VII. INVESTMENT CLIMATE Openness to Foreign Investment While the policy of the Russian Government is to encourage foreign investment, it has difficulties in creating a stable and attractive investment climate. There are no significant legal barriers to doing business in Russia; on the contrary, the absence of sufficiently developed civil, commercial and regulatory law is the key impediment to foreign investment. There are a number of additional factors that discourage foreign investment, including economic and political uncertainty, fluctuation of tariff rates and a nontransparent tax policy, continuous modification of commercial laws, which have caused confusion on the part of foreign traders and investors. Russia's poor credit rating also serves as a disincentive to companies looking for investment opportunities. Bureaucratic requirements can be confusing and burdensome to investors; large-scale ventures must be registered with the government - which may take up to a year. Bureaucratic discretion may be capricious in awarding tenders or development rights to companies. Ownership of real property is still being legislated, and a lack of protection of property has been of significant concern to investors. A seriously deteriorated infrastructure adds to the difficulties of doing business - telephone, roads and transport are all of poor quality and can impede business. Corruption in commercial transactions is prevalent and political problems in 1993 did little to enhance the environment. Foreign firms are cautiously optimistic about doing business in Russia, but remain wary of committing large amounts of capital until assured of greater stability, transparency in the laws, constancy in tax rates and other measures. Despite the problems detailed in this report, most U.S. companies in Russia believe the market opportunities justify the risks, uncertainties and considerable bureaucratic obstacles. Few established foreign companies are leaving and many continue to demonstrate an interest in Russia's rich mineral and human resources, world class high-technology and vast potential market. Russia enacted an investment code in 1991 which defines the permissible forms of foreign investments as well as the rights and obligations of the government and investors. Also in force are laws on enterprises, on joint stock companies and on the privatization of national assets, as well as several presidential decrees. In 1994 the government was preparing for the legislature draft laws on concessions and on free enterprise zones as well as a revision of the 1991 investment code. In addition, the government has been creating a number of institutions including a data base of potential joint projects between Russian and foreign investors, a development bank providing international credits for Russian companies to use domestically, two organizations to provide financing and technical assistance to projects, a government investment bank and a government agency to provide political risk insurance to foreign companies doing business in Russia. The 1991 investment code defines foreign investors as foreign legal entities, citizens, states or international bodies. Foreign investments may be made in all kinds of property (including intellectual), placed in entrepreneurial projects and other activities to derive profit. They may be in the form of wholly owned companies, joint ventures, portfolio investments or in (sometimes limited) rights to use land or other natural resources. Russian foreign investment regulation regarding permissible activities, prior authorization and notification requirements are confusing and contradictory. All foreign investments must be registered. The Ministry of Finance, local authorities and various central government bodies all register foreign investments. Prior approval is required for investment in new enterprises, using assets or existing Russian enterprises, foreign investment in defense industries (some of which may be prohibited by law) and investment in the exploitation of natural resources, as well as all investments of over 50 million rubles (USD 25,000) or investment ventures in which the foreign share exceeds 50 percent, or investment to take over incomplete housing and construction projects. Additional registration requirements exist for investments exceeding 100 million rubles (USD 50,000) and for investments using land or natural resources. Projects of foreign enterprises may also be subject to expert examination for ecological considerations or where a large- scale construction or modernization is envisaged. The 1991 investment law guarantees foreign investors rights not less favorable than those of Russian investors. The 1994 state program of privatization of state and municipal enterprises explicitly grants foreign investors the right to participate in auctions and tenders and to purchase privatization vouchers, although the Ministry of Finance is supposed to be informed of such actions. Some restrictions apply. For example, the federal government can restrict foreign access to enterprises in strategic industries such as defense, the energy sector, mining and minerals, transportation and communications. Where such investment is permitted, the federal counter-intelligence service is granted one month to present grounds for refusing acquisition by winning foreign firms. In cases where a foreign investor is the sole bidder, the state will conduct a special assessment before allowing acquisition. In addition, local authorities, which exercise control over "small enterprises" (in the food, retail and service industries, with less than 200 employees), may decide whether or not to allow foreign