Rules for investing in Russian strategic companies.

12.09.2011

Practical Law Сompany (PLC).

In 2011 Russia's large consumer market still seems attractive but foreign businesses are discouraged by the costs and complex bureaucratic procedures and legal uncertainty they face. They often do not make enough short-term profit for it to be worth investing in the first place. According to estimates from Renaissance Capital, it costs around 34% more to build a distribution centre in Moscow than it does in London, and it takes six times longer to obtain a construction permit in Russia than it does in Sweden.

The government has always considered foreign investment in the country as a top priority. In the early 1990s, Russia determined that the legal regime for foreign investor activities and profit allocation should be no less favourable than that applied to local investors, except for some specific exceptions determined by federal laws. The exceptions were not extensive and concerned the banking and insurance sectors, as well as the aviation industry. There was never any question of restraining foreign investment in Russia.

To strengthen the independence of the Russian economy and establish the country's sovereignty, systematic steps have been taken to develop special regulatory standards for foreign investment. Law 57-FZ on foreign investment in strategically important companies in the fields of national defence and security was eventually passed in April 2008 (Law). There have been some concerns raised about the Law, and various amendments to remedy defects in it have been proposed. Against this background, this article examines:

  • Key features of the Law.
  • Defects in the Law.
  • Amendments to the Law.
  • Further problems and amendments.
  • The Law in practice.

The Law

Foreign companies, both those already in Russia and those ready to invest in Russia, have expressed concerns about the Law. In addition to maintaining restrictions in the banking and insurance sectors, the Law has introduced a special approval procedure for foreign investment in another 42 sectors considered strategic by the government.

These include:

  • Radioactive substances and nuclear facilities.
  • Aerospace activities.
  • Oil and gas pipeline transport.
  • Rail transport.
  • Transport terminal services.
  • Exploration and mining in subsoil sectors of federal significance.
  • Television and radio broadcasting.
  • Editing and publishing of large circulation periodicals.

Under the Law, a foreign investor intending to exceed specific limits for capital subscription to, or gain control of, a strategic company, must obtain prior approval from a special government commission, the Government Commission for Control of Foreign Investment in the Russian Federation (Foreign Investment Commission). The Law also applies to transactions concluded outside Russia, if they might lead to control of Russian strategic companies.

Defects in the Law

There has been some suspicion of the Law, although other parties have queried how justified this suspicion is. Looking at its application over the last two years, it does not seem to create unnecessary obstacles for foreign participants in Russian strategic companies. However, practice has identified a number of defects in the Law, and the government recognises the need to revise parts of it.

The control exercised by the government under the Law should be limited by the fact that a foreign investor may not necessarily be investing in a strategic industry. However, it is difficult to identify whether a company is in a strategic industry or not (due to different interpretations of certain types of activity). The provisions when non-strategic companies take on strategic activities (such as banks that codify their information) are far from satisfactory.

The Law has made foreign investment in banking somewhat more complicated. To ensure secure data transfer through client-bank and internet-bank systems, credit institutions, especially banks, must now obtain licences from the Federal Security Service to use cryptographic devices and service them. Consequently, since the Law came into effect, even small banks have been classed as business entities of strategic importance for national defence and state security.

In practice, foreign investors acquiring a controlling stake in a Russian medium-sized bank must obtain approval for the transaction from the following authorities:

  • The Foreign Investment Commission.
  • The Anti-monopoly Service.
  • The Bank of Russia.

This means approval of a transaction is delayed by several months, with the investor incurring additional costs.

According to the Law, the Anti-monopoly Service can reject transactions involving foreign investors acquiring control over Russian banks. In such cases, Russian banks whose shares/participatory interests are the subject matter of the transaction have given up their licences to carry out cryptographic activities before the transaction, and then re-applied for their licence after the transaction.

In 2010/2011, defects in the Law were pointed out by many experts. The focus has shifted to how to remedy them.

Amendments to the Law

The Anti-monopoly Service and the Ministry of Natural Resources are working on amendments to the Law. The most pressing issues are, in the author's opinion:

  • Reducing the list of strategic activities.
  • Facilitating foreign investor access to Russian mineral resources.
  • Reducing the number of documents and other information that investors must submit for deal approval.

Some of these amendments have recently reached the legislative body (the State Duma). In March 2011, the State Duma passed draft amendments to the Law at the first reading. In particular, the draft law excludes work involving pathogenicity group IV infectious agents, and operation of radiation sources, from the list of strategic activities. In addition, subsoil use transactions carried out as part of another activity are exempt from regulation under the Law, provided there is no increase in the foreign investor's share in the subsoil user.

