perations in Russia for Foreign Investors.
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1. LEGAL ASPECTS
1.1 REGULATION OF FOREIGN INVESTMENTAccording to Russian laws, a foreign person (legal or natural) has the right to invest in Russian enterprises, to buy or sell Russian securities and to repatriate profits from Russia after payment of applicable taxes. At the same time, however, legislation governing foreign investment is still in a formative stage and exists in a very basic form; sometimes, the legislation does not adequately address all of the issues encountered by the investor. The law "On foreign investments in the Russian Federation" (01 July 1992) determines the legal and economic basis for foreign investment in the territory of Russia.
1.2 EXPECTED MAJOR CHANGESChanges in Russian legislation are currently being discussed. The government's declared goal is to support foreign investment in Russia and to create a favourable environment for such investors. So far, though, less attention has been paid to the securities market and portfolio investment, as the legislation was primarily focused on direct investment. Nevertheless, the changes will affect both areas, and it is possible that tax legislation will also be simplified in both spheres. Various guarantees and risk management schemes are currently offered by the Russian government, and by different national and multilateral financial organisations (OPIC, IMF, etc.) to investors. Different types of protection are available for different types of investors, subject to the international agreements in force on Russia territory. Foreign investment is generally viewed as one of the main sources of financing to restructure Russian economy. It is envisioned that privatised enterprises will enter the securities market with new issues, and that government guarantees will be available for the equity and debt issues of the largest privatised enterprises. However, large political concerns still exist related to the undervaluation of Russian privatised enterprises. Huge increases in stock prices after the initial privatisation offering is seen by some politicians as an indication of fraud in the privatisation scheme, and it is expected that new privatisation plans, aimed at the raising of money both for the enterprise itself and for the budget, will help to resolve this problem. New securities market legislation is currently under consideration by the State Duma. The major laws to be issued are "On the Securities Markets" and "On Joint-Stock Companies". A number of presidential decrees were issued for the regulation of securities market. The decree "On the measures of state regulation of the securities market in the Russian Federation" (4 November 1994) created the Federal Securities and Securities Market Commission, under the governance of Mr. Chubais, Vice-premier minister and former head of the privatisation ministry (Goskomimuschestvo or GKI). It has been declared by the Commission that new regulations will rely on the self-regulatory professional organisations (SRO's) of market participants. The proposed new legislation allows the Commission to grant licensing power to the registered SRO's. SRO's will be licensed by the Commission and power will be given to them to issue licenses to market participants. However, this provision has become a subject of debate in the State Duma and the outcome of the discussion is not clear yet. Changes are also advocated by the Central Bank regarding foreign currency regulations in Russia. The changes will affect the technology of money settlement involved in securities transactions. The various methods now available are described in the section entitled "MONEY ACCOUNTS AND CURRENCY TRANSFER". So far, there are two possible courses of development. The "hard way" is structured as follows: new regulations may require all transactions with Russian securities to be settled only in roubles, even if a foreign person is a party to the transaction. Under this new regulation, it will be necessary to sell foreign currency for roubles before purchasing any securities and to buy foreign currency before repatriation, increasing the currency risk of the market. Essentially this means that only I-type accounts will be used for investment, subject to all restrictions described below. An I-type, or Investment, Account allows execution of rouble investment transactions in Russia. It is covered in more detail in the section "MONEY ACCOUNTS AND CURRENCY TRANSFER". As Russian banks are already offering good services in the field of foreign currency conversion, though, it is possible that these risks would be lessened as conversion becomes cheaper and faster. Almost all securities in Russia are now quoted by major market-makers in dollars, thus further decreasing currency risk. The "soft way" may allow settlement of transactions in foreign currency also, if at least one party to a transaction is a foreign entity. If a Russian entity is settling a transaction with a foreigner, a Russian professional intermediary (a licensed broker or a bank) must participate in the trade as an agent, and report the transaction to the Central Bank.
It is not yet decided which type of regulation will be
implemented.
1.3 TWO METHODS OF OPERATING IN THE RUSSIAN MARKETForeign legal entities can choose between two methods of executing investment activities in Russia. They can either establish a registered permanent representative office -- a branch or a subsidiary in Russia -- or operate without such a registered local entity. If the second option is selected, operations in Russia are executed through unaffiliated specialised intermediary organisations (brokerage firms). According to Instruction 20 of the State Tax Inspectorate of Russia "On the taxation of profit and income of foreign legal entities" (14 May 1993, Paragraph 9): ╗ If a foreign legal entity carries out its activity not ╗ independently, but through an intermediary ╗ organisation, then such an activity of the former is ╗ not considered as an establishment of a permanent ╗ representation of the foreign legal entity. Double tax treaties entered into by the Russian Federation further clarify the status of a foreign entity acting without a permanent representative. Intermediary organisations mentioned above must fulfil the following requirements:
Therefore, to carry out investment activities in Russia without establishing a permanent representative office, it is necessary to operate with a brokerage agreement through a licensed Russian brokerage firm or through a Russian bank. All trading operations are then performed through this firm, allowing the tax advantages of operating without a representative office to be realised. If a Russian broker is acting as a professional intermediary for the foreigner, no official accreditation for the foreign investor in Russia is required. The only exception is sometimes in the case of direct participation (under the foreign investor's own name) in the privatisation of a Russian enterprise, as accreditation is required for the direct participation for privatisation auctions in Moscow. Indirect operations through brokers usually can be organised without such accreditation. In some cases, registration with the tax authorities is required for the use of double taxation relief. As described later, the opening of a rouble account in Russia is not clearly regulated; therefore, it is uncertain whether a bank needs to ask for registration with the tax authorities when opening an I-type account.
