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Strategic sector legislation in Russia: critique and proposal for change

Bam Joshua

Juris Doctor Candidate,

Pennsylvania State University, Dickinson School of Law

 

Introduction

From 1991 until mid-2008, no Russian law directly dealt with foreign direct investment in Russia. While some rules governed how foreign investors could interact generally with Russian business entities and other laws incentivized foreign investment in certain geographic areas, Russia had not yet considered a law detailing the types of entities and size of investments that foreign direct investors could invest in. The omission became serious in 2007 when a German entity attempted to purchase a controlling stake in a Russian entity heavily involved in Russia's infrastructure. No legal reason existed to prohibit the German entity from engaging in the proposed transactionhtmland no governmental agency explicitly had the power to block the transaction, but the takeover was thwarted by an ad hoc jumble of agency action and political disapproval. The fiasco led to Federal Law No. 57-FZ of 2008 which codified the limitations of foreign direct investors to participate in Russia's economy. However, the Strategic Sector Law that many thought would be a model of clarity and a representation of a softening Russian bureaucracy has only garnered investor confusion, fear, and anger. While Russia need not go back to the drawing board, it is time for a second set of amendments to the Strategic Sector Law that directly addresses investor's legitimate concerns while balancing appropriate levels of government oversight.

In 2010 Pepsi executed a $3.8 billion takeover of Wimm-Bill-Dann, the juice and diary king headquartered in Moscow. In 2011 a veteran foreign direct investor in Russia, British Petroleum (hereinafter: BP), proposed a £5 billion share swapping deal with State-owned oil company Rosneft. In 2012 BP completed a different deal with Rosneft in a series of transactions worth about $55 billion combined, but it was not the deal BP had been hoping for. BP currently owns close to twenty percent of Rosneft – a company heavily involved in subsoil exploration.The latest inflows of foreign direct investment in Russia, including the deals by Pepsi and BP, stand in stark contrast to foreign direct investment in Russia in the early 1990s and 2000s. From 1991 to 2001, foreign direct investment in Russia – a county of about 145 million people – totaled a mere $22 billion.  As a reference, annual foreign direct investment inflows over those ten years tended to be less than a single Pepsi-Wimm-Bill-Dann. In 2000 foreign direct investment in Russia was $2.7 per person compared to $316 per person in the U.S. and $39 per person in China for the same year.The current legal foundations of foreign direct investment in Russia are much sturdier than they were in the 1990s or early 2000s. However, if Russia wants to realize its great potential for foreign direct investment, it needs to consider constructive and meaningful amendments to its 2008 Strategic Sector Law – especially today as investors fret over Russia's political and administrative environment.

Economic Evolution

Foreign direct investment is usually defined as an:

«investment of foreign assets into domestic structures, equipment, and organizations. It does not include foreign investment into the stock markets. Foreign direct investment is thought to be more useful to a country than investments in the equity of its companies because equity investments are potentially 'hot money" which can leave at the first sign of trouble, whereas FDI is durable and generally useful whether things go well or badly»

Foreign direct investment became legally possible in Russia from about 1987. In 1991, Russia enacted a law specifically dealing with foreign direct investment. The 1991 Federal Law on Investment Activity defined foreign direct investment and created «free economic zones» – generally a «suspension» of the usually applicable laws in favor of rules believed to be more beneficial to commercial activity. The 1991 law was strongly influenced by lingering communist principles. In 1999 a new law, aimed at mitigating some of those lingering communist principles, created «Special Economic Zones» (preferential treatment for commercial activity), provided for similar treatment of foreign investors and Russian investors, and expanded the concept of private ownership. The 1999 Law was amended by Federal Law No. 116-FZ of 2005, which modified and solidified the existence of Special Economic Zones in Russia. The Russian government regulates entities in Special Economic Zones through a process of «accreditation.» Today, foreign direct investors must understand the law governing Special Economic Zones, the law governing strategic sectors, and many other domestic laws and international treaties before investing in Russia. This article will address issues with the 2008 law governing foreign direct investments into strategic sectors and its subsequent amendment only.

