Date: Sun, 20 Jul 2008
From: "Paul Backer" <pauljbacker@gmail.com>
Subject: Survival factors for foreign investors in Russia and CIS.
Survival Guide to Russia Business, Law, Regulations and Compliance
Part 4: Survival factors for foreign investors in
Russia and CIS.
By Paul Backer
pauljbacker@gmail.com
DISCLAIMER: This article is uncompensated. It is NOT legal advice. Everything
herein is personal opinion. It does not represent anyone else’s opinion. It does
not address any current or past client or employer matter.
WHY WRITE A “SURVIVAL GUIDE”? (Someone asked.) Having been in an environment requiring the rote generation of bi-weekly “success stories” there is something sordid about them. Why read how Bill Gates or President Medvedev ‘made it’? Never found these stories useful. Fracture analysis is useful. Failure teaches the heck out of you. It is more useful to learn which street corners are frequented by muggers (to avoid them) than learn where someone bought a winning lottery ticket.
Effective lawyering is not driven by sophism, it’s about stimulus and response. It is the ability to replicably produce a desired result through applying the right tool to a fracture point. A survival plan (assess, choose tools, implement) helps overcome, or better yet, anticipate and prevent failure. The hope is to suggest legal, regulatory and compliance best practices to prevail or at least identify where investors get mugged. Luck may be fickle, failure is a creature of habit.
SYNOPSIS: Project success is hard to predict. One of the more successful investments, I know in Russia, returns nearly 20% annually for years, free of local taxes, and was largely accidental. It’s much easier to identify a project saddled with failure factors. Your local mayor is a 20% owner of your project, wow… Bought a manufacturing facility and kept the General and Finance Directors on board, you don’t say… Signed over half of your real estate to your now former wife, good for you… Hired your girlfriend as a translator to accompany you to meetings, why not? And big projects are hardly immune, the ‘dead man walking’ spectacle of BP going on for years about being the one foreign investor who truly ‘gets’ Russia, ignoring clear failure factors is a morality tale in itself. I feel vaguely ashamed as I write this (shadenfreude?), but who can fail to learn something from the spectacle of the head of TNK BP celebrating (!!!) his work visa. How the mighty have fallen. So, a little about success and a lot about fracture points.
All happy families are happy in the same way, all unhappy families are unhappy in different ways. L. Tolstoy
Success is unpredictable. A private finance entity wanted to do projects in Russia. Meetings were held and projects proposed: a REIT, biofuel, gaming, Internet, etc. A couple seemed promising. Local investment opportunities require a quick response and funds were moved onshore to Russia and into rubles. Projects stalled. The funds were escrowed in VTB, MBRR and other ‘sovereign’ (too big to fail) RF banks. The banks pay 9-12% on term deposits, the dollar is undergoing a multi-year devaluation and a funny thing happened. Discarding the complexities of compound interest, $1,000,000 exchanged into 26,500,000 rubles a few years ago, at 10% annual rate, became 29,150,000, then 32,065,000, then 35,272,000. At the current ‘street’ exchange rate of 23.25, that’s slightly over USD 1.5 million. The funds are liquid by bank transfer on 5 business days’ notice (limited loss of interest if withdrawn before term), RF deposit insurance, tax exemption on earned interest below the RF CB refinance rate (11%). The product is available at 3% carry cost for the first year and 2.25% thereafter. Not bad. So, what didn’t go wrong?
A product (term deposit) was purchased, in a robust legal/regulatory framework, local public policy supports it, it didn’t require onsite commitment or active management that the investor was unwilling to provide and there was no local partner to fatally impact the undertaking. The primary risks were strategic rather than tactical. The RF banking system as a whole could fail, but what business model would survive the collapse of the national financial system? This would be a great moment to juxtapose successful business models with failed ones. Anyone got one? If you worked in a boutique practice, you don’t really have ‘teaching case’ quality long term business failures, those generally come from big firm practice.
