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

III. Meeting Russian Content Requirements

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

Sources of the Rules

There are at least three legal sources that have a bearing on this question: the Production Sharing Agreement for Sakhalin II signed by Sakhalin Energy in 1994, the PSA for Sakhalin I signed by Exxon Neftegas and its partners in 1995, and the Law on Production Sharing Agreements and its amendments, originally signed into law by President Yeltsin on December 30, 1995. Although the two PSAs antedate the passing of the PSA law, and are therefore “grandfathered,” it is clear that Russian authorities also look to the definitions in the PSA law as setting the standards they wish to achieve. In addition to the Sakhalin II PSA, SEIC’s Russian Content rules stem from its Supervisory Board Resolutions and Agreed Procedures.

Defining a Russian Enterprise

There are two distinct and often confused aspects of Russian Content. The PSAs for both Sakhalin I and II and the PSA law itself provide that the operators (ENL and SEIC) will grant “Russian Enterprises” a “priority right” or “preference” over non-Russian enterprises in awarding contracts.

What then is a “Russian Enterprise?” The PSA Law defines it as a “Russian legal entity,” which appears to mean that any company incorporated in Russia, even if all of its shares are owned by non-Russians, will be recognized as a Russian Enterprise. As stated above, however, for the purposes of the Sakhalin I and II projects, the PSA law does not apply as they have grandfathered PSAs, which control. Although ENL has interpreted Russian Content in the same manner as the PSA Law, its PSA defines a Russian Enterprise in the following manner: “If Russian natural persons, legal entities or government organizations own at least fifty percent of the stock of such organization.” (10)

Similarly, the SEIC PSA provides that a Russian Enterprise is defined as a company in which “at least fifty percent of its equity is held directly or indirectly by Russian natural or juridical persons or by any [Russian] governmental authority.” SEIC does not require that the bidding entity be formed at the time of its bid, but the founders must commit to form a compliant entity thereafter. The entity, once formed, must provide proof of compliance in the form of a certificate of incorporation and a list of its major shareholders evidencing at least 50% Russian ownership. If Russian Content is lost post-award, the company must notify SEIC and may be at risk for loss of its contract.

Measuring Russian Labor and Russian Materials

Although the Sakhalin I PSA does not contain specific percentage requirements, ENL requires its contractors to meet specific requirements similar to the 70% targets employed by SEIC.

SEIC’s requirements are specific and state that the company is to make its best efforts to maximize Russian Content each year with a target of reaching 70% Russian labor, materials, equipment, and services over the project life. SEIC considers materials and equipment to be Russian if they are procured by a Russian entity or individual, or by an entity otherwise compliant with Russian Content ownership requirements. Contractors must report on both Russian and Non-Russian material volume and man-hours. SEIC must track the number and US Dollar value of contracts awarded to Russian Enterprises.

Although it is relatively clear that Russian Labor means the employment of Russian citizens, which can be tracked by man-hours, the definition of Russian Materials is not as self-evident. For SEIC, the determining factor is the legal status of the source of procurement, without specific express regard to the country of manufacture. The PSA Law requires operators on an annual basis, to procure at least 70 percent of the total value of specified types of materials in the form of goods of “Russian origin.” (11) Pursuant to the PSA Law, the Russian origin requirement is satisfied where materials are produced by Russian legal entities and/or Russian citizens on the territory of the Russian Federation, from parts that are at least 50% (based on total value) produced in Russia by Russian legal entities and/or Russian citizens.(12) The 70% also only applies to materials, the expenses for the procurement and use of which are recoverable to the operator through its production share.(13) Thus, the PSA Law’s definition for Russian materials actually requires that a percentage of procured goods be manufactured in Russia, using Russian-manufactured parts. As stated above, however, this is not a requirement for the Sakhalin I and II projects as these PSAs enjoy grandfathered status.

(10) Although the ENL PSA is a confidential document, the Russian Content provisions have been discussed publicly in order to assist contractors in meeting these requirements.
(11) Federal Law No. 225-FZ “On Production Sharing,” December 30, 1995, as amended by Federal law No 19-FZ , as amended June 6, 2003 (“Law on Production Sharing”), Article 7(2).
(12) Law on Production Sharing, Article 7(2).
(13) Law on Production Sharing, Article 7(2).