As described below, investment operations without a
permanent representative office or branch in Russia are
more preferable for tax purposes. To monitor market
performance, control transaction execution and perform
public relations duties, it is obviously desirable to have
an office, phone number and representative in Russia. So
it is necessary to distinguish between such an office, and
a representative office that performs actual securities
trading (or any other Russia-based business activities).
The former can be established legally by an advisory or
management company related to the foreign investor. No
trading operations are carried out through such an office,
and for legal purposes it is the actual foreign investor
which directly enters into transactions through an
independent intermediary.
2. THE RUSSIAN BROKER
2.1 LICENSINGAs described in the previous section, it is necessary to select a licensed broker to carry out investment activities in Russia (specific issues related to working through a Russian bank are outside the scope of this Guide). For the investor operating through a broker without a permanent representative office, the broker can carry out transactions under its own name on behalf of the client. So far the licensing of brokers has been regulated by the "Regulation on the licensing of investment institutions in the securities market" issued by the Ministry of Finance (21 September 1992). Only legal entities can receive brokerage licenses, and it is possible for legal entities with foreign founders or shareholders to obtain licenses. The minimum capital requirement for brokers is not very high. At present the minimum equity capital required for the professional broker is 50 million roubles or approximately $10,000 at the exchange rate in April 1995, and the minimum capital for the professional dealer is 250 million roubles or approximately $50,000. The basic difference between two types of licenses is that the broker cannot act as both principal and market-maker for a client. The majority of large securities market participants in Russia have both licenses. The licenses are issued for an infinite term. A brokerage license can be cancelled for a number of reasons, including:
A licensed broker must employ specialists qualified by the Ministry of Finance. Chief executives and employees directly involved in securities transactions must be so qualified. Qualification exams are carried out by the Ministry of Finance and confirmed by the issuance of qualification certificates. The Ministry of Finance and its regional agencies are currently responsible for supervising the activities of financial brokers. Appeals are directed to the Ministry, as it has the power to cancel the license of any investment institution. The newly created Commission is authorised to regulate professional securities market participants. Currently, there are no procedures established, and it is expected that the Commission will be fully operational in mid-1995. The first self-regulated associations of securities market participants were created in the major financial centres of Russia in the autumn of 1994. As yet they are not fully recognised by the legislators and regulators of the market, but it is useful to check on the membership of any particular broker in these organisations. Moreover, until official recognition of the SRO's is introduced, reasonable care must be taken to check the reputation of the SRO itself, as some are not totally reliable organisations. 2.2 RELATIONSHIP WITH THE BROKERBrokerage agreements According to Russian legislation, Russian brokers must ask for written agreements and written instructions for each transaction. This request stems from Russian accounting requirements and from the necessity to present all documents to the tax authorities to certify the legality of each operation. A broad range of brokerage agreements currently exist. While larger brokers have special standard agreements, in most cases these firms are willing to modify these according to client needs. Agreements are valid for one transaction only; however, long-term agreements with special orders for particular transactions are also possible to arrange. The broker's bank An important thing to understand is that the bank which services your Russian broker becomes an essential element in the execution of the transaction. At minimum, foreign investors should obtain the following information about their broker's bank:
Buy/Sell agreements Each securities transaction in Russia must be executed in written form. Such agreements must be registered by licensed market professionals (if the broker executes a transaction for a client, it typically registers the transaction itself). There is a 0.3% securities transaction tax which is included in the sum of a transaction. For more detail, see the section entitled "SECURITIES REGISTRATION AND SETTLEMENT" below. Usually three copies of the agreement are signed (additional copies of the agreement are usually required by the issuer's registrar to be left on his file). If a buy/sell agreement is executed directly between the client and the broker, one copy is left with the client. If the broker executes an agreement with the third party on behalf of a client, the client has the right to demand one copy of the agreement. Currently there are two ways for foreign investors to enter in an agreement: a purchase agreement can be signed by an investor directly with the seller; or the investor can sign an agreement with a broker who in turn signs an agreement with the seller. For some registrars it is necessary to mention the name of the beneficiary in the written agreement if a foreign client is using the services of the broker. This can be accomplished as follows: 3 "ABC Broker" (Moscow), represented by Mr. Ivanov, and 3 acting on behalf of "XYZ Fund" (USA -- hereafter 3 referred to as the Buyer), and "XYZ Dealer", 3 represented by Mr. Petrov, (hereafter referred to as 3 the Seller), etc. If an agreement is signed directly by a representative of an investor, some questions may arise regarding whether it has in fact established a representative office in Russia. Current practices allow representatives to sign directly, but changes are likely to affect this type of transaction. If an agreement is signed with the broker, authorising the broker to purchase securities, it is necessary to specify payment details in the brokerage agreement or in supplemental directives. Such payment details are required to protect the broker from violating Russian currency legislation. In case of a sale to a Russian entity, a direct agreement between the fund and the buyer can cause the same tax problems associated with the existence of a permanent representative office. It is again better to authorise the broker to sign such an agreement. Brokerage fees Brokerage fees are agreed upon between brokers and clients on a case-by-case basis. Fees can vary greatly depending on the type of investment instrument and on the status of the market. For the most liquid issues, commissions usually range from 