One of the problems faced by foreign companies making acquisitions in Russia is finding adequate means of securing the indemnities of the selling parties that would have the effect of reducing the purchase price. For example, if a foreign investor (the “Purchaser”) wishes to purchase the assets or stock of a Russian company from their Russian owner (the “Seller”), neither legal due diligence nor audit can guarantee that post-closing financial sanctions will not be imposed on the target company by governmental authorities for some pre-closing fiscal violations. The Purchaser is willing to pay the purchase price on the condition that if any such penalties are imposed on the company prior to the expiration of the applicable period of limitations for imposition of such penalties, the purchase price will be reduced accordingly. To give effect to this condition, the Purchaser needs to find a legal mechanism capable of ensuring that, in such a case, the appropriate portion of the purchase price will be withheld from the Seller and refunded to the Purchase.
One of the means of protection of the respective interests of the parties to such transactions available under the law of some countries is the so-called escrow mechanism. This article examines the possibility of using this mechanism, including the possibility of opening escrow accounts, in the Russian Federation. Our analysis shows that although the use of an escrow arrangement presents a number of legal issues and technical difficulties under current Russian law, it may be possible, by involving both a foreign and a Russian bank, to employ escrow arrangements in cross-border acquisition transactions involving Russian sellers.
I. Definition of “Escrow”
The term "escrow," in general parlance under U.S. law, is an instrument, money or personal property delivered to a person (the escrow holder) by the depositor and which the holder contracts to retain until the happening or non-happening of an event. The terms under which the escrow holder acts are generally established by an agreement (the "escrow agreement") among the depositor, the escrow holder and a third party. If the specified condition is fulfilled before the specified time, the escrow property is to be delivered to the third party. Otherwise, the escrow holder is to return the escrow to the depositor. The escrow holder does not respond to the will of either of the parties until the fulfillment of the specified condition or expiration of the specified period of time. Before this, the escrow holder has power to deal with the subject matter in accordance with the agreement of those for whom he holds it, and this power cannot be terminated without the consent of both the depositor and the third party.
The effectiveness of escrow arrangements as a means of protection of the interests of the parties to various transactions is based on the principle that to constitute an escrow, the subject of the escrow must be delivered to a third party and the delivery must be intended as the obligor’s relinquishment of any right of possession and control of the subject matter. In other words, for an escrow to be valid, the delivery of the property must be irrevocable. Although the obligor retains a contingent right to repossess the property if the specified condition does not occur, while the property is in the hands of the depositary it must be beyond the possession and control of the obligor. Moreover, after the escrow agreement between the obligor and the obligee has been delivered to the depositary and accepted by it, the depositary has the duty of strict execution of its terms and conditions and may not be relieved of that duty unilaterally by any of the parties.
In the example above, the purpose of using an escrow arrangement would be that, pursuant to the agreement between the Purchaser and the Seller, a portion of the purchase price would be delivered by the Purchaser to a depositary bank, rather than directly to the Seller, and the bank would assume the obligation to dispose of the escrowed funds pursuant to the provisions of the escrow agreement. Thus, the Purchaser would not have any further control over the funds, and the bank would be obligated to transfer the funds to the Seller unless financial penalties were imposed on the company during the escrow period. On the other hand, if such penalties were in fact imposed on the company during the limitations period, the bank would be obligated to return the escrow funds, in full or in part, to the Purchaser.
II. Application of Escrow Arrangements in Russia
Russian law does not have a concept analogous to the concept of escrow. The two closest types of arrangements recognized by the Civil Code of the Russian Federation are the bank account agreement (Chapter 45 of the Civil Code) and the trust management arrangement (Chapter 53 of the Civil Code). As our analysis shows, neither of these arrangements is capable, without substantial modification, of adequately protecting the interests of both parties to an acquisition transaction.
