Russia's attempts to introduce large-scale competition into the Russian telephone industry got off to an encouraging start in late 1995 when a public offering of shares in Svyazinvest, the holding company representing the government's 51% stake in 85 of Russia's 87 regional operating companies, attracted the bids of several foreign investors. But a promising set of negotiations with the Italian state telephone company ended in an imbroglio at the year's end, turning imminent success into sudden, dismal failure. Ever since, Svyazinvest has been widely considered an unattractive investment, and the failed negotiations prompted concerns that Russia was incapable of successfully bringing off a major international investment. Recently, the government has taken steps to consolidate the ownership of Svyazinvest with that of Rostelekom, the partially-privatized, primary long-distance and international service provider, leading many observers to believe that Russia will soon have a telecommunications monopoly the likes of Deutsche Telekom or France Telecom. Given Russia's pro-competition communications policy, however, such an outcome seems unlikely.

Having sold off a 49% share in 85 of Russia's 87 regional telephone operating companies in 1993, the government pooled its remaining 51% interest in these companies to create a holding company.[1] Called Svyazinvest, the holding company was created during the summer of 1995 in order to bolster the rate of growth of public networks in Russia and to develop a common management policy for those networks.[2] At the time, there were more than 1,000 telecommunications operators in Russia, each with its own set of policies regarding fees, development and other areas.[3] Additionally, it sought to create a major competitor to Rostelekom.[4] In anticipation of Svyazinvest's future role as competitor, the Communications Ministry granted Svyazinvest a license to develop a long-distance and international network.[5]

Svyazinvest was created with foreign investors in mind.[6] As part of a pattern of large Russian companies seeking funds from western investors, the Russian government made an offer of a 25% share in the telecommunications holding company.[7] By drawing in foreign capital, the government hoped to gain the financial means to upgrade Russia's antiquated telephone system, which threatened to hinder economic development.[8] A successful sale would also provide funds to help the government cover its ponderous budget deficit.[9] Perhaps most importantly, the government sought to restore the credibility of its privatization program, which had recently come under fire.[10] While the first stage of privatization, launched in 1992, was widely praised for quickly shifting 80 % of the economy at least partially into the private sector,[11] the second stage, which began in 1995, did not fare as well. This phase was criticized as a secretive process which was carried out for the benefit of insiders,[12] with large shares in valuable Russian energy companies being sold to domestic banks for excessively low prices.[13] It was hoped that the Svyazinvest sale would set an example of fairness and transparency for future auctions.[14] In a move that showed its intention of assuring westerners of fair play, the Russian government selected a consortium headed by N. M. Rothschild & Sons, an investment bank based in the U.K., to find an investor.[15]

The dimensions of this offer were of vast, even historic, significance. Svyazinvest was valued at between $7.5 billion and $8 billion[16] and boasted 26 million customers.[17] The Russian government estimated that a sale would raise between $1.8 billion and $2 billion.[18] It would be the biggest foreign investment in Russia outside of the energy sector.[19]

The Stet Fiasco

While many elements of the offer were unclear, the terms set by the Russian government were not. Setting the deadline for bids at November 30, 1995, the government showed that it was not going to tolerate dithering by foreign investors.[20] In fact, the primary reason for the Russian government's haste was that its need for funds to apply to its huge deficit was reaching crisis proportions.[21] The other major condition was that the bidder offer at least $430 million and promise to invest $770 million over the next two years to develop Svyazinvest's operations.[22] In spite of the short notice and tall demands for financial guarantees, the offer drew inquiries from the Italian state telephone company and a consortium comprising Deutsche Telekom, France Telecom, and a company representing U.S. West.[23] By the end of the bidding period, the Italian company, Stet, was the highest bidder at $640 million, winning out over the consortium's bid of $450 million.[24] Stet additionally made the commitment to invest another $770 million in Svyazinvest's operations.[25]
¶5
For Stet, the Svyazinvest offer was a tremendous opportunity, even if there were some doubts about the Russian company. Stet was slated for privatization the following year, and it considered the time ripe for expanding into emerging markets such as Russia's.[26] In a country with huge growth potential, Svyazinvest appeared to be in position to be a major contender in the telecommunications business, already holding licenses for both cellular and long-distance services.[27]

