Russia: Increasing the Risk of Investing in Russian Companies
27 October 2000
Summary
Russia’s Duma may pass legislation redefining the influence Western banks have over the market of Russian companies’ stock on the New York Stock Exchange. Western banks have nominal ownership over issued foreign stocks, allowing them to influence Russian business practices to a certain degree. The new legislation would curb that influence, which could present a risk to foreign shareholders.
Analysis
Russia’s Federal Commission for the Securities Markets is pressing the Duma to amend legislation that governs issues of American Depository Receipts (ADRs) to Western banks. These amendments would limit the power depository banks have over the ADR market, but could increase the risks for foreign shareholders trading Russian stocks.
Foreign companies cannot offer stock directly on the NYSE, so they place a portion of their shares into a Western bank’s holding. The Western bank, now the depository bank, holds these shares on behalf of each company and issues certificates, or receipts, on these shares as ADRs.
Under current Russian legislation, the depository bank is the nominal holder and owner of the originally issued block of shares. This nominal ownership clouds an otherwise transparent foreign market in which Russian companies could know who the actual registered shareholders of the reissued ADRs actually are.
The new legislation would annul the terms of nominal ownership, enabling Russian companies to account for their registered shareholders. This, however, would limit the power depository banks have over the market. With no controlling body to interfere in company actions, Russian businesses have the tendency to engage in corrupt practices. The new legislation, therefore, would increase the risk for American investors trading Russian ADRs.
The Bank of New York (BoNY) has threatened to abandon Russia’s market if the legislation passes, according to an Oct. 20 Banking and Stock Exchange report. As a depository bank, The Bank of New York has considerable power and influence over the ADR market. It controls over an estimated $1.5 billion in ADRs with a daily turnover of $20 million to $50 million, reported the Banking and Stock Exchange. BoNY also holds a monopoly over Russian ADRs, though the bank will not confirm this quantitatively. But, in these facts alone, it largely controls the reissue of ADRs to American shareholders, which gives the bank power to influence the daily turnover of Russian stock.
Apart from the power of reissue, depository banks control the market through nominal ownership of ADRs. These banks can discourage shareholders from trading ADRs, refuse to reissue the stock, or arrest trading of Russia’s ADRs altogether. Because Russian legislation does not provide for registered shareholder accountability, the Russian companies cannot appeal to shareholders to resume trading, but must appeal directly to depository banks. Therefore, the bank somewhat controls the market and influences the companies that originally issued the stock.
In addition, nominal ownership allows the banks to influence Russian companies internally. Under Russian law, foreign ADR holders do not hold any voting rights. Shareholders can circumvent this law by turning over their voting rights to companies’ boards of directors who then vote on behalf of shareholders. BoNY, as a nominal owner of blocks of issued stock, has the power to turn over the collective voting rights on behalf of the bank, though not necessarily on behalf of shareholders.
Given depository banks’ control, Russian companies have to be somewhat transparent if they expect active and fair trading of ADRs on the NYSE. If the bank determines a company is corrupt or shady, it can use the levers it has over the company to hinder ADR trade. Diminished ADR trade will limit the amount of foreign revenue a company earns through foreign stock exchange, which typically is more lucrative than domestic exchange.
If the depository banks lose nominal ownership of ADR issues, then they lose many of the levers they hold over the market and the Russian companies. The technical duties would remain the same; they would still act as depository banks and still reissue stock to shareholders. However, the Russian companies would know the details of their registered shareholders and would be accountable to them, not to the banks. The depository bank would lose the power to act as if it were a shareholder in control of trading a large block of Russian stock.
Market influence provided by depository banks provides Russian companies with an incentive to be somewhat honest. Russia’s oligarchs, known for corrupt business practices and money laundering, run many of the companies that issue ADRs. The Bank of New York, through its levers, has the power to intercept or prevent some of these shady practices, thus ensuring profits and protecting individual shareholders.
If the bank loses power as a nominal shareholder, the registered shareholders would have considerably less market and company control acting as individuals, rather than as a collective. Everyone would have to decide to suspend trading, and everyone would have to hand over their ADR rights in complete agreement for the shareholders to exert the same influence the bank, as an owner, could exert. Given this improbability, the oligarchs would lose the incentive to avoid shady business practices.
Russian companies have already begun to register new shareholders, but the banks market influence remains, somewhat protecting shareholders. If the banks’ role changes, then foreign investors would run an increased risk of investing in a Russian business – and the risk of corruption would likely increase.
