Russian Due Diligence

Russian Due Diligence

December 01, 2003

By Laura Brank

I have been working in Moscow for more than eight years, and I constantly have clients coming in, dropping a memorandum of understanding on the desk and saying, “Look, we have signed this great MOU with these guys.  We have been dealing with them for six months, everything is great, can you just formalize everything?” I ask them, “Did you conduct due diligence?” They respond, “Well, no, because we have been working with them for six months, we have seen the licenses, we have looked at their charter and we are okay with everything.”

Due diligence is extremely important in any transaction, but it is even more important in the Russian context.

There is an expression that came out of the negotiations between Ronald Reagan and Mikhail Gorbachev over disarmament, where Reagan turned with a smile to Gorbachev, and said “doveryay no proveryay,” which means “trust but verify.” That is very much the case in all Russian deals.  All information from Russian partners needs to be verified.  This applies across the board, whether dealing with partners or a company in which one is investing, and even with suppliers.  One really needs to know with whom one is dealing, especially in light of the changes in the world since September 11, 2001 and the Enron and WorldCom collapses in the US.


Due diligence is critical in Russia for a number of reasons.

First, there is a lack of transparency in Russia, in terms of both ownership and financial statements.  Although this is becoming better, it can still be very difficult to find out who owns a company because companies are hidden behind layers of offshore entities.  Transparency is also a problem on corporate balance sheets.  There are a number of hidden liabilities with which a western lender or investor may not be aware because they are not captured on the company’s balance sheet.  These often involve sureties, guarantees, barter relationships and other kinds of trades.  Also, managers often keep two sets of books.  They used to do this for tax evasion reasons.  These days they do it to hide related-party transactions from authorities.

Another reason due diligence is so critical is that there is a lack of publicly-available information in Russia.  It is very difficult to perform quick research on asset filings or to determine whether a company’s stock has been properly issued.  This research takes considerable expertise.

Bribery also makes due diligence important in the Russian context.  Bribery may be a concern to a western investor, but it might not cross the radar screen of a Russian company — and thus may not be disclosed upon inquiry — because the company did not view it as a problem.  Is there bribery in all Russian companies? Yes and no.  There is a certain level of corruption in almost all Russian companies, but the scope and recurrence differ from one company to the next.  The Yukos case, in which bribery is alleged at the highest levels of the Russian oil giant, is an extreme — but cautionary — tale.  An investor or lender should find out if bribery is rampant and at what level.  Money laundering is prevalent as well, and should be investigated.

Environmental problems may also sneak up on an investor or lender.  Many Russian companies are violating environmental laws.  They do not think it is any big deal because they pay small fines and penalties.  Like bribery, environmental problems do not give much for concern to them and so they may not mention them to an investor.

Finally, any number of non-Russian laws may apply to a Russian company.  One example is the US “Foreign Corrupt Practices Act.” Many Russian companies now have to comply with it because they are listed on US exchanges.  There are similar laws in England.  The “USA Patriot Act” is another example. (See article on USA Patriot Act on page 28.)

What to Look For

Once the decision has been made to conduct due diligence on a Russian company, the question is what to look for.  The following is a discussion of the major issues to keep in mind.  All of this is very practical, not theoretical, advice.  These are issues that Chadbourne has seen over the course of being involved in Russian transactions.  For most of these items, Chadbourne has been involved in litigation or disputes arising subsequent to an investment by a foreign company.

The point of the due diligence is not to find problems that mean you cannot go forward.  It is to find problems and resolve them before committing a lot of time, resources and money to the project only to find out about these problems later.

First, an investor or lender must verify that the Russian company has been properly established and its shares were validly issued.

Shares acquired in a privatization give particular cause for concern because almost no privatization in Russia went off without a hitch.  It is very rare that a privatization was carried out in full compliance with the laws of the time.  President Vladimir Putin recently said, in connection with the Yukos matter, “Oh no, we are not going to go after all privatizations.  This is a unique situation because of the criminal element.” Whether or not that statement is entirely accurate will become clear over time.  However, even if the government does not go after an asset, a competitor might.  This is something to look out for.