At the same time, several aspects of the offer troubled the Italians. First, there was some doubt concerning the degree of control the holding company had over its 85 regional operating companies.[28] Lacking the requisite political clout with city governments, Svyazinvest had been unsuccessful at effecting local changes such as rate increases.[29] Second, it was unclear whether Svyazinvest would have access to the planned "fifty times fifty" fiber-optic network.[30] Access to this network would allow Svyazinvest to provide service over an additional 20 million lines.[31] Third, there were uncertainties regarding the regulatory regime under which Svyazinvest would operate, as well as the future parameters of Svyazinvest's relationship to Rostelekom.[32] Some industry executives were concerned that the Russian government would have difficulty establishing an appropriate blend of competition and cooperation between the two Russian companies.[33] Fourth, the possibility of Svyazinvest becoming a major competitor to Rostelekom was beginning to appear illusory since Svyazinvest had yet to make use of its long-distance license.[34] Finally, Stet worried that the political consensus which held Russia's free-market transition together might be short-lived, leaving open the possibility that Svyazinvest's commercial freedom might be restricted in the future.[35]

Other Western telecommunications companies, such as AT&T, were put off by these uncertainties and opted against bidding.[36] A major problem industry analysts mentioned was the lack of choice involved: instead of buying a package of 85 companies, many investors would prefer to be able to "cherry-pick" among the companies they believe most likely to succeed.[37] Companies declining the offer viewed obtaining a minority share in 85 Russian companies as an administrative nightmare. This is not an unreasonable assessment, especially given the extent to which the individual regions in which these companies operate have created distinct economic environments.[38]

The Stet deal ran into trouble when the uncertainties became too much for the Italian company. The hasty offer prepared by the Russians had left Stet with no time to perform the full due diligence review that ordinarily accompanies negotiations for sales of this scope.[39] Now that it had secured its place as the highest bidder, Stet faced all of the uncertainties that had given pause to other investors. Concern for the durability of political support for market liberalization became even more acute with the Communists' strong showing in the December parliamentary elections.[40] Shortly before the December 22 deadline for the closing, Stet decided to place the money for the purchase into an escrow account and demanded that certain investment conditions be met.[41] Specifically, Stet wanted a clear definition of the rights of Svyazinvest's 85 regional telecommunications companies, as well as a clearer picture of Svyazinvest's future relationship to Rostelekom.[42]

The Russian government responded with guarantees designed to allay the fears of the prospective buyer. The Russian Privatization Center (RPC), which organized the tender on behalf of the government, had already put a novel compensation scheme on the table, whereby more shares--up to seven percent of the total--would be offered to the investor if it turned out that Svyazinvest's assets had been substantially misreported.[43] Now the government offered a guarantee from the ministry of finance to buy back Stet's shares if Stet's demands were not met.[44] These guarantees were not enough for the Italians, who continued to insist on payment into an escrow account, but the Russian government refused, arguing that this request showed inappropriate distrust and strayed too far from the terms of the initial tender.[45] Having reached a stalemate, the parties left the negotiating table for good. The discussion was over.[46]
¶10

Aftermath: The Russian Government Picks Up the Pieces

The failure of the Stet deal was a demoralizing setback for Russia's privatization program.[47] To many, Russia had proved itself incapable of successfully carrying out a transparent international tender.[48] The absence of the expected funds left a large gap in the national budget, and critics of Russia's economic policy had fresh ammunition with which to make their case.[49] Even lawmakers who supported economic reform were prompted to speak out against the way the government was conducting privatizations.[50] The resulting acrimony has spawned legislative proposals such as that issued by the Duma (Russia's lower house of parliament) on February 21, 1997, which would ban foreign investment in electric utilities and telecommunications.[51] Seemingly, the government had lost its chance to salvage what was left of the public image of its privatization program.

