International Outlook: FSU/Eastern Europe

Judicial reform leaves unsolved problems in Russia’s oil business

Despite apparent positive changes in Russia’s investment climate in Russia, E&P investors should continue to carefully consider substantial legal risks

 A. Grant McCrea and Andrei Yakovlev, Dewey Ballantine LLP, New York

The combination of BP and TNK oil reserves in Russia is held up as an example of improved investment conditions, but substantial risks still exist.

 Last February, BP announced its largest investment in Russia, yet – $6.5 billion – to be made through a venture that combines the major’s Russian holdings with those of Tyumen Oil Co. (TNK), and its partner, Access-Renova. The new entity will become Russia’s third-largest oil company.

 Russian officials and foreign observers, alike, have praised the deal, holding it up as an indication of radical improvements in the investment climate of Russia’s oil sector. In the past few years, Russia has taken a number of important steps to improve the climate for foreign investors. Significant changes have been made in corporate law to ensure transparency and protection of minority shareholders. Important amendments have been made to procedural laws relating to commercial disputes. 

 However, foreign investors should not overestimate the BP deal or other large-scale projects as barometers of positive change in Russia’s investment climate. Substantial legal risks persist.

  RESOLUTION OF DISPUTES REMAINS UNCERTAIN 

 International arbitration is the method of choice to settle disputes relating to operation of foreign businesses, particularly in the oil sector. However, foreign firms may still find themselves with no choice but to appear before Russian courts. Reasons may include the following:

•  The other party to the dispute is a governmental agency.
•  As a matter of Russian law, a particular type of dispute cannot be arbitrated.
•  Although both parties have agreed to arbitration, the Russian party seeks (under various pretexts) to void the agreement, in the (frequently well-founded) belief that a Russian court will be inclined to rule in favor of a Russian party.

 The manner in which the Russian court system operates continues to cause considerable concern. Until this year, a Russian court was required to judge the merits of a dispute at the conclusion of a single hearing, irrespective of the complexity of the matters involved or the scope of evidence that needed to be reviewed. Considering that each judge would have six to eight cases scheduled for each day, proper adjudication of complex commercial disputes was not possible. 

 However, the new Russian Procedural Code came into force at the end of last year. It requires a number of preliminary stages in court proceedings.

 Yet, court calendars remain extremely tight and, generally, the same judges preside over them as did before the reforms. Judges continue to handle cases with a speed that is totally inadequate for proper review of complex commercial cases. Judges tend to reduce the newly introduced procedures to a minimum, and they often encourage parties to agree to skip certain stages altogether. Parties often find themselves reluctantly agreeing to such courses of action, fearing that failure to do so will antagonize the judge.

 Intense political pressure is often the most serious impediment to the fair resolution of disputes, particularly in Russia’s remote areas. The Russian jurisdictional rules often leave no choice to foreign oil companies but to appear in court proceedings in remote areas. 

 Economic and political life in many of these areas is dominated by one or two Russian industrial giants that are the principal source of revenue for the local budget, and they employ most of the local workforce. These communities tend to be of the “everybody knows everybody else” type. Almost invariably, the management or principal, individual shareholders of these entities hold senior positions in the region’s legislature or administration. 

 As a result, the region’s legislature and administration, and in many cases judiciary, are extremely mindful of doing anything that might be, or could be interpreted as being, contrary to the region’s major corporate players. Even if a favorable award against a Russian entity is obtained in arbitration, when it comes time to collect on the award, the party is back in the Russian judicial system. The award must be confirmed by a Russian court. 

 Enforcement of foreign and domestic arbitration awards is vested in Russia’s state commercial courts, and the considerations raised above apply equally to enforcement proceedings. Under applicable international conventions and Russian statutes, a Russian court is entitled to refuse recognition and enforcement of a foreign arbitral award, if it is found to be contrary to “public policy.”

 Unfortunately, the meaning of “public policy” in Russia has not been satisfactorily defined. In practice, Russian courts may exercise absolute discretion in deciding an issue. There is a particular danger in such sectors as mineral resources that Russian courts can interpret “public policy” to be identical to “national interest.” 

  INVESTOR CONFIDENCE

 During the past decade, corporate law and governance in Russia have developed from nonexistence at the beginning of the 1990s to a reasonably developed system of statutes today that is (generally) enforced. These statutes include a substantial Law on Joint Stock Companies (the mechanism by which most Russian and foreign oil companies organize their joint efforts) that has been amended extensively in the past five years.

 However, Russian statutes incorporate only very basic principles of corporate governance, and even these measures are not always sufficiently followed or enforced. In particular, shareholder rights, transparency of corporate decision-making and disclosure of information are causes for concern.

