MULTIGAMA

In 1946 Romania regained much of the territory it had lost earlier in World War II, but
Bessarabias and Bukovina remained in the hands of the Soviet Union. The Soviet-backed
regime, of which King Michael had served as figurehead since 1944, took over firm
control. The Romanian government became the most Stalinist of all the regimes in
Eastern Europe, which earned it a certain independence. Because the Soviet Union felt
more secure with this “hard-line” regime, it withdrew its troops in 1958, much earlier
than it did from other Eastern European countries. Thus the Romanian in their internal
operations and in their contact and trade with the West. When the Soviet Union invaded
Czechoslovakia in 1968, President Nicolae Ceausescu’s refusal to support the effort made
him extremely popular with the Romanian people. It also made him popular with Western
leaders: Ceausescu was applauded as a champion of democratic reforms. Ceausescu was
actually increasing the internal control during the period, and Romania soon had a more
centrally controlled economy than other countries in Eastern Europe except Albania.

Ceausescu liked to do things on a grand scale. He ordered oil refineries built even though
Romania had no oil for them to refine. He constructed massive steel mills that produced
products in large quantity but of such low quality that there was very little demand for
them outside Romania. He instituted a policy of economic self-sufficiency that resulted in
a large central bureaucracy, firms of tremendous size, and production of thousands of
products at costs that were prohibitive. In an effort to modernize the country, he
destroyed thousands of beautiful old buildings, including whole villages. In most cases
the architecture of the buildings that replaced them was nondescript at best. In other
cases, wide empty roadways, leading to public buildings, replaced the old buildings.
Agriculture was largely ignored during this period, and the living standard dropped as
Ceausescu attempted to reduce Romania’s foreign debt.

In the late 1980s the economy started to collapse. A group in the Communist
governmental hierarchy, prompted by a popular uprising, overthrew Ceausescu. After the
overthrow, Ion Iliescu was nominally head of the National Salvation Front, was voted
into power. Although Iliescu was nominally a Communist, his government quickly
attempted to portray itself as an important force in the movement toward free markets.
This led to the passage of Law Number 15, which provided that all of Romania’s state-
owned enterprise would be transformed into either joint-stock or limited liability
companies. It provided that Romanian citizens would receive, free of charge, nominal
securities representing 30 percent of the nominal share capital of the newly created
companies. The law also created the National Agency for Privatization. The Commercial
Companies Privatization Law Number 58, enacted in August 1991, specified how this
privatization should occur.

Private companies became legal, and small firms began to emerge immediately,
especially in Bucharest. Private enterprise was seen initially in the retail sector, but
eventually manufacturing firms began to appear in larger numbers. In some cases, such as
restaurants, these firms charged much higher prices, but they were also generally
perceived as providing better services or better products. By late winter of 1992, the
privatization board had completed its initial evaluations on a series of small firms and had
effectively privatized 50 very small state enterprises. The success with this initial series
of privatization gave the National Agency for Privatization confidence that it could move
forward and meet the government’s five-year timetable for privatization. In addition, it
was meeting with more success interesting foreign firms in joint ventures with some of
the larger state-owned enterprises.

INTRODUCTION
Early in March 1992, Dan Banu left his job as the chief of the quality assurance
department as Aversa, the largest pump manufacturer in Romania, to join his partners at
Multigama on a full-time basis. Dan had joined Aversa in 1978 as a member of a team
that designed pumps for the Romanian nuclear power plant being build at Cernavoda.
The plant had been funded by a $ 400 grant from the Canadian government. Dan and his
colleagues’ department handled designing, purchasing, and shipping of special pumps for
this power plant. The first nuclear pumps were produced in 1984, and by 1987 they were
producing pumps that were actually being used in the new plant.

The work group at Aversa was very unusual in that the engineers were in constant contact
with the Canadians. At the time, contact between Romanians and Westerners was very
restricted, but because this unit needed to be familiar with the ANSII Code requirements
for nuclear plants, frequent foreign contact required. There was some political
surveillance of the employees in this unit, but because their conversations with the
Canadians were highly technical, the political oversight officials concluded that the
contacts did not constitute a political problem. However, the engineers valued these
foreign contacts, which were forbidden for most Romanians, and they enjoyed their
conversations, which often centered on subjects with little technical relevance.

