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Typical transaction structures – public companies
What is the typical structure of a business combination involving a publicly traded real-estate owning entity?
Like in most other jurisdictions, there are two commonly used structures of real-estate-related business combinations in Russia: an asset deal (direct acquisition of real-estate properties) and a share deal (indirect acquisition of real-estate properties through acquisition of a share in an owner of the properties).
An asset deal is simpler and less risky but more expensive due to tax implications (VAT). A share deal is more cumbersome (among other things, due diligence of the real estate owner is needed and, in some cases, antitrust clearance is required) and riskier (risks inherent in the owner are added to the risks of the real estate), but less costly (share deals are VAT-exempt).
In addition, the real-estate transaction may take the form of a statutory merger (an absorption or a combination).
Typical transaction structures – private companies
Are there are any significant differences if the transaction involves a privately held real-estate owning entity?
The answer was not available at the date of publication.
Typical transaction process
Describe the process by which public and private real-estate business combinations are typically initiated, negotiated and completed.
As with most other transactions, the first step in entering into a real-estate-related business combination is negotiation and execution of a mostly non-binding term sheet or a similar document (a letter of intent (LoI), heads of agreement, a memorandum of understanding (MoU), etc) that grants the purchaser an exclusivity period to make the feasibility study and conduct due diligence on the target.
Subject to a successful purchaser’s due diligence, the parties negotiate transaction documents (a sale and purchase agreement and other documents, if applicable). Key provisions of the deal are closing mechanics together with warranties and indemnities (new instruments for Russian law, but already widely used).
Law and regulation
Legislative and regulatory framework
What are some of the primary laws and regulations governing or implicated in real-estate business combinations? Are there any specific regulations or laws governing transfers of real estate that would be material in a typical transaction?
Business-related real-estate transactions are regulated by the Civil Code and other laws containing provisions on the turnover of real estate adopted in line with the Civil Code. Other codified Russian statutes that regulate real estate status and transactions include the Land, Forest, Water, Housing and Urban Development Codes.
The transaction of real estate is also regulated by a range of federal laws, primarily, by the new Federal Law No. 218-FZ of 13 July 2015 on State Registration of Real Estate, which came into force on 1 January 2017 (the Registration Law).
The Registration Law establishes the procedure for legal acknowledgement and confirmation by the state of the emergence, change, transfer, limitation (encumbrance) or termination of titles to real estate. According to the Registration Law, real-estate property rights and cadastre registration systems have been united into a unified real-estate registration database to simplify the registration procedures and avoid discrepancies. In addition, the Registration Law provides for shorter periods of registration procedures and establishes an extraterritorial registration approach (which means that registration of title may be performed in any region of Russia, regardless of the location of the real estate).
Residential and agricultural real-estate assets are subject to specific regulation that is established by a range of federal laws.
Agricultural land transactions are regulated by a special law that establishes a range of restrictions on the procedure for obtaining agricultural land property rights and shares of ownership rights to agricultural land (land shares). As an example, the law determines a limited range of persons who have the right to acquire a land share without an apportionment procedure. One of the main criteria for obtaining agricultural land shares is the use of a land plot in shared ownership.
The Housing Code of the Russian Federation together with the Civil Code of the Russian Federation determine specific regulations for transactions with residential assets, such as additional material term of the purchase contract that is the list of the persons who, by operation of law, retain the right to enjoy property after sale, with their rights indicated.
Russian legislation does not clearly define the concept of commercial real estate and does not establish special regulations in respect of commercial real estate. So the common rules of the Civil Code of the Russian Federation and the Registration Law are applied to the transactions with commercial real estate. However, there are some differences in the use of commercial real estate, such as a more complicated procedure of concluding contracts for public utilities, a different tax regime, of which should be taken into account during negotiations and the structuring of the transaction.
Cross-border combinations and foreign investment
Are there any specific material regulations or structuring considerations relating to cross-border real-estate business combinations or foreign investors acquiring an interest in a real-estate business entity?
Russian law establishes the following restrictions in relation to ownership of real estate:
- foreign nationals and legal entities, in which more than 50 per cent of authorised capital is owned by foreign individuals and companies, may only lease agricultural land;
- foreign nationals and legal entities are not permitted to own land in seaports; and
- foreign nationals and legal entities are not entitled to own land located near borders.
As for the rest, foreign nationals and legal entities are free to acquire and own any other real estate in Russia. There are no requirements to comply with special procedures.
There are also some limitations in relation to acquisition of assets by foreign investors.
The acquisition of shares constituting the authorised capital of a legal entity having strategic significance and engaged in the use of subsoil of federal importance is subject to the prior consent of the Federal Antimonopoly Service, if, as a result of these transactions, a foreign investor or group of persons will acquire the right, directly or indirectly, to dispose of 25 per cent or more of the total number of votes attributable to voting shares that constitute the charter capital of such a legal entity.
Legal entities having strategic significance are those involved in:
- aerospace security;
- geological study;
- prospecting and extraction of minerals;
- extraction of aquatic biological resources;
- production of weapons, ammunition and their component parts, and explosive materials; and
There are restrictions and limitations in relation to the activity of insurance foreign-funded companies.
Finally, there are limitations in relation to the acquisition of shares in companies acting in the banking sector. The Bank of Russia has the right to impose a ban on increasing the charter capital of a credit institution at the expense of foreign investors and the alienation of shares in favour of foreign investors, if this results in the excess of quota determined by the Bank of Russia for participation of foreign investors in banking institutions.
