Anton Sitnikov and Ian Ivory of Goltsblat BLP (the Russian practice of Berwin Leighton Paisner) answer some key legal questions on investing in the Russian M&A market
Since the global financial crisis, Russian M&A deal volume has significantly reduced, but there has been a pick-up over the past 12 to 18 months, particularly in key industry sectors such as energy and natural resources, commodities and telecoms. There have been a mixture of public and private M&A transactions, including some very high-profile ones such as the TNK-BP sale to Rosneft.
The trend is towards Russian to Russian deals, or deals where international investors are divesting or selling down their holdings. The absence of large international financing transactions persists and the IPO market (and the associated M&A activity that this usually generates) remains muted.
Russian public M&A deals are structured in a similar way to private deals: either as a direct acquisition of shares in a target or an acquisition of a holding entity. The latter route is more popular on the market. There are discussed and expected case developments that would suggest that, regardless of the structure chosen, takeover requirements need to be observed. Those include, among others, voluntary or compulsory buyout offers when exceeding 30%, 50% or 75% of voting shares, and possible squeeze-out of minorities when exceeding the 95% threshold.
Private M&A is usually structured either as a direct purchase of Russian shares or as an acquisition of a so-called offshore holding company structure (usually in Cyprus or BVI) which in turn holds the Russian subsidiary, trading operations and/or business and assets.
In the case of a direct purchase of the Russian shares, in almost all cases a Russian law-governed sale and purchase agreement is used (particularly where a Russian notary needs to be involved to notarise the transaction). Such transactions are often supplemented with a foreign law-governed framework agreement and/or deed of warranty (usually under English law) in order to cover some of the typical provisions on M&A deals which are not yet fully developed or recognised under Russian law or by the Russian courts. These can include warranties and indemnities, conditions precedent, escrow arrangements, completion accounts, restrictive covenants, put and call options, tag and drag provisions, and so on. Such deal structuring arrangements, while common in recent years, are not risk free and are increasingly subject to challenge in the Russian courts.
Direct purchases of Russian businesses and assets (as opposed to shares) are less common, since these tend to be difficult and time-consuming to structure, require multiple transfers and third-party consents and are usually not so tax efficient.
In cases where the offshore holding company is acquired, the sale and purchase agreement will usually be governed by English law and will contain the full set of provisions you would expect to see on a typical M&A deal.
There are a number of sources of publicly available information on Russian companies.
The Unified State Register of Entities is maintained by the Russian Federal Tax Service, which is responsible for registration of Russian legal entities. Information on the register includes the company name; addresses including branches and representative offices; the general director; types of business activity; licences; authorised capital; founders; participants, their shares and any encumbrances (for joint-stock companies); information about company registration; and copies of constituent documents and quarterly information on the net asset value of joint-stock companies. Most of the information is publicly available, save for individuals' personal data and bank account details.
A limited amount of information on the state registration of companies is available on the website of the Russian Federal Tax Service (www.nalog.ru). Information on a decision of the registering authority to delete a dormant legal entity from the register can also be found here.
The Unified State Registers of accredited branches and representative offices of foreign companies are maintained by the Russian State Registration Chamber. These registers include limited information on the representative offices/branches and their overseas headquarters, such as addresses, phone numbers, activities and managers as well as information on accreditation.
Meanwhile, the Unified State Register of Real Estate Rights and Transactions is maintained by the Russian Federal Service for State Registration, Cadastre and Cartography and includes information on real estate in Russia, its owners, leaseholders (for leases of one year or more), encumbrances, and so on. An extract including information on specific residential and non-residential property is available to any interested person within five days of a request. Some information is available electronically at https://rosreestr.ru/wps/portal.
In terms of IP, the Rospatent and WIPO databases include information about owners and licensees of trade marks and patents. Electronic databases are available to the public at www.fips.ru and www.wipo.org. The WHOIS database available on the internet includes information about owners of domain names.
The Russian Federation Supreme Arbitrazh Court maintains an electronic database of arbitrazh cases which contains limited information about cases considered by state arbitrazh courts in Russia since 1996. Information is available on the internet at www.arbitr.ru.
The state registration bulletin publishes official announcements of decisions passed by legal entities on their liquidation, reorganisation, reduction of their authorised capital, announcements on acquisition of more than 20% of business entities' shares, information on net asset value and other statutory announcements published by legal entities. Information is available on the internet at www.vestnik-gosreg.ru.
The Kommersant newspaper is a resource authorised to publish bankruptcy announcements, the information being available on the internet at www.kommersant.ru.