Beginnings of Federal Law No. 57-FZ (2008)

The 1991 law created a definition of «foreign investment» that the 1999 law and its subsequent amendment incorporate. However, in 2004 it became clear, to President Putin at least, that rules attempting to define foreign direct investment and confine it to special economic zones would not provide a basis to protect the business entities themselves, which were the subjects of foreign direct investments. President Putin was especially concerned with business entities that were important to the infrastructure and security of Russia. In 2004, to save some of these «strategically important» business entities from becoming completely privatized by foreign direct investors and to save other business entities from bankruptcy, President Putin issued a decree. The 2004 Presidential Edict officially deemed some entities as «strategically important» to Russia's national defense and security. The specific list of entities included companies handling radioactive materials, working with the natural resources of the Russian Federation, or involved in aerospace activities. At the time the list was published, the Russian Government owned 25% to 100% of each of the 518 unitary enterprises and the 546 joint-stock companies on the list. The edict required foreign direct investors to obtain explicit approval from the president before privatizing or acquiring shares from the strategic entities listed in the Edict.

After three years of operating under the Presidential Edict, a 2007 transaction initiated by Siemens of Germany exposed the ambiguities and limitations of the edict. The transaction also exposed the power that Russia's political process held over its economy and sparked investor concerns about domestic investor protectionism. The transaction involved Siemens offer to buy a majority stake in Power Machines, a company that produced about 90% of the turbines in Russia. The Federal Antimonopoly Service (hereinafter: FAS) had no legal reason to block the transaction proposed by Siemens under the 1991 law, the 1999 law, or the 2004 Presidential Edict because Power Machines was not a listed entity. Still, many political officials did not favor the idea of a foreign investor controlling 90% of Russia's turbine production. In response to Siemens' bid, a Russian billionaire and Kremlin insider applied to purchase the exact same stock. Ultimately, the deal was vacated altogether, butthe ad hoc denial of a foreign direct investor's proposed transaction with a Russian entity prompted President Putin to call for legislation clarifying the rules for foreign direct investors and supervising State authorities alike.

Federal Law No. 57-FZ (2008)22

In mid-2007«many ministries and governmental institutions» began work on the legislation that President Putin had called for. A year later, Federal Law No. 57-FZ of 2008, «On Procedures for Foreign Investments in the Business Entities of Strategic Importance for Russian National Defense and State Security,» was passed amidst a global economic crises. Unlike the 1991 and 1999Laws which define and regulate «foreign investment,» the 2008 Law defines «control» and regulates «transactions.» In fact, Federal Law No. 57-FZ of 2008 creates a foreign direct investment regime similar to foreign direct investment regimes in the United States, India and other developed countries. The basic policy behind the foreign direct investment regimes in Russia, the U.S., and India is that foreign direct investors are generally free to invest as they please until they trigger the provisions of a law. Under Federal Law No. 57-FZ of 2008, foreign direct investors must understand three general rules before they can determine if a transaction with a Russian entity will or will not require governmental approval.

Firstly, the 2008 Strategic Sector Law includes a sweeping definition of «foreign investor» under Articles 2 and 3. Generally, the Strategic Sector Law classifies entities formed under foreign law or controlled by foreign entities as foreign investors regardless of the citizenship of their shareholders, owners or controllers. The Law does not apply to foreign investments governed by international treaties to which Russia is a party. The Law also does not apply to individuals investing directly in entities of strategic importance involved in subsoil activities if the Russian Federation directly or indirectly controls more than 50% of the total voting stock of thatNONEentity. Most importantly, the Strategic Sector Law provides different treatment for investments by foreign states or international organizations (like BP and Pepsi) and investments by individual foreign investors.

Secondly, Article 6 of the Law defines «Strategically important» entities by reference to certain activities deemed to implicate «Russian national defense or State security.» Some of the activities deemed to be «strategically important» under Article 6 include:

(1) modification of hydro-meteorological processes and phenomena,

(2) modification of geophysical processes and phenomena,

(3) using infectious agents (like dairy farming or food production activities), (4) setting-up, constructing, operating and/or decommissioning nuclear facilities,

(5) handling nuclear materials and radioactive substances...

(6), handling radioactive waste during storage, processing, transportation, and etc....

Regardless of where the transaction to conduct an Article 6 activity occurs, if the activity itself will take place in Russia, the obligations and limitations of the Strategic Sector Law may apply. This means that two non-Russian business entities who draft and confirm a transaction outside of Russia involving an Article 6 activity inside of Russia may be required to seek approval under the Law. These foreign entities would be forced to avail themselves of Russia's review procedures unless they ignore the law altogether and risk a subsequent declaration that the transaction is void or forget about the deal and invest elsewhere.