It was during this time that Dan and his colleagues concluded that the ways things were
done at Aversa were not optimal. They could see that the managerial practices lagged far
behind those used in other countries, especially Canada. With the overthrow of Nicolae
and Elena Ceausescu in December 1989, the Aversa management was removed. Ion
Iliescu, leader of the National Salvation Front, became the head of the interim
government. After six weeks in office, Iliescu restored the jobs of the deposed managers
as part of an effort to keep electorate sufficiently happy to vote for him in the upcoming
elections. To further enhance his party’s chances in the election, he increased wages for
workers and managers across the country, with no strings attached. At this point Dan and
seven of his colleagues decided that Aversa could not be changed from within and that
they must start their own business.
The first thing they needed was the 100,000 lei that the government required as a
business license application fee -1. They pulled together the money and got the license.
However, they didn’t have the manufacturing facilities or cash resources needed to
produce pumps, so they entered into a business arrangement with a Syrian exchange
student who was interested in selling bubble gum, curtains, and shoes. He sent them
goods on consignment, which they would then sell. An empty house was used as a
warehouse. The founding group of engineers appreciated this contact, because it provided
them with some valuable managerial experience. At this time little commercial interest
was being directed at Romania. As Dan Banu stated, “Only the Arab and Turkish people
had the courage to come to Romania in 1990. They didn’t have the best merchandise, but
they were not afraid to come.” They named the new firm Syryus.

The first shipment of consigned goods arrived in October 1990. Orders were solicited and
received almost exclusively by telephone. Interestingly, all of the goods were sold to
state-owned trade companies, which then resold them to individual consumers. The eight
engineers remained at Aversa during this period and worked in the evenings and on
weekends at the trading company-2. As revenues increased, the engineers began to quit
their jobs at Aversa so that they could work at Syryus full time. Dan Banu was the last of
the founders to quit his job at Aversa, and by the time he did Syryus has evolved into a
new firm, Multigama. After a time, the Syrian student had decided he wanted to do more
than just consign goods. It was decided that he would return to Romania and enter into a
joint venture wit the engineers. This business relationship resulted in company expansion,
and sales increased rapidly. This provided the entrepreneur-engineers the cash flow they
needed to begin manufacturing pumps.

MULTIGAMA BEGINS
They began with the manufacture of small pumps designed specifically for small farms.
The pump they built also proved ideal for smaller buildings, especially those in
Bucharest, where the water pressure was notoriously low. In addition, hot water is
produced centrally in Bucharest and then distributed to buildings. Additional pumps
permit the users to enjoy a more effective distribution, especially if they are on upper
floors or have multiple outlets for hot water.

Production runs were kept small in the beginning. The partners purchased 10 motors,
some miscellaneous parts, and a total of 20 kg of raw materials. Once the pumps were
produced, they were sold quickly, and all of the profit was reinvested. This reinvestment
was necessary, because bank credit was not available. At this time Romanian banks

1. U.S. dollar = 197 lei in 1990 at the official bank exchange rate.
2. The normal workweek in Romania was Monday through Saturday at this time.
required that loans be secured by assets worth at least 130 percent of the value of the
loan. The bank had little expertise in evaluating the assets, so they tended to be
ultraconservative. The legislature was still discussing what to do about land titles, thus
the banks were unwilling to accept land as collateral. Even if they had been willing, the
existing law limited the rights of property transfer in 1990. After the government returned
the land to the people it feared that farmers would be swindled out of their land by
unscrupulous investors, so it prohibited land sales. In many cases the new owners did not
have titles; they had pieces of paper that stated they would get title to the land in the
future if it was decided that people could have title to the land. Although villagers were
able to acquire 6 to 10 hectares, they did not get proper titles either. They received a
piece of paper that stated they had acquired the right to acquire the land. Thus, during this
period, new business were unlikely to look to banks as a source of funds, and there were
no other institutional sources.

As the demand for their pumps began to increase, the firm was divided into two
divisions, the trading company, Syryus, and the pump manufacturing company,
Multigama. They attempted to find a location in Bucharest for their production facilities.
They thought they could get the space needed if they agreed to pay all the overhead and
maintenance costs for an existing facility, since the decrease in demand for Romanian
goods had left many firms with excess production space. However, government officials
were reluctant to agree to this type of arrangement, and since the government still
controlled all the larger firms, Multigama was unable to arrange for any work space in
Bucharest. They spent from February to September of 1991 looking for suitable
production space and fell far behind schedule. Without their own production facility, they
were forced to have existing firms manufacture the components they needed.