Choice of law and jurisdiction
What territory’s law typically governs the definitive agreements in the context of real-estate business combinations? Which courts typically have subject-matter jurisdiction over a real-estate-related business combination?
According to general provisions concerning the law governing rights in rem, the content of a right of ownership and other rights in rem relating to immovable and movable property, the exercise and protection thereof are determined according to the law of the country where such property is located.
The emergence and termination of a right of ownership and other rights in rem relating to property are determined by the law of the country where such property was located, as of the time when the action was committed or another circumstance occurred that served as a ground for the emergence or termination of the right of ownership or other rights in rem, except as otherwise required under law.
Real estate disputes in Russia are resolved by either state commercial litigation courts, which are entitled to consider disputes in business relations, or by courts of common jurisdiction, which deal largely with individuals.
According to Russian procedural law the only proper court for to hear real-estate disputes is a court in the real estate’s location. However, if a dispute arises not out of rights to real-estate property, but out of an agreement stipulating rights and obligations of the parties, such a dispute may be brought before a court agreed by the parties.
Approval and withdrawal
What information must be publicly disclosed in a public-company real-estate business combination?
It is not that common in Russia to conduct real-estate-related business through a public company. Investors still cannot afford a sufficient level of transparency to successfully develop the real-estate business through public companies: the latter are subject to stricter reporting and disclosure obligations. In practice, a real-estate business is more frequently owned through a public company that is a result of the privatisation of a former state-controlled company that existed under the Soviet Union. This is especially true where employees are entitled to acquire shares of such company that significantly hampers aggregation by investors of more than 95 per cent of the entire share capital to activate procedures of squeezing out minority shareholders.
The legal definition of a ‘public’ company was introduced into Russian law in 2014. A public company under Russian law is any company whose shares or other securities are offered to an unlimited number of persons and not only one that lists its shares on a stock exchange.
Disclosure obligations of the public company are not business specific. In principle, an issuer shall disclose facts that could significantly impact the price of its shares. Approval of a statutory reorganisation (such as a merger or a spin-off) and of a ‘major’ transaction are specifically named in the regulations among many other corporate events that must be disclosed. Such disclosure shall take place on a day following the day when the respective event occurs save that details of a pre-approved transaction may not be disclosed until such transaction is executed.
A ‘major transaction’ is one transaction that exceeds 25 per cent of the balance sheet value of all the assets of the issuer, and also any other transaction referred to as such in the articles of association of the public company. Major transactions below 50 per cent of the assets’ balance sheet value fall under the competence of the board of directors, whereas major transactions of greater value are considered by shareholders. It often happens in practice that the balance sheet value of real-estate assets becomes very low over time due to amortisation, even though disposal of such assets could materially affect the business. To protect shareholders from leakage of company assets and from the subsequent impairment of their investments, it is quite common in Russia to expressly extend a list of major transactions in the articles of association of the company by supplementing such a list of transactions with real-estate objects irrespective of their value.
If a transaction is structured as a share deal it is also relevant that acquisitions and divestments of material shareholdings in a public company (more than 5, 10, 15, 20, 25, 30, 50, 75 or 95 per cent) shall be notified by a shareholder to both the financial mega-regulator (the Central Bank of the Russian Federation) and the issuer within 10 days following the transfer of shares, and the latter is obliged to disclose such facts without delay.
Moreover, a chief executive offer and members of the board of directors as ‘insiders’ shall pursue the higher standard of the disclosure and shall notify the financial regulator and investors (through the issuer) about disposal or acquisition of any number of shares of the issuer.
A transfer of participation interests in a limited liability company (LLC) is fully transparent as it is registered in the public register (the Unified State Register of Legal Entities) to become effective.
A high degree of privacy could be procured if the real-estate transaction is structured as a sale of shares of a non-public joint-stock company. Transfers of shares in such companies are recorded on a confidential basis by professional registrars or custodians and are not publicly notifiable.
As far as an ‘asset’ deal is concerned one should note that it is easily traceable via a search in the public register as a transfer of title to real estate is recordable in the Unified State Register of Real Estate and is deemed effective only when it is registered there. The register reflects the names of former and current owners, tenants and mortgagees.
Duties towards shareholders
Give an overview of the material duties, if any, of the directors and officers of a public company towards shareholders in connection with a real-estate business combination. Do controlling shareholders have any similar duties?
Members of the board of directors and a chief executive officer are bound by statutory duties to act reasonably and in good faith in the interests of a company. If they fail to fulfil their duties, the company or shareholder holding more than 1 per cent in aggregate in the company may bring an indirect claim against any director to recover damages caused to the company.
A shareholder, even if it holds a controlling stake in a company, does not owe any similar duties towards the company, save that it has a general obligation to exercise its rights towards the company in good faith and not with the sole reason of oppressing interests of the company or other shareholders. However, the controlling shareholder could be held jointly and severally liable with the company for any damages to a third party caused by a transaction entered into under the directions of the controlling shareholder. Moreover, other shareholders of the company are entitled to claim damages caused to the company due to the fault of the controlling shareholder.
The controlling shareholder of an insolvent company may be held liable to creditors of such company on a subsidiary basis if the company fell into bankruptcy due to the fault of such a shareholder.
