Residual Divestiture Following Mass Privatization: The Case Of Russia

1. Introduction. Some results of the Russia's  mass privatization program

The directly opposite evaluations notwithstanding the year 1992 is going to go down in Russia's history as the year when the wide-scale reform of ownership relations based on the detailed privatization legislation (more than one hundred of the basic documents only) took off. The program of the mass (voucher) privatization in Russia in 1992-1994 actually pursued a single objective: to temporarily distribute the private ownership rights on mass scale with the minimum of social conflicts but bearing in mind future re-distribution in favour of the "effective and responsible owners". During 1992-1994  the quantitative transformations were accumulating thus creating a "critical mass" (Table 1) [1].

Out of the total number of enterprises existing at the beginning of the privatization program (240 000), as of July 30, 1994 (the date of the finish of the mass program) about 41% altogether were privatized. Within the framework of the "small-scale privatization" more than 50% of all small enterprises were privatized in Russia. In the course of the "large-scale privatization" more than 20.000 of joint stock companies (JSC) were established on the basis of medium and large state enterprises; the shares of 16.500 of them were offered during the voucher auctions. By the end of 1994 in Russia there were about 40 million of shareholders of the newly established JSC or the voucher investment funds.

From the qualitative standpoint the single most positive result of this stage was the birth of the new economic mechanisms and formation of institutional and legal environment for the post-privatization functioning of the Russian businesses: corporate sector appeared, stock exchange and over-the-counter securities market and transitional system of the investment institutions were created.

At the same time the tasks which have not been accomplished within the framework of the 1992-1994 model-primarily restructuring of enterprises and attraction of investment - required such a privatization model which would at least partially compensate the enterprises for the virtually non-economic methods of sales during the first stage.

2. Specific features of the "cash" (post-voucher)  privatization

A. Major problems and decisive factors

In general the situation with privatization during the second half of 1994 - beginning of 1996, with its characteristic slowness and uncertainty, astonishingly resembled the year 1991 when the framework legislation already existed but the privatization actually did not proceed, when the political factor became especially important (political will under the conditions of political uncertainty), when the lobbying activity and spontaneous processes sharply intensified and when the endless official declarations did not have any basis in real life. However, there are some distinctly new features which in our view became crucial for the understanding of the nature of the present-day privatization process.

(1) "Investment or budget" dilemma. The fact that in 1992-1994 the investment as the goal of  sales was ignored in the course of privatization was easily justified because the voucher model pursued different objectives. Nevertheless when the "cash" stage began the "investment or budget" dilemma was quite apparently solved in favour of the latter both in 1995 and 1996, notwithstanding all the statements of the leaders of RF State Committee for the Management of State Property (GKI) concerning the beginning of the "investment era" in the Russian privatization after June of 1994. To a considerable extent this was the result of the political considerations behind a short-term tactical objective. Hence it becomes clear why the key criterion for the choice of the main type of sales (irrespective of the branch and the region) was to maximize the revenues of the federal budget.

(2) Problem of the object's selection. As it can be seen fr om Table 1 the "voluntary (initiated by the enterprise itself)" privatization (or at least submission of applications) was going on intensively in 1993 while in 1994-1995 the number of new objects to be privatized was steadily and imminently declining. At the same time, as a result of the mass privatization in 1992-1994 the state retained an unprecedented number of shareholdings in enterprises and the problem of their sale became the key issue as fr om the standpoint of the 1995-1996 privatization policy as such and for the purpose of intensive lobbying in this field (Table 2).

The liberal wing of the government regarded the commonly recognized fact that the state proved to be incapable of managing the federal shareholdings in such volumes and under such economic conditions which existed in Russia as the additional incentive for selling off these shareholdings. At the same time the task of organizing efficient sales of this equity became patently impossible because of the following reasons:

• the budget needs "larger, more expensive and quicker" sales;
• the temptation to have a lump sale of almost everything bumps into the harsh reality in the form of the lack of an adequate solvent demand and direct threat of the stock market collapse;
• sales of equity of the most attractive enterprises at the moment are extremely ineffective economically because of the obvious undervaluation of their assets and at the same time they are difficult due to the multilateral lobbying and changing of control in some industries which occurred under the guise of the institutional and legal reorganization;
• the worst loss-makers among the unsold enterprises (shareholdings) should be sold off in order to alleviate the burden of budget expenditure, however, it's unlikely that the buyers could be found;
• and, finally, the impact of purely political factors connected with the elections and the reluctance to give to the opposition arguments for criticism.

(3) Lawmaking activity. By the autumn of 1995 the State Duma drafted a number of documents directly related to privatization: amendments to the Law on privatization of 1991, draft law "On the alienation of shareholdings" which envisages that the parliament should annually approve the list of federal shareholdings to be sold and no less than four drafts of the framework law "On nationalization" including those which envisage the possibility of the nationalization to be initiated by the employees (labor collective) and about 50 bills suggesting the nationalization of particular largest enterprises. The communist majority of the State Duma which appeared as the result of the December 1995, elections has been creating favorable conditions for the adoption of these documents. However, any practical steps are  doubtful in the context of the results of  the presidential elections in Russia in June, 1996.

It's a well-known fact that even the mention of a possibility of enactment of some legislative act has a direct impact on the expectations of the economic agents (investors). Moreover, even the drafts of the most significant acts begin to live a life of their own affecting both the by-laws linked to them and the legislative structure as a whole. Fr om the investor's standpoint there are no more strongly destabilizing factors than economically unbalanced articles of the politicized bills.