There are also several business information agencies operating in Russia, such as SPARK (www.spark.interfax.ru), that provide a limited scope of information about business entities, including information from the Unified State Register of Legal Entities, limited financial and statistical information on the basis of the State Statistics Service database, and other information disclosed by the entity.
Finally, available legal databases include ConsultantPlus and Garant. These are useful for research where, for example, the target is a governmental entity or subject to special regulation. Particular court rulings may also be available.
While in general, due diligence on Russian companies tends to be within the same scope as any M&A deal, the following general aspects need to be taken into account: the limited number of public searches available and, if the deal is to be structured within Russian law only, the effective position of the courts tends to be pro-seller, not allowing for effective use of warranties with regards to underlying assets, indemnity provisions and suchlike. This means that due diligence review is not a mere exercise, but an important venture which cannot be overestimated. As to some particular things to keep an eye on, the following are worth noting.
First, a Russian company must have a net asset value (this calculation roughly comprises assets less liabilities as reported in financial statements) of no less than its authorised capital. Should the net asset value at the end of two years (not at the end of the first year) be less than the authorised capital, the company is required to either decrease its authorised capital or decide to liquidate. In such circumstances the company's creditors are entitled to require acceleration or early termination of the company's obligations. Should the company fail to either decrease its capital or opt for liquidation, the registering authority is also entitled to file a claim seeking to liquidate the company, although in practice this happens rarely.
The second consideration is the 1-1-1 rule for company structures. A Russian company cannot be 100% owned by another company if that company is, in turn, also 100% owned by another entity or person. In practice, a notary may refuse to certify a transaction which will lead to a breach of this rule, in cases where such certification is required (for example where 100% of a limited liability company is acquired by an entity which has a single shareholder).
Thirdly, as a general rule, where one spouse enters into a transaction dealing with the common property of the spouses, it is assumed that he/she is acting with the other spouse's consent. Even so, a written consent of the other spouse certified by notary is required for transactions for disposition of real estate, transactions which are subject to notarial certification (such as contracts for sale and purchase of shares in a limited liability company) and transactions which are subject to state registration. For all other assets, the cautious approach is to obtain spousal consent.
Fourthly, a general director is the sole executive body for a Russian company and by default has very wide powers to engage in transactions on the company's behalf. The powers of the general director may be limited by requiring approval of particular decisions or transactions by a general shareholders' meeting, the board of directors or the collective executive body of the company (in addition to such limitations provided for by law, such as major and interested party transactions). Nevertheless, the powers of this office are broad and need to be reviewed and verified in much greater detail than would be necessary in most western jurisdictions.
Acquisitions are subject to anti-monopoly control with the Russian Federal Anti-Monopoly Service (FAS) when certain control thresholds are reached. This also applies to indirect acquisitions through offshore holding companies. Intra-group transfers can also be caught by this, but usually have more preferential compliance treatment options. There are also various thresholds related to combined asset values, revenues and market share, but in practice the tests are quite stringent and most transactions are subject to an advanced clearance procedure. This usually takes approximately 30 days, subject to extension by FAS.
In the case of strategic companies, being those which are engaged in various activities relating to certain energy, infrastructure, defence, etc. industries, foreign investors are also required to seek advanced clearance before acquiring certain control thresholds. Foreign states and internationally controlled organisations are also subject to foreign investment laws.
The due diligence process on Russian deals tends to be extensive. This is driven by various different factors, including those mentioned above. A number of Russian businesses have complex ownership chains and histories. Verifying compliance with laws and regulations can be difficult where the legislation itself is sometimes confusing and subject to interpretation and differing opinions. There is also a strong desire from purchasers to identify and deal with problems up front in the pricing mechanism, rather than relying on the uncertainty of bringing and then enforcing a claim after completion. For the same reasons, the warranties and the disclosures relating to them are usually heavily negotiated.
Purchasers will usually seek indemnities for tax and environmental matters. Other areas, such as previous corporate reorganisations, tax planning schemes and specific issues arising from due diligence may also be added to the negotiations on indemnities. Parties sometimes agree to indemnities related to title for certain assets that are key to the business of the target. There is no market standard for whether or not to give warranties on an indemnity basis and this is a matter for negotiation.
Most deals are for cash consideration. Share consideration and loan notes are not common. The consideration will usually be subject to a completion accounts mechanism and an escrow account hold-back to cover warranty and indemnity claims. Earn out mechanisms are sometimes also used. Any deferred payments from the purchaser will usually be placed into escrow or covered by a parent or bank guarantee. Purchasers sometimes also use put and call options as a potential remedy to return the shares and get their money back in agreed circumstances.
