Russian Federation: Foreign Investor Interests In Relation To The Stock Of Russian Companies

Stock issued by a Russian company is often an object of investor interest and potential investments. Russian law provides that stock is usually acquired through the conclusion of a sales agreement with the shareholder. Agreements are generally concluded using standard models devised for stock purchase and sales transactions. However, it should be noted that Russian legislation is constantly changing and agreement models that were previously acceptable can quickly go out of date.

Therefore, stock purchase and sale agreement models used by investors may be at variance with updated Russian securities legislation and transactions which they regulate may be declared null and void by a competent court or by the Russian Federal Securities Commission. Foreign investors are required to be especially careful when acquiring stock in Russian companies, for they are required to observe both currency control and foreign investment legislation in addition to general civil law provisions and regulations as provided for in the Russian Civil Code¹. Current Russian legislation does not require notarization of transactions involving securities.

Paragraph 6 of Edict No. 1769 of the President of the Russian Federation of October 27, 1993, "Concerning Measures to Uphold the Rights of Shareholders" contains stipulations on the registration of transactions involving securities and stock. The Edict establishes that registration in the shareholders' register of a shareholder who has acquired rights as a result of a transaction performed independently of any investment institution and/or depository constitutes a registration of the transaction. Banks, depositories and investment institutions (except investment consultants) are empowered to register transactions involving stock and securities carried out with their participation.

Transactions with stock that do not involve professional securities traders are registered by a registrar by means of an entry in the registry book. Transactions with securities carried out with the participation of professional securities traders are registered by the professional securities traders. The registration referred to here does not constitute state registration in the sense of Article 164 of the Civil Code of the Russian Federation and has no bearing upon the validity or otherwise of the agreement.

The subject clause is an important clause in any purchase or sales agreement. Pursuant to Article 455, section 3 of the Civil Code of the Russian Federation, the terms of a sales or purchase agreement that stipulate the nature of the goods are considered agreed if the agreement defines the name and quantity of the goods.

The agreement must clearly state the name of the company whose stock are subject to sale or purchase, and the quantity thereof. The agreement must state the category of the stock (ordinary, registered, preference) and the type (if the issuer has issued several types of stock for each category).

Furthermore, pursuant to Article 5.2 of Federal Law No. 46-FZ of March 5, 1999, "Concerning the Protection of the Rights and Lawful Interests of Investors in the Securities Markets", shareholders are prohibited from carrying out transactions of stock in their possession until such time as the stock are fully paid and a share issue report has been issued. Share issue reports are registered in accordance with the procedure established by Article 25 of Federal Law No. 39-FZ of April 2, 1996, "Concerning the Securities Market" (hereinafter – the Law Concerning the Securities Market"). Any transactions that violate these provisions may be declared null and void.

Until the implementation of the Law "Concerning the Securities Market" (April 25, 1996), Russian legislation did not require the registration of share issue reports. Therefore, stock issued prior to the implementation of the above Law may be alienated without the registration of a share issue report. This is confirmed by the clarifications of the Federal Securities Commission set forth in Letter No. IB-2171 of the Federal Securities Commission of April 26, 1999. The Letter states that the requirements of Article 5.2 of the Law Concerning the Protection of the Rights of Investors do not apply to securities transactions performed after March 11, 1999 in respect of securities placed prior to the implementation of the Law "Concerning Securities", on condition that the original shareholders fully paid up the securities.

The principal legal objective of any sale or purchase agreement is to convey ownership rights to the subject of the agreement from the seller to the purchaser (Article 454, section 1 of the Civil Code of the Russian Federation). It is generally assumed that the selling entity is the owner of the subject of the sale. However, Article 455, section 2 of the Civil Code stipulates that an agreement may be concluded in respect of the purchase or sale of assets which the seller possesses at the moment of the conclusion of the agreement or which will be created or acquired by the seller in the future unless otherwise stipulated by the law and unless precluded by the nature of the subject of the sale. Since legislation of the Russian Federation does not prohibit sale of stock by entities, not holding title to such stock, stock sale agreements may be concluded by parties which have not yet acquired ownership rights over the stock at the time of the conclusion of the agreement. However, the seller must hold title to the stock at the moment of transfer of ownership rights to the purchaser.

It is important to give proper definition in the agreement to the moment of transfer of the ownership rights to the stock from the seller to the purchaser. Agreements often state that ownership rights shall vest in the purchaser at the moment of the signature of agreement, or upon the expiration of a fixed period following the signing of agreement, or upon payment in full of the amount due in respect of the stock. All of these methods of defining the moment at which ownership rights vest in the purchaser contradict current legislation and may cause the agreement to be declared null and void.