(4) New stage of the nomenclature's struggle to retain control in a number of industries which sharply intensified when the government started the discussion of different options for the sale of federal shareholdings. In fact there was a new (perhaps the next after the August of 1993) major collision between the "functional" and "branch" departments the conflicting interests of which are obvious: the budget considerations (to sell off the shareholdings) versus the need to retain the appearance of one's usefulness if not to the enterprises than, at least, to the government (to keep shareholdings). According to some experts in this situation the political factor also works in the interests of the "branch" people, primarily, because certain influential political groups put forward the slogan of "the efficient management of the federal property".

There was an obvious example of the "branch" people victory when on September 22, 1995, a giant holding company - "Russian Metallurgy" - was set up. There are similar projects in the machine building complex and petrochemical industry. Generally we may speak now about  the new attempts by the nomenclature to re-divide the property both in the regions and in the branches of economy. We can also presume that in 1996 when the law "On financial-industrial groups” comes into force (and in Russia these groups are rather amorphous conglomerates) it's going to assist not so much to the industrial growth but, primarily, to the consolidation of power of the particular financial and industrial alliances giving them more clout to lobby with the authorities.

B. Institutional and legal basis

The "Basic guidelines of the state program of privatization of the state and municipal enterprises in the Russian Federation after July 1, 1994" approved by Presidential Decree No1535 of July 22, 1994, serve even today (with a number of exceptions) as the basic document for the cash stage of privatization [3].

(1) The following key objectives were defined for the new stage: enhancing the efficiency of the economy as a whole and of individual enterprises as well; formation of a wide stratum of private owners and assistance to the establishment of strategic owners; mobilization of investments into production; contribution to the social protection of population and to the protection of the shareholders' rights.

(2) There were the following limitations during the privatization: (a) limitations in particular industries (list 2.1 - privatization prohibited, list 2.2. - according to the decision of the RF Government, list 2.3 - according to the decision of the GKI; list 2.4 - decision of the RF subjects or the local authorities, largest enterprises - decision of the RF President) and (b) those connected with the formalizing of the federal ownership of the ordinary shareholdings (51% and 25.5%) or the "golden share". The retained shareholdings should be transferred to the authorized institutions or persons [4] who would manage them.

(3) The major objects of privatization at the new stage can be classified into three types: state shareholdings in the privatized enterprises, sites of the privatized enterprises and real estate (see annex 2-A-(2)).

(4) During the sale of shares the following sequence of the privatization methods was envisaged: free transfer and/or sale of shares to the employees through a closed subscription; sale of equity (not less than 15-25% of the charter capital) through the investment tenders, commercial tenders and/or at an auction; sale of the remaining shares at the specialized auctions including the interregional and the nation-wide auctions [5].

(5) Classification of enterprises according to the type of sale. With some exceptions (treasury enterprises, those privatization of which was prohibited, enterprises with foreign interest and those for sale to the partnerships with the special preferences) all the enterprises with the balance sheet value of fixed assets over 20 million roubles as of January 1, 1994, are to be transformed into the open JSC. Their shares may be sold by any of the methods mentioned. All other enterprises with the balance sheet value of their assets less than 20 mln roubles are considered to be small and are to be privatized through auctions, commercial or investment tenders.

(6) As regards the valuation of assets GKI retained its old stance - the final sale price should be determined during the auctions/tenders. At the same time the starting valuation threshold was moved up and now it's based on the book value as of January 1, 1994, that is, it takes into account the first revaluation of the fixed assets after January 1, 1992 [6]. The starting price (including the price of equity being sold) may vary between 70% and two nominals.

For those JSC the privatization plan of which was approved prior to the enactment of the Basic guidelines (with the valuation as per the balance sheet of July 1, 1992) the starting price of the shareholding to be sold may be increased 20 times during the sale through the tenders or auctions. "The provisional methodology for the determination of the starting price of shares of JSC established in the course of the privatization process" of July 18, 1995 defines the starting price as the product of multiplying the nominal value of a share by the special increasing coefficient. The latter is calculated taking into account the change in the value of owner's equity according to the balance sheet of an enterprise, the situation at the regional or industrial (branch) market (on the basis of the actual sales figures), and provisions of the Basic guidelines. As a result the starting price may be 100 times higher than the nominal value of company's equity. If the date of an auction or tender is moved by more than 30 days the starting price is to be reviewed.

(7) Transparency: the information should be provided in the formal documents which are necessary for privatization such as company's charter, (based on the model one), and privatization plan (containing information on the enterprise, schedule and methods of sale etc.) Depending upon the importance of the property to be sold, there should be an advertisement in the periodic press concerning the envisaged sale wh ere the following parameters are to be indicated: date of sale, deadline for the submission of applications, methods of sale, location of enterprise, its major types of operations (products), amount of the charter capital, number of employees, number of shares to be sold (number of physical shares and as percentage of the charter capital), starting price and special conditions attached (if any).

The first "technical" document of the new stage was the "Procedure of sales of the JSC' shares at the specialized auctions" (GKI order N2469-P of October 6, 1994). The procedure of international and nation-wide specialized auctions was approved by the governmental decision N438 of April 28, 1995, "On the procedure of interregional and all-Russian specialized auctions for the sale of the shares of the open JSC established by the transformation of the state (municipal) enterprises". This document is also interesting because it for the first time included the idea of using the authorized banks for the purposes of cash privatization. In February 1995 the Russian Fund of the Federal Property (RFFP) together with the regional funds and a number of investment institutions set up the Federal Stock Corporation (FSC) with the status of the RFFP general agent in charge of the nation-wide and interregional auctions.