A great contrast existed between state-owned firms and the newer private firms. Phrases
such as a “warm place” and an “an orphanage for older workers” were frequently used to
describe the state enterprises. For instances, Don Banu felt that 2,500 employees could
achieve the same output as the 5,000 Aversa employees. He felt that privatization might
not be able to solve this problem, because social networks had been the source of new
employees for many firms in Romania. This meant that many employees were related or
close friends. Lacking established staffing and evaluation criteria, these friendships and
family relationships might make professional human resource practices impossible.

PRODUCTION BEGINS
For these reasons Multigama decided to find a private firm to do its manufacturing to find
a private firm to do its manufacturing in October 1991 they identified a small firm 100
kilometers from Bucharest that had been purchased by its employees. The firm was
currently producing small car trailers, and it had the necessary equipment and employees
to produce the small pumps required by Multigama. They entered into a manufacturing
agreement with this firm.
The production arrangements were completed just in time for Multigama to attend the
International Industrial Product Exhibit held in Bucharest in October 1991. Multigama
rented the cheapest display space available. On the first day of the fair a pipe broke, and
all water-using facilities, including restrooms, stopped working. Fair officials went to
Aversa for help, but it could not do anything. At this point Multigama stepped in and
provided one of its pumps. This earned the company a lot of free publicity at the fair, as
well as the personal gratitude of those exhibiting and attending the fair. In addition,
because theirs was one of the cheapest spaces at the fair, it was near a nonworking
drinking fountain. This allowed them to attach one of their pumps to the nonworking
fountain, which not only showed how well their pumps worked but also enhanced their
space and attracted additional people to their area. This led to their first order for 10
pumps. At the time of the fair they had manufactured only 5 pumps, so this order was
essential to their next production run, which was set at 30 pumps.

After the fair they began to advertise in newspapers, more to inform people that they had
pumps than to sell them. Because of supply shortages, it was more important to advise
people in Romania where they could find things than to generate new demand. A large
number of newspaper had been founded after the overthrow of Nicolae and Elena
Ceausescu and the great amount of competition kept advertising costs low.

The initial batch of 30 pumps sold quickly. Gradually, production runs were increased to
300 to 500 pumps. Currently Multigama is manufacturing between 500 and 700 pumps
each months. Newspaper advertising has been eliminated, because the partners believe
their potential customers are aware of them. Management still views advertising as
merely a way of informing predisposed buyers as to where they can purchase the goods
they need. Also, Multigama is selling all of the pumps it is currently capable of
manufacturing, which reduces its interest in advertising.

Product development has also expanded rapidly. The initial selection of three pumps has
been expanded to five models, each of which comes in two or three sizes. Currently, the
profit margins are lower and the turnaround is slower on the industrial (Multigama) side
if the firm. However, management is more interested in this side of the business. It
accounts for over 80 percent of the revenue, and management expects this percentage to
increase in the future. They have more expertise in this side of the business, too. They
have seen that it is easier to get trading business started, and they expect margins to
gradually fall in this area as more competitors emerge.

The organizational structure of Multigama has become more formal as the business has
grown. The eight original partners form the General Owner Assembly, from which they
elect a president. Once a month an administrative board, consisting of the owners and the
president, reviews a report from the president. In addition, the president must prepare the
general balance and financial report, which is due each March. This report is also
required by the government. It is expected that as the government’s privatization effort
expands, additional financial reporting will be required, and this will impact the firm.
DIVERSIFICATION
Multigama is planning to build a facility for both its own use and to provide rental
income. They plan to have apartments on the upper floors and commercial space for their
own administrative and to rent to other firms on the first floor. The rent will provide
needed revenue, while offering them room for expansion as the firm grows. They have
found a potential partner/investor, who wants to build a building in the center of
Bucharest. The government paperwork has been completed, and a contractor has been
hired. The building is expected to take one year to complete. To further test the feasibility
of this idea, Multigama ran a newspaper advertisement to announce what they were
doing. The response was a encouraging; several businesses have already committed to
rent some of the first-floor commercial space. They believe demand will be high because
there is housing shortage in Bucharest, and many of the commercial buildings started by
Ceausescu are of poor quality and will probably be demolished rather than completed.

Multigama is also considering the possibility of manufacturing food-processing

equipment. They have been developing a relationship with a Lynnwood, Washington,
firm headed by a Romanian expatriate. This potential partner has expertise in
refrigeration, which Multigama lacks.