The Law "Concerning the Securities Market" and Russian jurisprudence draw a distinction between the right of a shareholder to a share (the so-called "right to paper") and the rights of the shareholder with regard to the joint stock company that arise from the share (the so-called "right from paper"). The Law "Concerning the Securities Market" draws distinctions between the moments of vesting of various share-related rights depending on the nature of the share issue and the method used to register (document) the rights to the securities.

Pursuant to Article 29 of the Law "Concerning Securities", rights to registered non-documented stock vest in the purchaser as follows:

Pursuant to Article 29 of the Law "Concerning Securities", rights to registered documented stock vest in the purchaser as follows:

The same principle relates to the moment of transfer of shareholder's rights and obligations arising from stock. Pursuant to Article 29.3 of the Law "Concerning Securities", rights arising from a share issue vest in an acquirer of the stock, simultaneously upon the transfer of ownership rights.

In view of the fact that the conveyance of ownership rights from the seller to the purchaser is the principle legal objective (cause) in a sales and purchase agreement, the incorrect (void from a legal point of view) definition of the moment of conveyance of ownership rights may nullify the agreement as a whole.

The parties are generally free to define the terms of the agreement, including those terms that relate to the value of the agreement. Stock may be also acquired at their face value in accordance with legislation of the Russian Federation. The only exception arises in relation to the acquisition by non-residents of stock using S-type investment accounts (see below). Pursuant to paragraph 2.1p of the Statute "Concerning the Performance by Non-Residents of Transactions Involving Securities Issued by Russian Entities and Denominated in the Currency of the Russian Federation and Concerning the Performance of Conversion Transactions" (approved by the Central Bank of the Russian Federation of March 23, 1999, No. 68-P), transactions carried out using special non-resident S-type accounts must be carried out at their market value as defined in accordance with Decree No. 1087-r of the Federal Securities Commission of October 5, 1998, "Concerning the Establishment of a Procedure for the Identification of the Market Price of Issued Securities Traded on the Securities Exchange or via a Trader Operating on a Securities Market, and Concerning the Introduction of Limits on Fluctuations in the Market Price".

On stating the value of a transaction it should be borne in mind that in certain cases tax legislation allows the accuracy of the amount charged in respect of goods (work and services) to be verified for taxation purposes. In the event of understatement, the tax authorities may accrue additional taxes and penalties. However, these powers of the tax authorities should at present have no bearing upon agreements concerning the sale and purchase of stock.. Pursuant to Article 40.2.2 of the Tax Code of the Russian Federation, until the implementation of Part II of the Tax Code (January 1, 2001), articles that empower the tax authorities to adjust the amounts stated in agreements and to accrue additional taxes and penalties shall not apply to the determination of the market price of futures and securities. Accordingly, additional taxes cannot be accrued either against the seller or the purchaser in respect of transactions involving futures and securities, regardless of the amount of the transaction.

Investors investing into closed joint stock companies should bear in mind that the Law accords shareholders in such companies priority right to acquire further stock before third parties (the right of first refusal). Pursuant to Article 7.3.4 of Federal Law No. 208-FZ of December 26, 1995, "Concerning Joint Stock Companies", shareholders in closed joint stock companies have priority right to acquire stock offered for sale by other shareholders in the closed joint stock company at the price proposed to any other party. Pursuant to Article 7.3.5 of the said Law, the procedure and deadline for exercising the right of first refusal are established by each company individually.

A company's charter may provide for the priority right of the company to acquire its own stock if the shareholders have declined to exercise their priority rights of acquisition.

From a practical standpoint, before entering into a purchase agreement involving the equity of a closed joint stock company, investors should examine the company's charter to ensure that the method proposed for the exercising of the priority right corresponds to the procedure stipulated by the charter.

The proper definition of settlement terms is a very important consideration in the case of share purchase and sale transactions involving foreign investors. Such agreements must observe the legislative provisions concerning foreign investment and currency regulation and currency control.

Legislation on currency regulation and currency control views any foreign currency settlement between residents and non-residents as foreign currency transactions. Furthermore, pursuant to Article 1,10 of Law of the Russian Federation No. 3615-1 of October 9, 1992, "Concerning Currency Regulation and Currency Control" (hereinafter – the Law Concerning Currency Regulation), direct investments and portfolio investments (share acquisitions) are classified as foreign currency transactions linked with the movement of capital. Transactions of this type require the issuance of a license by the Bank of Russia (Central Bank of the Russian Federation). The said license must be received by the Russian entity which sells securities to the non-resident.