participation in their sale. Traditionally, all research and development in Russia was directly financed by the government and occurred in government owned or controlled institutes and organizations. The entire system is now in a state of transition. The government is providing less funding for research than in the past and individual institutions are actively soliciting international participation in research projects. Some of the projects in which American firms have begun active cooperation still receive significant Russian government funding as well. The legal basis for such cooperation is not yet firmly established in national laws, however, and the rights and obligations of all private parties (foreign or Russian) participating in government sponsored or subsidized research and development are spelled out in the specific contracts and agreements reached by the parties involved. Russian law offers few incentives to foreign investors. Those set out in the 1991 investment law, including certain tax benefits, have never been implemented, have been largely eliminated or superseded by subsequent laws and decrees. Recent decrees (issued in June 1994) offer certain tax benefits, but eligibility is restricted, and the decrees still await implementation. Russia is well along in reforming its foreign trade regime in line with market standards. Very few non-tariff elements remain. Russia has applied for accession to the general agreement on trade and tariffs (GATT) and its successor the World Trade Organization (WTO) and has submitted a memorandum of foreign trade regime. Russia has raised import tariffs in several stages beginning from zero when the Soviet Union collapsed. Most recently the government raised import duties across the board in March 1994; the average weighted tariff rose from 7-8 percent to 13- 15 percent, with some duties reaching 50 percent. After a public outcry the government in April suspended the new tariff until July and is currently revising the more controversial duties. Inherited Soviet-era qualitative restrictions on imports were initially limited to security and health requirements, but Russia's July 1993 consumer protection law stipulated official certification (by Gosstandart) of imported products for conformity to Russian technical, safety and quality standards. Certification is based on a combination of international and Russian standards. U.S. companies have complained of costly procedures and arbitrary certification requirements. A joint Russian-U.S. communiqu of December 1993 pledges cooperation on improving and simplifying certification, testing and quality assurance of U.S. and Russian products in each other's markets. Russia is establishing reciprocal standardization with the U.S. and other countries and acceptance of foreign certification by accredited institutions. Import licenses are required on the normal range of dangerous and harmful materials and goods. A draft law before the Duma would restrict land ownership to Russians, although foreigners would be able to lease land for up to 99 years. A November 1993 presidential decree imposing a two-year moratorium on foreign bank operations with Russian citizens appears to conflict with a September 1993 decree sheltering foreign investors from adverse legal changes for three years and contradicts the foreign banking law. It also violates the principle of nonretroactivity of law since it applies to foreign banks licensed in October 1993. A June 1994 decree practically reversed the November restrictions, but only for banks from countries which had an investment agreement with Russia in force. Since the U.S.-Russia bilateral investment treaty has not yet received Duma approval, the June decree does not apply to U.S. banks. Under current banking regulations, only 12 percent of the total capital in the banking system can be foreign owned. The Russian insurance industry is lobbying for similar protection, and the government recently circulated proposed regulations prohibiting foreign attorneys from counseling clients on Russian legal matters. From July 1992 exports of oil, gas, precious metals and other strategic raw materials were conducted by enterprises specially licensed by the Russian government. In 1993 a quarter of these exports were recentralized through government-controlled foreign trade organizations and involved domestic purchase below world prices and exemption from export taxes. All export quotas and licensing ended from July 1, 1994, except on products such as aluminum, involving international commitments. With very few exceptions, state imports disappeared from January 1994. Antidumping penalties imposed by the U.S. Department of Commerce on Russian uranium in 1992 were suspended in 1993 in return for export restraints. Commerce is investigating alleged dumping of Russian ferrosilicon. Requests for information have also been sent to Russian producers of titanium sponge, and consultations on potash have been held. Russian aluminum exports contributed to instability in world markets, the subject of multilateral talks at which the Russian government undertook to reduce aluminum exports. Conversion and Transfer Policies Russia has a unified exchange rate which floats based upon a daily Moscow interbank currency exchange auction where the Central Bank intervenes to smooth fluctuations. In practice, the Central Bank exerts considerable influence on the rate as it collects and resells most of Russia's export earnings. The ruble is fully convertible within Russia and CIS countries which remain in the ruble zone. There are currently no restrictions on profit repatriation. Foreign and domestic companies may acquire, hold and sell