Frequent Legal Issues for Contractors on
Sakhalin Oil and Gas Projects
(Appearing soon in the Russian Energy Law Journal)

I. Legal Theory and Sakhalin Practice

Presented by Jonathan Russin, Managing Partner of the firm’s Russian Practice Group. Mr. Russin is resident in Moscow, from where he directs the firm’s offices in Moscow, Yuzhno-Sakhalinsk and Vladivostok. He has been advising clients about Russian legal issues since 1988. In 1997, Mr. Russin became counsel to Mobil New Exploration & Production Ventures for the development of offshore oil and gas resources under the Sakhalin III PSA. He and the Russian Practice Group now provide advice to the PSA operators and their contractors and suppliers doing business on Sakhalin. Mr. Russin specializes in international commercial and investment matters and practiced law in Latin America for two decades before establishing the firm’s Russian operations. He is a graduate of Yale College and Yale Law School.

Pre and Post 1998: Developments in the Russian Legal System

The period from the break-up of the Soviet Union in 1991 until roughly the time of the financial crisis in the summer of 1998 may be characterized as the Structural Period for Federal Legislation. The current Constitution of the Russian Federation dates from 1993. The state planning apparatus disappeared in 1992 and a wholly unregulated and chaotic market immediately began to appear. Transactions happened, buyers and sellers made deals, but the absence of a legal framework characterized this as a period of legal uncertainty.

Gradually, the State Duma began to function, and laws designed to accommodate and regulate a market economy took shape. By 1998, most of the principal laws governing the functioning of a market economy were in place, including Parts I and II of the Civil Code, the statutes governing open and closed Joint Stock Companies and Limited Liability Companies, the law on Bankruptcy, a Federal Securities Commission to regulate share sales and the functioning of a stock market, the law on Production Sharing Agreements for the exploitation of natural resources, Antimonopoly legislation, to mention only a few.

The period since 1998 has been characterized by amendment, refinement and attempts to correct abuses that have arisen as the laws began to function in practice. The tax laws have been modified on a regular basis. In May 2003, President Putin, in his annual address to the Federal Assembly of both houses of the Russian Parliament, stated:

"Tax reforms in Russia are unfortunately becoming a constant and ongoing process. Yes, the measures proposed by the Government to reduce the tax burden are of course a move in the right direction. But the frequency of amendments to tax legislation clearly exceeds the allowable level."

The Duma continues to tinker with the implementing legislation necessary to put the Production Sharing Law fully into effect. Changes are being proposed to the Bankruptcy Law to correct abuses that have allowed shrewd and unscrupulous players to strip assets from supposedly bankrupt companies. So we are now in the period of usual legislative activity that characterizes the work of legislatures in most market economies.

Current Conditions

What are the peculiarly Russian characteristics of today’s legal and administrative environment? The Russian bureaucracy at all levels – Federal, Regional and Municipal – is characterized by multiple approval and extensive document requirements. President Putin pointed to this fact again in his annual address last year:

". . . the Russian bureaucracy has proved itself poorly prepared to develop and implement the decisions our country needs today. At the same time, it has proved itself good at obtaining benefits and revenues through use of its powers and position . . (2) The Russian bureaucracy today still has enormous power. But the quantity of power it has does not correspond to the quality. I must stress that to a large degree, this power has its source in nothing more than the superfluous functions of state bodies."

The Russian Federation is made up of 89 States, known within Russia as “Subjects of the Federation.” Sakhalin is one of the Subjects and has its own Governor and legislature. In too many instances, administrative decisions – such as licensing a company to carry out construction activities – require both local and federal actions. For this reason, the ability to coordinate the governmental requirements of companies between Sakhalin and Moscow is often crucial.

The Government is attempting to reduce the role of the bureaucracy. Recent legislation has reduced the number of commercial activities subject to mandatory licensing, and following last year’s annual address, President Putin tasked Prime Minister Kasyanov with forming an inter-ministerial commission on administrative reform. According to one published source: “Putin’s goal of improving the investment climate by weakening the base of the state mafia and general corruption is now at last reflected in practical government action under the determined leadership of Prime Minister Kasyanov and his deputy Boris Aleshin who is chairing a special commission set up in July to cut back the powers of the bureaucracy.” (3)

Corruption Issues and Avoiding Dispute Resolution in the Courts

Corruption in the bureaucracy remains an ever-present problem. Transparency International released its annual report in October 2003 and ranks Russia number 88 out of 133 countries. (4) On a scale of one to ten, with ten indicating the least corruption, Russia scored 2.6, slightly worse than last year at 2.7. (5)

And what about corruption among judges and court personnel? In June 2003, at a conference of Russia’s top judges the chief judge of the Supreme Court of the Russian Federation, Vyacheslav Lebedev, spoke out against corruption in the Russian judiciary. He noted that in 2002 some 60 judges were stripped of their powers “for actions disgracing honor and dignity.” (6) In our experience as a firm, it is difficult to predict when and if a court or a particular judge may be suborned. The fact that Russian law allows a right of appellate review in almost all cases increases the chance that a particular matter will eventually get a fair hearing. But generally, we advise clients to adopt strategies that will avoid the need to resolve disputes in court.

One technique to diminish the possibility of litigation is to structure relations with the other party to your contract in a way that creates a continual balancing of risks. As lawyers, we are trained to look at contract obligations and ask: “If the obligation is breached by the other side, what remedies are available to my client?” The answer is often: sue for damages, seek an injunction, or go to arbitration. But all of these remedies rely on a dependable, efficient and honest judicial system. Instead, we now advise our clients to analyze the terms of their contracts on a time basis, so that each exposed step by one party is balanced by a reciprocal exposure to the other.

To use a simple example, in a construction contract the obligation of the owner to make an advance payment should be balanced by the presentation of purchase invoices by the contractor, indicating the materials that will be obtained through the advance payment. Better still would be to make the advance payment directly to suppliers rather than to the contractor. The idea is to analyze contract performance by structuring a CPM or PERT(7) chart to insure that a risk exposure assumed at any given moment by one party is balanced by similar exposure of the other party. It is not always possible to structure a project so as to achieve a continuing balance of risks, but even so, this exercise will alert a party to particular points at which exposure is unbalanced, and it may be possible to require other kinds of guaranties from the other party to cover such contingencies. Again, the point of the exercise is to minimize the risk to resort to litigation or arbitration to remedy a contractual default.

Our experience indicates at least one bright spot in looking at the objectivity and honesty of the court system. In tax litigation we have found that the courts have acted in most cases based directly on the law and evidence before them. One could assume that regional courts are beholden to regional authorities and likely to favor the local tax administrators, but our experience indicates the contrary, and we have seen numerous instances where over zealous actions by the tax police have been remedied upon review in the courts.

(2) In his 2002 address the President directly called for limitations on corrupt bureaucrats.
(3) United Financial Group, Russia Morning Comment, October 10, 2003.
(4) For reference purposes, Finland is number 1, the U.S. is number 15 and Bangladesh is number 133.
(5) The Moscow Times, October 8, 2003, page 5.
(6) Pravda, June 16, 2003.
(7) Critical Path Method (CPM) and Project Evaluation Review Technique (PERT). These are technologies often used to plan the synchronization of activities required in complex construction.

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