Letter No. 12-3c-10/7392 of the Central Bank of the Russian Federation (CBR) of January 31, 1995 clarified that current foreign currency legislation of the Russian Federation does not regulate the activity of non-residents on the Russian market, and applies to residents of the Russian Federation only. Therefore, non-residents engaged in the purchase of stock issued by residents are not required to obtain licenses from the CBR. However, the Letter stipulates that transactions involving the sale of stock to non-residents in consideration for foreign currency constitute foreign currency transactions linked with the movement of capital and require the resident party to be in possession of the appropriate CBR license. Transactions involving the movement of capital performed without the prior receipt of the appropriate CBR license may be declared null and void.

The above Letter was issued in 1995 and therefore did not take into account recent amendments to foreign currency legislation. Pursuant to Article 1.7d of the Law Concerning Currency Regulation (implemented by Federal Law No. 192-FZ of December 29, 1998), settlements between residents and non-residents in the currency of the Russian Federation constitute foreign currency transactions. Therefore, since the entry into force of Federal Law No. 192-FZ of December 29, 1992, there are grounds, albeit questionable, upon which the sale of stock by a resident to a non-resident for Russian rubles could be deemed a foreign currency transaction linked with the movement of capital. Thus the settlement in rubles of a transaction between a resident and a non-resident involving the sale of stock would require the resident to obtain a license for the transaction from the CBR. The fact that ruble transactions with non-residents are classified as transactions linked with the movement of capital may be deduced from Article 1.10 and Article 1.7d of the Law Concerning Currency Regulation.

Pursuant to Article 1.10 of the Law Concerning Currency Regulation, foreign currency transactions linked with the movement of capital include:

a) direct investments into the charter capital of enterprises with the aim of earning profit and acquiring the right to participate in the management of the enterprise;

b) portfolio investments – i.e. securities acquisitions;

c) all other foreign currency transactions that are not categorized as current foreign currency transactions.

Article 1.7d of the Law Concerning Currency Regulation stipulates that settlements between residents and non-residents in the currency of the Russian Federation constitute foreign currency transactions. Therefore, in accordance with the sense of paragraph 10, settlements of this nature may be classified as "other foreign currency transactions that are not categorized as current foreign currency transactions", i.e. transactions linked with the movement of capital.

However, Article 1.8 of the Law Concerning Currency Regulation stipulates that "transactions involving foreign currency and securities denominated in foreign currencies are categorized either as current foreign currency transactions or as foreign currency transactions linked with the movement of capital". Therefore it may be deduced that although settlements carried out in Russian rubles between a resident and a non-resident constitute a foreign currency transaction, the transaction cannot be classified either as a current foreign currency transaction or as a foreign currency transaction linked with the movement of capital since the settlements were carried out in rubles, and not in foreign currency.

The logical ambiguity of the Law Concerning Currency Regulation precludes a clear conclusion on whether or not a transaction involving the purchase by a foreign investor of the stock of a Russian issuer in consideration for payment in rubles constitutes a transaction linked with the movement of capital, as such requiring the Russian resident to obtain a license for the transaction from the Central Bank of Russia.

Nevertheless, even if we do draw the conclusion on the basis of the above that the said transactions do not constitute foreign currency transactions linked with the movement of capital, there exist other restrictions on settlements in rubles between residents and non-residents upon the acquisition of stock by the non-resident.

Pursuant to Article 2.2 of the Law Concerning Currency Regulation, the procedure for the purchase and use of rubles by non-residents is established by the CBR. The Law permits non-residents to maintain ruble bank accounts at authorized banks. Pursuant to Article 2.4 of the Law, transactions performed in violation of the Law are considered null and void.

The procedure for the use of Russian currency by non-residents is currently governed by Instruction No. 16 of the Central Bank of the Russian Federation of July 16, 1993, "Concerning the Procedure for the Opening and Maintenance of Non-Resident Ruble Accounts at Authorized Banks" (in the wording of June 30, 1999 – hereinafter referred to as Instruction No. 16).

Section II of Instruction No. 16 stipulates that non-residents of the Russian Federation may open three types of ruble accounts as follows:

a) T-accounts (current accounts) (organizations and their branches only);

b) I-accounts (ruble-denominated investment accounts);

c) Bank accounts of non-resident physical persons.

All ruble investments and reinvestments within the Russian Federation, and purchases of foreign currency for rubles for the repatriation of profits arising from investment activity in the Russian Federation must be carried out by non-residents through their I-accounts (rubles). This does not apply to payments by non-resident banks in respect of equity stakes in resident credit organizations. Pursuant to paragraph 2.2 of Instruction No. 16, ruble I-accounts may be opened by either non-resident organizations or non-resident physical persons.

