Over Prosperity’s twenty-year experience of investing into Russia, corporate governance has represented the principal risk. Although we are able to identify and reflect upon occasions where the Prosperity funds have made poor investments or where investment theses did not come to fruition, in general, corporate governance malfeasance has proved to be the most significant detractor from the total returns over time. It is worth noting that, in spite of this corporate governance risk, the the Prosperity funds have generated substantial returns for investors (Rusian Prosperity Fund: +1,687 percent and 16 percent CAGR since inception in 1996 through to the end of August 2016)
Following the global financial crisis of 2008, the Russian state and Russian entrepreneurs have very much ‘grabbed the bull by the horn’ and we have seen such a stark reform of the corporate governance frameworks, business environment and regulatory system that the Russia of 2016 can hardly be compared with her 2008 version. The period of 2015 and 2016 to date has continued to see such, mostly positive, developments and we review some of the more important ones here – many of which we are pleased to note that Prosperity had a role in bringing to fruition. Sadly, there is a fly in the ointment, but as has long been the case with Russia, the vector is very clear and one should seek to see the wood for the trees.
Electronic Corporate Actions Reform
Russia’s completed Electronic Corporate Actions Reform was enacted on 1 July 2016, as of which date, the main Russian corporate actions are compulsorily electronic and all others are now also available in electronic form.
Investors experienced some of the benefits of this reform from early 2015, when electronic voting (i.e. voting without paper ballots and PoAs) became available and with the implementation of mandatory electronic distribution of general shareholder meeting materials.
Electronic voting has made this vital shareholder process very swift and highly convenient. A simple electronic interaction between an investor and their custodian allows for shareholder votes to be delivered to a registrar almost immediately, which has also allowed for more comfortable voting time-frames.
The electronic distribution of shareholder meeting materials eliminated the need to contact an issuer with paper requests for general shareholder meeting materials. Investors now automatically receive these important documents for all meetings from their custodians in electronic form twenty-days prior to a meeting.
From 1 July 2016, all Russian corporate actions have electronic form. Investors now enjoy the same level of comfort as present in the voting process – no paper, no PoAs and all interactions through the investors’ custodians alongside immediate delivery to a registrar/issuer.
Russia recognizes foreign nominees and non-legal entity holders
Since 2015, Russian law and the securities accounting system has recognised ‘foreign nominees’ as opposed to Russia-registered custodians – as nominees and, as such, their clients are now able to directly realise their full shareholders rights. If an investor is a client of a foreign nominee, it is important that the foreign nominee and the client are disclosed as such, allowing the investor to have all corporate rights and the ability to realise them individually through that nominee.
In June 2016, Russia’s Central Bank passed a clarification that eases the requirements for securities’ holders and the individualising details required for disclosure. It is now explicitly confirmed that shares may be held by non-legal entity holders, such as state agencies. In addition, the requirements for individualising details were significantly softened and shareholders may now, in practice, disclose themselves with those details that they usually use in their local market.
Regulation of related-party transactions streamlined
The existing regulation of related-party transactions is, on one hand, quite excessive, requiring the approval of almost any related-party transaction by, at least, the Board of Directors’ decision. On the other hand, the definition of a related party is based on an outdated affiliation concept that includes a lot of non-material connections, but fails to cover all control-relationships. This creates a situation Where the Board of Directors are ‘snowed under’ by non-material transaction approvals and miss cases of real conflict of interest.
In June 2016, Russia approved the new regulation of related-party transactions which will come into force on 1 January 2017. The new regulation will move a number of non-material related-party transactions to management’s competence and supersede affiliation rules with a control-concept. Boards of Directors will now be focused on significant related party transactions with material conflict of interest.
The reform will also provide some other positive amendments, including shareholders’ rights to request justification of non-approved related-party transactions and to claim damages caused by unapproved related-party transactions from the respective related party/ parties. Russia’s Central Bank has also recently amended related-party transaction disclosure rules with a requirement to disclose the grounds on which a respective party is recognized as related to a transaction. As such, shareholders will have more transparency and defence mechanisms.
DVP mechanism for mandatory tender offers
One of the most prominent problems with mandatory tender offers in Russia was that, to accept a tender offer and request respective payment, a shareholder, as a first step, had to transfer its shares to the offeror and then wait for payment. In a case of non- payment, the shareholder that wanted to claim the respective money had to sue the offeror and could not reclaim its shares until the case had been resolved by the court. This process could take years and, during that time, the shareholder was unable realise any of its shareholder rights. In cases where the shareholder lost the court battle, it could end up Without money, without respective dividends and, in practice, without shares, as its stake could be easily diluted.
On 1 July 2016, the procedure was changed. Now, to accept a tender offer and request respective payment, a shareholder has to just block the respective shares on its own account and wait for payment. As such, a shareholder may claim the respective money and, at the same time, retain all shareholder rights. This change in securing accepting shareholders’ rights has made the mandatory tender offer proceedings far more shareholder-favourable.
