Natalya Morozova & Rob Patterson Vinson & Elkins LLP Moscow

For several years, the ability of foreign companies to invest in the Russian oil and gas sector has been unclear, as various pieces of draft legislation have made their slow progress through the Russian system. Recent proposals in the US and Europe to restrict investment by foreign entities in the energy and other markets have not helped the process. However, the position has now been clarified, if not in a manner that is likely to have those oil and gas companies that have been waiting in the wings running off to their investment committees.

The Russian State Duma (legislative body) recently approved, at its third reading, the much-anticipated draft framework legislation regulating foreign investment in strategic industries, as well as a draft bill addressing restrictions on the rights of foreign investors to deposits of natural resources that are deemed to be of “federal significance.”

Types of ‘restricted industries’

The aim of the draft law, On the Procedure for Foreign Investment in Companies Strategically Important for the Defence and National Security of the Russian Federation, is to restrict foreign control of Russian companies engaged in the 42 “strategic” activities set out in the draft. The industries affected fall into a number of broad categories, including: military; nuclear energy; aviation and space exploration; projects to combat infectious diseases; natural monopolies (including the transportation of oil and gas by pipeline, railroad transportation, and services at transport terminals, seaports and airports); certain broadcasting and communications activities; and for the purposes of this article, the geological research, exploration and development of natural resources deposits of federal significance.

Clearance requirements and procedures

The draft law does not prohibit foreign participation in the affected industries entirely. Instead it provides for a clearance procedure, depending on the level of investment being made.

A foreign company (or a group of persons including a foreign company) seeking to acquire control of a company involved in a strategic activity (whether by acquiring more than 50% of its voting shares, obtaining more than 50% of the seats on its board or other management body, acquiring the right to appoint its chief executive officer, or otherwise determining the operations of a target through a management or similar agreement) must obtain prior approval of a special commission to be established under the regulations.

In cases where a number of other shareholders hold minority stakes, the acquisition of any voting interest below 50% also requires prior approval if the acquisition would give the foreign acquirer de facto control. These thresholds are reduced to just 10% if the target company’s activities involve deposits of natural resources that are of federal significance.

If the acquirer company is a foreign state or a legal entity controlled by a foreign state, then the thresholds for approval are reduced further, to 25% plus one share in the general case, and a mere 5% if the target is involved in the exploration and development of federally significant natural resource deposits. The acquisition of control over a strategic company by such acquirer is not permitted at all.

In the general case, once a foreign investor (or a group of persons including a foreign investor) has acquired direct or indirect control over more that 50% of the voting shares in a Russian strategic company, any further acquisitions in the same target are not subject to the prior approval requirement. However, this exemption does not apply to strategic companies holding rights to use natural resources deposits of federal significance.

The commission must usually make a decision within three months following the submission of the relevant papers, although this can be extended to six months in certain cases. In some cases the commission can require potential acquirers to undertake certain obligations, such as complying with a state secrets regime.

Types of natural resources deposits classified as ‘having federal significance’

As mentioned above, one of the activities that is subject to restrictions under the draft law (indeed, it is subject to more severe restrictions than other strategic activities) is “the geological research, exploration and development of natural resources in deposits of federal significance.”

These are given meaning in the draft law on amendments to the Russian Subsoil Law, the Law On the Continental Shelf and certain other laws that were also approved by the State Duma late last month. The deposits that qualify are the following:

Deposits of certain minerals regardless of quantities, such as uranium, diamonds, pure quartz, nickel, cobalt, platinum, beryllium, tantalum, lithium and rare earths of the yttria group.
Deposits containing “strategic quantities” of certain mineral reserves. These will be classed as “having federal significance” if they exceed 70 million tons of recoverable oil, 50 billion cubic metres of gas, 500,000 tonnes of copper, or 50 tonnes of gold.
Deposits located on any internal sea, territorial sea or the continental shelf or territories used in connection with state security and defense.

Restrictions on foreign investors introduced by draft law

Following several years of uncertainty as to the ability by foreign companies to acquire or keep control of significant natural resources deposits in Russia, the new draft law will, no doubt, bring much disappointment and frustration to foreign investors, potential and actual alike. Despite the hope that subsoil licences already issued would be “grandfathered” under the new law (a hope fostered by recent statements of the Ministry of Energy and Industry), it appears that the new restrictive provisions of the Subsoil Law are inapplicable only to production licences that were issued before its enactment.

For existing investors who do not already hold a production license, risks remain: the draft law entitles the Russian government to refuse to grant a production license to, or to terminate a combined geological research, exploration and production license held by, a company with 10% or more direct or indirect foreign investment, if it makes a discovery that falls under the criteria of a deposit of federal significance.

In addition, further to a general restriction requiring that a holder of a license for a deposit of federal significance must be a Russian company, the draft law allows Russian national defense and security executive bodies to prohibit participation of Russian companies with foreign investment in auctions or tenders for the rights to use deposits of federal significance.

Any transfers of already issued licenses for such deposits to companies with foreign investment that exceed the thresholds, or that do not otherwise comply with the criteria, outlined in the draft law on foreign investment in strategic industries, are now prohibited.

The draft law also imposes several restrictions that apply regardless of whether a license holder is a company with foreign investment, including that license holders for deposits located on the Russian continental shelf must be Russian companies having not less than five years experience of working on the continental shelf and having more than 50% of its voting shares directly or indirectly owned or otherwise controlled by the Russian Federation. This restriction effectively prohibits any foreign investment in the Russian continental shelf other than via the Russian state-controlled majors.

Whether the new law will signal a slowdown in investment by foreign oil and gas companies remains to be seen. Despite the uncertainty over the last few years, many foreign investors have continued to be active in Russia, either by focusing on smaller projects that were unlikely ever to be considered “strategic” or by partnering with large (possibly state-owned) Russian companies. It’s likely that 2008 will see a continuance of that trend.

About the authors

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Natalya Morozova [nmorozova@velaw.com] is a Russian attorney and a partner in the firm’s Moscow office. She has extensive experience in Russian mergers and acquisitions, corporate, project finance, securities, and antitrust law matters. Her corporate practice has involved many issues shaping Russia’s corporate environment, including protection of minority shareholders and structuring corporate relationships between Russian and non-Russian shareholders.

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Rob Patterson [rpatterson@velaw.com] is a co-administrative partner of the firm’s Moscow office, having previously been a partner in London. He is an energy transactional lawyer with a broad practice that includes international oil and gas transactions, cross-border mergers and acquisitions, project development and financing.

Russia imposes more restrictions on investment in oil and gas sector

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