0.05% to 0.2%. But for thinly-traded issues (such as recently privatised enterprises), commissions can be as high as fifteen to twenty-five percent (especially if a controlling interest in a company is being traded). The brokers are often trading as principals and commissions are usually included in the price. This is a normal feature of the market where brokers take upon themselves significant risks while consolidating a package of shares for the client by buying from individual shareholders. It is common practice for the broker to ask for a "success premium" for execution of a limit type order. In this case, a broker receives part of the funds saved for the client (usually ten to twenty percent). As liquidity increases and spreads narrow, it is expected that commissions will become more clearly identified and competitive among the brokerage firms. Communication As described above, in Russia almost all agreements are executed in the written form, signed by the authorised parties and sealed with corporate seals. According to the requirements of the Civil Code, brokerage agreements must be executed in written form. Therefore, direct meeting or postal exchange is a necessary part of the relationship. Client orders can be given to a broker in any agreed-to form, though, including fax or phone communication. The usual practice for the broker is to make a deal by phone, then to prepare and sign a written report on the deal. The major brokers are already installing recording equipment, and internal arbitrage of the Professional Association of Securities Market Participants (Moscow SRO) is prepared to take this as an evidence. The client should confirm acceptance at least on a monthly basis. An investment fund or its management or advisory company can maintain a representative in Russia that can be authorised by the brokerage agreement or separate power of attorney to give orders to the fund's broker. Such activity is not considered the establishment of a permanent representative office in Russia; for legal purposes, such orders are considered to be issued from abroad. For lack of any Russian legislation governing the legality or enforceability of electronic communications, such communication is rarely used and is always confirmed by fax or written order. However, brokers are trying to find some practical solutions to this problem. 2.3 ACCOUNTS WITH THE BROKERBrokers offer safe-keeping or custodial services to their clients, including nominee ownership registration and the settlement of transactions on behalf of clients, if the client is eligible for such service. For more details see the section "SECURITIES REGISTRATION AND SETTLEMENT" below. Certain difficulties are encountered with the maintenance of monetary (rouble or hard currency) accounts with brokers. According to Russian legislation, only banks have the official right to maintain monetary accounts on behalf of physical or legal entities and to arrange monetary settlement for all types of transactions. Brokers offer a range of solutions to this problem. Usually a client can transfer funds to the bank account of the broker according to the terms of the agreement for a specific transaction, although client money balances can be kept by brokers for a short period only. More details on money transfers are described below. New legislation will possibly provide a solution to the problem of accounts. However, finding a solution requires joint action from the government and the Central Bank, a process which seems unlikely to progress rapidly. ORDER TYPESThere are four order types to execute a purchase or sale transaction through a broker in Russia: 1) Accept a current price quoted by the broker (if he acts as a market maker in any particular security): In this case, a transaction is executed with the broker as a counterparty at the broker's bid or ask. Usually no commission is charged for this type of transaction. 2) Specify the exact counterparty and price: An investment manager or advisor can directly determine a buyer or a seller and negotiate contract terms. In this case, the broker would sign the agreement with the specified counterparty only for legal reasons. The broker can also supervise settlement. 3) Place a limit order: The foreign investor instructs its broker to find a buyer or seller at a price equal to or better than specified. A time limit is usually set and guarantees of payment or delivery are given. The broker is responsible for finding a counterparty and signing the purchase/sale agreement. Commissions are highest for this type of order, as brokers often risk their own capital in the accumulation of the block of shares requested (purchase order). Such orders are seldom executed at a price better than the limit price if no "success premium" is established. 4) Place a market or limit order for a specific market: As there are almost no organised markets in Russia, this type of order currently makes sense only for state bonds (GKO's) or financial futures contracts. For some equity securities it is possible to negotiate a price with a broker for a certain number of percentage points over the closing price of specified market. Transactions of this type were very common in the privatisation voucher market, but with the relative lack of importance of exchanges they are rarely executed in today's market. The only possible exception is the Vladivostok International Stock Exchange and the companies traded there. It is advisable to obtain quotes from the several major market-makers in the market for a particular stock prior to contacting the broker to execute the deal. In this way the best price can be obtained and the type of the order can be correctly specified. Price checks can be performed through the market information sources describe in Part C of this Guide. 3. TAXATION
3.1 GENERAL TAXATION RULESForeign persons operating in Russia without permanent representative offices pay taxes on income derived from sources on the territory of Russia. Such taxes are withheld at the source. Taxation is regulated by Instruction 20 of the State Tax Service, "On the taxation of profit and income of foreign legal entities" of 14 May 1993. Taxable income is derived on the territory of Russia only if a Russian entity is a buyer in the sale of securities by the foreign investor. Therefore, in transactions between two foreign entities settled off-shore, no taxable capital gains appear in Russia. The present section only applies to deals in which the counterparty is a Russian entity. Capital gains. For tax purposes, capital gains are classified as "other income" in Instruction 20 (clarified by a 6 May 1994 letter from the State Tax Inspectorate) and are therefore subject to a twenty percent withholding unless double taxation treaty relief is available. If a foreign person is operating through a broker, the broker is considered to be the source of the income, and taxes on capital gains must therefore be withheld by the broker. Such taxes on capital gains are withheld at the moment of transfer out of Russia, unless treaty relief is available. It