Structuring investments in the CIS

Robert Starr

Structuring

Investments in the CIS

The evolving, and often rudimentary, legal system in the Commonwealth of Independent States (US) ol’fers considerable challenges to Western investors. However, with careful planning and structuring, the risks inherent in acquisitions or joint ventures in Russia and other states of the CIS can be minimized. Based on extensive experience, this comprehensive article outlines issues that typically arise, particularly in Russia and Ukraine.

In contrast to Central European countries Poland,

Czechoslovakia

legal traditions

and Hungary,

of Russia,

Ukraine

such as

the precommunist

and other

states

of the

CIS are remote. Many of the essential legal bases for a functioning market economy have not been fully developed. Former Soviet republics are having to develop new laws in areas that were previously under all-Union jurisdiction. In certain

sectors,

wary of committing

foreign

investors

significant

are particularly

resources

without

strong

legal protection. For example, oil production sharing and concession agreements in Russia involve a complex approval process yet exemptions

and effectively require from other applicable

special legislation; laws (e.g., tax rules)

can be problematic.

Legal and Regulatory Environment A foreign investor in the CIS faces a uniquely untested and particularly fluid legal and regulatory environment, with a constant stream of new laws, often inconsistent isting legislation and sometimes given retroactive There are also gaps in the basic investment make tax planning and financial assumptions deed. For example, Robert Starr is a Partner in the Law Offices Salans Hertzfeld

6 Heilbronn

in London.

legislation

enacted

with exeffect.

rules that difficult in-

in Russia

in

December 1996 provides that foreign investors may establish operations through joint stock companies, limited liability partnerships and branch operations (among other ways). Implementing rules exist for joint stock companies, but special rules on partnerships and branches have yet to be adopted.

Investors

wishing

to take advantage

ious tax and other benefits that might accrue ship or branch were utilized thus face greater While

a branch

Ukrainian

is statutorily

law, in practice

due to lack of familiarity

available

under

it may be difficult with the branch

of var-

if a partneruncertainty. Russian

and

to register

form and bu-

reaucratic inertia. In one recent case, officials in Odessa insisted contrary to law that our client register a new company, rather than establish a branch of a Kiev-registered company. There

are other

legal gaps that concern

potential

for-

eign investors, particularly in a privatization context, e.g., successor liability, accountability of directors and officers for mismanagement or for placing personal interest ahead of their fiduciary duty to the stockholders, and more generally shareholder rights and remedies. Legislation in most CIS countries does not adequately address the concerns of some investors for debt and equity

Reprint:

28312

13

security

instruments

vertible

debt,

flexibility, ing rights,

or other

particularly veto rights

transferability, Foreign

or derivative

options

such as con-

Investors

will want

as relates to profits, cash flow, votand control, preemptive rights,

liquidation

investors

products

rights.

preferences

and other

must also appreciate

collectives, and the probable introduction of investment funds all pose substantial legal and management issues requiring careful attention. Particularly if certain shareholdings are reserved for future voucher holders, investment funds,

issues.

or the state itself, foreign

identify

the framework

and approve

investors

their future

may need to

partners

and rights

to

nature of much local legislation. For example, a recent environmental law in Russia states broad principles but nei-

key assets of the enterprise. In acquisitions of shares

in a state-owned

ther provides ecological standards nor clarifies the competence of various state bodies. Other recent legislation (e.g.,

balance sheet restructuring Uncollectible or unwanted

is usually a required exercise. assets may need to be written

antitrust, antimonopoly, regulation, intellectual

down, obligations to workers quantified, and the maintenance costs of nonrevenue-producing assets of a social

lending)

reflects

consumer protection, securities property protection and secured

a similar

gal rules lacking

tendency

clear guidance

to establish

on many

general

le-

infrastructure

inflation, ing state property tion of enterprises

is now charged

carefully

examined.

There

may be

limitations on the ability to dispose of unwanted or unprofitable assets. Profit and loss projections should reflect the uncertain market conditions, including the effects of

key issues.

