A SUPPLEMENT TO EUROMONEY/APRIL 1998: EASTERN EUROPE
Dmitry Vasiliev, chairman of Russia’s Federal Securities Commission (FSC), smiles as he leans back and says, wryly: “There is a new principle in Russia. The shareholder is always right.”
That implies foreign trust in the Russian legal system and a key task facing the government will be to bolster investor confidence. Following president Boris Yeltsin’s dismissal of the entire cabinet on March 23 a new administration will take on the task. At the beginning of March, then prime minister Victor Chernomyrdin had called on the government to protect investors’ rights. “This has great significance for all of us,” Chernomyrdin told those sitting around the table, “because foreign investment depends on it.” The occasion was one of the first formal meetings of a new commission to protect shareholders’ rights. “If we do not protect shareholders’ rights, they will invest elsewhere,” says Vasiliev, deputy chairman of the new commission.
This particular meeting had been called in response to the increasing volume of shareholders’ protests that Russian companies are riding roughshod over their rights as investors. Even president Yeltsin has come under fire as outraged investors roped in their governments to lobby on their behalf. His trip to Sweden at the end of last year was marred by complaints from Swedish forestry-industries company AssiDoman, while German chancellor Helmut Kohl is reported to have raised the issue of shareholders’ rights with the president.
One case in particular had the investment community up in arms. Knauf, a German construction-materials firm which has invested over $150 million in Russia, has been fighting for the past two years to regain control of Krasnodar gypsum company Kubansky Gips in which it has a majority stake. In mid-1996, Knauf fired the Russian director at the factory after materials worth hundreds of thousands of dollars disappeared.
Despite several court decisions in its favour, Knauf had been unable to take possession of the company it owned since the local authorities refused to recognize rulings by the federal courts. Knauf’s appeals to the local prosecutor were unsuccessful since the regional authority was not prepared to back a foreign owner against local management. In fact, the head of the Krasnodar region responded to Knauf’s pleas by renationalizing the factory, a decision that was subsequently nullified by the FSC.
In November the Moscow Times reported that the local management had hired a group of Cossacks to storm the plant and evict its German managers. Analysts say the incident is as shocking as one several years ago in which Krasnoyarsk Aluminium illegally deleted British Transworld Group’s name from the only share register.
Knauf, whose court orders were torn to pieces in front of its managers, complained to chancellor Kohl who brought the issue up directly with Yeltsin at the end of last year.
Last month first deputy prime minister Boris Nemtsov flew to Frankfurt to smooth things over with increasingly nervous German investors. “We were very concerned by this,” says Vasiliev. “It is of major importance to the community of international shareholders and we considered it illegal.” Vasiliev says that the situation at Kubansky Gips has become “more stable”. A new director and board have been successfully installed and Vasiliev expects the government commission on shareholders’ rights to reach a satisfactory conclusion. The federal prosecutor’s office is likely to bring charges against the local director and managers responsible for barring Knauf from the factory.
That the Russian government finally stepped in to resolve Knauf’s problems has done much to restore investors’ flagging confidence in the Russian legal system, particularly on the issue of enforcing federal court decisions in the regions outside Moscow. Last year foreign companies won more than two-thirds of the 1,600 suits they filed in the state arbitration courts, including MFK Renaissance’s December victory after a two-year struggle to gain board representation at the Novolipetsk steel mill. “We’re in court every week and we get the right result every time,” says Bruce Bean, managing partner at US-Russian law firm Coudert Brothers.
Even so, enforcement is still a problem. According to Vasiliev, the FSC has no clear guidelines or penalties to apply to companies that break the law. “We still can’t fine companies that violate shareholders’ rights and actions that would be considered criminal in the west are not covered by Russian [criminal] law – for example, removing assets, falsifying documents and fraud. This is one of the things we are working on.”
Two recent decisions by the FSC in particular have signalled that the Russian government has finally got the message about shareholders’ rights and is willing to throw its full weight behind the securities regulator. The first case was the FSC’s decision to suspend a convertible bond issue by oil company Sidanko, which is backed by the powerful Unexim group.
When it became public knowledge that Sidanko planned to issue convertible bonds in return for stock in its subsidiaries, William Browder, managing director of Hermitage Capital Management called his lawyers. Under the terms of the deal, Sidanko was to receive shares in subsidiary companies as sole payment for its bonds. Unexim affiliates MFK Renaissance and Kantupan Holdings were to swap stock in Sidanko’s subsidiaries for bonds that would convert into stock in Sidanko. “It was a way for Sidanko to increase its control of its subsidiaries by swapping shares in the holding company for shares in the subsidiary,” says an analyst. Minority investors were galled because the offer was open only to Unexim affiliates, which were to receive shares in Sidanko for a tenth of their market price.
Other investors, including Browder, faced a heavy dilution of their holdings as the number of Sidanko shares increased from 232 million to 640 million. “At the time, we were very unhappy about this,” says Browder who had bought into Sidanko in the early months of 1997 and become the largest shareholder in the 4% block not owned by Unexim and MFK Renaissance.
