A discussion of due diligence in Russia completes our four-part series on doing due diligence in the BRIC countries, which represent the world’s largest emerging markets. Some of the themes applicable to China, Brazil and India, and discussed in our articles in the past three issues, are equally relevant to Russia, including potential FCPA risks, relatively poor record keeping and occasional reluctance on the part of companies and management to share information with outsiders. Russian targets also 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 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 often 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. While most public companies in Russia are well aware of the due diligence process and its importance to investors, on occasion, management may nonetheless be reluctant to share information with outsiders for confidentiality reasons or concerns relating to the impact of a transaction on management’s own future or the business as a whole. Private companies are generally even more skittish about sharing information and may need a fair degree of prodding before they will do so.
  • Internal organization: The strength of the internal controls and organization of Russian companies varies greatly, with public companies that are subject to more extensive disclosure requirements and independent audits of their financial statements obviously being better situated than private companies. Most companies have legal departments and in-house counsel; however, decentralization of information and knowledge is a common issue. For example, even public companies may lack a comprehensive internal list or register of licenses and contracts, and documents may be held by various different departments. There is also often a lack of efficient communication between departments and/or affiliates. Another impediment is the lack of standardized documentation and good corporate housekeeping, e.g., minutes of shareholders meetings or board meetings are often not properly maintained.
  • 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, such as the unified register of legal entities or register of rights to real estate, have recently been improved greatly and are now widely used. However, a unified register of court cases is just now being launched. And there is still no unified register of licenses and permits.
    Therefore, in order to make sure a company possesses all requisite licenses and permits, separate requests to numerous licensing bodies is required. To complicate the situation, registers are known regularly to contain errors and omissions. This results in frequent challenges to the veracity of information in state registers, which means that an excerpt from a register is usually not considered dispositive evidence of whatever fact one is trying to verify. Although some resources are available via the internet, the information may well be dated and contain omissions.

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. Payment obligations may also arise under the laws and regulations applicable to water use, air protection, and the handling of waste. 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 (although criminal prosecution to date has been very rare).
  • Occupational safety and health: Russia has rather extensive occupational safety and health laws and regulations, and employers that fail to comply with such laws and regulations are subject to fines and other sanctions. However, the extent of enforcement of these laws and regulations also varies depending on the region and industry sector.
  • Insurance: Many Russian companies do not purchase insurance policies covering such matters as property loss/damage, product liability and third-party liability, other than if 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 antibribery perspective. The FCPA risk is, not surprisingly, higher in business sectors that operate under governmental concessions and authorizations. In addition, it should be noted that many large companies in Russia are state-owned or controlled, 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 antibribery laws.
  • Land use issues: Russian law recognizes private and state land ownership, as well as other categories of land rights and encumbrances. State ownership is divided into property of the Russian Federation (federal property), property of the various Russian regions and property of municipal entities (municipal property), but for various reasons it is not always clear which governmental body or official has the right to lease or otherwise regulate the use of real property. And Russian companies occasionally use land without proper title. To make matters worse, although title to real property in Russia is subject to state registration, in certain cases land rights are considered valid without such registration. Therefore, 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. Compared to common law jurisdictions, prior court decisions have limited precedential authority in Russia. That said, in 2010 the Supreme Arbitration Court was granted limited authority to make decisions that may serve as precedents (sometimes, unfortunately, with retroactive effect). Russian laws have undergone substantial development over the past two decades, and continue to progress rapidly. Currently, the Presidential Council is working on substantial changes 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, such as a prohibition on foreign investment in TV and radio broadcasting companies that reach more than half of the constituent entities of the Russian Federation or more than half of the general population. In addition to direct prohibitions, Russian law also establishes restrictions on foreign investment in companies whose operations are in an area of strategic importance from a national defense and security perspective. Such restrictions generally take two forms: either a quota is put in place for foreign investment in a certain market (e.g., there is 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 state. Such areas of strategic importance include certain types of activities relating to radioactive and nuclear facilities, weapons, arms, ammunition, explosive material and military hardware; encryption and covert gathering of information; aviation and aerospace; operations of natural monopolies; and use of subsoil plots of federal importance. In general, no unified set of prohibitions and restrictions on foreign investment exists in Russia. Such prohibitions and restrictions are instead scattered throughout a number of different laws and regulations, often with different definitions, rules and procedures.
  • Foreign exchange controls: Most of the currency control restrictions applicable to currency transactions between Russian residents and non-residents ceased to apply in 2007. However, there still is a prohibition on foreign currency transactions between Russian residents and a requirement to repatriate export-related earnings back into Russia, in each case subject to certain exceptions.
  • 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 are required to maintain a register of shareholders through an independent registrar (the company may generally choose from among dozens of licensed registrars in the market). Joint stock companies having less than 50 shareholders may maintain their own register (and in such cases the register may not be maintained properly and may need to be updated in connection with a sale).  Beginning July 1, 2012, all public companies, even if they have less than 50 shareholders, will be required to maintain their register of shareholders with an independent registrar. 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). The above described regime makes determining ownership of and transferring title to equity interests in Russian companies difficult and complicates the due diligence process.
  • Tax litigation: Business entities in Russia are frequently involved in lawsuits and administrative proceedings that challenge the interpretation and application of tax rules and regulations. Because entities within the same industrial sector are often involved in lawsuits and administrative proceedings challenging the same taxes and on the same grounds, it can be useful to attempt to ascertain what tax issues the competitors of a target have faced or are facing, as that will give some indication of the potential issues the target may have in the future.
  • Labor litigation: Russian laws grant employees extensive social security and labor 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 U.S. 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, financial institutions, professional participants in securities markets, investment funds, non-governmental pension or other funds, insurance companies, companies whose assets or turnover exceed the statutory thresholds and certain other categories of companies. However, enders often require independent audits of their borrowers regardless of whether they fit within any of the foregoing categories, so private companies with debt facilities outstanding may well have audited financials. Most large Russian companies, whether public or private, are audited by the “big four” auditing firms or a reliable Russian accounting firm. It is worth noting, though, that there are a number of local accounting firms in Russia that are less credible and not always impartial in performing audits.
  • 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.  Certain additional companies will be required to prepare such statements starting in 2015. Most publicly listed Russian companies are currently preparing consolidated audited financial statements in compliance with the IFRS or U.S. GAAP, although this is not required by law.
  • Related party transactions: Private companies in Russia tend to have extensive, and sometimes messy, related-party arrangements or interested party transactions, as they are often called. Failure to approve a transaction as an interested-party transaction may in certain cases result in the invalidation of the transaction upon claims by disinterested shareholders of the company, which is especially important to note for foreign investors since Russia does not always recognize conflict of laws principles, and even a transaction governed by foreign law and containing an arbitration clause in certain cases may be found invalid in Russian courts under Russian law.

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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 minimize risks to the greatest extent possible. Guidance from experienced, knowledgeable advisors is crucial to success in this land of still relative uncertainty.