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. Last Updated: 07/27/2016

Shareholders Rights: Round 2

During the bull market in Russian stocks, foreign investors may have been willing to turn a blind eye to breaches of shareholders rights. Tales of stock manipulation by majority shareholders and sketchy financial reporting were forgotten amid the general glee at surging stock prices.

But the Asian crisis has sacked Russian stocks, and investors who once accepted poor corporate governance as part of the terrain in Russia are becoming a bit more picky.

Western fund managers have warned in recent weeks that foreign investors won't return to Russiain force until the market takes significant steps toward greater transparency and fairness. President Boris Yeltsin this month appeared to agree with this assessment when he called for a crackdown on investor abuse.

Allegations of abuse of shareholders rights in two of Russia's biggest oil companies, Sidanko and Yukos, have emerged as test cases in the new attempt to clean up the market. The Federal Securities Commission recently announced it would investigate both cases.

Sidanko and Yukos, while acknowledging the market must adopt higher standards, have questioned the motivation and tactics of the minority shareholders complaining of abuse. Those protesting most loudly may be those who simply didn't analyze their investments closely enough, the companies say.

The pressure is on the securities commission and on Russian legislation itself to prove that rules do apply in an emerging market aspiring to international status. What follows is an examination of the Yukos and Sidanko cases under investigation:


Analysts have long criticized the oil holding company Yukos for allegedly removing profits from its subsidiaries, but a minority shareholder in the oil producer Tomskneft has been the first to confront the company openly.

Tomskneft joined the Yukos/Rosprom group, run by Mikhail Khodorkovsky, only in December when Yukos won a privatization auction for a big stake in Eastern Oil, a holding company that owns 51 percent of Tomskneft.

But a shareholder called Acirota, owning 13.6 percent of Tomskneft, is already dreading Yukos management. Tomskneft stock has fallen 58 percent to about $6.40 since Yukos acquired its stake in Eastern on Dec. 8. In that period, the Moscow Times Index of 50 leading shares fell 22 percent.

Anticipating that Yukos would begin stripping profit from Tomskneft, Acirota last month challenged Yukos to support a proposal calling for more transparency in company transactions.

Oil producers like Tomskneft may directly own all the oil wells, but holding companies, by owning 51 percent of their subsidiaries, have almost all the power. Yukos and other holding companies, Acirota alleged, abuse their controlling stakes in the subsidiaries to siphon off profits from the companies, leaving subsidiary stock worthless.

"Tax debts and the cost of production are left with the subsidiaries, while profits are illegally upstreamed to the parent," Acirota said in a press release.

Acirota's resolution called for audits of all transactions over $50,000 between Tomskneft and its holding company. Yukos rejected the proposal at a shareholders meeting earlier this month, prompting Acirota to appeal to the securities commission for an investigation into Yukos' alleged profit-stripping tactics.

Tomskneft in 1996 made a profit by Russian accounting standards of $41 million on sales of $845 million. But Acirota is concerned that as Yukos takes over, Tomskneft will suffer from "transfer pricing."

Under this scheme, the holding company forces an oil producing subsidiary to sell its crude oil at below-market prices and then exports it or sells it domestically for a hefty profit.

Graham Houston, a consultant working for Acirota, said Yukos' 1996 financial accounts suggest that the holding company was making a profit at the expense of its subsidiaries, Yuganskneftegaz and Samaraneftegaz.

Yukos' 1996 Russian accounts show the holding company made $230 million in pretax profit while Yuganksneftegaz lost $60 million and Samaraneftegaz registered a profit of $50 million.

Yukos' 1996 financial statements audited by Price Waterhouse to international standards paint the same picture, Houston said.

Those accounts show the holding company made a net profit after taxes of 531 billion rubles ($91.5 million) while the minority interests in the subsidiaries lost about 2 trillion rubles.

"That's an unusual picture," Houston said in an interview. "You usually don't get losses you are pawning off on minority shareholders becoming profit for the holding company."

Houston concedes he does not know exactly what prices Yukos paid its subsidiaries for the oil. But based on the international standard accounts, he notes that the holding company's total pretax revenue from crude oil production was about 12.3 trillion rubles, or $2.2 billion in 1996.

Dividing this figure by total oil production of 256 million barrels, it appears the holding company received an average of $8.60 per barrel of oil, Houston said.