Browder presented his case to the commission. He was joined by Boris Fyodorov, a deputy of Russia’s parliament, the Duma, and the chairman of United Financial Group whose clients also have minority stakes in Sidanko. Although Vladimir Potanin, head of Unexim, and Boris Jordan, head of MFK Renaissance, claimed at first that they had done nothing wrong, they quickly changed their minds in the face of adverse international publicity and pressure from the commission.
On February 13 the FSC suspended the issue. Two weeks later Potanin admitted in public that the issue “was a mistake”, possibly prompted by the vocal criticism of George Soros. “We were very pleased with the way they reacted,” says Vasiliev. “They admitted their mistakes and attempted to solve the problem.”
The FSC says that its decision to suspend the issue was based on the fact that the convertible bond contradicted decisions taken at earlier shareholder meetings and was therefore in breach of Russian securities law.
Browder says he is satisfied that the commission came up with the right decision: “We achieved what we wanted to achieve, as long as the next bond issue complies with the commission’s ruling that it be open to everyone.”
Another important step was taken by the FSC when it overruled a board decision giving excessive powers to directors. The case involves allegations that oil company Yukos has been transferring value out of its subsidiaries Samaraneftegaz and Yuganskneftegaz into the holding company. The FSC ruled that the decision to give company directors the power to transfer subsidiaries’ assets to the holding company was in breach of Russian law on joint-stock companies.
“The underlying problem is the way the oil companies were privatized,” says an analyst. At first, the government used vouchers to transfer company ownership into the hands of millions of workers. Later, through the loans-for-shares scheme, the remaining majority stakes were sold to single investors. Now, in order to restructure their asymmetric holdings into efficient, vertically integrated companies, the new owners need to gain full control of their subsidiaries. Regulators and investors alike are worried that the oil companies will ride roughshod over the rights of minority shareholders to gain full control of their subsidiaries.
“The issues are becoming far less black and white,” says Andrei Volgin, who as head of the Moscow committee for shareholders’ rights helped draft the securities legislation. “It is not always foreign investors who suffer at the hands of evil Russian company directors,” agrees Ed Kaufman, head of Salomon Smith Barney in Moscow.
In mid-March for example, the government’s 34% minority stake in Eastern Oil was threatened by the decision to hand over management control of the company to Yukos, which owns 54%. Russia’s state property committee claims the decision is in breach of an earlier board meeting and says that it intends to take legal action.
Shareholders in a subsidiary of Eastern Oil, Tomskneft, are also likely to protest against the decision. Shareholder group Acirota, which owns a 13.6% stake in Tomskneft and is led by US investor Kenneth Dart, has complained that Yukos is systematically transferring value out of its subsidiaries at the expense of minority shareholders. A press release from Acirota earlier this year called for an investigation into Yukos and challenged the company to produce transparent accounts. Acirota claims that “tax debts and the cost of production are left with the subsidiaries, while profits are illegally upstreamed to the parent”. Dart recently called for an independent audit of another Yukos subsidiary, Yuganskneftegaz, in his attempt to prove that Yukos has been stripping profits by transferring oil from subsidiaries to the holding company at below-market rates.
Eugene Tenenbaum, head of corporate finance at the newly created Yuksi (the result of the merger of Yukos and Sibneft), says that the economic arguments are all in Yukos’s favour, though he admits the practice of transfer pricing is under review. “You have to ask where is value created? The subsidiaries only extract oil, they don’t refine it or add any value.” Vasiliev admits that “transfer pricing is a problem; it does exist. But since it is out of our jurisdiction, we have passed the documents [concerning Yukos] to the chief prosecutor’s office and the commission for the protection of shareholders’ rights”.
At the centre of the row is the price which Yukos has paid its subsidiaries for oil. One analyst, who asks not to be named, says: “Just look at the books. Anyone can spot the holes.”
Tenenbaum, who came from Sibneft and was previously a director at Salomon Brothers in London, says he has not seen any holes in the accounts. “I can only go by the audited statements by Price Waterhouse and central-bank auditors Unicom, and these say that everything is fine. I’ve spent some time looking into this and nothing I’ve seen tells me there is a problem.”
Tenenbaum claims that Yukos is the victim of a dirty-tricks campaign. “Dart is greenmailing us. It’s orchestrated, well-planned guerrilla warfare from the Dart war room. This guy is in every subsidiary. He is not stupid. It was obvious that these companies would become vertically integrated from the way they were privatized and he was waiting for it to happen. Its bullshit – a sophisticated, ingenious plot. But we are not going to be held to ransom.”
Tenenbaum admits that the company’s accounts are not yet up to western standards. But he points out that Dart and his colleagues are sophisticated investors who knew what they were buying into. “These investors weren’t from Oklahoma. Ken Dart did exactly the same thing by holding up the Brazilian Brady restructuring a few years ago.”
In response to the criticisms, Yuksi is setting up an advisory body to negotiate with its minority shareholders: “We want to work with our shareholders,” says Tenenbaum. “But they have to work with us, not against us. We don’t have time to deal with investors who are trying to blackmail us and prevent us from getting on with the job of restructuring this company.”