is currently not clear how capital gains are determined under the existing Russian legislation. The tax authorities generally agree that the presentation of a document confirming the cost basis (usually the purchase agreement) is sufficient for the calculation of a gain. Letter N UY-4-06.58n of the State Tax Inspectorate ("On certain types of foreign legal entities' taxed income from the sources on the territory of Russia") of 6 May 1994 confirms that only an "increase of cost" is considered income and is therefore subject to taxes. Under current legislation, reinvestment of capital gains through the broker can be accomplished without taxation. However this type of operation requires rouble settlement. The provisions described above are not altogether clear and the possibility exists that a particular broker or the tax authorities (especially outside of Moscow) will have a different interpretation of the legislation. This can result in the serious problems with the transfer of money. General taxation rules require that all costs and gains are calculated in roubles and that the tax due is determined in roubles. Consequently, investors pay tax on inflation (phantom rouble gains). The problem will be resolved only with the subsequent development of legislation. Changes in the tax legislation, especially concerning investment, are being discussed at length, but it is not clear yet when the new legislation will appear. Dividend and interest. For dividend and interest payments, tax is withheld by the issuer of the equity or debt instrument. The payment in roubles is made to the account registered on the books of the issuer. For the details of rouble and currency payments see below. Dividend and interest payments to foreigners are subject to a withholding tax at the rate of fifteen percent. Securities transaction tax. All foreign and Russian persons operating in the Russian securities market are required to pay a securities transaction tax of 0.3% of the total transaction size for each transaction with non-government securities (payable by each side) and 0.1% for transactions with government securities (payable only by the purchaser). This tax is paid even when the trade is settled offshore between two foreign persons. The document certifying the payment is required by the majority of company registrars to register the transfer of securities. 3.2 DOUBLE TAXATION RELIEFForeign entities domiciled in countries with double taxation avoidance agreements with Russia are taxed in accordance with these agreements. To receive tax relief, foreign entities must submit documents confirming their domicile and applications for tax relief to the State Tax Service. Tax relief is available only to entities operating without permanent representative offices. Capital gains. Taxation of repatriated capital gains is regulated in various ways by different tax treaties. Proceeds from the sale of securities are generally considered to be exempt from Russian taxation. The Russian tax rate for capital gains is equal to zero for entities domiciled in:
Capital gains are fully taxed in Russia for entities domiciled in Japan. Dividend and interest. Maximum Russian tax rates for the dividends and interest derived on the territory of Russia (according to some tax treaties) are summarised in the following table: ееееееееееееееееееееееееееееееееееееееееееееееееееееееееееееееее I Country of Domicile I Interest I Dividends I эееееееееееееееееееееееееееееееекеееееееееееекееееееееееееееееее I Austria I 0% I 0% I I Belgium I 15% I 15% I I Great Britain I 0% I 0% I I Italy I 0% I 15% I I Canada I 15% I 15% I I Cyprus I 0% I 0% I I USA (with certain exceptions)I 0% I 15% I I France I 10% I 15% I I Germany I 5% I 15% I I Switzerland I 20% I 15% I I Sweden I 0% I 15% I I Japan I 10% I 15% I ееееееееееееееееееееееееееееееееееееееееееееееееееееееееееееееее Among tax havens and off-shore zones, only Cyprus has a full double taxation treaty with Russia (dated 1982). As a result, many investment funds, regardless of their country of registration, hold their assets in Russia through a Cyprus subsidiary. If such a structure is implemented, the Cyprus entity is legally considered to be the investor in Russia. 3.3 REPRESENTATION OF INTERESTSThe broker represents the interests of foreign investors in all relations with the Russian state tax authorities. Relations with the Russian state tax authorities are necessary only with regard to claiming an exemption from withholding tax or with regard to claiming a tax refund. If a foreign entity has a right to be tax-free, its interests in the tax inspection can be represented by its broker or by its legal adviser. The attorney submits the following documents to the tax inspectorate:
A stamped copy of the application returned from the tax inspectorate certifies the rights of an investor to use tax relief. The application can be made either before the transfer of money out of Russia, or within one year of such a payment. In the latter case, excess withholding tax paid to the state is returned to the investor. Such applications to the tax inspectorate must be renewed annually. While it is definitely feasible to use tax benefits for the repatriation of the capital gains, the situation with regard to dividend and interest payments is more complex. Before the payment is made to the foreign legal entity, it is necessary to notify the payer or issuer not to withhold. In some cases such notification is impossible, especially when a diversified portfolio is held. Application for the return of taxes withheld should be made in this case, and it is difficult to predict how long it will take to receive a withholding refund from the state. Under the current legislation tax relief is provided for a particular transaction (transfer of money abroad). The process of obtaining permission from the Tax Service can take several months. However, the current practice of some banks is to allow for brokers to initiate money transfers abroad, provided that all necessary documents are presented to the bank. 4. SECURITIES REGISTRATION AND SETTLEMENT
