This article is reproduced from "The New Europe in the World Economy", published jointly by ICC and International Systems and Communications Ltd of London to commemorate the 33rd ICC World Congress, Budapest, 3 - 5 May, 2000.

Foreign direct investment in Russia: Battling against the odds

by Jeffrey M. Hertzfeld

At the opening of this new millennium, the Russian market looms on the horizon as an immense opportunity for foreign investors - but one whose time has not quite come. To make it happen, much will have to change, and the new Russian president and his government should make such change a high priority in this year 2000.

Russia has much to make it one of the most exciting markets in the world today. It is a vast country stretching across Europe and Asia, possessing spectacular wealth in the form of exploitable natural resources, a large, skilled workforce, and nearly 150 million consumers whose needs are endless.

It is a country whose announced goals are to move towards a market system based on private capital investment and enterprise and to integrate rapidly into the world economy. Indeed, it has rapidly privatized the bulk of the assets of former state enterprises (although in many cases with a lack of transparency and fairness that has created an unfortunate legacy). It has also spawned tens of thousands of new small and medium-sized private enterprises across the country that are today only in their infancy , These hold the promise for the future and could be natural partners for foreign direct investors.

A marginal phenomenon
Yet, foreign direct investment remained a marginal phenomenon in Russia through the 1990s. In 1999, it amounted to a mere $2.2 billion. Both Russia and foreign investors alike have been the losers. Why has there been so little foreign investment to date and what needs to be done to change this in the coming decade?

One, perhaps cynical, explanation is that Russia may not really want foreign investment, and has only paid lip-service to the principle in order to gain the backing of foreign governments and international financial institutions. Russia's history, not just in the Soviet period but going back centuries, has been one of isolation from the West and distrust of the outside world.

Peter the Great sought to open a "window to the west" by building a city on the Baltic that today once again bears his name. But the German, Dutch and Italian specialists who were invited to Russia to assist in this venture were kept segregated from Russian society and, when their task was done, few were encouraged to stay on. During the communist period, foreign companies sold plants to the Soviet trading monopoly, but once the plants were built and commissioned the foreign specialists who built them were no longer welcome.

It takes time for attitudes to change. Many members of today's Duma distrust foreigners per se and believe their only purpose in investing in Russia is to rob the country of its riches by making quick profits and shifting them abroad. However, there is an enlightened segment of leadership in Russia which does not share this view, but to the contrary, recognizes that there are enormous benefits Russia can and should derive from foreign direct investment. They see how such investment can help by:
· upgrading and converting old and inefficient plants and establishing new ones;
· training local managers and workers in competitive international business techniques;
· generating economic growth through reinvestment;
· creating jobs;
· introducing new products;
· improving living standards;
· increasing tax revenues; and
· accelerating the country's integration into the world economy.

All investment decisions involve weighing the risks and opportunities. Since the opportunities offered by the Russian market are as great as ever, one must look to the evolution of the risks affecting investment in Russia to understand why, in the international competition to attract foreign investment, Russia has fared so poorly, and why, despite its huge potential, it is still today not perceived as a good risk for many interested foreign investors who have yet to take the plunge.

The catalogue of difficulties facing investors in Russia is long. But two big issues stand out. The first is the need for a level playing field in the marketplace where investors may compete on a fair and equal footing. The second is the need not merely for laws but for the "rule of law" which will give investors confidence that their rights will be recognized and enforced.

Levelling the playing field
Russia has established the foundations for a market economy - with competing private enterprises free to set their own production and sales objectives and free to set their own prices. Theoretically, in such an environment well-run and well-structure d enterprises should flourish, and inefficient ones should eventually fail. This has not been the case in Russia to date. Despite the enactment of bankruptcy legislation, many unprofitable, inefficient and unproductive enterprises survive as beneficiaries of government support, while profitable enterprises have become the target of costly demands of a burdensome bureaucracy with broad discretionary powers applying unclear and frequently contradictory rules and regulations.

The way the privatization of numerous state enterprises was run has resulted in many of them remaining in the hands of their previous managers with close ties to the government bureaucracy. These ties have frequently translated into special tax concessions, preferential access to land, reduced charges for energy and other forms of hidden subsidies in return for under-the-table payments and other inducements.

Managers have little incentive to restructure their enterprises, since they do not need to be competitive to survive. In this way, a large and fundamental distortion of the marketplace is perpetuated at the expense of competitors and society as a whole.