It has been very difficult to attract investors because Romania is not viewed as a good
place to invest. The EEC, Canada, and the IMF have directed their investment towards
energy generation, because there is currently a shortage of energy production capability
in Romania. In addition, most foreign credits have been going to state-owned firms, and
Romania’s existing Communist government status has resulted in its not being
considered for some foreign investment programs, especially those with government
sponsorship.

However, the best employees have been gradually moving to private firms. In the old
days, the large state firms were required to produce an item domestically, even if only
one of the items was needed. With privatization, the larger state-owned firms have been
left with labor forces geared to this type of response mode. The turn toward free market
operations and privatization has led to much speculation about what form of commercial
activity is most appropriate for Romania. Dan Banu feels that these factors will combine
to produce an environment that us more conducive to investments in new private start-
ups.
THE FUTURE
Banu and his partners are doing a lot of thinking and planning. They are trying to
determine where the best opportunities for profit exist and how to obtain the necessary
cash, or investors, to exploit these opportunities. In addition they are seeking ways to
move from a purely domestic mode to one more focused on foreign trade. Labor costs are
currently quite low in Romania, which will allow Multigama to price its product
competitively, and their pumps seem ideal for use in many less developed countries.
They are also concerned about their lack of managerial experience; all of the founders
still consider themselves primarily engineers. The potential effects of privatization are
unclear. They are aware that Aversa may find a powerful and efficient foreign partner,
which could limit Multigama’s potential for growth.

DISCUSSION QUESTIONS
1. As an executive of a multinational enterprise, would you to consider investing in
Multigama? What would be the main issues to consider?
2. What about investing in Aversa? What are the advantages and disadvantages of
investing in each?
3. Given the industries in which Romania had invested under the Communist
regime, how likely are these industries to help lead Romania toward economic
prosperity?
4. As an IMF or World Bank official, how would you target lending to assist in the
development of Romania?
5. Given their success to date, and the opportunities they have, what advice would
you give to Multigama’s management?

SOURCES
1. This case was prepared by Associate Professor John Butler as the basis for class
discussion, rather than to illustrate either effective or ineffective handling of an
administrative situation. Copyright 1992 by John E. Butler. No part of this
publication may be produced, stored in a retrieval system, or transmitted in any
form or by any means-electronic, mechanical, photocopying, recording, or
otherwise- without the permission of the author.
INTRODUCTION
In the aftermath of the collapse of Soviet-style communism in Russia and the breakup of
the Soviet Union, the Russian government has been trying to transform a centrally
planned economy in which almost all productive assets were owned by the state into the
vibrant market economy. A main tool in this task has been the privatization of state-
owned enterprises. The great hope of Russian reformers is that putting state enterprises
into private hands, and making them accountable to their owners for their performance,
will result in major efficiency gains and a more productive economy. This process began
in 1991 and by mid-1995 Russia’s private sector employed over 80 percent of the
nation’s nonagrarian work force, more than half of Russia’s estimated 240,000
enterprises had been privatized, and some 40 million Russians owned shares in more than
15,000 mid and large-scale enterprises. However, it was too early to say whether the
privatization process had been a major success.

THE PRIVATIZATION PROCESS

The Russian privatization process officially began in mid 1991 when Russian President
Boris Yeltsin signed a privatization law that created a state agency, the State Property
Committee, known by its Russian initials GKI, to oversee the transfer of state assets into
private hands. However, little happened until after the failed coup attempt in 1991 by a
small and poorly organized group of pro-Soviet politicians and generals. Following the
failed coup, and the subsequent breakup of the Soviet Union, Boris Yeltsin appointed a
young politician from St. Petersburg, Anatoly Chubais, to head GKI. Yeltsin gave
Chubais free rein to devise a program for rapidly privatizing the Russian economy, and
more importantly Yeltsin placed his then considerable political weight squarely behind
the privatization process.

Chubais quickly assembled a team of like-minded people, all of them young and all of
them willing to work all day, everyday, until they had attained their goal. To help decide
on a basic privatization strategy, Chubais and his team analyzed the privatization efforts
then being carried out in a number of other countries, including the gradual case-by-case
approach to privatization pursued in Poland and the rapid mass privatization approach
adopted by the Czech Republic.