 To address these and other issues, the Federal Commission on the Securities Market last year introduced Russia’s first corporate governance code (“the Code”). The Code was developed with the assistance of the business and legal community, including multinational firms present in Russia. Their intent was to raise the standard of corporate governance and improve investor confidence. 

 The Code recommends that companies mandate cumulative voting procedures for electing directors, to enhance minority shareholders’ voting power. Russian law mandates cumulative voting only for companies having more than 1,000 holders of voting shares. 

 The Code encourages companies to include more information in public prospectuses and financial reports that is more closely akin to what is seen in US securities regulations, rather than the meager offerings required by Russian law. 

 Commissioners recommend disclosure of voting agreements and types of affiliate transactions not currently covered by law, such as deals between the company and affiliated individuals and/or their relatives. The Code, however, is advisory, and thus not legally binding. So far, just a few Russian companies have adopted it. One of these is Yukos, one of Russian’s two largest oil companies.

 Although introduction of the Code is a positive development, investors’ concerns would have been better served if some provisions had been introduced into Russian law by statute. 

  SAFEGUARDS REMAIN INEFFECTIVE 

 In 1993, Russia signed the Energy Charter Treaty (ECT), which imposes direct obligations on participating governments with respect to protection and treatment of foreign investment in energy. This includes regulation of competition, environmental issues and energy trading. ECT allows private investors to take a government of the host state to either its national court or to international arbitration (including ICSID, the investment arbitration institution that operates under World Bank) at the investor’s choice. 

 However, the Russian parliament has not ratified ECT, which could have given extra comfort to foreign companies investing in energy. The ECT thus remains inoperative in Russia. It is not clear when, or whether, it will be ratified. 

  PSA GUARANTEES MAY BE SCRAPPED 

 In a blow to foreign oil companies, Russia is poised to scrap special legal protection afforded to foreign investors through production sharing agreements (PSAs). PSAs were introduced in 1995 through enactment of the Law on Production Sharing Agreements. The law was a significant legal reform. It accommodated investor concerns on most essential issues:

•  Insulation from the Russian tax regime’s unpredictability
•  Legal stabilization – terms of a PSA contract cannot be amended through introduction of new laws
•  Availability of international arbitration as a method for resolving disputes between foreign investors and Russia
•  Negotiability of key obligations of large-scale oil and gas projects. 

 An added advantage of the PSA regime is that it allows the investor to recover his costs before paying taxes, a distinct advantage in a country where most taxes are based on revenues, rather than profits.

 Although only five projects are being developed on the basis of the PSA regime, many more projects that promise to bring billions of dollars in investment are in the planning stages. Thus, the potential for future foreign investment on the basis of PSAs has been very significant. Without the stability of the PSA regime, most Western energy companies – mindful of foreign investors’ negative experiences in joint ventures in the early 1990s – are unlikely to make the multibillion-dollar, long-term commitments necessary to develop fields in places like Sakhalin and the Arctic.

 Nevertheless, Russian officials recently announced that, although they intend to preserve the five existing PSA projects, they will scrap a majority of the 33 additional projects still in planning. Officials believe that the business climate is such that investment in oil production is virtually guaranteed, even without PSAs. 

 The proposed scrapping of the PSA regime appears to be a very unwise move. The swift rise in oil production achieved by Russia since 2000 can be attributed to unusually favorable market conditions – low production costs and high oil prices. If these conditions change, sustainable development of future oil projects is likely to require foreign participation. If officials are so willing to easily scrap concessions granted to foreign investors under the PSA regime, imagine how difficult it may be to lure foreign companies back to Russia’s oil sector in the future.  

THE AUTHORS
	A. Grant McCrea is a partner with law firm Dewey Ballantine LLP, based in New York City. His principal area of practice is complex commercial litigation, including securities, corporate governance, banking, bankruptcy, toxic tort and environmental claims, insurance coverage, and international arbitration and civil and criminal appeals. Mr. McCrea earned BA and MA degrees in philosophy from McGill University in 1982 and 1986, respectively, as well as an LLB in 1985. In addition, he earned an LLL in 1988 from University of Ottawa. Mr. McCrea was named in the Euromoney Guide 2003 as one of the “world’s leading litigators.”
	Andrei Yakovlev is a New York and Russian-qualified attorney who is an associate with law firm Dewey Ballantine, based in the London office. He specializes in the areas of international capital markets, derivatives and project finance. In particular, Dr. Yakovlev has worked extensively on the structuring and financing of upstream petroleum projects in Russia and other countries of the former USSR. Dr. Yakovlev earned his first law degree from Moscow State Institute of International Relations in 1993, followed by LLM degrees from University of London, and Northwestern University School of Law in Chicago. He also holds a doctorate in law from Northwestern.