I. Introduction
Someone might view the economic crisis times as the best period to broaden one’s business horizons and invest into a new market. The fast growing markets such as China, Brazil, India and to some extent Russia are waiting for new investors. Russia, having more than 140 million inhabitants, i.e. potential consumers, and abundant natural resources remains mostly neglected by investors in many business fields. For decades Russian market was viewed as not a place for those faint-of-heart. Now the growth of political stability and positive developments in legislation make the investment less risky and more attractive. Nevertheless, the still existing differences between local and internationally recognized legislative frameworks and court practices make investors wonder if there is any possibility to opt out of the Russian legal rules.
This article will explore the reasons behind Russian corporate norms that explain the inflexibility of current legislation and court practice and discuss views on future development of the corporate law system of the country. Part II introduces an overview of the policy issues behind the corporate law created specifically for Russia as a developing economy. Part III analyzes the legislation and its drawbacks, provides advice for investors who for various reasons want to opt out of Russian law. Part IV discusses the reasons for the government amending the corporate law, gives a forecast of future developments and provides a general conclusion.
II. Why Russian Corporate Law is Different?
Russian Corporate Law created after the collapse of the Soviet Union was specifically fit to satisfy the needs of a country with a developing newly privatized economy and aimed at raising confidence in the capitalist model of society. [1] Professor Bernard Black, who devoted his scholarship inter alia to corporate law governance in emerging markets and participated in the creation of what is the basis of the current Russian corporate legislation, proposed a “self-enforcing” model of law that was supposed to trigger foreign and national investment and minimize transactional costs. [2] However, it was impossible to directly “plant” a western legal tree into the Russian soil. While such countries as the U.S. had a long history of courts regulating the issues of reasonableness of defensive actions in takeovers, fiduciary duties, conflicts of interest, Russian lawyers and judges had virtually no practical experience in corporate disputes as private business did not exist as a notion during the Soviet era. [3] The main idea of the “self-enforcing model” was to make it function through the actions of the first-hand participants (shareholders and managers) and not judges or government authorities. [4] As the court practice in the corporate field was undeveloped and cumbersome the legislators came up with the idea of simplicity and clarity of the statutory language; possible elimination of “vague” concepts, such as fiduciary duties, that are supposed to be evaluated by courts; a prevalent number of mandatory norms and strong legal sanctions as a counterbalance to the low probability of their real application. [5] The legislators tried to minimize agency costs by giving a single shareholder rights to protest “majority transactions” and “transactions with interest”, by establishing cumulative voting for election of members of the board of directors; a one (common) share – one vote rule; special rules for approval of transactions in which managers or large shareholders have a conflict of interest; requirements that a company issues and acquires its own shares only at market value; redemption and appraisal rights for shareholders who do not approve of reorganizations, and takeout rights that allow investors to sell their shares to a shareholder who acquires a controlling block of a company’s shares). [6] On the other hand creditors were not always well protected, especially in limited liability companies (LLCs) where until recently an LLC participant had the unrestricted right to exit the company anytime with the market value of her stock paid to her. [7]
III. Why You Might Not Need Russian Law in Russia?
It has been almost 15 years since the adoption of Russian corporate regulation. The market is open, relatively stable and corporate law has experienced serious changes, but the core concepts of the law have mainly stayed untouched as the abundance of mandatory provisions remained. A foreign investor coming today to the market and seeking an equity investment into a Russian company has mainly two options: a contractual joint venture based on a co-operation contract (not the best choice because of an unfavorable taxation regime) and an incorporated joint-venture. [8] There is always a possibility, for instance, in sales-purchase transactions to sign a contract with a Russian company under foreign law and include an arbitration clause containing choice of law and forum provisions. However, this makes sense if a foreign investor is not interested in controlling the company that has assets in Russia; otherwise joint-venture is the most suitable option. The two commonly used forms of joint-ventures are an LLC and a closed joint-stock company (CJSC – a private company where participants own shares that are not publicly traded); however, the choice of form mainly depends on the economic considerations and specific circumstances. [9] Some investors prefer LLC as they are subject to a lighter regulatory regime, while others choose CJSC as it offers higher protection to shareholders, although is more burdensome as it implies issuance and registration of shares. [10]
The main problem is that international joint-venture terms such as, inter alia, shareholders’ agreements and share retention agreements, options and certain governance standards and are not applicable to Russian incorporated LLCs and CJSCs. [11] Let’s imagine a courageous investor who comes to the market. He will be probably eager to enter into a share purchase agreement containing warranties protecting him from liabilities or inaccuracy of the financial statement. [12] However, under Russian law enforceability of such warranties is doubtful, as these warranties cover the company and other business issues not directly related to the shares. [13] Shareholders’ agreement, in its turn, for a long time did not exit in Russia. Traditionally in developed economies this type of agreement between shareholders has been used as a powerful tool of control over exercise of voting rights, election of company bodies, and distribution of profits. [14] However, under Russian law shareholders (and members of LLCs) did not have explicit right to enter into such agreements to add voting rights, change quorum requirements and rights to appoint managers. [15] Investors were also discouraged from using foreign law for shareholders’ agreements even if one of the shareholders was a foreign company; although theoretically it complied with Russian choice of law rules, courts did not share this point of view. [16] In a number of notorious cases shareholders’ agreements constructed under foreign law were viewed by Russian courts as founding documents of the company which cannot be governed by foreign law; as an unlawful restriction of civil-law rights (because shareholders were obliged to act in a certain way in accordance with the agreement) and as violation of public policy. [17]
