Imagine that you are a minority shareholder in a major Russian company (R). You attend the annual general meeting (AGM) only to discover that the controlling shareholder, another company (S), has authorized a massive issue of additional shares - something that was not mentioned even in passing in the notice of the AGM. These additional shares can be placed at the sole discretion of the board. The board is at liberty to place them with corporate insiders or a dominant shareholder such as S at below-market prices and without being subject to any rights of pre-emption (proportional allotment to existing shareholders). Once S and its affiliates have achieved a 75% shareholding (the level required for most major corporate decisions) R can be merged into S's group on terms which deliberately understate the value of the merged company. This will provide a huge windfall for the S group, dilute your shareholding and wipe out its value.
Seeing this coming, you attempt - as a significant minority shareholder - to secure representation on the board. Tactics are employed to prevent you. You call for independent auditors to ensure arm's-length terms but your call falls on deaf ears. You complain about the board's refusal to disclose financial and other information which would enable you to monitor R's performance. Finally, you are physically intimidated as you attempt to exercise your rights at the AGM.
All of the above are examples of treatment meted out to minority shareholders in Russian companies. "Minority shareholders have been abused so often and so blatantly over the last few years that the whole country begins to sound like a Harvard Business School case study in nightmarish corporate governance," says one international lawyer, who prefers to remain anonymous for fear of prejudicing the interests of clients whose investment in Russian companies he is actively trying to protect.
One problem is that Russia's Joint Stock Company Law (JSCL) only came into force in 1996. "It embraces some internationally-recognized principles of corporate governance," says the international lawyer, "but investors argue that many of its most important provisions are vaguely drafted and largely ignored by Russian managers." A further problem is that no one knows how the JSCL will be applied by the Russian courts. There have been few cases and even fewer published decisions.
One of the most significant was handed down by the Russian supreme court in April. In particular, the court drew a distinction between a company's charter, which is a public document and subject to state registration, and the foundation agreement, which is essentially a joint-venture agreement, setting out the rights and obligations between the shareholders. The significance of this distinction is that the foundation agreement had in practice been used to enshrine provisions which ran counter to the charter, such as exemptions from rights of pre-emption. The court reiterated that a foundation agreement containing provisions which contradict the JSCL is void. Pre-emption rights cannot be curtailed in this way. Companies whose charters predated the law were obliged to revise them to comply by July this year. As a result, no company can claim that its charter is "grandfathered" and therefore exempt from compliance either with the law or with the judgement.
In other respects the JSCL appears clear enough without resort to the courts, but it does not in fact provide complete protection to minority shareholders. For instance, failure to notify shareholders in advance of a prospective AGM item - one of the examples given above - does entitle a shareholder to go to court to seek redress. But the court will not reverse the outcome of the AGM if the complainant could not have affected the outcome (for instance through having too insignificant a holding) or if the infraction was minor or the complainant suffered no harm.
Although these are issues of fact, they can be difficult to establish in a court. Even proving your position as a shareholder can be an insurmountable initial hurdle. Russia suVers from a general failure to maintain independent share registrars and there are indications that some registrars are owned by the companies whose registers they keep. Equally, there is no guarantee that, for example, the sale of shares through investment tenders will be carried out fairly with the successful purchasers being entered on the appropriate registers.
The JSCL is even less helpful in the case of transactions at an undervalue. Only if a transaction exceeds 50% of the book value of the company's assets is shareholder approval required. Up to that point it simply requires the unanimous consent of the board - fine in a jurisdiction with a tradition of outside directors, but this is not the case in Russia. If, as a minority shareholder, your nomination of a representative to the board is blocked, this protection does not help you. Besides, the JSCL is drafted in such a way that post-facto ratification is perfectly legitimate, which encourages managers to go ahead and do the deal and worry about the legalities after the event. Further, the JSCL provides an exemption where the company can show that the transaction was carried out in the course of its business.
An additional problem is that, under the JSCL, while any new issue of shares must be priced at a level which reflects market value, this concept is poorly defined. Trading prices do not have to be taken directly into account when fixing the issue price. This allows the board substantial discretion in fixing an appropriate price - especially where the company's shares are illiquid - for instance in order to issue new shares to favoured shareholders, so diluting the holding of others.
There have been pleas to the Russian Securities and Exchange Commission to stipulate that, in the case of publicly-held companies, the market value is the same as the trading price. But this in itself can be difficult to establish because brokers are not yet required to quote two-way prices, something necessary to establish a definitive trading price.
Foreign investors resorting to law have been making as much noise publicly as possible. This may be the only solution. When similar issues of corporate governance arose in India a few years ago, they were only finally resolved through government intervention - because of the risk that foreign portfolio investment would desert the country.