foreign exchange freely, though hard currency cash transactions for goods and services within Russia are prohibited. In addition, the cumbersome payment mechanisms and the developing banking system in Russia are an impediment to business. Russian enterprises are required to convert 50 percent of foreign currency earnings into rubles by selling such currency on either the currency market or to the central bank of Russia. From January 1994 commercial banks will be responsible for monitoring the repatriation of export earnings. Without special permission it is illegal for Russian companies or citizens to maintain bank accounts outside of Russia for purposes other than operating expenses. Licenses are required for offshore accounts and can be difficult to obtain. Non- residents can open individual ruble accounts and commercial ruble accounts for servicing import/export operations and for investment. Both citizens and non-residents can maintain domestic hard currency accounts. Expropriation and Compensation The 1991 investment code prohibits the nationalization of foreign investments except following legislative action and where deemed to be in the national interest. Such nationalizations may be appealed to the courts of the Russian Federation, and are to be paid with prompt, adequate and effective compensation. While the domestic political situation remains somewhat unsettled, the current leadership is unlikely to nationalize foreign investment or engage in expropriation. However, local government interference in several cases appears tantamount to expropriation; arbitration on legal proceedings are pending in these cases. Dispute Settlement Russia is in a state of flux, having abandoned the rules and procedures of the former centrally directed economy, but not yet having adopted or implemented the laws and institutions necessary for a market economy. Russia has a body of conflicting, overlapping and rapidly changing laws, decrees and regulations which has resulted in an ad hoc and unpredictable approach to doing business. In this environment investors do not always know that they will be able to function under the rules in existence at the time the investment is made or what the rules will be in the future. Independent dispute resolution in Russia is difficult to obtain; the judicial system is poorly developed, and, according to some investors, can be corrupt. Regional and local courts are not accustomed to adjudicating either commercial or international matters, and they as well as Moscow are often subject to political pressure. Currently, there is no reliable or recognized system for recording secured interests such as mortgages. This may change if legislation is passed; however, this is likely to be a prolonged and uneven process. There have been several investment disputes involving U.S. investors in late 1993 and early 1994 that have come to the attention of the U.S. Embassy. None of these has been raised to the level of the Russian federal government. In the case of a Russian-American housing project, the American investor was driven out of the venture when the Russian partner re- registered the venture as a 100 percent Russian wholly-owned company. The dispute centered on whether the American partner had made its capital contribution to the charter fund of the joint venture. In another case, the American partner ceased participation in its venture, citing a "pattern of harassment, physical threats, attempted extortion and misinformation by the Russian partner, aimed at forcing (us) out." In this case, the Moscow city government supported liquidation of the venture, confirmed seizure of the land, building and assets of the venture by the Moscow real estate agency, and declared that continued operation of the venture was illegal. The American partner believes both the city and the Russian partner felt that the venture could make more money without the American partner, and therefore set out to drive out the U.S. partner forcibly. It is possible that the U.S. partner may appeal to Russian courts as well as to international arbitration. In a third case, the U.S. partner claims that the Moscow city government has expropriated three buildings, while the Russian partner claims that the U.S. partner has not fulfilled its obligations under the contract and the Moscow city government claims that the U.S. partner owes millions of dollars in overdue tax payments. The U.S. partner had contemplated legal action in the Russian courts but is reportedly pursuing the possibility of selling its share in the venture. The above disputes reflect a pattern in that they each involve investments by the U.S. partner in real estate deals, two of which are within the city of Moscow and one in the Moscow oblast. The disputes in two cases have centered on disagreements over whether contract obligations have been fulfilled. To date, U.S. companies have been reluctant to pursue legal action through the Russian courts, feeling that the Russian court system is incapable of resolving such disputes fairly, and have asked for the political assistance of the Embassy. Russia joined the multilateral convention on settlement of investment disputes between a state and foreign individuals or legal entities in 1992. Another long-standing problem is the failure of former Russian state-owned enterprises and the bank for foreign economic relations (Vneshekonombank or VEB) to pay U.S. companies over USD 229 million in trade payment arrears. Arrearages include payments owed for goods delivered under valid contract, frozen bank accounts, and unpaid letter of credit. The nonpayment stems from a number of factors, including the transition of state-owned