A due diligence inquiry should also look into whether the company’s charter complies with Russian law.  It may contain restrictions on foreign ownership.  In most cases this is illegal, but nonetheless such restrictions are often found and could cause problems going forward.

Registration is extremely important.  You cannot obtain shares in a Russian “closed” or “open” joint stock company unless those shares have been registered.  This is not a theoretical or merely formalistic issue.  For the last year and a half, Chadbourne has been working with a client that bought a majority interest in a mining company in the Far East.  It had purchased its shares from another western company.  Unbeknownst to this shareholder, the shares were not registered at the time the company was formed.  The minority shareholders were having some financial problems and decided that a good way to extract money — both from the majority shareholder and the company — was to take advantage of the fact that the shares had never been validly issued.  The minority shareholders had held the shares for six years at that point and had been receiving dividends from the company for the entire time.  Nonetheless, they challenged the validity of the share issuance because the shares had been traded before they were registered.

A share purchaser should also make sure that previous transfers were valid and all required approvals were obtained.  For joint stock companies, the only valid means of recognizing title is the transfer in the shareholders’ register, not a share certificate.  A purchase that drives a shareholder’s ownership percentage above 20% of a joint stock company or a limited liability company requires the approval of the Anti-Monopoly Ministry.  Also, there are pre-emptive rights for the existing shareholders to buy shares in joint stock and limited liability companies.  If the seller is another shareholder, the other shareholders must have waived their rights to those shares.

Next, ownership of assets should be verified.

A lender or investor should make sure that the Russian company holds the proper title to its assets, and that the approvals required in connection with the purchase of those assets were properly obtained.  The consequences of not receiving these approvals are that the Anti-Monopoly Ministry could unwind the transaction.  There may also be fines.

A recent example illustrates why this is important.  Chadbourne represented a lender that was providing a loan to Company A.  Company A had purchased substantially all of its assets from Company B.  As the transaction proceeded, it became clear that Company A had not obtained the major transaction approvals.  It also had not complied with the interested party transaction rules in connection with those transfers.  Amazingly, at the same time that we were doing our due diligence, the minority shareholders in Company B sued Company A for the return of those assets.  They said that the assets were illegally transferred due to failure to comply with the interested party transaction rules and the major transaction rules.  Luckily, in this case everything was resolved without going through the court system, but again it is just another example of how these things are not just theoretical.  The cautionary tale here is that in Russia — as well as other CIS countries — form often prevails over substance.  Issues that a westerner would consider to be non-substantive can have a huge impact on an investment in Russia.  Very, very clever Russian businessmen use the fact that form frequently prevails over substance to help rid foreigners of their investments in Russia.

Next are real estate and land issues.

Any ownership or leasehold rights to property must be registered in Russia in order to be valid.  This frequently comes up in the leasing context.  Nine times out of the ten, the Russian lessor will say, “Well, we do not want to register.  It is very bureaucratic.  It takes too much time.  It is expensive.” What it usually means is, “We do not want anybody to know because we do not want to pay taxes in connection with the lease.” A lease is not valid if it is not registered. (There are some exceptions for leases that are under one year in term.)

Tax issues always loom large in Russia.

An investor needs to make sure that the company in which it is investing — or with which it is doing business — is regularly making its tax filings and paying its taxes.  A company should also be making regular social and pension fund contributions.  Frequently Russian tax authorities, particularly in a company’s first year of business, will investigate a company to try to find fault with its accounting methods.

The investigation should also verify the existence of any tax exemptions the company claims to have, or even those you, as an investor, may have.  In another recent deal, a very large western investor started a big production facility in Russia about a year and a half ago.  The investor was entitled to certain tax exemptions, but it mistakenly thought that those exemptions applied at the federal, regional and city levels when in fact they did not apply at the city level.  The investor failed to pay city-level property taxes, and lo and behold, the authorities were all over it within a few days.

