Russian targets present a number of specific challenges that may significantly complicate the due diligence process. This stems in part from the fact that the legal framework relating to the ownership and use of land and other real property in Russia, and to some extent the proper recording of title to shares and participatory interests in Russian companies, are not yet sufficiently developed. Foreign investments in certain sectors are also subject to multiple and sometimes ambiguous prohibitions and restrictions.
And finally, Russian legal and accounting regimes are developing at a very rapid pace, so just keeping up with the changes and figuring out how they might impact an investment is itself a challenging task.
DUE DILIGENCE PROCESS
Familiarity with due diligence process and requirements: Russian companies' familiarity with the due diligence process and the relevant requirements is considerably dependent on the size, type and location of the relevant company. Unlike private companies, most public companies in Russia are well aware of the due diligence process, however, on occasion, management may nonetheless be reluctant to share information with outsiders for confidentiality, personal or other reasons.
Internal organisation: The strength of the internal controls and organisation of Russian companies varies greatly, with public companies that are subject to more extensive disclosure requirements being better situated than private companies. Most companies have legal departments and in-house counsel. However, decentralisation of information and knowledge, lack of good corporate housekeeping, standardised documentation and efficient communication between departments and/or affiliates are common issues.
Publicly available information: As a general rule, a search for publicly available information must be conducted at the public authority charged with keeping the particular sort of records sought. Public search resources are still generally underdeveloped, although some (e.g. unified register of legal entities or register of rights to real estate) have recently been improved greatly and are now widely used. Registers are known to regularly contain errors and omissions, and an excerpt from a register is usually not considered dispositive evidence of whatever fact one is trying to verify.
BUSINESS DUE DILIGENCE
Environmental compliance and enforcement: Levels of compliance by Russian companies with environmental laws, and the extent of enforcement, varies depending on the region and the size of a company’s operations. Russian environmental regulations generally establish a “pay-to-pollute” regime administered by federal and local authorities. If the operations of a company violate environmental laws or otherwise cause harm to the environment or any individual or legal entity, a court action may be brought to limit, suspend or ban such operations and require the company to remedy the effects of the violation. Any company or employee thereof that fails to comply with environmental regulations may be subject to administrative or civil liability, and individuals may, in addition, be held criminally liable.
Insurance: Many Russian companies do not purchase insurance policies covering such matters as property loss/damage, product liability and third party liability, other than where explicitly required to be maintained by law (for example, where a company operates hazardous facilities). Therefore, the scope and amount of insurance policies held by a company may well be inadequate in view of the nature of the business conducted by such company.
FCPA: Russia is still considered a “high-risk” country from an anti-bribery perspective. It should be noted that many large companies in Russia are state-owned or controlled, and therefore directors and employees of such companies are deemed to be “government officials” under the FCPA, with the result that payments made to them could run afoul of anti-bribery laws.
Land use issues: Russian law recognises private and state (federal, regional and municipal) land ownership, as well as other categories of land rights and encumbrances. Russian companies occasionally use land without proper title. In addition, for various reasons it is often difficult to determine with certainty the validity and enforceability of title to real property and the extent to which it is encumbered.
LEGAL DUE DILIGENCE
Regulatory environment: Russia’s legal system is primarily based on statute (although, the Supreme Arbitration Court has limited authority to make decisions that may serve as precedents). Russian laws have undergone substantial development over the past two decades, and continue to progress rapidly. Currently, Russian legislative bodies are considering draft amendments to the Civil Code, and as a result, Russia may be facing significant reform of its civil and commercial laws in the coming year. Many laws and regulations are relatively new and may contain broad and sometimes ambiguous provisions. As a result, government authorities and courts end up having broad interpretive and enforcement discretion leading to sometimes unpredictable results.
Foreign investment approvals and restrictions: Russian law establishes different regimes for foreign investment in various different sectors from a direct prohibition of foreign investment (e.g. a prohibition on foreign investment in certain TV and radio broadcasting companies) to restrictions on foreign investment in companies whose operations are in an area of strategic importance from a national defense and security perspective. The latter generally take two forms: either a quota is put in place for foreign investment in a certain market (e.g., a quota for foreign investment in the Russian insurance sector) or there is a requirement that each particular transaction involving foreign investment in certain strategic companies be cleared by the special governmental committee. Such areas of strategic importance include among others certain activities relating to radioactive and nuclear facilities, weapons, arms, ammunition, aviation and aerospace; operations of natural monopolies; and use of subsoil plots of federal importance.
Rights to shares and participatory interests: Most Russian commercial entities exist in the form of a joint stock company or a limited liability company. Joint stock companies having more than 50 shareholders (beginning July 1, 2012, all public companies) are required to maintain a register of shareholders through an independent registrar. Other joint stock companies may maintain their own register themselves. A transfer of shares in a joint stock company occurs at the moment of the change to the register. While limited liability companies keep registers of their shareholders (participants), such registers do not definitively evidence ownership of the participatory interest (instead, title passes at the moment of notary certification of the operative transfer document). This makes determining ownership of and transferring title to equity interests in Russian companies difficult and complicates the due diligence process.
Labor litigation: Russian laws grant employees extensive social security and labour rights and employee benefits, the costs of which are mostly borne by the employer. Additional rights and benefits may also be established by collective bargaining agreements between labor unions and employers, although unions have recently become more rare.
FINANCIAL DUE DILIGENCE
Accounting records: Accounting books and financial records of Russian companies are generally less transparent than those of US companies. Russia is currently implementing an electronic filing system aiming to improve the level of monitoring by Russian tax authorities and the transparency of accounting records generally.
Financial Audit: Independent audits of financial statements are only mandatory for public and listed companies, professional participants in securities markets and certain other categories of companies. However, most large Russian companies, whether public or private, are audited by the “big four” auditing firms or a reliable Russian accounting firm.
Accounting standards: As a general rule, Russian companies are required to prepare audited financial statements under Russian Accounting Standards (“RAS”). Under a new law adopted in July 2010, financial institutions, insurance companies and listed companies are also required to prepare consolidated financial statements in compliance with the IFRS, starting with their annual financial statements for 2012. Most publicly listed Russian companies are currently preparing consolidated audited financial statements in compliance with the IFRS or US GAAP.
Related party transactions: Private companies in Russia tend to have extensive, and sometimes messy, related-party arrangements or interested party transactions. Failure to approve a transaction as an interested-party transaction may in certain cases result in the invalidation of the transaction by Russian courts upon claims by disinterested shareholders of the company (even if a transaction is governed by foreign law and contains an arbitration clause).
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Russia is a large and growing market, full of potential opportunities. But investors must be wary of potential pitfalls and extra vigilant during the due diligence process in order to minimiSe risks to the greatest extent possible. Guidance from experienced, knowledgeable advisors is also crucial to success in this land of still relative uncertainty.
This condensed article originally appeared in fuller format as the final installment from a four-part series in the Debevoise & Plimpton Private Equity Report. PE Manager published the first three installments covering China, India and Brazil which can respectively be found HERE, HERE and HERE.
Alyona Kucher and Natalia Drebezgina are partners and Evgenia Berezkina is an associate in the Moscow office of international law firm Debevoise & Plimpton.