Dmitry K. Gladkov is an associate at the Moscow office of Debevoise & Plimpton LLC. The author received valuable assistance in preparing this article from Dmitriy A. Tartakovskiy. For further information, contact Mr. Gladkov by telephone at (7 095) 956-3858, by fax at (7 095) 956-3868, or by e-mail at email@example.com.
The purpose of this article is to share with foreign companies contemplating investments into the Russian sector of the Internet (Runet) some basic thoughts and concerns regarding the legal shape of Russian Internet projects. Currently, Runet is a rapidly growing business area, in terms of numbers of both Internet users and Internet operating businesses in Russia. In the course of our work in this area, we have had a chance to examine a number of Runet companies as possible targets for foreign investment. While Internet monsters like AOL or Amazon.com are still on their way to Russia, a number of Russian and international investment funds have ventured to select the most promising Runet projects, develop them and prepare them either for sale to a prospective strategic investor or for a public offering.
As a part of this selection process, Runet companies are typically subjected to due diligence investigations. Our experience in performing legal audit of Runet companies has shown that the level of compliance with the requirements of applicable Russia’s regulations is lower than one could expect. In most instances, even our preliminary findings made in the course of legal due diligence investigations of Runet companies revealed a wide range of problems that exist in this area. In fact, usually there was no section in the legal due diligence questionnaire that could be filled out with positive observations or conclusions.
1. Corporate Documents
In terms of their corporate structure, most Runet companies are not tailored for a particular project, but are purchased by the founders in a semi-established form. As a result, the foundation documents (charter and articles of association) of such Runet companies are quite standard and do not pose any serious risks for the investor. However, in most cases our review of corporate action documents (minutes of shareholders and board meetings, board resolutions, etc.) revealed that such documents either had not been maintained at all or had been maintained improperly. Moreover, corporate actions in Runet companies are typically taken without timely and proper notice to shareholders as to the date and agenda of the meetings at which such actions are taken. Consequently, those actions are exposed to the risk of being declared invalid in the event a shareholder chooses to challenge them.
2. Shareholder Conflicts
Another area of concern for the investor is possible disagreements among shareholders as to the value of their shares. It is quite common for Runet companies that their original founders withdraw from the company due to disagreements as to how the business should be developed or how the company should be run, without formalizing their withdrawal through sales of their interests, redemption of their shares, or otherwise.
As a result, investors acquiring such Runet companies may need to negotiate with several shareholders who have conflicting interests and different views on what may be the value of their stock. In the best case scenario, the investor will acquire the shares by paying a premium to the dissenting shareholders. In the worst case scenario, shareholders willing to sell their stock will provide the investor with documents that purport to evidence a waiver by the dissenting shareholders of all their rights and claims to their shares. Typically, neither the requirements of corporate approval and notice nor the rights of first and second refusal will be satisfied in such cases.
3. Sale of Assets vs. Sale of the Company
Any Runet company owner realizes that nobody will invest in his company unless the company eliminates its tax liabilities, cures currency control violations and resolves all other problems that make the company vulnerable to possible enforcement action by one or more of Russia’s numerous government agencies (the tax service and police, customs authorities, currency and export control agencies, etc.) In dealing with such problems, some Runet company owners attempt to abandon the troubled existing entity and to transfer all its assets to a newly formed company.
Although this solution has worked thus far, Russia’s tax authorities are learning their lesson rather quickly and are likely to begin to question the validity of such transfers in the future, based on relevant provisions of the Civil Code that distinguish a sale of a company’s assets from a sale of the company itself. If the tax authorities succeed in proving that the transaction constitutes the latter kind of transaction, the new company will be liable for all the tax and other liabilities (increased by penalty and fine amounts) that the owner sought to escape by abandoning the old company.
4. Assets of Runet Companies; Leases of Telecommunication Lines
Our experience of due diligence investigations of Runet companies has revealed that most of them use equipment and hardware owned by their founders or employees. However, these companies have no lease or purchase agreements for such hardware and equipment. All assets are used on the basis of personal relationships among the people working for the company.
As a general rule, newly established Runet companies do not generate any income and are unlikely to begin generating income in the foreseeable future. Therefore, they prefer to pass their deductible expenses, including expenses on the installation and leasing of their communication lines, Internet access fees and other operating expenses, on to their parent (founders’) companies. In order for them to do so, there must be no equipment lease or sublease agreements between the Runet company and its parent. Rather, the Runet company operates as a subdivision of its parent, having unlimited and free access to the parent’s communication lines and equipment (e.g., computers, hardware, office facilities, etc.). Once the company has been sold, the parent can disconnect its former subsidiary and deny it access to the parent’s resources. Therefore, Runet investors should take care to include provisions in the purchase agreement addressing this problem.