Impact of Privatization Legislation A new series of state agencies

nature

enterprise,

with manag-

and developing rules for the privatizain Russia, Ukraine and other CIS coun-

currency

restrictions,

transport, or other profitability. In most

factors

CIS countries,

shortages

that could there

of supply

materially

are frequent

or

impact

debates

on

on

tries, on a scale never before experienced. Basic rules of private ownership have had to be developed. The sinews

the extent to which priority treatment should be given to existing workers and managers. During the last years

of the command and distribution

of the Soviet regime assets of many state enterprises were leased to workers, sometimes with purchase options. In each country, to varying degrees, issues arise as to the

economy, with its state-supported channels and absence of marketing

supply and

cost accounting are being replaced. State enterprises are now required to be self-sufficient. It is far from clear how quickly

or smoothly

this process

in the face of political If a foreign

company

will proceed,

particularly

changes. is considering

a joint venture

with

a state-owned entity, it will want to identify and approve its future partners, and clarify future rights to assets previ-

possibility

of privately

negotiated

joint ventures,

and

particularly the extent assets to such ventures

to which the contribution of state is subject to the rules of the current

privatization

whether

participate

program,

state-owned

in new joint ventures,

entities

can

and the permissions

required. In Ukraine, for example, cases in which ministerial officials

we have encountered and heads of state

ously under the control of the state entity (e.g., property and mineral rights). The need to address such concerns marks a fundamental departure from the Perestroika period. In Russia, the government has opted for mass privatiza-

committees wish to approve joint ventures with predetermined foreign partners. However, they fear that a strict application of the privatization rules might result in the

tion and for the creation and distribution of vouchers. However, the emphasis thus far has been on “corporatiza-

sale of factory assets to the highest bidders, contrary to the wishes of the workforce. In Russia, it is (in principle)

tion” of state-owned entities (i.e., their transformation into stock companies). In Ukraine, voucher privatization is also being developed, but basic questions remain concerning the scope of privatization and the options available. Foreign investors will want to consider carefully any potential environmental liabilities and all existing rights

possible

to obtain

the necessary

approval

for such joint

ventures.

and obligations of the local enterprise, particularly if the enterprise continues to be bound under the old system of “state orders.” The fiduciary role of the relevant state property

24

agencies

and funds,

the rights

of any workers’

The Columbia

]ournal

of World Business

Secured Lending

Financial Infrastructure and Nonconvertibility

In many projects The lack of sufficiently

convertible

currencies

has given

rise to cumbersome currency laws and regulations which constrain the structuring of investments and money flows (including salaries and their benefits to employees, payments to suppliers, etc.). Valuing capital contributions of local and foreign investors

in the face of rapid

inflation

is also a major

issue,

there

is a need to create

potentially

bankable rights to use fixed and other assets in CIS countries. However, applicable legislation governing secured transactions are common “pledge” Ukraine,

may not facilitate financing techniques that in market economies. The recent laws on

in several CIS countries, including Russia and now permit assets to serve as security for financ-

ing, and lease rights

to land and other

real property

may

with multiple-class capital structures and other techniques frequently necessary to surmount value differences be-

be offered as security for borrowings. The procedures doing so, however, have not yet been well developed

tween

and remain

the assets contributed

by the partners.

Foreign

untested.

