ICGN article on Russia:
Demid Fedorov, Investor Protection Association of Russia
Oct 2012
Two Troublesome Delistings Expose Investor Vulnerability in Russia
Two recent events in the Russian business sphere have left international institutional investors with
heavy losses and the lingering question of “how is this possible?”
The events were the sudden delistings followed by the squeezing out of minority shareholders at two
solid second-tier Russian companies, Seventh Continent and Power Machines.
The two events have underscored a loophole in Russian law – one that exposes minority investors to a
constant risk of losing out on their investments.
Funds considering investing in Russian shares should be aware of these risks.
The Loophole
Under current Russian law, a public company whose controlling shareholder decides he no longer wants
his company to be public can delist the company and squeeze out minority investors at an enormous
discount (50-70 percent or more) to the market price.
This was exactly what is being done at two prominent second-tier Russian companies, upscale grocer
Seventh Continent and heavy industry manufacturer Power Machines.
It works as follows:
1. A controlling shareholder consolidates 75 percent or more of a company, typically through a
transaction with a large minority shareholder. Following this, within 35 days he must send a
mandatory offer to minority shareholders, offering them the option to sell their shares at a
specially determined price. If the company is publicly traded, this price must be not less than
the average weighted market price from the last six months of trading. If the company is
private, the price can be determined arbitrarily by an “independent assessor”. Typically, prior to
launching the delisting scheme outlined below, the controlling shareholder amasses not just the
75 percent required to launch a mandatory offer, but over 95 percent of shares, which is the
threshold necessary to forcibly squeeze out minorities.
2. The company delists. This has the immediate effect of dropping the share price, because while
shares are still traded even after delisting, the prices are at least 30 percent lower than on the
open market. Thus, delisting is in itself is a tool used to decrease the price of the shares, to
lower the cost of their subsequent acquisition. Further, the delisting creates the potential for
subsequent abuse, because now, since the company is private, he will no longer have to base
his buyout offer to minority shareholders on the market price of the shares, but will be able to
use an outside assessor. Further still, the outside assessor will be able to refer to the postdelisting share price as a basis for giving the company a low valuation. The procedure for
delisting is simple. It does not require the approval of shareholders, or even the board of
directors – a simple request from the CEO to the respective Russian exchange is enough, and
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the company’s shares stop trading the next day. The company is not even obligated to inform
shareholders of the delisting.
The controlling shareholder waits six months. Instead of sending the mandatory offer to
minority shareholders immediately after consolidating 75 percent of shares, as Russian law
dictates, the controlling shareholder typically waits six months, absorbing any associated
administrative fines. This is done so that when the controlling shareholder does eventually send
his mandatory offer to minority shareholders, he is not obligated to base the price of the offer
on the market price of the shares when they were traded, but can use his own assessors to
determine the price at will. This isn’t strictly necessary, since as soon as the company is private,
by law the controlling shareholder is not obligated to base his mandatory offer price on the last
six months of trading; however, in practice most companies do this so as not to raise red flags.
After six months passes, the controlling shareholder hires an “independent” assessor, who
typically values the company at a fraction of its market price when traded. Through backroom arrangements, the controlling shareholder convinces the assessor, which is often a tiny
company with no reputation to speak of, to come up with a low valuation for the company.
Right now, this is compounded by the fact that Russian company valuations are already low as a
result of the financial crisis – so the assessor’s valuation presents a discount to the already-low
market price.
The controlling shareholder launches a mandatory offer to minority shareholders using the
assessor’s valuation. At Power Machines, the valuation was 50 percent below the market price
prior to delisting. At Seventh Continent, it was similarly an estimated 50-60 percent discount to
the market price and analysts’ very minimum valuations. The controlling shareholder is fined for
launching the offer late (after over six months instead of the 35 days the law requires) by the
FSFR (Russia’s Federal Financial Markets Service), however the fines are so small that they are
nothing when measured against the millions of dollars saved by consolidating shares at half of
the market price.
The controlling shareholder launches a manipulation with offshores that results in the
mandatory offer becoming a mandatory buyout (“squeeze-out”), forcing minorities to sell
their shares at the offered price. In essence, the scheme is as follows: under Russian law, the
controlling shareholder gains the right to forcibly squeeze out minorities only if he acquired
over 95 percent of a company’s shares following a mandatory offer to all shareholders, not an
acquisition from a single shareholder. So, in order to gain the right to squeeze out minorities,
the controlling shareholder amasses 95 percent of shares, as mentioned in point 1., sells some
shares to another entity under his control, typically an offshore (or several of them), to get
below 95%. Because the concepts of beneficial ownership, affiliated persons, or a group of
persons acting in concert do not exist in Russian law, this legally counts as him genuinely his
stake in the company. The controlling shareholder then launches a mandatory offer to buy out
all other shareholder at a low price, has his offshores participate in the offer, thus selling the
shares back to himself and crossing the 95-percent threshold, which allows him to then launch a
squeeze-out of minorities at the same low price.
Finally, the controlling shareholder launches a squeeze-out of minorities, forcing them to sell
at a low price, completing the action. Minority shareholders are forced to sell their shares at
whatever price is offered, removing any hope they had of a getting a fair price for their shares.
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Recent Examples
As mentioned above, this scenario is currently unfolding at two prominent second-tier Russian
companies – Seventh Continent, a middle-to-high-end grocery store chain with stores all across
Moscow, and Power Machines, a large heavy machinery manufacturer for the energy sector, controlled
by oligarch Aleksey Mordashov, who also controls OAO Severstal, one of the largest steel companies in
Russia.