The third prong of the Strategic Sector Law revolves around «control.» As mentioned earlier, the Strategic Sector Law treats foreign states and international organizations differently than it treats individual foreign direct investors. However, all foreign direct investors must notify an «authorized (governmental) body» upon acquiring 5% ormore of the stock of an entity of strategic importance. This 5% notice obligation is separate and apart from foreign direct investment limitations under the Law. Article 2 of the Law limits foreign states and international organizations from obtaining direct or indirect control of more than 25% of the total voting shares of entities deemed to be strategically important and more than 5% of the total voting shares of strategically important entities involved in sub-soil activities. If a foreign state or international organization wants to exceed these limitations, it must first petition for approval under the Law. The rules for individuals seeking to invest directly in Russia are more lax. Under Article 5 of the Strategic Sector Law, individual foreign investors are permitted to control up to 50% of the total voting shares of a strategically important entity or up to 10% of the total voting shares of a strategically important entity involved in subsoil activities. Article 5 of the Law also prohibits individual foreign direct investors from being able to appoint sole executive bodies, appoint more than half of the board of directors, or appoint more than 10% of the board of directors when strategically important entities are involved in subsoil activities. The Article prohibits foreign direct investors from working through other individuals or entities to directly or indirectly exercise more control over entities of strategic importance than the law allows. This is Russia's effort to deter disguised or even secret shareholder agreements, but it is impossible to know how many foreign direct investors are really involved in these types of shareholder agreements.

The general rule of Federal Law No. 57-FZ is stated in Article 7: If a (1) foreign direct investor wants to engage in a transaction involving a (2) strategic entity or activity that exceeds the amount of (3) control allowed by the Law, the investor must (4) first seek approval by following the procedures set forth in Articles 8 through 14 of the Law. If a foreign direct investor already directly or indirectly controls more of a strategically important entity than the percentage allowed under the Law, that entity will not be able to engage in future transactions involving its stock. This provision of the Law practically freezes the stock of entities that are not in compliance with the Law.

For foreign direct investors to be considered for approval of a transaction implicating the Strategic Sector Law, they must submit an application conforming with the requirements of Article 842 to «the authorized body.» In turn, the «authorized body»is governed by procedures set forth in Article 9 of the Law. A 2008 Presidential Edict gave the title of«authorized body» to the FAS. The designation of «authorized body» emerged after a war between the Federal Security Service and the FAS. While the FAS ultimately won the title of «authorized body» under Article 9, the Federal Security Service did not walk away from the battlefield empty handed. Pursuant to Article 9, the FAS must register a petition upon receipt, ensure that the petition complies with Article 8 or send it back to the petitioner to remedy the issues, and determine if the petitioner has or will establish control over a business entity of strategic importance. If the transaction will not result in the petitioner obtaining control over a strategically important entity, the FAS sends the petition and its rationale to the petitioner and the Committee – which was also established by the 2008 Presidential Decree. If the FASconcludes that the petitioned-for transaction must be approved under the law, the petition is forwarded to the Committee which begins processing the petition. The law's inspection and analysis of the foreign direct investor also begins as discussed infra. Article 12 of the Lawpermits the Committee to approve the petition subject to certain obligations or conditions. However, if the Committee determines that the proposed transaction cannot be approved in any form, the Committee must notify the petitioner and provide grounds, adopted by the authorized body, for that decision. The entire approval process should not last more than three months, and petitioners may challenge the decisions and actions (or inaction) of the FAS and the Committee in court or at arbitration.

Article 15 states that any transaction involving a foreign direct investor and a strategic entity that fails to comply with the law is void under civil legislation. If the transaction cannot be declared void, the FAS may file a lawsuit to deprive the foreign direct investor ofvoting rights.Under Federal Law No. 57-FZ of 2008, a foreign direct investor receiving preliminary approval for a transaction by the Committee under Article 11 who is later denied approval for the transaction by the FAS under Article 9 must alienate the disputed stock within three months after the FAS notifies the foreign direct investor that final approval will not be granted.