Even if a foreign

company

for

were able

investors may also find that, due to the rapid devaluation of the local currency, even a modest investment may

to register a mortgage on real property, enforcement rules may not permit self-help and may require court action;

trigger

also, a creditor

application

of local securities,

antimonopoly

or

US$100,000 may involve prospectus registration requirements as a deemed public offering of securities. This same threshold

triggers

a requirement

to obtain

Anti-Monopoly

Commission consent. It is unlikely that this result was intended when the legislation was adopted last year, and a 50 million ruble threshold was established. Given the likelihood of continued currency

may be entitled

to the proceeds

of sale but

not the asset. Although possession may not be required to establish a security interest in movables, problems re-

other rules adding to the complexity of the government approval process. In Russia, for example, an investment of under

volatility

main. In Russia, for example, there is no centralized or uniform registration procedure for all forms of collateral. Inventory

financing

and floating

charges

may be particu-

larly difficult. Leasing and other techniques worth considering to overcome these gaps.

could

Most lenders strongly prefer an “offshore” structure wherever possible. The opportunities ing export

earnings

and establishing

escrow

be

security for utilizor foreign

in the region, we need to consider maintenance of value clauses in potential acquisitions or joint ventures. In

bank accounts require central

Ukraine

rowings may continue to require central bank consents, except for short-term trade finance (no longer than 180 days in Russia).

there is considerable

rency arrangements, being put in place.

including

uncertainty

as to future

the new currency

cur-

now

Another critical factor for many deals may be the applicability of rules providing for the compulsory sale of hard currency. Depending on their scope of application, such rules could

jeopardize

the viability

and structuring

of cer-

tain projects. The well-publicized forced hard currency sale rules in Russia are a good example of the type of obstacle that can complicate foreign investment. Although opportunities exist to minimize the impact of these rules, significant uncertainties remain, and the costs could be considerable.

“Self-Financing” Projects So-called justification

“self-financing” for export

projects finance

(where

the primary

is the revenue

earning

capacity of the project) can be the most difficult to realize in current circumstances. If outside finance for a project is needed, it should be explored as early as possible. Most projects will not qualify for outside financing without additional guarantees, and limited recourse financing is likely to be available only for a very small number of projects in which there is a demonstrable source of hard currency earning and adequate

Fall 1993

depend on each transaction, and typically bank approval. Also, hard currency bor-

security.

15

Local Guarantees The validity guarantees

Assessing Project Viability

and enforceability (bank,

ministry

Financial

of any locally-available

or other

sponsoring

authority)

need to be carefully scrutinized. Prospective Western lenders and the interested Western parties in the project will want to be sure that such guarantees are valid and can be called

on if necessary,

and that the guarantor

is

likely to have the necessary hard currency. Many of rhe entities from whom guarantees may be available will have had no track

record

in dealing

with Western

financial

institutions, and their financial capacity to meet any hard currency commitments will be difficult to evaluate. In the past, Western banks could often avoid commercial risk analysis, relying on a local foreign trade bank’s track record

as a sovereign

this type of approach

borrower.

Few projects

will allow

Western

countries

difficulty

in CIS countries,

the United

programs

States)

to assist in the fi-

assess-

testing

as-

sumptions regarding availability and cost of local supplies, raw materials, utilities, etc., determining creditworthiness of local parties offering collateral guarantees (and indeed,

their local authority

adequate

security

to provide

devices.

meaningful

to do so), and establishing Local borrowers

statistics

find it difficult

and accounts.

Projects in the CIS demand an extraordinary commitment in terms of effort and perseverance, as compared to projects in other countries, and the political environment in some CIS countries is increasingly uncertain. It is not surprising, therefore, that few Western banks currently have an “appetite” for such projects, and that many

A key element in such projects hard currency cash flow. Lenders

(including

have government-supported

have considerable

of projects

banks prefer to work on a fee basis as financial and syndicate leaders, rather than as lenders.

today.