The RF President's Decree N474 of May 11, 1995, "On measures to guarantee the federal budget revenues from privatization" also became rather important from the standpoint of accelerating the privatization and creating some basis for the increase of the budget revenues. According to the decree the Federal Commission in charge of the federal budget revenues resulting from privatization should approve a list of the federal shareholdings which cannot be sold before a certain time which would automatically remove all limitations for the sale of all other shareholdings. The decree also provides an incentive (for the local authorities) for the accelerated sale of the federal shareholdings because the federal budget is entitled to only 10% of the overall proceeds from the sale of the state - or municipally - owned property while it received 55% of the proceeds from the sale of the federal shareholdings. And, vice versa, the enterprises themselves are entitled to only 14% from the sale of federal shareholdings (contrary to the provisions of the decree of July 22, 1994, according to which it was envisaged to transfer 51% from the sale price of the enterprise (equity) to the special account of the same enterprise for the investment purpose) and during the sale of the state shareholdings owned by the subjects of the federation and municipalities - to 51% [7].

C. Problems of the existing shareholders in the context of sale of residual shareholdings

As a first result of the implementation of the 1992-1994 model in Russia at many of the privatized enterprises (JSC) the structure of equity ownership became such that none of the groups of shareholders had a stable majority. In practice the positions and influence of the managers who had been in charge of the enterprise prior to privatization were strengthened. In the spring of 1994 the share of internal stockholders was on the average about 60-65%; that of outsiders (external stockholders) - about 18-22% and the state's share was no more than 17%. During 1994-1995 two conflicting trends have surfaced which were connected with the beginning of the process of redistribution of the initial ownership rights:

• trend towards the closed structure of the new JSC (managers' policy or policy of the branch departments and or regional authorities);
• trend towards the erosion of the initial structure of equity ownership in favor of the managers and - if there was an interest towards this specific enterprise - of the large outside shareholders (banks, investment funds etc.).

The "Cash" model of 1994-1996 (in its practical aspects) can be evaluated only in the context of the both above-mentioned trends because it was exactly the struggle for the absolute control over the privatized companies which became the predominant feature during the "residual" sales of the state shareholdings.

Table 3 attempts to define the empiric relationship between the typical post-privatization structures of equity ownership and methods of the "residual" sale as well as with the secondary stock market. In our view there is a direct link, first, between the method of primary sale and a certain structure of equity ownership and, second, between the existing structure of equity ownership and the choice of the secondary (residual) sale method.

At the same time, taking into account the above-mentioned specific features of the "cash" stage, we can say that the interests of the state and other shareholders (including the holders of the controlling interest) during the choice of the secondary sale method are in conflict. Thus, the state (primarily in its capacity as the recipient of the revenues from the sale of its stake) would be interested in the auction-type methods. The management as one of the largest stockholders would be interested in consolidating its control giving preference to the investment and commercial tenders (which gives them the opportunity to formulate special conditions tailored to "their" buyers). The large outside shareholders prefer specialized auctions which provide the room for the sudden action in the course of the struggle for the offered stake. The branch ministries and regional authorities try to block the sales if they go against the interests of the nomenclature or regional financial and industrial elites. Such blocking sometimes coincides with the interests of managers who prefer to see the state among the large shareholders.

In this situation the seller (state) faces not the problem of the search for a buyer (because the buyer is obvious - the existing shareholders engaged in the struggle for control) but the problem how to sell the residual shareholding with the maximum effect for the budget. However, if we apply this criterion, the actual failure of the 1995 sales was explained by the fact that it was not the state who dictated the rules of the game. In other words, the residual sales result in considerable budget revenues only and exclusively in case if the consolidation of the controlling interest has not yet been finalized. If the control over the company has been established than it's highly probable that any attempts to sell using one of the existing options are doomed to failure because of the absence of buyers. To some extent it may be regarded as the buyers monopoly at least in those concrete cases when the residual shareholdings were offered for sale but there was no real competition. It can be safely presumed that those 900 "non-strategic" enterprises (out of 7.000) the relatively large stakes in which were offered for sale in 1995 had a "competitive" structure of equity ownership or the consolidation of the controlling interest by the already dominant shareholders was drawing to a close.

We can reach the same conclusion if we consider the relationship between the existing structure of equity ownership, secondary (residual) sales and the secondary stock market (Table 3). In this connection we believe that the following quantitative coincidence is very significant (and, we think, not accidental): there were 900 actual sales of the residual shareholdings and about 1.100 companies the shares of which had limited liquidity (out of the more than 25.000 existing in Russia).

Let us underline several practical conclusions from all the above-mentioned:

(1) Underwriting as the method of the secondary (residual) sale, either best effort underwriting or firm commitment underwriting, through the public or private placement is not acceptable because of the "mass" scope of these transactions in Russia except for cases when the most attractive shares of well-known enterprises were sold to the foreign financial companies. Paradoxically, the opposite practice exists in the West: if elsewhere in the world initially there is a placement among the strategic investors and only subsequently - among the purely financial investors linked with and trusting the strategic one, in Russia the the opposite is true: the crystallizing ownership structure (there are already large stockholders trying to gain control over the company) repels small (financial) investors during the stage when the full control is being established [8].

(2) The fact that the Russian privatization legislation has no provision for the direct sales method is rather absurd because a considerable number of sales while having a form of auctions or tenders actually are the direct sales to the specific interested party.

(3) In case of the sale of controlling interest (option (f) in Table 3) it's necessary to have a special methodology of valuation of the offered stock which would allow to increase the price because of the additional value of this stake. It's obvious that this transaction also can take place only when there is a concrete interested investor, however, the absence of such individual approach is apparently detrimental to the state.

