Article by Andrey Novakovskiy, Dmitriy Glazounov, Tatiana Kachalina, Serguey Baev Asia Law & Practice Euromoney Institutional Investor (Jersey) Ltd 2008

Introduction to the Russian stock market

Russia has been continuously enjoying good macroeconomic conditions, and many opportunities lie within reach of domestic and foreign investors. The country has the third-largest foreign exchange reserves in the world, a solid budget and trade surpluses, a growing middle class and a government stabilization fund of US$150 billion earmarked for infrastructure projects.

At the moment, the investment potential of Russia is considered as strong as ever. About 70% of the stock market activity is carried out by domestic investors who have money to spare and who are eager to support homegrown business. When one considers the low government and corporate debt, profitable companies with steady earnings growth, a financial sector with no exposure to subprime lending, and stock valuations that are among the cheapest among emerging markets, Russia's investment highlights are immediately apparent.

Despite the recent downturn on Russian stock markets due to the global credit crunch, and uncertainty as to the upcoming presidential election, securities of Russian companies seem ready to make a comeback in the near future. With above-average earnings growth rates of domestic corporations, Russia has become almost the cheapest emerging market in the world by price-to-earnings ratio, thus inviting a plethora of investors from every corner of the world.

Areas for investment

Commodities sectors like oil and mining are considered to have been the driver of Russia's phenomenal growth, though other sectors offer still better opportunities to investors.

Mobile telecommunications providers such as Rostele-com, Vimpelcom and Mobile System, leading Russian food retailers such as X5 Retail Group, Magnit, Lenta, food manufactures including WBD and leading Russian car manufacturers such as Autovaz and Severstal-Avto trade effectively and yield decent earnings with shares held by domestic and foreign investors.

Russian banking and finance have certain investment merits proved by recent remarkable demand for Sberbank and VTB securities.

After investment undernourishment over the past 15 years, Russian transport and logistics companies are presently on the rise – Transcontainer and FESCO seem to have beneftted from domestic and foreign investment.

Russia's power industry is also extremely enticing because it is one of the world's fastest-growing. Until recently, almost the entire power industry was in the hands of the state-owned RAO UES. However, the government has launched the reorganization of the RAO UES and presently OGKs and TGKs, subsidiaries to the RAO UES, are being sold to investors. Domestic and foreign investors take an active part in the process though the state will retain control.

Tools at hand

In recent years, the Russian economy has been demonstrating an upward trend and development of legal frameworks and infrastructure for financial markets is underway. The increasing number of domestic and foreign initial public offerings, secondary public offerings and fixed income transactions testify that Russian companies need greater investments and interest of investors, including foreign ones. Having established private and collective investment as priorities (the State Duma approved Amendments to the Federal law On Investment Funds in November 2007), Russia emphasizes the importance of financial and strategic investments involving domestic and foreign business. The state support recently proclaimed is bound to stir up investment processes and to serve as a guarantee for business investments, including foreign ones. Introduction of some new financial instruments, techniques, and improvement to the regulation of existing legal mechanisms perform a consequent result of rapid economic development and initiative of the state.

In 2007, the Russian securities market finally received a new financial instrument – Russian depositary receipts (RDRs), mainly targeted at attracting capital. The Federal law On Amendments to the Federal law "On Securities Market" came into force as late as in 2007 thus setting a legal basis for RDRs. They are a new type of registered security of no par value, representing the title over a certain number of underlying foreign shares/bonds of a particular class (or type) and entitling its holder to claim from the RDRs' issuer a corresponding number of securities and exercise of the rights, represented thereby. At the moment, the launch of RDRs may be considered as the most welcome innovation, bearing in mind that the tool streamlines the market's structure which the Russian securities market desperately needs nowadays. RDRs enable Russian investors to diversify their investments. The instrument expands significantly the scope of investment opportunities and does not limit the choice merely to Russian issuers covering investors against economic downturns. Given that the Russian securities legislation prohibits direct public circulation of foreign securities on local markets, whereas earlier Russian investors had to purchase such securities abroad via their foreign-based affiliates. Now RDRs allow them to reach the same goals in a time- and cost-effective manner. The Russian regulator, the FFMS, has significantly simplified the issuance procedure for RDRs reducing the number of stages. With RDRs, Russian companies are perfectly equipped to enter stock markets abroad, responding to the interests of foreign investors.

