EVOLUTION OF A PROJECT: Design and construction

In our previous article, using the example of the factory construction project we have devised, we went into detail about the main issues and legal nuances faced when the corporate structure is selected and put in place. We also discussed potential ways of financing the investment project, and the advantages and disadvantages of these. Having chosen a limited liability company as the structure, our investors discussed who should comprise the company’s members, and issues surrounding the distribution of profit. They also entered into a shareholders’ agreement, choosing Russian law to govern it (see Legal Insight No. 6, ‘Creating the corporate structure and financing the project:  what do you need to bear in mind?). In order to obtain the necessary financing (the options for which we also looked at in detail in the previous issue) and to meet the bank’s requirements for security to be provided, the investors are moving on to the next stage in implementing the project: selecting a land plot for the future factory, checking that it is “clean”, and subsequently acquiring title to it.

Once everything is ready, our protagonists will select the general contractor and make a start on construction. Read on to discover how they may protect themselves from unwanted ‘surprises’ when they acquire rights to the real estate, document the relationship with the contractor, and eventually launch the project safely.     

Selecting a site: how to guard against unwelcome surprises

Irrespective of whether the investor itself is implementing what has been conceived or whether it turns to a developer for assistance, land and acquiring title to it is a key issue if the project is to be successfully realised.  

Firstly, we need to have a serious think about the region we will choose for locating our factory. For example, according to the data of ratings agencies that assess the attractiveness of Russian regions, heading the table at the end of 2013 were Moscow and Moscow Region, the Far East, the Republic of Tatarstan, Krasnodar Territory, St Petersburg and Leningrad Region .

This absolutely makes sense, since the regions that are traditionally sought after by investors are those that have developed transport and engineering infrastructure along with high manufacturing potential in the regional economy. They are also financially stable. Most importantly, the regional authorities adopt a logical and transparent policy towards working with investors.   

After our investors have settled on a region, they then face the task of selecting the land plot on which they will build the factory. Of course, they may look at the option of acquiring an existing factory, but our investors are planning to manufacture an innovative product. For these purposes, it is more prudent and practical to construct a new build.    

We will examine two main methods for acquiring title to land:

purchasing the land plot outright, or leasing it under direct contracts with the right holders;

purchasing a company that has ownership title to or leases the land plot.

Of course, there are more complex ways of acquiring title to land, which involve many steps. However, generally, when land is purchased with a view to building various facilities on it, the above simple methods are used.

Purchasing the land plot outright, or leasing it under contracts with the right holders

The following are the main matters to which attention needs to be paid when a land plot is purchased or leased: 

Firstly: only a land plot that has undergone cadastral registration may be the subject of a sale and purchase agreement and a lease contract.

Secondly: it is essential for a prior investigation to be carried out into the seller or lessor's title.  The implementation of any project can be significantly affected by potential assertions of third-party rights as well as by the consequences of previous dealings with a land plot. A certificate of title on its own will not suffice. As a minimum, it is necessary to request the actual extract from the Unified State Register of Real Estate Rights and Transactions (the "Register"), in order to understand whether the seller/lessor is the actual owner of the land plot, and whether the Register contains entries recording encumbrances and restrictions that would prevent the transaction from going ahead. 

Thirdly: it is extremely important to be convinced that the structures on the land plot and belonging to the seller are being sold at the same time as the land, while there must be no other structures on the plot. If this condition is breached, the result could be that the transaction is invalid. This is because the legislation contains a direct prohibition on land being sold without the structures located on it if all of this belongs to a single person. No less important is to check all the restrictions there may be on the development and use of the plot. 

In Russia, land is broken down into seven categories according to its designated use. The land that is suitable for building a factory will either be classed as falling within land for "settlements", or to the land for "industry, energy, transport, communication, broadcasting, television, computer science, land for carrying out space activities, land for defence, security and another special designation." It is also important to be convinced that, as well as the category of land, the type of permitted use for the land plot is suitable for a building to be constructed for production purposes. 

