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. Last Updated: 07/27/2016

Shares in Custody: Another Way to Buy Russian




American Depositary Receipts are one widely


publicized way of getting into Russian equities from abroad, but U.S. brokers are also structuring deals that essentially offer underlying Russian shares to foreign investors. But as Erin Arvedlund reports, they may be wary of small investors.


NEW YORK -- If you're a small-time investor, buying domestic Russian shares in modest quantities might seem like an affordable way to get into an exciting market. But be prepared: Even though U.S. brokerage houses have found ways to get around rules discouraging the purchase of domestic Russian shares, they're not likely to take a sniff at you and your money unless you cough up millions of dollars on the spot.


Buying into Russian equities from abroad seems easy enough. Let's say you are investing in London or New York, and you want to get some equity exposure to the roiling Russian market, but not through an American Depositary Receipt offering.


Shares of Russian companies such as Gazprom and LUKoil are the kind most small investors would look at to spice up a portfolio, particularly since they represent blue-chip companies bent on attracting funds from outside stockholders. These companies and other giants are also the most likely candidates to issue ADRs, packages of shares that trade on foreign exchanges and are backed by underlying domestic shares.


For investors, ADRs offer safer packaging of risky securities. But that comes at a price: ADRs often trade at a premium to the price of the underlying stock trading in Russia.


Some investors, then, might consider trying to buy the domestic stock directly. And why not? Gazprom's domestic shares were the hottest stock of 1997, at one point trading four to five times cheaper than its foreign-listed ADRs.


Brokers in Russia used custody agreements to get around a Gazprom mandate that limits foreign ownership of the company: A Russian broker agreed to hold the domestic shares for the benefit of a foreign buyer, who in the brokerage's back office was listed as two or three offshore-registered shell companies removed from the original purchaser.


Why not repeat the magic if you're a small investor? Simply put, most brokers won't waste their time on individual investors. When it comes to Russian domestic shares, institutional clients still get all the attention.


For the sake of following the experiment, let's say you're an individual investor in New York itching to plop down $15,000 for domestic shares in Unified Energy Systems, Russia's power monopoly and a popular blue-chip stock.


Approached with such a scenario, the head of trading at Brunswick, a Moscow-based brokerage with a branch office in Manhattan, said their license doesn't permit the sale of domestic Russian shares to individuals.


Besides, Brunswick only handles individual accounts with a $1 million minimum, and those are being discontinued at the beginning of 1998. So much for the small investor.


Instead, the Brunswick trader suggested buying shares of Vimpelcom, Russia's first publicly traded cellular telephone company and first to list on the New York Stock Exchange.


"Buy Vimpelcom or something like that. Besides, the U.S. Securities and Exchange Commission has rules protecting individual investors from buying domestic shares" of foreign issued stocks, he added.


"There are probably a lots of brokers who say to themselves, 'We don't want to deal with small fries who are likely to sue us anyway,'" said one institutional money manager. "However, I'd be surprised if there's actually a law that forbade [large retail brokerage firms] Morgan Stanley and Merrill Lynch from doing so. But since they don't want to deal with small guys, their advice would probably be to buy a Russian equity mutual fund."


It's true that there isn't really a law against selling foreign securities in the United States, but there are Securities and Exchange Commission regulations governing into what kinds of securities individual investors should wade. It's called "seasoning," and every security marketed in the United States is supposed to be seasoned. If an individual investor wants a foreign security that does not yet have approval from the commission, it can't be sold in the U.S. market. But if it's not a new security and has been out in the public market for a while, then it's considered "seasoned" and eligible for sale.


Russia-based brokerages such as Brunswick and Renaissance mostly process big orders for Russian domestic shares from the massive retail brokers such as Morgan Stanley or Merrill Lynch, which in turn could dole out those shares to the small investor. Large banks such as Goldman Sachs generally have what is known as private client services for wealthy individuals, and they typically want to sign on a private client with no less than about $10 million.


Were retail brokers -- who execute buy and sell orders for individuals -- to try and get Russian shares themselves, they would likely work through their institutional investor departments anyway.


If you're not one of those $10 million sort of people, the broker would probably call his firm's international desk in London.


But because the order for, say, $15,000 worth of UES shares is so small, "they're not likely to want to talk to him. The system is not structured to let [such an investor] do so," said a New York-based broker with Schwab.


The broker said rather than sell relatively obscure and risky securities in small quantities, a brokerage such as Merrill Lynch or Schwab would likely steer the buyer toward lower-risk, higher liquidity shares.


Institutional investors -- meaning pension funds, portfolio and mutual fund managers, or even corporations -- would put in a large order for domestic Russian shares, and then rig the custody issue in the same way as any other security. A Morgan Stanley broker puts in an order to his institutional desk and then the shares are held in the firm's name, not in the name of the investor. (Individuals can hold the shares as well, but for convenience, the firm usually holds them for the benefit of the client).


So the main issue is whether the big retail brokers will want to do it, particularly for the trouble they'd have to go through to issue such a small order.


In the unlikely event that they would, the minimum order would depend on the firm and its standard commission structure, and the tax would be governed by U.S. legislation on capital gains.