The Forecast for Foreign Investment in Russia: Should Investors Expect a Warm Climate or Cloudy Skies?

I. Introduction

"If you do business in Russia, you will lose all of your money, because your Russian business partner will steal it from you, because he or she is a thief. And you will die, because the Russian mafia will murder you in your hotel bedroom when you visit Moscow or St. Petersburg."
-Daniel Thorinley  [1] at the St. Petersburg International Economic Forum.

The above quote seems to reflect the Wall Street Journal and CNN view of conducting business in Russia, who  repeatedly caution their readers and viewers about investing in Russia's emerging markets.

According to Dr. Daniel Thorniley, Senior Vice President of the Economist Group, [2] an organization providing analysis on international business and world affairs, this view is unequivocally wrong.  [3] He cites business success in Russia as the world’s best kept business secret. Yet this economic giant is largely being ignored by Western investors.


With an education system that has produced nearly 100% literacy, great emphasis on science and technology [4] seven consecutive years of steady economic growth and a consistent strengthening of the ruble,  Russia appears to be an extremely attractive target for foreign investment. However, direct foreign investment is still very low in comparison with other transition economies in Europe and by international standards generally, [5]. With U.S.  investment at a total of $1.64 billion, comprising just 3 percent of total foreign investment in Russia in 2006 [6], the question remains: Why are American investors so reluctant to invest their funds in Russia? 

This article will discuss how recent changes in Russian law and economic growth will impact foreign investment, what risks American investors may expect to face and the recourse available to an investor should a dispute arise.

I.  Russian Law Concerning Investment

 

For economic reforms to flourish and private investors and entrepreneurs to prosper, the legal system must effectively protect private property, defend economic rights against infringement, and establish a secure environment for investment and market relations. [7] In contemplating the accession of the Russian Federation (RF) to the World Trade Organization, a dramatic increase in foreign investment activity is anticipated. As a result, legislation concerning the regulation of foreign investment is becoming increasingly more important. Recently, there has been a surge in the passage of commercial laws as the Russian government seeks to rectify Russia’s negative image in the eyes of investors.

It is generally recognized that the Russian legal system provides the main legal guarantees, investment protection, and conditions for commercial activities that comport with international standards. [8]The Russian government is currently working on a law that will provide for oversight of foreign investment in the country’s strategic sectors, such as oil and gas. The codification of such policies, albeit restrictive, is seen by some U.S. officials as a positive step in improving the climate for foreign investment. One measure of  Russia's transparency and openness to investment will be the Strategic Sectors Law. According to early drafts that have been made public, this law would regulate government reviews of investments into 39 sectors of the Russian economy. [9] Strong, fair and transparent governing institutions, such as regulatory agencies, keep the business sector in line and encourage investment, by ensuring that investors understand where they are putting their money. [10]

Several American corporate giants like Boeing and Procter & Gamble already maintain a notable presence in Russia. [11] Others, particularly those interested in the energy sector, are waiting for the Russian government to define the "rules of the road" for exploration and development off-shore and in the Arctic before undertaking the mammoth capital investments needed to get such projects off the ground.[12] The core legislation governing the national regime of foreign investments known as the Federal Law "On Foreign Investments in the Russian Federation " provides fundamental guarantees and serves to open attractive opportunities for foreign investors.[13] This Russian law provides equal rights for foreign investors in the domestic market, guarantees the protection of property rights and ensures the fair settlement of disputes. [14] Additionally, Russia is engaged in expansive administrative reform and has significantly liberalized legislation regarding currency regulation and control. [15] Recent changes in antimonopoly law have also made implementation of direct foreign investments in Russia significantly easier.

II. Intellectual Property

 

Russia’s poor track record in improving intellectual property rights has historically hindered foreign investment. It was considered at one point to be a factor which could preclude U.S.approval to Russia’s ascension into the World Trade Organization. [16] For years, WTO negotiations between the  U.S. and Russia were slowed by Washington's concerns about Russia's weak stance on intellectual property. [17] In November 2006, the United States became the last major WTO member country to approve  Russia's  entrance into WTO by signing a bilateral agreement. [18]The agreement was tempered with a variety of specifications, and built a framework for Russia to crack down on piracy.  [19] In addition, it set a timeline for enacting laws on the counterfeiting of pharmaceutical and computer goods in a bid to address the country's poor record on intellectual property rights.[20]

Since signing the agreement,  Russia has made significant progress in addressing the widespread problem of intellectual property piracy and in fulfilling the requirements of the agreement. [21] When the timelines are completed, the agreement becomes subject to ratification by the U.S. Senate and must pass through one more hurdle before being finalized.[22]The US Chamber of Commerce, a private sector organization representing over three million business owners, has been advocating heavily for Russia's entrance into the WTO. [23]  Russia has allocated 3.7 BLN rubles (approximately $144.7 million) to the goal of resolving intellectual property rights  [24] and Russian authorities are currently trying to fight the problem by organizing raids, passing anti-piracy legislation and releasing anti-piracy ads.  [25] Some improvements are already visible; the crackdowns have led to a reduced number on kiosks selling pirated CDs, DVDs and software in Moscow, the nation's capital. [26]

Bill Robinson, an American attorney and leading expert on Russian business, suggests that in addition to governmental action combating piracy, a more fundamental change essential to shielding intellectual property rights has also taken place. [27] Russian attitudes about intellectual property are changing.