When the planned development is not in line with the designated purpose or type of permitted use of the land plot, a long process may be expected if the land category and/or type of permitted use is to be changed. The results of public hearings will have to be taken into account. The issue of the changing the category of land designated as agricultural land is decided at the level of the constituent entity of the Russian Federation, or by way of the boundaries of a settlement being changed. When plots that are designated as agricultural land are purchased, the local administration or the relevant constituent entity of the Russian Federation will have a pre-emptive right to buy, which will have to be observed.  

For a lease agreement, the purpose for which a land plot was granted is a material term of the contract. As a result, if the type of permitted use is not a match for the purpose stated in the contract, the contract may be held to be invalid.

An important point is that all regulatory and statutory documents governing construction on the plot need to be checked: the master plan, land use and development rules, planning drafts and land surveys.  At present, if no land use and development rules have been approved, the local government administration is deprived of the right to issue a construction permit. The only exception is Moscow Region. The lack of a planning draft and land survey for the district in question may make it more difficult to obtain the urban development plan for the specific plot in question. This document is needed if construction is to begin. There is no formal ban on the urban development plan being issued, but this is an extract, including from the planning draft and survey of the area. To this end, there is no unanimity in the case law regarding whether it is lawful to decline to issue the urban development plan. Thus, the risk that the start of construction will be delayed may be linked not only to the context of regulatory and statutory documents governing town planning activity, but also with such documents being absent. 
 
It is also important to inspect whether the land has been prepared from an engineering perspective, as well as checking pollution of the soil and groundwater.   If pollution is not discovered in time, this may be a cause for the investor to be held liable for infringing environmental obligations, even though fault may actually lie with a previous owner or with the users of adjacent land.

This means that our investors would be ill-advised to rush through their purchase before they have studied the land in detail from both a legal and technical perspective (carried out due diligence). 

A further point to consider is that the lease period is an important condition of the lease agreement for the land plot. Lease agreements for a land plot are subject to state registration if those agreements are for a period of more than one year.  If an agreement is entered into without any time period being stated in it, that agreement will be regarded as having been entered into for an indefinite period. Either party will then be able unilaterally to terminate it at any time, as long as the terminating party serves on the other party at least three months' notice of termination.

An owner or lessee may breathe easily and feel that it has long-term security in that capacity only once state registration of its ownership title or lease agreement, as appropriate, has been effected in the Unified State Register of Real Estate Rights and Transactions (the "Register"). 

When land is bought 'directly' or leased, an issue of major importance is what kind of current owner there is:

a private owner, or
a public body (the Russian Federation, a constituent entity of the Russian Federation, or a municipal body).

When it is a question of contracting with a private owner, there is practically complete freedom in such a case to select the terms and conditions, since these are solely the subject matter of commercial negotiations with the seller or lessor.  There are certain restrictions on foreigners acquiring land plots. However, these mainly concern land plots that are on land designated for agricultural use and land plots within border areas.  

On the one hand, it is more complex to acquire land from the state or from municipal bodies, since there is detailed statutory regulation of the terms and conditions on which such land may be bought or leased. Moreover, generally there are sample forms for sale and purchase agreements and lease agreements. State officials will be extremely reluctant to amend these forms.   However, on the other hand, this makes entering into transactions with the state a less risky proposition.

The general rules for acquiring ownership title to state land (i.e. for privatisation) are as follows:

Ownership title to land plots is granted only through competitive bidding procedures.  The only exception is when land is bought that is under facilities located on it.
The value of a land plot is set according to the outcome of a competitive bidding procedure, or, when it is granted for a specific purpose, at prices established under the relevant legislation.

It should be noted that, for investment projects that contemplate construction, state land will usually be provided by way of being leased out. It is standard for the right to lease land to be made available through competitive bidding processes, but land legislation makes provision for cases when a future lessor may lease a land plot after it reaches a preliminary agreement with local government authorities on where it will site its facility. If the urban development documentation has been fully worked through for the area in which a land plot is located, including the planning draft and survey for the area, then it is not permitted for the land plot to be granted with preliminary agreement of the place where the facility will be sited.
There is also no competitive bidding procedure for owners to acquire a right to lease real estate facilities located on land plots.