To balance the interests of shareholders and of shareholders and the company, Russian law (as amended in 2014) introduced two new concepts of resolving corporate conflicts. A shareholder of a non-public company could be expelled from the company by the court at the initiative of other shareholders if the shareholder so hampers the business of the company that it cannot continue running its business. If shareholders of a company face a deadlock situation where, for instance, they cannot agree on the candidacy of a chief executive officer or on any other matter material to the continuation of the company’s operations, any shareholder may require liquidation of the company through the court.
What rights do shareholders have in a public-company real-estate business combination? Can parties structure around shareholder dissent or rejection of a real-estate business combination, and what structures are available?
Shareholders holding shares of the same type (eg, ordinary voting shares) enjoy equal rights in relation to each share of such type. The scope of rights is not dependent on whether an issuer is a public or private joint-stock company. A voting ordinary share provides to its holder, among others, the right to vote at shareholders’ meetings and the right to information.
If the real-estate transaction is structured as a statutory merger and shareholders have sufficient votes, they can block approval of such transaction at a shareholders’ meeting. The same result could be achieved if, by operation of law or the articles of association of the company, a sale transaction were approved by shareholders at the level of a shareholders’ meeting. Both a merger and a major transaction must be approved by a supermajority vote of shareholders, which is 75 per cent of all shareholders participating in the voting, provided that more than 50 per cent of all votes are registered for the voting.
Shareholders that voted against or did not vote on a merger or a major transaction if the value of such major transaction is more than 50 per cent of the balance sheet value of all assets of the company are entitled to sell their shares to the company at a price determined by an independent valuation.
Not much can be done by the acquirer to combat shareholder dissent and the success of a transaction will, in most cases, depend on whether the acquirer received a sufficient amount of affirmative votes from shareholders. Russian law does not provide for a mechanism to compel shareholders to sell its shares other than through a ‘squeeze-out’ procedure that could apply only if the acquirer managed to consolidate more than 95 per cent of shares of a public company, under the condition that at least 10 per cent of those shares were purchased by way of making a mandatory or voluntary public offer.
If the real-estate transaction is done by way of making a public offer to buy out shares of a public company, the board of directors of the public company has a limited ability to resist such acquisition. The board could influence an outcome of the transaction mainly through recommendations that it is obliged to deliver to shareholders following receipt of the offer. The board is, however, incapable of taking any other notable action. From the date when the offer is made and until 20 days expired after the offer lapses or after the board is re-elected at the initiative of the offeror (depending of what happens earlier), powers of the board are limited by operation of law and only shareholders are entitled to take a decision on such matters as:
- issuance of additional shares;
- placement of securities or security instruments convertible into shares including options;
- entry into transactions in excess of 10 per cent of the balance sheet value of the companies’ assets or transactions with a conflict of interest; and
- amendment of the terms of engagement of persons holding positions in management bodies of the company, such as increasing their compensation or approval of additional bonuses triggered by the termination of the engagement.
A transaction approved by the board in breach of these limitations may be challenged in court by shareholders of the company or the offeror.
Are termination fees typical in a real-estate business combination, and what is their typical size?
Security deposits are widespread in real-estate transactions and are usually used in place of a break-up fee. Break-up fees are not popular, as the amount of the break-up fee contractually agreed could be reduced by the court. The amount of the security deposit is determined on a case-by-case basis but rarely exceeds 3 per cent of the transaction value. The buyer pays a deposit to the seller usually for an undertaking from the seller not to consider and accept competing offers. Should the buyer fail to complete the deal, the seller retains the security deposit.
The security deposit is the kind usually used in practice and it is not a classic deposit regulated by law (a legal deposit). The legal deposit stipulates that the buyer loses the deposit if it quits the transaction but also that the seller shall pay double the deposit to the buyer if the seller walks away. The legal deposit is used rarely.
It took a some time for the Russian courts to recognise the security deposit as a separate security instrument different from the legal deposit and an advance. For a long time a dominant view of the courts was that the security deposit should be treated as an advance payment and until recently the courts satisfied claims of buyers by refunding the security deposit in a majority of cases.
Are there any methods that targets in a real-estate business combination can employ to protect against an unsolicited acquisition? Are there any limitations on these methods?
The answer was not available at the date of publication.
How much advance notice must a public target give its shareholders in connection with approving a real-estate business combination, and what factors inform this analysis? How is shareholder approval typically sought in this context?
Statutory mergers, irrespective of whether they are in the form of an absorption or a combination, and major transactions (as described in question 7) require the approval of shareholders. At least 20 days’ prior notice must be serviced on shareholders to convene a shareholders’ meeting to approve a major transaction and 30 days’ prior notice is required to approve a merger, unless longer notification periods are set out by the articles of association of the company. Starting from 1 January 2017, major transactions entered into by a joint-stock company could be ratified after they are signed or closed. Prior to that, the prior approval of shareholders was required.
Taxation and acquisition vehicles
Typical tax issues and structuring
What are some of the typical tax issues involved in real-estate business combinations and to what extent do these typically drive structuring considerations? Are there certain considerations that stem from the tax status of a target?