A. Bank Account Agreements
Bank account agreements are governed by Chapter 45 of the Civil Code. Civil Code Article 845 provides:
“1. Under a bank account agreement, the bank undertakes to accept funds coming to, and deposit in an account opened for, its client (the owner of the account), to follow the client’s instructions to disburse and pay out specified amounts from the account, and to carry out other operations on the account….
3. The bank may not determine or control the purposes of the client’s use of its funds, or impose other restrictions, not provided for by law or by the bank account agreement, on the client’s right to use its funds in the client’s discretion.”
Thus, in our example, the Purchaser can deposit the agreed portion of the purchase price in a special purpose bank account pursuant to a bank account agreement with the bank. Under the agreement, the bank will undertake to hold the funds in the account for a specified period of time (the duration of the limitations period) and to pay them out to the Seller upon the expiration of that period, provided no penalties attributable to the Seller’s pre-closing fiscal violations are imposed on the Company within this period. Arguably, the above provision of Civil Code Article 845.3 allows the bank to impose such restrictions on the Purchaser’s right to use the funds in its bank account if such restrictions are “provided for by the bank account agreement.”
However, this transaction mechanism is unlikely to meet the Seller’s approval in our example. First, Article 858 of the Civil Code provides that the client’s right to control funds deposited in the client’s bank account and to dispose of such funds in the client’s sole discretion may not be restricted, except in the event of seizure of such funds or suspension of operations therewith by decision of authorized government agencies in appropriate circumstances. Moreover, under Civil Code Article 859.1, the client may terminate the bank account agreement at any time. Clearly, these provisions would create serious problems for the Seller under the above transaction mechanism.
B. Trust Management
Chapter 53 of the Civil Code recognizes the concept of trust management. However, as they exist under the Civil Code, trust management arrangements differ from escrow arrangements in many important respects and require substantial modifications in order to be used to protect the interests of the parties to an acquisition transaction, as discussed below.
Article 1012 of the Civil Code provides:
“1. Under a trust management agreement, one party (the founder of the trust management) delivers to the other party (the trust manager), for a certain period of time, assets for trust management, and the other party undertakes to perform the management of such assets for the benefit of the founder of the trust management or a third party designated by the founder of the trust management (the beneficiary)….
2. In performing the trust management of assets, a trust manager may take, in accordance with the trust management agreement, any legal or other actions with respect to such assets for the benefit of the beneficiary.
Restrictions with respect to particular actions in connection with trust management of assets may be imposed by law or by contract.”
Thus, in our example, if the parties choose to use trust management arrangements to protect their interests in the transaction, the Purchaser will establish a trust, designate a bank selected by the parties as the trust manager, deliver the agreed portion of the purchase price to the trust manager and designate the Seller as the beneficiary of the trust. In such a case, the trust may be established for the duration of the limitations period.
However, such an arrangement will not protect the interests of both parties to the transaction. Civil Code Article 1012 requires that trust management be based on a trust management agreement between the founder of the trust and the trust manager. The beneficiary of the trust management arrangement is designated by the founder of the trust in the trust management agreement and is not a party thereto. Moreover, unlike escrow arrangements, a trust management arrangement may be unilaterally terminated by the founder of the trust pursuant to the provisions of para. 5 of Article 1024.1 of the Civil Code. Finally, the terms of the trust management agreement may be modified by agreement between the founder of the trust and the trust manager, and the provisions of Chapter 53 of the Civil Code do not require the consent of the beneficiary to such modifications.
Thus, in our example, the Purchaser may either unilaterally terminate the trust management agreement or change its terms by agreement with the bank acting as the trust manager. In either case, the consent of the Seller will not be required. As a result, this mechanism is not capable of effectively protecting the Seller’s interests in the purchase transaction.