Acquiring a company that owns or leases a land plot

Title to a land plot may be acquired by way of shares or membership interests being bought in a company that owns or leases the plot. 

Of course, purchasing a company simplifies many points that are linked in particular to documenting the transfer of rights to the land plot and re-executing contracts for electric power supply and use of infrastructure. This model also allows tax savings to be made, since VAT does not apply to transactions with membership interests and shares. We note that VAT also does not apply to transactions with land; however, if a built-up plot is purchased, then VAT needs to be paid at 18% on the purchase of the buildings and structures.   

However, alongside the benefits of purchasing a company, there is also a fly in the ointment. This relates, for example, to the fact that when a company is acquired, it is not just the assets but also the liabilities that are acquired. These cover all of the potential obligations of the company in question, which may be hidden, by accident or design, at the negotiation stage and when the transaction is entered into. This could involve obligations under business contracts, financial transactions, obligations to pay tax or customs and other payments, and social obligations to employees under employment contracts. 

Also, when a company is purchased that has a long-term lease agreement for a land plot, there is a need to check whether the tenant has properly performed all the terms and conditions of the contract, especially in terms of paying the rent and making other necessary payments (investment payments, infrastructure payments, those to buy out the right to lease, and so on).  Very commonly, lease agreements will contain a term that if there is a delay of a specified period of time in such payments being made, the lessor may unilaterally terminate the contract - irrespective of whether the amount owed is subsequently paid. 

Accordingly, in such a case, it becomes especially vital for legal and financial due diligence to be carried out before the transaction is put in place.

Below we set out a summary of the most common 'surprises' our investors should beware of when they select a plot on which to build their factory:

1) What is proposed to be sold is not actually the land plot itself, but the buildings and structures, along with the right subsequently to purchase or take a long-term lease of the land plot under them.  This is not a critical risk, but there could be a nasty surprise with, for example, the cost to subsequently buy a land plot that is state-owned, because at present such price is calculated based on the cadastral value, which approximates to and at times may even exceed the market value. 

2) The designated purpose and/or type of permitted use of the land plot being purchased is not a fit for the planned operations (town planning requirements, long-term development plans for the area in question, it being impossible to obtain licences and permits, and so on). In this connection, major importance can sometimes attach not even to restrictions set directly on the land plot itself, but to matters such as whether a neighbouring facility has a buffer zone in which it is prohibited to site the planned factory.     In such a case, there is a material risk that it will prove impossible to obtain the permission documents for construction.

3) There are unregistered items on the land plot that have the characteristics of real estate (hangars, railway tracks, on-site asphalt roadways, concrete fences), and an attempt is made to sell this as movable property. If such items are retained on the plot once it has been purchased, there is a risk of the previous owner demanding that its ownership title to such items (and the relevant part of the land plot underlying them) be recognised.

4) There are encumbrances that prevent transactions from being entered into - for example, a mortgage, easements, a lease, rights arising from regular use, the land being earmarked to be used by the state and similar.

5) State or municipal authorities or officers of companies exceed their powers to dispose of lands (there are no corporate approvals or antimonopoly law is infringed). Fairly often, land which by the general rule should be disposed of by local municipal authorities are actually disposed of by regional or federal structures which lack any lawful authority to do so. Or else, when a land plot is disposed of, the available grounds for dividing up ownership of the land plot are ignored (there being items of real estate assigned to federal or regional businesses; rights to use land plots which such businesses previously had , and so on). In such a case, there is a high risk that the transactions with the land plots will be held to be invalid. Moreover, recently there has been a rise in the number of cases in which executive orders regarding land plots have been cancelled by the authorities that issued them, under a self-regulating procedure. In cases of this nature, not even the expiry of the limitation period may serve as protection for an investor, since the courts take the view that such deadlines do not apply to self-regulation. 

