Russia's top law firms say they aren't interested in merging with any of their international competitors. But they face some difficult decisions about their future, says Chris Johnson

It was a grim morning in November 2008 when Andrey Goltsblat (pictured above), managing partner of leading Russian law firm Pepeliaev Goltsblat & Partners (PGP), set out for one of the most difficult meetings of his 20-year career. Moscow was already deep in the grip of winter, the streets buried beneath inches of snow. But it wasn't the weather that troubled Goltsblat as he arrived at the firm's premises and headed to the office he shared with Sergey Pepeliaev, the firm's senior partner. Goltsblat had a dramatic announcement to make: he was leaving the business they'd spent the last two decades building together. And he was taking half the firm with him.

Neither man will talk about exactly what was said in that meeting – Pepeliaev would only describe his reaction as "appropriate" – but it's safe to say that Goltsblat's news didn't go down well. In one fell swoop, nine partners and a full 70 lawyers – PGP's entire corporate practice and the firm's heads of real estate, dispute resolution and employment – left to join UK firm Berwin Leighton Paisner (BLP).

Pepeliaev wasn't the only one caught by surprise. The move, which led to a messy and protracted separation that rumbled on for almost two years, sent shock waves through the industry. The Moscow market was still in the midst of the worst downturn since the 1998 financial crisis, when most international firms scaled back their presences significantly. That a UK firm with no real existing practice in the country would decide to open a new office was surprising enough. That it would do so by taking a 70-lawyer team from a Russian firm – the first and, to date, only such move ever seen in Moscow – and that it would also woo someone of the calibre of Goltsblat, one of the country's best-known lawyers, was nothing short of sensational. Overnight, BLP went from being a relative nobody in Russia to operating one of the biggest international law firm offices in the city.

Goltsblat's decision prompted Russia's other leading firms – such as Egorov Puginsky Afanasiev & Partners (EPAP), ALRUD Law Firm and Magisters – to reassess their own future. An international merger would solve many of the predicaments they face over succession and growing competition, and would help them break into a transactional market where they're still outgunned by US and UK firms. Many of Goltsblat's peer firms are sceptical, however, questioning whether the benefits outweigh the cost of losing the lucrative international referrals open to independent firms.

For Goltsblat, the combination to create Goltsblat BLP, as his firm is known, made perfect sense. "There was a level of corporate transactions that we just couldn't access as part of a Russian firm," he says. "The biggest Russian deals always go to the big international firms. It was frustrating, but there was nothing we could do. We realised that having the best lawyers doesn't count for anything if you don't have a strong enough brand. Now we have both – it was the natural next step." The firm has since landed work from clients such as Unilever Rus, 20th Century Fox CIS, Panasonic and Mars.

Perhaps unsurprisingly, Pepeliaev sees things differently. He believes that Goltsblat has made a "strategic mistake" in exclusively associating his team with one international firm.

"If a foreign law firm engages another international firm to provide services in Russia, it risks losing the client," he says via an interpreter. "Russian firms have the advantage [for referrals from international firms] as there is no competition, and Russian clients prefer using us because we're a national firm with a better understanding of the Russian market and Russian problems. To give that up is a strategic mistake."

In some respects, they are both right. There are practices in which the Russian and international firms genuinely compete toe-to-toe – usually in areas that are subject to complex local issues or that require close dealings with the Government and related authorities, such as intellectual property (IP), tax, real estate and employment. A general reluctance among international firms to engage in litigation in the Russian courts – save for a few notable exceptions, such as the teams under Chadbourne & Parke's Mikhail Rozenberg, Baker & McKenzie's Vladimir Khvalei, and Dechert's Ivan Marisin, who recently joined from Clifford Chance (CC) – means that Russian firms also dominate on domestic litigation.

Most Russian firms will do a good trade in mid-market corporate transactions and advising on the Russian aspects of international deals, but when it comes to competing with the foreign interlopers on high-end corporate or finance work, the domestic firms have the odds stacked against them.

In some emerging markets, such as China, local firms are practically guaranteed a role on any cross-border transaction, thanks to protectionist regulatory regimes under which foreign firms cannot practice domestic law. Russian firms have no such protection, so they face competition on a much more level playing field. Furthermore, the majority of transactional work in Russia – particularly M&A – is actually carried out under English law.

"English law is a global medium for commerce, even in Russia," explains Dmitry Afanasiev, chairman of EPAP. "It's one of the major challenges for Russian firms. It's difficult for Russian firms to compete in this environment, as [English law] is not our main focus."