Boutique firms know and stick to narrow market segments, often on a project success basis. Reputation for effectiveness is everything. Small law firms must be very selective on client recruitment and retention. It probably is possible to ‘fail’ the legal end of a transaction, compliance, a Eurobond, M&A, PPP, IPO, project or syndicated finance, but luckily for boutiques, the market response is immediate and brutally efficient. You fail, you get no money or new clients. If your firm’s business model does not include millions for real estate and advertising, it’s all word of mouth. A French colleague joked, “The big firms buy art, ads and buildings, small guys invest in deputy prefects and commissioners.” Fail your clients and starve. Support one too many failure magnet projects, and yours fails.
The major law firms have a very different business model. Does that mean that they are ‘bad’? Of course not, some types of transactions and clients require major firms. Try doing a road show for a $500,000,000 IPO represented by the law firm of Heckle and Jeckle. Not fun or a memory worth revisiting. No boutique can produce a McKinsey brick. Many of the most talented and respected professionals work for the major firms. You get a pension and do transactions that sometimes last years. Boutiques do projects, major law firms create industries. But, choice of a lawyer is a separate article, I think.
Assessment. Are you a dinosaur? Seriously. A Russian friend put it best (he is a judge who got harangued by a foreign investor in court), whom he described as “Addicted to the ‘Made In’ label”. Two guesses at that investor’s court ‘result’. Russia changes completely every few years. It’s not a good or bad thing, it just does. The poverty of the mid 90s, boom times in 97-98, collapse, current boom. What’s next? Something new. It’s not for the faint of heart or those unable to adjust. Personally, I am having a real problem adjusting to the $22 pot of tea in Coffeemania.
Work a few years and then watch it all vanish in the ’98 crisis and then willingly COME BACK and put your firm’s payroll into a Russian bank. It’s not easy. I am old enough to remember when being American was cool and sexy, and didn’t mean an annual 10-15% pay cut compared to anyone paid in Euro or rubles. What’s the practical point? It is that one should enter these markets with a somewhat realistic appreciation of what you bring and what you are willing to do to succeed. Know your exit strategy, every day should be a step closer to it. Be ready to get knocked down, kicked, then dust yourself off and smile or invest in the Baltics.
Tool 1. Identify and avoid low viability strategies. Investing in the sense of finding someone to take your money is easy. Usually, you even get a pretty story at the start and then another one when your money doesn’t come back. Traditional passive investing in Russia and much of CIS lacks a sound success record. Passive investing largely lacks a viable local historical tradition in Russia/CIS. If, as an investor, you expect to be an ‘absentee landlord’ you are likely to fail. With a good lawyer you are likely to fail much, much more slowly. If you invest in something tangible, chances are much better. Compare the returns of those who got VTB term bank accounts (a product) with those who bought VTB stock (passive ownership), a big difference.
Many made big money on Russia and CIS real estate, natural resources, products and services. Anyone make money investing in local intellectual property? Don’t be shy. Let’s see hands. Having worked spirits and gaming, including Stolichnaya, there are billions of dollars’ worth of IP in Russia and CIS. Doesn’t mean that you as a foreign investor can have it.
Tool 2. Is local public policy against your business model? Folks used to make CFC for refrigerators for the U.S. market. Others made asbestos. Legal business, employing lots of people, then it stopped being one. End of story. Russia and several other CIS nations unite permission based property systems with a powerful public policy component. If you as a foreign investor are considering a business model involving biotechnology (particularly blood products), arms and munitions, encryption and other strategic areas, think twice.
Don’t be tone deaf. If the local government passes legislation identifying market segments as strategic or if significant local stakeholders signal that it is strategic, consider taking them at their word and stay out. A major reason for employing experienced local legal counsel is to help ascertain whether a perceived threat is a shakedown artist pimping nonexistent relationships or the real thing. Understanding and managing administrative resource is definitely a separate topic. Suffice to say that if your local administrative relationships are mismanaged to the point that you find yourself tempted to or (sigh) giving “the world is watching, the whole world is watching” speech, stop. Give your lawyer at least some chance to sell your business and get at least some of your money back. It looks silly, folks will laugh at you.
