CONDUCTING DUE DILIGENCE IN RUSSIA
Laura M. Brank
Over the last several years, many Russian companies have begun to recognize the value of transparent operations and sound corporate governance, making foreign investment in Russia and commercial relationships with Russian partners more attractive than in the past. At the same time, investors need to be cautious before moving forward in Russia.
Proper due diligence is critical for a number of reasons. First, it is important to know with whom and what you are dealing. Often times, there are multiple ownership levels in Russian companies, and true owners are hidden behind offshore entities. Second, a Russian company may have “hidden” liabilities such as sureties, guarantees, or other contingent liabilities that are not accounted for in the company’s books. Third, even if a proposed partner or acquisition target adheres to good corporate governance principles in Russia and is upfront about any possible legal violations, there still may be issues of concern to a U.S. investor that may not be at all apparent or problematic to a Russian company. Such issues often arise in connection with environmental, labor, tax, and currency matters.
What to Look for in Potential Transactions
Legal Status and Proper Establishment. The first order of business in any transaction is to determine the legal status of the Russian company with which you are seeking to do business. For example, if the shares of the company were originally issued through privatization of a state-owned enterprise, the privatization documents must be reviewed to ensure that the initial transaction conveying title to the purchaser complied with the tender/auction requirements.
Due diligence should ensure that the company’s charter complies with Russian law. Foreign investors should also confirm that the charter does not contain any restrictions on foreign ownership.
Proper issuance of shares of a Russian company generally requires shareholder approval and registration of the shares, typically with the local branch of the Federal Commission on the Securities Market. Additionally, any licenses issued with respect to certain industries (particularly those involved in the exploitation of natural resources) must be reviewed carefully to ensure that the company has the proper authority to carry out its activities. Licenses may also contain some restrictions on foreign ownership.
Ownership of Shares. In the case of an acquisition, to ensure that the shareholders have good title to the shares of the target company, due diligence should confirm that all necessary corporate actions-including special approvals that may be necessary if the state owns a stake in the enterprise-have been taken. Almost all Russian shares are “uncertificated,” and ownership is recorded in book-entry form in the shareholder register.
If acquiring newly issued shares, investors should check whether the issuer’s charter grants existing shareholders preemptive rights to participate in the purchase of the shares. Closed joint-stock companies and LLCs always grant preemptive rights, and they may also grant rights of first refusal.
Corporate Governance Issues. Investors should also be familiar with the authority of each governing or management body within the Russian company in question to ensure proper signatory authority. The charter of the company and various internal regulations and powers of attorney should be carefully reviewed. It is not uncommon for a Russian party to subsequently argue that a given company official was not authorized to execute a particular agreement.
Ownership of Assets. If an investor is considering an asset acquisition (as well as certain large share purchases from the issuer), it is necessary to confirm that additional corporate approvals have been obtained. For example, any transaction involving assets in excess of 50 percent of the balance sheet value of a Russian company’s assets requires a qualified majority vote at a general meeting of shareholders. Transactions between the company and an “interested person” (including managers, directors, and shareholders with 20 percent stakes) must be submitted to the board of directors, the company’s audit committee, and the company’s auditor.
Real Estate and Other Property. All real property, including land, and any transactions involving real property or land, must be registered with an appropriate registering body, which in most cases will be the local registry for immovable property, in order to be valid. Therefore, where real estate is involved, most due diligence will involve reviewing title certificates, purchase contracts, leases, and mortgages to ensure that they have been registered and, for mortgages, notarized. It is also important to verify with the registering body whether any liens have been filed and to confirm that use of the real property is permitted, especially with regard to land use.
Tax Issues. With regard to taxes, all of the company’s tax filings should be reviewed, but it is also important to investigate any actions the tax authorities may have brought against the company and to verify the validity of any tax exemptions or audits on which the company may be relying. Finally, particular attention should be devoted to the company’s arrears to social funds, if any, as well as medical and education obligations.
Liabilities. It may be very difficult to identify the many liabilities Russian companies potentially face. Where violations of environmental or labor regulations are identified, often only small penalties are applied, which can mask the true extent of a problem. Any existing court cases or documents concerning administrative proceedings against a target company should be carefully analyzed, with particular attention to documents related to the use of hazardous materials.
Contractual liabilities may also be a problematic issue. Particular attention should be paid to the legality and enforceability of real estate leases and joint activity and consulting agreements. If there has been any litigation against the company, investors may be unable to access court records to conduct their due diligence, since court records are generally not available to the public.
Labor Matters. Even though Russian labor is generally inexpensive, many remnants of the Communist labor system remain and thus a company’s labor structure should be carefully analyzed. Collective employment agreements may affect how the company operates, but even without a collective agreement there may be serious restrictions on the termination of employees. Also, there may be hidden payroll issues, including payment schemes that are not clearly reflected in the company’s books.
The due diligence process in Russia is never easy, but recognizing and resolving fundamental issues early on could save a great deal of time, expense, and headaches in the future.
Laura Brank is the managing partner of the Moscow office of Chadbourne & Parke, LLP (www.chadbourne.com).
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