The approach chosen by the GKI team was strongly influenced by the conditions
prevailing in Russia at that time. In early 1992 the Russian economy was still centrally
controlled by ministries or subministries, each running an industry. The GKI team
realized these organizations might not easily or willingly give up their authority.
Reporting to the ministers were legions of so called “red directors,” the former
communist party apparatchiks spread across Russia who actually ran state enterprises on
a day-to-day basis. As products of the old system, these individuals were likely to attempt
to frustrate any reform effort that limited or deprived them of power.
The GKI team decided that tackling this network of entrenched bureaucrats would require
more speed and scope than finesse. The process they devised was driven by three goals.
The first was to move quickly to break up the old Soviet system before opposition could
build, primarily by privatizing most state assets within two years. The second goal was to
“divide and conquer” the potential opposition by splitting the red directors away from the
ministries. The reformers aimed to entice the red directors into supporting the
privatization program by offering them ownership stakes in the enterprises they were
already managing for the state. The theory was that the industrial ministries, stripped of
their assets, would then be left to wither. A third goal was to quickly create a broad base
of property owners who would be opposed to reversing the changes.

For small enterprises and assets, such as shops, restaurants, and apartments, the reformers
chose to leave details of the privatization effort to local authorities. The thinking of GKI
was that such decentralization of responsibility would result in a more rapid and flexible
approach to privatization. The most common approach was to auction small enterprises
and assets for cash. Often the buyers were workers themselves. The approach proved
successful, and by 1995 over two-thirds of small businesses in Russia had been
privatized. These small businesses have become the foundation for a growing middle-
class, which the reformers hope will back further efforts to push the Russian economy
toward a free market model.

For midsized and large enterprises, the GKI adopted a mass privatization strategy that
utilized a voucher system. Modeled after the system used in the Czech Republic, the first
step was for thousands of state enterprises to be transformed into “corporatized”
companies with shareholdings, with some portion of their shares to be slated for auction.
The Russian government then issued vouchers, available from October 1992 to January
1993. For a fee of 25 rubles (then about 10 cents) each Russian was eligible to receive
one voucher. About 144 million vouchers were given out in this way, meaning that about
97 percent of the population took up the offer. Each voucher had a face value of 10,000
rubles (i.e., about $ 25). The voucher holder had three options: sell the voucher for cash
( a lively market for vouchers soon developed); use the vouchers to bid at auctions for the
shares in corporatized firms; or invest the vouchers in private mutual funds that would
then purchase packets of shares.

To win over managers and workers of state enterprises, as well as local politicians, GKI
allowed each state enterprise to choose form a menu of privatization plans. To varying
degrees, the plans allotted packets of shares, and in many cases controlling stakes, to
company insiders in exchange for cash or vouchers, or sometimes straight giveaways.
Another portion of the shares would be auctioned to voucher holders who were not
company employees, and in many cases a third packet of shares was reversed for the state
to sell later for cash or investment tenders commitments to make substantial investments
in companies in exchange for blocks of shares. When managers and workers could
choose to keep a controlling interest in their privatized business, they usually did so.

One of the earliest large enterprises to be privatized under the voucher arrangement was
the Bolshevik Biscuit Factory, Russia’s largest cookie factory, which was auctioned off
in December 1992. Roughly 80 percent of the company’s shares were put up for auction
and all were sold. More voucher auctions followed with another 17 companies being
auctioned off during December 1992. Throughout 1993 and the first half of 1994 several
hundred companies were privatized each month under the voucher program. For the
grand finale in June 1994, when the vouchers were set to expire, stakes in 2,621 medium
and large enterprises were auctioned. By the end of June 1994, 86 percent of Russia’s
industrial labor force was working in the private sector.

Since June 1994 Russia has moved to a less systematic and more cumbersome process of
selling still more state-owned business, along with the remaining state stakes in many
companies for investment tenders. Investment tenders allow large investors to put up the
big money that is needed for restructuring companies in exchange for big stakes.

Alfa Kapital, a Moscow-based investment company that has 2 million shareholders and
stakes in more than 60 companies, is typical of the new enterprises that are purchasing
state-owned shareholdings in return for investment guarantees. Alexei Kalinin, Alfa
Kapital’s managing director of long-term investment, works to restructure and turn
around companies in which Alfa holds ownership stakes. Before 1992 the directors of
these companies answered to government ministers who were concerned with the
enterprises’ ability to meet centrally determined five-year plans. Now they answer to
Alexei Kalinin, who cares about profit.

EVALUATING THE PROCESS

Although Russia’s privatization process achieved its primary goals of rapidly
transforming state-owned enterprises into private entities, the process has had critics. One
criticism is that the tilt toward giving shares to insiders-enterprise employees the same
red directors who had presided over the poor management of the enterprises when they
were state owned. Critics have suggested that old Communist elite were among the
largest gainers of the privatization program. Several studies in Russia have concluded
that new owners and managers are more likely than old insiders to restructure a newly
privatized company. GKI supporters counter that form a political standpoint, the
approach was necessary to win support from managers and workers for the privatization
process.

