Russia enacts new law on foreign investments in strategic areas

By bne IntelliNews June 5, 2008

Ben Aris in Berlin -

Investors bit their tongues after the Kremlin introduced a new law on strategic sectors in April to limit foreign participation in 42 different sectors. The hope was that although some businesses have, in effect, been put off-limits to non-Russians, at least the clear rules would improve the investment climate as the uncertainty over the fate of foreign money in things like oil and gas was definitely hurting it.

Deputy Prime Minister and Finance Minister Alexei Kudrin has already called for the number of strategic sectors to be reduced on June 2, but conceded that for the time being the new controversial law adopted at the end of April was probably an improvement.

The Kremlin's liberal faction hates the strategic sector's legal ring fence. But the law signed by then-president Vladimir Putin on April 29, "On Procedures for Foreign Investments in Companies of Strategic Significance for National Defense and Security," doesn't ban foreign investment completely in these sectors. However, it does restrict them to owning no more than either 10% or 25% of companies, depending on the sector. And less well published were the parallel changes in the law "On Subsoil" that together with the strategic sectors law now more clearly govern foreign investors access to the all important oil and gas sector.

The first victim of the new law came only a month later. Deutsche Bank Trust Company Americas said on June 3 that it has stopped issuing Global Depositary Receipts (GDR) for shares of a number of Russian issuers indefinitely because of the restrictions. Among the companies affected are steelmakers Severstal and Novolipetsk, silver miner Polymetal, gas producer Novatek and oil producer Bashneft.

Deutsche Bank did not explain why it had cancelled these GDR programmes, only that the books had been closed "until further notice." A source with knowledge of the situation told Interfax that the law enacted in May restricting foreign investment in strategic sectors of the Russian economy was to blame and that the law needs to be changed for the books to reopen.

Teacher's notes

Foreign investors who want to work in one of the sensitive industries, such as oil and gas, gold mining, defence, nuclear energy, bits of telecommunications, the media, aviation or aerospace, to name but a few, now have to apply for special permission to a governmental commission.

The introduction of the law provoked a storm of criticism bemoaning the "creeping state-ism" of the increasingly autocratic Putin administration. However, the irony of the new law is that the uncertain fate for foreign investors already working in these sectors - particularly following the Yukos affair - has been a bigger drag on inbound investment and that the clarity of the law will probably boost investment in the short-term. "But it is not just Russia," Alexey Frolov, a partner at Baker & McKenzie in Moscow, said in a recent report on the strategic sectors law. "The rest of the world has been busily introducing very similar laws to protect their own industries from foreign investors."

The "International Investment Perspectives: Freedom of Investment in a Changing World" study conducted by the Organisation of Economic Co-operation and Development (OECD) in 2007 revealed that several countries have recently tightened their regulation and administrative practices to restrict foreign presence in sensitive areas. France and Germany have made themselves the butt of jokes for introducing closed lists of sectors and activities that restrict access for foreign investors on security grounds. Likewise the US Congress last year amended the procedures under the Exon-Florio Amendment (first enacted in 1988 to counter the perceived threat of the Japanese expansion), adding critical infrastructure and foreign government controlled transactions to items for review by the Committee on Foreign Investment in the US - a committee that has come close to shooting down several recent acquisitions by Russian companies in the US, according to bne sources. In Canada and Japan, an overhaul of foreign investment regulations related to national security is also under consideration.

"The OECD report calls for an open investment regime, but admits that ownership of mineral producing companies has become a political issue. According to the report, these concerns have been further strengthened by deliberate investment strategies in some countries to secure control over such resources for political or national security reasons as much for economic reasons. Russia's move to establish a framework for addressing national security concerns in investment policy is not at all out of place, but actually in line with what the rest of the world is doing," says Frolov.

Federal significance

The strategic investment law puts clear limits on foreign investments in the listed sectors, but does not ban them completely. Indeed the Kremlin realizes that in many of these sectors it badly needs foreign know-how and management skills to realize the potential of things like hard-to-reach oil deposits on the Russian Continental Shelf.

Under the new rules, private foreign companies wishing to buy a Russian asset have to obtain preliminary permission to acquire more than 50% of the shares in strategic companies.

Conscious of the growing power of sovereign wealth funds, there are separate rules for foreign state-owned companies that have to go through the same procedure if they want to buy more than 25% of a strategic Russian company. And foreign state-owned companies are banned from acquiring control - either directly or indirectly -over strategic companies.

The new law introduces even more stringent restrictions on the activity of foreign investors in the natural resource sectors. The cap on foreign companies that want to buy a company holding the right to use "subsoil plots of federal significance" is set at 10% of the company's equity. Getting permission to buy even 10% in one of these companies is going to be hard, as the law says it will be allowed "only in exceptional cases and only upon a decision of the Russian government."