An Amendment: Federal Law No. 322-FZ (2011)56

In 2011 the Strategic Sector Law was changed to ease restrictions governing foreign direct investors and to simplify some of the procedures required for approval of petitioned-for transactions covered by Law. The amendments came in the form of Federal Law No. 322-FZ of 2011 which generally does five things:

(1) Exempts international financial organizations from the law if theyhave been established under agreements or treaties to which Russia is a party

(2) Exempts transactions between strategic entities controlled by Russia and Russian citizens unless the Russian citizen has dual citizenship

(3) Increases the permissible amount of control individual foreign investors in strategic entities involved in subsoil activities may obtain from 10% to 25% under Article 5 of Federal Law No. 57-FZ of 2008

(4) Removes the «operation of radiation sources,»«data encryption by banks,» and «distribution and maintenance of cryptographic devices and services» from the list of activities deemed strategically important under Article 6 of Federal Law No. 57-FZ of 2008, and

(5) Simplifies the procedure for approving petitions by providing for one approval by the FAS instead of preliminary approval by the committee and final approval by the FAS under Articles 9 and 11 of Federal Law No. 57-FZ of 2008.

Many investment firms in Russia believe that the FAS is preparing a second set of amendments, but no tentative date has been established yet and the substance of this second set of amendments is not known either.

 

TheCommittee and First Applicants

The Committee reviewing foreign direct investor petitions was originally composed of seventeen members, with Vladimir Putin serving as Chairman of the Committee. The Committee members approve or deny the petitions of foreign direct investors by majority vote, which is valid if more than half of the Committee members are present. Currently, the Committee is composed of 19 members who continue to approve or deny petitions by majority vote.

At the inaugural meeting on 10 October 2008, the Committee discussed two easily approvable transactions proposedby foreign direct investors. The first transaction involved AleniaAeronantica's acquisition of a 25% block of stock in Sukhoi Civil Aircraft for $183.1 million. The transaction had already received President Putin's approval before the Strategic Sector Law emerged in August of 2008, and the Committee quickly approved the transaction officially. The second transaction also received President Putin's approval before the Strategic Sector Law came into force in 2008. The transaction involved Archangel Diamond Corporation's acquisition of a 49.9% stake in ArkhangelskoeGeologodobychnoePredpriyatie which owns exclusive subsoil rights to the VerkhofinaGrib Pipe Diamond Mine. However, when the Committee approved the Archangel Diamond – ArkhangelskoeGeologodobychnoePredpriyatie transaction, its approval came with a condition under Article 12 of the Strategic Sector Law. The Archangel Diamond Corporation eventually terminated the Share Purchase Agreement due to unresolvable issues with the Russian Government. One of those issues was the condition the Committee attached to their approval of Archangel Diamond's petitioned-for transaction. The condition was that the Russian Government would have exclusive authority to control the amount of diamonds the strategic entity (and the foreign direct investor) would be permitted to process from the mine. Archangel Diamond would not agree to this condition.

Article 12 of the Strategic Sector Law permits the Committee to attach certain obligations or conditions to the approval of a foreign direct investors proposed transaction which may include:

(1) Compliance with state secret regulations

(2) Continuous production of supplies for state defense orders

(3) Adherence to certain prices or tariffs under the Federal Law on natural monopolies

(4) An agreement to follow the Russian Government's instructions in the event martial law is declared

(5) An agreement to maintain the same number of employees for a time, and/or

(6) Limitations on processing natural resources extracted from Russian subsoil.

From 2008 to 2009, when the global economy was falling into recession, the FAS received 108 requests for clarification of the Law, 87 applications from foreign direct investors for preliminary approval of proposed transaction resulting in control, and 323 notifications that investors had permissibly acquired 5% or more in stock of a strategic entity. Twenty-three applications were returned to investors during that year due to petitioners not gaining control over strategic entities. The Committee actually reviewed 20 of the 87 petitions for preliminary approval under the unchanged Strategic Sector Law.

From the law's enactment in 2008 through the 2011 Amendment to the Strategic Sector Law, the FAS has considered 243 petitions from foreign direct investors for approval of transactions under the Law. Seventy-three of those 243 petitions were returned to petitioners due to «non-establishment of control over strategic economic entities.» ThetsyCommittee has reviewed more than 137 of the 243 applications, and only eight petitioned-for transactions have been denied. Of the eight petitioners denied approval for their proposed actions, none have appealed the decision to any Russian tribunal. Russia's domestic courts may hear foreign direct investor disputes under the Law, and International Arbitration Tribunals have found jurisdiction to resolve disputes between foreign direct investors and the Russian Government as well. From 2008 through the 2011 Amendment, the Committee approved Twenty-six petitioned-for transactions subject to certain obligations or conditions.