Another frequently voiced criticism is of the voucher system. The state gave away many
valuable assets for virtually nothing. In many other countries the government first
restructured state-owned enterprises to make them more efficient and then sold them to
the highest bidder, often for considerable financial returns. In Russia, the state placed
enterprises in private hands in exchange for 144 million 25 ruble (10 cent) vouchers,
leaving their new owners to get on with the restructuring. This was a serious mistake on
two counts, argue the critics. First, the state received no revenue from the privatization
process, and second, many of the new private owners simply lacked the capital required
to restructure their enterprises. However, GKI supporters contend that imperfect as the
process was, it was the only way of rapidly shifting ownership of enterprises in to private
hands. Russia simply did not have the luxury of taking its time to turn around state
enterprises and then selling then to the highest bidder.

Many newly privatized enterprises are finding it difficult to raise the investment funds
they need from the capital market to restructure their operations and purchase new
equipment. Consider the experience of Red October, a privatized Moscow based candy
company with an 80 percent market share in the local region. Red October did raise $22
million. However, this was the short of expectations, primarily because there was little
interest among foreign investors in buying the shares of a Russian enterprise, albeit one
with a dominant position in its local market.

GKI is facing similar problems in its attempt to sell remaining state-owned stakes for
investment tenders. In the first nine months of 1995 GKI raised only $36 million from the
sale of investment tenders, far short of the $ 2 billion target set for the whole of 1995.
The poor showing is largely attributed to a lack of interest by foreign investors. The point
was driven home in December 1995, when Stet, the Italian telephone company, pulled
out of a deal to purchase a 25 percent stake in the Russian regional telephone holding
company, Svyazinvest, for about $1.4 billion.

While the lack of interest by foreign investors may be in part due to the current poor state
of the Russian economy, much seems to be attributed to the confusing state of Russian
property laws and uncertainty as to the long-term direction of economic and political
reform in the country. Russian property laws are highly ambiguous and have deterred
many foreign investors. For example, Russia’s emerging stock market went into a serious
slump in late 1994 when many foreign investors discovered they could not be sure they
owned the stock they had paid for. Company insiders could simply strike their names off
the shareholder registers, most of which the companies themselves ran. As odd as it
might seem, at the time there was no legal recourse to such action.

The decision by Stet to pull out of its planned investment in Svyazinvest also illustrates
some of the problems Russia has in attracting foreign investors. Stet reportedly pulled out
of the deal because it did not have a chance to perform due diligence on Svyazinvest and
because of the confusion over the legal status of many of Svyazinvest’s operations. In
particular Stet wanted the rights to the 85 regional telecommunication companies that
form Svyazinvest to be clearly defined and was pressing for a clearer definition of the
relationship between Svyazinvest and Rostelecom, Russia’s dominant telephone
company and Svyazinvest’s future competitor. Apparently these definitions were not
forthcoming from Russian authorities.

In a further development that may have influenced Stet’s decision, in December 1995 the
Communist party emerged as the big winner from parliamentary elections with close to
25 percent of the vote. Many Communist candidates had promised during the election
campaign that they would revoke “unfair” privatizations, and while they claimed to be in
favor of private ownership of businesses, they also claimed to be against the sale of land
to the public. While the power of the Duma, Russia’s parliament, is relatively limited
compared to the power of the Russian president, many fear that the Communists will now
 be able to frustrate any attempts to improve Russia’s tax code or property rights
legislation to make the country more attractive to foreign investors. Moreover, there are
growing fears that the Communists might do well in the 1996 presidential elections,
which could bring Russia’s economic reforms grinding to a halt.

Since the early 1990s, foreign investors have been attracted to Russia by a number of
favorable factors, including the large size of the domestic market, the sustained long-term
growth rates in the economy (including a rapid recovery after the 1998 financial crisis),
the high quality and low costs of human resources, and macroeconomic and political
stability. We provide below a brief history of the legal and regulatory framework
governing foreign investment in Russia and the impact of this framework upon doing
business in Russia. We then describe some of the key limitations on foreign investment in
Russia, including several constraints now in place and others that are currently under
consideration.

