Legislative developments have created a very uncertain position in the event of a strategic field classification and this needs to be factored into existing investments for exploration of potentially large deposits.
If during exploration a licence holder discovers a field that meets "strategic field" qualifying criteria1 (a "Reclassification Event") it becomes a Strategic Subsoil Company ("SSC").
If there is a Reclassification Event, a further governmental consent is required for the licence-holder to move to exploration and production.
The consent requirement applies irrespective of whether SSC has foreign investment.
If the SSC has non-governmental foreign investors it is specifically provided that the authorities may, if they consider that there is a threat to national defence and security, either: (a) refuse to grant an exploration and production ("E&P") licence; or (b) if there is a combined licence, terminate the rights of the SSC under the combined licence in respect of E&P. There is a compensation regime contemplated but this is unlikely to provide sufficient downside protection.
This is a potential significant exposure to loss of E&P rights.
It is unclear if any level of foreign investment (be that holding companies or foreign equity (direct or indirect)) will be allowed. There is a 10% or below non-controlling permitted foreign investment threshold (5% in respect of foreign state/international organisations) in respect of investment into existing SSC, but this permission does not clearly apply in relation to after-the-event classification. There is also an exemption from the consent requirement where the SSC is more than 50% owned (directly or indirectly) by a Russian state company; this should provide protection for existing joint ventures with state champions where there is a Reclassification Event provided the investor has a veto on below 50% divestment by that state champion. Of course, this provision gives the state champion an entrenched position.
It is unclear what approach the authorities will take: (a) will they permit intermediate offshore holding companies provided they are happy with ultimate beneficial ownership? (b) will the regime in respect of existing SSC apply, thereby permitting sub-10% (5% in the case of non-governmental) and non-controlling interests, allowing preference share structures and a foreign investor who, if invested, would require classification, to sell sub-participation to other foreign investors so that, individually, no such foreign investor will have an offending stake?
All this remains unclear and, accordingly, contractual documentation will need to be drafted very flexibly to preserve optionality.
At present, to avoid the potential loss of valuable E&P rights, foreign investment may need to be decreased or perhaps wholly eradicated from a particular SSC or even from whole structures, either in terms of foreign equity ownership (direct or indirect) and/or intermediate (offshore) holding companies and what follows are some thoughts on what steps an investor and its onshore counterparty might take to mitigate these risks contractually.
Of course, all investors, both foreign and Russian, face exposures here, but, in particular, a foreign investor will be concerned about its Russian partner being able to independently pick up the lost E&P rights without disincentive, or protection for the foreign investor, and may prefer an explicit mechanism to deal with this issue.
There have already been situations - subject to litigation - where parties have sought to use a strategic classification to void pre-existing obligations and we would see this as a potentially very significant issue which pre-existing documentation may not have addressed.
The current market situation may present a good time to amend such documentation.
Revisiting Exit Provisions
It is even more important than before to ensure that each subsoil licence is held by a separate licence-holding SPV, perhaps with an individual rather than master offshore holding company; this will assist in avoiding one reclassification "contaminating" a more complex and multi-project structure.
In relation to joint ventures (51:49) with state champions it is important to check the state champion's divestment (and sub-participation) rights (and the foreign investor's rights in that context) as any move below a 50% holding where there has been a Reclassification Event will result in the foreign investor having an unauthorised holding.
Beyond this, we would advocate the following structural amendments:
- a right to require the SSC to be transferred to non-offending joint venture parties with compensation, or, although this is of doubtful efficacy in the Russian context, a part of the equity in the SSC (proportionate to the interest in the SSC being divested) to be held in trust (with the divesting investor having no rights of operational determination of the SSC);
- a right to swap voting into (non-voting) convertible preference shares (or some other form) of equity – (convertible) debt swap (although, again, it is not clear that such mechanisms will circumvent the legislation);
- a right to reconstitute the offending holding into a broader group of smaller holdings;
- a right to require the sale of the licence-holding SPV; and/or
- a right to surrender equity in return for compensation (as in (1)).
Other possibilities which could be considered involve a flip into an unincorporated joint venture or a Russian simple partnership with the offending investor as a passive (financial) investor. These have not been attractive investment structures in the Russian space, and, again, it is unclear that this would assist.
Providing (further) funding by way of secured loans could also be considered but the legislation and its restrictions impose limitations on the SSC's equity as collateral.
In all cases, to the extent that the field development has been carry or jointly financed with shareholder debt, documentation will need to provide whether such funding will continue, and, if so, on what terms. The future funding provisions will be dependent on which of the above options is taken and whether the intention of the parties is to preserve the status quo insofar as possible, only dispose of the SSC and continue with the joint venture in respect of other joint venture licence-holding SPVs (if applicable) or terminate the joint venture entirely.
Consideration will also need to be given to anti-embarrassment provisions and restrictive covenants, as a key concern will be that an investor provides significant funding pre-discovery, is then disenfranchised with consequent write-off of past investment, and then discovers that their partner is able to start over on a go-it-alone or new joint venture basis. Clearly, any financial incentive in the joint venture structure and arrangements that might inadvertently promote that result should be removed.
Investors in a Russian natural resources joint venture where there is a risk of a Reclassification Event must have an option to remove the licence-holder from the structure or to divest or restructure, and, as appropriate, get paid back entitlements and contributions immediately or on an acceptable deferred and secured basis. This is particularly a concern for foreign investors, especially where they have provided disproportionate funding.