At Seventh Continent, the entire cycle has already taken place, with the situation only pending the
outcome of lawsuits launched by the Russian regulator FSFR and joined by the Investor Protection
Association. Minorities were squeezed out, suffering estimated discounts of 50-70 percent on the value
of their shares; their shares have been blocked, yet so far they have not received any money. In
conducting the squeeze-out, the controlling shareholder violated a direct order of the FSFR, for which he
was fined the largest amount levied upon a Russian company in 2012 by the FSFR; however, this was
reportedly only $250,000 – nothing compared to the benefits of the squeeze-out. The situation is
ongoing.
With Power Machines, the holding company of oligarch and Severstal owner Aleksey Mordashov
acquired a 25 percent-plus-one-share stake from Siemens, the German engineering conglomerate,
consolidating over 95 percent of shares as a result. At the time, Siemens sold its shares at 40 percent
below their market value, for undisclosed reasons, leading to considerable speculations. Since it is
difficult to understand why Siemens would conduct the deal on such unprofitable terms for itself, there
were speculations that Siemens may have arranged to compensate for this loss in the terms of a
simultaneous deal it carried out with Mordashov, that of the joint venture “Interturbo”, in which
Siemens holds 65 percent and Power Machines holders 35 percent. As it appears, this 40-percent
valuation was then used as an indirect basis for the price offered to minority investors as part of the
mandatory offer, because the price was the same as during the Siemens deal. The proceedings are
currently at the stage of the voluntary offer, with Mordashov having sold part of his stake to an
undisclosed party, thus decreasing his official holding to 85 percent. A squeeze-out is expected to be
launched shortly.
Earlier, a similar and highly publicized situation took place at Nutrinvestholding, a prominent dairy
products manufacturer that delisted its shares just 1.5 years following its IPO, causing minority investors
losses of over 95 percent on their shares.
Conclusion
In essence, the arrangement outlined above allows a controlling shareholder to squeeze out minorities
at a fraction of the market price of the shares. If consolidation of 100 percent of shares is the goal and
business reputation is not a consideration, this arrangement becomes the most logical step. Buying out
minorities at the market price is just less economical when compared to delisting, to quote the head of
Nutrinvestholding, Malofeev. This is especially tempting in down markets, when one can often buy out
minorities at below the IPO price, essentially resulting in “free money” for the controlling shareholder.
Ownership structure, court practice and reputation considerations and in Russia are all stacked in favor
of this mechanism:
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The risk is common to nearly all Russian companies because of the highly concentrated
ownership structure, which means that acquiring the large stakes necessary to launch the
procedures outlined above are always within reach.
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Courts usually take the side of the controlling shareholder. In court proceedings, minority
shareholders may not even be allowed to call into question the “independent” assessor’s
valuation of the company, because it is not made available to them, and thus none of its
assumptions can be questioned.
Nor is company reputation a stopping factor: as the cases of Power Machines, Seventh
Continent and Nutrinvestholding, show, solid second-tier companies are certainly not immune.
With Power Machines, the involvement of blue-chip Severstal owner Mordashov suggests that
even blue chips are potentially susceptible.
Reputation is effectively the only thing standing in the way of a controlling shareholder wishing to
consolidate 100 percent of his company in this way. However, as pointed out above, it is rarely
considered, and, in fact, is scarcely a concept that exists in Russia, as investors are often perceived to
have short memories. The hands-on involvement of Konstantin Malofeev in the demise and delisting of
Nutrinvestholding did not prevent him from gaining de-facto control and management rights at
Rostelecom, the state-owned telecom giant.
By abusing the loophole outlined here, controlling shareholders cast a negative light not only on
themselves, but on Russia as a destination for investment. The fact that such abuses are still possible
under Russian law is likely to scare off many funds looking to invest in BRIC economies. This is confirmed
by recent data from EPFR, which shows investors fleeing Russia and moving towards China and Brazil.
What’s Being Done
From a legal standpoint, there are many ways to eliminate this loophole, but so far the political will for it
has not been there. However, there are active efforts being undertaken, which investors hope will bear
fruit. The Moscow Financial Center government working group tasked with establishing an international
financial center in Moscow is developing proposals to the government to eliminate the loophole, with
the effort headed by Denis Spirin of activist fund Prosperity Capital Management and supported by
representatives of the Investor Protection Association. There are two primary initiatives worth noting in
this light: the establishment of the concept of beneficial ownership and affiliated parties in Russian law,
and the establishment of new delisting procedures that afford investors some basic protection.
Among other legal initiatives, the Highest Arbitrage Court of Russia is working on an official letter
regarding this situation, where they are expected to state their dissatisfaction with the status quo.
Further, the regulator FSFR is developing a draft law that, among other things, seeks to close this
loophole.
From a practical standpoint, the Investor Protection Association has developed a “Black List” of Russian
issuers, holding companies and persons involved in shareholder abuses in the past. The intent was to
provide a single-source database of such abuses, so that if, for instance, the same persons reach out to
the markets again in the future, investors have full knowledge of who they’re dealing with. For instance,
it may be beneficial for investors to know of Malofeev’s past with the Nutrinvestholding delisting as they
decide about investing in Rostelecom, or about Power Machines as they decide to invest in other
companies affiliated with Mordashov or Severstal.
Russia remains an attractive destination for investment, with valuations low even compared to its BRIC
peers. Investors can find great returns here, as many funds’ track records show, however, navigating in
this market requires care and knowledge.
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