4.1 SHARE OWNERSHIP REGISTRATIONAll equities in Russia are issued in book-entry (or registered) form. For the majority of enterprises certificates are unavailable and shareholder rights are certified only by receipts (extracts) from the issuer's registrar. Under the existing obscure legislation, all issuers with more then 1,000 shareholders are required to give their registers to the third-party registrar (affiliated company are thus far considered a valid choice). Some issuers are still keeping the registers themselves, a practice especially common among banks. Extracts from the register are usually signed by the registrar's employee and sealed by the registrar's seal. Transfer of an extract does not mean property transfer, and no endorsement can be made on the extract. However, some registrars require return of the extracts when the transfer instruction is given. The majority of the registrars require visit of the authorised representative of the shareholder to their location; in most cases this is in the same town or region as the issuer. Payment for the transfer of registration is established arbitrarily by the registrar. Various pricing practices can be encountered, ranging from a fixed payment per transfer, to a percentage of the transaction (up to four percent of the deal). A common practice along these lines is one percent of the total transaction (payable by either of the parties); typically, the registrar's fee is split evenly by the parties. The concept of nominee ownership was introduced in the Russian legislation by a number of presidential decrees and government regulations. It is expected that the new law will clarify these issues and bring the concept within strict legal boundaries. So far, any person registered in the shareholders' register other than a beneficiary owner is considered to be a nominee. The registrar is obliged to register transfer from the beneficiary to the nominee on the written instruction from the former, delivered in the usual way. It is not a problem with some registrars now, but there are certain companies which are establishing prohibitive requirements for nominee registration, or just simply decline such registration, under the pretence of technical or legal reasons. The nominee owner is obliged to disclose the beneficiary owners to the registrar at least once a year, before the shareholders meeting. However, it is common practice to execute special agreements between the registrars and organisations offering nominee services, and these agreements can establish differing disclosure rules. 4.2 DEAL REGISTRATIONAs mentioned above, current Russian legislation requires that every buy or sell securities transaction must be registered by the professional market participant (i.e. licensed broker/dealer or bank). This registration is done only for fiscal purposes, and the registering entity is generally responsible for the collection of the securities transaction tax. It is important to understand that deal registration is not directly connected to the registration of a property transfer and is usually done before it. Deal registration is typically done by a Russian broker representing the client's interests, or by a Russian market- maker, acting as a counterparty to the deal. Sometimes the broker charges a fee for the deal registration, but this is a rare practice among major market participants, and terms can be negotiated. It is current practice that only deals which are settled through the books of any domestic entity (issuer's registrar or local depository) are subject to this registration. If the deal between two foreign entities is settled on the books of a non-resident nominee, then no registration is necessary under the current legislation and the securities transaction tax is not realised. 4.3 SECURITIES DELIVERY IN THE RUSSIAN MARKETThe lack of an effective settlement infrastructure is the largest source of risk and illiquidity in Russia's emerging financial markets. With the exception of short-term state bonds (GKO's) and financial futures, settlement is altogether unconnected with the market where the transaction was executed. Even the rare exchange-based transactions in equities are settled by the brokers directly through the shareholder's registers. The three major ways to get securities delivery in Russia are described below. 1. Settlement directly through the shareholder's register: The register is kept by the issuer or by its appointed registrar; registrars often are affiliated with the issuer. Long trips across Russia to register share transfers at the issuer are common and add to investor expenses. Rules followed by registrars and their prices are different from issuer to issuer. Sometimes notarised copies of the incorporation documents and registration certificate from the country of registration are needed for a foreign shareholder to be entered into the shareholder register. It is always necessary for a foreign investor to issue power of attorney to its local representative in order to allow him to act on the foreign investor's behalf. Usually brokers provide registration directly in the client's name as one of the settlement options. Registration of the securities can be effected by the broker based on the presentation of appropriate documents giving power of attorney and other required documents from an investor. For more details on the required documentation, please see below. 2. Registration in the broker's name as a nominee owner: The broker can register securities purchased for the client in its own name as a nominee owner and perform safekeeping services for clients. In this case, the broker opens an account for a client and gives the client receipts confirming the status of this account. The client has the right to demand direct registration in its own name at any time. All dividend distributions are directed to the client through the broker and the client has the right to vote its nominee-held shares at shareholder meetings either directly or based upon a power of attorney given by the broker, depending on the corporate rules of the issuer. Registration through the broker can facilitate and accelerate settlement if the broker is itself a buyer or seller in the transaction. 3. Registration in the name of a third-party depository as a nominee: Several types of Russian and foreign financial institutions can act as depositories under the current Russian legislation. Nominee registration through a depository is effected in the same way as registration through a broker. The basic obligations of a depository are the same as for brokers. The first method of delivery -- through the shareholders register -- is the most reliable currently available in Russia; it is indeed the method which best guarantees property rights. All other types of delivery still leave an investor exposed to the registrar risks, which include arbitrary deletion from the register, dilution of the shareholders capital and delayed delivery of information on corporate actions. Conversely, registration through the nominee can substantially reduce travel risks and expenses, and also the risks of untimely settlement (in all cases other then deposit/withdrawal of shares). 