OECD PRINCIPLES OF CORPORATE GOVERNANCE ON SHAREHOLDER RIGHTS
AND EQUITABLE TREATMENT:
THEIR RELEVANCE TO THE RUSSIAN FEDERATION
Paper by
Mr. Stilpon Nestor
Head of Corporate Affairs Division, OECD
and
Ms. Fianna Jesover
Project Manager, Corporate Affairs Division, OECD
_______________________1 The opinions expressed in this paper are the authors’ own and do not necessarily reflect those of the OECD.
1. The context 1
The 1998 financial crisis in Russia has been a catalyst in bringing corporate governance issues to the forefront of the economic policy debate in the country.  As liquidity started to dry out, enterprises became confronted with the realities of market forces and the importance of building a strong corporate governance framework.  Well-publicised corporate governance abuses, which did not seem to matter in the buoyant equity boom of 1997, were perceived as a major impediment to investment. Insiders stripped enterprises of their assets by various means. Investors have often seen their shares diluted by controlling shareholders.De-capitalising companies have trampled upon the interests of creditors, using insolvency proceedings as a strategic tool to avoid payment discipline. These weaknesses have been compounded by serious deficiencies in the tax and accounting systems as well as institutional structures.
As the result of the first meeting of the OECD/World Bank Corporate Governance Roundtable in June 1999, it was agreed that the protection of shareholders is a key and urgent issue to be dealt with by Russian policy makers. But why is the protection of shareholders a fundamental aspect of corporate governance in Russia today? That is because attracting external equity finance is crucial. In other transition and emerging economies, external equity finance is just another option among many for corporate financing. But Russia does not have the luxury of these options. The option to us
e the banking system as the corporate governance and finance locomotive was retained in 1994 and it proved to be detrimental. Contrary to what the designers of the loans-for-shares scheme and its successors professed, banks did not lead an investment boom in Russian enterprises. Rather they appear to have used enterprise assets to leverage and enrich themselves and their owners, giving new meaning to the word “conflict of interest” in the process.Following the 1998 collapse of the financial sector, most of the Russian banking sector is in terrible shape-- and the Russian enterprises are left to their own devices.
Some transition economies have capitalised on foreign direct investment (FDI) as a driver of corporate investment and restructuring. At the same time, a corporate governance model based on the widespread presence of foreign strategic investors in key sectors of the economy needs a strong and carefully cultivated political climate. In the case of Russia, this does not seem to be politically feasible. Hence, FDI in Russia in 1998 was a meagre USD 1.5 billion, less than FDI in Hungary, and a tiny fraction (i.e. a little more than 2%) of the inflows that occur yearly in China. While promoting FDI should be on the top of the agenda in some areas (indeed, the banking sector) it is unlikely that a huge FDI inflow will occur in the medium- term. This leaves external equity financing as the only credible solution for the investment-starved large Russian enterprises.
Equity based finance also corresponds to other key characteristics of the Russian corporate landscape. To begin with, for better or for worse, the Russian corporate sector is dominated by large enterprises, more than any other transition economy.  As a result of mass privatisation most large enterprises have quite dispersed, public ownership, even though they are not “listed” in the strict sense of this word. That is why
the Federal Commission on Securities Markets (FCSM) has been responsible for any issue of securities by these companies; there were approximately 25.000 share issues last year alone. While controlling shareholders have emerged in most of these, a large number of these shares are still held by workers, small domestic investors and foreign investors. The predominance of this enterprise profile suggests both that protection of outside investors is important and that, if such protection is ensured, the market could become more liquid with less of an effort as in, say, developing or emerging markets with entrenched family ownership.
While transparency, disclosure and strong independent boards are also crucial for corporate governance, their function is broader. They are of relevance in the effort to improve all types of governance, whether state, bank or strategic partner- driven.  The development of disclosure rules and board practices is, in most countries strongly linked to the actual development of the market.  On
the other hand, the protection of minority shareholders is much more a rule- based fundamental, the ground upon which the other prerequisites for external finance will grow. At this stage, low liquidity, shallow markets and the limited possibility of exit is another reason for focusing on shareholder rights improvement; shareholders cannot really sell so they need to exercise voice. Finally, improving shareholder protection also has a powerful signalling role to play; as most of the Russian market’s poor reputation stems from shareholder abuses, it is progress in this area that will be most effective in “turning the tide”.
There are two important aspects to the corporate governance debate. One concerns the legal framework and its implementation and the other the business environment, corporate and investor attitudes, in short the behaviour of private sector institutions.