Official Export Credit and Investment Programs Most

institutions

ing the viability

to see detailed ally reputable

advisers

typically is projected and investors will expect

feasibility studies prepared by internationorganizations and capable of independent

verifications.

nancing of exports to and investments in Russia and other countries in the region. If available, official export credit

Other important factors in such a project can include the involvement of experienced contractors and efficient

agency or investment guarantee important element of a financial

operators, institutions

involvement can be an package. Official export

quality production, and profitability. Financial may prefer to see foreign control over opera-

credits and guarantees typically provide longer credit terms than are available commercially and at more com-

tions, either management

petitive

to project debt service, and any deferred amounts repaid from cash flow. Assured transportation arrangements can

interest

rates,

thereby

facilitating

commercial

lending. Official export credits and guarantees mize residual risk exposure, free up commercial for other issues, nancial package,

add credibility and facilitate

to the structuring syndication.

help minilending of a fi-

The programs of the European Bank for Reconstruction and Development, the World Bank and the International Finance Corporation are likely to be of increasing importance

as sources

of debt and equity

projects in CIS countries. Nonetheless, and equity capital remains very “thin”

capital

for

the market for debt in terms of the

number of financial institutions willing to participate and the exposure they are willing to accept on a particular project. Only well-structured and well-secured transactions are likely to succeed. The institutions will typically look to such other factors as the importance and priority of the project to the country, its inherent logic and viability, the nature and market acceptability of guarantees offered, and additional elements of security available. 16

contractually or through ownership, with or other fees at least partially subordinated

be essential. Adequate arrangements assuring reasonable controls on manning, including hiring and dismissal of labor, are important issues. These are particularly sensitive in projects which could be affected by the mandatory provisions of local labor legislation giving strong protections to workers (in Russia and some other CIS countries the labor codes are currently being updated). In a typical resource processing project, lenders would expect to see “supply or pay” undertakings, and may want some linkage of supply prices to off-take prices. Some portion of supplier payments may also need to be subordinated to debt service depending on off-take pricing, with deferred payments (plus interest) paid from project cash flow when off-take prices exceed agreed levels. Additionally, the size and type of project can play a role

The Columbia Journal of World Business

in acquiring low capital

needed

finance.

Investments

cost and short-term

payback

with a relatively period

perceived as more likely to succeed under present conditions than larger projects. Projects designed to refurbish or upgrade vestment

existing operations by means of incremental into improve quality and productivity can be more

attractive facilities.

to financiers

than proposals

for entirely

the country

is often

a key ingredient.

legal con-

(including

expropriation,

nationalization

will involve

riots and civil commotions; kidnap and ransom; certain war risks; and such contingency risks as failure to honor

a fixed fee engineering

financial guarantees supply commitments,

and

contract with a foreign firm having a strong reputation and some prior experience in covering

tion and start-up.

engineering,

The contractor

provide some credit support formance guarantees.

procurement,

construc-

will be expected

for the project,

to

including

per-

vocation

in the event of default revocation of export

of off-shore

repatriation

Private Investment Corporation States. Private sector coverage ums are costly. Typically,

and in some cases a local company will undertake the construction and erection work, with the Western contractor supplying fairly standard equipment warranties.

Barter, Countertrade and Other Techniques

to see a hard currency

pricing

mecha-

nism. In some cases there are local off-take commitments as well. Lenders may also wish to see standby funds available, typically by way of equity contributions. A key factor

in many

projects

is the presence

of a sub-

stantial Western corporate commitment to provide some credit support, typically in the form of residual completion and performance

obligations.

banks

(OPIC) in the United is limited, and the premi-

to enhance

policy

proceeds

credit

support

are asfor a

“off-take”

commitment by a substantial foreign company, preferably with some form of credit support to mitigate commercial risks, such as a floor price or a reference

arrangements.

insurance

signed to leading project.

may expect

on loans or licenses or re-

To some extent these risks can be covered under certain government-sponsored programs, such as the Overseas

However, foreign contractors may have only limited ability to provide completion guarantees for such projects,

