Strategic Sectors Law Update – First Commission Meeting of 2013 and Amendments to Law

On April 19, PM Medvedev held the first Foreign Investment Commission meeting of 2013. At the outset, Medvedev noted that Russia received over $50 bln in FDI inflows over the course of 2012. This statement is drawn from Central Bank of Russia (“CBR”) data, whose measurements often differ from other sources. For example, the OECD measured 2012 FDI inflows into Russia at $31.3 bln, while UNCTAD put the figure at $44.1 bln. By any measure, however, Russia experienced a decrease – ranging from 8 to 17 percent depending on the source – of FDI inflows in 2012. This is somewhat important because Kazakhstan and Ukraine received substantial increases of FDI inflows in 2012. And although those two countries receive much less FDI than Russia, they both have higher FDI as a % of GDP than Russia (i.e., a more ‘saturated’ FDI market). The downward trend is worrisome to Russia because it has yet to fulfill its potential as a recipient of FDI and has made foreign investment (particularly FDI) a linchpin of its economic modernization program.  Interestingly, Medvedev reported that the Commission has thus far issued decisions for $3 bln worth of deals, which amounts to anywhere from 6 to 10 percent of all FDI.

Deals Reviewed at the Commission Meeting

To date, the following deals were publicly reported as having been considered by the Commission at the meeting:

  • Polymetal Acquisition of Ural-MPG – the Commission approved the acquisition by Polymetal International plc of Ural-Metally Platinovoy Gruppy (Урал-металлы платиновой группы).
  • Asseco Poland Purchase of R-Style Softlab – the Commission approved Asseco Poland S.A.’s purchase of R-Style Softlab, a Russian developer of automated banking systems. The Softlab deal was covered by the SSL because Softlab works with encryption products.
  • Republic of Kazakhstan Gains Share of Urals Electrochemical Plant – the Republic of Kazakhstan received approval to acquire a 25 percent stake in the Urals Electrochemical Plant, which works with nuclear energy.
  • Abbott Proposed Purchase of Petrovaks Pharm – perhaps the most interesting story was the deal that was not approved. Specifically, American pharma giant Abbott was prohibited from acquiring Petrovaks Pharm (Петровакс Фарм), a manufacturer of vaccines. The deal between Abbott and Petrovaks was concluded in mid-2012. Abbott planned to use the acquisition as a way to localize production in Russia, where it currently does not have any factories. Coincidentally, the denial of Abbott’s application opens the door to a Russian pharma company – Farmstandart (Фармстандарт) – which is reportedly also seeking to acquire Petrovaks. Most importantly, this the first time that a the acquisition of a pharmaceutical company was denied on the basis of strategic, national security concerns. Petrovaks manufactures three medicines: Longidaze (treatment for connective tissue problems), Polyoxidonium (an antiflu treatment), and Grippol (a flu vaccine). Presumably, the denial of Abbott’s application was based on Petrovaks’ role in manufacturing Grippol.

Proposed Amendments to the Strategic Sectors Law (“SSL”) The Commission also addressed proposed amendments to the SSL, which have already been submitted to the Duma. I have created a copy of the SSL, which shows the amendments in redline format. Here is a summary of the main changes:

  • Tax Resident Exemption Clarification – in a previous post, I evaluated an earlier change to the SSL, which was intended to exclude from the law’s application transactions involving companies under the control of the Russian Federation and citizens/tax residents of the Russian Federation. The goal of the change was to exclude the many deals involving offshore entities ultimately owned/controlled by Russian businessmen and the government. Unfortunately, a wording error by then-President Medvedev’s team resulted in an ambiguous/incomplete remedy. The Medvedev team’s error consisted of one word – between (между) – immediately preceding the list of organizations to whom the law was intended not to apply. My understanding is that this word had the legal effect of limiting the exemption to transactions literally between the various entities indicated, rather than all transactions involving any of these entities. Thus, for example, if Rosneft would have purchased BP’s stake in TNK-BP via an offshore entity, it would have had to apply for approval by the Commission. My sources in Moscow tell me that the между problem was raised with Russian officials responsible for the previous amendments, who acknowledged the error but added that it would be unacceptable to point out the mistake because it came from the President. The pending amendments address the issue by deleting the между from the relevant section.
  • Definition of Control Broadened – the amendments broaden the understanding of ‘control’ over a strategic company to include situations where a written or oral agreement has been made to vote a certain way at meetings of shareholders, board of directors, etc. (bloc voting agreements).
  • Food Sector Excluded from Law – the law excludes the food/drink sector from the law. That sector had previously fallen under the law’s coverage via the ‘infectious agents’ category, as many food companies work with bacterial cultures related to dairy products, which are considered ‘infectious agents’.