In principle, shareholder rights and equitable treatment are primarily (but not by any means exclusively) a prescriptive, framework issue. But, there is a further distinction to be made between issues related to the adequacy of the legal framework and issues related to its implementation. In Russia, there has been quite a lot of progress in the legal framework of shareholder protection. In 1996, Russia adopted a “Joint Stock Company” law (the Company Law) that set out the basic principles of shareholders’ rights and corporate governance.  This law, albeit far from perfect, is a sig
nificant improvement from the confusing legal framework that existed at the time of mass privatisation in 1992. In 1999, the Law on the Protection of Investor Rights (the Investor Protection Law) increased the powers of the FCSM and improved the previously weak framework set by the Federal Securities Law of 1996 (the Securities Law).
governanceIn contrast, enforcement is weak.  The source of this weakness can be found in the fundamental public governance problems that have been plaguing Russia for the last 10 years.  The judiciary, at least at its lower levels, is under-paid, over-worked and often corrupt. Local authorities often have an overbearing influence on judges, but also on company management; while they might have some legitimate stakeholder concerns in a one company-town environment, a lot of their interventions are motivated by their commercial interests, of the crony capitalism variant. But even when fairness prevails, enforcing a judicial decision might be a difficult and long process with uncertain outcomes due to the weak enforcement infrastructure.
At the same time, the behaviour of the private sector towards shareholder rights is also very important. It can be argued that it might even be more important in the short term in the Russian environment, as the basic confidence on the operation of the rules has not been established. On the corporate side, Russian companies are starting to show signs of wanting to turn the page on their sin
ful past. Realising that outside finance will not materialise unless some evidence of good behaviour emerges; managers are starting to sound increasingly open to investor concerns. Assuming this trend is confirmed it might be viewed partly as a result of recent ownership changes and the demise of the banks as key corporate governance principles.
But there is along way to go. On one hand, Russian enterprises have likely developed the worst reputation in the world for abusing shareholder rights. On the other hand, investors and the financial market intermediaries that serve them are becoming more vocal and organised, not least because of new powers to drive investor protection, conferred to them by the 1999 Investor Protection law. But here there is also work to be done both from a normative and a market development perspective. Market participants need to be perceived as playing by the rules that integrity can be built into the market. Most importantly, Russia lacks domestic institutional investment of a size that corresponds to its corporate sector. The earlier experiment of trying to use mass privatisation funds to create such institutions was a failure but the state might need to support their emergence. It is through these institutions that savings will be mobilised and thus boost both domestic investment and corporate governance progress.
In the following pages we will go through the first two chapters of the OECD Principles of Corporate
Governance on shareholder rights and their equitable treatment and look through their prism at the Russian corporate governance condition. The Principles were drafted with listed companies in mind, i.e. companies that have outside small shareholders and institutional shareholders as well as insiders (such as families or other block holders). This means that they are well adapted to serve as a tool in assessing the Russian corporate governance environment for large companies.
The Principles are general in nature and global in view; many of the problems that Russia faces will be only loosely connected to their language. Some of them will be of great relevance to Russia of today while others will be of less. In other words, the Principles are a first global language on corporate governance not a set of one-size fits all prescriptions. As such they are helpful in focusing the debate.  Correspondingly, the purpose of the paper is not to offer solutions but to draw a picture of the main issues using the Principles language. In turn, it is hoped that Russian policy makers will consider solutions that will deal with the problems of corporate governance in a comprehensive and coherent way.
I. The Rights of Shareholders
The first chapter of the OECD Principles concerns the protection of shareholders’ rights and the abilit
y of shareholders to influence the behaviour of corporations.  The Principles list some basic rights including those to: obtain relevant information, share in residual profits, participate in basic decisions, fair and transparent treatment during changes of control, and fair use of voting rights.  Shareholders as the legal owners of corporations should expect to be able to enjoy these rights in all jurisdictions.
A.  Basic shareholder rights
The Principles explicitly state the most basic rights of shareholders.  This includes: ensuring adequate methods of ownership registration, conveying or transferring shares, participating in the company’s profits, obtaining information on a timely basis, participating and voting in general shareholder meetings.  The Company Law provides the explicit foundation for most of these rights; the duty to provide information to the shareholders was considerably expanded through the Securities Law. But there are still remaining issues in the way these rights are defined, enforced, and implemented.
Russian Company law provides for only registered shares in joint stock companies. In this, it is quite advanced even compared to a number of OECD countries. This implies that property rights protection begins with ensuring investors that their share ownership is registered in the company’s b
ooks. The Securities Law spells out the rules for registrar’s operation and shareholder’s rights to obtain proof of ownership from the registrar, while the Company Law requires all joint stock companies to maintain a register of its shareholders.  Companies with more than 500 shareholders must appoint an independent company licensed by the FCSM as a registrar.  Securities’ trading in Russia requires that any transfer of securities be recorded in the issuing company’s share register and/or depository.
Companies and their managers have directly or indirectly controlled many registrars; this was a source of abuse early on.  There have been several cases of refusal to re-register share transactions or of illegally changing share registration from common to preferred, in order to prevent shareholders from exercising their voting rights. Recent efforts have been aimed at increasingly replacing company- controlled registration with independent professional registrars.  An indication of progress is that the number of registrars has fallen significantly from 500 in 1996 to 125 in early 1999.
B.  The right to participate in and be sufficiently informed on decisions concerning fundamental corporate changes.
Key shareholder rights are the participation in any decision concerning fundamental corporate chang
es and the right to be informed of options to address these changes. These fundamental changes can be amendments in the corporate chapter; authorisation of additional shares; and extraordinary transactions that result in a fundamental change of the asset structure.
