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Hidden layers

Ben Aris reports from Moscow on the project finance legal reforms put forward by President Putin that look positive on paper, but in reality are fraught with difficulties.
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The very long-term money available from true project financing is very tempting for Russian companies, but Russia’s rickety legal system and the untried nature of many of the laws mean only a handful of deals have been made.

Most project financing in Russia is actually financing of projects. It may seem like a semantic quibble, but the order of the words hides a world of

difference. True project financing is about limiting risks to well-defined legal boxes that separate the assets and cashflow from the sponsor of the project. A Russian company might have the right to mine a lump of ore in the ground but to finance the construction of a mine and smelter using project financing, it must set up a special purpose vehicle (SPV) – a separate legal entity – and transfer the exploitation licences to the project company.

The idea is that the investor can assess a project on its own merits without having to worry about, say, a Kremlin attack disrupting their partner. Even if the sponsor disappears, the project should remain untouched and investors can recoup the loans from either the cashflow or by selling their controlling shares in the project. The sponsor, as the major shareholder in the project company, usually receives the profits as dividends.

Today, the biggest Russian companies can command a maximum of seven-year loans on international capital markets, while the maturities on project financing deals can be double this. But as project financing deals are legal beasts they are very complicated to organise.

“Most money lent to Russian companies goes to the blue chips and it is easy to do. Bankers don’t bother to look at the ins and outs of LUKoil’s privatisation any more. They just do the basic due diligence on those things that affect the loan to LUKoil,” says Mark Kirch, a lawyer with Linklaters. “But in project financing, you have to get your hands dirty and get right into everything – environmental issues, supplier contracts, permits and licences. Everything.”

Russia’s blue chips have established track records, but an SPV is an unknown entity and creditors need to check everything about it to make sure it is a viable and legally solid company. Despite administrative reforms introduced in 2001, setting up a squeaky-clean SPV remains almost impossible in Russia.

“You need thousands of permits to organise project finance and often the laws are contradictory or you get caught in a catch-22 situation where you can’t get a permit until you have a second one, but to get the second you need the first,” says Mr Kirch. “The lenders look and they already see legal problems right at the beginning which forces you to weigh up the risks.”

To swing a project financing deal, the lenders have to be happy on three points: that assets can be adequately secured; that the loans will be repaid; and that the general political and legal climate is predictable and stable.

President Vladimir Putin has scored well on the last point since he came to power in 2000. His biggest gift has been political and economic stability after the chaos of the Yeltsin years. In his first year in office, he rammed through a raft of reforms including the beginnings of judicial reform. While some analysts say that the reform effort is currently losing momentum, more and better laws continue to appear on the books.

“The legal system is becoming more coherent and there are fewer contradictions than a decade ago. There is a tremendous improvement as the law has evolved in the last 15 years to a point where the law on paper is coherent and well ordered,” says Jason Verville, from the European Bank for Reconstruction and Development’s debt recovery team.

A tender conflict

However, Russia scores less well on the other two points. The first problem projects face, all of which have involved natural resources so far, is attaching the licence to dig up oil, gas or metal to the SPV.

“Licences are issued to a named company and are very difficult to transfer as they are personally granted to each company. If you want to move the licence then you have to have a tender and this introduces the risk you might not win it,” says Mr Kirch.

Securing the ownership of land is another legal headache. A new land code passed last year allows foreigners to own Russian land for the first time since the 1917 revolution. And changes to the mortgage laws in April reduced notary’s 1.5% of the land’s value fee to 0.3% and capped it at $100, which bankers have welcomed as a major step forward.

However, the legacy of Russia’s soviet past still confuses land rights: the Bolsheviks nationalised all land, which was parcelled out between federal, regional and municipal authorities. But as no one “owned” the land under the Soviets, no clear distinction was ever made between the rights of the users. Lawyers say that land ownership rights remain hazy.

“You can buy land, but before your name the registry is empty,” says Yulia Voskoboinikova, lawyer at Linklaters. “It affects everything – the pipes, the plants, the platform – as they are on land. It is an emotive issue and it is surrounded by politics.”

Getting paid by a delinquent project poses even bigger problems. Normally, if a project misses repayments then the creditors can step in, exercise their right to grab the SPV’s shares and take control of the company. However, under Russian law, any transfer of ownership has to be done with an auction.

“If something goes wrong and you exercise your rights to take control of the shares, then there has to be an auction, which introduces another set of risks. No one quite knows what would happen as no one has taken these risks on before,” says Mr Kirch.

In the handful of project-financed deals so far, investors have got round this problem by registering the company offshore. For example, Sakhalin Energy, which holds the licence to oil and gas deposits in the island of Sakhalin, is actually registered in Bermuda. If something were to go wrong, then creditors can grab the shares there without the need for an auction.

But things are improving. Businessmen report that both the Moscow and St Petersburg arbitration courts are functioning well, but go outside of Russia’s “twin capitals” and the process becomes a lot less predictable.

“The processes of the bankruptcy laws are, on some occasions, not strictly observed by the local and municipal authorities, who exert tremendous influence over the process. The courts in the regions don’t see the same volumes of cases and so have less experience,” says Mr Verville.

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Read more about:  Central & Eastern Europe , Russia