Regulatory framework

Foreign acquisitions of Russian businesses operating in a wide range of industries are restricted or regulated by the government. Such restrictions exist in particular in the form of (i) state approval to acquire equity stakes in banks and insurance companies; (ii) regulation of investments into certain types of industries listed in the law regulating foreign investment in companies having strategic value for national defence and security; and (iii) prohibitions on investments into certain other types of businesses, spread across other laws and regulations.

In addition, if the acquiring company and the target (and their respective groups) collectively meet certain financial thresholds, an acquisition of over 25% of the shares in a joint-stock company and over one-third of the equity interests in a limited liability company may require a prior consent or a post-closing clearance from the Russian Federal Antimonopoly Service, the competition regulator, even where the acquisition would have no conceivable impact on competition in Russia.

Banking and insurance

Investments by non-Russian investors into credit institutions are subject to compliance control by the Russian Central Bank. All investors are required to obtain the prior approval of the Central Bank for any acquisition of a holding of more than 20% in a credit institution. Approval is subject to substantial financial disclosure by the acquirer and subject to it meeting certain financial requirements.

The prior consent of the Russian Ministry of Finance is required when a foreign investor acquires an equity stake (of any size) in an insurance company. Due to the restriction that an insurance company may not write certain types of policies if more than 49% of its shares are held by foreign investors which are not domiciled in the EU, a foreign investor’s worldwide structure should be examined before it attempts to make an investment into a Russian insurance company.

Strategic industries

Russia in 2008 enacted a federal law that regulates non-Russian investment in companies having strategic value for national defence and security, that also covers Russian investments structured through foreign entities (Strategic Law). Despite initial declarations that the Strategic Law would simply create the necessary clear-cut rules of the game for foreign investors contemplating investments into certain sensitive industries, the Strategic Law has been construed and applied so that virtually any Russian acquisition by a non-Russian investor now risks requiring a Strategic Law approval. For dealmakers it means that, in additional to conventional legal due diligence and anti-trust compliance, the deal requires a separate Strategic Law analysis.

Determining whether a given transaction falls within the scope of the Strategic Law involves the following two-step analysis.

Strategic status

It first needs to be determined whether the target company is considered to have a strategic value. The strategic value designation applies to any company engaged in any of the 42 fields of activity listed in the law. These include arms and military technology, aerospace industry, radioactive materials handling, transport and disposition, mineral resource exploitation, and work with bacteriological agents.

The Strategic Law does not require any of the strategic operations to be a core business activity for a company to qualify as strategic. Indeed, a company need not even actively engage in a strategic operation; if it has a licence to engage in a strategic activity, it is deemed to fall within the ambit of the Strategic Law. Therefore, a company engaged in common commercial activities, but holding a licence for performing any of the strategic operations for ancillary purposes, qualifies as strategic. This formalistic approach enormously broadens the application of the Strategic Law to Russian businesses that have no real strategic significance for national defence and security. While the law has been widely criticised on this basis, the amendments proposed to date for the most part do not restrict its scope. As a result, foreign investors contemplating investment into enterprises which might qualify as strategic should undertake a full scrutiny of the target company’s day-to-day operations and licences.

Transactions requiring prior clearance

Once it has been determined that the target business is strategic, it then needs to be determined whether the transaction involves a foreign investor or its affiliates and results in the establishment of direct or indirect control over the strategic business.

Control can be established not only through holding the majority of voting shares, but also through holding a lesser amount of voting shares, provided that the ratio between the number of such voting shares and the number of the remaining voting shares held by other shareholders allows a foreign investor (or its affiliates) to determine decisions to be made by the strategic company.

Where the investments are being made by foreign governments or international organisations or companies controlled by them, the threshold for direct or indirect control triggering the requirement for approval is reduced to 25%.

Investments into companies engaged in exploitation of natural resources on certain qualifying land (so-called subsoil plots of federal importance) require a prior clearance if the foreign investor seeks to acquire over 10%. Investments into such companies by foreign governments or international organisations or companies controlled by them leading to the establishment of control are banned outright and the acquisition of a minority stake of over 5% will trigger a consent requirement.

Approval process

Transactions falling within the scope of the Strategic Law require the prior consent of a special government commission, which consists of key members of the government and is headed by the Prime Minister. The process of obtaining prior approval is burdensome and time-consuming. Applications for obtaining prior clearance should be reviewed within three months. However, the review period may be extended for a further three months, and in practice more than six months can elapse from the time that an application is filed until the time a decision is issued.

