Chasing the bear – Sanctions bite on Russia’s legal market

10.11.2014

Legal Business

As US and EU-led sanctions take their toll on Russia, Legal Business speaks to the country’s leading lawyers to discover whether any opportunities can be salvaged from the crisis.

Russia-based lawyers are a hardy bunch, conditioned to working in a volatile market where ups turn into downs on an almost annual basis. No matter how good things might appear, they are well aware that some form of political interference or economic disaster might be lurking around the corner. Most get by on the knowledge that Russia’s lucrative market is remarkably robust and that in the long term it always seems to bounce back.

Yet, even for the most seasoned western lawyers who went through the Russian sovereign debt default of 1998, the events of 2014 are proving an altogether different experience. While previous Russian misdemeanours were largely tolerated – be it the Russo-Georgian war of 2008 or the politically motivated imprisonment of Mikhail Khodorkovsky in 2003 and the subsequent dissolution of Yukos – it has been impossible for the West to ignore Russia’s actions in Ukraine. Russia’s annexation of Crimea in March 2014, the subsequent war and support of separatists in Ukraine’s eastern Donbass region, and the inevitable ratcheting up of economic sanctions from the US, EU and other western states, has led to a situation so intractable that few can see an obvious way out.

‘We’ve imposed sanctions on Russia for engagement in a conflict where they don’t even admit they are there,’ says the Moscow managing partner of one global law firm. ‘Which begs the question that if they don’t admit they’re even there, then how are you going to set a trigger which they then satisfy to help release the sanctions? It’s a bit of a Catch 22.’

The recent arrest of Vladimir Yevtushenkov, the oligarch and owner of the Russian conglomerate Sistema, following allegations of money laundering, has shaken confidence even further, contributing to a sense of unease about where this combined political and economic crisis might be heading. As a result, many international firms in Moscow would only speak to Legal Business on condition of anonymity, while other firms usually quick to provide a sound-bite on developments in countries where they are active, including Skadden, Arps, Slate, Meagher & Flom and White & Case, have been uncharacteristically quiet on Russia.

‘There is no point in spinning this really,’ says another Moscow managing partner. ‘I’ve been here since the Yeltsin years, and I have to say it’s never been as bad as this. In terms of overall economic impact, international reputational damage, attitude of Russians, a potential brain drain, it’s just bad on every level.’

‘People are really depressed unlike before, because in the past there was a sense that we’d get out of it,’ adds the office head of one US firm. ‘Now it’s such a huge political issue. It’s the trust issue. When one party has lied to the other, and the credibility and the trust has been destroyed, it takes years to rebuild that.’

Known unknowns

Aside from the huge human cost and political upheaval that have arisen from the crisis, the subsequent US and EU economic sanctions are also hammering the business market.

‘Most of our Russian clients do not have good expectations about the long-term effect of the sanctions, and many believe that worse is yet to come,’ says Evgeny Zhilin, managing partner of Russia’s YUST Law Firm. ‘A few of our international clients have decided to postpone their Russian projects. Generally, M&A is down, capital markets is almost zero.’

The sanctions, which started in March 2014, initially targeted Russian politicians and businessmen working within President Vladimir Putin’s inner circle, as well as certain government-linked institutions such as Rossiya Bank.

‘The initial set of sanctions had more of a psychological and political than an actual economic effect,’ says Vladislav Zabrodin, managing partner of the Russian law firm, Capital Legal Services. ‘The latest package of sanctions, related to a substantial reduction of financing and specifically related to sectoral sanctions, was more significant.’

The most painful sanctions have undoubtedly been the debt financing restrictions on Russia’s largest banks – Gazprombank, Bank of Moscow, Russian Agricultural Bank, Sberbank, Vnesheconombank (VEB) and VTB Bank – whereby any external credit they receive is limited to 30 days’ maturity. This has inevitably hit the capital markets practices of several major firms based in Moscow, both as issuer’s and arranger’s counsel, including White & Case, Morgan, Lewis & Bockius, Clifford Chance (CC), Allen & Overy and Linklaters (for a more detailed table of who acts for who, see ‘Sanctioned Markets’). The financing restrictions don’t just apply to the banks, and western financiers are approaching Russian borrowers with caution, regardless of whether they are sanctioned or not.

