Palms & Company Document

Bank Due Diligence in Extending Credit Lines to Publicly Owned U.S. Corporations Initiating Equity Investments in Russia

by

Dr. Pyotr Johannevich van de Waal-Palms

Although the financial statements of clients a bank's commercial loan department may evidence ample strength to support your credit lines, indications of intentions to engage in operations in Russia may be an early warning sign of potential deterioration in sources of recovery. Operations initiated through "tender" are a red flag suggesting it would be prudent to "read between the lines" of agreements covering such tenders. Here are some of the traps and pitfalls to look for.

1. Statements that mineral resources to be used in the production process, are owned and remain the property of the State of Russia (Russian Federation). Licenses may be limited permits to 'develop" rather than own.

2. Tender agreements frequently call for

• non-refundable pre-payment of projected taxes and license fees in the millions of dollars to local instrumentalities of government. Commencement of construction may be prohibited until such payments are made. At each step of the process there are significant forfeiture penalties for not continuing.
• Preparation of feasibility studies, land reclamation studies, etc. may be required costing millions of dollars, without relief from contractually committed starting dates for construction in the event completion of such studies is delayed.
• Payment of significant sums may be required into general social and economic funds and funds for the development of indigenous people's.
• Construction of facilities to offset environmental impacts may be required, such as fish hatcheries, without defined procedures for documenting adverse impact.

3. The agreements may require additional pre-payments to third parties such as inventors, authors, parties previously designated by the government, through 'grants', as the owners of resources the government is now subsequently granting the applicant. Future claims, currently undisclosed, of a similar nature may arise during the life of the license

4. Agreements may be subject to the approval of other state agencies such as the State Technical and Ecological department without relief to the applicant from contractual agreements with the government in the event of refusal of approval.

5. Russian law may require mandatory sale of production to monopoly Russian government agencies such as Roskomdragnet. Although agreement may stipulate that prices will be at world-market level the agreements will generally be silent about denomination of the currency and timing of payments. In effect the company may have no control over its projected revenues which may become long term receivables.

6. Silent hidden partners potentially exist in the form of an average of 20 instrumentalities of government which, by law, may have decision making powers during the life of the corporation.

7. Agreements generally enumerate that raw materials used in the production process are not the property of the corporation and cannot be pledged, bought or sold.

8. Licenses are not transferable, thereby limiting divestiture and exit strategies through the sale of assets. In effect investment in land, buildings and plant would be of no value to a buyer who was unable to obtain a new license independently.

9. Agreements may specify that failure to achieve a predetermined minimum production or profit performance constitutes breach of the license and subjects the owners to forfeiture of their license and/or assets.

10. Agreements may specify that failure to extract a predetermined percentage of ore from each quantity of raw material in accordance with "estimates" submitted by the applicant constitutes a breach of the license. Usually provision is made for correction of such under-performance by the payment of additional fees.

11. Agreements may require that 90% of the workers employed must be Russian nationals and that 75% of positions that require special education, after the factory has been constructed, must be filled by Russian nationals.

12. Agreements may require re-investment of up to 50% of profits in Russia during the term of the license.

13. In effect all contractual agreements are with a Sovereign nation which possesses certain immunities.

14. Claims of "force majeure" may permit the government to 'suspend' operations until disputes regarding such claims are resolved.

15 Liability is imposed upon the applicant for all damages resulting from non-performance. Non-performance is defined in accordance with Article 21 of the Law of the Russian Federation, under which there may be no adequate recourse according to accepted norms of "rule-of law".

16. The court of jurisdiction for arbitration procedures may not be specified.

17. Russian legislation of stock companies (corporations) may give effective control to Russian minority stockholders What this all adds up to is that very viable economic opportunities may in fact be "structured" in such a manner as to provide ongoing revenues to the Russian government which would be larger in the event of commercial failure of the project, than they might have been if the reverse happened. A cynic might conclude that the intent of the agreement was to facilitate expropriation through commercial contract provisions intended to result in breach. There is significant "case history" that indicates such concerns are warranted. The best time to correct such shortcomings is before one get into any such agreement.

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