Option agreements, under which one party has the right to demand purchase of its shares by another party and the other party assumes an obligation to sell the relevant shares, are strictly limited under Russian law, as it is not clear whether such a transaction may be at all conditional on the actions of one party. [18] Share retention agreement (in which parties agree not to dispose of their shares in a joint venture unless special circumstances occur) is in its sense a negative covenant and, thus, its enforceability is questionable. [19] Moreover, Russian law does not contain an event on default provision when breach of one party would make it sell the shares in the joint-venture to the other member of the company at a specified price. [20]
Thus, investors, not satisfied with the rules of Russian corporate law, started searching for a new market for law which eventually resulted in jurisdictional competition between Russia and, not surprisingly, offshore zones. The concept of the corporate market for law is a relatively new one and implies that with free trade, faster communication and transportation shopping for legal regulation of corporations (business entities in many jurisdictions are regulated by the laws of the place of incorporation) is like shopping for other goods. [21] Incorporating offshore is, basically, killing two birds with one stone: minimizing tax burden by incorporating in a jurisdiction that has a favorable double taxation treaty with Russia, a favorable domestic tax regime and a flexible corporate law regulation. [22] The most popular offshores are Cyprus and Netherlands (popularity of Cyprus is explained both by its favorable tax treaty and by its common law legislation and, thus, flexibility in administration and corporate governance). [23]
While the simplest structure of this joint-venture is a company incorporated in an offshore zone which wholly owns a Russian subsidiary, the most sophisticated one might represent a three tier structure including several investment vehicles, intermediaries, a treasury company located offshore and Russian subsidiaries owning assets in Russia. [24] This might be achieved by the transfer of the title in all shares in a Russian incorporated joint-venture to an offshore holding company. [25] The advantages of this incorporation are legally binding and enforceable shareholder agreements and other internationally recognized methods of shareholder protection (limited only by the legislation of the offshore jurisdiction).
IV. Will Russia Ever Win the Jurisdictional Competition Battle? Prognosis and Conclusion
So far Russia was constantly losing its jurisdictional ‘battle’ to offshore zones. One of the main reasons why offshores have not become even more popular was their dubious reputation as tax evasion vehicles. However, their reasonable use by investors as a means of creating a more stable company has significantly changed this belief in the Russian market.
Nevertheless, there have always been investors who feel ‘uncomfortable’ if not hostile to dealing with offshores, and until recently Russian law had practically nothing to offer them. The revolution in corporate regulation was a long awaited one and happened in the winter and summer of 2009. Amendments to the Laws on Joint-Stock and Limited Liability Companies finally introduced shareholders’ agreement into Russian Law (in addition to a number of other important provisions); and amendments to Law on Pledges made pledges over Russian shares a more attractive proposition to a lender. [26] These substantial improvements of the legislation seem to be the response of the government dissatisfied with the offshore fashion that furthers residual non-repatriation of profits through offshore structures to Russian beneficial ownership. [27] The question arises: have these amendments really changed anything? In the short term perspective the answer is: “No”. Unless and until investors see a significant amount of shareholders’ agreements being enforced in Russian courts, they will still prefer to incorporate offshore rather than in Russia.
Now under Russian law shareholders are permitted to coordinate exercise of their voting rights; refrain from transfer of shares until certain circumstances occur; perform coordinated actions in connection with managing of the company; acquire shares at a pre-determined price (or) when certain circumstances occur. [28] However, it is still not clear whether the agreement can be governed by foreign law, or whether the use of tag-along and drag-along provisions contradicts the Russian Civil Code stating that contracts may be conditional only on circumstances which are not under control of the parties to the contract. [29] Furthermore, breach of the agreement does not invalidate the decision made by the general meeting of shareholders in violation of the agreement and only provides to the non-breaching parties recourse to contractual remedies stipulated in the agreement. [30] Consequently, the listed amendments will unlikely lure investors into incorporating in Russia.
Moreover, Russia proving the theory that jurisdictional competition is supposed to discipline the government at the same time refutes it in another respect. [31] The recent Decree of the Federal Financial Market Service imposes 5% of the company’s stock limit on the amount of a Russian company’s shares offered in an overseas IPO. [32] This amount is generally considered inadequate for an IPO and, consequently, the amendment “could spell the end of Russian IPOs on international securities markets” (31 of 48 Russian companies trading on foreign and domestic stock exchanges placed their shares on foreign exchanges in 2006-2007). [33] While this amendment might have the aim to increase liquidity of the domestic securities market by forcing investors to purchase shares of Russian companies in Russia, it will likely cause a new wave of offshore incorporations, as Russian issuers can transfer assets to an offshore holding which in its turn can freely trade them on international stock exchanges. [34] Thus, Russia will lose its jurisdictional competition ‘battle’ again.
