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. Last Updated: 07/27/2016

Russia's ADRs Under Unlikely Attack

From LUKoil to Unified Energy Systems, the crown jewels of Russian industry are traded on U.S. financial markets as ADRs - financial instruments that act as "proxies" on Wall Street for the shares of companies based abroad.

But even though American Depositary Receipts are used by nations all around the world to tap Wall Street pockets, in Russia they have an unclear legal status. About 50 of the nation's leading corporations have sold ADRs on Wall Street - every one of them, as it happens, through the Bank of New York - but while an ADR may be attractive to foreign investors, under Russian law it is not crisply recognized as an ownership stake in a corporation.

Now this potentially weak legislative link is being hammered at by a cohort of critics. They include Alexander Shokhin, a former finance minister now in the State Duma's banking committee, and Natalya Gurfinkel-Kargalovskaya, a Bank of New York senior vice president who has quit and is now suing the bank in a Moscow court.

So far, Shokhin and Gurfinkel-Kargalovskaya are not being taken terribly seriously as a threat to the ADR program. The stock market in fact has risen this week, in imitation of the Dow Jones, with the RTS Index up 4.02 percent Tuesday and another 4.2 percent Wednesday.

But what's at stake is mind-boggling. Were critics to derail Russia's ADR programs, it would affect the ownership structures and investment plans of almost every major Russian corporation.

Moreover, trouble with Russian ADRs might translate into trouble with the entire ADR concept. If so, Wall Street would not be happy.

Russia's ADRs represent companies that have a total market capitalization of about $50 billion, yet they are a mere 3 percent of all depositary receipt programs. All ADRs taken together represent companies with a market capitalization of $6 trillion, according to data placed on the Bank of New York's web site - and that is about one-fifth of the U.S. stock market.

Are ADRs Like Forwards?

And if it is still in the realm of the absurd to think the tag-team of Shokhin and Gurfinkel-Kargalovskaya might bring down the ADR market, it is worth noting it was also considered ridiculous to think Russian financial-market players and regulators would simply shrug off ruble-forward-contract obligations - another derivative instrument. And yet they did, stiffing their erstwhile Western partners to the tune of $10 billion.

Sympathetic Russian courts ruled that forward contracts - a kind of insurance policy bought and sold commonly among financial-market participants - were actually "gambling instruments."

The courts could do so because there was little legislative underpinning for the concept of a currency-forward contract - and ADRs are arguably in this same legal no-man's land.

So far, only LUKoil, the nation's No. 1 oil company, has found the demarche against ADRs an alarming prospect. In a press release Wednesday, LUKoil warned that emasculating ADRs would be "a blatant violation of shareholder rights."

"The country would lose investors' confidence for good," the statement quoted LUKoil vice president Leonid Fedun as saying.

Other players have reacted coolly.

"The market is driven by expectations of a breakthrough in the political arena, not by the statements of [Communist leader] Gennady Zyuganov or Shokhin," said Sergei Pinchuk, a spokesman for UES. As to the foggy legality of the ADR regulatory framework in Russia, Pinchuk dismissed talk of that, saying, "This is common knowledge."

Spotlight on BoNY

ADRs were first born in 1927 in response to a British law prohibiting local companies from registering their shares overseas. They did so anyway, getting around the law with the fig leaf of a "proxy" stock that traded on Wall Street instead of the real stock.

As has been the case so often in recent months, the Bank of New York is again at the eye of the storm. Before it made headlines as part of a multibillion-dollar Russian money-laundering investigation, the bank was best known for being the Wall Street-ADR connection for Russia - and indeed, for the world.

In addition to a de facto monopoly on the Russian ADR market, the Bank of New York says it has a 70-percent share on the global ADR market.

Gurfinkel-Kargalovskaya, who handled much of the bank's Russian business, said management has left her a scapegoat for the money-laundering brouhaha and has ruined her reputation. If she wins her $270 million lawsuit, her lawyers suspect the Bank of New York will be reluctant to pay out.

They are already thinking ahead to seizing the bank's property in Russia - most notably the $1 billion it holds in shares of Gazprom, Tatneft, UES and other mega-corporations that are the collateral behind ADRs.

While Gurfinkel-Kargalovskaya presses her attack via the courts, Shokhin has opened a second front via U.S. and Russian stock-market regulators.

Shokhin announced last month he had filed written complaints about the way ADRs were run through the Bank of New York with the U.S. Securities Exchange Commission and with its Russian counterpart, the Federal Commission for Securities, or FKTsB.

Shokhin said the Bank of New York has over the years been in a unique position to influence how ADRs are voted back in Russia at general shareholders meetings.

He argued that the Bank of New York has basically been in cahoots with the managements of the parent Russian companies that run ADR programs - with the bank getting the profitable business of serving up Wall Street cash as investment zakuski, or hors d'oeuvres, and the corporate management in return getting to enjoy the money that comes in from share emissions without the headache of a loss of ownership control.

ADRs and UES

One context for Shokhin's public attack on the ADR program is a campaign of pressure against Anatoly Chubais, the head of UES, the national power grid.

Chubais is one of the giants of the Russian political scene, but these days his position is tenuous: Acting President Vladimir Putin has criticized UES as poorly run, other Cabinet minister have called for the sacking of Chubais, and they have been joined in that by Zyuganov.

The state owns 52 percent of UES, but needs to line up 75 percent of all shares to vote Chubais out as CEO. Chubais, however, has a loyal 30 percent following among foreign shareholders, most of which are actually ADRs that Shokhin says are a gift from the Bank of New York to the nation's most famous "economic reformer."

Shokhin was far from the first to attack the use of ADRs at UES shareholder meetings to shore up Chubais. The Audit Chamber, parliament's budgetary watchdog, issued a report more than a year ago arguing that ADR-holders had no right to vote in an April 1998 shareholders meeting. The chamber argued the results of that meeting should be overturned.

UES stock traded calmly in response to that Audit Chamber attack, and also barely noted Shokhin's complaints. But when Putin last month backed Shokhin up with a complaint that UES was a poorly run company, UES shares dropped 10 percent in value.

So in a nation where rule of law is often based on what the president says, one question to watch will be: How far does Putin share Shokhin's concerns? Is Putin simply rattling Chubais' cage, or is he prepared to support Shokhin's wonkish ADR critique?

And Then There's RDRs

If Russian investors are blas? about Shokhin's legal arguments, that is in part because they are used to trading on capital markets despite omissions and inconsistencies in securities legislation.

Just one example: Russian law sees a security as a tsennaya bumaga, a valuable paper. Sometimes a security trade takes place entirely in the virtual world, yet the law makes no allowance for electronic transactions.

"By defining a 'security' as a document, Russian legislators assumed a traditional impractical approach," said Sergei Avramov, an associate with legal firm Baker & McKenzie. He said lawmakers are now debating amendments to the security law to recognize paperless markets.

There is also an intriguing project underway to create Russian Depositary Receipts - proxies that would let Russians buy a piece of Wall Street. The project was launched last year by a group that includes Deutsche Bank, Templeton, Troika Dialog and the law firm Landwell CIS and is being worked on together with representatives of the Central Bank and the FKTsB.

"We hope to finalize it by summer," said Maryann Gashi-Butler, managing partner with Landwell CIS, a correspondent law firm of PricewaterhouseCoopers. "Later, we could extend the concept to ADRs in Russia."