Russia: Special Report - Tied up in Red tape

Doing business in Russia can be unpredictable at best. For foreign investors, sticking to the rules is the key to success.

by World Business
Last Updated: 23 Jul 2013

One name strikes fear into the soul of every foreign investor active in Russia: Oleg Mitvol. Mitvol is the deputy head of Rosprirodnadzor, an environmental agency that is the bane of many foreign-owned natural resources companies doing business in the country. It was Mitvol, for example, who led the assault on Sakhalin II, the $20 billion oil and gas project off Russia's far eastern coast.

He took a group of journalists around the island of Sakhalin, pointing out every apparent environmental infringement he saw. Shell, the controlling partner in the project, was flummoxed by the assault and insisted that Sakhalin II observed all the regulations required. But it looked like Mitvol, once described as the "attack dog of the Kremlin", could not be called off - until Shell sold a controlling stake in the project to state-owned Gazprom for $7.5 billion. Then it appears the project's environmental credentials improved suddenly.

Mitvol then turned his attention to a group of smaller foreign-owned natural resources companies. Last year, he launched an attack on Peter Hambro Mining for its method of auditing its reserves, but appeared placated after Peter Hambro, CEO and owner of the gold mining company, flew to Moscow to meet him. However, in April, the attacks on Peter Hambro started again, which has since lost around 15% of its value, as well as attacks on Imperial Energy, Urals Energy and other natural resources firms that have listed on AIM in the past two years. Mitvol claims the companies have pumped up their reserves figures, then cashed in on AIM. The companies say that their reserves auditing is done by international auditors in line with international practice.

Privately, they admit to being bewildered by the attacks. Hambro says: "It's hard to know what or who is behind them. Obviously, there is tension within the government about the activity of the agency." In fact, Mitvol's boss has repeatedly called for him to be fired.

Mitvol is in some ways representative of the Russian business and political climate, where 80% of the activity of analysts and journalists consists in trying to guess the intentions of the government, which hides away behind the Kremlin's 15-foot walls. For example, last year, Bill Browder, the head of what was then the largest Russia-dedicated fund, Hermitage Capital, was abruptly denied a Russian visa. He says: "I still don't know who was behind it or why."

Everyone had a different theory of which powerful person Browder had annoyed with his unique brand of loud shareholder activism. Despite complaints from everyone from Clare Furse, head of the LSE, to the UK government, Browder remains in London, and his fund has lost hundreds of millions of dollars in investment.

Another example of the opacity of Russian politics and business is the Yukos affair, a three-year saga in which the state slowly ground down the leading oil company into bankruptcy. The Kremlin's line was that this was strictly a legal case involving tax evasion and fraud by Yukos' owner, Mikhail Khodorkovsky. But it was believed to be at least partly to do with Khodorkovsky's growing political ambitions. Although Putin said the state was not interested in bankrupting Yukos, which gave some plucky foreign investors the courage to buy back into the firm's devastated shares, the firm was eventually forced into bankruptcy. Its assets were sold off in a state auction that appeared to be open and competitive, but was really - most analysts believe - a stage-managed event.

The Yukos affair shocked foreign investors, because it showed just what could happen to a company if it got on the wrong side of the state. Khodorkovsky is currently kicking his heels in a prison in Siberia; other associates have been arrested or met mysterious deaths. Even his Western accountant, PricewaterhouseCoopers, has been fined $24 million by a Russian court for assisting in tax evasion. There is a sense among foreign investors that you'd better behave yourself. Stephen Jennings, CEO of Renaissance Capital, one of the most successful brokerages in Russia, says: "A degree of self-censorship is required in Russia, unfortunately."

The extent of the Kremlin's sway over investors was made clear this April, during the Russian Economic Forum in London, an annual jamboree that in past years has attracted many of the top businessmen and politicians working in Russia. This year, however, the word went out from the Kremlin that Putin preferred politicians and businessmen to attend Russia's home-grown conference instead, the St Petersburg Economic Forum in Putin's home-town. Hundreds of delegates, including foreign investors such as Jennings, cancelled their attendance in the days running up to the forum.

Some people believe the regulatory uncertainty that exists in Russia is just a way for bureaucrats and officials to seek bribes. Russia is certainly a country where corruption flourishes. Transparency International rates it the 90th least corrupt country, out of a list of 145. Indem, an anti-corruption think-tank, reported in 2005 that Russian companies and individuals pay over $300 billion in bribes each year.

