BUSINESS ON SAKHALIN
and Control of Joint Venture Companies
Sakhalin Energy Investment Company (SEIC) and Exxon Neftegas Limited
(ENL) are obligated under their Production Sharing Agreements (PSAs)
with the Russian Government to use at least 70 % Russian materials and
services (Russian Content) in the construction and operation of their
In many cases both SEIC and ENL are requiring contractors to meet the
Russian Content requirement as a condition to qualifying to bid on their
Bidders for both SEIC and ENL
contracts are faced with the requirement of forming a bidding company
whose shares are at least 50% owned by Russian shareholders. The usual
corporate form to comply with the 50% Russian ownership requirement is
the formation of a Russian
limited liability company or LLC (sometimes known by its Russian
initials as an “OOO”). One of the principal issues confronted by the
non-Russian shareholders in this situation is how to deal with the issue
of control and direction of the 50:50 joint venture company. In our
experience there are three main approaches to this question.
Mutual Sharing of Control
Russian law governing the formation and operation of LLCs is relatively
extensively detailed and sets out a number of requirements that cannot
be varied by the parties. One of the fundamental rules is that the
requirements of Russian law cannot be varied by an agreement between the
shareholders that attempts to override the obligatory provisions of
Russian law. The type of Shareholders Agreement often used in the United
States and England in which the shareholders agree in advance on the
division of seats on the Board of Directors, on the selection of the
Managing Director, and on the budgeting and financing of future
operations of the LLC has frequently been found by Russian courts to be
unenforceable. Russian law
requires that these issues remain open for review and decision by the
shareholders at the yearly meeting or at the times established in the
The standard Russian LLC with relations between shareholders
subject to review and decision at regular shareholder meetings is
probably best suited for a situation where the Russian and foreign
parties are making equal contributions to the management and operations
of the joint venture company. Both parties will look to Russian company
law to regulate the mutual control features of their joint venture.
should be noted, however, that Russian custom and tradition gives
substantial authority to the Managing Director of a Russian LLC.
Although the authorities of the Managing Director can be limited
by the bylaws and by narrow delegations of authority from the
shareholders or the Board of Directors, much operational discretion will
still rest with the Managing Director. The choice of this officer will
be a major decision for the joint venture partners.
Disproportionate Control Via Management Agreement
One of the classic solutions used
in situations where the foreign shareholder is in fact providing a
disproportionate part of the financing and expertise of the LLC is to
have the shareholders unanimously agree in the charter of the LLC that
the management functions of the company will be contracted to a third
party. A Management Contract
between the LLC (usually approved by unanimous vote of the shareholders)
and the foreign shareholder conveys operating responsibility on the
foreign party. The
Management Contract can be for a definite or indefinite period, and can
be drafted to allow for termination only by decision of the shareholders
(where a 50:50 structure could block any decision in which the
shareholders are divided) or for breach by the management company, which
would require a final court decision that such a breach had occurred.
of control under a Management Contract does not remove all aspects of
participation by the Russian partner.
Russian company law requires that changes in the structure of the
LLC such as decisions to amend the Charter, to increase or decrease
authorized capital, to reorganize or liquidate, and to pay dividends are
in the exclusive competence of the shareholders and cannot be delegated
through a Management Contract. One additional technique used to address
a situation where there is an imbalance between the contributions of the
two partners in a 50:50 joint venture is to create different attributes
to the shares held by each partner, for example, by establishing that
the shares held by the partner making the disproportionate contribution
are entitled to a greater percentage of dividends.
In general the solution to the
problems associated with disproportionate contributions by the partners
is to address the issues presented through structures permitted by and
consistent with Russian company law, rather than to attempt solutions
through the use of standard U.S. or English style Shareholders
Agreements which run the risk of being ruled unenforceable by Russian
Through Two Tiered Structures
The third approach to the issue of control
is to create a Russian structure that avoids the participation of a
local partner. For this
purpose it is necessary to incorporate two Russian companies.
For example, Company A is established as a Russian LLC and is
100% owned by foreign shareholders.
Company A then incorporates a Russian subsidiary, Company B, that is
100% owned by Company A.