In addition, the very concept of trust management of money seems to be somewhat problematic under the Civil Code. Specifically, Civil Code Article 1013.2 prohibits trust management of money as a separate object (i.e., not a part of a pool of assets that includes both money and tangible and/or intangible assets), except in cases where such operations are specifically permitted by law. Although a good argument can be made that such permission to engage in trust management of monetary funds is given to banks by the provisions of Article 5.2 of the RF Law on Banks and Banking Activity, which provides that credit organizations may enter into transactions for the trust management of monetary funds pursuant to contracts with individuals and legal entities, the legal nature of agreements for the trust management of money is somewhat obscure, and it is unclear whether the trust management provisions of Chapter 53 of the Civil Code are applicable to such agreements.
B. Other Potential Problems
In addition to the above legal problems associated with the use of bank account agreements and trust management arrangements to protect the interests of the parties to an acquisition transaction, under current Russian law such operations may present considerable tax risks, problems associated with currency regulation and control, currency devaluation risks, and technical difficulties.
1. Tax Risks
The opening of an account with a Russian bank requires prior registration with the tax authorities. In certain circumstances, a foreign company opening a bank account and conducting bank account operations in Russia runs the risk of creating a “permanent establishment” for tax purposes. On the other hand, if in our example the bank account is opened in the name of the Seller (a Russian company), the escrow funds deposited in the account may be considered by the tax authorities to be transaction proceeds that are subject to taxation on the date they are deposited in the bank account. In addition, changes in the value of funds deposited in foreign currency that may occur due to exchange rate fluctuations also may be regarded by the tax authorities as taxable income of the Seller.
2. Currency Control Problems
Payments made by the foreign Purchaser to the Russian Seller in foreign currency are very likely to qualify as “operations connected with movement of capital” within the meaning of Article 1.10(e) of the RF Law On Currency Regulation and Currency Control (the “Currency Control Law”). Under Article 1.10(f) of the Currency Control Law, such operations require prior approval of the Central Bank of Russia. The process of obtaining such approval may take several months.
3. Currency Devaluation Risks
In our example, if the funds are placed in escrow in Russian rubles, the parties run a considerable risk associated with possible devaluation of the ruble as compared to the currency of the Purchaser’s country. Which of the parties will ultimately bear such currency devaluation risks depends on whether financial penalties are imposed on the acquired company during the escrow period.
4. Technical Difficulties
In addition to the legal issues and risks discussed above, most major Russian banks and Russian branches of foreign banks refuse to take their clients’ funds for trust management due to serious technical difficulties presented by such operations. Specifically, Article 4.4 of Instruction No. 63 On the Procedures for Conducting Trust Management Operations and On Accounting of Such Operation by Credit Organizations of the Russian Federation, approved by RF Central Bank Order No. 02-287 of July 2, 1997 (Instruction No. 63), prohibits banks operating in the Russian Federation from keeping trust management funds in their own accounts and requires them to open special purpose accounts with the Central Bank of Russia (for foreign currency) or another Russian bank (for rubles).
Moreover, under Article 3.4 of Instruction No. 63, banks that take their clients’ funds for trust management may not use such funds to make loans or extend credits. Thus, in order to derive income from such funds, the bank has to use them in various commercial operations, including securities market operations, which requires the bank to have appropriate departments and professionals capable of conducting such operations. Consequently, to recoup its expenses associated with trust management, the bank has to charge fees for such services. Considering the fact that Russian banks are required to create cash reserves against clients’ funds, such trust management fees may be substantial.
III. Proposed Mechanism
As an alternative to the bank account or trust management arrangements discussed above, a foreign company making acquisitions in Russia may consider using a mixed arrangement, as outlined below. In our view, the proposed mechanism will allow the parties to such transactions to adequately protect their interests and to solve potential tax, currency and technical problems.