The issue goes some way to explaining Goltsblat and Pepeliaev's fundamental disagreement over strategy. For an ambitious corporate partner such as Goltsblat, a merger with an international firm could allow the team to break through this glass ceiling to access these highly remunerative and previously off-limit deals. In tax – PGP's best-known specialty, even when Goltsblat was there – a Russian firm is already more than capable of competing at the top end of the market.

"We're getting deals that we would never have got before because they're governed by UK law," Goltsblat says, citing recent transactions for Mars, Kimberly-Clark, and Nissan. "You can't be serious about M&A or finance [in Russia] without UK or US lawyers."

According to Mergermarket, international firms utterly dominate Russia's big-ticket transactional landscape. In each of the last two years, just one Russian firm featured in its top 10 M&A advisers by aggregate deal value: EPAP. One Russian managing partner insists that such data is skewed, as many Russian firms do not publicly disclose deal information.

This may be true, but there is in fact a strong argument that their standing in the market is actually overstated by such figures, as data providers tend to recognise all parties on a deal equally, irrespective of the level of their involvement. So a Russian firm merely providing local law advice on a cross-border transaction would receive the same credit as the lead international firm that actually structured it.

Take EPAP's role in advising Russian aluminium giant Rusal on its record-breaking 2007 merger with national rival Sual and Swiss commodities trader Glencore. The assignment is often cited by domestic firms to show that they can compete for the highest-value transactional deals. However, EPAP partnered with Ashurst on the $30bn (£19bn) deal, while sources with knowledge of the matter also credit Sual and Glencore's lead counsel Linklaters with much of the heavy lifting in putting the transaction together. Even Afanasiev admits that it would not have been possible for EPAP to have advised Rusal without these firms' English law expertise.

Many Russian firms hope to gain an edge from the Government's current drive to encourage Russian companies – particularly those with any state interest – to use Russian law for transactions. Some, such as state-owned Russian Corporation of Nanotechnologies, now exclusively use Russian law on deals, while the Ministry of Economy has also been insisting that some transactions be conducted under Russian law, according to one Moscow-based corporate partner retained recently by the ministry.

Russian president Dmitry Medvedev, himself a former lawyer, has made legal reform one of the key goals of his tenure. Some progress has been made, including changes to corporate law to formally recognise shareholder agreements. However, the well-established tendency of Russian investors to structure deals using offshore holding companies in foreign jurisdictions such as Cyprus and the British Virgin Islands means that international law is likely to remain the tool of choice for the foreseeable future.

"Some Russian companies may want to use a Russian joint venture vehicle, but there are still serious limitations," says Herbert Smith Moscow managing partner Allen Hanen. The most common joint venture vehicle in Russia, the limited liability company, is one stumbling block. Under this structure, it is possible for minority shareholders to expel majority shareholders if they are found to be in "gross violation" of their duties.

While many Western European jurisdictions have structures with similar provisions, in Russia the catch is that such disputes would be decided in Russian courts. As one international firm partner who wished to remain anonymous says: "International investors are still wary of the independence of the Russian courts – particularly once you go outside Moscow or if the other party has any state interest. You could soon find yourself forced out of your own business."

When assessing the likelihood of further consolidation within the Moscow market, it is tempting to draw parallels between Goltsblat's move and the wave of law firm mergers that swept Germany during the late 90s. Within the space of 18 months, all but a few leading German firms had been snapped up by international players from the UK or the US.

"The firms in Russia face the same issues as those in Germany a decade ago," says White & Case Moscow office head Hermann Schmitt, who has firsthand experience as one of the partners at Frankfurt-based Punder Volhard Weber & Axster during its merger with CC in 2000. "It's still early days for Russia, but the top firms will have to decide whether they want to merge or accept that they may have to face being pushed down the market, or even possible disintegration."

It is not inconceivable that an international firm in Moscow would choose to merge with a Russian firm. Despite already having one of the largest offices of any international firm in Russia, CMS – the Moscow-only pilot combination of CMS' UK (Cameron McKenna), German (Hasche Sigle) and French (Bureau Francis Lefebvre) arms – held merger talks with Magisters in late 2006.

Both parties declined to comment, but one source close to the negotiations said that they were ongoing for a year, and that the two firms held a number of "get to know each other exercises" before the talks were finally called off. (The firms remain close and regularly refer work to each other, however. CMS is even leasing space from Magisters in Kiev.)