Design and construction stage

So, legal title to the land plot has been acquired; we can make a start on preparing the necessary documentation and proceed directly towards construction.
From the standpoint of current Russian legislation, the factory our investors are planning to build is a hazardous production facility (HPF). Tied in with this will be certain specifics for executing documents. However, on the whole, there is a fairly standard procedure for executing 'permission' documentation.

First step: obtaining the urban development plan for the land plot from the relevant local government body.  This will contain information about all requirements for designation, and parameters for development and for locating facilities on the land plot. At the same time, engineering studies may begin and technical conditions may be obtained so that utility providers may connect the future factory to infrastructure and communications networks. 
Second step: direct design work, taking into account and based on the investors' wishes, the results of engineering surveys, and technical conditions, as well as having regard to the requirements and restrictions for development (information about which will be contained in the urban development plan for the land plot).  Since the factory that our investors have conceived is a hazardous production facility, the list of benchmark data for design will further be supplemented by industrial design requirements.
Third step: undertaking a state or non-state expert review of the project documentation (depending on the class of danger assigned to our factory, as a hazardous production facility). 

In general, when a factory is constructed that involves cutting-edge technology being applied, obsolete construction norms and industrial safety rules are not appropriate. Therefore, if it is identified, at the stage when the facility is being designed, that there is a need to deviate from construction norms, this should be included in special technical terms and conditions.  In addition, if it is intended to depart from industrial safety requirements for an HPF that is undergoing an expert review, justifications for this and the relevant supporting documents should be prepared.  

Fourth step: obtaining a construction permit (issued by the relevant local government authority), which is the main document allowing the construction works themselves to be started on the land plot. Currently, the Russian Town-Planning Code sets out an exhaustive list of the documents required for such a permit to be obtained. 

Now that we have in earnest reached the start of construction, the time is right to examine how we will work together with the party on which so much depends in terms of the investment project being a success - the general contractor. 

Documenting the relationship

Obviously, the quality and speed of construction depend on the professionalism and experience of the particular contractor. But in those cases where the general contractor does not vindicate the expectations vested in it, a competently drafted contract will allow the investor to pay for the work done in an amount that precisely matches its worth, while receiving compensation for delays and for work of inadequate quality.  

Experience shows that, when a relationship with a general contractor is documented in legal terms, there are characteristic weak spots that contractors may use to avoid liability. For example, in an overwhelming majority of cases, complex facilities cannot be constructed without the design or plans inevitably being revised, one brand of equipment being substituted for another and similar changes. When instructions are given regarding adjustments or when they are confirmed, it needs to be borne in mind that a contractor may subsequently use any changes during the construction process to justify a delay in performing the work and it being exempted from liability for this. The contractor is also released from liability for delay when the customer fails to perform its cross obligations under the contract, such as providing design and technical documentation, the construction site, and, where the contract so provides, electric power supply and water supply.  

Current legislation obliges the contractor to inform the customer of defects in design documentation, materials supplied, and the possible adverse consequences of the customer's instructions, as well as other factors that could have an impact on the quality of the works or could lead to a delay. In the knowledge that they face such a requirement, contractors habitually use any pretext to send letters to a customer stipulating factors that could result in construction deadlines being shifted.   As a result, by the time the construction period is over, the contractor has in its hands evidence that it was obliged to work in conditions of extreme complexity.  If there is a delay, it is easy for a contractor to prove that the reason for this was not a fault on the contractor's part but something the customer did.