Historical Background
The opening of Russia‘s economy to foreign investment was part of an overall strategy of
rapid conversion from a planned economy to a market economy. As a result, after the
breakup of the Soviet Union many formal obstacles to foreign investment were promptly
eliminated. Russia evolved from the enforcement of a complete prohibition on foreign
investment in virtually all sectors, to espousing a fundamental freedom to invest, subject
to strict limits in certain sectors and, in most cases, to governmental approval or
notifications (de jure or de facto).
 
From a legislative prospective, the process of liberalizing the Russian economy first
required the formation of a regulatory basis to support new market relationships. As the
process has matured, numerous revisions to laws have been needed to address practical
issues and to bring the Russian framework for investments into conformity with
international practices.
 
There were several significant milestones in this process:
 The adoption in 1993 of the new constitution, which explicitly protected property
and other economic rights, including those of foreign investors
 The introduction of the first and second parts of the Civil Code in 1995 and 1996,
respectively, establishing the basic principles for commercial relations
 The enactment of corporate legislation - laws on joint-stock and limited liability
companies - and other laws governing various aspects of commercial activity.

 
Overshadowing these significant legislative reforms, from the perspective of foreign
investors, was the frequent reshuffling of Russian governmental officials and the
relatively long timeframe for implementing legislative reforms. These aspects of the
Russian political and economic systems have inhibited many potential foreign investors
from making long-term commitments, and as a result the relative amount of direct foreign
investment in Russia has remained quite limited from year to year in comparison with
other countries.
  
Although valid concerns in the past over inadequate legal protections for minority
shareholders and inconsistent application of the law toward foreigners have been largely
assuaged, there are lingering concerns which continue to hamper the inflow of foreign
investment to Russia. Selective application of laws and the possibility of differing
interpretations of a given rule in different regions, or among different officials within a
region, have complicated the decision to invest in Russia. Continuing corruption in the
Russian judicial system and the widespread perception that Russian judges yield to
political pressure continue to lead foreign investors to avoid, when possible, the
resolution of disputes in the Russian courts. Informal barriers to foreign investment in
Russia are still considered to be a serious impediment to new investments.
 
Nonetheless, Russia has made significant improvements in its business environment in
recent years through the adoption of laws protecting property rights and corporate
governance rights of investors, reforms in the law on insolvency and the establishment of
regulatory and judicial institutions needed for the functioning of a market economy.
Russia also has signed bilateral investment treaties and double taxation treaties with
many countries and has signed (but not yet ratified) the Energy Charter Treaty, which is
applied in Russia provisionally.
 
Freedom of Investment, But with Restricted Sectors
 
A law specifically governing foreign investment in Russia (the "Law on Foreign
Investments") was passed in 1999 and amended in 2002, 2003, 2005 and 2006. This law
stipulates national treatment for foreign investors and gives them the right to engage in
investment activity in any form authorized by law. It guarantees compensation for
expropriation, authorized repatriation of profits and capital, and contains a grandfather
clause providing protection against increases in mandatory payments for some large
projects in which foreign investors have participated. Investors are guaranteed to be able
to sell their investments and to repatriate their investment proceeds. The Law on Foreign
Investments also grants to foreign investors a number of other guarantees, including
among others a right to participate in the securities market, in the privatization of Russian
state assets, and in the ownership of real estate. However, most of these guarantees are of
a declarative nature with a broad reference to the procedures set forth by applicable
Russian legislation.
 
Officially, Russia maintains restrictions (through quotas on participation and otherwise)
on investments in the following sectors:
 Aerospace
 Natural gas
 Insurance
 Electric power
 Defense
 Natural resources
 Large scale construction projects
 
There is no single statute or code unifying the treatment of investments across all Russian
economic sectors, and to date no single piece of legislation has applied "national
security" across the board as an overriding criteria for the approval or disapproval of a
particular investment. Consequently, a de facto "national security exception" exists to the
general rule of freedom of investment, with a number of Russian federal ministries
playing special roles in the approval process for investments proposed by foreign parties.
 
Sector Quotas and Entry Barriers
 
In certain industries, there are quantitative limitations on participation by foreign
investors. In others, there are structural barriers which channel foreign investors into the
establishment of Russian businesses. These limitations and barriers are intended both to
control access to those industries and to protect domestic companies from undue foreign
competition. For example:
 
The Russian insurance industry is subject to a 25 percent limit upon participation by
foreign entities in the aggregate capital of Russian insurance companies. A Russian
insurance company whose charter capital is more than 49 percent held by one or more
foreign parties becomes subject to certain qualitative limitations upon the scope of its
activities (i.e., it cannot offer life, property, compulsory insurance).
 
