| JRL HOME | SUPPORT | SUBSCRIBE | RESEARCH & ANALYTICAL SUPPLEMENT | |
Old Saint Basil's Cathedral in MoscowJohnson's Russia List title and scenes of Saint Petersburg
Excerpts from the JRL E-Mail Community :: Founded and Edited by David Johnson
#43 - JRL 2008-140 - JRL Home
Date: Thu, 31 Jul 2008
From: "Paul Backer" <pauljbacker@gmail.com>
Subject: Surviving Rule of Law in Russia and CIS, nationalization, compliance, governance.

Survival Guide to Russia Business, Law, Regulations and Compliance
Part 5: Surviving Rule of Law in Russia and CIS, nationalization, compliance, governance.
By Paul Backer
pauljbacker@gmail.com
International corporate and securities attorney in private and public practice focused on Russia/CIS from 1994.

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 A “SURVIVAL GUIDE”? Lawyers are not useful in starting a business, we are not about dreams we are about fracture points. Starting a Russia/CIS business may be about inspiration, keeping it operating and in your possession until you are ready to exit is all about the 7Ps. Proper prior planning prevents piss poor performance. Avoidable failure is a great teacher, its pain aids the learning. Corporate survival and effective lawyering are about replicable results driven by stimulus and response. Applying best practices to a fracture point for replicable results is professional activity. Anything not replicable is not professional activity. The survival guide’s best practices drive replicable results through assessment, tools and implementation.

SYNOPSIS: Rule of Law is not a test of virtue of either the investor or the enforcement authority. Rule of Law is about enforcement consistency. Businesses enjoy a Rule of Law environment if market participants can identify the rules of the game and the rules are consistently applied to them as a (sub) group. The clarity of the rules and the consistency of their application determine the strength of Rule of Law. Rule of Law is not about ‘fair’, it is not the Rule of Mom and Dad. If a foreigner is arrested, his Embassy seeks to ensure consistent not ‘fair’ local treatment. Does Russia/CIS have Rule of Law? Yes, with a vengeance, and not in the way of U.S. or EU Rule of Law. Strong Rule of Law is not necessarily positive from the business perspective. In many ways, business in Russia/CIS was easier for entrepreneurs when Rule of Law was much weaker. The current environment for investors is arguably a Tyranny of Law. Relatively minor and previously ignored compliance and governance failures led to demise of multi-million dollar projects. There is hope, Rule of Law as applied in Russia, Kazakhstan, and several other CIS states is highly mechanical application. Mechanical application is predictable and can be harnessed.

“I don’t conceive it to be the function of an advocate or the function of a lawyer to make a moral judgment on the rectitude of an accused case. Fortunately, it isn’t expected or required of lawyers to make moral judgments, the guilt or innocence of the defendant is determined by the jury.” Edward Bennett Williams.

The definition of chutzpah is a man convicted of murdering his parents asking the judge for leniency in sentencing, because he is an orphan. Attributed to Ed Koch.

Some feedback. A reader wrote that the dollar return on depositing rubles at 10% in a RF bank with monthly compounding and dollar depreciation was over 20% for years. My point was that if Russia’s banking system fails, little will be left standing and historically, “too big to fail” is not a bad guide to successful regional investing as long as investment is not passive. A comment was that I am an apologist for the Russian government, lack empathy for the suffering of investors, and how can I write about Rule of Law in light of ‘recent events’ and ‘corporate injustice’. ‘Corporate justice’ is what exactly? Ronald McDonald as the kindly sheriff of Mayberry? Empathy? I got empathy, I get weepy every time we close a Eurobond. Who doesn’t?

Show me a guy talking about an ‘unfair’ transaction, and I will show you a guy who usually failed to plan, thought he was in the ‘Wild East’ and lost control of his deal. Often, the trick is just to see trouble coming and take a short step out of its way. I did represent the interests of governments on natural resource, securities, telecom, gaming and spirits matters. Once or twice whipped the major firms on the other side. Felt good and built relationships, but in fifteen years don’t remember ever being hired as an apologist. Clients hire you to displace their opponent, apologizing is done far more cheaply by the client himself. As to “recent events”, I am just not sure what the twin sagas of TNK BP and Mr. Browder have to do with Rule of Law as applied to business in Russia/CIS.