Runet generally follows the U.S. e-commerce pattern. Internet shops operate separately from already established traditional stores and supermarkets. Very few Russian supermarkets sell their products on-line, and, by the same token, very few Internet shops have a well-established trade infrastructure (i.e., warehouses, delivery services, payment facilities, supplier networks, etc.) Thus, an attractive web design of a Runet shop and sophisticated software used by it do not guarantee that the business will operate successfully without distribution facilities necessary to deliver purchased items to the purchaser.
6. Intellectual Property
One of the important issues to which any Runet investor should pay special attention is the protection of the company’s intellectual property. The company’s rights to trademarks, web-site designs, the software that makes the company’s Internet shop running and programs that facilitate payments should be properly documented and registered. Unfortunately, most computer programmers -- founders of Runet companies – are not sufficiently knowledgeable about potential copyright, trademark or other intellectual property issues or relevant intellectual property protection rules and mechanisms.
It is quite common for Runet companies to copy their competitors’ designs, use pirated programs, or simply not to have any paperwork for software products that they create for particular projects. In most instances, software used by Runet companies is not licensed or legally purchased and is not recorded on the company’s balance sheet. As a result, such software has no value that could be protected and against which amortization could accrue.
In addition to these intellectual property protection problems, Runet investors may also face problems associated with preventing the former owners of the company or third parties from forming a “duplicate” company that engages in the same kind of operations and has an identical or similar web site.
7. Registration of Domain Names
The domain name of the target company is another potential problem for the investor to deal with. Usually, a company’s Internet domain name is the same as the company’s registered trademark. Under Russian law, however, domain names are not considered to be trademarks, and therefore, they do not enjoy the same level of protection. While unauthorized use of domain names by third parties can be prevented by registering the domain name with a specialized government agency charged with the duty to effect such registration, in many instances domain names of Runet companies are registered not in the name of the company itself, but in the name of the individual founder of the company. Therefore, a foreign investor who desires to acquire such a company should take care to include in the purchase agreement a separate provision for the transfer of all rights to the domain name.
Moreover, due to the asset borrowing arrangements between Runet businesses and their parent companies described above, even properly registered domain names are quite frequently maintained on the parent (founder’s) company’s server. As a result, when a user attempts to visit the site at the specified address, the user will be automatically readdressed to the parent’s server. Such an arrangement creates certain risks for the investor, for, absent an agreement between the Runet company and its parent concerning server space use, the parent may cut the Runet company off once the company has been alienated.
8. Payment Systems
Most Runet shops sell their products for cash on delivery, although several Internet payment programs have been implemented in Russia recently (e.g., CyberPlat, Access). The problem with these programs is that nobody has ever checked their compliance with the certification, licensing and permission requirements of Russia’s Federal Agency for Governmental Communications and Information (“FAPSI”). Although FAPSI has not yet questioned the legality of the use of those payment programs, there is no assurance that it will not do so in the future, especially considering the fact that importation and operation of encryption software are subject to a number of restrictions imposed by current legislation.
Some of the payment system providers have obtained FAPSI approvals for their programs. However, those providers prefer not to disclose to their clients the fact that every time the client installs such payment software with encryption elements on the client’s computer, the client must obtain FAPSI permission and a license for the use of such software.
9. Acquisition Techniques
Although techniques used to acquire Runet companies do not differ substantially from techniques used in acquisitions of other Russian entities, Runet companies are relatively young and, unlike most Russian companies, have no privatization records and risks associated with privatization violations. On the other hand, most Runet companies available for purchase are owned by individuals who, for various tax and security reasons, are reluctant accurately to report to the tax authorities the price at which they sell their shares and to receive cash on their bank accounts in Russia. If the investor makes arrangements for such a seller to receive its cash off-shore, the investor runs the risk of the acquisition being invalidated as a violation of Russia’s currency control requirements and antimonopoly rules.
The foregoing general observations are based on our experience in facilitating foreign investments in Runet. Our experience shows that foreign investors acquiring Runet companies will typically have to face a number of legal issues, including corporate governance, regulatory compliance, taxation, intellectual property protection and other issues. While many of these legal problems are common to all acquisition transactions in Russia, some of the Runet sector acquisition problems are unique and require special attention. Foreign investors purchasing companies in the Russian sector of the Internet should make sure that such problems are timely and properly addressed and that a solid legal foundation is established for their future business activities.
Debevoise & Plimpton has a substantial practice in the field of online services and other new media and has been at the forefront of Internet-related legal services. Due to the rapid growth of the e-commerce sector and the convergence of traditional and newly created media technologies, our experience in this area has included advising both media and non-media clients on legal issues arising in the process of formation and operation of web sites and web site businesses and pursuit of other e-commerce opportunities.