The proposed arrangement contemplates that the Seller and the Purchaser select a foreign, rather than Russian, bank to act as the escrow agent in the transaction (the “Agent Bank”). Under the proposed arrangement, the parties enter into a three-party agreement, governed by foreign law, with the Agent Bank for the opening of an escrow account outside of Russia. Pursuant to the escrow agreement, the Seller deposits in the escrow account that portion of the purchase price that the Seller and Purchaser have agreed would be withheld. The Agent Bank undertakes to pay the escrow amount, in full or with appropriate deductions to satisfy the Purchaser's claims, over to the Seller upon the expiration of the escrow period and pursuant to the terms of the escrow agreement.
Further, the key term of the escrow agreement is the Agent Bank’s obligation to pay the escrow amount to the Seller in Russia and in Russian rubles. To this end, upon the expiration of the escrow period the Agent Bank will have to transfer the funds from the escrow account to its hard currency account in a Russian bank, convert the funds into Russian rubles and deposit the rubles in its ruble account in the Russian bank. The funds will then be transferred to the Seller’s account from the ruble account of the Agent Bank.
This arrangement will allow the parties to avoid all the potential problems discussed above. First, the proposed mechanism is based on a three-party agreement, under which the obligations of the Bank run to both the Purchaser and the Seller so that none of the parties can terminate or modify the agreement without the consent of the other two parties. Second, because the escrow agreement in the proposed mechanism is governed by foreign law, it will not be subject to the provisions of Civil Code Article 1024.1 that allow the founder of a trust management arrangement unilaterally to terminate it at any time. For the same reason the escrow agreement will not be subject to the provisions of Civil Code Articles 858 and 859.1 that prohibit banks from restricting their clients’ ability to control funds in their bank accounts. Finally, the proposed mechanism will allow the parties to the transaction to avoid the tax and currency devaluation risks mentioned above and to comply with all applicable currency control requirements, as discussed immediately below.
A. “Operation Associated with Movement of Capital”
Under the three-party escrow agreement among the Seller, the Purchaser and the Agent Bank, the Russian Seller will be entitled to payment of the escrow amount upon the expiration of the escrow period. However, the escrow amount will be payable to the Seller in Russian rubles, rather than in foreign currency. As a result, the transaction will constitute a Russian ruble transaction between a resident and a non-resident of the Russian Federation. Although such a transaction will still constitute a “currency operation” within the meaning of the Currency Control Law, under Currency Control Law Article 1.8, it will not qualify as an “operation associated with movement of capital” and therefore will not be subject to the requirement of prior Central Bank approval, in accordance with Currency Control Law Article 1.7(d).
B. Foreign Currency Accounts of Russian Residents Outside of Russia
Under Article 5.2 of the Currency Control Law, Russian sellers may open foreign currency accounts outside of Russia only in the instances specified, and on the terms established, by the Central Bank of Russia. Thus, the question is whether the Seller will be deemed to have opened a “foreign currency account outside of Russia” within the meaning of the Currency Control Law. A strong argument can be made that it will not.
First, the proposed arrangement will not allow the Seller to exercise direct control over the escrow account opened with the Agent Bank outside of Russia and to consider the escrow account its own. Second, because the escrow amount will be payable to the Seller in Russian rubles, the Agent Bank will make the payment from its ruble account with a Russian bank, as discussed in Part III.D below. Thus, the account from which the payment will be made will not qualify as a “foreign currency account.” Therefore, the Seller will not be required to obtain Central Bank approval of the transaction.
C. Making Payments in Russia
The proposed mechanism involves the receipt of ruble payments in the Russian Federation. This will allow the parties to avoid the application of Article I.8 of Central Bank Letter No. 352 of May 24, 1991 (Letter No. 352), which provides:
“The payment of money in rubles, the provision of services or the delivery of any assets in [Russia] with subsequent receipt of an equivalent in foreign currency abroad, as well as the receipt of money in rubles as an equivalent for payment of foreign currency, the provision of services or the delivery of assets abroad, shall not be permitted.”
Under the proposed arrangement, both the delivery of assets (the acquired company) and the receipt of the money occur in the territory of the Russian Federation. Therefore, the transaction does not violate the above prohibition of Letter No. 352.
