The costs/benefits of disclosing beneficial ownership OECD, Russian corporate governance roundtable meeting 11th-12th November 2004 All financial and other information contained in this presentation has been obtained from and prepared on the basis of publicly available data which has not been verified by Vostok Nafta Investment Ltd. for its completeness or accuracy; Vostok Nafta Investment Limited does not make any representation or warranty (whether express or implied), nor does it assume any liability, as regards completeness or accuracy of financial or other information which has been obtained from such publicly available sources.
Contents • The need for disclosure of beneficial ownership. • Examples of how Sibneft and TNK hide true ownership. • Related parties masquerading as independent shareholders. • The UK regulatory environment. • Other problems related to the enforcement of Corporate Law and Securities Market laws in Russia.
Policy framework • The Russian equity market has a number of unique features which are relevant to framing policy. The single most important factor is that many shareholdings have been created as a direct, or indirect result of voucher privatisation, as opposed to entrepreneurs looking to access equity capital. This fact has two critical implications; • Having completed voucher privatisation, the Government should protect the interests of shareholders as an extension of its privatisation policy. • The negative consequences of poor corporate governance – a low share price and/or a lack of access to equity funding is an entirely counter-productive disincentive. In many companies a dominant shareholder whose is extracting cash flows is actually interested in lowering the share price in order to deter minority investors. • In summary, market mechanisms on their own are not an adequate disincentive to stop bad corporate governance in Russia – legislation and penalties to stop self-dealing are also vitally important.
The case for shareholder activism • Vostok Nafta is involved in a major legal challenge to the way in which a Russian oil company (OAO “Slavneft-Megionneftegaz”) is run. Part of that challenge involves uncovering the beneficial ownership of a multitude of Russian, Cypriot and BVI companies. • We believe that this work is important not only because it helps secure our assets, but also helps in the wider context of improving property rights and frustrating the pernicious practice of transfer pricing.
Beneficial ownership – why is it important? • The key concern for minority shareholders is to understand the nature and extent of any related party transactions – that can only be determined if a company’s ownership structure is clear. • This issue is particularly relevant in Russia where financial industrial groups tend to own numerous companies in various sectors which trade with each other – thereby creating conditions for transfer pricing. • An understanding of who owns what generates a number of related benefits in the areas of; • Competition policy; • Takeover code; • Fighting corruption and fraud. • These latter areas are not the concern of minority shareholders – but we briefly touch on them.
Ownership structures in Russia • Financial Industrial Groups control multiple enterprises, accordingly the potential for related party transactions are infinitely greater than in the UK where companies are 70% owned by financial institutions.
Existing disclosure of beneficial ownership and related parties • Ownership disclosure in Russia is improving, however it still focuses on the owner of record rather than the ultimate beneficial owner. • The existing Russian disclosure can be combined with GAAP accounts, international company searches and press statements to build up a fairly accurate picture of ultimate ownership. However this exercise requires time, money and effort. This data should be voluntarily disclosed, there is no valid reason to hide such data. • By combing different data sources it is possible to work out what has not been disclosed.
Risks arising from non-disclosure of beneficial ownership • The key risk relating to non-disclosure is that related party transactions will be carried out between entities under common ownership or control without shareholders being aware of any relationship. In addition to this obvious threat, we identified two related risks;
Beneficial ownership – the majority masquerades as a minority • Based on the results of various extraordinary shareholder meetings, we understood that three Cypriot entities (Edie, Select and Hassla Holdings) consistently voted “for” related party transactions. • By voting on those issues, the Cypriot entities were representing themselves as being independent (within the meaning of Russian law). Further the registrar (OAO Registrator R.O.S.T.) was similarly certifying that the Cypriot entities were allowed to vote by including them in the quorum. • We spent many months uncovering the ownership of those entities in order to determine that three Cypriot individuals apparently owned the three Cypriot entities, implying that those individuals owned some USD 480 million worth of Megionneftegaz ordinary shares. • Further one of the “independent” companies nominated 3 members of TNK’s management to the Board of Megionneftegaz in March 2002*. • Our investigation showed that the Cyprus companies were ultimately owned (via a trust agreement) by OAO Sibneft and OAO TNK (acting jointly).
Related party voting patterns • Megionneftegaz failed to even ask shareholder approval for most of its related party transactions and sold oil to related parties in contravention of the requirements of article 83 of corporate law. • For those transactions where the Board did actually bother to invite allegedly independent shareholders to vote, 27.5% of “independent” shareholders consistently voted in favour of related party transactions.