enterprises to private management and the collapse of the bank for foreign economic relations. Virtually all debts are owed by former Soviet entities within the Russian Federation. Since 1990, when U.S. companies first began reporting payment delays by the Soviet Union, the U.S. government has interceded on behalf of more than 70 companies collectively owed more than USD 350 million. So far, 13 companies have received full payment totalling USD 78 million and an additional 15 companies have received partial payments totalling USD 70 million. However, at least 70 U.S. companies are still owed over USD 220 million for goods delivered under valid contracts and an additional USD nine million for frozen VEB accounts and unpaid letters of credit. The Russian government converted the frozen VEB accounts to a series of U.S. Dollar denominated, interest paying bonds. The first tranche of bonds was recently paid in full. Political Violence The political climate in Moscow is currently stable but unpredictable over the medium to long term. After the violent political confrontation of late 1993, politics have returned indoors. There is no political terrorism active, while political demonstrations remain modest in size and nonviolent. Neo-communist and ultra-nationalist forces pursue their goals primarily within the halls of the new legislature. Leaders of most political groups stress the need not to repeat the violence of the previous year. However, the February 1994 amnesty of the leaders of the September-October 1993 armed opposition to President Yeltsin reintroduced into the political system a number of forceful individuals, some of whom have records of organizing and leading political violence. Crime has become one of the most frequently cited concerns of foreign business, particularly those businesses involved with large amounts of cash and goods. While organized crime is not new to Russia, reforms of recent years have seen an increase in the range and frequency of criminal activity. Unfortunately, legal and judicial reform have not kept pace with economic and criminal advances. A comprehensive revision of the civil and criminal codes is underway. However, the courts remain slow and ineffective, and corruption is pervasive throughout society, including in the government. Much crime is tied to commercial activity, with one half of all entrepreneurs in a recent survey reporting that they must pay kickbacks and protection to stay in business. Failure to make these payments is sometimes fatal and may prove a disincentive to business creation. President Yeltsin and his government acknowledge that crime and corruption are major problems and have asked the parliament to speed adoption of needed legislation. Pending this legislation, a presidential anti-crime decree authorizes detention of suspected organized crime members for 30 days and gives the authorities broad powers to review financial records. Meanwhile, Prime Minister Chernomyrdin has announced that the government will spend two trillion rubles to fight crime in 1994-95, and adopt tougher measures against official corruption. Performance Requirements Performance requirements are not imposed by Russian law, and are not widely included as part of private contracts. However, they have appeared in the agreements of large, multilateral companies investing in natural resources. Investors are not required to disclose proprietary information to the Russian government as part of the regulatory approval process. Right to Private Ownership and Establishment Both foreign and domestic legal entities may establish, purchase, and dispose of businesses in Russia. Investment in those sectors affecting the national security (insurance, defense, banking, natural resources) may be limited. In theory, there is equal treatment of state and private enterprise. In practice, however, since some of the economy is still in the hands of state monopolies, private enterprise, especially if it presents possible competition, is at a disadvantage. Protection of Property Rights A presidential decree issued last October gives all Russian citizens the right to own, inherit, lease, mortgage, and sell real property (including land). However, lack of supporting legislation has thus far made the decree ineffective. Uncertainty on title to land and mineral rights persists; particularly confusing is the issue of jurisdiction of federal, regional and municipal authorities over various types of property. Many companies find themselves negotiating with all possible levels of government in order to conclude a deal. In 1992-93 Russia enacted laws strengthening the protection of patents, trademarks and appellations of origin, semiconductors, computer programs, literary artistic and scientific works, and audio/visual recordings. The patent law, which accords with the norms of the world intellectual property organization, includes a grace period, procedures for deferred examination, protection for chemical and pharmaceutical products, and national treatment for foreign patent holders. Inventions are protected for 20 years, industrial designs for ten years, and utility models for five years. One must wait four years before applying for a compulsory license. The law on trademarks and appellations of origin introduces for the first time in Russia protection of appellations of origin and provides for automatic recognition of Soviet trademarks upon presentation of the Soviet certificate of registration. The law on copyright and neighboring rights, enacted in August 1993, protects all forms of artistic creation, including audio/visual recordings and computer programs as literary works for the lifetime of the author plus 50 years and is compatible with the Bern convention. The September 1992 act on topology of integrated microcircuits protects semiconductor topographies for ten years from the date of registration. Russia has acceded to obligations of the former Soviet Union toward the Universal Copyright Convention, the Paris Convention, the Patent Cooperation Treaty, and the Madrid Agreement. Under the unratified U.S.