The numbers seem encouraging, but one commentator suggests that many of the applications approved by the Committee are petitions by entities formed under foreign law but controlled by Russian citizens. The assertion alone raises a number of questions: (1) how many foreign direct investors in Russia are actually foreign, and (2) is Russia engaged in a course of domestic investor protectionism disguised as foreign direct investment? The answers require comprehensive studies beyond the scope of this article.

 

Analysis

In 2011, foreign direct investment in Russia was $56 billion – which makes Russia one of the fastest recovering countries in terms of foreign direct investment (FDI) inflow after the 2008 economic crisis. Despite the growth inFDI after the 2008 economic crisis, foreign direct investors still have cause for concern. Early analyses of the 2008 Strategic Sector Law by the Oxford Analytica Daily Brief Service suggest the Law may complicate transactions for foreign direct investors who are not establishing 'control' over strategically important entities since all foreign direct investors are now required to provide 5% notice under Article 14 of the Law. Practically, the Law has added an extra set of procedures for investors who do not trigger the Law at all. The procedures that govern the form of foreign direct investor's 5% notice to the authorized body is not yet entirely clear. This extra layer of administrative burden on foreign direct investors may deter some foreign direct investors fromdirectly investing in Russia altogether. For foreign direct investors who do trigger the provisions of the Law, the test for determining what kinds of transactions may constitute a «threat to national defense or security» is not defined in the Law and involves a subjective determination by the Federal Security Service, the Ministry of Defense, and potentially the Committee itself. This subjective approach fuels foreign director investor fears of protectionism and promotes unpredictability under the Law. A clear list of factors used to define a threat to national defense or security should be provided under the Law to curtail internal political pressures and increase predictability in the business environment. In fact, clarity and ease of filing for foreign direct investors under Federal Law No. 57-FZ of 2008 and its subsequent amendment should be a priority for future amendments. Articles 8-14 of the Strategic Sector Law could easily be clarified and simplified by providing a standardized form to foreign direct investors who then fill-in blanks or check boxes since Article 8 of the Law asks for standard information. A standardized form would also answer the question of how much detail investors must include in their petitions as Article 8 fails to provide any such instruction. A system of online filing for approval and 5% notice would increase the portability of petitions for reviewing state authorities, allow timely filing and receipt of FAS decisions, modernize an area of Russia's business culture, and attract foreign direct investors concerned with the administrative burden of investing in Russia.

However, amendments providing clearer and simpler filing requirements will do nothing to increase investor perceptions of Russia's political, internal administrative, and macro-business environment. In 2011, Russia ranked 143 out of 183 countries in the Corruption Index, which measures perceived levels of public sector corruption. Russia's rating of 2.4 out of 10 on the Corruption Index places it behind Ethiopia, Pakistan, Lebanon, and many others.Russia also ranks 120 out of 183 on the World Bank's Doing Business Index. A comprehensive survey of foreign direct investors conducted by Ernst and Young in 2012 shows that 53% of foreign direct investors are primarily concerned with «improving the effectiveness of law» in Russia. Forty-seven percent of foreign direct investors said Russia needs to work on reducing bureaucracy, and 37% of foreign direct investors said enhancing the transparency of business regulations would make Russia a more attractive investment environment.» Sixty-two percent of foreign direct investors surveyed said that Russia's political, legislative, and administrative environments needs improvement. Foreign direct investors most often complain about the high level of governmental discretion involved in the political and administrative environment in Russia. Critics suggest that foreign direct investorsneed not only be cautious of high-level politics and state intervention, but also poor business practices by local business partners and interference with business relations at the local administrative level. Those critics suggest that Russia's culture may be ingrained with a lack of respect for property rights and hold little concern for interference with business relations. Due to low levels of research and development in the country, foreign direct investors believe that Russia's culture of innovation and entrepreneurship needs improvement as well. These concerns fall outside the scope of Federal Law No. 57-FZ of 2008 and its subsequent amendment, but the issues heavily weigh on investor's initial decision of whether or not to attempt to grapple with the Strategic Sector Law at all.