The launch of RDRs was initially intended for foreign companies extending their financial activity to Russia. Such companies are formally recognized by the Russian legislation as non-residents, but actually their core activities take place in the Russian territory through numerous subsidiaries. RDRs enable them to penetrate the Russian market with less effort. Major Russian banks rendering services to foreign companies rate highly the RDR capability to win foreign issuers to the Russian market. Also, companies from the Commonwealth of Independent States lacking in representation in Russia view the Russian capital market as an attractive investment vehicle. Here their securities have better chances as compared with their local markets' capacity.

RDRs are expected to enhance the attractiveness of the Russian capital markets and to be instrumental in their development. As the Russian economy enjoys macroeconomic stability and growing domestic investment, stabilization of rouble liquidity and rising consumer demand, all these factors provide a fertile field for the development of this new security, capable of bringing foreign investors and issuers to the Russian market.

Pitfalls along the way

The obvious inclination of foreign investors to enter the Russian market and to take up shares in Russian companies encounters certain obstacles in Russia. Entrepreneurs are apprehensive of notorious corruption and the gap between state authorities and business society. Non-residents wax indignant when laws regulating their business in Russia are amended by state bodies without consulting major market players.

Another challenge companies often face is that state authorities (federal, regional or local) are not eager to respect interests and rights of enterprises because of certain officials' or functionaries' standpoints, even if there are strict provisions of law regulating specific situations or problems. Officials often respond too late thus putting companies to extra expense. Moreover, state authorities are often reluctant to consult companies officially about their activities; bureaucrats also prefer to keep themselves aloof at crucial points.

Under the circumstances, the cognizance of local financial and legal advisers may be essential as it helps to foresee difficulties or avoid them completely.

Recent legislation novels

Despite certain flaws in the regulation of business activities and foreign investments in particular, the Russian government does take measures to maintain steady economic development and to create a favorable investment climate which appeals to foreign investors. The modernization of the legal framework is justly considered as a priority in Russia and the adoption of the Federal law On Amendments to the Federal law "On the Securities Market" (enacted as of December 30 2006 and coming into force in 2007) is the evidence of the utmost concern of local authorities for streamlining the market. The law introduces RDRs and opens up new possibilities to companies seeking to enter the Russian securities market (law firm Liniya Prava was a part of the working group of the FFMS elaborating this law).

Another step in the direction is work on the draft Federal law On the Procedure for Making Foreign Investments in Commercial Organizations Which Are Strategically Important to the National Security of the Russian Federation which was approved by the State Duma in the first reading. It is aimed at making investments in strategic industries of Russia more transparent. More laws have been recently approved and/or adopted by the Government of the Russian Federation aimed at establishing favorable conditions for entrepreneurial activity. Recent Federal Law amendments include: n Electronic Signature, On Investments to Finance the Cumulative Part of the Retirement Pension in the Russian Federation and On Subsurface Resources; n On Technical Regulation

To simplify the procedure of agreeing the draft official responses of the Government of the Russian Federation to the technical regulations worked out by entrepreneurial organizations on their own initiative. Other amendments to the Federal Law include:

On Legal Status of Foreign Citizens in the Russian Federation to exempt employees of representative offices of legal entities from the need to receive a work permit if the staff is of the size agreed on when they were accredited; and Amendments to Article 59 of Part One of the Tax Code of the Russian Federation were made to approve the procedure for considering the debts concerning client payments in bankrupt banks and recognizing them as bad debts, and subsequently writing them off.

Improving the legal framework

To improve even more the investment conditions and settle no less urgent matters, some definite efforts should be made.