(4) Quite the contrary, in some situations (option (c) in Table 3) the state is obligated to get rid of its shareholding in favour of one of the parties immediately and by any method (which would be of course lobbied by the interested parties). This happens when the management and external shareholder do not have control but effectively neutralize each other's efforts which endangers the further development of an enterprise.

(5) The problem of transparency in this context becomes simultaneously extremely urgent and far from realistic. True, it's hardly worth placing your hopes on the managers' desire to disclose in good faith the real information about their company to the potential outside aggressor (which would bring about the loss of control), to the small shareholders - employees of the company (it may result in social conflicts) or to the state supervisory bodies (because that may end in them being held responsible up to the criminal charges).

In accordance with the RF Law "On joint stock companies" (articles 88-93) the JSC shall provide to their shareholders access to their documents and copies of these documents (charter, the emission prospects, balance sheets, financial statements, minutes of the general meetings and the board's meetings etc.), however, there are no clearly defined sanctions if these requirements  are not fulfilled. Besides, the law stipulates only annual publication of the company's balance sheet and financial statements while previously the quarterly publication was required.

As regards the transparency of the transaction itself (and its terms), it's also difficult to expect that the information of its real results is going to be disclosed because the formal sales schemes usually serve as a front for the set of measures (not widely advertised) to gain control over the company.

Hence it's apparent that parties in this struggle won't be interested in detailed information or that it's senseless to insist on transparency when you can hardly find a single buyer. Perhaps, the only exception was in case of the several biggest specialized auctions in 1995 when the insufficient advertising and information resulted in the lower than expected budget revenues.

D. Protection of the small shareholders rights

In the context of the above-mentioned the problem of protecting the rights of small shareholders especially when the consolidation of the controlling interest is being completed becomes extra serious. The year 1995 when the first general meetings of shareholders were held by the companies established in the course of the mass privatization was characterized by the numerous scandals connected with the discriminatory practices against small shareholders [9]. The following infringements became the most typical:

• "dilution" of the outsiders' share in the charter capital through the new share issues in connection with (or without any connection) the revaluation of the fixed assets  (JSC Maritime Shipping Company, JSC Komineft);
• dividends announced and approved at the meeting of company's shareholders are either not paid or there are decisions by the general meetings to pay the dividends only to a part of the shareholders (usually the employees of the company);
• intentional deletion of records from the register of shareholders (Krasnoyarsk aluminium plant) or keeping of records by the registrars dependent upon the company.

During the first half of 1990s the basic company documents (general and privatization) envisaged only a standard set of shareholders' rights: the right to take part in shareholders meetings; right to receive dividends and right entitling to a share of the assets during the liquidation of a company [10]. The RF GKI Methodological recommendations on the implementation of the Major guidelines of July 22, 1994 which accumulated the crucial existing provisions of the 1993-1994 legislation included three following prohibitions which serve the interests of shareholders:

• - it's prohibited to issue additional shares if more than 25% of the company's capital are owned by the state (previously - more than 10%);
• - it's prohibited to increase the amount of Charter capital by changing the nominal value of the previously issued shares (including the change in connection with the revaluation of the company's fixed assets) until 90% of the initial issue are sold;
• - it's prohibited to purchase and sell, transfer or exchange shares (stocks) between the legal persons if more than 25% of their charter capital are owned by the state.

When the RF Law "On joint stock companies" entered into force on January 1, 1996 [11] it signified some positive legal (although not yet actual) shift:

• following the RF Civil Code it stipulated the preferential right of the shareholders - owners of the voting stock to acquire the additionally placed shares of the company pro rata the voting stock belonging to them (article 40) in order to keep their share in the company's charter capital unchanged if it is provided for by the company's charter and an open subscription with cash payments is envisaged [12];
• the right of the shareholders to demand that the company should redeem the shares owned by them at a "fair" market price (determined by an independent valuating auditor) in case of reorganization, large transactions or changes in the company's charter adversely affecting the shareholders' legal status was introduced (articles 75-76). The companies were allowed to redeem in this way no more then 10% of their net assets [13];
• it was for the first time stipulated that during the acquisition of 30 and more percent of common shares the buyer (or affiliated persons) shall be obligated to make an offer to the stockholders to sell their common shares at the price not lower than the average weighted price of acquisition of the company's shares during the last 6 months before the purchase of 30 and more percent (article 80).

3. Privatization process in 1995

A. General results

In general during the first eighteen months of the announced cash privatization in Russia there was no privatization boom. The enterprises still cannot regard privatization as a significant source of investment. So far there has been no transformation of the potential investment demand (which unquestionably exists) into the real one. As it was already noted above the privatization in 1995 pursued one single predominant objective - to finance the deficit of the federal budget. Initially, the federal budget revenues from privatization had been planned in the amount of 8.7 trillion roubles but later (the law of December 27, 1995) the amount was adjusted to about 5 trillion roubles (Table 4).

In order to evaluate (from the budgetary standpoint) the methods applied in 1995 we can analyze the percentages of the revenues received by the budget when different privatization methods were used. Out of the total amount of 7.3 trillion roubles more than 80% were received during the last two months of 1995 when the loans-for-shares schemes were applied. The latter altogether brought 5.1 trillion roubles or 70% of the federal budget revenues. Placement of the convertible bonds of LUKoil which happened at the same time provided additional 12% of the total budget revenues. The investment tender for 25% of shares of Sviazinvest (1.9 trillion roubles for the budget) did not occur in the end.