The Ernst and Young Survey shows 39% of foreign direct investors surveyed believe the mining, oil, and gas industries will attract the most foreign direct investment in Russia over the next three years. Twenty percent of foreign direct investors believed that information and communication technologies willattract the most investments.  Entities engaged in subsoil and telecommunications activities in Russia are strategically important entities under the Law, and tend to be closely related to the infrastructure of Russia as well – which Russia hopes to improve and modernize through increased foreign direct investment. When the Strategic Sector Law was initially being discussed in 2008, then-Minister of Economics German Gref, strongly opposed including activities of natural monopolies like pipeline industries, rail transportation, seaport and airport activities, and electricity and heating grids in Article 6 of the Law.«It is wrong to stoop to restricting investment in infrastructure,» Mr. Gref said as the law was being drafted in 2007.«While talking about the priority of the security framework, the government hasforgotten about the need to improve the mechanisms of management.» Federal Law No. 322-FZ of 2011 did not address Mr. Gref's concerns. In fact, the 2011 Amendments to Federal Law No. 57-FZ of 2008 were criticized by investors as failing to address one of foreign direct investor's major concerns – the list of activities in Article 6. Early analyses of the 2008 Strategic Sector Law revealed that the Article 6 list scared foreign direct investors away from entering into any type of business relationship with Russia at all and consequently deterred much needed modernization. Despite FederalLaw No. 322-FZ of 2011, foreign direct investors continue to be limited by the Strategic Sector Law's control restrictions when directly investing in entities engaged in printing, fishing, infectious agent (like dairies or food production), and telecommunications (deemed to be a natural monopoly) activities. However, with regard to fishing, Russia may have a legitimate national security or defense argument. Sturgeons in the Caspian Sea neared extinction in early 2008 due to overfishing in the caviar trade. A ban on sturgeon fishing in the Caspian Sea is currently in effect until 2013. Further, Russia's telecommunications industry and its infrastructure may not require much more innovation or modernization. Russia ranks fourth in the world for its volume of operational landlines and cellular phone use and has recently become one of the world's largest consumers of Internet. Still, foreign direct investors and law firms in Russia hope a second set of amendments will narrow the Article 6 list of activities deemed to be strategically important under the Law.

Economic protectionism of domestic investors continues to worry foreign direct investors despite Russia's accession to the World Trade Organizatin (hereinafter: WTO) in 2012. Neither Federal Law No. 57-FZ of 2008 nor Federal Law No. 322-FZ of 2011 addressed the heart of investor fears sparked by Siemens' proposed transaction with Power Machines – that the stock Siemens bid on was nearly awarded to a domestic investor who bid on the same stock much later but gained the advantage as a Russian citizen. Protectionism compounded with investor perceptions of politicaland administrative corruption in Russia create a formidable obstacle for foreign direct investors. The Ernst and Young survey found that 70% of foreign direct investors who were not already established in Russia had no plans to invest in Russia in 2013. Protectionism under the amended Strategic Sector Law may even affect Russian citizens. In 2009 the Committee delayed a petition by a Russian citizen looking to purchase the Russian oil company RussNeft (not to be confused with the largest State owned oil company Rosneft). The Russian citizen was proposing to purchase RussNeft through a corporation owned piecemeal by nearly 100 offshore entities. Now Deputy Prime Minister of Russia Igor Sechin, who was puzzled by the fact that a Russian citizen had been caught in the net of Federal Law No. 57-FZ of 2008, said at the time that he preferred RussNeft be purchased by a business entity that was or would be registered in Russia – a Russian entity. The full impact of Russia's accession to the WTO in mid-2012 on Russia's perceived course of domestic protectionism remains to be seen. However, Russia should take affirmatives steps by stating in a future amendment to the Strategic Sector Law that no discrimination will occur in approving or denying foreign direct investor petitions based on the entity's or individual's home state or whether or not a Russian entity or individual seeks to execute the same transaction.