 

    There were two schools of thought about intellectual property when I began working in the Soviet       Union. One thought was: we are a poor country and we can’t afford Microsoft, so it’s OK to steal it. The other school of thought was: we are as smart as anyone else in the world, and if we do not have a legal regime in place to protect our work and our efforts, then they will be worthless to us. That second school of thought is winning out. [28]

In spite of Russia's seemingly strong commitment to protecting intellectual property rights, a Russian court has acquitted the former head of music download website www.allofmp3.com of violating intellectual property laws. [29]The site, which offered song downloads for as little as 20 cents, drew international attention after it was declared a stumbling block in Russian WTO accession talks with the   

For additional information on this topic refer to the article by David Blomgren located here. [30]
 

III. Nationalization & Trends in Increasing State Ownership

Roughly three-quarters of the Russian economy has been privatized, [31] but some investors cite the fear of nationalization (the transfer of privately owned assets into public ownership) as a reason for their reluctance to invest. In contrast, Bill Robinson, a respected lawyer and representative of businesses in Russia since 1990, thinks that nationalization is an insignificant risk and one which is easily insurable.[32]

 

Although there has been increasing state ownership in strategic sectors like aerospace, “national champions” of private industry such as energy and metals continue to grow alongside with these state giants. [33] Though the government is reasserting its position and ownership of some state resources, there is increasing privatization in the utilities sector. [34] Experts urge foreign investors not to view this trend of state capitalism as a threat, but as a way to cement the foundation of the country’s economic system which will, in turn support the rest of the markets. [35]

 

Moreover, there is evidence that this trend of state capitalism seems to be working well for  Russia. Many Russians who view the Soviet Era as the glory days of economic prosperity, cite the return of a strong government as a source of pride, and assert that it has boosted consumer confidence. [36] Russians view the strategic sectors as one of their economy’s greatest strengths. [37] They favor the new protections against foreign investment in these areas and stress that maintaining Russian control of these resources will have a positive impact. [38]

 

V. Legal Remedies and Access to Courts

While analysts from leading multinational financial institutions such as Merrill Lynch, Morgan Stanley, and Goldman Sachs are confirming that Russia is one of the top emerging markets in the world, [39] many investors who seek to capitalize on the emerging prosperity in Russia face a litany of legal ambiguities which can lead to frustration. [40]

Currently, there are two venues in which a foreign investor can address a legal dispute with either the state or another company. [41 ]They are the state arbitration (arbitrazh) courts and the International Commercial Arbitration Court (ICAC), a branch of the Russian Chamber of Commerce and Industry.  [42] The ICAC, which was created in 2005, has a primary advantage, in that its decisions are enforced internationally.[43] However, since this forum is still relatively new, having originated in 2005, most lawyers are still unfamiliar with it and prefer the state arbitration courts with shorter litigation times and lower fees.

Foreign investment in the 39 strategic sectors of the Russian economy is monitored by the Federal Security Service (FSB),[44] the agency responsible for carrying out many functions formerly performed by the KGB. Investors that have either inadvertently or purposely committed their funds to one of these sectors will not be without due recourse, as the actions of the FSB in relation to foreign investment are still subject to oversight by Russian courts. For example, if the FSB finds out that foreigners have bought up shares in a strategic enterprise via Russian front companies, it will have to report this to the authorized body, and the government commission will challenge the deal in court. [45] 

Russia's extremely vague and overly complex tax laws often present another potential stumbling block to foreign investors.[46] The Russian government is in the process of clarifying these laws, but in the meantime investors should be aware that being challenged by Russian tax authorities for underpayment is a distinct possibility. [47] This possibility was evidenced recently, when the Russian government threatened to revoke PricewaterhouseCoopers’ license to operate in  Russia, for unpaid taxes but then agreed to extend it for five years. [48] Though investors should be aware of the above concerns, it appears that Russian courts are not unfriendly to the plight of foreign investors trying to solve disputes. Data suggests that foreign plaintiffs receive favorable rulings in at least half of the cases that they file before arbitrazh courts. [49]

VI. Conclusion

 

RussiaRussiaAre foreign investors squandering valuable opportunities by not capitalizing on the business opportunities presented by the growth of the Russian economy? Or perhaps the reluctance to take on the risks Russia  presents is justified? Is  Russia really unsafe for foreign investors? Or is this just a stereotype propagated by the Western media fueled by doubt that Russia  will ever be able to adopt a true market economy? Perhaps there is a genuine misunderstanding of Russia ’s strengthening government?  Will the reforms touted by Putin’s administration really be enough to address  Russia's historical problem of poorly defined property rights and protect investors? The answers to many of these questions will undoubtedly be revealed in the years to come.