-Russian bilateral investment treaty, Russia has undertaken to protect investors' intellectual property rights. In addition, the bilateral trade agreement mandates protection of the normal range of literary, scientific and artistic works through legislation and enforcement. Russia does not belong to the Rome Convention, and protects only sound recording first produced in Russia. The authorities are currently engaged in a comprehensive revision of the Russian criminal and civil codes and of administrative regulations pertaining to intellectual property rights, strengthened penalties, the establishment of specialized courts, particularly a patent court, with trained and experienced judges and attorneys, and trained police and customs officers. So far, legal enforcement of intellectual property rights has been a low priority of the Russian government, as is evident in the widespread marketing of pirated U.S. video-cassettes, recordings, books, computer software, clothes and toys. The Russian intellectual property agency, established in 1992 with direct accountability to the Russian president, was given responsibility to develop and coordinate state IPR policy, promote copyright protection, and collect and distribute royalties. It was replaced in October 1993 by the revived Russian authors organization, a semi-official agency combining the inherited supervisory functions with advocacy of author's commercial interests. Regulatory System: Laws and Procedures The legal system in Russia is in a state of flux, with the various parts of government struggling to create new laws on a broad array of topics. This has produced a large body of conflicting, overlapping and rapidly changing laws, decrees and regulations affecting domestic and international economic matters. In this environment negotiations and contracts for export sales or investments are complex and protracted. Investors must carefully research all aspects of Russian law, and in the absence of commonly accepted and enforceable commercial codes, investors must ensure that each contract conform with Russian law and that they embody the basic provisions of such codes. Contracts must likewise seek to protect the foreign partner against contingencies which might arise in such a situation by fluidity of laws. Keeping up with legislative changes and presidential decrees is a daunting task. Uneven implementation of laws creates further complications; various officials, branches of government and jurisdictions interpret and apply regulations with little consistency and the decision of one may be overruled or contested by another. In addition, while a foreign investor may win a favorable decision from a Russian court, enforcement of judgments is problematic. Such requirements may be less burdensome than reaching final agreement with local political and economic authorities; registration can be a lengthy bureaucratic process, particularly where mineral resources or defense production are involved. Corruption is widespread and the fears of some Russian officials that foreigners will purchase Russian assets at below-market rates can impede bureaucratic approval. The government has only recently begun to introduce auction tenders for official procurements. Noncompetitive bidding is sometimes used to award contracts for very large government projects involving natural resources. Cases exist of tenders awarded to U.S. companies being subsequently revoked by the government in the interest of domestic competitors. An established and transparent set of regulations regarding bidding is lacking, but a law of concessions for development of raw material reserves is in preparation. A major complaint of foreign business is the tax structure. Russia imposes numerous taxes including profits, excess wage, withholding, payroll, road use, property, VAT, import and export tariffs, excise and local taxes. These taxes may total more than a company's profit - proving a very real disincentive to both Russian and foreign businesses, and an incentive to avoid payment. In addition to high rates, taxes have been changed frequently and radically, often with no warning and sometimes with retroactive effect. Businesses are unable to rely on a particular tax regime and may suddenly find themselves unable to make a profit. Finally, tax authorities may seize assets without appeal and are paid a commission on taxes collected, increasing the chances of malfeasance. Efficient Capital Markets and Portfolio Investment The commercial banking system in Russia is only five years old, but rapid progress has been made in its development in the last two to three years. The 20 to 30 largest banks are approaching western standards, offering a full range of services. But the market is evolving quickly, making it difficult for the Central Bank and other participants to keep up with trends and changes in market practices. There are already over 2,000 registered commercial banks in Russia, most of them established in 1991. The three largest banks are still the former state banks: Sberbank, with over RBS 63 trillion in capital has 40,000 branches in Russia; Agropromstroybank has another 1,000 branches; and Vneshtorgbank. Many of the commercial banks in Russia are small; only 10 percent have a capital base exceeding