One of the most troubling provisions of the law is found in Article 10, which provides the Federal Security Service with authority to conduct investigations into foreign direct investors before approving or denying a petitioned-for transaction. The experience of one veteran foreign direct investor in Russia, BP, provides an illustration of how foreign direct investors may struggle with equality in business relationships in Russia despite Federal Law No. 57-FZ of 2008. BP's experience in Russia also illustrates the breadth of Article 10 of the Law. Asmentioned supra, BP has been fostering a business relationship with Rosneft, Russia's largest State owned oil company. Originally, BP expected the relationship to result in subsoil exploration opportunities and a degree of influence over the economic future of the State owned oil company. Today, BP owns a twenty percent stake in Rosneft, but the British-based oil company had its sights set much higher:

A prospective partnership between BP and state oil company Rosneft was torpedoed (in February of 2012) by litigation from BP's Russian partners in existing joint venture TNK-BP even though the Rosneft deal had Putin's apparent blessing. For smaller-scale investors, sticky-fingered officials and local rivals or partners can bend a pliant legal system to undermine presumed property rights.

Kremlin-Rosneft insiders have effectively confined BP to a limited position in its relationship with Rosneft.While BP still has a stake in Rosneft, it is far less than a partner in the company, and BP's 20% stake in the oil company doesn't come with any influence over Rosneft's future. As BP struggles to find ways to drill in Russia despite its relationship with Rosneft, Rosneft has bought BP out of TNK-BP (BP's Russian partners) and started drilling in the Arctic and the Black Sea with it's new friend and foreign direct investor, ExxonMobil.Rosneft's relationship with BP is a prime example of how the political and administrative environment in Russia and the loose criteria for approval under the Strategic Sector Law provides «sticky-fingered officials» with ample discretion to pick favorites. There is another morale to the story though – regardless of being approved under Federal Law No. 57-FZ of 2008, foreign direct investors may still be limited by issues in Russian business culture.

Before BP's downhill relationship with Rosneft, the British based oil company attempted to foster a relationship with a different State owned company – – Gazprom. After BP petitioned the FAS for approval of proposed transactions with Gazprom under then emerging Federal Law No. 57-FZ of 2008, Article 10 of the Law became applicable as the law came into effect. Under Article 10 of the Federal Law and the presidential decree establishing the administrative framework of the Law discussed supra, the Federal Security Service may conduct «operational searches» of the offices of petitioning foreign direct investors under Article 12 and Article 13 of the Law. Article 10 also provides the Federal Security Service with a list of information it must provide to the Committee concerning whether or not a proposed transaction represents a threat to national defense or security. However, Article 10 does not provide a checklist for the scope or duration of these operational searches. In addition to the responsibilities ofthe Federal Security Service outlined in Article 10, Article 13 provides the Federal Security Service with authority to request and obtain documents and other information from petitioners when conducting its investigation into whether the petitioned-for transaction constitutes a threat to national defense or security. Article 13(5) provides that any state, commercial or«protected secrets»will not be publicly disclosed, but the Law does not exempt these secrets from being discovered or obtained by the Federal Security Service or the FAS. The operational search' authority and the authority to request and obtain information from petitioners granted to the Federal Security Service under the 2008 Law was not modified or eliminated by the 2011 Amendment. Therefore, foreign direct investors seeking to establish control in strategic entities doing business in Russiaremain at risk that the FSB will require them to open their companies to extensive and seemingly limitless searches. BP experienced one of these searches firsthand in mid-2008. The Federal Security Service searched BP's Moscow headquarters, TNK-BP, in relation to a pipeline dispute, but the search would have been permitted under then emerging Article 10 of Federal Law No. 57-FZ of 2008.«They were scanning through pages of documents, looking for the word Gazprom,» said one source familiar with details of the investigation.One BP employee was even arrested under allegations of espionage. New amendments to the Strategic Sector Law should provide the FSB with criteria that effectively limits the scope and duration of permitted searches of foreign direct investor's files and offices. Criterion limiting Article 10 searches would not onlyprotect foreign direct investors and curtail internal political pressure but also provide the FSB with a clearer goal that could be accomplished efficiently.

 

Moving Forward

Accession to the WTO has not been Russia's only advertisement to foreign direct investors. In 2011, President Putin invited sixteen of the world's leading investors, controlling about $2 trillion in investable assets, to Moscow for a briefing on a Russian Direct Investment Fund. President Putin said Russia would invest in the Fund which would invest with foreign direct investors to build roads, produce medicines and modernize ports and warehouses. Many of these infrastructure-related activities are conducted by strategically important entities that fall under the scope of the Strategic Sector Law. The sixteen investors remained cautious. Critics say the investment fund will have little impact without systemic changes to accompany it since foreign direct investors are more concerned with corruption in Russia and Russia's complicated bureaucracy than finding an investment partner. Someconcerns may be mitigated by Russia's newest draft changes to the Civil Code. These changes are designed«to introduce fundamental changes to property rights, obligations, contracts, security instruments and intellectual property».