The price Yukos reported it earned for its oil is extraordinarily low compared with market prices, and thus the price paid to its subsidiaries was likely lower still, Houston said.

Average crude oil domestic prices in 1996 were about $10.60 a barrel, Houston said. And Yukos would have received even more for the 25 percent of its production that it exported. The average export price in 1996 was about $18.50 per barrel.

The Price Waterhouse-audited financial statements stated that Yukos paid its subsidiaries an amount approximately equal to domestic prices. Yukos acknowledged in a note to the accounts that it may be liable to return some of the export profit to subsidiaries.

"During 1996 Yukos entered into a number of agreements with its subsidiaries whereby all crude oil production is transferred to Yukos at amounts which approximate domestic prices, although approximately one-fourth of such crude oil is sold onward by Yukos at international prices," reads a footnote in the audited accounts. "The Company may have a liability for some portion of the difference between international and domestic prices."

The accounts do not quantify this liability. Shareholders in Yuganskneftegaz and Samaraneftegaz may soon call for an audit of subsidiary accounts to calculate the export profit denied the subsidiaries, Houston said. U.S. food-container tycoon Kenneth Dart, the lead shareholder in Acirota, is also believed to hold stakes in both Yukos subsidiaries.

A Yukos spokeswoman denied that the company earns excessive profits from its export sales, saying taxes and transport tariffs eat up much of the profit. In a statement handed out at the Tomskneft shareholders meeting, the company defended its transactions.

"Acirota forgets that, first, Yukos' basic organization of intra-company trade flow has undergone an international audit," the statement read. "And second, the holding company pays in full for the services of Transneft for the transport of the oil, for export excise taxes, and returns capital to the daughter company in the form of capital investment, etc."

Acirota agrees that there is nothing wrong with a holding company buying oil from its subsidiaries and reselling it. But the price offered must be a fair market price, and the transaction must be open to inspection, the shareholders argue.

The resolution Acirota proposed at the Feb. 6 special shareholders meeting called for an independent auditor to assess whether transactions between Tomskneft and its parent company are conducted at a fair market price as mandated under the law on joint stock companies (See box).

Yukos, however, opposes the resolution and stands by its decision to vote it down. Yukos attorney Dmitry Gololobov maintained that transaction prices between Yukos and its subsidiaries are already audited by an independent firm, and approved by the independent members of the subsidiaries' boards.

Auditing every transaction would be extraordinarily expensive and would slow down Tomskneft's operations, the attorney argued at the shareholders meeting.

"The federal Law on Joint Stock Companies offers shareholders holding small packets of shares in a company sufficient legal means to protect their interests," Gololobov said. "Attempts by minority shareholders to introduce additional protections of their rights, including introducing changes and additions to the charter, often bring additional and absolutely unjustified expenses tothe company, which is profitable neither to the majority nor the minority shareholder."

Ultimately, Gololobov argued, a shareholder should take his complaints to court if he thinks them legitimate.

Acirota says it would rather not have to fight one battle at a time through lawsuits. "We don't think we should have to go to the courts to get information that by law should be available to all shareholders," said an Acirota representative.


Nine times out of 10, corporate decisions that infuriate minority shareholders are perfectly legal under Russian law, Boris Jordan, president and chief executive of invest bank MFK Renaissance, said at a news conference last week.

The U.S. citizen acknowledged, however, that many corporate decisions are not "in the spirit of an international approach to minorities or shareholders in companies."

Jordan knows a thing or two about battles for investor rights. Renaissance recently rallied minority shareholders to fight for board representation at the Novolipetsk Metallurgical Combine and for an open, fair share issue at Norilsk Nickel.

Now Jordan is on the other side of the fence, negotiating with minority shareholders in Sidanko who say their stakes have been severely diluted by an issue of convertible bonds announced in December. The deal involves a swap of stock in Sidanko's subsidiaries for shares in the Sidanko holding.

Renaissance and partner Uneximbank control 96 percent of Sidanko, while foreign investment funds hold 4 percent. Uneximbank head Vladimir Potanin this month asked Renaissance to field investor complaints concerning the issue, which the securities commission suspended pending results of its investigation.

Minority shareholders say they should have been included in the convertible bond issue that nearly triples Sidanko's charter capital but limits participation to two groups connected to Uneximbank.

Sidanko offered the bonds only to Uneximbank affiliates Kantupan Holdings Ltd. and MFK investment bank in exchange for their stock in Sidanko's subsidiaries. This allowed Sidanko to boost its direct control over subsidiaries to about 75 percent.