Structuring real-estate transactions is tax driven in Russia. As an example, a transfer of a real-estate object (other than a land plot or residential premises) is subject to value added tax (VAT) at the rate of 18 per cent, whereas a transfer of shares is free of VAT. Acquirers do not always favour the idea of buying shares of a holding company in order to buy real property, as it usually leads to extra costs and additional time for the buyer to carry out due diligence on the target holding company and to negotiate protection with the seller in connection with the potential claims of a third party to the target company. Should the buyer be reluctant in choosing a tax-neutral structure for the seller, as a matter of practice the seller will in any case transfer the tax burden to the buyer by increasing the purchase price.
As a general rule, a shareholder being a Russian tax resident holding shares of a Russian joint-stock company (JSC) or an LLC for more than five years may benefit from a participation exemption if such shares were acquired after 1 January 2011, which means that a disposal of such shares will not be taxable with income tax. However, the application of this exemption in relation to the company whose assets are more than 50 per cent comprised of real property located in Russia is uncertain.
In the case of individuals, Russian tax residents holding an ownership title to a residential apartment or house for more than five years are also exempted from income tax when selling such real-estate assets.
It was quite common for foreign or quasi-foreign investors to hold real-estate assets located in Russia through offshore entities and, in particular, through limited liability companies incorporated in Cyprus, and to sell real property via a sale of shares of such Cypriot vehicles. However, since 2017, the sale of shares in a Cypriot company, more than 50 per cent of assets of which consist of real-estate objects located in Russia, is taxable in Russia with income tax at the rate of 13 per cent if the seller is a Russian tax resident, at the rate of 20 per cent if the seller is a Russian or foreign company, or at the rate of 30 per cent if a seller is an individual who is a non-Russian tax resident.
Another option popular for Russian tax residents was to establish a holding company in tax heavens such as Panama, British Virgin Islands, Bahamas, St Kitts and Nevis, etc. These offshore companies were holding the shares of Russian companies owning real estate and earning income by selling those shares. However, owing to the new controlling foreign companies rules (the CFC Rules), which came into force in 2015, if the seller is ultimately controlled by a Russian tax resident a sale of shares of the company holding title to real property may require the Russian shareholder of such a seller to pay 13 per cent income tax in Russia, if the shareholder is an individual, or 20 per cent income tax if the shareholder is a Russian legal entity.
In green field and brown field projects, investors may enjoy tax exemptions and other tax benefits granted by a particular region of Russia. Tax benefits vary from region to region. It is recommended to explore this question before making a final decision on whether to start a project of this kind in Russia.
Mitigating tax risk
What measures are normally taken to mitigate typical tax risks in a real-estate business combination?
See question 13.
Types of acquisition vehicle
What form of acquisition vehicle is typically used in connection with a real-estate business combination, and does the form vary depending on structuring alternatives or structure of the target company?
A type of vehicle used by the acquirer depends on the structure of a real-estate transaction and the tax status of the acquirer.
If a transaction is arranged as a statutory merger it should be taken into account that only legal entities existing in the same legal form can be merged into one or the other or combined. For instance, to combine a JSC with an LLC it will first be necessary to transform a JSC into a LLC, which is only possible if the JSC is not a public company and the number of shareholders of the JSC does not exceed 50. Alternatively, the LLC shall be converted into a JSC in the first instance.
LLCs and JSCs are the typical legal forms for pursuing any business in Russia. The basic difference between them is that LLCs do not issue shares and cannot be listed on a stock exchange without prior conversion into JSCs. For the same reason, the business of LLCs is less regulated and not controlled by the financial regulator (the Bank of Russia), which also makes their administration easier and less costly.
Both types of legal entities are organised in a way to safeguard that their shareholders that do not bear liability in connection with the business these companies run. Shareholders could be liable for operations of these companies in the exceptional cases described in question 7.
Depending on the tax status of the acquirer, it may choose to use an offshore entity as acquisition vehicle (see question 11). The same could also be demanded by a financing bank, especially if it is a foreign bank. A typical organisation of the acquisition vehicle in this case is established in Cyprus in a form of an LLC that expedites enforcement of a pledge of shares of that vehicle.
To enjoy deferment of tax payments an investor could elect to transfer its real property into a closed investment fund and exchange its real property for units issued by the investment fund. A disposal of assets by a management company of the investment fund is exempted from taxes. The maximum term for which any investment fund could be established is 15 years. A dissolution of the investment fund and a redemption of units could constitute a tax event for the investor, depending on financial results of this transaction for the investor (ie, on whether the investment fund was profit or loss-making for the investor).
Tax ‘pass-through’ structures such as real estate investment trusts (REITs), are not available in Russia.
Board considerations in take-private transactions
What issues typically face boards of real-estate public companies considering a take-private transaction? Do these considerations vary according to the structure of the target?
In a Russian public company the board functions as a supervisory board rather than as a management (executive) board and not all transactions come to its attention. The board considers some major transactions (as described in question 7) and also certain transactions with a conflict of interest (not vested in the shareholders), as well as other transactions transferred to the competence of the board by the articles of association of the company.
As mentioned in question 8, when taking any decision members of the board are bound by the statutory duty to act in good faith in the interests of the company. Therefore, where the board needs to vote on a real-estate transaction it is likely that members of the board would insist on an independent valuation of the such transaction and on engaging a third-party expert to assess the potential impact of the transaction on the business of the company.
A director also has to inform the company beforehand if his or her voting on a transaction would give rise to a conflict of interests for the director and the company, and must refrain from voting on such transaction. In case the director votes on the transaction where he or she has personal interest, such transaction could be further contested by the company or its shareholders in the court.