The subsoil plot

The definition of what counts as a "subsoil plots of federal significance" has partially been laid out in the amendments to the Subsoil Law, but this part of the new regime is still a work in progress. Currently the definition includes:

i) subsoil plots containing deposits and showings of uranium, diamonds, high purity quartz, the yttrium group of rare earths, nickel, cobalt, tantalum, niobium, beryllium, lithium, or the platinum group of metals (irrespective of the size of the deposits);

ii) subsoil plots containing recoverable oil reserves above 70m tonnes, gas reserves above 50bn cubic meters, hard rock gold reserves above 50 tonnes and copper reserves above 500,000 tonnes;

iii) subsoil plots located in the inland sea waters, territorial sea waters, or on the continental shelf of the Russian Federation; and

iv) subsoil plots that can only be developed using land classed as defence and security land.

What is still missing is a definitive subsoil plots of federal significance list. The Federal Agency for Subsoil Use is in charge of drawing up the list, but it is not ready yet. However, the Ministry for Natural Resources has previously published a list of undistributed deposits that are considered strategic, which were defined by using the same criteria as the new amendments so it is already possible to have a good guess at what is for sale and what is not. But this list only covered the undistributed deposits - 10 oil fields, 24 gas fields, five copper and one gold deposit - and didn't mention those that already belong to Russian companies and the state.

On top of the restrictions already mentioned, assets on Russia's continental shelf come in for an even harsher regime, where the state carves out a special role for itself.

According to the amendments on the Subsoil law assets on the continental shelf, such as the island of Sakhalin, only companies that are at least 50% controlled by the state can own these assets. This restriction has caused a wail of complaint not only from the foreign investors, but also Russia's leading domestic companies, who point out that they lack the technology, equipment and funds needed to develop massive oil and gas resources on the shelf on their own. They have to partner with foreigners if they are get the oil and gas out of the ground in these places. "But the law doesn't prohibit foreign investors from establishing joint ventures with Russian state controlled companies. As the latest trend in the oil and gas industry reveals, in order to succeed in doing business in Russia, Western majors have to find the right Russian state-controlled partner. In this respect, the amendments don't seem to drastically change the rules of the game in the oil and gas sector but serve to clarify them," says Frolov.

Lay of the land

So far none of these changes make things much worse and to a degree they actually improve the investment environment by clarifying the rules of the game. The worst that can be said of the Kremlin is that it's not doing anything that the other major powers are doing.

However, the one place where the new laws have clearly made things worse is with geological exploration. Since the collapse of the Soviet Union, both Russian and foreign investors have been reluctant to invest in geological exploration as exploration licenses effectively carried no guaranteed conversion rights into a production licence once a commercial discovery had been made. The safest way to proceed has been to acquiring licences to deposits already recorded in the state register of reserves in Soviet times: if another company pulls strings to get the production license then at least the company has not lost any money on prospecting.

The upshot is little exploration work has been done over the last 17 years. The Soviets explored western Siberia pretty thoroughly and started production on many of the biggest fields. However, as this produced more than enough oil little prospecting was done in eastern Siberia, which has a very similar geology and is widely believed to contain rich oil deposits. Just no one has been to look yet.

The lack of exploration will only exacerbate the recent trend of falling oil production in Russia. Most of the Soviet-era fields currently being exploited are either mature or already in decline. Heavy investment is needed simply to maintain current production levels, while demand for oil is rising all the time. The decrease can't be offset by production at the new oil fields coming on stream. The International Energy Agency's World Outlook 2007 says that even in the best-case scenario growth of the oil production in Russia might stall in 2010 to 2012 and is not likely to resume until 2015.

The exploration issue was tackled as part of the amendments to the subsoil law, but lawyers believe the Kremlin fluffed it and if anything will reduce the amount of foreign investment going into exploration. According to the amendments to the subsoil law, if a foreign investor with an exploration license finds a deposit that counts as a "federally significant," the government withholds the right to refuse a production license. And if a foreign company found the same deposit with a combined license for geological survey, exploration and production then the government may decide to terminate the license on national security grounds. The only solace for the investor is that in both cases the government promises to pay for the cost of all the work done during the prospecting, plus a little something extra as a reward. But these are hardly terms to bring in the big boys who will only work if they believe they can have a share of big finds.

Still, the bottom line is that these new rules won't actually change the status quo that emerged from Putin's eight years as president; a delicate balance between the interests of the state and the private companies in these sectors. "The key take away is that the new law has is no outright prohibition on foreign companies owning stakes in strategic companies; what the law has done is given the power to block or let the deal go ahead on a case by case basis. What the strategic law definitely does do is encourage foreign investors to think strategically," says Frolov.

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