The annual income received from the standard methods of sale which amounted to 1.1 trillion roubles (or 15% of the overall income) demonstrated the extremely low effectiveness of the mass auctions and tenders as means to replenish the budget. It's significant to note that branch-wise 47% of this amount were received from the enterprises of the fuel and energy complex. As regards the enterprises involved, the concentration of the income sources becomes even more noticeable: sales of shareholdings in 13 enterprises belonging to different branches provided for more than 70% of this amount, 30 enterprises (the specialized federal auctions) - brought 75%, 900 enterprises - 90%) The remaining shareholdings in 4.622 enterprises offered for sale in 1995 (Table 2), thus, brought (together with the income from the closed subscription among the employees) no more than 10% of the indicated amount.

Perception of this trend resulted in more emphasis being put on the sales of the more (potentially) attractive large enterprises. In August of 1995 GKI drew up a plan-schedule for the sale of shareholdings in the privatized enterprises for September-December of 1995 which at that moment included 136 large Russian enterprises among them Russian JSC " Energy system of Russia”, LUKoil, YUKOS, Sidanco, the Volga-Don river shipping company, Sviazinvest, shares of the nuclear industry enterprises, precious metals producing companies, air companies and airports, chemical and machine-building complexes, light industry, metallurgy, lumber and wood-processing industry, fuel and energy complex, geological companies. Among the methods of sale the auctions and specialized auctions of different levels were predominant, 44 investment tenders were envisaged. It was expected that the federal budget revenues from the sale of the shareholdings in these 136 enterprises would amount to about 4-5 trillion roubles [14].

Taking into account the relatively high attractiveness of the enterprises included into the schedule it could be safely presumed that potentially there would be demand for many of these stocks. At the same time we believe that subordination of these sales to the current budgetary purposes turned into a rather negative factor since the relative attractiveness of these enterprises in accordance with the world standards accompanied by the sound preparation prior to the sale would allow to drastically increase the revenues of these transactions both for the budget and for the enterprises themselves.

B. Standard methods of sale

(1) Specialized auction for the sale of shares

The specialized auctions became, in essence a cash variety of the earlier voucher auctions. It's a method of selling the shares through an open bidding during which all the winners get their shares at the same price while, in order to participate, an application should be submitted indicating the total amount of payment and the number of shares to be purchased.

In Russia altogether 831 such auctions were announced in 1995. The first interregional and all-Russian auctions began only in June of 1995, by October 14 such auctions were held and during the whole year (according to Federal Stock Corporation) - 30 of them took place (Russian JSC "Energy system of Russia”,, Rostelekom, Uralmash, oil companies, Novorossiysk shipping company, Vyborg pulp and paper plant, Ust-Ilym wood-processing plant, a number of medium-size enterprises).

Initially, with the starting price equal to 20 nominal values of shares, the average difference between the sales price and starting price was 2.5-3 times. This allowed to review the 20 nominals ceiling for the starting price and make it higher.

Although, according to the results of all the 1995 auctions the sales prices were on the average 3.3 times higher than the starting price (the maximum was registered in case of Medexport when the sales price was 35 times higher) investors have not demonstrated a noticeable interest towards these sales (Malin, 1996). The following factors contributed to this situation:

• competition from the state securities (including the state savings bonds and municipal bonds);
• competition from the loans-for-shares auctions wh ere significantly larger shareholdings or controlling interests were offered (for instance, 51% of shares of Sidanco or Sibneft);
• sales of “blue chips” in small shareholdings of 10-15% (15% of Sidanco's shares offered; 74, 79% of them bought);
• in a number of cases the auctions did not take place at the initially announced time or were cancelled even after the start of the applications submission (YUKOS);
• attempts to sell the shareholdings at prices higher than the market price [15];
• the special auctions for the sale of shares of the oil and some other companies actually turned into the primary placement of their shares which additionally complicated the setting of starting prices in the absence of the market quotations.

As it was to be expected the legal persons were predominant at these auctions, money-wise (84% of the total funds) although 89% of applications were submitted by individuals. According to the existing estimates the applications from physical persons for the amount of more than 100 million roubles can be attributed with the high degree of certainty to the managers of the companies the shares of which were sold (Privalov, 1995). In fact the population did not use given to the physical persons opportunity to participate in the special auctions. At the same time it's practically the only way for a small investor to acquire shares since almost all the operators of the secondary market of corporate securities deal with large shareholdings.

As regards the experience of the secondary sales of shareholdings as compared with the primary sales from the standpoint of their market value, in general, such a comparison is unlikely to be correct since during the primary sales the voucher methods were used. Only the relationship between the sales price of a shareholding and the existence of a controlling interest owned by a non-state stockholder can be clearly traced. It's also important to bear in mind that the shares of a number of enterprises were for the first time offered at the stock market, therefore - during the sale in lots - the starting price was determined taking into account the result of sales of the first lots.

(2) Cash auctions

Although this method of shareholdings sale was used more often than the others (4052 auctions in 1995) its contribution to the budget was minimum as compared to the loans-for-shares schemes and specialized auctions (Table 4).

A considerable part of these auctions simply did not take place due to the different reasons including the following major ones (GKI, 1996):

• absence of applications during the sales of shares of "unattractive" enterprises;
• absence of applications due to the high starting price of shares;
• absence of applications because the controlling interest belonged to one investor[16];
• refusal of the auction's winner to conclude sales contract or to pay;
• insolvency of the company;
• the necessary documents were not submitted to the property fund either by the company or by the  local property management committee (82 cases in St. Petersburg, 73 cases in the Krasnoyarsk Territory);
• conflicts were presented to the arbitration courts for resolution, privatization plans were changed, etc.

