowledge of the energy sector, he has substantial experience advising on broader corporate and commercial matters, including M&A transactions, joint ventures, financings, corporate reorganisations, and a wide range of commercial contracts.

Patterson is an English-qualified solicitor who has been recommended "for his cross-border mergers and acquisitions, development and project financing work" in a leading directory of oil and gas lawyers.

Contact information

Rob Patterson
Vinson & Elkins

Lesnaya Plaza
4th Lesnoy Pereulok, 4
4th Floor
125047 Moscow Russia
T:  +7.495.544.5800
F:  +7.495.544.5801
E: rpatterson@velaw.com
W: www.velaw.com