Winter Is Coming: Responding to a Chilling Enforcement Landscape in Russia

Eager to attract foreign investment and counteract the currency crisis, the Russian government continues to position the country as a more transparent place to do business than a generation ago. Although Russia’s anti-corruption laws have been on the books for years, and were recently revised to OECD standards, weak enforcement limited their effectiveness. At the same time, economic sanctions and rising tensions with Western nations bring renewed urgency to the Kremlin’s long-sought objective to reduce dependence on Western countries for high-value goods. Competing efforts to market Russia to a global audience while continuing to privilege domestic producers are likely to enhance the importance of Russia’s Federal Anti-Monopoly Service (FAS), the agency responsible for carrying out a lengthening list of enforcement mandates from Moscow. A spike in FAS action is likely to increase the risk to multinationals of unwarranted regulatory scrutiny, selective prosecution, and exclusion from public procurements.

Recent public remarks from the Deputy Head of FAS, Andrey Tsyganov, presage a darkening horizon for foreign companies operating in Russia. Over the past several years, FAS has seen its mandate grow from a limited focus on competition laws to now include control and oversight of public procurement, foreign investment in strategic sectors, and proactive anti-corruption and transparency initiatives. Despite FAS’s reputation as a generally fair and restrained regulator, FAS will almost certainly take aggressive action to investigate collusion, pricing violations and corruption. Local companies doing business with multinationals are also likely to face added scrutiny.

In this chilling enforcement landscape, Western companies operating in Russia should assess their risk profile with local partners, validate reporting mechanisms for newly publicized corruption cases, and review their strategy for engagement with local and other enforcement authorities who may raise questions about corruption and collusion investigations by FAS and other local regulators.

Balancing Understanding and Belief About Anti-Corruption Enforcement

Russia’s anti-monopoly regulator, the Federal Anti-Monopoly Service (FAS), was established in the post-Soviet era as the country’s principal administrative and civil enforcement agency for competition law. Unlike other regulatory bodies, FAS has experienced stability in its senior ranks and a relatively consistent enforcement approach over the past decade. Although FAS is subject to the current priorities of the government, its methods generally are not predatory or prone to internal abuse as seen with certain other enforcement agencies.

Starting in February 2006, and increasingly in subsequent years, the government rewarded FAS with an increasing role in the enforcement of anti-corruption initiatives focused on public procurement. The government often directs FAS to undertake sweeping investigations of alleged corruption and pricing violations in industries they view as dominated by foreign market participants. To support this expanding portfolio of investigation and enforcement, FAS’s personnel at its Moscow headquarters has nearly doubled in the past few years.

Historically, U.S.-led anti-corruption investigations involving conduct in Russia were not accompanied by parallel anti-corruption investigations or enforcement by their Russian counterparts. U.S. authorities typically receive little cooperation from Russian authorities, who have either declined to pursue or quietly dropped cases. For example, the SEC recently acknowledged the assistance from banks in Lithuania, Latvia and other Eastern European countries as part of its resolution with Bio-Rad Laboratories, Inc., but Bio-Rad’s Russian subsidiary and multiple unnamed agents which allegedly received payments to influence Ministry of Health officials have not otherwise been subject to criminal or administrative sanctions. These resolutions stand in stark contrast to the routine cooperation afforded to the DOJ and SEC by local authorities, and the increasingly common, and highly publicized, parallel investigations and prosecutions.

According to Tsyganov’s recent remarks, the Russian government—still the largest purchaser of goods and services in Russia—has just begun to understand and respond to bribery and collusion in public procurement. As part of this campaign, President Putin recently ordered FAS to investigate prices of pharmaceutical products in the Russian market, particularly those purchased in public tenders. Its preliminary findings concluded that the market was infected by “thousands of cartels” resulting in dramatically higher prices, in some cases 160 times higher than the expected prices. Aleksandr Protsenko, FAS Nashla Zavyshenie tsen na lekarstva v 160 raz, Rossiiskaya Gazeta, September 21, 2016, https://rg.ru/2016/09/21/fas-nashla-zavyshenie-cen-na-lekarstva-v-160-raz.html. The review is ongoing, but FAS’s public statements about their preliminary findings suggest they could allege that Western pharmaceutical companies inflated prices in comparison to Russian producers. Kirill Bulanov, FAS Zayavila o Zavyshenii Tsen na Nekotorye Analogichnye Lekarstva v 160 Raz, August 26, 2016, http://www.rbc.ru/society/26/08/2016/57c076209a79472ac4f712ae.