[1] The Best Kept Business Secret in the World , Russia Blog, http://www.russiablog.org/2007/08/russia_is_the_best_kept_busine.php (

[2] The Economist Group, http://www.economistgroup.com/ (last visited Sept. 9, 2007).

[3] Best Kept Secret, supra note 1.

[4] U.S. Department of State, Background Notes-Russia, http://www.state.gov/r/pa/ei/bgn/3183.htm, (last visited Sept. 10, 2007).

[5] U.S. Department of State, 2006 Investment Climate Statement –  Russia ,  http://www.state.gov/e/eeb/ifd/2006/62376.html, (last visited Sept. 10, 2007) [hereinafter Investment Climate].

[6] Russian Federal Statistics Service, Volume of Foreign Investment in the Economy of the Russian Federation in 2006, http://www.gks.ru/free_doc/2007/b07_12/23-12.htm (last visited Sept. 8, 2007).

[7] Press Release, World Bank, World Bank Supports Legal Reform in  Russia (June 13, 1996),   available at: http://194.84.38.65/mdb/pressreleases/36/legal_eng.pdf.

[8] Vitaly Glinkin, Investment Climate in Russia, Fin. Times Bus. Recorder (June 11, 2007).

 

[9] Jeffrey Reuben III, Undersecretary of State for Economic, Energy and Agricultural Affairs to the American Chamber of Commerce in  Moscow, Remarks on Challenges and Opportunities for Economic Relations Between Russia and the U.S.(July 18, 2007).

[10] Id.

[11] CNBC’s Morning Call: Investing in Russia, Interview with Daniel Yergin (CNBC television broadcast June 11, 2007) available at: http://today.msnbc.msn.com/id/19156384.

[12] Id.

[13] Glinkin, supra note 8

[14] Id.

[15] Id.

[16] Intellectual Piracy is the Biggest Stumbling Block to Russia’s WTO Accession, Russia Today, Sept. 29, 2006, http://russiatoday.ru/business/news/5922.

[17} Miriam Elder, U.S., Russia Sign 800 page WTO Deal, Moscow Times, Nov. 20, 2006, at 1, available at www.buyusa.gov/russia/en/mt112006.pdf  .

[18]  Id.   

[19] RT Spotlight with Al Gurnov: Daniel Christman (Russia Today television broadcast Aug. 13, 2007) available at: http://russiatoday.ru/spotlight/release/631/video [hereinafter RT Spotlight].

[20] Id.

[21] Id.

[22] Elder, supra note 17.

[23] Id.


[24] Russia Tries to Protect Intellectual Property Rights, Russia Today, Aug. 20, 2007, http://russiatoday.ru/news/news/4500
 

[25] Id.

[26] RT Spotlight, supra note 19

[27] Bill Robinson, Remarks at the Discovery Institute Real Russia Project event: Russia: Friend, Foe, or What? at 20 (April 18, 2007) available at http://www.discovery.org/scripts/viewDB/filesDB-download.php?command=download&id=1394.

[28] Id.

[29] Allofmp3.com Head Not Guilty, Russia Today, Aug. 16, 2007,  http://russiatoday.ru/news/news/12529.

[30] David Blomgren, Russia and Piracy: Will Their Weak Stance on Intellectual Property Hurt Their Chances of WTO Entrance?, U. Ill. J. Bus. L. Soc’y, April 12, 2006 

[31] Investment Climate, supra note 5.

[32] Robinson, supra note 20

[33] Charles Ganske, Is Russian State Capitalism  Working? Russia Blog, Apr. 12, 2007, http://www.russiablog.org/2007/04/earlier_this_week_we_were.php.

[34] Robinson, supra note 20 

[35] Vladimir Kuznetsov, Russia’s Rising Ambitions, Russia Blog, July 27, 2007, http://www.russiablog.org/2007/07/russias_rising_ambitions.php#more

[36] Telephone Interview with Sophia Mintz, Russian Expatriate residing in Cleveland, Ohio (Sept. 9, 2007)

[37] Interview with Yelena Kurkina, Business Analyst at Deloitte, Moscow ( Sept. 10, 2007)

[38] Id.

[39] Vladimir Kuznetsov, Update on Investing in Russia’s Growth Sectors , Russia Blog, Aug. 6, 2007, http://www.russiablog.org/2007/08/investing_in_russias_growth_se_2.php.

[40] Troika Dialog et al., The Institutional Investor – MICEX Stock Exchange Guide to Investing in Russian Stocks and Bonds 20, (2007) available at:  http://www.iimagazine.com/article.aspx?articleID=1364274.

[41] Id.

[42] Id.   

[43] Id.

[44] The Government Prepares Restrictions on Foreign Investment in Strategic Sectors of Economy, Russkii Kurier, July 23, 2007.

[45] Id.

[46] Troika Dialog et al., supra note 37 at 21.

[47] Id.

[48] PwC Withdraws Yukos Audit Reports, Russia Today, June 25, 2007,  http://russiatoday.ru/business/news/9777.

[49] David E. Miller, Combating Copyright Infringement in Russia:  A Comprehensive Approach for Western Plaintiffs, 33 VAND. J. TRANSNAT'L L. 1203, 1207 (2000).