‘We do a lot of due diligence work and many projects were suspended,’ says Eleonora Sergeeva, deputy managing partner of the Russian law firm, Padva & Partners. ‘We have clients who have honestly said to us that they can’t pay the whole bill and asked for some reductions because they had investment from the US and their credit lines have been suspended.’

Damaging prohibitions have also been introduced on the export of goods and services to five Russian energy companies – Gazprom, Gazprom Neft, Lukoil, Surgutneftegas, and Rosneft – that might support the exploration or production of Russian deepwater, Arctic offshore or shale projects. Certain high-profile projects have been put on hold as a result, most notably for ExxonMobil, which must wind down its multibillion-dollar Arctic oil joint venture with Rosneft in the Kara Sea, a $3.2bn deal that was signed back in 2011, with Freshfields Bruckhaus Deringer advising Rosneft and Skadden Arps advising ExxonMobil. Rosneft has been a lucrative source of projects and M&A work for several firms, including Freshfields and Linklaters, which both advised Rosneft on exploration deals with Statoil, as well as Cleary Gottlieb Steen & Hamilton, which advised Rosneft on its acquisition of BP’s stake in its Russian joint venture company, TNK-BP. Royal Dutch Shell has also had to put on hold the joint exploration and development of two offshore Arctic blocks which it agreed with Gazprom Neft, a deal in which Morgan Lewis advised the Russians.

In addition, energy companies including Novatek, Rosneft, Gazprom Neft and Transneft are also not allowed to raise debt with more than 90 days’ maturity. This has hit several project financings that these companies have been involved in, including the $20bn plus Yamal LNG joint venture project, in which Novatek had a 60% stake, and in which Latham & Watkins and White & Case advised the sponsor company (Yamal LNG) and lenders respectively. In these instances the projects will continue, but much of the funding will have to come from the project company’s shareholders – including Novatek, Total and China National Petroleum Corporation – or from lenders unaffected by the sanctions, such as the Chinese banks.

Even though these sanctions are quite targeted, the bigger problem for the business community, however, comes from the collateral damage that the sanctions have caused to sectors and entities not specifically targeted.

‘The sanctions are actually quite specific and limited to certain projects, but that said, while the direct effect of the sanctions might not be as widespread as people perceive, the indirect effect is,’ says Rick Burdick, chair of Akin Gump Strauss Hauer & Feld’s global energy and transaction group and managing partner for the firm’s international offices. ‘They create uncertainty in the market place and the question is: what is next?’

The fact that the most recent round of US sanctions included companies that aren’t state-owned, such as Lukoil, which is a major client for Akin Gump, certainly raised concerns that the net would be cast much wider than just those entities linked to Putin and the Russian state.

‘Part of the issue over recent months has been that every few weeks a new raft of sanctions have come out and international investors sit back and think: “We’ll hold off Russia business because the guy/company that’s not on the list this month might be on the list next month,”’ says Chris Allen managing partner of Latham & Watkins’ Moscow office. ‘People are spooked and thus indirectly the whole market is affected.

‘We are cautiously optimistic sanctions will at least not worsen and that market participants will get used to the “new normal” and start to appreciate and look at the various Russian companies that are not sanctioned and are in pretty good shape. If that occurs we should start seeing some decent pockets of transactional activity developing in the coming months. Clearly an unwinding of sanctions would be even better.’

Illiquid assets

Deals are certainly being done and many projects in sectors untouched by the sanctions, such as retail, mining and natural gas, continue, albeit with more caution when it comes to structuring contracts.

‘We see the effect on contracts where there are sanctions clauses being put in,’ says Stefan Weber, head of Noerr’s Moscow office. ‘In general, foreign investors request more flexibility than in the past, reserving for themselves more opportunities to walk away from the project.’

Even in the debt sphere, a recent restructuring by Rusal of $5.15bn of pre-export finance term facilities, in which Cleary Gottlieb and CC advised Rusal and the creditors respectively, illustrates that finance deals can still be pushed through.

There is also hope that investment from Asia, particularly China and South Korea, will pick up some of the slack. ‘Recent events are only strengthening the trend that Russia’s focus in terms of foreign trade is shifting eastwards,’ says Sergey Pepeliaev, managing partner of the Pepeliaev Group. ‘We have already handled a number of successful projects in this area.’

Even though there is increased interest from China, most agree that it won’t be enough to fully substitute the freeze in money coming from the west. Replacing decades-old relationships that were nurtured with western business partners cannot happen overnight.