BBC reports, TNK BP is a project jointly approved by the RF and UK governments under President Putin and Prime Minister Blair, with $5 billion in annual profits. Is TNK BP really a “business”? HP and many other companies got started in a garage. What size garage do you need to accommodate the entourages of a RF President and a UK Prime Minister? To me, TNK BP is a multinational sovereign finance project outpaced by events and political change. As usual a lot of decent folks on every side got caught up. But, gauging TNK BP impact on actual business in Russia is like evaluating how a failed NASA space shuttle launch affects commuter flights from NYC to Boston. Probably not that much.

As to Mr. Browder, to me, his background is not an obvious one for an ethicist. To me, his experience may be a good example that how one starts a business impacting how that business is treated later. The situation has a lighter side, with Vladimir Putin repeatedly asked if he heard of Browder. Putin doesn’t remember Browder, ever. It’s like the Simpsons episode where Homer snaps, because Monty Burns can’t remember him, ever.

The less light side is about Mr. Earl Russell Browder, NKVD, Mr. Safra, reported early Hermitage activity, etc. It’s online, if you are interested. I am certain that both BBC and Russia will host him again. I am not a fan of Mr. Browder at the same time it is hard for me to see why he should be denied a visa. If there is a dispute and he is willing to travel to Russia and be subject to RF law, how is that a risk to Russia? Russia survived worse. I personally can’t look for ethical guidance to Mr. Browder. I am just not able to extract Rule of Law or corporate governance lessons from his moral teachings.

So, what does Rule of Law mean for your Russia/CIS business? Quite a great deal. It’s not about being a good guy or shudder, the government being fair to you. Governments are not in the ‘fairness’ business, it is not what governments do. Governments enforce rules guided by their ideology to achieve their objectives. One key distinction is that Rule of Law is not universal in Russia/CIS, it is class specific. There are distinct pluses and (to some extent) increasing minuses to being a foreign investor. Most foreign investors are not seeking to effect sweeping social change in Russia, they seek to ensure that the rules of the game are identifiable enough for the investor to be able to enter and exit.

Rule of Law in Russia/CIS never was and never will be the same for everyone, particularly foreigners in the post-Soviet space. The foreigner were always treated differently, initially much better, and now sometimes much worse than local nationals. The key issue is whether the foreign investor will be treated consistently among his and similarly situated classes. Without degenerating into a law review article, based on my experience the current answer is largely ‘yes’. To me, the key indicators are that foreign investors have won court decisions and effectively access government enforcement resources in Russia and CIS.

It’s an interesting point to debate, and I am willing to do so offline, but for the sake of this article and its (hoped for) brevity I will just make it a flat statement. If you are not treated the same as other members of your class, it’s usually one of two things, bad choice of counsel or of local cooperating party/administrative resource. If regulatory impacts happen to your business that don’t happen to similarly situated businesses in Russia/CIS it is a very good sign that something is structurally wrong with your project. That kind of warning is cheap at any price.

Getting back to Rule of Law. The primary recent Rule of Law development is that fairly minor and previously unenforced violations of compliance regimes in Russia and CIS led to involuntary uncompensated transfers of project ownership, particularly in natural resources, real estate, licensed activity and passive investment. And yes, “involuntary uncompensated…” is a very awkward way to say ‘nationalization’, the key point, is that it isn’t. Some characterize any time government authority is exerted to take their stuff as nationalization. But, Rule of Law allows the responsible officials to derive the benefits of nationalization without its pain. This is what makes property distribution through Rule of Law so attractive and what makes corporate governance and compliance a fairly sudden priority for survival in Russia/CIS.

Outright nationalization, a state sponsored mugging, the naked use of government authority to coercively transfer private property rights has become a rarity in Russia/CIS. Nationalization is inelegant, hard to do, unfashionable and generates public outrage. Nationalization is predictable, preventable and defeatable. Perhaps, most significantly, nationalization is economically inoptimal, limiting the value of the captured object. Once you seize a project, and if you are seen as taking it illegitimately, what do you do with it? Nationalization is a lot of work and wasted administrative resource for comparatively little return. It requires specific legislation and the willingness, at some government level to endure criticism, to wear the mantle of a villain.

On the other hand, the involuntary transfer (seizure) of property rights, because a natural resource owner failed to provide an environmental report is protecting one’s citizens through Rule of Law. It is virtually impossible to make a compelling case against timely submitting required reports, even if the previous owner failed to ever do it in the preceding ten years. Try effectively arguing against paying fines for flaring oil gas if the fines are in your PSA or license. Not fun. Feel your counsel’s pain trying to rally support if you lost an oil field due to failing to file environmental reports for a few years. Particularly if each report costs less than $5,000. Imagine the expense of the time travel involved in retroactively filing timely compliance reports. It can be done, but it is wholly avoidable and very expensive. Seriously, how do you argue in favor of not filing environmental reports? Well, arguing is easy, but how do you win?

