MOSCOW BLOG: Time for Kremlin to up ante in fight to protect investors

By bne IntelliNews September 24, 2010

bne -

It's time for the Kremlin to ante up with action if it wants to stay in the high stakes poker game of trying to win foreign investment. So far, all it has put on the table is a promise to make things better.

There has been an enormous amount of talk about the need to modernise Russia by bringing in foreign capital and skills. But despite a few big deals designed primarily to improve corporate-government relations, foreign direct investment is still falling. And investors may abandon Russia completely if the Kremlin doesn't ensure the right thing happens in a high-profile corporate governance case that has been running since the summer of 2008, which is about to come to head.

The Supreme Commercial Court of Russia is due to rule in the next few weeks on a shareholder dispute, which, if it goes against the plaintiffs, will make a mockery of all the Kremlin's promises of change and openness, and calls into question its ability to transform the system it claims to control.

On the face of it, the dispute between Russia's largest foreign portfolio investor, Prosperity Capital Management (PCM), and Russian businessman Leonid Lebedev, the owner of a majority stake in the thermal power plant TGK-2, looks like a technical issue.

The story started just before the global economic crisis struck in 2008. A company called Kores, owned by Lebedev, had bought a majority stake in the TGK-2 power station, triggering a mandatory buyout of the minority shareholders at a price where the stock was trading at the time. Moreover, the buyout is backed by a bank guarantee - in this case from Sberbank - so that the minority shareholders are sure to get their money even if the owners of the controlling stake renege on their obligations.

The point of this set-up was to encourage foreign (and domestic) investors to fork out the billions of dollars that were needed to transform Russia's power sector and unbundle the assets held by the state-owned monopoly United Energy Systems.

And this was not just any privatisation. This was Russia's flagship reform and a huge success. After a decade of GDP growth averaging 6.8% a year, power demand had risen to almost match demand and unless Russia starts to build new power stations soon, any further growth will be stymied by blackouts. Indeed, the whole issue was highlighted when Moscow was plunged into darkness at the start of 2008 after a substation caught on fire, briefly interrupting power supplies. The crisis has reduced demand, but the need for new power capacity will return soon now the economy is growing again.

Ordinarily, the deal would have sailed through, but after the collapse of Lehman Brothers in September 2008, stock prices took a bath and Lebedev started back-peddling fast to avoid paying out the $300m he owed minorities - his shares in TKG-2 were worth a fraction of their pre-crisis value.

Farce piled on farce

This story is not just about one foreign investor, as several Russians have also been caught up in the fight and include, amongst others, the Deposit Insurance Agency, which holds the bank bailout fund that guarantees deposits in banks.

Denis Spirin, corporate governance director at PCM, describes Lebedev's rationale for reneging on the mandatory buyout as "farce piled on farce."

First, Lebedev brought a case vs. Kores as the matter of fact suing himself to obtain an injunction prohibiting minorities to accept the buyout offer, next Kores got an injunction preventing Sberbank from paying out on its guarantee. Then Kores brought a case against the minorities, claiming that it was a foreign company and so subject to newly minted "strategic investment law" limiting foreign investment into strategic sectors and won. (TGK-2 has a license on treatment of radioactive material and uses it for technical purposes.) As Kores hadn't applied to the Federal Anti-monopoly Service (FAS) for permission to buy TGK-2, it shouldn't have been allowed to - ergo, it didn't have to pay off the minorities.

This is simply silly. At the time of the power privatisations - arguably the largest privatisation of a state's assets ever - the power companies were explicitly excluded, as the whole point of the privatisation was to attract foreign investment. "So the mandatory buyout under Russian law turns out not to be mandatory, but subject to the valuation of the shares in the market. And the bank guarantee is not a guarantee, but only valid if the seller is not going to lose money," says Spirin.

PCM and the other minorities appealed against all of Kores' victories in court to the Supreme Commercial Court, which were rejected in July. Furthermore, the court refused to send the case to the Presidium, the highest authority in the country.

However, the case was reactivated when two more domestic minority shareholders in TGK-2 brought more-or-less the same case as PCM to the Supreme Commercial Court. But this time, before the appeals were filed, FAS released a judgment that Syntez and Kores were Russian companies after all and so not subject to the strategic investment law.

The FAS ruling is good news for foreign investors for several reasons. First, this ruling was rushed out in the middle of the summer break when few Russian bureaucrats are at their desk. Second, the judgment is from the very body that is in charge of deciding who is subject to the strategic investment law and deals with the applications from foreign investors who want to invest into these sectors. Finally, FAS is an executive body which reports to special governmental commission on strategic investments headed by Prime Minister Vladimir Putin and, according to PCM, its case was brought up at the last Commission's supervisory meeting and discussed by the Kremlin's bigwigs.

Now everyone is waiting for the second ruling by the Supreme Commercial Court on the new case brought by the Russian minorities against the Kores victories that is due in the next few weeks.

If it again throws the appeal out, then the following things become enshrined in law by precedent: companies like Gazprom and Lukoil are actually "foreign companies" and cannot invest in Russia because they also have foreign subsidiaries; bank guarantees are worthless pieces of paper; and the power sector has become one of Russia's "strategic sectors" and every one of the privatisations must be reviewed and possibly cancelled.

In short, foreign investors cannot invest in Russia, as any privatisation is open to the risk of being deemed "strategic" and cancelled at the whim of the courts. Not only will Russia's attractiveness as an investment destination be completely undermined, but Medvedev's promises to change things to make them more attractive for foreigners will be proved hollow.

Of course, what lies beneath this legal jockeying over domicile definitions and the court "rulings" are the simple problems that Russia has always faced. It is obvious that Syntez should be classed as a Russian company, as it is owned by a Russian, all its assets are in Russia and its business is in Russia. However, courts often rule for reasons other than logic or the law.

The fact the FAS rushed out its ruling (indeed, that it spoke out at all) suggests there is a fight going on in the corridors of power: the liberals (and, hopefully, the Kremlin) want the rules to work, but this fight shows the legal system has a life of its own. The bottom line is that if a fund like PCM, which has been in Russia from the beginning of its transition, is well connected and is a major player in the power and energy reforms, can't protect its interests, what hope does anyone else have?

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