In Russia, these rights are quite ill defined and smaller investors are often prone to abuse by managers or controlling shareholders. The company law’s provisions on share issuance are sufficiently broad to allow a systematic share dilution and the disregard of pre-emption rights by existing shareholders. The YUKOS case pretty telling in this respect; a substantial minority shareholder was excluded from the Annual General Meeting (AGM) and subsequently not allowed to participate in the increase of capital that the AGM decided. In addition, many companies have disregarded the law by issuing shares without AGM authorisation. Another typical example is the failure to notify shareholders allowing them to exercise their pre-emptive rights; and the fact that there is practically no sanction in the law for failing to notify. Finally, some companies (e.g. Sidanko) have tried to use the issuance of convertible bonds as a means of share dilution, as there is a regulatory loophole on filing requirements (and subsequent control) of these issues. The FCSM responded successfully to this regulatory challenge. It has not been as successful in the YUKOS case.
The Company law provides for shareholder approval of major transactions (or unanimous BoD approval when the value is less than 50% of the book value). But the provisions are vague and do not provide for any sanction related to the breach of the approval procedure. The Company law does provide for the possibility of an appraisal and buy- back of existing shareholders, when some fundamental changes (mainly control-related and exhaustively enumerated in the law) occur without their consent. However in practice this right is hard to enforce without an independent appraisal mechanism. Appraisals up to now have been below investor expectations--the case of RAO United Energy Systems buying back foreign investor shares due to a breach of foreign ownership limits might be a case in point.
A number of the early disputes on issues related to major transactions originated in the pre-company law era, in which many companies chose their own privatisation charter which still remained in force irrespective of it being contrary to the Company law. In order to ensure compliance with the joint stock company law, the FCSM required all Russian companies to amend their corporate charters in July 1996. Charters not properly amended were to be deemed invalid.  However, to date only a few charters have been corrected, thereby undermining the effectiveness of the law.  The FCSM does not have an instrument to penalise companies who continue to violate this law.
C.  The right to participate effectively and vote in general shareholder meetings and to be informed of the rules; including voting procedures, that govern these meetings
One way for shareholders to influence the company is through the exercise of their voting rights at the AGM.  This presupposes a system, which allows the effective participation of shareholders and the accurate representation of their views through the proxy mechanism.  The Principles stress the importance of supplying shareholders with sufficient and timely information concerning the date, location and agenda of general meetings.  In order to enable more full participation in meetings by investors, some OECD countries have increased the ability of shareholders to submit items on the agenda by simplifying the process of filing amendments and resolutions.
The Principles encourage efforts by companies to remove artificial barriers to participation in AGMs.  In some OECD countries, management and controlling shareholders have sometimes sought to discourage other shareholders from trying to influence the direction of the company by charging voting fees, prohibiting proxy voting and requiring personal attendance at meetings to vote. Many companies in OECD countries are seeking to develop better channels of communication and decision-making with shareholders. The Russian Company Law provides detailed rules on the procedures for calling and conducting an AGM, which seem to meet the norms corresponding to the
OECD Principles.  However, in practice, a number of systematic violations have been reported.  The most prevalent has been the failure to give a shareholder adequate notice (if at all) of the time and location of the AGM and notification of the agenda. It is hoped that recent case law by the courts, declaring AGMs null and void for this type of violation, will discourage abuse.
A key factor in the accountability of companies to owners is the process by which shareholders vote. There have been numerous cases in Russia where procedural requirements for voting during the general meetings are not observed and shareholders are prevented from voting on various grounds. The Principles recommend that voting by proxy be generally accepted.  Companies increasingly favour the use of technology in voting, including telephone and electronic voting, in order to broaden shareholder participation. In Russia proxy voting is still quite rudimentary and casting votes in absentia is in practice impossible.
D.  Capital structures and arrangements that enable certain shareholders to obtain a degree of control disproportionate to their equity ownership should be disclosed.
In some OECD countries, management and controlling shareholders use corporate structures, such as groups of companies, pyramids and shareholder agreements to redistribute control over the comp
any in ways that deviate from proportionality. As a result, some shareholders bear more risk than others do, even though they are holding identical instruments. Effective control and strategic direction of an enterprise by a major shareholder is not in itself undesirable and the Principles show no preference regarding what ownership structures might best achieve this goal.  Ownership and control structures should, however, under all circumstances be transparent. That is because outside shareholders need to properly assess how control is exercised to evaluate their own position and interesting in providing equity finance. It should also be noted that in situations where the market is narrow and the block-holders are a prevalent form of control, it might be wise to introduce tighter regimes that, in addition to disclosure, mandate for the active protection of minority shareholders and an increased responsibility of controlling entities.
A frequent complaint about the Russian market has been the lack of transparency in corporate capital arrangements. Corporations have often adopted intricate patterns of cross-ownership with financial institutions, in the form of financial-industrial groups (FIGS).  Many of these groups are now disintegrating as a result of the banking crisis and, in the process, major shareholders are trying to expropriate minority

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