4.4 CLEARANCE, SETTLEMENT AND CUSTODYIn the absence of a liquid and organised market, there exists almost no need for sophisticated clearance procedures in the Russian equity market. The market for state rouble-denominated debt instruments is so far effectively handled by the MICEX trading system. To date, there are only a few specialised domestic depositories in Russia offering settlement and custodial services. Russian banks are almost completely uninvolved in this business, although a growing number of them have declared their intentions to develop such services; the Russian banks are also large players in the market, and it will require time to build confidence in their operations. Several local specialised custodians have developed reliable services for the market participants. The USAID-sponsored Clearing and Settlement Companies (CSO) project is in the process of establishing regional CSO's in major financial centres such as Moscow, Saint Petersburg, Novosibirsk, Ekaterinburg and Vladivostok. The companies are designed to provide unified clearing and settlement procedures for all securities markets in Russia. It is not clear if or when these CSO's will become operational. The Moscow CSO, called the Depository and Clearing Company (DCC), is currently seeking ways to obtain capitalisation and the necessary legal status to receive American SEC qualification to service US investors. Though all CSO's are founded by the major local market participants (including the ten largest Russian brokerages in Moscow), the founders still have little or no trust in their operations and settlement typically goes through the shareholders' registers. Demand for custody services in Russia comes mostly from foreign investors. Domestic ones are not accustomed to custody services, and those required to use a custodian (voucher investment funds) almost always work through affiliated custodians. Currently, there are two models for custody operations in Russia. The first model is a nominee registration on the books of the issuer. A number of uncertainties arise in this case, including dividend processing and tax withholding, and registrar requirements for the documents supplied in connection with transfer. In addition to this, custodians are seldom prepared to take registrar risks. However, this model is implemented by a number of international financial institutions in Moscow, including CS First Boston and ING Bank. Both of them are also large market players and brokers, and they offer custody services only to their own clients. This means that the market is effectively restricted for their clients, and the clients have poor access to the quotations available in the Moscow market. The second model makes the custodian a go-between for the client and the issuers' registrars, but the name of the client appears directly on the books of the issuer. Based on the powers of attorney issued by the client, the custodian is initiating transfers in the register and receiving extracts confirming deliveries and current positions. This model is implemented by recognised global custodians, including the Moscow offices of Chase Manhattan and CITIBANK. Foreign customers also retain Moscow offices of international lawyers in this capacity, (such services are currently provided by Clifford Chance, Milbank Tweed, White & Case and some others); however, organisations of this type charge very high prices for these services. With reasonable care it is possible to find a local sub- custodian to perform the task. Several Russian institutions, including DCC mentioned above, or the RINACO Depository (one of the subsidiaries of RINACO Group), offer such services to domestic and foreign securities professionals, and are considered reliable counterparties. 4.5 DOCUMENTS AND REQUIREMENTSForeign investors willing to obtain shares of a Russian company with registration of the shares on the books of the issuer's registrar should provide to his broker (or to the custodian doing actual re-registration) a set of documents which comply with the requirements of appropriate governmental bodies and corporate registrars. The list below consists of the fullest possible set. Some registrars have more strict requirements, some less. It is best to contact your broker or local custodian to determine the requirements of the particular registrar. List of documents. 1.Incorporation Certificate (copy). This must be legalised by the Russian Consulate in the country of incorporation (some registrars will settle with a copy stamped by a corporate seal or just a photocopy if the original is shown to them). Instead of legalisation by Russian Consulate, it is also possible to supply apostille with a notarised translation in Russian (some registrars will settle without translation or notarisation); 2.Corporate by-law (copy and Russian translation). Both of these documents must be notarised and legalised at the Russian Consulate (again this is the most stringent requirements; most of the registrars will settle for less, some will be happy to have a simple copy in English on their file); 3.Power of Attorney. This should be provided in Russian (some registrars will be satisfied with English POA) for opening accounts with any registrar and further re- registration of shares to the name of the investor. Power of Attorney should be issued in one of the following forms:
Power of Attorney should feature:
It is preferable to issue several copies of such POA (every time a settlement is arranged, the broker will have to leave one POA at the registrar's office) to be kept on file duly signed and stamped, and issued for an extended time period with blank spaces for the name, passport data and signature specimen of the attorney, if it is issued to a natural person. Providing these documents to a broker in advance does not expose the investor to any risk of unauthorised conversion of its property since the POA gives very limited authority to a broker: it does not allow him or his agents to obtain any information about the accounts, get the statements of accounts, trade or transfer securities from the account, etc. If for some reason the investor does not want to leave the broker with such flexible documents, or for such an extended period, the POA documents can be arranged on a much more limited basis, specifying the particular registrar, the number of shares, the delivery terms, etc., which also has the name of the attorney and his passport data specifically spelled out and already in place, with a much nearer expiration date. This may cause a delay in the delivery of shares, however, and will certainly cause inconvenience to the broker, while giving little or no additional security to the client. EXTRACTS.If an investor wants to receive an extract (receipt) from the registrar's book certifying that its account has actually been credited with a particular number of shares, it has to add the additional clause to the POA enabling the attorney to obtain the extract. In this case, the investor will need to disclose to a broker or custodian the status of its account at the time of the transaction, but will benefit from having first-hand information on the counterparty's performance. Delivery of the extract to the investor can be arranged by fax or a courier service. 4.6 HOW TO MAKE A DELIVERYIf an investor is selling securities, he has several options to give in order to transfer shares out of his account:
To authorise a broker is technically the easiest way, but requires a certain degree of trust. Risks can be minimised by specifying the quantity of securities to be transferred (if the client is selling less than he owns) and by limiting the time to expiration of the power of attorney. Provision of the above documents in advance will allow the brokerage company to perform deals quickly and efficiently, thus minimising commissions and will allow the client to sell purchased shares more quickly. 5. MONEY ACCOUNTS AND CURRENCY TRANSFER