The government decided to renew its efforts to auction off a portion of Svyazinvest in November 1996.[52] This time, however, it was even less clear what investors were being offered, and a successful sale seemed more elusive than the year before. First, the State Property Committee dismissed the group led by N.M. Rothschild & Sons that had been working on the tender.[53] Apparently, the group has been replaced by Most Group and Alfa Bank, two large Russian banks.[54] Since these banks have previously displayed no interest in telecommunications, it is feared that, if hired, they may choose to buy stakes in the company themselves rather than conduct an international offering to generate maximum revenue.[55] Second, the relationship between Svyazinvest and Rostelekom promised to become only more muddled. As late as September 1996, it was believed that the government would set up Svyazinvest as a long-distance rival to Rostelekom.[56] However, the government's decision to re-auction a 25% share of Svyazinvest was accompanied by a decision to combine the government's 51% voting stake in Rostelekom with Svyazinvest.[57] The goal of the planned merger was to make the 25% share in Svyazinvest more attractive to western institutional investors in the international public offering slated for the following year.[58]

The proposed merger led many to believe that the Russian telecommunications industry was returning to a monopoly situation. Russia's commitment to privatization and pro-competition policy, expressed in the Law on Foreign Investments and the Communications Act, was called into question by this decision.[59] Officials of the World Bank, which was advising the Russian government on privatization, criticized the move, saying it threatened to stifle the growth of private companies such as PLD Telekom.[60] Additionally, in March 1997 the government abolished the Communications Ministry and replaced it with a State Committee for Communications and Informatization.[61] While the stated purpose of this restructuring was to accommodate an increasingly privatized Russian telecommunications industry,[62] the uncertainty of the authority of the new Committee has given rise to concerns that its creation may result in a monopoly.[63] If the Committee is not to have the same degree of authority, it is feared that the reins of governmental control over telecommunications will pass to Svyazinvest.[64] In part because a replacement for the outgoing Communications Minister has not yet been named, there is much speculation that the Committee will indeed not have the same authority as the Ministry.[65]

However, it is not clear whether there really is a telecommunications monopoly on the horizon. Officials from Rostelekom have denied any plans for creating a telecommunications monopoly, and claim that there will be no change in Rostelekom's decision-making structure.[66] Moreover, the landmark World Trade Organization agreement signed by 70 nations in February 1997 has set the stage for the establishment of open, competitive telecommunications markets around the world.[67] Although Russia did not sign the WTO agreement, it is possible that the deal could influence non-member countries, including emerging markets such as Russia's.[68]

The transfer of voting shares from Rostelekom to Svyazinvest has yet to take place, and President Yeltsin still has the chance to block it by refusing to sign a presidential decree ordering the transfer.[69] Yeltsin may quite reasonably conclude that a transfer of a controlling interest in Rostelekom, the state's main long-distance and international service provider, to Svyazinvest, the state-owned holding company with a controlling interest in 85 of Russia's 87 regional operating companies, would contravene the pro-competition policy embodied in the 1995 RF Communications Act.[70] These policy considerations, in addition to the possible influence of the WTO agreement, may give Yeltsin second thoughts about approving a transfer that could turn back the clock on the liberalization of Russian telecommunications.
¶15

