Some Practical Guidance for Avoiding Disputes Arising from Commercial and Investment Activity in Russia and Ukraine

by Ethan S. Burger, Ludwig & Robinson &

Irina Paliashvili, Russian – Ukrainian Legal Group, P.A.

(Washington, D.C.)

At first glance, the current economic, legal and political situation in both Russia and Ukraine seems to preclude the establishment of profitable long-term business relations. But with proper pre-transaction planning, successful business deals are possible. Foreign businesses operating in such an environment are likely to encounter frequent and often intense disputes with their joint venture partners, agents, customers, suppliers, providers of land, buildings and regulatory approvals. Such disputes fall into four broad categories:

(i) good faith disputes arising from imperfectly crafted documents, the failure of documents to address necessary issues or unanticipated situations. It is exceedingly difficult for businessmen and their lawyers to properly anticipate the myriad of contingencies that may have to be addressed in a contract. As transactions get more complex, there is a greater likelihood that written documentation will prove inadequate. Consequently, except with respect to straightforward purchase-sale agreements, contracts must be analogized to constitutions, establishing mutually acceptable procedures for addressing changing circumstances.

(ii) disputes arising from a party’s inability to perform their obligations under a contract or pay for goods or services received (whenever feasible, doing business by means of letters of credit and bank guaranties is advisable). Many Russian and Ukrainian enterprises are unable to meet their financial and other obligations. Often this is because they themselves are creditors of debtor-organizations that lack the financial resources to pay their bills. Much of the Russian and Ukrainian economy is demonetarized with settlements between local enterprises occurring through barter and the issuance of promissory notes. For political and sociological reasons, the authorities and the courts are unwilling to force debtor-enterprises into bankruptcy. Consequently, western businesses need to exercise great caution before entering into contractual relations with such enterprises.

(iii) bad faith disputes where the local party may or may not have the ability to perform its obligations, but irrespective of its financial position has no intention of performing them. Such enterprises often are tied to organized crime and frequently have protectors within the federal and local government structures.[1]

(iv) disputes arising because government officials may feel that other parties may do more for the region (or for the individual government officials themselves), such as offering (implicitly) a future economic stake in an ongoing business relationship, including future employment for such officials or their families.[2]

Generally speaking, litigation and arbitration often do not yield satisfactory outcomes with respect to Categories (ii) through (iv). The time and cost of prevailing by legal means are likely to be high, and when all is said and done, one may find that, even if successful, one will not be made whole.[3] In light of this, businessmen should focus their efforts on avoiding entering into transactions where the parties have divergent expectations of the benefits and risks involved.

The absence of reliable mechanisms for enforcing one’s rights in Russia and Ukraine means that businesses need to (i) perform at the outset of business relations a thorough due diligence on potential joint venture partners, customers, suppliers, and government officials with whom they will be working, and (ii) have in place a management system to monitor the evolution of such relationships – such a system reduces the risk of good money being invested after bad.

It is also worth noting that with regard to Category (iv) disputes, it is often said that “corruption only survives in the shadows”. For this reason, it is advisable for foreign businesses to initiate and maintain regular contacts with state officials at all levels throughout the course of a project, since such officials are likely to be less tolerant of improper conduct than certain officials involved in a particular project. A single corrupt official might be tolerated by his immediate superior, but not by members of other regulatory or oversight bodies.

Where a project or contract involves funding from foreign banks, foreign countries or international financial organizations, there is a greater chance to avoid the consequences of corruption since other officials at the national level who benefit from the existence of such programs do not want to see such programs jeopardized.

With regard to “good faith disputes” (Category i), mediation[4] may offer a viable means for achieving a satisfactory solution. It may be advisable to include appropriate mechanisms (including mediation clauses) in relevant contracts to prevent disagreements from developing into full-blown disputes.[5]

If a dispute is not resolvable by mediation, it is most likely to be settled through the court system or arbitration (although costs are likely to be high and the outcome not received in a timely manner).