Lenders

Special

straints may affect the borrower’s right to insure certain risks with foreign insurers. Foreign investors and lenders may want to have a number of risks covered by insurance, and denial of access); loss of profits/business interruption; contract frustration, repudiation and embargo; strikes,

a project

construction international

Insurance

e.g., confiscation

new

Performance Guarantees and “Off-lake” Commitments Often

Insurance

can be

Barter

and countertrade

(or compensation)

transactions

was a feature of trade with the USSR but these are less prevalent today in the CIS. Some firms seeking to export to the USSR in the past found

that they were under

strong

pressure to commit to imports. This was particularly true of plant exports, where local parties sought to pay (at least in part) by export of the products manufactured in the plants. This type of deal was practiced in a number of sectors,

such as forestry

products,

chemical,

natural

gas

and metallurgy. Counterpurchase obligations can range from a small percentage of the export contract value to as much as 100% (more if interest payments on credit export credits are involved). There are no well-developed institutional structures to coordinate operations in CIS countries. In practice, it is very difficult to arrange countertrade in products that are within the jurisdiction of different supervisory agencies. Although counterpurchases of certain commodities (e.g., metals, petrochemicals, feedstocks) can be disposed of with relative ease, we have encountered problems of quality assurance as well as difficulties in obtaining

Fall 1993

17

promised

supplies.

Manufactures

and other

Leasing

items can be

particularly problematic. The local buyer will typically prefer to cover the buying and selling obligations in a single contract. This can be highly prejudicial to the Western should be resisted if possible. Export

and import

transactions

contract should,

partner

A potentially attractive financing technique in some cases can involve leasing. There can be advantages, for example, in financing

and

capital

goods

imports

through

finance

leases, whereby the lessee typically has an option to acquire title for a nominal consideration at the end of the

to the extent

possible, be covered by separate, unlinked contracts. Failure to observe this rule can prejudice financing and credit insurance on the export transaction. The Western

lease term. In some situations, such a finance lease may be more attractive to the lessee than bank credits (e.g., lower annual payments in early years, and an opportunity

exporter

to finance

will usually

seek to have payment

tive deliveries He will want

made independently, the counterpurchase

a third

party.

He will resist agreeing

supply

and counterdeliveries.

for the respec-

in agreed obligation

currencies. assignable

to

to “simultaneous”

Depending

on the situation,

the exporter may want to reserve the right to choose from as wide a selection of goods as possible, while the local partner may want to limit this. Other key negotiating issues often

include

the time frame

within

which

counter-

up to 100%

of value).

In certain

cases,

can be combined accepting goods

with countertrade obligations produced on equipment leased

cal party). Traditionally,

leasing

to certain

has been particularly

types of movables,

such as ships,

leasing

(e.g., to the lo-

well suited aircraft

and

rolling stock. However, leasing can also be an attractive means of financing critically needed equipment and other imports. It would not be surprising if greater emphasis

purchases are to be effected; quality and pricing of countertrade goods; sanctions for nonperformance; force majeure; geographic or other restrictions on resale; and

were put on leasing in the future as a means of financing necessary imports by CIS countries. These transactions

compliance

tially adverse tax consequences. Also, the impact of special legislation on leasing (as in Russia) may need to

with all applicable

governmental

export quotas and authorizations). The application of licensing procedures

rules (e.g., for imports

and

need to be structured

with care to take account

be considered.

exports, new customs regimes closer to Western practices, and new tax rules all pose potential complications for countertrade operations. Even assuming that all local legal

Land and Other Property Issues

hurdles

Establishing

can be overcome,

a countertrade

deal could

run

afoul of Western government regulations, such as antidumping rules. We would therefore expect barter and counter-

of poten-

is particularly

ownership complex,

rights

to property

bureaucratic

in CIS countries

and time consuming.

trade to become increasingly problematic. In the past many Western companies were able to exploit the benefits available under bilateral trade arrangements between the USSR and such countries as Finland,

Under recent Russian legislation, for example, the relevant state property committee (either at the federal, regional or municipal level) must be involved. Leasing approvals may be similarly required. In Russia, work continues on draft legislation to permit foreign-controlled entities and for-

India and Turkey. Although the old clearing may have been scrapped, there are currently

eign persons to own land. In Ukraine, further land legislation is also expected. At present, foreign-controlled enti-

arrangements opportunities

for structuring deals in a particular CIS country to take advantage of benefits available under that country’s agreements with other countries, including other CIS and former COMECON countries.