Company B is eligible to bid on Sakhalin
I and II projects because it is a Russian company, the shares of which
are 50% or more owned by a Russian shareholder.
Although this structure has been found to meet the legal
requirement for Russian Content,
it also results in the creation of two companies both subject to the
payment of Russian taxes on their operations.
There are obviously advantages and
disadvantages to each of these three approaches.
The choice will depend on an assessment of all the circumstances
involved in each tender offered by SEIC and ENL.
Relevant issues will include: Will the services required be
performed in Russia or offshore?
How much of the required work will be subcontracted?
To which partner?
What will be the resultant cash flow and tax structure?
The control issue will be an important -- but not the sole --
factor determining the structure of the Russian LLC.
There is no easy solution to cost overrun
issues. The enforceability in Russian courts of an agreement between
joint venture partners in which they obligate themselves, if required,
to increase their contributions to the capital of the joint venture
company is questionable, since it can be argued that these obligations
violate the principle that the shareholders of a Russian LLC are only at
risk for the original amount of their paid-in capital. It is also
doubtful that Russian courts will enforce the typical cost overrun
provision that requires the partner who fails to provide additional
financing to agree in advance that the share ownership of the Russian
LLC will be increased by the amount of the additional contribution from
the other partner. Faced with the enforceability of such a provision, it
is likely that a Russian court will rule that a decision on the increase
of share capital can only be made at a meeting of shareholders called to
approve the actual increase, and that the shareholders cannot be
obligated to approve such increase by contract in advance of the actual
Russian law will permit one of the partners
to provide additional financing through a loan to the joint venture
company, and the loan will be enforceable against the Russian LLC.
However, changes in the proportion of share ownership or in other
aspects of the structure of the LLC cannot be determined by Shareholders
Agreement in advance and will require the decision of all parties at a
shareholders meeting called to specifically approve the proposed
Regrettably there is significant distrust of
the fairness and evenhandedness of Russian courts among both foreigners
and Russian citizens. As a result, many contracts involving agreements
between Russian and non-Russian parties call for arbitration of disputes
outside of Russia. The Russian Federation adheres to the New York
Convention on the Enforcement of Arbitral Awards,
however, the record in
for enforcement of foreign arbitral awards without independent
reexamination by Russian courts is spotty at best.
In addition to enforceability questions the
process of obtaining a foreign arbitral award and then requesting
enforcement in Russia is likely to be both more
time consuming and less effective than seeking redress for grievances
directly from a Russian
One of the distinctive features of the
Arbitrazh Court system is the availability of
pre-trial injunctive relief which can often spell the difference between
immediately stopping a partner’s violation of shareholder rights and
waiting for the enforcement of a final foreign arbitration award.
Unfortunately I cannot yet report to you on
the decisions rendered by Sakhalin
courts on the enforcement of foreign arbitral awards. To our knowledge
there have not been decisions by Sakhalin
courts on this issue.
Russian Labor Law, Employment Contracts, Overtime, “Extreme North”
Employment Law and Employment Contracts
The Russian Labor Code expressly provides
that its terms apply to labor issues involving foreign persons and
foreign legal entities. The labor relationship of a non-Russian citizen
employed by a foreign company to provide services in Russia will be
governed by the Russian Labor Code. The key to the applicability of the
Code is the place of employment. If the employee is rendering services
the Code is applicable. Other provisions of the Code make unenforceable
any employment agreement provisions that contradict obligatory
provisions established by the Code, including any agreement that
attempts to make the law of another jurisdiction applicable to the
employment relationship. Contractors and subcontractors on PSA projects
who use foreign employees for services in Russia
must understand that their ex-patriot employees, even though hired under
contracts governed by the law of their home jurisdiction, are entitled
to all the pro-employee benefits provided by the Russian Labor Code.
The Labor Code generally restricts the use
of overtime employment to a very limited set of emergency circumstances
faced by the employer, such as the making of emergency repairs to gas,
heating electric and other public services or when work is required “…to
prevent a catastrophe, an industrial accident or to undertake remedial
actions after catastrophe, industrial accident or environmental
The Code requirements permitting overtime services are very restrictive
and do not allow employers to use overtime for such usual purposes as
meeting contract or other non-emergency deadlines.