A good lawyer can get you almost any required license to start operating, but why would you ‘invest in a lawsuit’? It may be worth considering avoiding investment in objects that can’t, for public policy reasons, be foreclosed on. If your investment object is the core employer in an area (gradoobrazuyushee predpriyatie), it is unlikely that you would be permitted to freely dispose of it. If railroads are part of the national strategic defense scheme, it’s not a good idea to accept them as collateral.
Tool 3. Mind your shop. Amazing how folks who recognize the validity of the 50 mile rule at home, forget it overseas. Are you going to be onsite? How often? Do you consider the Ritz Carlton lobby as ‘onsite’ for your project in Samara? Who is going to watch your interests? If you do not have an office in Russia and do not plan to open an office, who controls and monitors your investment and reporting? Will that person be loyal, competent and have an identity of legal interests with you?
Considering any of the following? Installing online internet cameras to supervise your employees. Relying on a non-Russian speaking major firm lawyer at 500 Euro per hour. Perhaps, annual audits by a big international shop based on locally sourced documents. Your local partner as primary source of reporting and monitoring. Is being ‘really angry’ at the local partner when you don’t get your monthly financials a key part of your strategy? Don’t.
If you are unwilling to put boots on the ground in Russia/CIS, why invest here? A project where you have no loyal source of monitoring and reporting is unlikely to succeed. An option with a good historical record is a dedicated virtual office in Russia, with a legal and a part-time tax advisor to monitor the project and required compliance, provide accurate monthly statements, pursue document and correspondence retention policies and keep an eye on your investment. These folks can also support your other projects in the region. Your virtual office in Moscow has limited ability to generate ALL reporting from scratch, but it will go a long way toward identifying missing and most importantly, faked reports.
Tool 4. Avoid the ‘power player’ delusion. One size does not fit all. A local stakeholder may lack influence in other jurisdictions. Russia and many CIS states have permission based property systems. In a myriad ways, a local stakeholder is indispensable to getting started quickly. If you want to take over a factory, you need stamps and signatures. A person with that authority is vital to your timeline. He may become a personal friend and a minority shareholder in the project.
It doesn’t mean that he could help you with ongoing operations or exit strategy. As an example, you may require a local prefecture to sign off on acquiring property at the municipal rate. Currently, for office space in Moscow it is reputed to be somewhere in the $250-400 per meter, commercial rate nears $2,000. It is of course, in the interest of the local prefecture to intimate that they can provide value beyond the initial signatures. To an extent, that is true. To a great extent it’s not. A prefecture can certainly impact your interaction with agencies subordinate to it. It is very unlikely that they can meaningfully support your interaction with federal agencies.
Your project needs are very likely to evolve beyond your initial core local players. Your counsel should continuously work to ensure that you accurately identify the support that your project needs as it grows. To a considerable extent, having your project develop serious tax, regulatory or other problems strongly indicates that your project’s needs moved on beyond the initial key stakeholder. Today’s key stakeholder is tomorrow’s pensioner.
As an aside, one of the great misperceptions about Russia/CIS is that everyone must be bribed to do their jobs. Nonsense. Lots of people register companies, receive drivers’ licenses, and complete a myriad administrative tasks without paying a penny in nonproductive rents. It takes longer. Much longer, because you get no preferential treatment. But, avoiding unnecessary scheming has distinct advantages. It creates much more durable models by eliminating potential unproductive rent seeking down the line. It’s also a great way to train young lawyers and your staff to do things in an appropriately transparent manner, making it much easier to monitor your own expenses and raising the value of your project. Projects which are widely seen as operating outside of the legal frameworks get treated that way by the enforcement authorities.
