Redefining Russia
Essay by Philipp Windemuth published September, 21st 2010 in The Moscow Times.
Philipp Windemuth, Partner of White & Case
After studying in Russia in the 1980s and working in Russia as a lawyer for the past 19 years, I feel confident that Russia has strong potential for a bright future.
When Mikhail Gorbachev took over in 1985 the world changed, and on Dec. 25, 1993, under President Yeltsin, an independent Russia enacted its new constitution by national referendum. Article 1 of the Constitution states that “Russia shall be a democratic, federal state, subject to the rule of law.” Article 3 states that “the multinational people of the Russian Federation shall be the vehicle of sovereignty and the only source of power in the Russian Federation” and Article 8 states that “unity of economic space, free movement of goods, services and financial resources, support for competition and freedom of any economic activity shall be guaranteed in the Russian Federation.” This was the first such document in Russia’s thousand-year history.
Changing the country to conform to the new Constitution will of course take some time.
Following Yeltsin’s election in 1991, Russia’s privatization in the 1990s and later under presidents Putin and Medvedev, Russia has rewritten virtually its entire legal and tax system. The new laws are not perfect — since no laws are — but they confirm to the world that Russia has a stated goal of establishing a market-based economy in accordance with international standards.
The result was that, after the 1998 financial crisis, Russia’s gross domestic product grew approximately 7 percent each year, doubling real disposable incomes in Russia, until the global recession hit in 2008. In 2009 the Russian economy shrank by around 7.9 percent but, according to the World Bank, in 2010 it is projected to grow again by 5 percent to 5.5 percent, albeit with unemployment remaining around 8 percent.
On the real estate side, market capitalization rates for office and retail centers in Moscow, after rising from around 9 percent in 2007 to 13 percent in 2009 have now fallen again to around 12 percent to 12.5 percent, vacancy rates are dropping and investment volume is increasing, including in regions outside Moscow. That said, the majority of acquisitions today do not include foreign investors. Given that prices today are 30 percent to 40 percent below the “pre-crisis” rates, Russian investors are likely to benefit from this over the longer term.
Why be optimistic?
First, Russia is the largest country in the world, owning some of the world’s largest oil, gas and other natural resources, and with a population of 140 million. The Russian people have a literacy rate of 99.4 percent, a median age of 38.5 and, judging from my experience, a wide-spread desire to modernize their country. As Russia’s new generation becomes richer, and more integrated internationally, it will demand more freedom, better legislation and stricter implementation of the rule of law.
Second, it is well known that in order to ensure more stable long-term growth and successful competition in international markets, Russia must diversify its economy, improve its financial system, improve health care and education, fight corruption, invest more in infrastructure and support small and medium business.
President Medvedev has acknowledged this in many instances, but many of his words have not yet been turned to action. However, anyone doing business in Russia will have seen that the quality of legislation in Russia under President Medvedev, who is a lawyer, has markedly improved and the Russian press has become significantly more open. With the growing Russian middle class, Russian politicians will need to act more in the interests of the Russian people if they wish to remain in power.
Third, the United States, the EU and China understand that they cannot dominate the world economy on their own and that Russia, if approached with understanding and respect, will be a valuable partner in ensuring a more stable future.
With the Russian market evolving, and an increasing number of commercial transactions being made in Russia, the use of Russian law rather than foreign law is becoming more common in the country. However, as all lawyers in Russia know, in certain areas Russian law does not yet comply with international standards. What can international lawyers in Russia do to help here?
They can analyze Russian law and suggest improvements. For example, if the following were changed, the Russian property market would become more stable and more attractive to Russian and international investors:
- Statutes of Limitations — under current Russian law, any prior owner of property can bring a claim against a third party owner within three years after the prior owner, including arguably the Russian state, “knew or should have known” of its claim. In practice, this means that any owner faces a risk of claims from prior owners, arguably including the Russian or regional governments, for an indefinite period. Lawyers must therefore spend lots of time analyzing such potential claims and parties must spend time negotiating how to allocate the risk. This should be changed by ensuring that previous owners in no event bring a claim to recover their property after the expiration of a fixed period, following the original transfer. For comparison, this period is 10 years in Germany.
- Representations and Warranties — in most jurisdictions, including the United States, the United Kingdom and Germany, sale and purchase agreements include “representations and warranties” under which each party provides guarantees as to its capacity, rights and ownership, for which the other party can hold it liable if breached. Russian law does not provide for representations and warranties, making Russian law contracts less protective for the parties. This is one of the reasons why investors in Russia try to structure transactions under non-Russian law. This could be changed with a fairly simple amendment to the Russian Civil Code.
- Escrow Agreements — Russian banking and other legislation needs to allow for escrow accounts. An escrow account is where the purchase price is placed with a trusted third-party bank or other institution, and is the standard way of closing many M&A and property transactions, since it largely eliminates the risk that one party may transfer the shares or property it has promised on a given date, while the other party may default on its payment obligation. Without this, projects concluded in Russia are more risky, complex and time consuming to complete.
- Preliminary and final Agreements — Under Russian law, binding purchase and sale, or binding lease agreements for objects of real estate cannot be concluded until after the relevant object has been completed and registered. It is therefore market practice in Russia to conclude so-called “preliminary” agreements before the object is completed, to be replaced by final agreements after completion. This of course raises the risk that a party to the preliminary agreement may refuse to conclude the final agreement in breach of its obligations. This risk could be eliminated by allowing binding lease and purchase agreements to be concluded during the development stage, which is standard in other jurisdictions.
- Put-call options — Russian law now allows for shareholder agreements, however it does not yet contain provisions allowing shareholders to enforce “put-call options,” which are options to obligate another shareholder to buy or sell shares in the relevant company, pursuant to such agreements. As this is an important tool in regulating joint venture arrangements this should be changed.
- As to corruption, while Russian law has made progress in this regard, a further tool could be to establish a protected web site, for example, “Anti-korruptsia.ru”, on which Russian citizens targeted by corrupt officials or illegal raiders can post their complaints, along with relevant evidence, which are then investigated by a special anti-corruption agency.
In addition, a general way in which lawyers may assist Russian and foreign investors in international transactions is: (a) to help their clients choose the correct partner; (b) to differentiate between material market or legal risks and non-material issues; and (c) to prepare agreements not only from the perspective of their client but also from the perspective of the counterparty, ensuring that the counterparty will be treated fairly and with respect. The goal in international transactions in Russia must be to create a “win-win” situation, upon which both parties will look back with satisfaction.
To conclude, my optimism about Russia stems from its historical ability to overcome large obstacles, its large land mass and natural resources, the size, intelligence and strength of its population and its increasing integration into a more globalized world. A small anecdote captures this in a few sentences.
A German friend of mine was standing in the ticket line at the Hermitage Museum in St. Petersburg with his father. When they reached the front of the line, the lady behind the counter offered his father the reduced veteran’s ticket. My friend was embarrassed, and explained that his father was indeed a veteran, but had fought on the wrong side. The lady nodded, and handed him the veteran’s ticket.