An even greater distortion has emerged from the increasing reliance in Russia on barter transactions. While barter has been a technique for living "outside the system" since Soviet times, its dramatic growth in recent years is due in part to the government's failure to restructure the clearly unreliable banking system in the wake of the August 1998 financial crisis, and in part to the failure to reform a tax system whose punitive effective rates and ambiguous rules have encouraged widespread non-compliance. Much of this barter activity, at worst, goes unrecorded and untaxed and, at best, understates the true value of the goods exchanged and facilitates the concealment of income.

Thus, companies engaging in barter often escape the tax and other costs of compliance with the rules of normal commerce and by-pass the obstacles of the highly bureaucratized Russian economy. The net result is that they enjoy an unfair competitive advantage in relation to those companies trying to play by the rules.

Companies with foreign investment tend to be prime victims of these distortions. Foreign investors as a group do try to pay their taxes and play by the rules. Yet, because they are highly visible and perceived as having deep pockets, they become inevitable targets for administrative harassment.

Russia has perfected a system of red tape that can make the simplest business démarches complicated. It is hard for many western businessmen to comprehend why a company that could be established in the United States, France or England in a matter of hours and at nominal cost should entail weeks and weeks of administrative formalities in Russia. Foreign investors, disinclined to pay bribes, suffer especially long delays in obtaining licenses, permits, or authorizations from governmental agencies. Deadlines stipulated in the law for government agencies to perform their duties are disregarded with impunity.

Foreign investors in trying to comply with the rules are confronted by the maze of contradictions and ambiguity still typical of Russian legislation and regulation. Despite good faith in compliance efforts, they all too often end up subjected to arbitrary claims for tax payments, customs duties, currency violations and the like, with associated fines and other sanctions capable of crippling or even shutting down their operati ons. A level playing field should include access to reliable and unified interpretations of the rules by the government agencies responsible for applying them.

Oil and gas and the oligarchs
Nowhere has the system been more weighted against the foreign investor than in the oil and gas sector, the very sector in which Russia should be most actively encouraging the participation of foreign oil companies, not only for their capital contribution, but for their advanced technology and experience.

Nearly all the major international oil companies and many smaller ones have expressed interest in participating in the exploration and development of Russia's oil and gas reserves and willingness to commit modern technology and billions of dollars of capital on a long-term basis, provided Russia creates investment conditions compatible with international practice and which take account of the long-term character of investments in this sector.

Such conditions include an opportunity to share in the production generated by the investment, a clear and reasonable tax regime which allows an equitable return on investment, a stable set of rules, and an equal opportunity to obtain and exercise rights to the oil and gas fields. Russia falls short on all of these conditions.

Privatization of the former Soviet oil production enterprises has resulted in these assets falling under the control of the so-called oligarchs who by and large have not wished to share production with foreign companies, particularly as the oligarchs found that they could obtain ready access to international capital markets. More than one western oil company has been unjustly deprived of license rights or shareholder rights through the machinations of the oligarchs in the corridors of government power or through their manipulation of the courts.

At the same time, the oligarchs have taken steps to move control of these privatized assets into specially created, highly opaque off-shore vehicles and to put much of the revenues derived from export sales into off-shore bank accounts even though this deprives their production companies of the means with which to upgrade existing facilities and open new fields. Pressure to correct this situation is bound to grow in the coming period, particularly if world oil prices remain high; the oligarchs may find it in their interest after all to team up with experienced western partners.

Greater respect and better enforcement of legal rights
The 1990's witnessed a truly remarkable legislative effort as Russia. put in place a legal framework designed to address the rights and obligations of participants in a market- oriented economy based on private ownership and profit. In a few short years, the country adopted:
· a new civil code defining inter alia, contract and property rights;
· laws on private joint stock companies and limited liability companies;
· legislation establishing and regulating private trading in securities and the protection of the rights and legal interest of investors in securities;
· law on bankruptcy; and
· a law against anti-competitive practices.

There are still gaps in this legislative framework where the new Duma could well focus legislative effort - intellectual property rights, tax reform and the adoption of accounting standards in line with international practice, labour legislation and the emotional issue of private ownership of land.

Despite their shortcomings, it is fair to say that the laws in place represent a significant achievement. Indeed, the concerns of foreign investors today tend to relate less to the laws themselves than to the actual application of these laws when dealing with their Russian counterparts and government agencies and when seeking enforcement of their legal rights before the courts.

Foreign investment implies a relationship of trust and confidence between all participants, including shareholders, managers, employees and creditors. The host government creates the environment in which this relationship exists. A civil code and corporate laws can define certain principles of the relationship, but implementation of these principles in practice requires a local business culture which is ready to play by the rules.

