1
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.
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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.

3
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.

4
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.

5
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 companys 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.

6
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.

7
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.

8
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

Majority shareholders masquerade as minorities In the case of Megionneftegaz three Cypriot companies (Edie, Select and Hassla) voted for all related party transactions our investigation showed that these entities were ultimately owned and controlled by majority shareholders. By participating in voting they rendered article 83 of Corporate Law nugatory.
Majority shareholders influence professional advisors/market participants Any securities market requires strong and independent professional participants notably auditors, valuers and registrars. In the case of Megion, we believe that the registrar (OAO Registrar R.O.S.T.) was not independent and that it failed to execute its responsibilities with adequate care.
9
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 TNKs 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).

10
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.

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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.
12
Related parties what is not disclosed is often
the most relevant
13
The independent shareholder registrar ROST
Source Website ROST (www.rrost.ru), Federal
Securities Market filings NGK Slavneft and
Megionneftegaz.
14
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
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ROSTs role as Megionneftegazs registrar

• The following events took place whilst ROST acted
  as registrar for Megionneftegaz
• Austro (Cyprus) Limiteds voting papers for
  Megionneftegazs 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
  entitys 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.

16
ROSTs role as Megionneftegazs registrar

• Vostok Nafta identified and received confirmation
  that some 40 individuals received voting papers
  for Megionneftegazs 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.

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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.

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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.

19
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.

20
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.

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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 arms 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
companys capital are required to inform a
regulatory information service.
22
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 persons 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 companys compliance with listing rules.

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Closing words on enforcement
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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.

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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.

26
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.

27
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-?/04 decision 26th May 2005. 2
Tyumen Court of cassation, 12th October 2004.
28
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-?/04. 2 case A75-1936-?/04
Judge Oparinas decision dated 2nd September 2004.
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Court decisions relating to declaring related
party transactions invalid

• Even if the related party transactions reduced
  the companys 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-?/04 Judge Oparinas decision
dated 2nd September 2004.
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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

Nature of violation Liability under Russian law Closest equivalent liability under English law
Serious breaches of accounting legislation in preparation and presentation of accounts. From USD 69 up to USD 104 (20 to 30 Minimum Wages) payable by the responsible corporate officers (Article 15.11 of the Administrative Code) Unlimited fine on directors.
Issuers failure to disclose information or disclosure of misleading information in response to a shareholders query From USD 690 to USD 1,035 (200 to 300 Minimum Wages) payable by the company (Article 15.19(1) of the Administrative Code) Unlimited fine on directors.
Failure to present evidence upon a court order Up to USD 175 (up to 50 Minimum Wages) payable by the responsible corporate officers and up to USD 3,500 (up to 1,000 Minimum Wages) payable by the company (Articles 66, 119 of the Arbitration Procedure Code) Contempt of court leading to sanctions ranging from sequestration of assets to imprisonment.
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Further information

• Most of the court decisions referred to in this
  presentation have been posted on Vostok Naftas
  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 [phone]  Fax [phone]
4223 Tel [phone] 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.Pauls
Churchyard London EC4M 8SH Tel [phone]
4422 www.shlegal.com