Footnotes

[a] Steven M. Chernoff is a third-year student at Boston College Law School who has three years' experience working for American companies in Moscow and St. Petersburg. He recently worked as a summer associate for an U.S.-based law firm in St. Petersburg, where he spent a substantial portion of his time researching the regulation of telecommunications in Russia.
[1] See Timur Faroukshin, Russia Pools Its Telco Shares, Comm. Week Int'l, Sept. 18, 1995, available in WESTLAW, 1995 WL 9771887.
[2] See id.
[3] See id.
[4] See id.
[5] See John Thornhill, A Long-Distance Call: The Italian Telecoms Group's Bold Drive Into Russia Will Be a Test of Nerve and Will, FIN. TIMES, Dec. 14, 1995, available in WESTLAW, 1995 WL 11166048 [hereinafter Thornhill, A Long-Distance Call].
[6] See Neela Banerjee, Major Investment in Russia Is Stymied As Pact With Stet Runs Into Trouble, WALL ST. J., Dec. 26, 1995, at A4 [hereinafter Banerjee, Major Investment].
[7] See George Graham and John Thornhill, Russia Seeks Dollars 2bn From Sale of Stake In Telecommunications Group, FIN. TIMES, Oct. 10, 1995, available in WESTLAW, 1995 WL 9160886.
[8] See Douglas Lavin and Steve Liesman, Russia Phone Offer May Get No Answer, WALL ST. J., Oct. 11, 1995, at A10.
[9] See John Thornhill, Italians Set to Pay Dollars 1bn for Russian Telecommunications Stake, FIN. TIMES, Nov. 30, 1995, available in WESTLAW, 1995 WL 11162485 [hereinafter Thornhill, Italians Set].
[10] See Thornhill, A Long-Distance Call, supra note 5.
[11] See Chrystia Freeland, Russia's Privatisation Programme: From Bang to Whimper - Collapse of the Telecommunications Sale to Italian Group Stet Has Wide Implications for the Country's Transition to Capitalism, FIN. TIMES, Dec. 29, 1995, available in WESTLAW, 1995 WL 11168253.
[12] See Robert Graham and Chrystia Freeland, Italian Group Denies Russian Telecom Deal Is Off: Why the Proposal Has Run Into Trouble, FIN. TIMES, Dec. 28, 1995, available in WESTLAW, 1995 WL 11168129.
[13] See Thornhill, A Long-Distance Call, supra note 5.
[14] See Chrystia Freeland and David Lane, Russian Poll Result Blamed as Italian Deal Fails, FIN. TIMES, Dec. 27, 1995, available in WESTLAW, 1995 WL 11167999.
[15] See Graham and Thornhill, supra note 7.
[16] See id.
[17] See Thornhill, Italians Set, supra note 9.
[18] See Graham and Thornhill, supra note 7.
[19] See Thornhill, A Long-Distance Call, supra note 5.
[20] See Thornhill, Italians Set, supra note 9.
[21] See Graham and Freeland, supra note 12.
[22] See Thornhill, Italians Set, supra note 9.
[23] See id.
[24] See Heather O'Brian, Stet Is Seen Playing Roulette With Bid to Buy Stake in Russian Phone Concern, WALL ST. J., Dec. 11, 1995.
[25] See Thornhill, A Long-Distance Call, supra note 5.
[26] See Thornhill, Italians Set, supra note 9.
[27] See O'Brian, supra note 24.
[28] See Thornhill, A Long-Distance Call, supra note 5.
[29] See Banerjee, supra note 6.
[30] A joint project between the Russian Communications Ministry and a consortium of telephone companies from Europe and Japan led by U.S. West to link 50 Russian cities using 50,000 kilometers of fiber-optic cable.
[31] See William G. Frenkel, Legal Regulation of Telecommunications in the Russian Federation, EAST/WEST EXECUTIVE GUIDE, Feb. 1, 1997, available in WESTLAW, 1997 WL 9039859.
[32] See Thornhill, A Long-Distance Call, supra note 5.
[33] See id.
[34] See Banerjee, supra note 6.
[35] See id.
[36] See Lavin and Liesman, supra note 8
[37] See id.
[38] See Philip Hanson, Regions, Local Power and Economic Change in Russia, in CHALLENGES FOR RUSSIAN ECONOMIC REFORM, 21, 24-25 (Alan Smith ed., 1995).