New Corporate Governance Code implementation
The previous Russian Corporate Governance Code was approved in 2002. Although it was basic, that Code played a positive role in forming Russian corporate governance. The new, far more sophisticated, Corporate Governance Code was drafted to supersede the 2002 Code. The Government and Central Bank approved the Code in early 2014.
As soon as the Code was approved, Prime Minister Medvedev ordered it to be implemented at the thirteen largest state-controlled companies. The Governmental Expert Counsel established a working group to monitor that process, with the main focus being on the implementation of the recommendations related to the role and effectiveness of the Board of Directors, internal audit, internal control and risk-management functions. At the same time, the Moscow Exchange incorporated part of the Code’s rules into its listing requirements.
The state-controlled companies approved their own Implementation Road Maps for the Code’s recommendations took significant steps during 2015 and 2016 to date in its executing. Bashneft and
Rostelekom have led the way, with a substantial number of Code-related improvements.
The state-controlled companies approved their own Implementation Road Maps for the Code’s recommendations took significant steps during 2015 and 2016 to date in its executing. Bashneft and Rostelekom have led the way, with a substantial number of Code-related improvements.
During 2015 and 2016 to date, the Moscow Exchange has twice amended its listing rules to further gradually implement certain additional requirements of the Code, including Board of Directors’ members’ independence criteria.
The Government approved the Corporate Governance Road Map
The Agency for Strategic Initiatives is a non-for-profit organisation Whose Supervisory Board is chaired by President Putin. In spring 2016, the Agency drafted a Corporate Governance Road Map that was later approved by the Government. The Road Map intends to endorse a number of the long-awaited reforms needed to improve corporate governance in Russia. It includes, amongst other enhancements, a voting ban on quasi-treasure shares, Board of Directors’ members’ access to documents of controlled companies and the defence of shareholders’ rights during corporate restructurings. The Agency is famous for its ability to ensure strict compliance of relevant state authorities with the terms and content of its road maps.
The fly in the ointment
In accordance with the current Russian regulation, large-scale transactions are those that have a cost greater than twenty-five percent of a company’s assets and are outside of the ordinary business activity of the company. Such transactions have to be approved by the Board of Directors or, when the cost is more than fifty percent of the company’s assets, by a general shareholders meeting. In the latter case, shareholders have to be offered a buyback of their shares. Unapproved, large-scale transactions can be contested in court if it results in damages to the company, but in practice, only by the controlling shareholder.
Together with related-party transaction regulation, large-scale transaction rules will also be changed on 1 January 2017. Saving the same asset thresholds as at present, the approving bodies and buyback requirements and the scope of large-scale transactions will be limited only to those that lead, in effect, to corporate restructuring, liquidation of a company or a significant alteration of its business. Any shareholder with one percent of voting shares will be able to contest unapproved large-scale transactions in court There Will be no need to prove that it causes damages to the company.
On one hand, this is negative in that large-scale transactions will now, for the most part, be moved to management’s competence. This will lower the transparency and the liability levels. On the other hand, it is positive that shareholders with greater one percent of voting shares will have the right to contest the residual, most crucial, large-scale transactions, solely on the basis of their non-approval. This will increase shareholders’ ability to defend the key assets of a company. However, the latter types of large-scale transactions do not really occur in large public companies’ activities. As such, this part of the transactions’ regulation’s reform has a negative impact on shareholders’ rights.
The second negative legislative change that took place during 201 5 and 2016 to date relates to squeeze-out regulation. Previously, squeeze-outs were only possible in cases Where a party makes a tender offer, acquires a ten or greater percentage of voting shares and, at the same time, crosses the ownership threshold of ninety-five percent of voting shares. In such cases, the squeeze-out price should be no less than the tender offer’s price. Here, acceptance of the tender offer by holders of not less than ten percent of voting shares is a form of guarantee of a squeeze-out price’s fairness.
The changes that have taken place have added an additional squeeze-out procedure for companies that had a single shareholder prior to a merger and had less then five percent of minority shareholders following the merger. Minorities of such companies can be squeezed-out after a tender offer accepted by fifty percent of minorities.
As a positive intricacy, controlling shareholders of such companies can now carry out a squeeze-out in a transparent manner. Previously, they used to move ten percent of their own shares to some formally non-connected offshore and then buy them back through a tender offer at an artificial price before conducting the squeeze-out. The new regulation effectively provides them a stimulus to carry out a squeeze-out in accordance with the law, without controlled companies’ involvement.
However, as noted, the new procedure requires the acceptance of just fifty percent of minority shareholders. That is less than the holders of ten percent of voting shares and less than ninety percent of minorities recommended by the European Takeovers Directive. The new regulation provides fewer guarantees that a squeeze-out price will be fair to minority shareholders and, on the whole, looks like a negative change for them.
Denis Spirin — Director, Corporate Governance
Article by Prosperity Capital Management