I wanted to wait to discuss this until the draft law was out, but I am tired of waiting so here goes. The last time we looked at the strategic industries law in March, I posted draft amendments from the Ministry of Economic Development. The draft amendments were mid-course on their way through the RF government drafting process, and I noted that there were not any significant changes, but rather they represented a codification of existing agency rules and practice.
Lazeika is Russian for “Loophole”
At the end of March, the Association of European Businesses in Russia hosted a conference, which highlighted an alarming and previously unreported problem with the interpretation of certain language now found in the law. The strategic industries law regulates investment by (i) individual foreign investors and (ii) “groups of persons/entities to which a foreign investor belongs” (“группа лиц, в которую входит иностранный инвестор”). The first class is simple enough – it includes any foreign person or legal entity (e.g., Coca-Cola), which wants to acquire a controlling investment over a company in a “strategic” sector (e.g., manufacture of explosives).
The second class, however, is apparently the source of all evil here because of the rigidly literal interpretation adopted by Russian courts (in fairness, this may be a civil law issue and thus the fault lies with the drafters of the statute and not the courts). Specifically, Russian courts have held that it includes any group of companies, where at least one of the members is a foreign legal entity. Though this reading is textually correct, it is almost certain that the drafters meant foreign groups of companies – i.e., groups of companies whose corporate structure places final decision making power in the hands of a foreign entity. Under Article 9 of the Law on Competition, that is essentially one of the ways how the term “group of persons” is defined – e.g., a number of companies with a common majority or controlling owner. The problem arises from the wording in the Strategic Sectors Law, which encompasses groups of persons that include a foreign investor, and not foreign groups of persons. This applies even if the foreign investor is not involved in any way with the strategic sector company targeted for acquisition.
This poorly-worded provision has produced absurd results, including Federal Anti-Monopoly Service (FAS) rejections of applications from 100% Russian companies, which have foreign sister companies. Two of these companies – OOO “Kores Invest” and OOO “Krom” – attended the conference and explained their experiences and frustration. They also provided the letters they received from the FAS about the rejections. The Association for the Defense of Investor Rights also gave a presentation. Using concrete examples, it demonstrated that under the current FAS and judicial interpretation of the “group of persons” provision, almost all major acquisitions by Russian companies – e.g., Gazprom, Rosneft – would have to be nullified because they all include majority foreign-owned or controlled entities within their company holdings.
Proposed Amendments – Will Promises Be Kept?
The FAS sent representatives to the conference and issued a press release shortly after explaining that it would address the “group of persons” problem in the anticipated amendments to the Strategic Sectors Law (the draft amendments I published did not do so). At the end of last month, the FAS announced that it had submitted the draft amendments to the government for consideration before submitting them to the Duma. The release stated that the amendments would do the following:
- Banks are excluded from the cryptography sector under Art. 6;
- Establishes a framework for transactions involving a “group of persons” under existing legal exceptions;
- Reduces the list of strategic activities subjecting banks to the pre-verification requirement, except those banks in which the Russian Federation is a party;
- Clarifies the legal rules, which broaden the statutory exception in the Strategic Sectors Law for mineral resource companies that issue more shares, and as a result the rights of the foreign investor over the use and disposal of such shares does not increase; and
- Clarify the requisite documents that must be included in a foreign investors application, to decrease errors in the application process
The FAS release also said that a second set of amendments are being readied in consideration of proposals from foreign investor groups and government agencies. The FAS claims that this package will include “almost all the proposals from foreign investors that were approved during the meetings.” The one exception, however, was the recommendation that the amendments liberalize the criteria for determining control in the subsoil sphere. Currently, control in the subsoil context is: (i) ownership of 10% of voting shares; (ii) right to appoint a single executive body or 10% or more of the members on the group executive body; or (iii) the unconditional right of the foreign investor to choose 10% or more of the members on the Board of Directors or other management body. The Strategic Sectors Law only applies to “subsoil areas of federal significance.”
Investment in Russia – High Stakes
The announced changes must be understood in the context of a growing consensus – both within Russia and abroad – that investment, and particularly foreign investment, is necessary for Russia to modernize its economy. Furthermore, this discussion is no longer hypothetical, with several recent analyses predicting that Russia will collapse into low-growth economic stagnation by 2013 if it does not start making progress with its reforms and infrastructure development. When the Strategic Industries Law was first proposed by Pres. Putin in his 2005 Annual Address to the Federal Assembly, the idea was to set up “rules of the game” because the influx of foreign investment was too much for Russian leaders to adjudicate on an ad hoc, case-by-case basis. It was only intended to make investment in Russia more convenient for the government, not necessarily better for foreign investors. Then, as the crisis deepened, the tone changed to one of investment promotion, and making investment in Russia the most enjoyable part of a Western executive’s day.
Now, one can sense a little desperation setting in – the Russians know they have avoided a 1998-like catastrophe (or worse), but it is dependent on unsustainable budget expenditures, even assuming a “positive” oil price. With no massive reserves and skyrocketing oil revenues, Russia’s economic and fiscal challenges are put on an accelerated track. And now that the all-you-can-eat buffet of Western capital flows to Russian firms is closed – indeed, revealed as a sham – there is nowhere else left to turn. The only option is for Russia to be wise with how it allocates the scarce public funds it still possesses, while creating and encouraging a business environment that will attract outside money, both in the form of foreign direct investment and foreign portfolio investment, not to mention domestic investment.
It is cliche to say Russia faces an existential threat – it has spoiled many such predictions – but it is difficult to envision a scenario in which Russia finds a sustainable and upward course over the next century without making all the right policy choices in the next few years.