Furthermore, pursuant to paragraph 2.2.3 of Section II of Instruction No. 16, settlements on I-accounts in respect of non-privatization transactions may be carried out by all non-residents except non-resident physical persons which are not registered as business entities in the country of their citizenship or place of permanent residence. Pursuant to paragraph 3.2 of Section II of Instruction No. 16, expenses related to investment transactions may not be covered from the ruble accounts of non-resident physical persons.

Generally, all transactions carried out by non-residents involving the purchase of stock should be effected from ruble-denominated I-accounts. According to Instruction No. 16, non-resident physical persons who are not registered in their country of origin as business entities are not permitted to engage in investment activity from ruble accounts in the Russian Federation.

Non-resident physical persons, including non-resident physical persons who are not registered as business entities in their country of citizenship, and non-resident legal entities, are permitted to acquire securities issued by Russian entities using ruble S-accounts, which are governed by Instruction No. 79-I of the Central Bank of the Russian Federation of March 23, 1999, "Concerning Special Non-Resident S-Accounts" (Hereinafter – Instruction No. 79-I).

S-accounts may only be used in respect of transactions involving securities that are included in a list that is specially approved by the CBR Board of Directors.

Pursuant to paragraph 6.2.2 of Instruction No. 79-I, ruble amounts may be transferred from S-accounts (investment) by non-resident physical persons or legal entities:

Thus, non-residents may acquire Russian securities from residents in consideration for non-cash ruble payments as follows:

Furthermore, the terms of the Central Bank instructions referred to above are formulated in such a way, that it is possible to deduce that no ruble settlements can be made in respect of the securities of Russian issuers outside the stated ruble investment accounts. Thus, even cash settlements paid by non-residents to residents in respect of acquired securities, including cash settlements paid by non-resident physical persons by-passing the investment account, are considered unlawful.

This conclusion is confirmed by the fact that the above instructions were issued with the purpose of implementing Article 2.2, Article 7 and Article 9 of the Law Concerning Currency Regulation.

Article 2.2 of the Law Concerning Currency Regulation stipulates that the procedure for the acquisition and use by non-residents of the currency of the Russian Federation shall be established by the Bank of Russia. Article 7 of the Law relates to the right of non-residents to open and maintain ruble accounts in accordance with the procedure stipulated by the Central Bank of Russia. Since no regulations are stipulated with respect to the procedure for the use of rubles in cash settlements of investment transactions whereby non-residents acquire Russian securities, current regulations requiring the settlement of such transactions by bank transfer as established by the CBR instructions should be considered the only admissible approach.

Pursuant to Article 180 of the Civil Code of the Russian Federation, an entire transaction is not rendered void by the voiding of a part thereof if it may be reasonably considered that the transaction would have been concluded even without the void part. However, Article 2.4 of the Law Concerning Currency Regulation stipulates that any transactions carried out in violation of the Law are null and void. Therefore any inconsistency between the terms of settlement between the resident and the non-resident and the currency regulation legislation may be considered grounds for rendering the entire transaction null and void, regardless of the provisions of Article 180 of the Civil Code.

The issue of settlements in rubles between residents and non-residents is regulated by Statute No. 503 of the Central Bank of the Russian Federation of August 15, 1997, "Concerning the Cessation of Foreign Currency Settlements in the Russian Federation in Respect of Goods (Work and Services) Sold to Physical Persons". Paragraph 1 of the Instruction stipulates that all transactions between legal entities, independent entrepreneurs and physical persons (resident and non-resident) in respect of goods (work and services) sold thereto in the Russian Federation shall be settled in rubles only. By quoting the appropriate paragraph of the Statute it may be possible to argue that cash settlements in rubles between a resident entity and a non-resident physical person in respect of stock acquired by the latter from the former are lawful. However, the said Statute makes no reference to the nature of the settlement (cash or non-cash), and makes no special reference to investment transactions involving the acquisition of securities by non-residents. Therefore, the Statute has no bearing upon the requirement to comply with the procedure for settlements in rubles upon the acquisition of securities by non-resident physical persons as stipulated by the legislation of the Russian Federation on currency regulation and currency control. That procedure, as stated above, requires that such settlements should be performed via ruble-denominated I-accounts or C-accounts and does not envisage the use of cash settlements.

The issue of terminating an agreement arises if the agreement has been concluded in violation of the legislation or if for other reasons the investor does not wish to go through with the obligations undertaken under the agreement.