Similar limitations apply to participation by foreign investors in certain other sectors,
such as mass media (including broadcasting) and aviation.
 
New Regulations under Consideration
 
In the context of WTO accession and national security concerns, the Russian government
and the State Duma currently are considering new regulations on foreign investment.
 
A historical quota restricted foreign capital participation in the Russian banking sector to
12 percent of the aggregate amount of charter capital of Russian banks. This quota was
cancelled, but Russian bankers recently asked the government to reinstate it, after Central
Bank figures showed that the level of foreign bank ownership of Russian banks reached a
high of 10.98 percent in October 2005. (The previously high point was 10.7 percent,
reached in 1999.) In the still-ongoing negotiations over Russia‘s accession to the WTO,
officials of the Russian Central Bank have indicated that Russia would be prepared to
more than double the historical quota, thereby allowing foreign banks to acquire up to 25
percent of the aggregate charter capital of Russian banks. Some Russian bankers have
called for a new quota to be set between 25 and 30 percent.
 
Notwithstanding the historical quota on ownership of Russian bank shares, at the first of
the year Western banks wholly owned 40 Russian banks, and another 91 Russian banks
had foreign shareholders. Moreover, Western banks had increased their share of the
Russian national market for loans to nearly 40 percent. The attraction of the Russian
banking market to foreign banks has been accentuated recently by new programs for
deposit insurance and credit reporting bureaus, as well as by improved authority for
banks to issue mortgage-backed securities in the future.
 
Large foreign companies considering initial or further investments in Russia appear to be
willing to accept limitations upon their entry into sectors deemed "strategic" by the
Russian government, as long as the foreign investors receive guarantees that there will be
no limitations in non strategic sectors beyond anti-monopoly laws and regulations.
 
 
The recent wave of offshore offerings of securities involving Russian companies
demonstrate that Russia’s legal reforms, despite their unfinished status, have nonetheless
empowered Russian companies to tap the international capital markets for significant
amounts of debt and equity. A continuing string of issuers from Russia and other former
Soviet states have listed global depository receipts (in aggregate, more than $5 billion
during 2005) for relatively small blocks of their ordinary shares on the London Stock
Exchange. Recent moves to remove the "ring fence" against foreign ownership of a large
percentage of Gazprom shares and the related elimination of offshore "grey-trading" in
Gazprom shares by foreigners acting through Russian brokers, should only boost interest
in Russian equities generally. As foreign ownership of equity in Russian companies
becomes more commonplace, and as the process for obtaining Russian governmental
approvals for investments in strategic assets and infrastructure projects becomes clearer
and more standardized, the level of comfort should increase dramatically both for
potential investors and for Russian government officials and politicians.

DISCUSSION QUESTIONS
1. What are the strengths and weaknesses of the Russian privatization process?
Could a better process have been devised?
2. Do you think the privatization of formerly state-owned enterprises is sufficient to
induce foreign companies to invest in Russia? If not, what else needs to be put in
place before Russia becomes an attractive location for inward investment?
3. What are the nature of the political and economic risks confronting foreign
investors in the Russian economy in late 1995? Given the nature of these risks,
and the existence of attractive investment opportunities else-where in the world,
what approach do you think foreigners should adopt toward investing in Russia?

SOURCES
1. Allen, M. “How It Works: What Is Privatization Anyway?” The Wall Street
Journal, October 2,1995, p. R4.
2. Banerjee, N. “Major Investment in Russia Is Stymied.” The Wall Street Journal,
December 26,1995.
3. Freeland, C. “Russia’s Privatization: From Bang to Whimper.” Financial Times,
December 29, 1995, p.2.
4. Guyon, J. “Russian Firms Face Fund-Raising Woes.” The Wall Street Journal,
April 19,1995, p.B6.
5. Lane, D. “Communists Blamed as Telecom Deal Collapses.” Financial Times,
December 27, 1995, p.1.
6. Liesman, S. “Russian Communists Are in New Breed.” The Wall Street Journal,
December 19,1995.
7. Rosett, C., and Liesman, S. “Much Has Gone Wrong with Russia’s Privatization
Efforts; but Much Has Gone Right.” The Wall Street Journal, October 2, 1995, p.
R14.
8. “Special Report: Russia’s Emerging Market. The Sale of theCentury.” The
Economist, April 8, 1995, pp. 5-9.