RUSSIAN UPDATE – Changes in Russian Foreign Investment Regulations To Ease Restrictions
- On November 16, 2011, President Dmitry Medvedev signed into law amendments to the Federal Statute “On the Procedure of Foreign Investment in Businesses with Strategic Importance for the Defense of the Country and the Security of the State” (Strategic Companies Statute).
- The amendments are expected to ease the stringent restrictions that Russia puts on foreign investment.
- The amended law would allow the acquisition of banks and the purchase of 25% of stock in certain Strategic companies without the prerequisite approval by the government committee. There are some other minor changes.
The Strategic Companies Statute
The Strategic Companies Statute was adopted in April, 2008. Generally, the statute provides for mandatory approval by a special governmental committee of any deal that falls within certain criteria.
The core rule, at first glance, is quite simple – acquisition of control in a company of strategic importance for national defense and security requires preliminary approval by the government committee (Committee). As one can see, there is a two part test:
- The target must be a Russian company that has strategic importance for national defense and security (Strategic Company) AND
- The acquirer, a foreign investor, seeks to obtain control of that company.
The statute further defines what a Strategic Company is and what constitutes acquisition of control.
According to definitions contained in the Strategic Companies Statute, a Strategic Company is a Russian company engaged in one of the predetermined activities of strategic importance for national defense and security. There is a long list of such activities including (with some reservations) exploration of natural resources, the extraction of aquatic biological resources, TV and radio broadcasting, etc…
The statute also deems the cryptographic industry to be strategically important for national defense and broadly defines it. One may say this strategic area is not inherently attractive for foreign investors looking towards Russia. However, defining it as strategic has some inadvertent but significant effects. Organizations like banks and other financial institutions that widely use cryptography in communications with their clients become Strategic Companies.
Acquisition of Control
The statue is fairly precise on what constitutes control. The rule of thumb is that the ability to directly or indirectly manage more than 50% of issued and outstanding shares (participatory interest or other form of voting rights) in a Russian company constitutes control. Other parts of the disjunctive test include:
- The right or authority to determine decisions formally to be made by the controlled entity;
- The right to appoint the chief executive officer or more than 50% of the management board, or unconditionally elect more than half of members of the board of directors of the controlled entity; or
- Being a managing company of the controlled entity.
With regard to Strategic Companies that are engaged in geological research and exploration of natural resources in fields of federal importance (strategic energy exploration companies), a significantly lower threshold is set. In this case the number of 10% of voting rights is enough to trigger the Strategic Companies Statute control provisions.
Certain deals are exempt from the restrictions of the statute. Exemptions apply to strategic energy exploration companies, 50% of the voting rights in which are controlled by the Russian government.
Admittedly, the law inhibited foreign (sometimes even domestic investors) more than would otherwise be necessary to protect a legitimate governmental interest in national defense and security. The shortcomings of the law that has been widely discussed include an unjustifiably low thresholds of control in strategic energy exploration companies; vague procedures for approval of transactions; almost unfettered discretion of the Committee in imposing conditions on the deals.
The Amendments are tailored to cure some of the challenges that were created with the adoption of the Strategic Companies statute:
First of all, private banks are no longer generally considered to be strategic companies. The exemption, however, is not absolute. It does not apply to banks that, although economically private, are still partly owned by the Russian government. The degree of ownership is immaterial – even one share is sufficient. This seriously limits the scope of the exemption, as the Russian government owns a stake in the vast majority of leading domestic banks which in reality control the market.
Secondly, probably in response to numerous complaints from market participants, the definition of control with regard to strategic energy exploration companies has been changed. The control threshold is now 25% instead of the 10% initially set. Although not a fundamental change, this will probably ease the deal making process.
The third significant change is rather related to domestic investment. Because of some specifics of the Russian legal system and law enforcement many Russian companies still prefer to manage and sometimes operate their businesses through entities incorporated offshore. This situation is still a case even if a Russian company predominantly operates domestically.
In Russian law the term “foreign investor” has purely a legal rather than an economic interpretation. It is simply defined as an organization incorporated in a foreign country, the legal capacity of which is governed by laws of a foreign country. As a result of this interpretation, unbeknownst to Russian lawmakers, many domestic equity transactions automatically fell within the stringent restrictions of the Strategic Companies Statute.
In response to the problem described above, the amendments exempt transactions between companies, the beneficiary owner of which is a Russian tax resident, from the preliminary approval requirements.
Other changes to the statute mainly concern procedural provisions. Those are exemptions for international public financial organizations, some clarifications of procedure in order to make it more transparent, and some other minor changes.
To sum up, the amendments to the Strategic Companies Statute, probably, will not drastically impact the investment climate in Russia. However, another step towards the liberalization of the domestic market has been made.