Other Pitfalls

Environmental liabilities need to be investigated.  An environmental impact assessment should be prepared in connection with obtaining a license for any natural resource project.  Licenses are also required with respect to the discharge of pollutants whether into the air, the water, the soil.

The penalties for violating Russian environmental laws are not very high, and thus some companies do not worry very much about these violations.  But for financing reasons, it is very important that there is an environmental program in place and that it is monitored to ensure that there is no violation of environmental laws.

Contractual liabilities are another problem area for many Russian companies.  Some companies are so desperate for financing in the early stages that they agree to outrageous terms to provide all of their output at a very “reasonable” price to a purchaser.  Alternatively, they may have engaged in very long-term supply contracts in order to get the financing.  The due diligence investigations should look into whether there is a way out of those types of contracts.

The Russian employment system is still very much a remnant of the Soviet system.  There have been some changes since the market economy came along, but they are not dramatic.

The investigation should look to how the company terminated employees and how it has been paying employees.  With respect to the latter, some Russian companies have developed tricks to get around social fund taxes, which are based on a percentage of what each individual employee is paid monthly.  To lower that amount, Russian companies often engage in various schemes where they are paying insurance premiums or all sorts of other things.  Recently one Chadbourne client refused to go forward with a deal because of this problem, which had gone back many years.

Bribery is a common problem in Russian companies.  There are anti-bribery laws on the books in Russia.  These laws not only catch payments to government officials, but also those made to commercial persons in order to win or retain business.

Currency issues are very important in Russia because there is a concerted effort to ensure that there is no capital flight out of Russia.  The restrictions have lessened over the course of the last few years.  They were especially tightened after the 1998 crisis.

Earlier this year the mandatory conversion requirement dropped to 25%.  In other words, 25% of the hard currency that a Russian company receives for the export of its oil must be converted into rubles and cannot be converted back into dollars unless there is a specific purpose for doing so.  Regulations govern what is an adequate purpose for these measures.

Oil and Gas Deals

There are issues that are specific to oil and gas deals.

The due diligence inquiry needs to look at whether the Russian company obtained all of the relevant licenses.  This inquiry can be time-consuming; rumor has it that ExxonMobil needed 44 different licenses in connection with one of its projects.  The benefit is worth the cost, though, as liability for failure to comply with licensing requirements can be severe.  In the worst-case scenario a project could lose its license.  Noncompliance includes not meeting the required levels that you need to in accordance with the law, not making timely payments of taxes, etc.

The license investigation must go deeper than simply asking whether all the required licenses were obtained.  Was the licensing authority authorized to give that license? There is a lot of competition between the local and federal governments, and all the steps must have been followed.  Some licenses may have restrictions on foreign ownership.  These are almost always completely unconstitutional and do not accord with the law on foreign investment.  It is something an investor can fight.  Chadbourne represented a client who complained that, for whatever reason, the local government had imposed some crazy restriction on foreign ownership.  It took us a while to get rid of the restriction, but finally the local government dropped it.

For any company that is a party to a production sharing agreement, the investigation needs to look at whether all the relevant government agencies have signed off on the production sharing agreement and whether it meets the requirements of the production sharing agreement law, which was amended this June.

Companies that export oil raise additional concerns.  The company should not have substantial debts with the customs authorities for the export or import of its product.  Any such arrears could prohibit it from exporting in the future.  The company must have all relevant contracts in order if it is putting its product through a pipeline.  Any tax indebtedness of a Russian company could prohibit it from putting its oil through the pipeline system.  This happened to a major Russian oil company two years ago; Transneft suspended throughput of the company’s oil as a result of the company’s tax arrears to the Russian government (despite the fact that the Russian government was a shareholder in this company).