In a number of cases the cash auctions (usually in the form of closed tenders) became the final stages of specialized auctions during which not all the offered shares had been sold. Thus, for instance, in January of 1996 0.022% of shares of Rostelecom were offered for sale in 14 lots. The selling price was 3.800 roubles per share (20% lower than the secondary market price) with the starting price of 3.200 roubles.

(3) Investment tenders

According to the Russian legislation the criterion used to sel ect the winner is the total amount of investment discounted for the duration of the investment period at the refinancing rate of the RF Central Bank on the date when the results of the tender are decided. The tender is open from the standpoint of participation in it and closed from the standpoint of the form in which the applications are to be submitted.

The following exhaustive list enumerates conditions of tender:

• the period of investment should not exceed 3 years or should be determined by the privatization plan;
• the purchased shareholdings are to be paid for at their nominal value (at present the shareholdings are to be revaluated using the GKI methodology);
• not less than 20% of the total amount of investment should be transferred to the issuer's bank account within one month upon the conclusion of a contract;
• the issuer's outstanding debts should be repaid.

The last of the enumerated conditions is one of the most often used. For example, the conditions of the repeated investment tender for 18.5% of shares of the Yaroslavl mineral processing plant announced for March of 1996 envisage that the total amount should include investment (lowered from 100 bln roubles to 60 bln roubles) and the sum of the enterprise's debts to the budgets of all levels (36.8 bln roubles). Similar conditions were put forward at a number of commercial tenders. Another condition used during the tenders was moratorium for the sale of shares purchased at an investment tender until the investment program is fully executed. Such condition, in particular, was attached during the sale of 16.7% of shares of LUKoil in December of 1995.

In 1995 556 shareholdings of the Russian enterprises were offered for investment tenders. As in case with the cash auctions (and largely because of the same reasons) a large part of them did not take place. For instance, out of 19 investment tenders announced by the Penza Regional property fund ten did not take place because of the absence of applications (Kozak, 1995). The major problems in this connection are the lack of the local investors and investment resources, long-term nature (and long-term payback) of investment, failure to fulfill the investment obligations on the part of the tender winners, unclear land legislation.

There are many legal ways to get a shareholding in an enterprise without fulfilling one's investment obligations: the shareholding may be redeemed by the issuer itself through an affiliate; several affiliated companies may participate in a tender and the winning company would reject the transaction in favour of its partner-company which offered a much lower price; there may be manipulations with the timing of bringing in investment etc. All this creates potential grounds for a subsequent cancellation of transactions by courts. It's an open secret that at present the system of investment tenders (even open) quite often is nothing but a hardly veiled form of a direct sale to a particular investor who is known in advance and who from the beginning participates in drawing up an investment program and terms of the tender tailored to him.

We can safely assert that the majority of the investment tenders which were held had nothing to do with investment but in reality it was consolidation of stock in order to achieve control. In the best possible case-usually, when a foreign company wins the tender - the long-standing relationship is getting legally formalized. In 1995 foreign companies were recognized as winners of 26 investment tenders.   As a rule they were oriented towards the lowest risk investments, on the average between 5 and 10 million US dollars with the wide diversification of their interests by branch and by region. The overall volume of foreign investment resulting from these tenders amounted to 280 mln US dollars.

One of the best known examples of attracting a really strategic investor (although it did not take place) was the commercial tender with investment conditions for 49% of shares of Sviazinvest. This company is really a financial holding and 85 regional telecommunication enterprises of Russia (except for Tatarstan) contributed each 51% of its shares to the Sviazinvest charter capital. At the first stage of the tender 25% of the shares (+1 share) were offered with the investment program of 770 mln dollars for two years.

At the second stage (in 1996) the remaining 24% of the shares for sale were to be offered at the special cash auctions for portfolio investors. Out of this shareholding 7% should have been reserved as an additional guarantee to the strategic investor until the international audit of the holding is completed in 1996. At the same time the controlling interest (51% + 1 share) was to remain in the federal ownership. The conformity of the tender with the international standards was confirmed by the International Financial Corporation (IFC) and European Bank for Reconstruction and Development (EBRD) which were planning to purchase the company's stocks on the same terms as the winner of the tender.

On November 30, 1995 the Italian state telecommunications company "STET" was announced to be the winner; besides the investment program, it was to transfer to the budget more than 2.9 trillion roubles for the acquired shareholding. Formally the transaction failed because of a conflict over the mechanism of payment for shares ("STET" was to transfer money to an escrow account until the licences of the Sviazinvest subsidiaries were re-registered and until the Russian party fulfills a number of other conditions).

Numerous experts offer a widest possible variety of potential reasons why this transaction, largest in the history of privatization in Russia, fell through: the winner's refusal was explained by the results of the parliamentary elections on December 17, 1995; the transaction was badly prepared (there was no international audit, no issue prospect, etc.) which, apparently, was also explained by the hasty way the holding company itself had been established, i.e. specially for this sale, "STET"'s lack of funds; problems with the subsidiaries caused by the redistribution of profits since many of them had been included into the holding against their will (St.Petersburg telephone network went to court to dispute the decree concerning its inclusion into the holding, it also proved to be impossible to include into the holding the shares of the relevant company of Tatarstan); the RF Ministry of Communications (of which Sviazinvest is virtually a part) refused to provide institutional and technical support to the transaction with "STET" at the last stage; accidental character of the STET's winning (after its only competitor - consortium US West, Deutsche Telecom, France Telecom - which was "closer" to the RF Ministry of Communications refused to transfer the next guarantee deposit for some vague reason) etc.