Tool 5. Avoid creating local minority shareholders. It is very hard to get the genie back in the bottle once a foreign investor gives away equity. Creating a local equity stakeholder eliminates a person deeply vested in your success and creates a competitor for the remaining equity. A competitor whose capacity for effective mischief materially outweighs his nominal equity.
A foreign investor doesn’t know local law and lacks local relationships. He is not likely to build ones stronger than the local guy. The foreign investor is always passing through, he is not going to move to Samara and raise children there. To me, ‘banya diplomacy’ is largely the attempt to make alcoholism deductible as a business expense. Local legal, regulatory and enforcement frameworks are much more durable than many investors think. Respect them.
It is inoptimal to dismiss local legal, political, regulatory and tax structures as ‘dysfunctional’. The fact that a system functions in ways that we don’t like does not make it dysfunctional. No legal, regulatory or tax structure is long term (10+ years) dysfunctional. Most function exceedingly well, they just don’t function in ways that we like or believe to be fair. The American and EU securities regulations systems target the protection of rank and file investors, the widows and the orphans. Russian and CIS systems can be argued not to share these priorities. One of reason is that they don’t really have rank and file investors, perhaps because they don’t protect them.
From a legal and management perspective it is far preferable to compensate local stakeholders based on ongoing contribution to project success rather than through equity. Local stakeholders are just that, local. This gives them tremendous advantages in an adversarial situation. If they own a share of the project, their ability to impact it may be completely disproportional to the extent of their ownership. In some local legal systems a minority shareholder (as low as 10%) can sue to expel the majority shareholder from his own business for acting against the interests of the enterprise. They know the local politicians, judges, police and have daily access to the site, employees and documents. If at all possible, leave Pandora’s Box of local minority shareholders closed. If not possible, work with your lawyer to make the best of it.
As a note, it is a huge oversimplification to ascribe the preference for local stakeholders to ‘corruption’. You are visiting, the local will be there his whole life. He is vested, he has an actual stake in the geographic location. He is known. He is trusted.
Tool 6. Collateralize and protect your investment. It is much easier to enforce registered property (collateral) rights than securities rights. Registering collateral and other property rights is a very effective tool to prevent the dilution of your rights. Avoid ‘pure equity’ investments. If you invest to purchase something, it must be pledged to protect your rights until repayment or some other exit event. If you invest $10,000,000 for 70% ownership of a cement plant in Samara, the plant must be pledged as collateral plus its intellectual property, brand names, patents, and key exclusive legal rights. Don’t transact with physical persons, ever. If you co-invest or co-own with a physical person, your next new shareholder could very well be his former spouse.
Tool 7. Walk through your transaction. Thirteen years ago at Georgetown I was blessed to have a joint venture class taught by someone who pioneered transacting in the region. Subsequently, I have ‘walked transactions’ for over a decade as a physical exercise with lawyers. Identify potential chokepoints by tracking your transaction from raw materials entering the object to finished product going out to customers. A transactional attorney should help you determine whether your transaction will work and if your interests can be secured, not just if it is ‘legal’.
If you are invest in a cement plant in Samara, what are the indispensable properties/rights connected to that enterprise? Is it worth owning the plant if the electricity supply contract is not under your control or if the territory under the plant can be re-assigned with a signature? Who owns the equipment in the plant? Who owns the road/railroad siding to your plant, are there exclusive contractual rights that impact your project? Are the assets pledged? Are you about to invest millions into purchasing an enterprise under criminal prosecution for intentional bankruptcy or tax fraud? Have material judgments been awarded against this company? Check local tax, court and land documents to limit surprises. Check the local press coverage of the enterprise. This is not unique to Russia or the CIS, how many investors in the U.S. got a great deal to buy a future CERCLA site?
Tool 8. Accept and plan for entropy. You invest in a developing economy, because you seek disproportionate returns. The degree of certainty from due diligence is less than in developed economies. Audits reflect the documents made available for the audit. Documents get lost. Sellers hide and destroy documents. Sellers are often weak operationally and administratively, particularly in compliance. That’s why many of them are sellers.