Time frame for take-private transactions
How long do take-private transactions typically take in the context of a public real-estate business? What are the major milestones in this process? What factors could expedite or extend the process?
A timetable for a going-private transaction in the real-estate sector is determined on a case-by-case basis with due consideration of objective deadlines as set out by law (eg, the term of a statutory reorganisation) or by constitutive documents of the parties (ie, timing for obtaining corporate approvals) and subjective deadlines as agreed by the parties to the transaction (eg, a time for due diligence, an environmental audit and valuation of selling assets).
In practice, many factors could significantly influence the time frames of the real-estate transaction, in particular:
- the structure of the transaction: whether the transaction is done as an asset or share deal and whether due diligence on a target company, in addition to the due diligence on real property, is required;
- whether the transaction is in the form of a merger (if so, at least 3.5 months will be necessary to complete the transaction);
- the structure of financing of the transaction: whether the acquirer needs to leverage its investment and what security lenders accept;
- whether the acquirer has to refinance pre-closing indebtedness of the target company;
- the type of selling assets: whether an ongoing business or an unfinished construction is sold,
- whether pre-closing restructuring is needed (ie, a spin-off of selling assets);
- the size of the transaction and whether merger control clearance is required;
- whether the transaction is for cash or in-kind consideration;
- what payment method is selected for the transaction (eg, settlements through an escrow account, opening of a letter or credit, etc);
- what corporate approvals are to be obtained by the parties involved in the transaction; and
- what third-party consents are required to close the transaction.
The process of doing a private real-estate transaction depends on the structure of the transaction. For instance, phases of the transaction in the form of a sale of real-estate assets may include:
- the negotiation of a non-binding term sheet, a MoU or a binding preliminary agreement depending on whether the seller and the buyer are ready to make a firm commitment to sell and to buy the asset, respectively;
- the buyer’s due diligence;
- the negotiation and signing of definitive agreements;
- a pre-closing search to confirm title to the real property and the absence of undisclosed encumbrances;
- the fulfilment of other conditions as agreed by the parties; and
- the closing of the transaction.
Closing is usually split into stages, as registration of rights of the acquirer and lenders (as the case may be) to the real-estate assets cannot be completed within one day. That implies that payment of the purchase price is not, typically, structured as a one-time payment but is made in instalments. The buyer is usually reluctant to accept the real property by a deed of transfer before conveyance of title from the seller to the buyer is properly registered, in order to not bear earlier the risk of eventual loss or damage of the real property and costs of its maintenance earlier.
Are non-binding preliminary agreements before the execution of a definitive agreement typical in real-estate- business combinations, and does this depend on the ownership structure of the target? Can such non-binding agreements be judicially enforced?
In practice, parties to civil relations in Russia usually use LoIs and MoUs to fix their preliminary arrangements at the negotiation stage. However, such non-binding arrangements generally cannot be judicially enforced and may be used in court only as evidence of real intent of the parties in case of conflicting provisions of a disputable contract.
The only way to make the preliminary arrangements legally binding and enforceable is to sign a preliminary agreement that should be executed in the form prescribed for the main agreement, and contains the subject matter and conditions of the main agreement.
According to recent legislative amendments, fulfilment of obligations arising out of preliminary agreement may be secured by an advance deposit (articles 380-381 of the Civil Code of the Russian Federation). In case of failure to fulfil the obligation to execute the main contract by a responsible party who that the advance deposit, the deposit shall not be refunded by the other party. If the party who received the deposit is responsible for a breach of the preliminary contract, the party is obliged to pay the other party double the deposit.
To make the preliminary agreement enforceable, it is very important to agree on the details of actions of both parties on conclusion of the main agreement: which party should send an offer to conclude the main agreement, within what term, under which circumstances shall this offer be deemed received and accepted by the other party, and what are the grounds for the party to be regarded as having avoided its obligations.
It should also be noted that the construction of a preliminary agreement does not provide parties with adequate remedies to enforce the other party to conclude the main agreement. Therefore, use of an agreement on option rights (article 429.2 of the Civil Code), which have recently emerged in Russian legislation, under which one party by virtue of an irrevocable offer entitles another party to enter into one or several agreements upon the conditions provided by the option, has become more common in real-estate-related business combinations.
Article 434.1 recently included in the Civil Code provides liability for conducting unfair negotiations in entering into an agreement. As a general rule a party that conducts or interrupts negotiations on the conclusion of a contract in bad faith must compensate the other party for the losses incurred. This article allows parties to conclude an agreement regulating the negotiation procedure. Such an agreement may specify the requirements for bona fide conduct of negotiations, establish the procedure for allocating costs for negotiating, and other similar rights and duties. For now, this kind of agreement is not widespread due to its novelty in the Russian legal system.
Describe some of the provisions contained in a purchase agreement that are specific to real-estate business combinations? Describe any standard provisions that are contained in such agreements.
Real-estate-related purchase agreements usually include the following specific provisions.
Representations and warranties
Article 431.2 recently included in the Civil Code of the Russian Federation provides liability of the parties in case of giving unreliable representations to the other party, either before or after making a contract, about the circumstances that are significant for concluding the contract, its execution or termination (including those that are related to the subject of the contract, the authority for making it, correspondence of the contract to the legislation applicable thereto, availability of required licences and permits, its own financial status and those related to a third person). Such a party is bound to compensate the other party at the request thereof for the losses caused by unreliability or to pay the forfeit provided for by the contract. The liability provided for by this article shall ensue, if the party that has provided unreliable representations has proceeded from the assumption that the other party will rely on them or had reasonable grounds to proceed from such an assumption.