Mechanisms used to hide TNK/Sibneft ownership in Megionneftegaz Source: Company searches, TNK and Sibneft GAAP accounts, NGK Slavneft and Megionneftegaz Federal Securities Market filings.
The “independent” shareholder registrar ROST Source: Website ROST (www.rrost.ru), Federal Securities Market filings NGK Slavneft and Megionneftegaz.
How independent is ROST? • 4 out of 5 members of the Board work for Millhouse Capital – the manager of a majority stake in Sibneft. One of those Board members was also a Board member of NGK Slavneft. • Via its management of a dominant stake in AO Siberian Oil Company, Millhouse Capital can indirectly control an estimated 27% in Megion plus a further 12.6% through various trust arrangements, Millhouse apparently manages a significant stake in ROST. • “Independent” shareholders who are ultimately owned by TNK/Sibneft appear to have no trouble in receiving and returning voting papers for the 29th January 2004. Source: website ROST (www.rrost.ru), information on Board of Directors of NGK Slavneft from FSC quarterly filings. Rost ownership data from website Bankpress.ru
ROST’s role as Megionneftegaz’s registrar • The following events took place whilst ROST acted as registrar for Megionneftegaz; • Austro (Cyprus) Limited’s voting papers for Megionneftegaz’s EGM held 29th January 2004 were sent by post to Austro (Cyprus) Limited using ZAO Brunswick UBS Nominees postal address. The combination of a foreign recipient with a Russian entity’s postal address rendered the envelope undeliverable. • Related parties (Edie, Select and Hassla) are inappropriately included in the quorum for voting on related party transactions, thus rendering the safeguards in article 83 of Corporate Law useless.
ROST’s role as Megionneftegaz’s registrar • Vostok Nafta identified and received confirmation that some 40 individuals received voting papers for Megionneftegaz’s annual general shareholders meeting (25th June 2004) on or after the deadline for the return of voting bulletins to Megionneftegaz (22nd June 2004). • The explanations provided to date such as “problems with the post”, mistakes by the nominees and inaction on the part of the issuer simply lack credibility.
The costs/benefits of disclosure • The costs of disclosure are essentially zero – the costs of non-disclosure are extremely high. The complex web of trusts/offshore ownership companies utilised by TNK/Sibneft to hide their ownership in Megionneftegaz are both expensive to set up and costly to maintain. • In terms of benefits of disclosure – the obvious benefits are; • To allow minority shareholders to understand and quantify the risks of related party transactions; • To build up a factual case to pursue corporate malpractice suits via the court system; • To understand whether key market participants such as the auditor, valuer and/or registrar are really independent.
The costs/benefits of disclosure • There are other benefits of disclosure, not strictly relevant to minority shareholders, but none the less useful such as making it harder for politicians to hide ownership of substantial assets.
Ownership disclosure – UK experience • The UK recognises (as does Russia) that it is important to disclose information on significant shareholders. • The UK regulatory regime is robust and sets out very clear responsibilities and mechanisms for disclosure, the UK regime; • Clearly defines ownership arrangements and specifies in detail what type of ownership does and does not need disclosure; • Clearly defines the various thresholds for ownership disclosure (both increases and decreases); • Clearly defines responsibilities for disclosure (and information dissemination); • Clearly defines penalties for non-disclosure, or inaccurate disclosure.
Ownership concepts • UK disclosure requirements are worded in such a way that it is impossible to evade the spirit of the law. The regulatory regime includes disclosure requirements related to a number of key concepts; including; • direct or indirect ownership; • Interest or right conferred under an agreement; • The nature of pooled investments; • An obligation to disclose the steps taken to ensure independence between an entity and its largest shareholder; • The use of negative representations.
Summary of UK regulatory regime on ownership notifications Companies Act 1985 (as amended) Disclosure of information on controlling shareholder (30% or more) or who controls majority of Board. A statement explaining how the issuer is able to carry out business independently of the controlling shareholder and that any transactions with the controlling shareholder will be on an arm’s length basis. Listing requirements UK Listing Authority (Financial Services Authority) Shareholder disclosure of all interest above 3% (and subsequent increases of 1%); Company discloses all information received from major shareholders within 1 day of the receipt of such information. Continuing Obligations UK Listing Authority (Financial Services Authority) Takeover code & Substantial Acquisition Rules Panel on takeovers and mergers Shareholders acquiring more than 15% of a company’s capital are required to inform a regulatory information service.
Summary of penalties relating to failure to disclosure • In the event that a company requests a shareholder to disclose ownership (pursuant to 212) and that shareholder fails to do so and/or makes a materially misleading statement the person is “liable to imprisonment or a fine, or both”. Further a company can request a court to freeze the non-disclosing person’s shares. • Directors (without exception) are responsible for ensuring that all necessary information included in listing particulars. Directors of a company (individually and collectively) are responsible for a company’s compliance with listing rules.