USD 1 million. Many banks were founded in the 1991-92 period by enterprises as an expedient way to draw directed central bank credits and still have only one large depositor and borrower: the enterprise that founded it. Because the banking system in Russia is undergoing such a dramatic transformation, it is still suffering from growing pains that temper the full trust and confidence of the populace. The absence of legislation against fraud and false advertising; allegations of ties to organized crime; inadequate capital and accounting standards; insufficient resources for bank regulation and supervision; and an inefficient payments system are all barriers for a successful transition to a market system based on safety, soundness, and prudential concerns for depositors. Legislation is currently being drafted or contemplated, but it will be several years before it can be fully implemented. A regulatory system to facilitate portfolio investment is virtually nonexistent and, while stock and commodities exchanges do exist, they do not meet western standards in any area. Most trading is in an unorganized and unregulated over- the-counter market. Bilateral Investment Agreements Russia has bilateral investment agreements with 16 countries: Finland, Belgium and Luxembourg together, Great Britain, Germany, France, Netherlands, Italy, Canada, the People's Republic of China, Austria, South Korea, Turkey, Spain, Switzerland and the United States. The U.S.-Russia BIT, signed by Presidents Bush and Yeltsin in June 1992 has been ratified by the United States, and in 1994 awaits ratification by the Russian side. In addition, the U.S.-Russia trade agreement, which allows both sides to extend MFN treatment to the other's exports, and a treaty for the avoidance of double taxation, entered into force in 1992 and 1994, respectively. OPIC and other Investment Insurance Programs In an agreement ratified at the June 1992 summit, the U.S. Overseas Private Investment Corporation (OPIC) is authorized to provide loans, loan guarantees and commercial and political investment insurance to American companies that invest in Russia. By the end of 1993, OPIC had committed more than USD 400 million in finance and insurance to 25 projects in the NIS having a total investment value of USD 1.2 billion. In addition, plans are underway to provide some additional USD 500 million in financing to projects in the NIS within the first half of 1994. OPIC's pipeline for the NIS includes an estimated USD 2-3 billion in potential financing for more than 500 projects registered for OPIC insurance representing nearly USD 40 billion in potential investments. To handle larger projects in the NIS and worldwide, OPIC has doubled the amount of insurance and quadrupled the amount of finance -- to USD 200 million -- it will commit to individual projects. Although OPIC currently does not provide inconvertibility insurance for Russia, it is investigating the possibility of opening coverage on a limited basis. Russia is a member of the Multilateral Investment Guarantee Agency. Labor The Russian labor market is undergoing a slow and painful transformation. The country's labor force is still largely suited to the needs of the Soviet-era command economy. As a result, the labor market is very inflexible and ill-suited to the rapidly changing needs of the Russian economy. There is a large supply of skilled workers in heavy industries and defense, but the demand for their skills is falling rapidly, and workers are reluctant or unable to move to other regions in pursuit of employment opportunities. Although official unemployment remains low at about 1.5 percent, a large number of Russian workers, perhaps as many as 10 percent of the workforce are underemployed, forced to work shortened work- weeks or placed on extended furloughs. The only sector of the economy where employment is increasing is in banking, insurance and other business services. However, there is a shortage of trained workers to fill the growing demand in these areas. Labor-management relations in Russia are strained. The official unions, which represent the bulk of Russian workers, operate in a subservient role to enterprises managers, in much the same way they did in the Soviet era. Workers have little confidence in the official unions, and therefore feel powerless to challenge management. This, coupled with concern about economic restructuring, has resulted in increasing worker anxiety and unrest. The Russian government tries to adhere to ILO conventions protecting worker rights. However, because of the massive changes in the Russian economy and government apparatus, the government's protection of worker rights is inadequate. Foreign Trade Zones/Free Ports Russia announced the creation of 13 free trade zones in 1991. However, no law yet exists to regulate these areas and little has been done to develop them. Capital Outflow Policy Without permission it is illegal for a Russian legal entity or citizen to maintain a bank account outside of Russia for more than operating expenses; licenses are required for offshore accounts and can be difficult to obtain. Little legitimate outward investment is occurring; most capital outflow is the result of simple capital flight or of a growth in criminal transactions. Capital flight is a significant problem, with an estimated USD 17-20 billion having left the country in recent years. Many Russian experts believe the figure is much higher, and there is concern in the government about a continuing problem. Major Foreign Investors The major foreign investors are the United States, France, Germany, South Korea, Italy, Austria, and the United Kingdom (see appendix A for data).