Minority shareholders don't agree with Jordan's assertion that the bond issue was fair. They say they were never informed the issue would be limited to insiders, nor that the bonds would be sold so cheaply. According to United Financial Group-Paribas, the bonds were sold for a price equivalent to about $1.60 per share, or about one-tenth of the market price.

"We weren't notified in any way that they were going to sell the stock to themselves at below market price," said one minority shareholder. "And even if we had been, being warned of that isn't an acceptable excuse."

Renaissance to date has heard complaints only from minority shareholders in the holding company, who are concerned about dilution. But market analysts say minority shareholders in Sidanko's subsidiaries will be equally peeved if they are not offered the chance to swap their stock for holding company stock at the same favorable terms Kantupan and MFK have been offered.

Jordan and Potanin last week argued that all shareholders knew about the terms of the bond issue, saying fund managers who claim to have been caught unawares simply didn't do their homework before buying into Sidanko.

"It is a strange situation when a fund manager who apparently tells his investors he's an expert in a market and understands all the nuances ... says a particular happening in the market is a surprise," Potanin said last week at a news conference. "It seems to me this seriously undermines his reputation."

Renaissance and Uneximbank maintained the bond issue fully complied with Russian law. But Bernard Black, an expert on joint-stock company law, noted three aspects of the bond issue that may have broken the law. (See box on Joint Stock Company Law.)First, Sidanko may have slipped up in not allowing minority shareholders the chance to vote the issue down.

The company did hold a shareholders meeting in December 1996 to approve a closed subscription issue of 402 million convertible bonds.

But Sidanko vice president D.V. Maslov said at the meeting that all daughter-company shareholders would be allowed to take part in the bond issue, according to a copy of the meeting minutes.

"Discussing the mechanism of the convertible bond issue is not on the agenda at today's shareholder meeting," Maslov said. "At the same time, straying beyond the boundaries of the agenda, it is possible to say that the strategy of the company regarding this question is to give equal rights to every shareholder."

According to one Sidanko shareholder, the company decided to limit participation in the bond issue at a November board meeting. Jordan, who sits on Sidanko's board, said last week he did not recall this.

The question, however, should have been put to shareholders not connected to Uneximbank, Black said. Such shareholders, in legalese called "noninterested parties," have the right under Article 83 of the joint stock company law to reject transactions between the company and any shareholder owning more than 20 percent of the company.

What's more, Article 38 of the law stipulates that a company must issue stock at no less than 90 percent of its market value. Sidanko's issue does not appear to fulfill this requirement, Black said.

Finally, Article 71 states that the board of directors is required to act in good faith and in the best interests of the company.

"If they issued bonds at less than their market value, one could argue that they acted not in good faith, nor in the interests of the company," Black said.

Current negotiations with shareholders appear to be focused on dollars and cents and not on precise points of law.

"We will do whatever it takes to make sure all minority investors retain at minimum the value they had prior to the transaction," Jordan said last week. "I think that Potanin would say that he of all the financial-industrial groups has a different attitude toward the investor community and wants to make sure he keeps it very friendly given that we regularly tap the international capital markets to raise money for our various companies."

Jordan maintained that because Uneximbank had almost tripled Sidanko's worth by bringing key deals to the company, the value of shareholders' stakes remains the same even after the share issue that decreases the percentage of their holdings.

Uneximbank has boosted Sidanko from a $1.5 billion to a $5 billion company, Jordan said, by increasing the holding company's control of its subsidiaries, acquiring a controlling stake in a massive Siberian gas development project called Kovykta, and attracting British Petroleum as a strategic partner. BP in late December bought a 10 percent stake in Sidanko for $571 million and has pledged to contribute billions more to develop the Kovykta field.

Investor-savvy Uneximbank is almost certain to make peace with its shareholders and to ensure that investors don't lose money in the bond issue. But some would argue that this is no substitute for the strict rule of law.

Russian legislators could bolster adherence to joint stock company law by clearing up minor ambiguities that complicate shareholder attempts to enforce their rights, Black said.

But greater disclosure of corporate dealings will ultimately prove the key tool in wiping out shareholder-rights violations, he added.

"Sunshine has proved to be a great disinfectant for American companies who might otherwise be tempted to engage in various nefarious activities," Black said. "It will prove effective in Russia, too, if given a chance to operate."