Cyprus has long been a popular offshore haven for Russian investors. But will their strong business ties survive the island's banking crisis? Alexei Dudko and Andrew Gamble assesses the challenges ahead

The Cypriot banking crisis in March caused plenty of headaches for Russian businesses. It is no secret that Russian businessmen hold a significant amount of funds in accounts with Cypriot banks. 

Historically, the island has been the most popular jurisdiction for Russian investors, mainly because of the favourable double taxation treaty concluded with Russia (and with more than 40 other countries), flexible corporate governance rules, confidentiality and unique geography. 

The legal system in Cyprus – being based on English law – is by no means less important than the attractive taxation regime. Russian corporate legislation is traditionally famous for a number of mandatory rules that can make it too rigid. 

As a result, it has become quite common for deals involving Russian assets to effectively take place at the level of an ultimate or intermediate holding company incorporated in Cyprus. This structure is often supplemented by a shareholders' agreement governed by English law. The latter would typically contain a London arbitration clause.

Cyprus is the unrivalled leader in terms of inward investment into Russia (29% of the total incoming cashflow). In view of the strong Russo-Cypriot ties (which also include a $2.5bn (£1.61bn) loan from Russia to Cyprus in 2011 to support its economy), the recent capital restrictions, suspended transactions and a forced bank rescue have come as a shock to investors. 

Withdrawal symptoms

After nine days of compulsory bank holidays starting on 16 March, together with the dramatic rejection by the Cypriot parliament of the initial conditions for the financial rescue – all bank deposits up to €100,000 (£84,300) being subject to a 6.75% bank levy; those with deposits over that subject to a levy of 9.9% – Cyprus finally managed to agree a deal with the Troika. 

The terms of the deal – the first EU-sponsored bank bail-in – has imposed dramatic losses on deposits of more than €100,000 in the Bank of Cyprus and Cyprus Popular (Laiki) Bank. 

Laiki Bank, the second largest bank in Cyprus, will be split into a good assets bank and a bad assets bank. The bad assets bank (comprising uninsured deposits over €100,000) will be liquidated. The good assets will be merged with the Bank of Cyprus, whose clients should also expect steep losses, including a 'haircut' on deposits of more than €100,000.

On 28 March, banks opened again but were still subject to severe interim restrictions on capital transactions. A day limit for transactions between legal entities was set at €5,000 (£4,200). Payments above that threshold required the approval of a special committee of the Central Bank of Cyprus. Daily withdrawals of cash by a physical person were limited to €300 (£250). No export of euronotes from Cyprus in excess of €2,000 (£1,700) was allowed. 

There has since been some relaxation of the restrictions; for example, internal payments up to €300,000 (£253,000) per transaction that fell within the normal business activity of the customer were allowed without the special committee's approval.

For weeks, transactions routed via Cyprus through a Cypriot vehicle, or where escrow accounts or loans with Cypriot banks were involved, have been paralysed. Lawyers have been reviewing contracts and analysing applicable law in an attempt to fit the events into the definitions of business day, offset, default and force majeure provided for under those contracts. 

For example, where Cypriot banks have financed non-Cypriot borrowers that hold deposits in these banks, one of the major questions is whether the borrower may consider applying for set-off to reduce their debt and in such a way to recover the full value of their deposits.

When the first wave of panic died down, an inevitable question arose: is it safe to stay in Cyprus and would not it be better looking out for a new offshore destination? 

Is the season over?

Deadlocked deals and financial losses are a valid reason for losing confidence in Cyprus, even if its benefits, such as the taxation regime, corporate governance and confidentiality, have not been substantially damaged so far (an increase of the corporate tax rate by 2.5% could hardly worsen the situation any more given the circumstances). Still, would a new offshore jurisdiction be more advantageous than the Cypriot one? Operational costs, as well as director and audit requirements, vary from jurisdiction to jurisdiction. 

But materially, there is one benefit businesses are trying to gain from the use of offshore structures: low tax rates. Some offshore jurisdictions, such as The Netherlands or Luxembourg, may have a slightly higher recognition among Russian authorities than, for example, British Virgin Islands (BVI), Seychelles or Cayman Islands. In fact, The Netherlands is the second most popular jurisdiction for structuring investments into Russia (13% of the incoming cashflow) and Luxembourg, with a 4% share, holds the fourth place in the top offshore list after the BVI (12%). A more global problem, however, remains: are these jurisdictions safe for investments and, if things turn sour, would a new economic crisis damage them?