Let's point out two of the few positive features. First, it important precedent when the tender was organized by financial advisor (in this case - consortium wh ere the leading role belonged to NM Rothschild and Sons Ltd.) which undertook to have the offered stocks sold on the tender's terms and at a price not lower than the initial one. Second, according to Salomon Brothers, the telecommunications enterprises were valuated approximately 7 times higher than the current market quotations. In all likelihood the second attempt to hold the tender may take place only after the presidential elections in June 1996 and with a different format.

C. New methods of privatization at the cash stage

(1) Loan-for-shares scheme

The initial proposal made by a consortium of the largest Russian banks to the Government (on March 30, 1995) envisaged that the shareholdings in 43 enterprises retained in the state ownership were to be transferred to the banks in order to be held in trust for 5 years in exchange for the loan to the Government equal to the planned budgetary revenues from privatization with the subsequent sale of shareholdings to strategic investors. The Presidential Decree N478 of May 11, 1995, directly charged the government with the task of developing the mechanism which would allow to pledge and to hand over the companies' shares in the federal ownership to legal persons for the trust management.

This Decree - "On the procedure of pledging the shares in federal ownership in 1995" - in its final draft was signed on August 31 as Decree N889. The same Decree approved the mandatory terms of loan agreements (winner - the RF Ministry of Finance), of the pledge (winner - GKI) and commission (winner or the third party - the Russian Fund of the Federal Property) as well as "Rules of holding the auctions for the right to conclude loan agreements, pledging the shares in Federal ownership and commission" [17]. In a sense the decree gave a legal definition to the term "bank consortium" for the purpose of this specific case.

Auctions are considered to have taken place if there was more than one participant and each of the participants guaranteed that the credits would be extended in the amount not less than the starting price using the shares as collateral.

According to the adopted scheme a special auction commission decides who would become potential participants, what would be the starting price of a shareholding (amount of loan) and sets additional conditions. Contender (a group of contenders) allowed to participate submits to the commission a tender indicating the amount of the loan. The party which offers the largest amount is recognized as the winner. Then credit agreement, pledge agreement (in exchange for the loan) and commission agreement are signed with the winner. The latter agreement gives to the commissioner (which is either the creditor or has an agreement with the creditor) the right to sell the shareholding by any method except for the investment tender after September 1, 1996. 30% of the positive difference between the sales price of shares and the amount of all the relevant liabilities of the Russian Federation go to the commissioner and 70% - to the RF budget.

The interest on the loan is calculated for the equivalent amount in ECU at LIBOR + 0.5% annually for three-month deposits as of the date of signing the agreement. In fact, the state is getting the loans with the interest 2-3 times lower than the market rate.

The starting price was established by the commission on the basis of 60-90% of the shareholding's market value depending upon its size. There was an argument in favor of such an approach referring to the world and domestic experience in the field of loans with the pledge of highly-liquid assets. During this the starting prices of the auctions offered to the commission by the members of the bank consortium turned to be 2-5 times lower than the approved ones.

The pledgee is entered into the state property register as the nominee holder of the corresponding stocks. He has the right to vote at will except for the issues related to reorganization and liquidation, changes in the foundation documents, change of the charter capital, securities issue, some property transactions and loans, participation in the establishment of organizations and subsidiary companies approved of the annual reports of the company.

There were 29 items on the initial list of enterprises approves by GKI. This list which was actually compiled according to the banks' request included the majority of the most attractive large Russian enterprises.

Quite naturally each of the items on the list became the subject of the bitter behind-the-curtain struggle. As a result 8 enterprises were withdrawn from the list by Presidential Decree N1230 of December 7, 1995 "Issues related to the pledging of shares in the federal ownership in 1995". Several enterprises of the lumber and wood processing complex (Arkhangelsk and Solombala pulp and paper plants, Bratsk lumber plant) started court proceedings against GKI in order to block "their" auctions for the duration of the Decree N889 in 1995. The Ministry of fuel and energy also strongly opposed the entry of "its" enterprises into the auctions demanding for itself a coordinating role in the management of shareholdings. JSC Beloretsk metallurgical plant fought for its exclusion from the list with the help of the representative office of Bashkiria in Moscow.

In a number of cases strong opposition on the part of the enterprises managers led to the appearance of many additional requirements towards the auctions. There are both objective reasons behind this (ignoring the financial interests of the enterprise itself when the revenues are transferred to the budget) as well as desire of the enterprises management to gain control over the process of sales (if they didn't succeed in getting their enterprise withdrawn from the relevant list). In particular, there were the following additional conditions: getting the status of the auction's organizers (Surgutneftegaz), reduction of the shareholding and prohibition to sell it until the process of formalizing the federal ownership over it is finished (Norilsky Nickel), repayment of the enterprise's debts (Surgutneftegaz), increase of the starting price of shares by adding to the amount of loan a similar amount of investment for the enterprise's needs (Norilsky Nickel), dividing the shareholding into 12 lots in order to dilute the controlling interest which was being formed (Sidanco), offer to the government to extend a loan in exchange for their own shares (LUKoil), combining the auction with an investment tender (YUKOS), preventing participation of foreign investors and some others.

However, there is also a possibility of a "separate" solution by the enterprise management and a specific bank within the already formed financial and industrial alliances (bank Menatep - YUKOS oil company).

