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

II. Management and Control of a Russian Enterprise

Presented by Jonathan Russin, Managing Partner of the firm’s Russian Practice Group.

Bidders for contracts awarded by the Sakhalin I and II operators must consider the benefits of meeting Russian Content requirements, that is to bid through a company the equity of which is at least 50% held by Russian natural or juridical persons. Meeting Russian Content requirements is discussed in further detail below, but often entails the creation of a 50:50 joint venture. The usual corporate form to comply with the 50% Russian ownership requirement is the formation of a Russian (8) limited liability company or LLC (sometimes known by its Russian initials as an “OOO”). One of the principal issues confronted by the non-Russian shareholders in this situation is how to deal with control and direction of the 50:50 joint venture company. In our experience there are three main approaches to this question.

Mutual Sharing of Control

Russian law governing the formation and operation of LLCs is relatively extensively detailed and sets out a number of requirements that cannot be varied by the parties. One of the fundamental rules is that obligatory requirements of Russian law cannot be avoided by an agreement between the shareholders that attempts to override them. The type of Shareholders Agreement often used in the United States and England, in which the shareholders agree in advance on the division of seats on the Board of Directors, on the selection of the Managing Director, and on the budgeting and financing of future operations of the LLC has frequently been found by Russian courts to be unenforceable. Russian law requires that these issues remain open for review and decision by the shareholders at the yearly meeting or at the times established in the company bylaws.

The standard Russian LLC, with relations between shareholders subject to review and decision at regular shareholder meetings, and with control shared in proportion to equity ownership, is probably best suited for a situation where the Russian and foreign parties are making equal contributions to the management and operations of the joint venture company. Both parties will look to Russian company law to regulate the mutual control features of their joint venture.

It should be noted, however, that Russian custom and tradition gives substantial authority to the Managing Director of a Russian LLC. Although the authorities of the Managing Director can be limited by the bylaws and by narrow delegations of authority from the shareholders or the Board of Directors, much operational discretion will still rest with the Managing Director. The choice of this officer will be a major decision for the joint venture partners.

Disproportionate Control Via Management Agreement

One of the classic solutions used in situations where a foreign shareholder is in fact providing a disproportionate part of the financing and expertise of the LLC is to have the shareholders unanimously agree in the charter of the LLC that the management functions of the company will be contracted to a third party. A Management Contract between the LLC, usually approved by unanimous vote of the shareholders, and the foreign shareholder, conveys operating responsibility on the foreign party. The Management Contract can be for an extended period and can be drafted to allow for termination only by decision of the shareholders (where a 50:50 structure could block any decision in which the shareholders are divided) or for breach by the management company confirmed by a court decision.

Delegation of control under a Management Contract does not remove all aspects of participation of the Russian partner. Russian company law requires that changes in the structure of the LLC, such as decisions to amend the bylaws, to increase or decrease authorized capital, to reorganize or liquidate, and to pay dividends, are in the exclusive competence of the shareholders and cannot be delegated through a Management Contract.

One additional technique used to address a situation where there is an imbalance between the contributions of the two partners in a 50:50 joint venture is to create different attributes to the shares held by each partner, for example, by establishing that the shares held by the partner making the disproportionate contribution are entitled to a greater percentage of dividends.

In general, the solution to problems associated with disproportionate contributions by the partners is to address the issues presented through structures permitted by and consistent with Russian company law, rather than to attempt solutions through the use of standard U.S. or English style Shareholders Agreements, which run the risk of being ruled unenforceable by Russian courts.

Undivided Control Through Two-Tiered Structures

The third approach to the issue of control, which may be useful in the context of meeting the Sakhalin PSA Russian Content requirements discussed below, is to create a Russian structure that avoids the participation of a local partner. For this purpose it is necessary to incorporate two Russian companies. For example, Company A is established as a Russian LLC and is 100% owned by foreign shareholders. Company A then incorporates a Russian subsidiary, Company B, that is 100% owned by Company A(9). Company B is eligible to bid on Sakhalin I and II projects because it is a Russian company, the shares of which are at least 50% owned by a Russian shareholder. Although this structure meets the legal requirement for Russian Content, it also results in the creation of two companies, both subject to the payment of Russian taxes on their operations.

There are obviously advantages and disadvantages to each of these three approaches. The choice will depend on an assessment of all the circumstances involved in each tender offered by SEIC and ENL. Relevant issues will include: Will the services required be performed in Russia or offshore? How much of the required work will be subcontracted? To which partner? What will be the resultant cash flow and tax structure? The control issue will be an important, but not the sole factor determining the structure of the Russian LLC.

(8) In this situation Russian company law requires that one of the two Russian companies have more than one shareholder. In this case, the assumption is more than one foreign shareholder of Company A. In the alternative, Company A could have one foreign shareholder and Company B would then need two shareholders.
(9) The use of an offshore company with 50% Russian ownership is also permitted; however, Russian companies and individuals are restricted in investing in companies outside Russia, making the use of an offshore joint venture more theoretical than realistic.