Assessment. Your feelings about Rule of Law are good stuff for cocktail conversation, but have nothing to do with keeping you in control of your project to monetize the time and money that you invested. What are the risks to your business from local Rule of Law? What are you required to do? How do you do it? Depends what business you are in and what kind of an attorney you have in Russia/CIS. I don’t mean ‘good’ or ‘bad’ attorney, but whether you have one who understands how projects start, operate and are exited or if you have one billing you for his time rather than project result. Is your guy only able to get local signatures or on the other extreme, only able to tell you what the Constitution says?

My favorite example is a local Russian attorney who helped a client get all the signatures required to buy a natural resource field. The process took slightly more than six months, all of the signatures were gathered, stamped, etc. The field license was revoked within 120 days, because none of the compliance in the preceding years was done and several notices were ignored. I can’t speak to the client’s feelings, never met him. But, it my friend, the attorney felt genuinely aggrieved that the client was mad at him. He was asked to help do the sale, he did the sale, what’s the problem? OK, before we digress, let’s pick choosing local counsel as the next article.

Tool 1. If your activity is licensed, do you know your license and background legislation? What are its requirements? It may sound deeply exaggerated, but it is not unprecedented to miss two reports and be fined around $400 for each, but be unaware that willful and repeated violation of reporting requirements leads to loss of license altogether and thus imperils a multimillion dollar project. Look at the required reporting, verify that the reports were actually made. This is not meant to sound obvious, but reporting is made to clearly identified federal, regional and local government entities and must be properly receipted, otherwise it doesn’t exist.

Many foreign investors have found it sensible to do their local partners reporting for him to ensure project safety. Please be aware that if your specific license does not contain requirements spelled out in the relevant Law on …. [fill in your activity] or the provincial/local regs, follow the law and the provincial/local regs. Over-reporting is legally far less dangerous than under-reporting. You can turn back the clock if the responsible agency seeks to revoke your license, but it is unnecessary and expensive.

If you are buying an oil or gas field, ask to see the receipts for the required environmental and exploitation reports, know sanctions for failure to report. Look at your license, you may have reporting requirements specific to your region. Some licensing is territorial, some is federal, some is both. If your local partner or the seller can’t produce proof that reports were filed, presume they weren’t. If he got away with it for ten years, don’t assume you will. A legal opinion that your ownership of an oil field does not violate the RF Constitution or Civil Code is not just inherently worthless (sound opinions look at applicable statutes) it is also worthless, because it doesn’t inform you whether you are acquiring 10 years of violations along with the field.

Note, the application of Rule of Law to natural resources is almost wholly mechanical. Reports are filed or weren’t. Incoming reports and other required documentation are recorded when received. If a report to a government entity is not logged in when received, then it is effectively not made. Not ‘brought to office’, not ‘left on desk’, not ‘mailed by registered mail’, was it receipted or not? This is where a local office or a virtual office shines. It involves topics previously discussed virtual office, control of correspondence, etc. If notice was sent of a violation to your local partner and he forgot to tell you, wouldn’t you just feel foolish?

Tool 2. Taxes and knowing your number. Taxes are a separate topic. Briefly, violating the tax regime is one of the easiest ways to lose your business. How do you trigger a negative event? One leading ways is to badly choose local counsel. If you design a tax optimization scheme, be absolutely certain of the person you are scheming (pun) with. Better yet, don’t scheme directly. It is an oft reported local story where a fly by night tax entity is hired to design a framework which then promptly reports that framework to the tax authority and then collects more of your money to solve the problems they created. Very few things make entrepreneurs feel as alive as battling tax authorities, but if you don’t need the thrills, they can be avoided by not directly engaging local tax professionals.

Please, please, please don’t be the one who outsmarts everyone by engaging some shady local character to do offshores. This may cause shock and dismay, but if you use a local schemer to form your offshore empire, the first thing that person shops to the responsible authorities are the names and locations of the offshores. Use reputable service providers.

Back to taxes, anyone can be inspected, but it is very strongly rumored that the RF tax authorities firmly rely on ‘magic numbers’, depending on your inspectorate. Certain events are triggered at certain turnover levels. One way to avoid a triggering event is by not keeping all of your revenue eggs in one basket. It may be easier to book income through simplified VAT regime companies in some circumstances. Above a certain amount you have to sue to get your VAT refund. It’s not personal, it’s a magic number.