‘I don’t think the Hong Kong dollar is going to substitute the US dollar when it comes to financing,’ says Andrey Goltsblat, managing partner of Goltsblat BLP, the Russian practice of Berwin Leighton Paisner. ‘Everyone is shouting: “We’re going east!”, but there is not enough clarity and understanding of the projects. If you have built up relations over years, how can you change the attitudes and language skills? That will take time. We have to understand the east, but it’s not going to be as easy as with the west.’

Moscow offices with strong restructuring and insolvency practices are also preparing for swathes of debt that are due to be refinanced in the coming year. The problems currently faced by the Russian mining and metals company, Mechel, a significant client of CMS, which is struggling to refinance $8.7bn of debt, indicate that less liquidity in the market is having an effect.

‘The interesting question is what happens next year as a lot of the existing debts become due for refinancing,’ says Logan Wright, managing partner of CC’s Moscow office. ‘Some of that debt will be sitting with sanctioned entities and therefore the banks involved won’t be allowed to refinance it. And the Russian banks won’t have sufficient liquidity to refinance every deal.’

Another seemingly unlikely source of work for some firms is from Ukrainian and international companies seeking to offload assets located in the Crimea. ‘Despite the turbulence, we keep good ties with our friends among Kiev law firms,’ says Andrei Gusev, managing partner of Borenius’s office in St Petersburg. ‘From time to time I’m approached by them about selling assets in Crimea and if we can work together with them. The tricky question is which law you apply: sometimes both Russian and Ukrainian law should be applied for the sale to be recognised locally and internationally. As an office of a European law firm, because of the sanctions I can work for the sellers and not for the buyers.’

The knotty question of which law applies to assets based in Crimea is also something that disputes lawyers are trying to grapple with, since there is almost certainly going to be a lot of contentious work linked to Russia’s annexation of the region.

Untouchable clients

Another headache for law firms is how the sanctions impact their client relationships. While firms can continue to advise highly lucrative clients like Rosneft on most matters, anything involving capital raisings over 90 days, or the development of shale, or deepwater and Arctic oil projects, are strictly out of bounds. The same applies to any debt raisings for the named Russian banks.

‘For the most part we’ve found we’ve been able to continue helping clients on what they’ve been doing,’ says Wright. ‘The biggest impact has been on all the work that we do for the Russian state-owned banks on their capital raisings.’

Firms acting for these banks would also have to recoup their legal bills within 30 days if they don’t want to fall foul of the new restrictions on long-term credit.

Several firms also had strong relationships with some of the designated individuals who were put on the US Treasury’s original sanctions list in March 2014. Putin’s judo partner, the oligarch Arkady Rotenberg, was a regular client of Hogan Lovells’ Moscow office. Though Hogan Lovells said it was ‘not commenting on specific client matters’, this relationship will almost certainly have been affected after Arkady and his brother Boris were included on the US Treasury’s sanctions list for being ‘members of the Russian leadership’s inner circle’.

While some clients are pragmatic about being turned away and appreciate that their lawyers’ hands are tied, others rail against the fact that such relationships, often cultivated over many years, can end so quickly.

‘Clearly there are various firms around this market that unfortunately have had to step away from one or two mandates because of the way the sanctions have impacted,’ says Allen. ‘Naturally this is a very sensitive issue, although we have found Russian clients to be very understanding.’

‘One can expect it could be difficult and that the client might feel very let down,’ adds Alex Gerbi, a London-based partner at US disputes leader Quinn Emanuel Urquhart & Sullivan. ‘Particularly if it’s a client you have worked with for years and with whom you have a strong relationship, or where you are part-way through an important mandate. As much as one would say: “I’ve got no choice, this isn’t my fault, this is imposed upon my firm and the international market by the decisions of the US and EU politicians”, the client might well not understand it like that, and see it as a betrayal, and as their lawyer not being able to stand up for them during difficult times, not valuing the relationship.’

There is also a distinction between the way in which US and European firms have been hit, as the US sanctions have generally been stricter than those imposed by the EU.

‘Clearly European law firms are operating at an advantage to US law firms in this market because the US sanctions came in earlier and they came in much tougher,’ says Wright. ‘Even though there has been a bit of catch up since then, there was much less likelihood that the European law firms would get caught on something mid-mandate.’