D. Compliance with Central Bank Payment Procedures
Article 2 of the Currency Control Law provides that “all payments between residents and non-resident in the currency of the Russian Federation shall be effected in accordance with the procedure established by the Central Bank of the Russian Federation.” Presently, the Central Bank requires that ruble payments between residents and non-residents be made only through the non-residents’ ruble accounts opened with authorized Russian banks and in accordance with the procedure and account regime established by Central Bank Instruction No. 16 of July 16, 1993 On the Procedure for Opening and Maintaining Accounts of Non-Residents in the Currency of the Russian Federation by Authorized Banks” (Instruction No. 16).
Under Article I.1 of Instruction No. 16, foreign companies, including foreign banks, may open investment (I-type) ruble accounts with Russian banks. Moreover, under Article 5.2 of Instruction No. 16, funds in investment accounts of non-residents may be used, per instructions of the owners (managers) of such accounts, for the following purposes:
· to make payments under transactions for the purchase of objects of foreign investments, including privatization objects;
· to make payments under transactions for the purchase of securities denominated in foreign currency; ruble-denominated shares of stock, with the exception of shares of stock of resident credit organizations purchased by non-resident banks; ruble-denominated securities (except ruble-denominated shares of stock) issued by residents, if the period from the date of execution of the appropriate transaction to the maturity date exceeds one year; ruble-denominated treasury bonds, if the period from the date of execution of the appropriate transaction to the maturity date exceeds one year;
· to transfer advance payments to the seller’s account (including the account of relevant Property Funds as payments for the participation in tenders (auctions) for the purchase of privatization objects) in connection with transactions for the purchase of privatization objects;
· other operations.
Thus, payment of the escrow amount by the Agent Bank to the Seller in Russian rubles from the Agent Bank’s I-type investment account with an authorized Russian bank will be in compliance the requirements of Instruction No. 16.
E. Using the Escrow Account to Facilitate Third Party Transactions
An important question presented by the proposed mechanism is whether a foreign agent bank that has opened an investment account with a Russian bank in its own name may use that account to facilitate third party transactions. This question has been addressed by the Central Bank in some of its letters responding to private inquiries. For instance, Central Bank Letter No. 12-1-5/2711(012739) of April 4, 1999 provides:
“Funds of third parties may be deposited in ruble [investment] accounts even though such third parties are not the owners of such accounts, and payments authorized under the regime of such accounts may be made from such accounts, provided the owner of such [investment] account enters into an agency agreement [with the third party] (under which the account owner is the agent and conducts operations on the account on its own behalf).”
Moreover, currency control specialists of the Central Bank are of the view that the owner of an investment account may deposit third party funds on the account and make payments from the account in order to facilitate the third party’s transactions, provided there is an agency agreement between the account owner and the third party authorizing the account owner to carry out such operations. This position is also supported by the practices of major Russian and foreign banks operating in the Russian Federation.
Thus, in our example, the escrow agreement should contain provisions authorizing the Agent Bank to act as the Purchaser’s agent in making payments through the Agent Bank’s ruble investment account in the Russian Federation. Once the escrow funds have been transferred from the escrow account to the Agent Bank’s foreign currency account with a Russian bank, converted into Russian rubles and deposited in the Agent Bank’s ruble investment account, the Agent Bank will transfer such funds, in Russian rubles, to the Seller’s ruble account, on behalf of the Purchaser and in accordance with the terms of the escrow agreement.
F. Currency Devaluation Risks
The proposed arrangement will also allow the parties to avoid risks associated with possible devaluation of the Russian ruble. The escrow amount will be deposited in the escrow account in foreign currency for the entire duration of the escrow period, and the conversion of the escrow funds into Russian rubles will be completed over a short period of time at the last stage of the transaction. This mechanism will eliminate the possibility of losses due to exchange rate fluctuations and devaluation of the ruble.