Regulatory assaults on foreign firms appear to be ways of trying to shake fruit from the tree. Individuals claiming to represent the Russian customs agency recently approached Bank of New York and said it would sue the bank for $22 billion for money-laundering activities in the 1990s, to which the bank had already admitted, but that the bank could avoid this by paying a smaller sum. The bank refused, so the customs agency is now preparing its $22 billion suit. Its lawyers say the offer to BoNY was an "out-of-court settlement offer".

How can foreign investors manage this opaque and unpredictable environment? The best defence to regulatory attacks is to make sure you obey all the rules. If you cut corners or fail to fill in all the paperwork required, you put yourself at the mercy of bureaucrats, who may take advantage of your weak position. James Cook, manager of the Aurora Fund, which has been investing in Russia for over a decade, says: "We've never had to grease anyone's palm. There are regulations and as long as you follow them you can do good business."

Cook's previous fund, the Delta fund, was involved in a high-profile court case over the Lomonosov porcelain factory, which, due to the historical nature of the asset, provoked "quite a lot of rumblings". But Cook says: "We had to defend our rights (from a Russian corporate raider), and we won. So it shows you can win within the system."

Second, the lesson of Sakhalin II is that it's better to try and pursue your interests quietly within the system. Cliff Kupchan, senior Russia analyst at political risk agency Eurasia Group, says: "Shell made a mistake by very publicly complaining about the situation. The lesson that TNK-BP has taught us is that if you have a problem with the authorities, quietly pursue your interests within the system."

TNK-BP, the oil and gas joint venture in which BP has a 50% stake, has had problems of its own. It was presented last year with a $1 billion back-tax claim, but managed to reduce this through negotiations with the tax authorities. John Baldwin, chief advisor on Russia at BP, says: "It's a dual process. You try to negotiate with the tax authorities and see the nature of their concerns and claims. If that doesn't work, you seek adjudicational clarification through the courts."

Baldwin adds: "In terms of your relationship with the state, you have to rely on the fact that you've made a success of the company and done what you set out to do. Then, even if your local partner isn't flavour of the month, your success still gives you a measure of defence and legitimacy." He stresses the importance of "doing what you said you'll do", perhaps a reference to Shell's doubling of its costs in the Sakhalin II project, a factor that Kupchan says prompted the regulatory attack.

Another important way to succeed in Russian business is to have strong political contacts, both in your own government and in the Russian authorities. Kupchan says: "My advice would be to cultivate the best high-level contacts you can with the presidential administration and with the regional administration. That will decrease the chance of problems."

Per Kaufman, Russia and CIS manager for Ikea, says: "We recently built two large shopping malls in the Russian region of Tatarstan, which cost about $500 million. We wouldn't have made such a large investment if we weren't made to feel welcome by the local administration."

It pays to have a local partner. Baldwin says: "Russia is not a place where you always get clear messages. Part of what a local partner brings is its lines of communication with the state." Local partners give foreign investors better relations with the local authorities; it also can give them quicker access to the market than setting up a greenfield operation; and it provides them with local market know-how and information.

Hambro says: "You have to find a very good Russian partner. I have a number of Russian businesses with my Russian partner, Pavel Maslovsky. If you were Russian and came to England looking for business, how easy would it be for you to operate without a local partner?"

But what do local partners want from foreign partners? Partly, of course, access to capital. Many Russian banks are enjoying growth rates of over 100% in their lending portfolios, and are hitting capital constraints. Selling a stake to a foreign bank gives them access to that bank's deep pockets and means they can borrow internationally at significantly cheaper rates. But more important is access to technology. Russian technology is suffering from 20 years of under-investment, and many Russian companies are now prepared to pay to bring in partners or contractors that can supply them with cutting-edge expertise and technologies.

Basic Element, owned by tycoon Oleg Deripaska and the biggest holding group in Russia, recently bought stakes in two Western construction firms, Hochtief and Strabag. Konstanin Panin, spokesman for the group, says: "Hochtief and Strabag are undisputed leaders in construction in Europe in their respective fields. Hochtief specialises in construction, development and airport management. Strabag is good at building modern highways and tunnels. By entering these companies as a shareholder, we gain access to and benefit from their latest European technology and know-how."

What are the differences between the business cultures of Russia and the West? Cook says the days of signing deals in the banya (steam bath) and then drinking gallons of vodka are over, but that "personal relations probably still count for more in Russian business than they do in the West".

- Environmental enforcer Oleg Mitvol - the "attack dog of the Kremlin" - inspects a map during a trip to the island of Sakhalin.

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