Nevertheless, European firms with US-qualified lawyers or US offices still need to separate those parts of their practice from any work that might breach the US sanctions. Non-US firms also have to consider the fact that much of their liability insurance will be underwritten through the US. ‘If you act on a matter that is not in line with US sanctions, then your insurance probably won’t be able to cover it,’ says one managing partner of an international firm. ‘There are a number of practical wrinkles that have to be worked through.’

Russification

One consequence of this is that Russian law firms are taking the opportunity to step into the breach when their international rivals can’t act.

‘We’ve heard of public tenders being announced to represent Russian state-controlled companies in relation to contractual disputes where western partners chose to terminate contracts with reference to the sanctions that were introduced,’ says one Moscow-based disputes partner at an international firm. ‘We know that European and Russian firms have been pitching with differing results. In some instances, the Russian clients who intend to sue western contractors were making an express decision not to go with international firms having interviewed them and received the feedback that should further sanctions be introduced they’d probably opt out of the litigation.’

This doesn’t just apply to disputes (for which we provide a more detailed analysis in ‘Straining the bonds’), but also to corporate relationships as well. ‘There is a trend among Russian corporate clients to diversify the external counsel pool by engaging Russian firms in addition to the international law firms,’ says Mikhail Kazantsev, a corporate partner at Egorov Puginsky Afanasiev & Partners. ‘This is a precautionary measure to ensure that if a company is subjected to sanctions the external legal work will not be interrupted.’

‘It would be fair to say that the best Russian firms are using the opportunity and trying to capitalise on this front,’ adds Alexei Roudiak, managing partner of Herbert Smith Freehills’ Moscow office. ‘However, it’s not just a question of whether you can or cannot pick up work on a given project exploiting the situation in the market, it’s also a question of whether you have the relevant knowhow, institutional experience and a team of professionals who can do these specific types of projects and deliver the result.’

Another potential outcome is that if international firms do start cutting staff, Russia’s domestic firms – or even the Russian clients themselves – will be able to recruit some of the displaced, but highly trained, Russian lawyers.

‘If things continue to go badly between the US and Russia, firms will inevitably have to consider shedding people,’ says Laura Brank, head of Dechert’s Russia practice. ‘Russian firms will benefit but Russian companies are even more interested in picking up these lawyers from western law firms given the experience such lawyers bring, especially if Russian companies are unable, for whatever reason, to retain a foreign law firm.’

So far, there haven’t been any direct cuts at law firms as a result of the sanctions, as many international offices remain relatively lean after a spate of redundancies in 2009. Nevertheless, most firms aren’t hiring and for the time being secondments and natural attrition are dealing with any excess capacity. Most feel that they will be able to take a more informed view in 2015, the hope being that the political situation might have calmed down by then.

Even if the situation does improve, and if the sanctions are dropped, there is a widely held belief that the legal market can’t return to the way it was.

‘The legal landscape is shifting and I’m not sure it’s going to shift back soon,’ says one partner at an international firm. ‘The market is going to become more “Russified” and certainly less dominated by European and US aspects.’

Even before the current crisis hit there was a trend towards greater localisation in the legal market and a drive to bring business back to Russia. Reforms to the Russian Civil Code, which were introduced on 1 September, have helped modernise the country’s civil and commercial laws. Meanwhile, a draft ‘de-offshore-isation’ law is also in the offing (see ‘Cyprus: another challenging year’), which is designed to bring more Russian companies home. If these prove successful, then the pre-sanctions push to have more contracts governed by Russian law will accelerate dramatically.

‘Of course there are some international law firms that realised well in advance that they needed to have more Russian partners and decision-makers, and those firms are in a better situation now,’ says Vassily Rudomino, senior partner at the Russian law firm Alrud. ‘Those firms who have failed to do it are suffering now because they aren’t able to meet the expectations of the clients.’

It’s something that the most well established international firms are all too aware of, especially since they have no intention of leaving the market.

‘At the end of the day we’re an international law firm with an office in Russia but we’re also a very strong Russian law firm with a majority of Russian lawyers and they are very good at what they do,’ says Wright. ‘So I’m confident that whatever may happen we will have a strong business here.’

It seems likely that if such international practices want to retain their position in the market, most will have to be restructured and Russified even further.

by Anthony Notaras

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