Important flexibility is provided, however,
through the Russian concept of the “Non-fixed Work Day” and through
seasonal adjustments to the work day, The Non-fixed Work Day is used by
many private and governmental organizations to provide the type of
additional time flexibility that is needed to meet deadlines and extra
work requirements. While sanctioning the general concept of the
non-fixed work day, the Labor Code is largely silent on its detailed
implementation. In practice most employers negotiate the terms of the
non-fixed work day in written employment agreements with designated
employees. Under such
agreements employees are not subject to the eight hour daily or forty
hour weekly time limits; they may be required to stay at work beyond the
standard work day or to begin work earlier than the usual opening hour,
provided these non-standard hours are used only “occasionally.” For
construction work the use of the non-fixed work day allows the employer
to set the hours of work in accordance with actual construction needs.
The usual practice is for the employer to divide his employment roster
between persons employed on fixed schedules and those employed under the
non-fixed work day concept.
The extra hours worked by non-fixed work day
employees, however, are not considered overtime work, and they are not
separately compensated. Instead the employer and employee agree in
advance to the total compensation to be paid per month under the
non-fixed work day agreement. This agreed compensation is deemed by the
Labor Code as compensation for the full service rendered, although the
employer has the right to make bonus payments at its discretion. The
only additional benefit required by the Code is that the employer must
provide additional vacation time to the employee in the amount they
negotiate in the employment agreement, but not less than three calendar
days in addition to the statutory vacation time.
The Labor Code also permits the employer to
adjust the work day seasonally so as to require a longer work day in the
daylight hours of summer balanced by shorter work days in the winter. So
long as the total of work per year does not exceed normal quantity of
working hours established by the Labor Code,
no overtime pay is required.
“Extreme North” Conditions
Under the Russian labor law the
entire island of Sakhalin
is considered to be a hardship zone, and all employees are entitled to
special benefits as a result of working in hardship conditions. The law
distinguishes areas on Sakhalin classified as “approaching” the Extreme
North (the city of Yuzhno-Sakhalinsk is
included in the “approaching” category) and actual Extreme North areas
(the towns of Nogliki and Oha, for example). The major benefit to
employees is increased salary and vacation allowances.
Salaries in Yuzhno-Sakhalinsk are increased by coefficients
amounting to 2.1 times base salary, and in Nogliki and Oha the
coefficients amount to 2.6 times base salary.
In labor agreements with employees working on
Sakhalin it is important to break down the total amount of
compensation and to separately show the calculations for base salary,
area coefficients and seniority increases.
Failure to do so can result in a court ruling that the employee
is entitled to receive these hardship benefits in addition to the stated
salary. The result could entitle the employee to receive from 10 to 60
percent of total compensation as additional hardship benefits.
An employee working a standard
40-hour week in Yuzhno-Sakhalinsk is entitled to 16 calendar days of
vacation in addition to the standard 28 calendar days required for all
employees. In the cities of
Nogliki and Okha the employee receives an additional 24 calendar days
above the required 28.
Other Laws and
Regulations Affecting Contractor/Subcontractor Operations
Applicable to Expatriate Employees
The Russian Tax Code provides that foreign
individuals resident in Russia will be subject to a flat 13% income tax
on all compensation received for their services in Russia. A resident is defined as any
person spending 183 days or more in Russia during 12 successive months.
Under recent changes foreign employees working in Russia as Highly Qualified
Specialists are taxed at 13% from the beginning of their work in this
rank. This lower tax rate is also applicable to all Russian employees.
The Tax Code now also requires,
however, that persons spending less than 183 days on Russian territory
are subject to withholding and payment of income tax at a flat 30% rate
on income received for the time spent in
Russia. This provision appears to apply
even where the expatriate employee is employed by an offshore company
and is paid in foreign currency at an offshore bank. The key question
triggering Russian income tax liability is whether the expatriate
employee receives compensation for services rendered on Russian
territory. This requirement, however, is not reconciled with the
practical question of how an offshore company not registered for tax
purposes in Russia is to withhold and pay such
employee’s Russian tax. No
regulations have yet been issued by the tax authorities on this point.