Not all of the conditions put forward by enterprises were satisfied, however, it's interesting to emphasize the following tendency: the higher the lobbying potential of the enterprise the more of the conditions were satisfied (to the maximum degree - in case of LUKoil and YUKOS, to the minimum - for Sidanco).

As a result only 17 enterprises were offered at the auctions and in case of  5 of them (JSC Bor, Techsnabexport, West Siberian metallurgical plant, Kirovlesprom, Tuapse sea port) there were no bids. These auctions failed because of different reasons. For example, in case of JSC Bor (Maritime territory) there were huge debts accompanied by the lack of prospects for the marketing of the pulp and paper products. In the situation with JSC Techsnabexport, apparently, there was a need to retain a special control of the state over the exports of radioactive materials.

The 12 auctions which took place (Table 5) together brought to the budget 5.1 trillion roubles including 1.5 trillion of the repaid debts of enterprises to the state as compared with 2-3 trillion earlier envisaged for 29 enterprises (Table 4).

The experience gained in the course of the loans-for-shares auctions brought to light many procedural drawbacks in this scheme's format which was used during 1995:

• possibility of prior collusion between the auction's participants;
• participation in the auction of the bank authorized to collect bids and retainers;
• problems related to the setting of the starting price;
• problem of working out the list of enterprises between the functional and branch departments, regional authorities and the enterprises themselves;
• problem of verifying the authenticity of documents submitted by the applicant and conformity of the bank guarantee with the legislation's requirements;
• problem of a potential use of the state funds deposited with the commercial banks;
• insufficiency of the publicly available information on the issuers of the pledged shares;
• inconsistencies between a number of provisions of different regulatory acts.

In general the practical application of this scheme may be evaluated as follows:

• from the legal standpoint - it was a loan agreement under the pledge of shares with the right of subsequent sale of the pledged collateral;
• according to the formal world standards and transaction procedures - it can be described as (a) direct negotiations with the previously determined bank; (b) to some extent guaranteed underwriting (it's important to bear in mind that none of the underwriters would undertake the placement of securities without already having in mind specific investors - in this case the underwriters themselves);
• actually, - it was a veiled redemption of the shareholdings by enterprises themselves or their purchase by the interested banks (financial and industrial groups). As an objective argument we can mention the fact that even in September of 1996 we would hardly be able to expect the appearance in Russia of potential resident buyers with the similar or larger funds.

It would be naive to think that the term "auction" in this context means the beginning of some competitive bidding. It would be also naive to think that Menatep in future is going to voluntarily relinquish the controlling interest in YUKOS or ONEXIMBANK - the controlling interest of the Norilsky Nickel. We believe that in real life there were only direct sales to the known in advance buyers. And the price was somewhat lower than during the de jure sale because formally it was a pledge [18]. It's also important to point out that in cases of many enterprises the participation of foreigners was prohibited which also influenced the price of transaction. It became actually oriented only towards the relatively weak resources of the Russian commercial banks.

There was also no need to provide solutions to the legal problems in connection with the anti-monopoly regulation because such problems would have arisen only in case of sale. The loans-for-shares scheme also created a convenient political screen because hypothetically, there was always room for manoeuvre (if the opposition's criticism became too severe it was possible to buy back the shareholding). We believe that there was another valid objective, i.e. securing financial allies in the political struggle because different (new) authorities would very likely be much more inclined to withdraw the shareholdings by a "simple" redistribution of property.

In principle this method as such is quite acceptable in case of such important sales under the specific Russian conditions, the question is how to guarantee the efficiency of each particular transaction for the state and for the enterprise at least in medium-term perspective.

Since it still may happen that the pledged shareholdings would not become the property of the banks because of the different reasons (such a possibility is not ruled out by the bankers themselves) then at the stage when the pledge is valid the banks would be really interested not in the strategic management but in obtaining (retaining) the accounts of enterprises, in getting out of them as much profits as possible.

This factor (accounts) is crucially important in explaining the banks motives: transfer of the YUKOS accounts from Incombank to Menatep was the most important, if not the sole, reason why Incombank tried to participate in the loans-for-shares auction. There is a possibility of other schemes as well, for example, - a bank extends a loan to the enterprise at the excessively high interest rate then the funds are channelled for its repayment; actual profits may not be shown on the reports and tax forms which would bring about lower prices of shares and it would be possible for the companies affiliated with the bank to purchase them cheaply (Zharkov, 1995). We believe that it's too early to give specific appraisals of the scheme at this stage but we can at least formulate three possible scenarios of further developments:

a) Bank (it’s affiliate company) as the owner. If in the end the winning banks would de jure become owners of shareholdings then the problem of the efficient long-term management of the enterprise by the bank becomes crucial. The conflict between Norilsky Nickel and ONEXIMbank has become symptomatic of the problem. In this particular case the conflict would likely be solved only when all the legal rights of the parties as regards managing of the enterprise are clearly defined and the "irreconcilables" (possibly) are removed. Besides the court proceedings connected with the results of the auctions the managers of enterprises may resort to the tactics of "poison pills".

b) Bank as commissioner. If the bank due to some reasons decides to sell the pledged shareholding, one thing becomes clear so far: the state is never going to get 70% of the surplus proceeds that is the difference between the price of sale and the amount of the state's liabilities vis-a-vis the bank. It's obvious that the shareholding is going to be sold at the price of initial transaction to the specific buyer with zero surplus revenues and only subsequently the real sale with the maximum profit would take place. This is one of the most serious legal loopholes in all the scheme.

c) Redemption of the shareholding by the state. So far it's not clear what the state is going to do with the pledged shareholdings. It was not by accident that the onset of the pledge holder's right