Most recently, the Minister of Health reported to President Putin on the status of the Ministry and FAS’s review of medicine prices. The Minister explained that the review found substantial mark-ups in prices of medicines procured via public tenders. In response, the government is designing a system for “real-time” monitoring of prices at public tenders, with comparisons to market prices in other markets. As a result, the Minister predicted that the difference between public tender prices of medicines and average market prices will drop by at least 60 percent. In his comments, FAS Head Igor Artemyev criticized the practice of foreign producers engaging in faux-localization by changing packaging of drugs produced abroad. Artemyev claimed the companies pursued this strategy to evade price registration requirements for foreign producers of medicines, and noted that FAS is cracking down on this practice. Putin expressed his approval of their work, noting that “knowledge increases sorrow” and his dismay over the absence of criminal cases in relation to procurement violations. President of Russia, Meeting with Government Members, October 12, 2016, http://en.kremlin.ru/events/president/news/53079.

Even before this investigation, public procurement activities accounted for most of the published FCPA settlements concerning misconduct in Russia. Additional local scrutiny of public tender activities could accelerate this trend. Tsyganov also reported that Russia’s recognition of the budgetary impact of pricing collusion and corruption in procurement resulted in a 10 percent increase in prosecutions over the past year under existing anti-corruption laws, continuing a trend which has seen prosecutions double from their 2012 level. Tsyganov further articulated FAS’s refined strategy of competition law enforcement amid a modest uptick in complaints to focus on fewer but more significant cases. If executed as described, this renewed enforcement agenda will increase exposure under local and other anti-corruption laws for companies operating in Russia.

Pushing
Nash
[Ours] Over Vash [Yours]

Proactive investigation of perceived corruption in public procurement and a more judicious response to complaints are two components of a broader strategy likely to energize the Russian enforcement landscape in a manner not likely to favor foreign companies. Russia, similar to other emerging markets, has long offered preferences and incentives to encourage direct investment and technology transfers from American, European, and Japanese companies. Though intended to spur domestic competence and eventually competition against the leading foreign manufacturers in these industries, these initiatives have not always yielded positive results.

Perhaps the most dramatic example was the failure of the Skolkovo “tech park,” a suburban area outside Moscow touted as a Russian Silicon Valley—relying on substantial support from global technology companies. Six years after its announcement, Skolkovo achieved modest success but fell short of the promised multibillion dollar investments—in part due to corruption. Russian investigators raided Skolkovo’s central offices and arrested two senior managers and detained a visiting foreign executive. In the eyes of many Russian officials, partnerships such as Skolkovo too often result in opportunistic business models with valuable tax advantages for the foreign partner but without substantive investment of capital and technology into the domestic partner, leading to administrative scrutiny.

Indeed, the Russian government’s sense of urgency to fulfill this import-substitution mandate intensified as a consequence of deteriorating relations with the West, including sanctions that limit access to capital and technology, and in response to a budgetary squeeze from declining oil prices and increased military expenditures. Public procurement laws offered explicit price preferences for domestic producers competing in public tenders and now allow the government to ignore bids from foreign manufacturers.

More recently, the government passed a decree requiring public purchases of technology from solely local sources where possible. Decree of November 16, 2015, On Establishing the Prohibition of Purchasing Foreign Software in Procurement for Government and Municipal Needs, http://government.ru/docs/20650 (2015). This spawned a proactive campaign by the municipal and regional governments of Moscow to seek substitutes for industry-standard software with locally produced, untested equivalents. Foreign producers unable to point to substantive investments in local production can also expect the Russian government to impose additional roadblocks to participation in public procurement, if not seek to exclude them from public tenders entirely.

Mitigating Risks of Regulatory Harassment and Corruption

Foreign companies are undoubtedly at increased risk of regulatory and administrative action. The Russian authorities’ treatment of McDonald’s over the past two years is instructive of the breadth and publicity characteristic of these retributive campaigns. In April 2014, the company closed all of its restaurants in Crimea following Russia’s annexation of the territory. By August, Rospotrebnadzor, the Russian consumer protection agency, conducted over 200 safety inspections, leading to the closure of 12 McDonald’s restaurants in Russia, including its iconic Pushkin Square location (the first McDonald’s restaurant in Russia, opened during the Soviet era).