5.1 TYPES OF TRANSACTIONSCurrent legislation allows both rouble and foreign currency settlement of securities transactions between foreign and Russian persons. However, the legislation is not consistent, several provisions contradict each other, and it is expected that changes and clarifications will be made soon. Possible courses of development were described in the Section 1 of this Guide. If a Russian entity can provide off-shore settlement, it is done without notification to the Russian authorities and has no tax implications in Russia (with the exception of a securities transaction tax). It should be noted that Russian market professionals now offer off-shore settlement to their clients fairly often. The following description summarises possible ways of settlement in Russia, along with the pro's and con's of each method. All questions of off-shore settlement between two non-Russian counterparties are left out of the scope of this report. The current practices allow the use of the I-type rouble account or direct operation through the account of the broker. We can recommend using the domestic account of the broker in representing the investor's interests for as long as it is permitted by the legislation. a. Purchase of securities by a foreign entity. a.1. Foreign currency payment. The Russian banking system is rather developed, so that payment in a foreign currency can be sent directly to the account of a Russian counterparty within Russia. Additionally, almost all Russian professional market participants can accept currency payments from non-resident counterparties. For this reason, the non-resident investor does not need to open a foreign currency account on the territory of Russia. There exists a large uncertainty, however, as to whether or not Russian entities must obtain a special license from the Central Bank of Russia to sell Russian equity securities for foreign currency. The general practice is that licensed market participants are authorised to perform such transactions; however, regional brokers often experience difficulties with the receipt of foreign currency. (A special license from the Central Bank can be received, but the procedure takes several months and is completely inappropriate for the securities market, as it was designed for direct foreign investment.) This type of settlement is the fastest method. Moreover, because almost all prices are quoted in US dollar terms, there are no currency risks involved. Legality, though, is not entirely clear because of the licensing uncertainties described above. This puts significant legal risks with the Russian counterparty; therefore, this method of payment may be unacceptable to some Russian brokers, due to the opinion of the bank of local tax authorities. a.2. Rouble payment. This type of payment can be effected through an I-type account opened with the Russian bank. The procedure to open an I-type account is described in this section. All Russian counterparties can accept rouble payment. This way of payment is undoubtedly legal. In fact, the unquestionable legality of this type of money transfer is the single reason to use it. Opening an I-type account in Russia is a complicated process. The legislation is still very uncertain, with the major issue being how an organisation without a permanent representative office in Russia can open an I-type account. The latest instruction of the Central Bank allows for such an account, but this adds additional uncertainty to the absence of an exact definition of a representative office. Therefore, the risk exists that arbitrary determinations can be made, and foreign investors will be charged with tax claims as if they had representative offices. With a majority of the prices quoted in US dollars, the usual way to execute an agreement is to specify a dollar price and effect payment according to the exchange rate on the date of payment. Substantial risks can arise with the currency conversion. In some cases the purchase of roubles can be done without opening an I-type account through the broker's account at a Russian bank. In this case the brokerage agreement needs to refer to the sale of foreign currency. This method of settlement is heavily dependant on the degree of trust in the Russian broker. b. Sale of securities by a foreign entity. b.1. Foreign currency payment. When selling securities, the foreign investor theoretically can receive foreign currency from the Russian buyer. To make the payment, the Russian counterparty needs to present a copy of the purchase agreement to its bank, as well as the documents certifying payment of appropriate taxes (twenty percent withholding tax) or certification of a tax exempt status of an investor. Russian market participants are often reluctant to pay in hard currency, though. Current legislation can also ask a Central Bank license from the Russian counterparty; requirements for the issue of this license are obscure and practically non-existent. It is almost impossible to make a foreign currency payment from a Russian counterparty to a foreign entity through the account of a Russian broker, because of the prohibition on foreign currency transfers between Russian entities. 2.Rouble payment. Rouble payment can be received through an I-type account. All risks described in the making of rouble payments from an I-type account are also presented below. Transactions can also be settled through the broker's rouble account with foreign currency purchased later by the Russian broker through its bank on a currency exchange. In order to buy foreign currency on an exchange, brokers must provide their banks with the following documents:
If hard currency is already held in the broker's bank account (whether received directly or bought), such funds can be repatriated to an account specified by an investor. Hard currency residing in the account of a broker, but belonging to a foreign investor, can be transferred from the broker's account into a Russian bank, then to an account abroad. In order to effect such a transfer, the presentation of the following documents to the bank is required:
Requirements vary from bank to bank, and some banks may be unacquainted with operations of this type. Foreign investors should discuss the transactions to be effected with the broker and the broker's bank before entering into a brokerage agreement. c. Receipt of interest and dividend payments. Dividend and interest payments in Russia are commonly done in roubles (the only exceptions are foreign currency- denominated shares and promissory notes of some banks). The I-type account number of an investor or the account number of the broker should be given to the issuer's registrar. In both cases conversion to a foreign currency would be a necessary step in the repatriation of profits. 5.2 OPENING AN I-TYPE ACCOUNT IN RUSSIAN BANKSAccording to the instruction of the Bank of Russia "On the procedure of opening and maintenance by the authorised banks of non-residents' accounts denominated in the Russian currency", it is possible to open special I-type (investment) account for execution of investment transactions in Russia. According to the latest changes it is possible to open such an account without opening a permanent representative office in Russia. The major question is in the status of the persons authorised to operate the account: if some of them are present on the territory of Russia, it may qualify as an establishment of a representative office. One possible way of solving this problem is to issue power of attorney for the account management to the brokerage firm authorised to represent investor's interests in Russia, as is described in Section 2 of this Guide. The opening of an I-type rouble account in a Russian bank for a non-resident legal entity requires:
The bank, at its own discretion, has the right to require from an applicant additional documents, testifying to the non-resident's solvency. Currently, there are several Russian banks opening I-type accounts and providing reliable services. Among the foreign-owned banks, CITIBANK Moscow offers convenient services -- for a not insignificant price. Another bank with US capital, Dialog Bank, also provides I-type accounts. 5.3 OPERATING AN I-TYPE ACCOUNTThe instructions of the Bank of Russia have established general rules for operations through I-type accounts. Specific rules for operation are determined by the particular account agreement with the bank. All rouble payments associated with investments on the territory of Russia, as well as purchases of foreign currency for roubles received in connection with repatriation of profit from the investments on the territory of Russia, must be cleared through I-type accounts. Only one I-type rouble account can be opened in one of the Russian banks. It is important to note that non-resident banks cannot perform settlement in roubles for operations connected with foreign investments in Russia through their rouble correspondent accounts in the authorised banks of Russia. Only I-type accounts can be used for this purpose. It is prohibited to effect several types of transactions through I-type accounts:
Money can be sent to the I-type accounts only by wire transfer; cash withdrawals from I-type accounts are prohibited. 5.4 CURRENCY EXCHANGEForeign currency can be sold and purchased through the broker's account in its domestic bank or through the I-type account. According to the current Russian legislation, all foreign exchange transactions are to be executed on licensed currency exchanges or through interbank markets. If operating via broker, it is necessary to know through which bank the broker operates and what that bank's charges are. Traditionally, the Russian currency market has been the most strictly and conservatively regulated financial market in Russia. Regulations for the currency market are developed primarily by the Central Bank of Russia. The aftermath of October 1994's "Black Tuesday" saw the Central Bank further tighten currency market regulations. To date, six exchanges have been licensed -- in Moscow (MICEX), St. Petersburg (SPCEX), Novosibirsk (SICE), Vladivostok (APRCE), Rostov-na-Donu (RICE) and Yekaterinburg (URCE). Trading on these exchanges is executed with the direct participation of the Central Bank. Exchange rates from city to city are comparable, and MICEX is the principal exchange because its volume is several times larger than the regional exchanges. The MICEX carries out exchange transactions with US dollars and German marks. Only member banks have the right to trade on the exchange. Settlement between participants is carried out no later than the third banking day (taking into account holidays in Russia, Germany, and the United States) after the day of the transaction. Authorised banks can transfer money to client accounts earlier, if such a transaction is provided for in the client's contract with the bank. Today, major banks usually deliver currency or roubles to clients on a same day or next day basis. At present, the exchange fee on the sale or purchase of foreign currency on the MICEX is 0.1%. In addition, a special Moscow tax of 0.1% was established in 1994 for all exchange transactions; both of these are charged to both parties of a transaction. After the introduction of the Moscow tax, the market became less active and more transactions began to be carried out directly between the banks. Transactions are also often executed directly between banks and their clients, with the most recent MICEX exchange price serving as the benchmark. 5.5 HEDGINGNo legal environment for the derivatives market exists today in Russia. However, there is a rapidly developing self-regulated derivatives market in some areas based upon vague Russian legislation in other areas. There are currently several instruments available, some of which are traded on exchanges, while others are over-the-counter. Liquidity and cost differ widely. There is one major exchange where dollar futures contracts (other currency-based derivatives are almost non-existent) are traded: the Moscow Commodities Exchange (MTB). The average daily turnover of the market is twenty-five to thirty million US dollars and total open positions total fifty to seventy million US dollars. The contracts are of $1,000 and $5,000, and expire monthly; contracts can be opened nine months out. There are many brokers offering services at the MTB and it is not difficult to find a reliable bank or a large brokerage house with competitive rates and market access. Several other exchanges exist with much smaller volumes. MICEX has announced the upcoming start of derivatives trading. This marketplace has the potential to become a major market in Russia, because all major banks are members of MICEX. However, major banks are also involved in MTB trading, so it is difficult to make any predictions about the future of this market now. Another Moscow exchange, the Moscow Central Stock Exchange allowed some brokerage firms affiliated with the management of the exchange to make illiquid margin deposits, which resulted in the failure to honour $7.5 MM worth of contracts and halted trading for over one month. It has re- opened its doors, but with significantly reduced volume. The OTC market consists of more elaborate transactions in dollar options and some swap contracts; other exotics have also been reported. The expiration date for a custom-made OTC contract is agreed to specifically by the parties. However, the contracts will generally not exceed six months given the excessive risk involved for either of the parties in the current environment. Counterparty reliability and credit risk are the most difficult questions concerning today's derivatives market; with OTC trading, the credit risk of a contract equals the credit risk of the parties involved, so traders should review their counterparty's balance sheet and off-book liabilities. With exchange- traded futures, the situation is more complicated as the parties must assess the credit risk of participants and of the clearing house. The capitalisation of existing clearing houses is usually very low. 
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