However, it should be noted that even before the amendments to the Civil Code a party given unreliable representations could challenge a contract and claim for damages alleging that the transaction had been made under the influence of an aberration (articles 178-179 of the Civil Code).
Taking into account these provisions, normally parties include in a contract the following groups of representations and warranties (R&Ws):
- representations in relation to the legal status of the seller and the purchaser that each of them has the requisite power and authority (corporate and other) to own their property and to carry on their business and are lawfully empowered to execute and deliver the agreement;
- representations in relation to the property acquired under the agreement (that the seller has full and unrestricted legal and beneficial ownership of the property, no encumbrances, etc); and
- warranties in relation to the future status of the property (quality of the property, claims of the third parties, etc).
Covenants related to financing
Covenants usually determine some financial status that must be maintained by the borrower (eg, minimum dividend payments level). Typically, once a covenant is broken, the lender has the right to call back the obligation from the borrower or renounce the contract.
Recently, the Civil Code was supplemented with article 406.1 regulating compensation for the losses resulting from the occurrence of the circumstances defined in a contract. This provision allows parties to conclude an indemnification agreement, which is usually part of a main contract establishing the amount of compensation that may be awarded to a party should the circumstances determined by the parties occur. It is very important to note that this construction differs either from the concept of damages or from the concept of liability, which is why parties should conclude the indemnification agreement to achieve the legal effect of indemnification provisions.
Are there any limitations on a buyer’s ability to gradually acquire an interest in a public company in the context of a real-estate business combination? Are these limitations typically built into organisational documents or inherent in applicable state or regulatory related regimes?
If the buyer is considering acquiring, alone or together with affiliates, more than 30, 50 or 75 per cent of a public company it needs to take into account that crossing these thresholds will trigger the statutory obligation of the buyer to make a mandatory offer to all remaining shareholders of the target holding shares of the same category the buyer plans to acquire. Such offer shall be made in relation to all shares of the target of that category not acquired by the buyer in the going-private transaction. The offer cannot be conditioned by any circumstances other than obtaining the necessary governmental consents (such as merger control consent or consent of the governmental committee controlling foreign investment into strategic business in Russia). Moreover, the offer shall provide for cash consideration and the offeror has to obtain a bank guarantee in the amount equal to the aggregate market value of all shares subject to the offer.
The mandatory offer bid is irrevocable once made. At the same time the courts support the view that the acquirer will be released from the obligation to make the mandatory offer if it divests its shares or part of them within 35 days following completion of the acquisition transaction so that its stake in the target public company falls below the statutory thresholds.
Certainty of closing
Describe some of the key issues that typically arise between a seller and a buyer when negotiating the purchase agreement for a real-estate business combination, with an emphasis on building in certainty of closing? How are these issues typically resolved?
The following closing conditions are typically included in purchase agreements:
- bring-down of R&Ws and compliance with covenants: parties to a purchase agreement usually negotiate whether the bring-down of the R&Ws should be as of the closing date only or as of both the closing date and the signing date;
- delivery of the purchase price (to the seller or in escrow with the notary);
- third-party consents: the buyer in a purchase agreement will typically negotiate provisions requiring the seller to obtain certain third-party consents and compliance with mandatory regulations (this especially matters in relation to building); and
- specific conditions and deliverables: these deliverables may include any real-property-related deliverables.
Since recently legislation (article 310(3) of the Civil Code) allowed parties to include provisions in the contracts establishing a fee related to termination rights. However, this provision may be only included in relation to termination rights to provided by the agreement. If a right to termination is established by an imperative provision of law (not by an agreement), including it in the agreement of the termination fee is prohibited.
Who typically bears responsibility for environmental remediation following the closing of a real-estate business combination? What contractual provisions regarding environmental liability do parties usually agree?
Unfortunately, ecological issues have not become as crucial for Russian business as they have in developed economies. Still, due to the fact that Russian authorities are becoming less reluctant to turn a blind eye to ecological infringements, the purchasers in a real-estate-related business combination tend to insist on inclusion of the vendor’s liability in transaction documents that may include payment of the indemnity, compensation of the purchaser’s losses, and, in the worst case scenario, rescission of the whole transaction.
Other typical liability issues
What other liability issues are typically major points of negotiation in the context of a real-estate business combination?
As regards to liability issues in the context of real-estate-related business combinations, parties usually negotiate range of liability incidents, kinds of penalties and their amount. A purchaser typically insists on including in the contract provisions establishing the seller’s liability in case of withdrawal of the property from the purchaser on the grounds that arose before the execution of the contract and establishing grounds for indemnities. In turn, the seller typically insists on provisions establishing liability for breach of payment obligations.
Sellers’ representations regarding leases
In the context of a real-estate business combination, what are the typical representations and covenants made by a seller regarding existing and new leases?
It is very important for the real-estate property acquirer that, in advance of the deal closing, he or she was aware of all the existing encumbrances over the property, including lease agreements. Therefore, the R&Ws section of transaction documents normally includes the vendor’s statements as regards the leases, such as the exhaustive list of the leases, their terms, terminations clauses, etc. The covenants regarding the leases typically include an interdiction on (or the purchaser’s pre-approval of) entering into new leases within the period between the execution of the transaction documents and the deal closing and interdiction on deterioration of the provisions of the existing leases for the landlord.