Only preventive measures taken in good time will help such a situation to be avoided. We will list a few of them:

stating in the contract that the contractor, when it begins to implement any changes in the project and in the method of performing the work, acknowledges that it is ready to perform the contract by the due date, and any changes to the due date or the contract price in this case will be documented by an agreement of the parties.

periodically asking the contractor and receiving written confirmation that it is ready to perform the work by the due date. This very correspondence may later be used to establish the actual reasons for construction deadlines not being met.

apply a provision that the contract price is firmly fixed.  This is down to the fact that the contractor may claim that the contract price should be increased in view of changes made by the customer to the subject matter of the contract, as well as in the light of additional work being carried out at the customer's instruction. In this case, the provision acts to safeguard the customer's interests. Even if amendments are made to the subject matter of the contract or additional works are carried out, the contractor must immediately warn the customer that the price has increased. A contractor that has failed to do so on time must perform the contract, relating the right to be paid at the price set in the contract. However, it may not demand payment for the additional works performed.

Supervising the progress of the works

It is possible to supervise the progress of work either by dividing the work up into stages, or by signing a monthly acceptance certificate of works performed and a statement of their value. In practice, it is not possible to carry out monthly checks of the quality of work performed. At the same time, current legislation assumes that acceptance of a stage of the works assumes a fully fledged inspection, including in relation to quality. So that it properly reflects the sense behind monthly acceptance certificates being signed, the contract should stipulate that such certificates are signed only in order to oversee the volume of work performed and payment, and that they do not deprive the customer of the right to put forward claims in relation to defects in the work in question.

If it is necessary to mothball construction or to change the contractor, the customer may unilaterally withdraw from the construction contractor agreement. In this case, the contractor is entitled to be reimbursed for the cost of work it has performed, of materials it has purchased and supplied on site, and other expenses. However, this amount in total may not exceed the value of the ready result of the work. Therefore, even at the stage when a construction contractor agreement is being entered into, it is reasonable to include a right for the customer to withdraw partially from the contract. This is to avoid future disputes, should the customer decide to refuse to implement a part of the project.

Accepting results

Final acceptance of the result of the work is one of the most crucial steps on the path to launching the factory successfully. Often, investors wish to begin production more quickly, so agree to accept work with defects that do not prevent operation. Further, doubts arise as to whether it is worth reflecting defects in acceptance certificates and whether it will subsequently be possible to require a contractor to remedy them.

Not only does the current legislation prevent this, but it also states directly that a customer may refuse to accept work in full if there are material defects that prevent a facility from being used in accordance with its designation.  If there are minor defects, a bilateral certificate of acceptance is drawn up, which lists these defects and the procedure for eliminating them. If the defects do not prevent a document from being obtained regarding the constructed facility being in line with the project documentation and technical regulations, and if the investor does not wish to advertise defects before the topping-out ceremony, then a separate confidential document may be executed. This would be signed by only the contractor and the customer, and would be binding on them.     

As a general rule, the customer is deprived of the right to demand that obvious defects be remedied if these are not referred to in the acceptance certificate. But when the construction contractor agreement is drafted, it is important to remember the rule that allows the parties to include in a contract a right for the customer to accept only on a formal basis without checking quality. Claims may then be asserted for any defects, even obvious ones, to be remedied during operation. If the contractor agrees to such a term, making a stipulation to this effect is the best way to protect the customer's interests.

Starting to operate the facility

The commissioning permit for the factory is the document that confirms construction is at an end.  It is issued by the relevant regional administrative authority. To obtain the permit, as well as the standard set of documents, an owner of a hazardous production facility needs to enter into a contract for compulsory third-party liability insurance and this has to be submitted to the relevant regional administrative authority. The contract should cover damage caused by an accident.

Moreover, it will be mandatory for the factory to be registered in a special state register of hazardous production facilities.  Only once this registration is in place may the green light be given for manufacturing activity to start.

The next task for our investors is to recruit qualified personnel for the new factory and to build an effective model for relationships with employees. In the next issue, we will relate how to work with employment agencies in conditions where agency labour is banned. We will discuss the most sensitive points of employment and migration legislation. We will also share our experience of dealing with trade unions and of implementing a special assessment of labour conditions. In addition, we will touch on the topic of legal tools for fighting against corporate corruption, internal abuses and infringements of company policies on the part of employees.