Companies unable to comply with Russia’s localization mandates should be prepared for selective enforcement of anti-corruption, anti-monopoly, and tax laws. Accordingly, foreign companies should consider steps to mitigate the likelihood and potential impact of being targeted by the Russian authorities, taking account of their industry and likely exposure to enforcement scrutiny. These steps may include the following:

• Limit exposure through local joint ventures: While a minority stake in a joint venture with a local manufacturing partner permits a foreign company to take advantage of localization preferences, and generally exercise greater control over the operations and finances of a local partner, it remains challenging to identify local parties with sufficient competence, capital, and compliance bona fides. Although established Russian companies often tout their experience with other Western partners, experience does not guarantee lower risk. The recent SEC enforcement action against Analogic Corp. in relation to its ultrasound subsidiary, BK Medical, is illustrative. BK Medical’s largest distributor for its ultrasound business allegedly directed a decade-long scheme in which invoices and sales contracts were artificially inflated in order to justify large mark-ups in sales to government customers. BK Medical then transferred the difference between the inflated and actual sales prices to unknown third parties at the distributor’s request. In addition to robust due diligence at the outset, direct oversight of key functions, regular audits, and internal controls consistent with global best practices can mitigate the compliance risk associated with efforts to localize operations.
• Expand scope of relationships with local distributors: Western companies can also attempt to qualify for local preferences by incorporating as much domestic value-add as possible (e.g., perform packaging and labeling in Russia). However, FAS has also signaled that it may begin to scrutinize whether these arrangements provide sufficient domestic content to meet the legal requirements for tax breaks and other preferences. Similar to a joint venture, a foreign company must insist upon greater transparency into the distributor’s operations and more sophisticated compliance systems and controls as part of the expanded scope.
• Revisit approach to engagement with authorities: Voluntary disclosure and proactive engagement with regulatory authorities are not common in Russia. But a constructive, open dialogue with FAS and potentially certain other regulators may achieve salutary results in the right situation. For example, some companies have sought FAS approval of their commercial policies, which can offer a measure of protection from subsequent complaints from a local distributor or partner if a compliance audit, investigation, or routine due diligence identifies grounds to terminate the relationship.
• Review crisis management protocols: Even if risk mitigation steps protect against the risk of selective enforcement, they cannot insulate foreign companies from unannounced inspections and information requests which may come as part of a broader, proactive review of an industry or market. A policy and formal response plan for local regulatory investigations should reduce the chance that a “dawn raid” will result in the loss of key documentary evidence that the company would otherwise use to investigate and prepare its defense. Foreign companies should also think more broadly about responding to investigations, including the following steps:

•  o  Conducting proactive, internal reviews in response to publicly disclosed investigations of officials or third parties with which they have interacted, even if official reports do not name the foreign company;
•  o  Determining the company’s level of comfort with proactive or reactive communications with regulators;
•  o  Initiating public relations efforts designed to reassure customers about the company’s brand and commitment to compliant business practices;
•  o  Assigning responsibilities to ensure appropriate input from the legal, compliance, and business functions; and
•  o  Refining ongoing reporting and escalation procedures to regional or central offices to ensure the company can identify themes and respond to questions from non-Russian regulators, where appropriate.

• Conduct strategic review and realignment: In an era of escalating tensions and increasing scrutiny from local regulators, it may be appropriate to develop or update a formal roadmap for local and global leadership to govern the company’s general posture to regulatory pressure in Russia. Strategic guidance can simplify tactical decisions and objectives in spite of the increased likelihood that a regulatory request or formal investigation may be motivated by factors beyond the company’s control.

Conclusion

Despite these strong headwinds, foreign companies will continue to be enticed by the opportunities in Russia: the largest consumer market in Europe, an educated workforce, significant growth potential, and in the near term, the possibility of acquiring assets at a discount due to the currency devaluation. However, in the face of deteriorating relations with the West, the Russian government has increasingly prioritized its fight against corruption and aspiration toward self-sufficiency as issues of national security.

Multinationals operating in Russia should be mindful of these developments and adjust their strategy in Russia accordingly. New anti-corruption enforcement initiatives against local officials may lead to hostile treatment from local regulatory authorities, speculation in the media, and in a worst-case scenario, a decline in the value of local operations. As FAS and other regulators become more aggressive and strategic in their pursuit of foreign companies, an appropriate response strategy—including the possibility of addressing parallel local and global reviews—is critical.