Consequences of not obtaining clearance

Transactions concluded without prior consent are void. Any interested party may bring a claim to apply the consequences of the transaction being void – to unwind the transaction and return the parties to their ex-ante positions. In cases where the consequences of the transaction being void cannot be directly applied (for example, because the transaction requiring approval concerned the transfer of shares in a foreign company, which a Russian court would lack jurisdiction directly to unwind), the court will strip a foreign investor of voting rights with respect to the strategic company and invalidate resolutions adopted by the strategic company’s management bodies subsequent to the foreign investor gaining control. With these special powers vested in the court, the exposure for foreign investors who have disregarded the Strategic Law requirements is likely to last much longer than the three-year statute of limitation period.

Other restrictions

Other restrictions not covered by the Strategic Law are contained in various laws and regulations (including licensing requirements which apply to the target company rather than its acquirer) and include investments into television network and broadcasting companies, companies owning agricultural land and land located close to state borders, and investments into share registry companies. Most of these laws and regulations are rather archaic and can be easily circumvented by a foreign investor through structuring of the acquisition. However, few investors are prepared to risk losing their investment, however remote the risk may be.

Acquisition documentation

Governing law

Due to the questionable validity under Russian law of legal concepts contained in Western-type acquisition agreements, many if not most sophisticated acquisitions of Russian companies are documented and negotiated under foreign law – predominantly English law – and disputes are submitted for resolution by international arbitration forums located outside of Russia. Moreover, due to the problems associated with enforcing arbitral awards in Russia and complexities with Russian closing mechanics, it is often advisable for the purchaser to structure a share acquisition by purchasing the shares of a non-Russian holding company (typically located in Cyprus due to the favourable tax regime) which owns the shares of the Russian target.

If a transaction is nevertheless governed by Russian law (as may be demanded by a Russian counterparty since it provides less protection to the purchaser), the main enforceability and predictability problems will relate to the following areas:

Representation and warranty

Other than a general warranty of quality which is implied into contracts for the sale of goods, the concepts of representation and warranty have no distinct legal meaning under Russian law. It is impossible to predict what measure of damages a Russian judge would apply in calculating the losses suffered from a breach of representations and warranties. Importantly, it can be difficult to obtain damages for any breach of representations and warranties regarding the ownership or condition of a target company (other than warranties regarding title to the shares).

Indemnity

As with representations and warranties, a breach of an indemnity carries no clearly defined legal consequences under Russian law. Many Russian legal commentators have noted that there is a risk that any indemnification provisions written in a Western style may be characterised by Russian courts as insurance coverage or a bank guarantee. As the former may only be provided by a licensed insurer and the latter only by a financial institution, the indemnification provision risks being unenforceable against any Russian party providing an indemnity who is not a licensed insurer or a financial institution.

Russian law does not expressly recognise share option contracts, particularly where the put or call option is given in favour of a party that is not a current shareholder of the company whose shares are the subject of the option. Although Russian law recognises the similar concepts of conditional agreements and preliminary agreements, both lack a key feature of the option, namely the right of one party to initiate the sale at its own discretion. An irrevocable offer – another recognised instrument which is very close to the common law concept of an option – does not afford a reliable solution either, as the law does not recognise contracts made in the form of an offer. As a result, it is highly questionable whether contractual provisions typically contained in a share option contract (a covenant not to create encumbrances, for example) would be upheld. It is also unclear whether an irrevocable offer could be drafted in such a way as to enable it to be exercised in respect of only a portion of the shares, or to provide for payment of both the option and strike prices.

Conditions precedent

Under Russian law conditions precedent cannot be dependent upon the acts of the parties – only matters which are outside the parties control can be stated as conditions precedent. As a result, a particular action or step by any of the parties to a Russian acquisition agreement cannot be included as a condition precedent to its completion. Particular problems could arise with conditions precedent relating to internal corporate approvals or even regulatory approvals where it could be said that a party may influence the satisfaction or non-satisfaction of such conditions.

Typical warranty package

The typical warranty package contained in a share purchase agreement (governed by non-Russian law) for acquisition of a Russian business does not differ substantially from what is seen in the UK and other EU deals, although certain nuances exist.

The duration of the seller’s liability under the warranties and indemnities will typically be limited to a three-year period, which is a general statute of limitation period in Russia.

Areas such as pension schemes are of no particular relevance in Russia, as Russian employers virtually never put such schemes in place.

Environmental compliance is only beginning to attract real attention from buyers as concepts of environmental liability gradually develop. At present, exposure for environmental liabilities mainly exists with respect to the government, rather than to private parties (such as owners of neighbouring properties), and the vast majority of environmental compensation claims are brought by the federal or regional authorities. Damages are calculated using statutory formulas and a methodology which often results in disproportionately low compensation being imposed on the polluters.