18

ties may own improvements on land (but not land). As in Russia, ownership of improvements gives certain rights to the underlying land.

The Columbia

Journal

of World Business

Intellectual Property Protection

in some areas.) certain

Russia,

Ukraine

and other

cess of replacing

states

of the CIS are in the pro-

older USSR laws on intellectual

property

(patents, trade and service markets, copyright, etc.). Russia has also adopted laws protecting computer programs and databases, as well as semiconductors. It is still too early to judge whether some of the recent legislation provides effective protection and whether it will be possible to obtain prompt and effective relief for infringements. The new Russian and destruction

trademark

law allows

of offending

trademarks,

for removal

which

are taxed

at much

tax rates and rules may apply to (e.g., “middleman” higher

operations

rates in Russia),

or in cer-

tain sectors (banking, insurance, securities operations etc.). As currently applied, the top marginal CIS tax rates on individuals (including foreign citizens) may be higher than in many Western countries, base. Tax planning to minimize personal

taxation

investment benefits.

but the right to

Different

types of activities

should

project,

be an indispensable

including

Gaps in existing

complicate

and on a very broad both corporate and

structuring

tax

part of any

for tax treaty

rules (e.g., on transfer

pricing)

this task.

destroy or seize counterfeit goods remains untested. Ukraine and other states of the CIS pose particular

Labor Legislation

problems as all intellectual property protection used to be controlled from Moscow. Failure to register within specified time frames invalidate intellectual property rights ob-

Russia seems ahead of Ukraine and other states of the CIS in modernizing its labor law. These countries have not

tained

under

Soviet law.

Where a project involves acquisition of intellectual property rights, particular due diligence is required. In the former Soviet Union, the enterprises producing certain goods were not necessarily those who designed the goods, as research and development was generally left to separate design

bureaus

export rights) zations.

or institutes. was generally

Also, marketing in the hands

(including

of other

organi-

known the concept of “employment at will,” which affords an employer broad rights to terminate employees. Investors

If recent

in Russia

and Ukraine

we are likely to see a bewildering patchwork laws in the region, covering enterprise profit taxation,

VAT, import

taxes, property taxes, land taxes, and charges imposed by different

and export

of new tax taxation, tariffs,

excise

and other types of taxes governmental authori-

Federation may not grant tax privileges on an individual basis, nor may they impose taxes in addition to or in excess of those of the Russian Federation. Special attention must also be paid to the effective tax rate, as many categories of expense generally allowable in the West are not fully deductible in CIS states. (The new

Fall 1993

labor rules may

(customer

lists, processes

etc.), rights

to inventions

created

employee.

is any guide,

ties (such as payments for use of natural resources). Investors will want to investigate whether the government has legal authority to provide exemptions or additional tax privileges. Under a tax law adopted in July 1992, regional and local governments in the Russian

U.S.-Russia

that applicable

Other Issues

experience

personal

anticipate

during the course of employment, or the extent to which covenants not to compete are enforceable against the departing

Taxation

should

provide extensive protection to workers, even if their performance is unsatisfactory. Further, local law may not deal adequately with such issues as protecting trade secrets

tax treaty

attempts

to overcome

A host of other issues may need to be taken into account in structuring a particular project. For instance, many projects

to date in Russia

have been profoundly

affected

by major changes in the import/export regimes, including licensing and tariff levels. Special problems arise in a number

of sensitive

sectors,

e.g., defense

conversion

and

mineral resource extraction. Also there are areas in which foreign arbitration and application of foreign law will be foreclosed. A prudent foreign lender or investor will want to consider alternative dispute settlement mechanisms providing the maximum security possible under the circumstances. Structuring a project to qualify under an investment protection treaty could also be helpful. The USSR signed a number of these treaties with Western countries but many did not come into force before the demise of the USSR.

this problem

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