Many Russian sellers will try to include the indemnities within many of the limitations on liability that apply to the warranties. This is a matter for negotiation. Many sellers also want time and financial caps to apply to any and all claims under the sale and purchase agreement, not just the warranties and indemnities.
One key point is that Russian law does not recognise the concept of escrow, and so any escrow/retention arrangements relating to the purchase price and warranties are structured outside of Russia and under English law.
For various legal, regulatory and risk management reasons, the Russian offices of international law firms do not hold client accounts in Russia and so the mechanics of payment of the purchase price and transfer of the shares at completion need to be carefully structured, particularly where the transfer takes immediate effect on notarisation. This normally involves either an escrow arrangement under English law or the delivery of a bank letter of credit at the completion meeting.
Another point is that restrictive covenants are difficult to structure under Russian law and it is very difficult to successfully enforce an English law restrictive covenant in Russia. Injunctions and orders for specific performance are also difficult to obtain and/or enforce. Where restrictive covenants are included into the English law sale and purchase agreement, the purchaser will usually look to bring a monetary claim against an escrow or assets outside of Russia in the case of breach.
In regard to waivers, the general position under Russian law is that a person cannot waive his/her rights at law. This can be problematic in the case of directors resigning at completion and being asked to waive their rights and entitlements to bring employment claims.
Where an English law sale and purchase agreement is used, there will usually be an arbitration clause (rather than the jurisdiction of the English courts) because Russia is a signatory to the 1958 New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards. There is no agreed protocol for recognition of English court judgments in Russia and so the position with these is much more uncertain.
Following a recent ruling, it is vital that the arbitration clause is symmetrical – that it gives equal rights to both parties – otherwise there is a real risk that the Russian courts will deem the clause to be invalid and will instead rule that any disputes relating to the agreement must be heard in the Russian courts.
Recent case developments also suggest that transactions with regard to Russian shares cannot be made subject to arbitration and thus must be heard in Russian state Arbitrazh courts. This has been quite an unexpected development and there are hopes that this practice will change back.
Another point is that a currency conversion clause is often needed where the price is calculated in one currency (often US dollars), but the underlying revenues, and so on, which may the subject of a calculation or deduction (such as in the completion accounts, an earn out mechanism or a warranty claim) are in Russian roubles.
Finally, the sale and purchase agreement will often be in both English and Russian and it is important to expressly state which language will take precedence in the event of an inconsistency. It is also necessary to stipulate the correct language for notices under the agreement, including any attachments. This is important if a dispute arises and there are large amounts of supporting documents relating to the dispute which require translation.
There is no market standard. Under Russian law the general period for bringing claims is three years, although special shorter and longer terms are provided in certain cases by law. The period for tax claims is usually three to four years, which is linked to the time during which the Russian tax authorities can usually reopen tax assessments for earlier periods.
These periods are not absolute, however. Many deals will involve offshore structures where the time periods for claims (such as for tax) may need to be longer. International buyers may expect longer periods in some cases, and different statutory time limits may also apply depending on the choice of governing law for the contract, unless these are expressly reduced.
As mentioned above, deeds of warranty, framework agreements and put and call options under English law are sometimes used. Financing documents can be under Russian or English law, depending on the circumstances, and English law-governed LMA-style loan documentation is often used. The security for Russian assets will be governed by Russian law. There are also various types of transactions (such as direct transfers of real estate, employment arrangements) where Russian law must be used.
Shareholders' agreements for Russian companies must generally be governed by Russian law to avoid potential challenges in the Russian courts. This does reduce the flexibility of the parties to agree commercial terms, since a number of legal provisions such as tag and drag rights, deadlock and shoot-out provisions, good/bad leaver, and so on, are difficult to structure under Russian law and/or are not fully tested in the Russian courts.
At an offshore level where the holding company in question is not Russian, the shareholders' agreement is usually governed by English law and structured along the usual lines you would expect to see for an English shareholders' agreement. As mentioned above, there are issues with enforcing injunctions and specific performance in Russia, and so structuring the shareholders' agreement at an offshore level is also an attractive one if one party needs to specifically enforce its rights under a drag along or call option and is not satisfied with just receiving a damages award.
Having said this, the Russian government is pushing hard to limit the use of foreign laws and offshore structures in relation to Russian deals. Where the transaction is essentially Russian to Russian, any attempt to artificially introduce a foreign element is frowned upon and subject to challenge in the courts. In the case of Russian government bodies and state-owned enterprises, they are often required to use Russian law in most cases.