International finance centers play a significant role in Russian foreign direct investment (FDI). For example, in 2012 it was observed that 11 of the 40 main recipients of Russian FDI were IFCs. Of these finance centers, the largest recipients were the BVI, the Cayman Islands and Cyprus.
Despite the popularity of these IFCs in Russia, there has been little serious analysis as to why such IFCs have been used to structure FDI into and out of the Russian Federation. In fact, most discussion about the role of IFCs in Russia has come from the more lurid style of journalism, rather than arising from objective analysis.
Discussion has focused on isolated and sensational stories, rather than general patterns of investment. Drawing on my recent article on The Role of Offshore Jurisdictions in the Russian Law Journal, the leading English language legal publication in Russia, I explore here some of the issues surrounding IFCs and Russia.
Common narratives about IFCs
We so often see Russia and IFCs discussed in terms of corruption, secrecy, tax evasion and capital flight, that we are minded to accept it as true. Over time, the constant repetition of these messages leads us to simply accept the mantra. However, if we look closer, these assertions simply do not stand up to close scrutiny.
For instance, after reviewing the pre-existing academic research on this subject, it became clear that such studies were clearly tinctured by bias and failed to test or validate their own operating assumptions about the actual use of IFCs. In a sense, most academic research on the use of IFCs in Russia is based on value judgments rather than objective analysis.
To move the discussion to the evidence, I conducted a study of all cases that related to Russia and came before the BVI courts. After all, if corruption was a valid issue, it should be raised before the courts for judgment. The court judgments revealed that claims relating to fraudulent, dishonest or unlawful conduct were raised in 17 percent of all cases and were not proved to the satisfaction of the court in any case. As a result, there was no factual support for such claims.
If then, there are few facts to support the traditional narratives of why IFCs are popular in Russia, the question then arises as to why they are used in practice. The answers can be found by looking to the legal rationale for using IFCs.
The legal context
Recent Russian history has been characterized by periods of political and economic instability. The Russian legal framework has offered little to offset this instability, with undeveloped corporate laws, weak enforcement mechanisms, an inexperienced judiciary, and little concept of corporate governance. As a result, investors in Russia had to consider legal and political risk, how to protect assets and how to enforce property rights.
In the face of an uncertain investment environment, investors turned to the legal certainty and solutions offered by IFCs, which could offer more supportive institutions and a clear, tested code of commercial law. By incorporating offshore, investors could rely on common law rights and remedies, thereby gaining access to Western principles of corporate governance, and could structure co-investments in ways that were not possible under Russian law.
In addition, by incorporating in an IFC as opposed to other common law jurisdictions, Russian investors could avoid the higher costs, taxes and more cumbersome regulations associated with developed common law jurisdictions, such as the U.K. and U.S. As a result, IFCs could offer greater cost, legal and regulatory efficiencies and Russian entrepreneurs could focus on creating business, rather than being bound by the costs of complying with innumerable and often irrelevant regulations.
The use of IFCs
In order to understand the way in which IFCs were used by Russian investors, it will be instructive to look at some examples of the way in which IFCs offered legal and practical solutions. Three key reasons can be seen in the ways that IFCs are used and these are: asset protection; access to capital; and the protection of shareholder rights.
In terms of asset protection, IFCs have been used to protect assets against the risk of expropriation by unscrupulous business partners or the government, or to protect family assets from dissipation through the use of trust structures. IFCs were chosen given that Russian law was, following the collapse of the Soviet Union, characterized by uncertain property rights and inadequate enforcement remedies to protect against expropriation or dissipation. In addition, as a civil law jurisdiction, there was no concept of trusts, which limited the potential range of solutions for preserving wealth and assets.
In terms of access to capital, Russian investors have preferred to use IFCs to raise capital, given the structural problems in Russia, which has been characterized by political instability, high taxes, an insolvent banking system and the weak protection of property rights. In contrast, IFCs offer well regulated, stable and mature legal and financial systems where deals could be structured without excessive cost.
In addition, international lenders preferred to lend to companies incorporated within IFCs as they were familiar with such entities and could take comfort that any security over their assets would be capable of enforcement before recognized courts under a predictable system of law.
In terms of shareholder rights, IFCs have been used to take advantage of the shareholder rights and remedies available under common law jurisdictions. This was of particular importance to Russian investors, given that Russian law had historically refused to recognize shareholder agreements and did not provide for common provisions relating to share transfers, restrictions on the sale of shares and corporate governance provisions relating to board appointments and voting. As a result, Russian investors preferred to incorporate in IFCs, where they could rely upon common contractual and statutory provisions relating to shareholder rights and take comfort in the fact that such rights were enforceable.
Since my earlier article, various legal changes have occurred in Russia and the international investment environment which merit consideration.
In the past year, Russia has been subject to specific and targeted sanctions and the Russian government has brought into force new “de-offshorization” laws. It is still unclear whether these changes will have any effect on the role of IFCs within Russia, although the author’s view is that they are likely to have a very limited impact. The sanctions are limited in scope and relate more to targeted political objectives than general commercial activity, although the sanctions have had a wider market effect, impacting on the value of the ruble and reduced investment. The de-offshorization laws are primarily focused on tax matters which concern controlled foreign corporations (CFCs).
As has been discussed, the role of IFCs relates to much more than tax, and this holds true for any jurisdiction, given that CFC laws in other jurisdictions have failed to dent the popularity of IFCs globally. It appears that stability, predictability and justice are the key drivers for the use of IFCs, rather than the popular narratives about tax and secrecy.
The wider discussion
What is interesting is that the findings outlined above are widely understood in the Russian financial community, where the legitimate role of IFCs is beginning to be discussed more openly.
For instance, in a recent interview with the Russian International Affairs Council, the Russian lawyer and entrepreneur Alexander Rappoport observed that “our legislation, including the corporate one, has a lot of serious flaws. I think that our offshoring is largely due not so much to economic conditions as to legal aspects. People went offshore not for tax evasion…but because the legal framing left much to be desired.”
It is therefore clear that the nature of debate about the role of IFCs can change. In fact, the debate must change, because it is clear that journalists have had the monopoly on discourse up to this point, but this monopoly has been based on poverty of analysis and paucity of fact. It is our role, as professionals and as custodians of our common law traditions to make a positive case for the role of IFCs.
The author hopes that this paper, along with other articles in the field (of which there are a growing number, a notable example being the recent paper by Gordon & Morriss, Moving Money evidences a change in the nature of discussion about the role of IFCs in the international financial system.
It is also hoped that tired narratives about tax evasion and secrecy can now be dispensed with, and the focus will turn on the legitimate role and stability that IFCs bring.