Legal due diligence
Describe the legal due diligence required in the context of a real-estate business combination and any due diligence specific to a real-estate business combination. What specialists are typically involved and at what point in the transaction are the various teams typically brought in?
The main fields of legal due diligence required in a real-estate-related business combination include:
- real estate (title check);
- business (review of the operational contracts) and ecological due diligence;
- industrial security check (when applicable);
- litigation; and
- in cases of share deals:
- financial (loans, credits, suretyships, guarantees, bills of exchange and other financial transactions); and
- labour due diligence.
Normally, at the initial stage (before execution of an LoI) express due diligence is completed to identify the key risks of the transaction (in a real-estate-related business combination it is focused on the property title check). Once the LoI is signed, all other members of the legal team - corporate, labour, litigation experts, etc - proceed with analysing their fields simultaneously.
How are title, lien, bankruptcy, litigation and tax searches typically conducted? On what levels are these searches typically run? What protection from bad title is available to buyers and does this depend on the nature of the underlying asset?
To perform title, bankruptcy, litigation, tax and other types of the due diligence, besides the documents provided by the target, legal teams research:
- public databases, such as official web portals of the Federal Tax Service (corporate and tax status);
- Federal Bailiff Service (enforcement procedures);
- Federal State Registration;
- Cadastre and Cartography Service (real estate);
- federal arbitration courts (litigation and bankruptcy);
- federal bankruptcy web resources; and
- other databases.
Protection from bad title in Russian business is quite scarce. In fact, it is limited to the title insurance also not being very widespread owing to the high insurance fee, which is a result of the high risks of this type of insurance in Russia.
Representation and warranty insurance
Do sellers of non-public real-estate businesses typically purchase representation and warranty insurance to cover post-closing liability?
The answer was not available at the date of publication.
Review of business contracts
What are some of the primary agreements that the legal teams customarily review in the context of a real-estate business combination, and does the scope vary with the structure of the transaction?
Among the real-estate-related documents that legal teams typically review in the course of the legal due diligence, the following should be named:
- title documents (sale and purchase, swap, donation and other types of agreements, delivery and acceptance acts, and extracts from the Unified State Register of Real Estate certifying the title);
- documents that establish various encumbrances over the real-estate property (lease or sublease, mortgage, servitude and other types of agreements);
- documents certifying payment for the real-estate property by its current owner; and
- other documents that certify proper acquisition of the property by its current owner and previous owners, technical plans and utility agreements, etc.
The range of the documents to be examined for a share deal is much broader and includes title documents to the shares (sale and purchase, swap, donation and other types of agreements, documents certifying payment of the issued capital, and documents of the registrar), documents that establish various encumbrances over the shares (charge, option and other types of agreements), documents certifying payment of the shares by its current owner, and other documents that certify proper acquisition of the shares by their current owner and previous owners, and a wide range of documents certifying good standing of the company.
Normally, the documents related to the period of three years before the transaction (the standard statute of limitations under Russian law) are reviewed, but in some cases (eg, when the current owner acquired the real-estate asset through privatisation) such period may be extended.
Breach of contract
Remedies for breach of contract
What are the typical remedies for breach of a contract in the context of a real-estate business combination, and do they vary with the ownership of target or the structure of the transaction?
Normally parties use the following basic remedies for breach of a contract in respect of a real-estate business combination:
- award of damages (including lost of profits);
- rescission (termination of contract); and
- specific performance.
There are often difficulties with the enforcement of an arbitration award as usually it is extremely difficult to force the breaching party to properly fulfil its obligations even with the enforcement order. Unfortunately, there is currently no acceptable solution this problem.
Suspension of performance
The remedy does not appear to be available in relation to an anticipated breach, even if it is clearly going to occur and would be material. It should also be noted that this remedy may be operated only against corresponding obligations that are not fulfilled and is not applicable to obligations that are duly performed.
Retention of property
The creditor may retain the property in his custody, even despite the fact that after this thing has passed into the creditor’s possession, the rights to it have been acquired by the third person.
How does a buyer typically finance real-estate business combinations?
Due to a lack of liquidity in Russia against the backdrop of the Ukraine-related sanctions, currently it is difficult to leverage an acquisition and, in particular, an acquisition in a real-estate sector with debt financing.
Raising funds with major Russian banks supported by the Russian government (ie, VTB, Sberbank, etc) is currently much more feasible than with foreign banks. That is also the reason that the application of Russian law in finance transactions, which were historically conducted predominantly under English law based on Loan Market Association (LMA) forms), has become more common.
Complex structures of lending that include senior debt and junior forms of financing (eg, mezzanine debt, high-yield debt, etc) are extremely rare in the Russian debt market. Where in addition to the acquisition loan existing indebtedness of the target is supposed to be refinanced, the lenders financing the acquisition transaction may also grant a loan to the target company for this purpose.
The acquirer may consider securing financing against the target’s assets as there are no statutory limitations in this respect even in relation to public target companies. Successfully using the assets of the target as security for debt assumed by an acquisition vehicle will depend on the condition and value of underlying assets of the target company as assessed by banks; and the ability of other shareholders of the target company to block such security arrangements as a ‘related party transaction’ made for the benefit of a particular shareholder at the level of the board of directors or of a shareholders’ meeting (as the case may be).