Russian corporate law was created as a “self-enforcing” model but with a clear idea that the development of the market should be joined by the development of the legal system. Evolution of law is impossible without the evolution of the judiciary, which in its turn in Russia should be supported by strong anti-corruption program that is already being implemented at least on a partial scale. [35] It is certain that offshore structure will be used in the future, unless a law is adopted prohibiting operations of offshore owned subsidiaries on the Russian territory, which is unlikely. The analysis provided in this paper suggests that until the government and the judiciary clearly decide whether they are adopting a strongly pro-investor policy, such issues as the one of the IPO regulation will be turning investors towards a better market for law which is offshore havens. It might be that the government with the existence of a better anti-corruption control and promotion of corporate governance culture will be more willing to abandon self-enforcing model of corporate law, to give Russian courts more leeway in deciding corporate cases and provide companies with a more flexible regulation.
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[1] Bernard S. Black, Reiner Kraakman, Anna Tarasova, Guide to the Russian Law on Joint-Stock Companies (in Russian) 20 (Labirint Press 1999), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=246670.
[2] Id.
[3] Id. at 25.
[4] Id.
[5] Id.
[6] Gainnan Avilov, Bernard S. Black, Dominique Carreau, Oksana Kozyr, Stilpon Nestor, Sarah Reynolds, General Principles of Company Law for Transition Economies (English Version) 10 (Stanford Law Sch., John M. Olin Program in Law and Economics, Working Paper No. 165), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=127208.
[7] Federal’nii Zakon N 14-FZ ob Obshestvah s Ogranichennoi Otvetstvennost’ju [Federal law on Limited Liability Companies], N30 Rossiiskaia Gazeta (Russian Newspaper), Feb. 17, 1998; Federal’nii Zakon N 208-FZ ob Akcionernih Obshestvah [Federal Law on Joint-Stock Companies], N248 Rossiiskaia Gazeta (Russian Newspaper), Dec. 29, 1995.
[8] Hermann Schmitt, Joint Ventures in the Russian Federation 1 (2009), http://www.whitecase.ru/articles/jointventure2008.pdf.
[9] Id. at 2.
[10] Id.
[11] Christopher Rose, Doing Deals in Russia – 5 Useful Tips 1 (2008), http://www.fbird.com/assets/Doing%20Deals%20in%20Russia__932008114212.pdf.
[12] Id.
[13] Id.
[14] Ilya Nikiforov, Ilya Bulgakov, Marina Nohrina, Shareholders’ Agreements under Russian law: is there an alternative? (in Russian) (2006), http://www.epam.ru/index.php?id=22&id2=511&l=rus.
[15] Id.
[16] A. Bogomazov, LLCs: Russia gives Way to Shareholders’ Agreements (Dec. 2008), http://www.russianlawonline.com/content/llcs-russia-gives-way-shareholders-agreements.
[17] Id.
[18] Schmitt supra note 8, at 7.
[19] Id.
[20] Id.
[21] Erin A. O’Hara and Larry Ribstein, The Law Market 3 Oxford University Press (2009).
[22] Nicholas Moore, Justin Vaughan, Markets emerge 3 (2009), http://www.herbertsmith.com/NR/rdonlyres/3339CE53-490D-46E8-B037-5864AD213E6F/12456/Marketsemerge.pdf.
[23] Rose supra note 10.
[24] Moore, Vaughan supra note, at 7.
[25] Schmitt supra note 8, at 8.
[26] Moore, Vaughan supra note, at 3.
[27] Id.
[28] Briefing, Herbert Smith LLP, Shareholders’ Agreements under Russian Joint Stock Company Law (Aug. 2009), http://www.herbertsmith.com/NR/rdonlyres/6379F4C5-AA4A-4E0E-9BCE-68860220B5FC/12032/7650ShareholdersagreementAug09.pdf.
[29] Id.
[30] Id.
[31] O’Hara, Ribstein supra note 18, at 4.
[32] Prikaz Federalnoi Sluzhby po finansovym rynkam, [Decree of the Federal Financial Market Service] N 09-21/pz-n, N194 Rossiiskaia Gazeta (Russian Newspaper), Oct. 14, 2009.
[33] Glenn S. Kolleeny, Anton Fedotov, Draft Amendment to Stop Russian IPOs Abroad 1 (Aug. 2009), http://www.salans.com/~/media/Assets/Salans/Publications/Stop%20IPOs%20abroad%20final.ashx.
[34] Id. at 3.
[35] Federal’nii zakon N 273-FZ o Protivideistvi Korrupcii [Federal Anticorruption law], N266 Rossiiskaia Gazeta (Russian Newspaper), Dec. 30, 2008.