The role of government institutions and the judiciary is essential in promoting respect for the law. Unless they are prepared to apply the law and enforce rights and obligations under the law in an even-handed and consistent manner, those rights and obligations are meaningless and the development of a business culture respectful of legal rights will not emerge.

The law in their own hands
To date, the record is distressing. Foreign investors are assured non-discriminatory treatment in Russia by law, by the constitution and, in many cases, by international treaties. But, many foreign investors have found it difficult, if not impossible, to have their rights recognized, particularly when they find themselves in conflict with a politically powerful or well-connected Russian party.

Why is this? The reasons are undoubtedly multiple. In some cases, it may be attributable to a genuine lack of understanding of the existing legislation by many bureaucrats and judges, since it does reflect a cultural departure from the not-so-distant past. In others, it may reflect an ingrained nationalist bias.

However, in many cases, the most likely explanation is that improper influence has been exerted, resulting from inducements, coercion or conflicts of interest. How can one really expect the governor of a region who is sitting on the board of a privatized oil company not to favour his own company's interests? Can one expect a regional judge, appointed and paid locally, to rule against his principal local constituent? And, for that matter, can one truly expect a government ministry, when the state itself owns 49 percent of a privatized oil company, to deny that company's request to withdraw a previously issued oil license from an inconvenient foreign investor? These questions are, unfortunately, not rhetorical.

Russian legislation does allow shareholders in companies with foreign investments to have their disputes settled through international arbitration if they so provide in their foundation agreements or the charter of their joint entity. The possibility of submitting shareholder disputes to a neutral third country forum has been widely applauded as providing a further assurance that foreign shareholder rights in Russian companies are well protected.

However. international arbitration without reasonable assurance of local enforcement may turn such protection into an illusion. Russian courts around the country have regularly refused to recognize and enforce international arbitration awards rendered against Russian parties. Not long ago, we brought two parallel arbitrations in Stockholm on behalf of a foreign investor against its Russian partner for having violated the provisions of the charter of their jointly-owned Russian hotel company as well as those of management agreements governing the hotel operations. Two separate awards were obtained in favour of the foreign investor.

Enforcement of one was refused by local courts, despite Russia's obligations under the New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards. Enforcement of the other was upheld by the Russian Supreme Court, only to be blocked by a spurious extra-judicial "protest" by the procurator's office at the very moment when the bailiffs sought to seize the judgement debtor's bank account. Our client was finally able to recover its damages by seizing assets in Canada. But not all Russian judgement debtors have assets abroad, and in those cases, the foreign investor may be left without an effective remedy to enforce its rights. We have recently obtained enforcement in Russia of another foreign arbitral award - a multi-million dollar judgement against a major Russian oil company. It remains to be seen whether this is the start of a positive trend, or merely an exception to the rule.

Investor's choice
A level playing field and a rule of law require an honest, even-handed and efficient bureaucracy and judicial system, implementing reasonable rules in a consistent and predictable manner. It also requires the evolution of a new business culture in Russia which favours compliance with rather than avoidance of the rules and a system of values which encourages productivity and efficiency in the workplace.

Such a change cannot be achieved overnight, but can be achieved over time. Failure to do so will certainly discourage foreign direct investment. However, even more importantly, it will carry a heavy political, social and economic price - continuing decline in the country's economic performance with still lower levels of new investment, higher rates of unemployment, and a growing percentage of the population living below the poverty level.

The concerns expressed here are in large part as relevant to most domestic investors as they are to foreign investors in the Russian economy. However, the basic difference between the two is that the domestic entrepreneur is condemned to cope with local conditions while the foreign investor is free to choose from among competing host countries and to decide which one offers the most attractive balance of risk and opportunity for his investment. A country's success in attracting foreign investment is therefore a measure of its domestic success as well.

It is in the West's interest as much as Russia's for the process to succeed. Yet, as one US government official put it, we cannot want reform in Russia more than the Russians do themselves. The willingness or unwillingness of foreign investors to invest can, however, effectively communicate to Russian policy-makers the need for change.

There is today a huge pent-up interest for investment in Russia. As and when positive change occurs, I believe that foreign direct investment will dramatically increase and such investment will indeed become a motor for economic growth and prosperity in Russia in the coming years.

Jeffrey M. Hertzfeld is a senior partner in the international law firm, Salans Hertzfeld Heilbronn (Paris). He is a member of the OECD Steering Committee on foreign investment in Russia and the ICC European Arbitration Group.