In fact, many businesses completely disregard environmental laws as they find it cheaper to pay compensation and environmental fines than to employ technology and personnel that would enable them to improve compliance with environmental requirements. The government is proposing a new package of environmental legislation aimed at introducing stricter liability for environmental violations. As a result, general environmental indemnities may become a norm.

Tax liability represents one of the most significant exposures for buyers. This is mainly due to the heavy tax compliance burden which results from unsophisticated government revenue collection. Foreign investors should be aware that virtually all businesses in Russia will encounter tax claims and that tax litigation is an inherent part of their day-to-day interaction with the tax authorities. As a result, a wary buyer will insist on a general tax indemnity in addition to the tax warranties.

Conversely, because a significant number of tax disputes (70%, according to 2010 surveys) tend to be resolved in favour of the taxpayer, sellers agreeing to general tax indemnification will insist that they be able to take the sole-conduct of third party claims in relation to matters arising under the tax indemnity and tax warranties, so as to ensure that the target company properly defends all its rights in administrative proceedings and in court and that the buyer does not simply disregard the possibility of recovering losses from the tax authorities on the basis that they can be passed on to the seller. As Russian tax authorities are able to re-open any tax returns made by a company over the last three years, the liability of the seller under the tax warranties and the tax indemnities will normally last for four years.

Property warranties are usually quite extensive, even where the properties are not of substantial importance in the context of the deal, due to the generally low level of property rights protection in Russia, and, as a result, are heavily negotiated. It is recommended to have separate distinguishable warranties in relation to any buildings, structures and facilities which are being purchased and in relation to the land plots on which the buildings are located. In relation to the buildings, there should be a warranty which specifically states that all relevant permits have been obtained in relation to the construction, development and exploitation of the buildings. In relation to the land plots it is important that there is a warranty which states that the boundaries of the land plots have been accurately determined and there are no disputes with third parties which own adjacent land plots.

Information that can be accessed in public registers is rarely accepted by the buyers as information that is deemed to be automatically within their knowledge, due to the unreliability of information contained in such registers.

Escrow arrangements

It is generally not possible to use a Western-style escrow arrangement for direct acquisition of a Russian business where the parties would deposit money and undated share transfer documents with an independent escrow agent who would release them at closing in accordance with the escrow agreement.

As settlement of Russian shares can only be effected by a Russian share-registry company or a Russian depositary, while cash settlement can only be made by a Russian bank, there is only one type of institution in Russia that can provide services involving transfers of both shares and cash, namely a Russian bank holding a licence to carry out depositary operations.

Although such banks have developed products that are very similar to escrow arrangements, notably joint purchaser/seller instructions to block shares until payment has been made with a subsequent automatic transfer to the purchaser’s account, there is an inherent risk in such agreements that either the seller or the purchaser could challenge the irrevocability of the joint instruction and retract the shares/cash before the transaction is completed. Nevertheless, in the absence of any alternatives on the Russian market, these arrangements are frequently used.

If the purchase price is paid outside of Russia, the parties can use the services of an offshore bank which has a Russian subsidiary licensed to carry out depositary operations and structure a similar settlement arrangement, which would involve putting money into a true escrow account from which it would automatically be transferred to the seller’s account with the same bank upon receipt of evidence from the bank’s subsidiary that transfer of shares has been completed.

This arrangement mitigates the risk of the seller retracting its share transfer document after the funds have been remitted to its bank account and, conversely, the risk of the buyer retracting its wire instruction after shares have been transferred to its bank account. The arrangement would involve a four-party agreement between the seller, the buyer, the offshore bank and its Russian subsidiary.

Escrow type arrangements do not work when acquiring an interest in a Russian limited liability company (LLC). As a result of changes in the law introduced in 2009, all transactions purporting to transfer title to an LLC interest need to be notarised in the presence of the parties or their authorised representatives. By law, title passes to the buyer immediately upon notarisation; it is not possible to notarise undated or pre-executed transfer documents and deposit them with a third party.

The notarisation requirements have created a more general problem with documenting LLC interest acquisitions. Since notaries are required to explain to the parties their respective rights and obligations under the documents they certify, many notaries refuse to certify acquisition agreements governed by English (or other non-Russian) law as this goes beyond their expertise. Additionally, arguably, a conditional acquisition agreement (regardless of its governing law) cannot be used, as title needs to pass immediately upon notarisation.

As a solution to both these problems, a number of practitioners have suggested, and some notaries have agreed to use, separate short-form transfer documents which parties execute in front of a notary as part of the closing process. These transfer documents address only the technicalities of the LLC interest transfers, with all substantive matters being dealt with in the main acquisition document, which does not require review or certification by a notary.

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