TRM Comments on Meeting and Amendments

The Commission meeting and proposed amendments are remarkable in a few ways. At the outset, there is a continued recognition from the FDI numbers that Russia is (a) not returning to its pre-crisis FDI inflow levels and (b) not fulfilling its potential and stated goals in attracting foreign investment. Indeed, Medvedev implicitly conceded as much in his opening statements about how 2012 “was, of course, not very easy” in terms of foreign investment. So, the natural follow-up question: what is Russia doing to reverse these trends?

The Abbott decision does not bode well for several reasons:

  1. National Security Concept: in my opinion the vaccines industry is not unequivocally and inherently related to “national defense and state security.” Yes, people need vaccines to be healthy, and a country is incapable of self-defense if all of its citizens are dying or in the hospital because they lack access to vaccines. But there is no direct military application, such as the production of weapons or defense measures against biological weapons. That said, there is a way to look at having unquestioned and unlimited access to flu vaccine as a ‘state security’ issue – imagine a scenario where there isn’t enough Grippol at state pharmacies for Russian citizens in the midst of a deadly flu pandemic. In such a case, the Russian government would want to have as many pressure points as possible to apply to the manufacturer of Grippol, and Russian ownership = more pressure points. Still, this is a much broader concept of ‘national defense and state security’ than was promoted during the drafting of the SSL, and can be grouped with similar moves, such as the last-minute inclusion of media, internet, and fisheries.  
  2. Warning Shot to Western Pharma Companies: the decision also seems to me like a shot across the bow of western pharmaceutical manufacturers, who have experienced increasing pressure from the Russian authorities over the past several years. The pressure has included highly questionable interpretations of Russian antitrust law by the Federal Anti-monopoly Service (“FAS”) with respect to whether a given pharma company occupies a ‘dominant’ market position. In past cases, FAS has defined the ‘market’ to consist of one pharma company’s patented drug – even if competing treatments exist – which by definition means the pharma company the occupies a dominant position. Market dominance allows the FAS to deploy much more comprehensive and severe controls on a pharma company – e.g., interfering with the company’s right to choose its own business partners. More recently, the Russian government has proposed a requirement that government agencies and companies procuring a product may select a foreign source only if there is no equivalent product made in Russia (i.e., similar to ‘Buy American’ provisions of U.S. spending bills). Russian lawyers that I have spoken to indicated that this measure – although applicable to multiple categories of goods – is aimed primarily at western pharmaceutical companies. Now, the Abbott decision seems like another hostile message, even those ready to localize production.
  3. Written Law/Public Statements vs. Practical Realities: the Abbott case also underscores one of the central risks to doing business in Russia: the gap between written laws/regulations and public pronouncements welcoming investment, and the reality of coming up against local competitors with powerful connections and a paranoid government that has embraced the timeless Russian tradition of turning within in the face of threats, real or imagined.

Finally, the draft amendments reiterate the issues illustrated by Abbott. Namely, it took a nearly two years to eliminate one erroneously-placed word from the 2011 amendments, simply because flagging the issue with the president’s office was a nonstarter. Moreover, the only other substantive limitation of the SSL’s coverage found in the amendments relates to yogurt makers, who probably should not have been included in the first place. Indeed, one gets the sense that the Russians are experts at generating a never-ending stream of new laws, amendments, clarifications, etc. But even where changes to the written  law are significant – and they are not in this case – the underlying reality of everyday practice remains the same or grows worse. The unmistakable impassivity of Russian decision makers when facing one of their main economic/modernization challenges is discouraging.

As always, we end with a video of Medvedev from the meeting:

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