What are the typical obligations of the seller in the financing?
It is not typical for the seller to assume any specific obligations in connection with raising funds by the buyer. The degree to which the seller will be ready to cooperate with the buyer in this regard in each particular case will be very much contingent on the seller’s willingness to sell the asset.
As noted in question 27, Russian law does not set out any restrictions for the target company to provide financial assistance to its shareholders, including the issuance of upstream guarantees and the establishment of a pledge (mortgage) over the target’s assets, even if the target is a public company. Should the buyer plan to leverage its acquisition against assets of the target, in most cases it will need to negotiate closing mechanics of real estate and financial transactions with the seller and the bank, respectively. Thus, either the seller will be ready to use the target assets as security before receiving the full purchase price or the bank will allow the buyer to draw down a loan before the security rights are properly established and perfected, as a mortgage of real-estate assets located in Russia only becomes valid upon its registration in the Unified State Register of Real Estate.
What repayment guarantees do lenders typically require in the context of a property-level financing of a real-estate business combination? For what purposes are reserves usually required in the context of property-level indebtedness?
In cases of secured lending, the borrower may expect that the lender will take real-estate assets as security in the first instance. For this purpose a mortgage over real-estate objects should be established. For the mortgage to be effective it must be perfected by registration in the state register of real property. Lenders usually accept real property as security with at least a 30 per cent discount from its market value as confirmed by an independent appraiser’s report obtained at the borrower’s cost. In certain cases a discount may reach 100 per cent.
In addition, lenders may require that shares of the acquisition vehicle are pledged and may also request a suretyship of the target company or of a parent company of the acquirer, in the worst case scenario, if other security is insufficient.
It is not common for lenders to take reserves. However, a loan agreement could provide for earlier prepayment of the loan upon receiving rental income from an investment property. In this case, the lender usually requires that the borrower receives any such income into the account opened with the lender and enters into an arrangement with the lender that allows the latter to write off funds from that account without the order of the borrower. Such a cash management structure is used instead of a pledge of a bank account. The latter has recently been allowed by law, but is still not widely used in practice due to uncertainly of application and enforcement of the relevant rules.
As additional security, the lender may insist that the rights to a rental fee under lease agreements are pledged and, more rarely, assigned to it, usually in the form of a security assignment where the rights are transferred to the lender only if and when the borrower is in default.
What covenants do lenders usually insist on in the context of a property-level financing of a real-estate business combination?
It is customary in Russia to do lending based on LMA standard agreements. Even if a financial transaction is made under Russian law it is very likely that a loan agreement will still contain a majority of provisions typical for an LMA agreement as adopted against Russian legal background. Simpler form agreements can be seen in the case of the financing of small-size transactions.
It can, therefore, be expected that a loan agreement will include broad negative pledge clauses and other positive and negative covenants and information undertakings usually met in LMA agreements. Some typical LMA standard covenants could be made more specific to cover requirements to repair, maintenance, management, insurance and subletting of real property. Whether the loan will also include financial covenants and the frequency of testing those will be contingent on the type of the loan, assets used as security and the term of the loan.
Typical equity financing provisions
What equity financing provisions are common in a transaction involving a real-estate business that is being taken private? Does it depend on the structure of the buyer?
It is more typical for project finance transactions (ie, relating to real estate construction and development) that lenders would require shareholders of the project company to capitalise the company to a certain level. Classical ratio demanded by banks is 30 per cent of equity against 70 per cent of debt. In rare cases banks could agree to change this proportion to 20 per cent against 80 per cent. It should be noted though that owing to the instability of the construction and development business, many foreign banks closed their quotas for the project financing of this sector and those that are engaged in such projects tend to be Russian banks.
A common approach is difficult to identify in relation to acquisition finance. On a case-by-case basis, the buyer wishing to leverage a going-private acquisition transaction may be asked by lenders to fund a certain percentage of the value of the transaction with equity to demonstrate its strong commitment to maintaining and developing the acquired business in good faith.
Collective investment schemes
Are real-estate investment trusts (REITs) that have tax-saving advantages available? Are there particular legal considerations that shape the formation and activities of REITs?
REIT-type structures are not recognised in Russia.
Private equity funds
Are there particular legal considerations that shape the formation and activities of real-estate-focused private equity funds? Does this vary depending on the target assets or investors?
As compared with the US and the UK, private equity investing (including private equity funds focused on real estate investments) has only started to make its first steps in the Russian market.
Russian law provides for three types of investment funds: open (where the investors are entitled to accelerate put options on their shares at any time), closed (where the investors are restricted from selling their shares to the fund within the whole investment period) and interval (where the investors are entitled to accelerate put options on their shares within the certain intervals).
Due to the illiquid nature of real estate investments, a fund with a focus on real estate may be structured only as a closed investment fund.
Depending on the investment strategy, an investment fund may be restricted from attracting contributions from unprofessional investors (an investment fund for qualified investors) or may be allowed to attract contributions from any types of investors. In the former case, the potential scope of investments is much broader and, hence, the investments are subject to a higher degree of risk. Also, only investment funds for qualified investors are allowed to act as combined funds (ie, to invest in any types of asset, except cash).
Information provided correct as of 30 September 2017.