The state regulation can be optimized by measures including: (i) preparing proposals to accelerate the reform of the technical regulation, and involve representatives of the business community in the development of draft technical regulations and public discussion and review. This also applies to the work of expert commissions for assessing amendments to regulatory legal acts of the Russian Federation and to the draft normative documents of the federal government bodies in the technical regulation sphere; (ii) stepping up work in creating a legislative base for a greater exchange of electronic tax, accounting and finance documents and for giving a legal status to electronic archives; (iii) analyzing foreign experience and preparing proposals to improve measures to counteract the illegal distribution and sale of certain types of goods; (iv) analyzing the practice of applying the legislation of the Russian Federation concerning mandatory product certification and preparing proposals to improve the system of mandatory confirmation of the products' conformity to the established requirements and on eliminating excessive barriers for their circulation; and (v) analyzing the enforcement of legislation of the Russian Federation concerning the legal status of foreign citizens regarding simplification of the procedure of employment of staff that are employed by representative offices and branches of foreign legal entities, and preparing proposals concerning expediency of its further enhancement.

As to the solution of the tax and accounting issues, (i) the review of amendments to Article 59 of the Tax Code of the Russian Federation that provide legal basis with regard to recognizing arrears and debts of organizations that have been liquidated as at the date of the decision being passed to recognize such amounts as bad debts and to write them off should be accelerated; and (ii) the practice of using "negative invoices" in other countries and preparing proposals to use it in Russia should be analyzed.

The regulation for financial institutions and capital markets should be improved by (i) preparing proposals to exempt from the unified social tax non-state pension insurance or voluntary pension insurance payments (contributions) made to the benefit of the employees at the expense of the employer; (ii) reviewing the issue of making amendments to the legislation of the Russian Federation determining requirements on establishing insurance reserves by non-state pension funds; (iii) accelerating the drafting of the amendments to the Federal Laws On Insolvency (Bankruptcy) and On Insolvency (Bankruptcy) of Credit Organizations in relation to the introduction of the liquidation netting; (iv) accelerating the drafting of the amendments to the Federal Laws On Banks and Banking Activity and On the Central Bank of the Russian Federation (Bank of Russia) in relation to the improvement of conditions of managing bank risks (information exchange) and bank supervision on consolidated basis; (v) preparing proposals on implementing the system of tax regulations for derivatives and other financial instruments; and (vi) preparing proposals concerning working out a comprehensive approach in relation to improving the legislation of the Russian Federation concerning pledges.

As to the basic economy sectors, (i) ensuring the adoption of the federal law on foreign investments in commercial organizations which are strategically important to the national security of the Russian Federation and completion of the elaboration of drafts laws on patent agents and on the transfer of know-how are most significant for Russian industry, construction and high-tech; (ii) continuing work on abolishing or reducing rates of import customs duties on farm products and semi-finished products for the food industry that do not grow and are not produced in sufficient quantities in the Russian Federation, on abolishing or reducing on a regular basis rates of import customs duties on certain types of technological equipment for the food industry, that are not manufactured in the Russian Federation, at the suggestion of foreign investors and on improving the legislation of the Russian Federation and enabling mechanism related to veterinary and phytosanitary control in the Russian Federation are badly needed for optimization in the food and agriculture industries of Russia; (iii) ensuring an exchange of information with foreign investors for creating stable and predictable conditions when developing natural resources and stimulating investments to the Russian sector of nature and resources including remote areas and the continental shelf shall benefit Russian natural resources area; (iv) continuing work on introducing amendments to the legislation of the Russian Federation intended to introduce the institute of authorized consignees and to unify it with international conventions shall simplify customs procedures; (v) preparing proposal for amending the Federal Law On Concession Agreements with regard to the interests of investors and lenders for implementation of transport projects, for amending the Statute On the Investment Fund of the Russian Federation with a view to making greater use of the financial resources to prepare and implement transport public-private partnership projects, for enhancement of the framework of state support of transport public-private partnership projects and development of logistic centres and participation of foreign investors in the reconstruction of sea, river and airports are important for public-private partnership in transportation, etc. (See the communique of the 21st of the Foreign Investment Advisory Counsel (FIAC) under the Government of the Russian Federation at communique21.php)

Taking into account all the points discussed, it should be underlined that Russia needs a comprehensive programme for enhancing its investment image considering the sophistication of the legal framework. The state has already made definite efforts to solve particular difficulties of investors in Russia and this can be considered a step forward to a general increase of capital infow into the Russian economy.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.