Tool 3. Who is your daddy? Know who has the right to inspect you and under what circumstances and how. This may sound ridiculous, but do you actually know who your business reports to? Let’s try the easy ones: tax authority, police, fire inspectors, maybe sanitation and epidemiological service (if you employ people or work with food). How about cash register inspectorate, customs, department for fighting economic crime, etc.? It may sound like a dramatic exaggeration, but one Moscow business was inspected 45 times in one year. Not 45 inspections, but inspected by 45 separate municipal, regional and federal entities. They survived and thrive. A very important part is not just know who you report to, it’s also knowing what their rights are.

For example, did you know that your local policeman (uchastkovii) must open a case file on you and/or your business before conducting investigative activities? Don’t chat with people who can take away your stuff. If you are part of someone’s revenue stream, any excess verbiage can only hurt you. As a conscious exercise, make a list of who your business reports to. Know what their inspection rights are, and most importantly what your notice rights are.

Imagine that you are running a boutique law firm in Moscow a few years ago, and suddenly the police can enter law firm premises without a warrant. You know, just drop by for a chat and do some light reading. What do you do? Call the BBC? Write a scathing op/ed piece for the Moscow Times? As a form of therapy, why not? But mostly, you adapt and overcome. You move key operations into residential real estate. You don’t keep original documentation on premises. If you are on the far edge of security consciousness, install degaussing strips in doorways. A zoning violation is punishable by a fine, but they need a warrant to get into an apartment. This is one of those moments when I prefer uniformed militia as security, they feel perfectly comfortable telling an officious (but not official) government busybody where their bus gets off.

Implementation. The idea is simple, know your obligations, verify that they have been carried out. Ask to see receipts and get official excerpts from relevant logs. Know the rights of those who inspect you. Know what triggers inspection and other Rule of Law events, and it is largely mechanical. Avoid telling your secrets to those who can gain materially by disclosing your secrets to the responsible authorities. One distinct advantage of large firms is that much of their activity is covered by actual Bar Association rules, not the shadowy interplay of mutual favors and obligations. Avoid being a one time customer, but more on that next article.

A quick discussion as to why there is such a high dependence on mechanical triggering events. This is largely due to the fact that the government has the same problem as most entrepreneurs, monitoring the functionality of subsidiary enterprises. How do you keep prosecutorial, tax authority, licensing, natural resources, sanitation and epidemiological authorities and other revenue (and problem) generating entities from running amok? Control them through establishing mechanically determined trigger events. This is why President Medvedev describes controlling the number and frequency of inspections as a key aspect of fighting corruption. This is not naive or cynical, it is a recognition that Rule of Law in Russia/CIS is mechanical and one of the few reliable tools when trying to control literally hundreds of thousands of officials spread out over one of the largest landmasses in the world with fairly low levels of computerization.

So, what does it cost? Roughly, all-in your compliance costs should be around 3-4% of the value of the project, including legal and tax compliance and reporting. For other specifics see previous pieces. You can pay more, but the key to effectively protecting your interests is to make it an ongoing, not an anecdotal process. If you are constantly playing catch up and staggering from crisis to crisis, most likely you will be bled white by either your local partner or the local authorities or your counsel. As an example, the process of confirming compliance with required reporting can take weeks of generating inquiries. It’s not a high tech process, but it is a document intensive one. Much cheaper to have an actual or virtual staffer minding a process than have your 500 Euro an hour lawyer follow it up every 4-6 weeks as he remembers it.

Finally, remember that the Russian/CIS Rule of Law system is not the U.S./U.K. model of common law and equity, it is more Germanic, focused on accountability, on registries, document logs, proper placement of stamps, outgoing correspondence numbers, rules for document production, etc. Boxes and checks for those boxes. The mechanical approach and formalism are driven by the need to track and control action and distribution of revenue and power. Everyone reports to someone, and ultimately to the capital. If you understand what drives the folks keeping an eye on your business, it helps you manage them. And that’s why prepared beats the heck out of smart 95 out of 100 times in Russia and CIS. It’s shameful, but it’s always kind of funny to see ‘smart’ weeping softly in the dust. The weeping, it has a musical quality to it.

Next article: factors in choosing local counsel.

As always, questions and suggestions to pauljbacker@gmail.com.