In practice, moving a business from Cyprus can be done in various ways. Legally, a Cypriot corporate vehicle may be re-domiciled in a different jurisdiction; its shares may be swapped or sold; it may also be merged or liquidated. Whatever option is chosen, it will be a time-consuming and relatively complex process. Depending on circumstances, relocation may require extensive paperwork including publications in the press, notification of creditors, preparation of financial statements, and so on. 

Transfer of shares is not an easy way out either. In most cases, it would trigger disclosure of the ultimate beneficiaries and require regulatory approvals from the Russian authorities where a change of control over assets located in Russia is going to take place. 

Foreign-to-foreign transactions are within the scope of Russian merger control rules. An intra-group transaction may be exempted from regulatory approvals but will not prevent ultimate beneficiaries from being disclosed to authorities.

Finally, existing shareholders' agreements and loan facilities may provide for restrictions on, or contain special conditions relating to, the transfer of shares in a Cypriot holding company, and, therefore, no transfer may be done effectively unless it complies with relevant contractual terms.

Let us go to court

Whether to rush to courts seeking an injunction against restructuring or to plan a strategic claim for damages against Cyprus and its banks largely depends on the circumstances of each particular case, including the type of deposit, its amount and the terms of contractual arrangements. 

What is clear is that the crisis has already opened a Pandora's box of litigation.

Certain affected depositors have already brought actions to challenge the administrative orders of the Central Bank of Cyprus in relation to the restructuring of the Bank of Cyprus and Laiki Bank. Some of these depositors have even managed to obtain court injunctions suspending the respective orders in connection with their deposits. 

However, such proceedings will depend ultimately on the outcome of the proceedings regarding the constitutionality of the restructuring. Even if the restructuring is declared constitutional under Cypriot law, the affected parties could still consider whether the restructuring and the capital control rules correspond to EU law, eg the principle of free movement of goods and capital. 

Further actions for damages against the respective banks, their directors, auditors and the Central Bank of Cyprus for alleged negligence in managing the activities of the banks could also be contemplated. Some Russian depositors have already started bringing actions in Russian commercial and general jurisdiction courts against the Bank of Cyprus and Laiki Bank for breach of their contractual duties to return their Cyprus deposits. A successful attempt to secure such a claim by way of an interim order freezing the shares of Laiki Bank in its Russian bank subsidiary, Rosprombank, has been reported.

Meanwhile, actions against Cyprus, including initiating investment arbitration proceedings on the basis of investment protection principles, such as non-discrimination and compensation for expropriation, as provided for in the respective international investment protection treaties concluded by Cyprus with other countries, are also discussed. 

Surprisingly, there is no effective investment treaty between Russia and Cyprus. Although Russia signed a bilateral treaty on mutual protection of investments with the island in 1997, it has not been ratified. 

Today, Cyprus has about 16 bilateral investment treaties (BITs) with several countries including Israel, Czech Republic, Hungary, Seychelles, Armenia and Belarus. The admissibility of a claim shall be determined by such issues as the nationality of an investor, as well as how exactly and which investment is affected. 

Meanwhile, threats of claims are passing between the countries at the centre of the EU banking crisis. It is reported that the former Greek owners of Laiki Bank have filed a notice of dispute against Cyprus under the 1992 Cyprus/Greece BIT in relation to the Cyprus state's takeover of 84% of the bank's equity in 2012. 

For its part, Laiki Bank is claiming against Greece for its alleged failure to make financial assistance available to its Greek subsidiaries – under the same BIT. 

Russia's reaction 

The Russian state has taken a cautious approach so far. On the one hand, Russia's prime minister Dmitry Medvedev said the restructuring amounted to the confiscation of other people's money and warned that the Russo-Cyprus double taxation treaty could be reviewed. 

On the other hand, while admitting that the money of certain Russian state companies was trapped in Cyprus, the Russian Government has repeatedly urged Russian businesses to bring investment onshore in line with its previously announced 'de-offshoring' policy. It has refrained so far from any unilateral actions against Cyprus. 

The Cyprus financial crisis poses serious challenges to Russian businesses, both strategic and operational. It only serves to underscore the links between Russian business and the EU – Russia cannot be immune from an EU economic crisis.