Both the Russian and Ukrainian court systems are divided into courts of general jurisdiction and commercial (arbitrazh) courts.[6] In recent years, there has been a considerable improvement in Russian and Ukrainian legislation governing the court system. Still, both countries’ courts are plagued by a lack of resources, judges of uneven quality (who are often vulnerable to outside influence and susceptible to bribery), and a lack of reliable mechanisms for the enforcement of judicial decisions and arbitral awards.[7]

Both Russia and Ukraine have enacted Laws “On International Commercial Arbitration”, dated July 7, 1993 and February 24, 1994, which authorize the use of international commercial arbitration to resolve (i) disputes arising from contractual and other civil legal relationships involving foreign trade and other types of international economic relations (if one of the parties is located abroad), and (ii) disputes of enterprises with foreign investors and among their participants (Article 1, Point 2). Even though both Russia and Ukraine adhere to the 1958 United Nations Convention on the Recognition and Enforcement of International Arbitral Awards, some western parties have encountered considerable frustration in getting local courts to recognize the validity of such foreign arbitral decisions, which sometimes are not enforced since the party against whom the decision was issued has powerful protectors. Another problem with opting for dispute resolution pursuant to international commercial arbitration is that interim remedies may not be available unless contained in a decision of the arbitral body. This means that a respondent may have time to dispose of assets once the arbitration process has been initiated.[8]

Nonetheless, if the value of a transaction is substantial, it is usually advisable to provide for dispute resolution by international commercial arbitration rather than to avail oneself of the local courts. In certain circumstances, it may be preferable to provide in the contract that a party has the option of seeking resolution of a dispute either by international commercial arbitration or by a local court. This may be particularly important if one fears that the local entity might dispose of its assets prior to the resolution of the dispute.

It is also desirable when possible to provide that one’s contractual relations be governed by the foreign law of a developed industrial country rather than local law, since the law of such foreign countries is more likely to be stable. This is generally permissible under both Russian and Ukrainian legislation – we note, however, that is not possible to opt out of Russia’s or Ukraine’s regulatory schemes and corporate norms.[9]

It is often advisable before entering into a contractual relationship with a Russian or Ukrainian party to prepare a transaction “framework” document detailing the range of issues that must be addressed and setting forth concepts for the transaction to be successfully completed.[10] Ideally, this document will stimulate a dialog between the parties concerning issues that will have to be addressed in any formal contractual relations. It will give the parties an opportunity to learn how the other does business and help establish personal relations that may be critical in overcoming unforeseen problems

At the present time, there are only fairly limited sources of information that can offer useful management intelligence and financial information on most enterprises, but this situation is improving. Consequently, to reduce the risk of a non-performance, non-payment or a delayed payment situation from arising, we suggest that our clients, at a minimum, obtain from potential joint venture partners, customers, and clients (hereinafter the “Partners”) the following documents prior to entering into any agreements:

1. Recently issued notarized copy of the Partner’s Certificate of Registration.[11] This document in Russia will have been issued by the relevant registration chamber or body of the Ministry of Justice, and in Ukraine by the relevant Administration.

2. One notarized copy of the latest complete version of the Partner’s corporate charter (with all relevant amendments). If possible, the authenticity of this document should be checked with the body that registered the Partner as a legal entity. This document should be carefully reviewed to determine which official or officials of the Partner has authority to sign the proposed agreement. It is also possible that a separate corporate document authorizes the relevant persons to sign contracts on behalf of the Partner. Typically, the General Director has the authority to sign the agreement, but above certain monetary thresholds other approvals may be necessary, such as by the board of directors (sovet direktorov) or management board (pravlenie). If the Partner’s corporate charter is not the relevant document authorizing the person to sign a contract on behalf of the Partner or if approvals are required, the foreign party should insist on receiving a notarized copy of the relevant document(s).

3. Documents establishing the other parties’ rights to relevant property (buildings, land, equipment, etc.) In particular, if one is seeking to acquire securities in a Russian or Ukrainian entity, one must confirm that such securities were issued and registered in accordance with applicable legislation and properly reflected in the issuer’s security register.

4. Notarized copies of relevant licenses and permits.

5. For some transactions, reviewing annual financial reports and balance sheets for the last two fiscal years will be essential. These documents will give you some idea of the financial health of the company. One should interview the Partner’s Chief Bookkeeper to confirm that its budget has allocated enough money to pay for anticipated financial obligations. In addition, one should ask to be able to contact the enterprise’s independent auditor and, if feasible, obtain the Partner’s consent to review its tax status with the local tax inspectorate.

6. A notarized copy of the enterprise’s pledge register.

7. A reference letter from the Partner’s local bank stating that the Partner has been a reliable customer for a number of years. One should also obtain permission from the Partner to contact the Bank directly to confirm the information in the letter.

8. Depending on the nature of the relationship, it is worth contacting local government officials to learn more about one’s potential partner. In the case where a governmental body is guaranteeing obligations, a request should be made to be provided a copy of the document setting forth the legal basis for the issuance of such guaranty by the relevant state body, as well as the document authorizing the guaranteeing of the relevant transactions.