Work Permits for
Article 18 of the Russian Law "On the Legal Status
of Foreign Citizens” establishes requirements for obtaining work
invitations and work permits in
Law provides that the government will establish an annual quota
stipulating the number of expatriates who will be allowed to work in
for 2010 was 611,080 work invitations; for 2011 it was 499,650; and for
2012 it is 460,510. The trend is to reduce the number of permitted
foreign employees. However,
the quota is not applicable to foreigners who qualify as Highly
Qualified Specialists, which designation can usually be acquired by
expatriates employed at an annual salary higher than Rubles 2,000,000.
invitations and work permits for expatriates working in Russia are
issued by the Federal Migration Service or its territorial bodies. The law contemplates that
for each work invitation the employer will make a security deposit with
the Federal Migration Service covering the costs of return
transportation from Russia
to the employee’s home country.
However, as currently interpreted, the deposit can be avoided by
providing a guarantee letter from the employer for home transport
expenses. Employers can only obtain work invitations and work permits
for expatriate employees with whom they have direct employment
This paper attempts to outline the principle requirements for the
topics addressed which are likely to be relevant for companies planning
to provide contract services to the operators of the
Sakhalin I and II projects.
In order to provide a general overview, the paper necessarily
simplifies and in some cases omits dealing with many of the requirements
and considerations which will affect any specific transaction.
© Russin & Vecchi, L.L.C.
by Jonathan Russin, Managing Partner of
Russin & Vecchi LLC, at the 2012
Sakhalin Oil & Gas
and updated in accordance with current
legislation of the
as of September 2012.
slight differences in the definition of
Russian Content in the two PSAs;
however, the differences are not
material as far as the obligations of
contractors to meet Russian Content
requirements are concerned.
instances ENL has accepted bids by
companies incorporated in
but 100% foreign owned.
We understand, however, that
these are considered to be exceptions
from ENL’s general 50% Russian ownership
The use of
an offshore company with 50% Russian
ownership is also permitted; however,
Russian companies and individuals are
restricted in investing in companies
outside Russia, making the use of an
offshore joint venture more theoretical
changes were introduced to the Limited
Liability Companies Law in July 2009,
and the Law now expressly permits the
use of Shareholder Agreements to define
However, the interpretation to be
given by the courts to the application
of this provision remains uncertain. We
recommend that any provision in a
Shareholder Agreement that might be
challenged as a limitation on the
general rule that shareholder decisions
must be taken pursuant to the voting
procedure established in the company
charter should be viewed as vulnerable
to possible adverse court action.
Charter of the LLC may grant the right
to make a decision on specified
questions to the Board of Directors.
(See art. 33 of the Federal Law “On
Limited Liability Companies.”)
disadvantage of this solution is that
the corporate profit tax rate (rather
than the dividend tax rate) will be
applied to that part of the dividend
that exceeds the proportion of shares
established by the charter.
8 In this
situation Russian company law requires
that one of the two Russian companies
have more than one shareholder.
and SEIC were originally satisfied that
the two tier option met the Russian
Content requirements of their respective
ENL, however, has recently
changed its position and now requires
that the ultimate beneficial owner of at
least a 50% share be Russian.
judgments, as distinguished from
arbitral awards, are only enforceable
where the issuing country and Russia are
signatories to treaties providing for
enforcement of court judgments, or where
it can be proven to the satisfaction of
the Russian court considering the
request for enforcement that reciprocal
enforcement is available for Russian
court judgments in the country where the
judgment was granted.
should not be confused with private
arbitration. The Arbitrazh Courts grew
out of the Soviet system for resolution
of disputes between State enterprises,
and these Courts today have jurisdiction
over most commercial disputes between
Labor Code of the
According to art. 91 of Labor Code normal duration
of working time cannot exceed 40 hours
Labor Code, Article 104. Even in these emergency
cases, the worker must consent to the