Magisters now has a "strategic co-operation" for projects and infrastructure work with UK law firm Pinsent Masons, which doesn't have an office in Moscow.

For international firms that don't have a Moscow presence – but want one – a merger could help make up for lost time. Some US and UK firms have already shown interest. Valery Medvedev, managing partner of leading Russian IP boutique Gorodissky & Partners, says that his firm had received approaches from "several" specialist international IP firms, but that "we didn't consider it seriously, as we're already at the top of the market."

Before he finally agreed to join BLP, Goltsblat held talks with at least five other international firms, including SJ Berwin, according to a source involved in the negotiations. Two separate Moscow managing partners at international firms also say that they received calls in the last 18 months from headhunters on behalf of a New York firm looking to establish an office in Russia. Sullivan & Cromwell, Cravath Swaine & Moore and Weil Gotshal & Manges have all become more active in the Russian market in recent years, but all three declined to comment on whether they were responsible for the approaches.

One major hurdle to such a merger is how Russian firms are organised. Not all Russian lawyers or firms are as international in their training, approach or outlook as Goltsblat. Many are, well, a bit too Russian. The complicated and opaque internal structures employed by many Russian firms, which are still largely geared towards rewarding the founding partners, would be incompatible with a modern international legal business.

This is partly because the legal market in Russia is almost entirely unregulated. There is an organised Bar – the advokatura – but lawyers only need to be members if they wish to act on criminal proceedings or appear before the Constitutional Court of the Russian Federation. A 2008 report by Public Interest Law Institute director Dmitry Shabelnikov estimated that there were fewer than 65,000 members of the advokatura in Russia, compared to around 430,000 unregulated lawyers.

Most law firms, be they Russian or international, wouldn't want their lawyers to be registered anyway. Thanks to an antiquated legal quirk, advokatura members cannot be employees, meaning that they effectively have to sit as partners within the business. Hardly an ideal situation, but Russia's Ministry of Justice is aware of the need for change. It is currently working on a far-reaching reform, according to sources that have consulted the Government on this issue.

Another stumbling block to widespread merger activity is the simple lack of credible targets. "There are still very few quality Russian firms," admits Vassily Rudomino (pictured), senior partner of ALRUD, a referral partner of Slaughter and May.

"That's good for us as there is less competition, but it means that international firms have little to choose from [when pursuing a merger], and to persuade [the targets to merge] would not be easy. Who among the international firms has a flow of [Russian] work that would adequately substitute [for] the referral work we get now? If they had enough, then they'd already be here."

It's a valid point. The scarcity of Russian firms even approaching international standards means that the select few that do have a near monopoly on international referrals. The US firms, which typically have less extensive Moscow presences than their UK rivals, are particularly fruitful sources of work.

The potential loss of referrals was one of the major risks that Goltsblat took in choosing to side with BLP, a firm that had previously generated little work in the country. While at PGP, Goltsblat's corporate team was one of the preferred members of Slaughter and May's 'best friends' network, meaning that it received work from leading European firms such as Germany's Hengeler Mueller, Italy's Bonelli Erede Pappalardo, Spain's Uria Menendez and France's Bredin Prat. Goltsblat admits that the move has cost him these lucrative referrals, and that BLP has not yet replaced this deal flow with work of its own.

"We send more work to London than they send to us, but that was anticipated," he says. "The strategy was always to build the business from here." The team still receives work from US firms such as Simpson Thacher & Bartlett, McDermott Will & Emery and Willkie Farr & Gallagher, he adds: "American firms don't care if you're independent or not – they just want good lawyers."

Goltsblat is also busy developing ties with Quinn Emanual Urquhart & Sullivan, Wachtell Lipton Rosen & Katz and Davis Polk & Wardwell, although the firm has not yet received any formal assignments through these connections.

Goltsblat is still some way from achieving the goal he set with BLP managing partner Neville Eisenberg of establishing Goltsblat BLP as one of the leading international firms in Russia within five years, but in the two years since its launch, the business has been relatively successful. Revenue grew 22% in the 2009 financial year and was up by over 60% in the first half of 2010 – a strong recovery after falling 10% in the firm's first year of business – while headcount has grown steadily from 70 to over 90 today.