Where relevant, one should explore the possibility of including in the relevant contract documents bank guarantees, pledges of property and property rights (especially property located off-shore), the keeping of deposits in off-shore bank accounts, etc.

The best advice for handling vexing business disputes in Russia and Ukraine is to exercise caution before getting started, develop good planning documents outlining what business objectives are sought, hire the best people you can find to implement such planning documents and try to settle business disputes amicably whenever possible.

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[1] See Ethan S. Burger, “New Legislation on Enforcement of Judicial and Arbitral Decisions in Russia”, Russia Business Watch, Summer/Fall, 1997.

[2] Practically speaking, small companies tend to encounter more problems from corrupt officials since such companies are not as likely as big corporations to offer potential benefits to a region.

With the anticipated entry into effect of OECD Convention on Combating Bribery of Foreign Public Officials in International Business Transactions, signed on December 17, 1997, U.S. companies will be less likely to operate under a competitive disadvantage.

[3] It is often helpful to seek the intervention of one’s own embassy in cases where a lack of concern by the local authorities contributes to one’s problems.

[4] Mediation is a process in which a third party (the mediator) seeks to assist two or more parties involved in a dispute to reach a voluntary, negotiated resolution of their differences, usually embodied in a formal written agreement. Mediation differs from adjudication and arbitration in that the mediator, unlike a judge or arbitrator, has no authority to impose a solution on the parties. Advocates of mediation believe that it is not only more cost effective than other forms of dispute resolution, but that mediated solutions are superior since they are crafted by the disputing parties themselves.

[5] It might appear that the business environment for mediation in Russia and Ukraine is not suitable, given that their legal systems are not well developed. But in fact this situation may be the very reason why mediation could be appropriate - the parties do not have to refer to changing legislation and adjudicators of varying quality to resolve their disputes.

[6] In addition to the use of the court system, parties may seek a resolution of their disputes by so-called treteiskie sudy (literally “third courts”) which can be either ad hoc arbitral tribunals or existing arbitration tribunals The best known arbitration tribunals are, the International Court of Arbitration of the International Chamber of Commerce in Paris, the London Court of International Arbitration, the Arbitration Institute of the Stockholm Chamber of Commerce, the International Arbitration Court of the RF Chamber of Commerce and Industry and the International Commercial Arbitration Court of the Ukrainian Chamber of Commerce and Industry. There is also the option of having ad hoc arbitration. In such a case the parties may choose to use UNCITRAL Rules or other rules – in which case it is important to specify how the arbitrators are to be appointed.

[7] In 1997, Russia enacted Laws “On the Executory Procedure” and “On Judicial Marshals” to address the situation where, according to Ministry of Justice data, less than 50% of the country’s judicial decisions were enforced (See Ethan S. Burger, “New Legislation on Enforcement of Judicial and Arbitral Decisions in Russia” in Russia Business Watch, Summer/Fall 1997, Volume 5, Number 3). To date, Russia’s judicial marshal system is not yet fully operational, in part due to budgetary constraints. Similarly, this year, Ukraine enacted its own Law “On the State Enforcement Service”, but whether implementing this legislation and adequate funding will be feasible remains to be seen.

[8] Despite the language in Article 9 of both Russia’s and Ukraine’s Laws on International Commercial Arbitration (both of which are based on the UNCITRAL model) that “an application of a party to a court before or during an arbitral proceeding with a request for the adoption of conservatory measures and the issuance by such court a determination on the application of such measures are not incompatible with an arbitration agreement”, neither country’s Arbitrazh Procedural Codes explicitly authorize the adoption of conservatory measures (the equivalent of a preliminary injunction) where the parties to a contract have agreed to international commercial arbitration. It is thus doubtful that a Russian or Ukrainian judge would feel that he could order conservatory measures in a case over which he did not have jurisdiction irrespective of the language contained in the relevant contract’s dispute resolution provision.

[9] See with respect to Russia, Fundamental Principles of Civil Legislation of the USSR and Republics, Article 166, dated May 31, 1991, and with respect to Ukraine, the Law “On Foreign Economic Activity”, dated September 19, 1991, Article 6.

[10] Such a document may be titled a “protocol of intent”, but in practice a protocol of intent typically is not sufficiently detailed.

[11] We note that Russia has still not adopted a law on the state registration of legal entities. In the interim, Presidential Edict No. 1482 “On the Regularization of the State Registration of Enterprises and Entrepreneurs on the Territory of the Russian Federation”, dated July 8, 1994, establishes the relevant norms.