[39] See Banerjee, supra note 6.
[40] See Freeland and Lane, supra note 14
[41] See Banerjee, supra note 6.
[42] See Freeland and Lane, supra note 14
[43] See Thornhill, Italians Set, supra note 9.
[44] See Freeland and Lane, supra note 14
[45] See Graham and Freeland, supra note 12
[46] Or, as the protagonist in Mikhail Lermontov's classic A Hero of Our Time opined upon prevailing in a duel during which each side had accused the other of foul play: "Finita la comedia."
[47] See Freeland, supra note 11.
[48] See id.
[49] See Freeland and Lane, supra note 14.
[50] See Freeland, supra note 11 (criticisms by Grigory Yavlinsky, leader of Yabloko, Russia's leading pro-reform party).
[51] See Duma Seeks Investment Curb, FIN. TIMES, Feb. 22, 1997, available in WESTLAW, 1997 WL 3775354. The chances of this proposal being passed by the Federal Assembly (the upper house) and surviving a presidential veto are slim to none, according to sources in the legal profession and telecommunications industry in Russia.
[52] See Russian Government Signs Telecom Sale Order, TELECOMWORLDWIRE, Nov. 11, 1996, available in WESTLAW, 1996 WL 13728980.
[53] See Betsy McKay et al., Moscow's Actions May Ease Fears On Ruble but Not on Privatization, WALL ST. J., Nov. 27, 1996, at A7.
[54] See Erin Arvedlund, Russia Plans to Sell 49% of Phone Giant, ST. PETERSBURG TIMES, Jan. 27, 1997, available in the Worldwide Web at http://www.spb.su/times/index.html.
[55] See McKay et al., supra note 53.
[56] See, e.g., A New Rival Steps Into the Game, RUSSIA EXPRESS BRIEFING, Sept. 30, 1996, available in WESTLAW, 1996 WL 8618950 [hereinafter A New Rival].
[57] See McKay et al., supra note 53.
[58] See Nicholas Denton and John Thornhill, Banks Plan Russian Telecommunications Merger, FIN. TIMES, Nov. 15, 1996, available in WESTLAW, 1996 WL 13948720.
[59] See id.
[60] See id. PLD Telekom is a Russian long-distance operator in which Cable & Wireless has a 32% shareholding.
[61] See Umarov, The Communications Ministry gets its Marching Orders, BIZEKON NEWS, March 17, 1997, available in WESTLAW, 1997 WL 7801581 [hereinafter Umarov, The Communications Ministry].
[62] According to one high-ranking official in the new Committee's Department for International Cooperation, the Committee will operate as a semi-private organization akin to the Federal Communications Commission in the United States.
[63] See Umarov, The Communications Ministry, supra note 61.
[64] See Mikhail Umarov, Svyazinvest to Gain From Government Shakeup, EAST/WEST COMMERSANT, Mar. 31, 1997, available in WESTLAW, 1997 WL 9404718 [hereinafter Umarov, Svyazinvest to Gain].[65]

See id.[66]

See John Thornhill, Rostelekom Seeks to Calm Investors, FIN. TIMES, Jan. 22, 1997, available in WESTLAW, 1997 WL 3768180 [hereinafter Thornhill, Rostelekom Seeks]. One Moscow-based western telecommunications executive with whom I spoke said that Rostelekom is known for its very market-oriented administration and prudent business decision-making. Therefore, he said, he was not surprised that Rostelekom would decline to become entangled with such a massive and unruly set of companies as Svyazinvest.
[67] See Negotiators See "Hard Work" to Turn WTO Agreement Into Global Law, MOBILE COMMONWEALTH OF MASSACHUSETTS. REP., Mar. 10, 1997, available in WESTLAW, 1997 WL 8577541.
[68] See id.
[69] See Umarov, Svyazinvest to Gain, supra note 64
[70] See RF Communications Act, RF Federal Act No. 15-FZ, ch. III, art. 20, Jan. 20, 1995, available in WESTLAW, 1995 WL 147859 (Rus.Legis.).

© 1998 Steven M. Chernoff. Published with permission of the copyright holder.