Many Russian/CIS investment projects represent an intertwined web of companies and mutual obligations. Many Russian/CIS investment projects experienced ownership transfer through bankruptcy. Expect that there are some liabilities that are not discoverable through due diligence. Historically, 10-25% deviation from expected debts, liabilities, etc. is not unusual. Escrow a part of the purchase price to deal with contingencies. If your seller refuses to accept an escrow of 15-25% of the purchase price for a limited period of time, that’s a very strong indicator that he may either lack an accurate picture of the object himself or of something worse and intentional.
Tool 9. Take local laws and regulations seriously. If you are acquiring a natural resource site and the previous owner never filed environmental statements and never had problems, there is no reason to expect that to continue. Same goes for labor law violations. Do not expect to be treated in the same way as the previous local owner. You will not be. The seller’s cousin who runs the natural resource compliance authority is not your cousin.
This does not mean that your local partner seeks to deceive. He may genuinely expect that you will be treated as he was treated. You won’t be. It is embarrassing to jeopardize a multi-million dollar investment, because it failed to provide a few thousand dollars’ worth of compliance reporting. It is possible to purchase the cement plant in Samara, it is not possible to purchase relationships.
Tool 10. Put in your management. Always change the General and Finance Directors. What do you do if the General Director has unique relationships with local authorities? Change him, always. If you need his expertise, pay for it, but that’s no reason to leave him with signature rights over your property. If your project can be rendered nonviable through the change of one executive, is it a good idea to invest?
Implementation. Historically, initial monitoring and compliance costs average around 3.5 to 5% of the project value with the costs significantly diminishing for larger projects and as best practices are put in place. It’s not cheap. It is worth looking at the economics involved.
Class A office space in Moscow averages around $2,000 per square meter per year. A local attorney from a good school with 2 to 3 years of corporate experience and serviceable English who would have commanded a monthly salary of $1,000 to $2,000, 4 years ago, now costs around $3,000 to $4,000, before taxes. Multiply those costs for a major law firm where a Partner’s time can approach $1,000 an hour after VAT.
A virtual office with a lawyer and an accountant dedicating a significant portion of their time to supporting your projects runs Euro 6,000 to 8,000 a month. It provides a ready source of executive staff should you want a brick and mortar office in the future. Noncompete provisions are largely unenforceable in Russia/CIS. It’s good to have staff, it’s even better not to have to pay for the full cost of their support infrastructure until it makes sense to do so.
Using the Samara cement plant as an example, a lawyer local to Samara instead of Moscow would seem much, much cheaper. It is a false saving. Counsel local to a project site (outside the capitol) lack experience and training in: language and corporate culture, GAAP and/or IAS accounting standards, requirements of foreign investors and ethics. The following are common.
Obstinate formalism and a lack of comprehension of commercial imperatives. The moral hazard or the ‘capture’ of your counsel, ‘your’ attorney based in Samara and monitoring a project in Samara is vulnerable to impacts from local stakeholders. For a local attorney, a foreign investor is an abstraction, the local mayor, police, enterprise employees are a daily reality and may be relatives and clients. What if your strategy is to materially RIF local staff? What if you are buying a manufacturing facility to turn it into a golf course or a hotel? If your attorney stays in Samara after your exit, will that affect his loyalty to your objectives?
Historically, it is far easier to scale down a Moscow attorney to develop implementation capacity locally than to scale up a provincial attorney to be effective in the capitol. A provincial attorney is less likely to have meaningful relationships in Moscow. Key financing and exit strategy functions are likely to be executed in the capitol. A foreign investor is much more likely to be physically present in the capitol to guide support staff in the desired implementation of tasks and reporting. Ultimately, Russia and many CIS states are ‘top down’ regulatory, economic and political systems. Having to choose, it is likely preferable to risk losing a local regulatory or court decision and prevail on appeal in Moscow than vice versa.
Next article, Rule of Law.
As always, questions and suggestions to pauljbacker@gmail.com.