The firm now has over 450 clients, around 70% of which are international companies, including Nike, Volkswagen and 14 other members of the Fortune 500. As a result of what Goltsblat describes as "rapid growth" in the sector, BLP's former finance head Simon Allan is due to relocate from London to Moscow in January 2011 to lead Goltsblat BLP's banking practice.

Goltsblat admits that he thought the team would re-attract its old PGP clients "much faster," but estimates that 90% – including Alcoa, Danone, Mars and Nissan – have now moved across to Goltsblat BLP.

Pepeliaev (pictured) would not comment on whether this figure was accurate, but says that while there was a period in early 2009 "when part of our clients left and followed Andrey," many of those clients have since returned. A number of clients, such as Coca-Cola, Dresdner Bank, Motorola, Unilever and Volkswagen had remained loyal to the firm, which has since been rebranded Pepeliaev Group, he says.

As with so many things in Moscow's booming consumerist economy, the final hurdle in any proposed merger between an international and Russian firm would be money. It may seem surprising, but the partners at the leading Russian firms often earn far more than those at even the most profitable global giant.

"There is an expression in America: Show me the money," EPAP's Afanasiev says. "I'm not sure anyone can show us better money than we can make as a domestic Russian firm."

His firm's five equity partners took home an average $7.8m (£4.9m) in 2009 – profits per equity partner (PEP) almost twice that of New York super-boutique Wachtell, although Afanasiev would not comment on claims made by one source familiar with his practice that he personally earns in the region of $25m (£15.6m) a year.

Those at Pepeliaev Group, meanwhile, pocketed a cool $2.1m (£1.3m) on average last year. Not in the same ballpark as EPAP, perhaps, but still enough for it to have placed 15th in last year's Am Law 100 PEP rankings if it were a US firm. But such sensational figures are almost entirely due to leverage. Less than 3% of EPAP's 172 lawyers are equity partners, compared to an average of 23% across The Am Law 100.

Russia's firms may argue that there's no need for them to change. They generally coped better with the pressures of the financial crisis than their international peers, which suffered the dual squeeze of higher costs (in particular, associate salaries) and falling demand. "In the last few years, the market hasn't been driven by high-value capital markets and new money M&A," Hanen explains.

"Many international firms have found it challenging to adapt their model." As in other jurisdictions throughout Europe and the US, this has led to traditionally selective firms low-balling in a desperate attempt to buy work. The managing partner of one Russian firm says he had recently been undercut on a $400m (£250m) financing by a UK international firm that offered to do the work for a miserly $30,000 (£18,800) fixed fee.

But the leading Russian firms will eventually need to adapt in order to survive. Most still operate through outdated founding partner models, where those who established the firm retain a tight grip on its strategy and, perhaps most importantly, its equity. Dmitry Afanasiev at EPAP, Vassily Rudomino at ALRUD, Sergey Pepeliaev at Pepeliaev Group: it would be difficult to imagine where these firms would be without these dominant figures.

Yet without a more progressive partnership structure with clearly defined career paths for junior lawyers – a change that would also help them retain associates in the face of continued poaching by their international rivals – Russia's firms face some serious succession issues.

Even their traditional heartland of advising Russian clients is not safe. The global economic crisis has seen a subtle convergence in the practice models of international and Russian law firms. With international clients less active in Russia, US and European firms have been increasingly focusing their efforts on work for major domestic clients.

And with strong benches of Russian lawyers – at Linklaters' Moscow office, for example, 75% of all fee-earners are Russian – there is nothing to stop them from handling more Russian law. As Linklaters Moscow managing partner John Goodwin says: "It doesn't make a jot of difference to us whether a transaction is UK or Russian law." The level of competition is only going to increase.

It's not all bad news, however. As the market continues to mature, it is becoming more Russian in nature. There is a real opportunity for domestic firms that can combine their local market knowledge and deep business contacts with more Western standards of practice. The successful firms will be those that focus on their key strengths, develop and maintain their relationships with their core Russian client base and modernise their internal structure.

Founding partners must accept the need to loosen their grip on their precious equity and also to invest more in training. EPAP recently introduced a $2m (£1.3m) annual training budget for its lawyers. "It's definitely something where we need to compete better against the globals," Afanasiev says.

The standard among the Russian law firms is gradually improving, but all still face some difficult decisions if they wish to continue to prosper in a market that is rightly considered one of the world's most dynamic. As its evolution continues apace, Russia's leading firms need to ensure that strategic hesitance doesn't mean they're left behind.

This article first appeared in Focus Europe, a publication from Legal Week affiliate ALM.