Main enforcement issues • The OECD is right to focus on enforcement issues (Chapter 5 of the White Paper). We have distributed a separate paper which details key issues of policy enforcement – in summary these are; • Excessively literal interpretation of legislation which allows Russian courts to ignore and/or contradict the clear intention of legislation in order to achieve the “required” outcome; • A total lack of realistic penalties to deter corporate wrong doers. • A total lack of interest and activity on the part of the market regulator – the Federal Service for the Financial Markets. • These factors mean that even well intentioned legislation can be usurped and that confidence in the Russian legal system and securities market remains low.
Specific examples of poor enforcement • We have posted a number of lower court decisions on our website (described in our paper) which highlight the ways in which legislation is deliberately misinterpreted, here we summarise the following important decisions; • The Federal Service for the Financial Market letter from 17th July 2004; • The Tyumen court of cassation decision on the disclosure of information. • Court decisions on declaring related party transactions invalid.
The FSFM decision on related party transactions • In response to various complaints (most of which remain unanswered to this day), the FSFM sent us a letter (04-BC-04-1/2912). This particular complaint centred around the fact that numerous related party transactions had never been approved (or even voted upon in general meeting), the FSFR concluded; • “it can be confirmed that the transactions with them [the related parties] are executed in the ordinary course of business and in accordance with point 5 of article 83 of the Law [on joint stock companies] do not require approval prior to their execution, and information on such transactions does not require disclosure in accordance with the Decision on information disclosure..”. • This conclusions effectively even denies the existence of article 83 of corporate law, which clearly sets out that related party transactions should be approved.
Russian court decisions on disclosure of information concerning related party transactions • The lower court refused to force Megionneftegaz to disclosure information pursuant to the Federal Law on the Securities Market, Russian accounting legislation and Instructions of FSFM (No.32, superseded by 03-35/ps). The reasoning includes the following statement1: • Only a 25% shareholder can have access to accounting records; • The data being requested is confidential; • The court of appeal maintained this position, the court of cassation in Tyumen2 further added that; • The data subject to disclosure in accordance with the ongoing disclosure requirements (Article 30 of the Federal Law on the Securities Market) is not actually ongoing disclosure – but disclosure required at the time of listing. This decision seeks to deny the need for ongoing disclosure. 1 - A75-1738-Г/04 decision 26th May 2005. 2 – Tyumen Court of cassation, 12th October 2004.
Court decisions relating to declaring related party transactions invalid • In none of the cases we brought did the court ever declare a related party transaction to be void – even though the fact that the transaction took place was finally acknowledged, the fact that the parties were related was acknowledged and the fact that the shareholders never approved the transactions was also acknowledged. • The reasoning includes the following concepts; • In the absence of the actual related party contracts (which the courts refused to request and the defendants refused to provide) the claimant cannot particularise its case1; • Even if such documents were available a shareholders primary right is to have a representative on the Board of a company and that right is not affected by the conclusion of related party transactions2. 1 – case A75-1598-Г/04. 2– case A75-1936-Г/04 – Judge Oparina’s decision dated 2nd September 2004.
Court decisions relating to declaring related party transactions invalid • Even if the related party transactions reduced the company’s profit there is no direct link between profits and dividends and therefore no impact on a shareholders financial interests3. • This reasoning can only be described as bizarre, the net effect is to make it impossible to prevent below market related party transactions – thereby rendering section 83 of Corporate Law meaningless. 3 – case A75-1936-Г/04 – Judge Oparina’s decision dated 2nd September 2004.
A final word on enforcement • The OECD correctly identifies a lack of meaningful sanctions as further reason why corporate law is not adhered to. The table highlights the laughable nature of many Russian sanctions;
Further information Most of the court decisions referred to in this presentation have been posted on Vostok Nafta’s website (www.vostoknafta.com). Further questions on legal issues should be addressed to; Questions on Russian law should be addressed to: Mr. Yuri E Monastrsky Managing Partner Novinsky Boulevard, Moscow 121099, Russia Telephone: +7095 231 4222 Fax:+7095 231 4223 Tel: +7 095 231 4222 www.mzs.ru Questions on international law and applying Russian law in foreign courts should be addressed to: Mr. Richard Gwynne Partner Litigation Department Stephenson Harwood One, St.Paul’s Churchyard London EC4M 8SH Tel: +44 (0) 20 7329 4422 www.shlegal.com