The draft law proposes liberalising the acquisition by foreign investors of control over Russian banks in which the Russian Federation has no share participation. At the same time, transactions involving acquisition of control over major state-owned banks will still require approval by the Foreign Investment Commission. The draft law will also introduce changes to specify the transaction approval procedures provided by the Law.

However, it seems that not all the amendments to be introduced by the draft law aim to reduce administrative barriers. For instance, the Ministry of Defence will be authorised to issue opinions about a potential threat to Russia's defence capacity from a proposed transaction. The time limit for the Federal Security Service and the Ministry of Defence to prepare opinions on whether a transaction affects Russia's defence capacity and state security is to be extended from 20 to 30 days (without changing the general time limits for considering applications).

The draft law also extends the time for concluding agreements between the Anti-monopoly Service and the applicant foreign investor by up to 30 days, if the Foreign Investment Commission approves the transaction, subject to conduct-related conditions. According to a spokesman from the Anti-monopoly Service, the amendments generally aim to simplify a number of procedures for foreign investors.

However, it is important to wait and see what the final version of the draft law looks like before giving opinions. A number of other amendments are anticipated and their contents have not been disclosed.

Further problems and amendments

In the meantime, application of the Law has revealed some other problems. The Law applies to acquisition of control over Russian strategic entities not only by foreign investors but also by groups of persons including foreign investors. A foreign investor may specifically create a Russian company to evade the Law. To avoid this, the Law includes limits on acquisitions not only by foreign investors but also by the group to which they belong.

The resulting problem is that the mere fact of a foreign legal entity belonging to the acquiring group of persons means, in relation to acquisition of control over a strategic entity, that approval must be obtained from government authorities under the Law. Large Russian companies have been facing a number of difficulties connected with this provision.

Some minor amendments to the Law came into effect on 1 July 2011. In theory, they provide applicants with several advantages. For example, if a Russian applicant fails to attach a required document from the Unified State Register of Legal Entities or Private Entrepreneurs to an application for prior approval of a transaction sent to the Anti-monopoly Service, the information is provided to the Anti-monopoly Service by an inter-agency request to the Unified State Register of Legal Entities or Private Entrepreneurs.

The government is generally considering further improvements to the Law. The Prime Minister, Vladimir Putin, has pointed out that gaps allowing some participants in economic activities to evade the law and not obtain approvals for transactions with strategic assets should be closed. However, the decision-making procedure should be simplified and made easier for bona fide investors.

The Law in practice

The Law does function in practice. In particular, in 2010, the Foreign Investment Commission considered 57 transactions applications and refused to approve only three transactions. Therefore, the Foreign Investment Commission cannot be said to be a barrier to investment inflow. It is undoubtedly striving to strike a balance between strategic interests of the state and a favourable investment climate. Is there a contradiction between the two? Not really, if we look at the global practice and the experience of developed countries.

It is worth noting one of the first cases when the Law was applied. In 2009, the Foreign Investment Commission received an application from Basic Element for prior approval of transactions involving the acquisition of shares in the Russian oil company, NK Russneft. The application was filed on behalf of Basic Element by one of its affiliates registered in a foreign jurisdiction (En+ Group).

The Foreign Investment Commission planned to consider the application, but postponed it because a number of mandatory documents were not submitted. The transaction is subject to the Law because one of the oil fields involved (Varieganskoye) is classed as being of federal strategic importance.

In the last few months, the Foreign Investment Commission has been considering two applications relating to the acquisition of RussNeft by companies in Basic Element's corporate group and by Glencore. According to different sources, Basic Element has already purchased shares in RussNeft. However, since it is not possible to obtain the Foreign Investment Commission's approval and due to financial problems, Basic Element cannot complete the transaction, and is currently considering disposing of the acquired stake.

In general, it is not yet possible to judge the effectiveness of the Law or its negative impact on investments. There is not yet any relevant court practice.

Ultimately, the government aims to maintain the interest of foreign investors in the Russian markets by all possible means. It will therefore do its best to stabilise the economy, working in a variety of areas. Positive trends can already be seen as a result of its efforts, from both a legal and an economic perspective. The latest Eurobond issue is a benchmark example. Russia's launch of its first bonds on international markets since the 1998 crisis was a success, and this will definitely stimulate further foreign investment.

The draft federal law on liability of members of governing bodies which provides for optimisation of their position for the benefit of shareholders and other participants might also facilitate adoption of international standards for foreign investments into Russia.

Contact details

For all issues related to publications, news and press releases, please contact:

Ksenia Soboleva

Head of PR and Communications

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