However, if the agreement is deemed null and void by the investor for any of the above reasons, the issue of termination will not arise, since pursuant to Article 167.1 of the Civil Code of the Russian Federation, a null and void transaction cannot give rise to legal consequences other than those directly linked with the null and void nature of the transaction, and the transaction is deemed void from the moment of its conclusion. No rights or obligations therefore arise with regard to a void transaction. A void transaction gives no rise to any consequences beyond the actions of the parties thereto. The legal consequence of a void transaction is the restoration of the parties to their initial state (restitution), the main objective being to eliminate the consequences of the actions taken in implementation of the void transaction (the return to each of the parties of whatever was received upon the fulfillment of the void transaction).

Pursuant to Article 168 of the Civil Code of the Russian Federation, any transaction which is at variance with the legislation or other regulatory instruments is deemed void unless the law establishes that the transaction is contestable and envisages other consequences with regard to the violation. Article 166, section 1 of the Civil Code of the Russian Federation stipulates that void transactions are invalid regardless of whatever ruling is issued on the matter by a court of law. Any interested party may claim the implementation of the consequences of the invalidity of a void transaction.

The issue of terminating agreements which are deemed valid is governed by Chapter 29 of the Civil Code of the Russian Federation. Generally agreements are terminated at the request of the parties (Article 450, section 1 of the Civil Code), or on other grounds as established by legislation (e.g. Article 451 of the Civil Code). The parties may also provide for the right of either party to terminate the agreement unilaterally (unilateral refusal to implement an agreement – Article 450, section 3 of the Civil Code). In such cases, the agreement is deemed terminated as from the moment of the unilateral termination.

In cases where the parties are unable to agree upon the termination of an agreement and the law and the agreement do not provide for the right to opt out of the agreement on a unilateral basis, the issue of termination is referred to a court of law.

The court terminates the agreement on the basis of an application lodged by the plaintiff. The plaintiff's application is accepted only after the terminating party has received a written refusal from the other party to consent to the termination of the agreement (Article 453 of the Civil Code of the Russian Federation).

A clause on the unilateral termination of an agreement must be included therein if the parties wish to have the possibility of terminating the agreement unilaterally.

The consequences of terminating an agreement must be taken into consideration. Upon the termination of an agreement, the parties are released from the obligations that they have undertaken. However, in accordance with Article 453, section 4 of the Civil Code, the parties to a terminated agreement do not have the right to demand the restitution of whatever was fulfilled in accordance with their obligations prior to the termination of the agreement. This regulation may be overcome by agreement between the parties.

Should the executing party (seller of the securities, purchaser of the securities) wish to recover its assets (securities or cash respectively), in the absence of the consent of the second party this will be impossible, even via the courts. The only way to recover anything of the losses incurred in this case would be to lodge a claim of unjust enrichment against the party which received satisfaction under the agreement.

This work has considered some of the more important issues that arise when one invests in the stock of a Russian company and has described the issues surrounding the conclusion and implementation of stock purchase/sales agreements and the consequences arising from such transactions. The following conclusions are of value to business efforts in the area of transactions with Russian stock.

1. Practice shows that before concluding a share purchase agreement, the share purchaser should always ensure that stock is fully paid up by the founding parties upon placement and that the share issue report has been duly registered with the appropriate authorities as stipulated by the Federal Securities Commission. It is recommended that the purchase agreement should include the details of the state registration of the share issue report and should specifically mention that the purchased stock have been fully paid up.
2. In view of the binding nature of legislative provisions on stock ownership, ownership rights to stock may only vest in the purchaser at the moment stipulated by the Law. The moment at which ownership right vest in the purchaser depends on the nature of the stock and the procedure used to register the purchaser's rights. The use of any other definition of the moment at which ownership rights are transferred will place the agreement at variance with the law.
3. If the issuer of stock offered for sale is a closed joint stock company, the investor should ensure, prior to concluding an agreement, that the other shareholders of the company have exercised their right of first refusal, otherwise the agreement may be declared null and void.
4. Clauses in share purchase and sales agreements concluded between residents and non-residents that stipulate the performance of settlements in cash may be deemed null and void and at variance with the Law Concerning Currency Regulation (Article 2.2, Article 7, Article 9) and the regulations issued by the CBR on the basis thereof.
5. In relation to non-resident physical persons acquiring Russian stock, payment settlement options include:

6. Parties to a stock purchase or sale agreement are advised to conclude a separate agreement or to include in the original agreement a clause stating the non-applicability of Article 454 of the Civil Code of the Russian Federation in the event of their intention to provide mutual restitution following the termination of the agreement.