Ironically, one commentator suggests that poor foreign direct investor perceptions of Russia means that the country is greatly undervalued. Jim O'Neill, of Goldman Sachs, who coined the «BRIC» designation, recently noted that, «... the perception of Russia has made the country a value play among the other BRICs». Undervalued or not, clear criteria for what constitutes a «threat to national security,» clearer and easier filing procedures, an anti-discrimination provision, a narrower Article 6 list, and a limitation on «operational searches» under the Law will attract the attention of resourceful foreign direct investors scared away by unpredictability and opening their offices to the Federal Security Service. Russia should also consider changes in legislation to narrow the list of Article 12 conditions to exclude some of the obligations like maintainingcertain employees or processing limited quantities of natural resources as these conditions unduly usurp business and economic authority from foreign direct investors.

Russia's foreign direct investments inflows have grown from $1.16 billion in 1991 to $10.2 billion in the first quarter of 2012. Actually, the first quarter of 2012 was down about $3 billion from the first quarter of 2011, but the number does not reflect the expected boost in Russia's investment attractiveness after Russia acceded to the World Trade Organization (WTO) in August of 2012. The WTO encourages members to maintain «commitments to lowercustoms, tariffs and other trade barriers, and to open and keep open services markets.» The World Bank expects the move to add three percentage points to Russia's GDP once Russia is settled in. Ernst and Young expect foreign direct investment in Russia's services sector to grow up to eleven percent based on past experiences of nations acceding to the WTO.Russia's new commitment to a system of global norms, like those the WTO encourages, should mitigate Russia's perceived leanings toward protectionism, but Russia's actions will speak louder than its words.

The chief executive officer of Sberbank, Herman Gref, noted that Russia's primary goal is to reform its system of federal and local government, its second goal is to reform its system of education, and its third goal is to create a syspdftem of business values.If Russia can accomplish these three goals, the politi­cal, administrative, and cultural climate in Russia would be ripe for foreign direct investment. As it is, Federal Law No. 57-FZ of 2008 is a good start for Russia – the Law provides a general framework for foreign direct investors seeking to invest directly in Russia's strategically impor­tant entities.The 2011 changes have added some constructive and meaningful provisions to the Strategic Sector Law. Still, Russia is a long way from attract­ing the kind of foreign direct investment that a diversified economy, a manageable bureaucracy, a clearer and less invasive Strategic Sector Law, and a culture with business values could muster. Until then, it is too early for champagne.pdftem of business values. If Russia can accomplish these three goals, the political, administrative, and cultural climate in Russia would be ripe for foreign direct investment. As it is, Federal Law No. 57-FZ of 2008 is a good start for Russia – the Law provides a general framework for foreign direct investors seeking to invest directly in Russia's strategically important entities. The 2011 changes have added some constructive and meaningful provisions to the Strategic Sector Law. Still, Russia is a long way from attracting the kind of foreign direct investment that a diversified economy, a manageable bureaucracy, a clearer and less invasive Strategic Sector Law, and a culture with business values could muster. Untilthen, itistooearlyforchampagne.

 

Conclusion

If Russia truly wants to capitalize on its potential for growth in foreign direct investment in the country, it should propose a meaningful second set ofamendments to its Strategic Sector law that includes the following:

1. a simplified 5% notice requirement where investors need only fill-in blanks on a template form,

2. a uniform system of template forms for information requested by the Strategic Sector Law so that investors can easily complete forms and file them quickly,

3. a narrower scope of Article 6 activities to allow foreign direct investment in activities like dairy farming and infrastructure activities posing only minimal threats to national defense and security, and

4. limits on the government's ability to enter and search business premises and require disclosure of confidential proprietary information and other trade secrets.

The above proposals decrease bureaucracy, limit government involvement and abuse without detriment to governmental oversight, curtail bureaucratic and political abuse, and attract foreign direct investment. If Russia fails to address these concerns, the country will scare away emergent, skeptical and niche foreign direct investors working with large amounts of capital