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1. Background
2. Methodology Elaboration
   1. Object of assessment
   2. Assessment techniques
3. Ratings
4. Information Disclosures
   1. Obligatory information disclosures
   2. Voluntary disclosures of additional information
5. Ownership Structure
6. Board of Directors and Management Structure
7. Shareholder Rights
8. Expropriation Risk
9. Corporate Governance History
10. Sources of Information

1. Background

Corporate governance has increasingly become an aspect taken into account by investors nowadays when selecting companies to invest in.

The corporate governance situation in Russia is known to be rife with problems and generally seen as inadequate by the world investment community.

This has come as a result of a number of factors, including the following:

• poor transparency of Russian enterprises and the Russian market as a whole;
• lack of legislative regulation;
• unsatisfactory enforcement system in Russia, including inefficient performances by many courts;
• peculiar incentives driving Russian managers and major shareholders to put struggles for control over a company or asset withdrawals before the need to increase the company's capitalization or profits; and
• low liquidity of most Russian companies' securities, which leave so-called external corporate governance mechanisms inoperable, with investors disappointed by a company, for example, being unable to sell their shares easily and thus to "vote with their feet".

This lends all the greater importance to internal corporate governance mechanisms, comprising shareholder participation in the management of the company, the board of directors, and information disclosures.

Investors' practical experiences in Russia demonstrate that in order to be successful here, it is essential to analyze the corporate governance efficiency of a target local company more carefully than elsewhere in the world. Since not all investors are in a position to be able to do such research, the need has arisen for an indicator that would reflect the corporate governance situation in a particular company and its compliance with the recognized principles of good-faith corporate governance.

A well-considered approach to investments in Russian enterprises should rely on performing a thorough review of the issuers' internal documents and specifics regarding the establishment and activity of their governing bodies, identifying the technologies they use to take principal corporate decisions, as well as the liability of officials, and investigating the company' relations with the government and the investment community. It is also necessary to take a look at the history of a company's corporate conflicts and the ways its management has chosen to defuse them.

When it comes to assessing the development of a business in Russia, it is all too often vital to judge its commercial steadiness and promise not so much on the basis of financial standing indices or market prospects for product distributions as on the company's approach to advancing its business, as reflected in its internal management structure (allocation of responsibilities and powers among its principal bodies) and in its external corporate environment (equity participation in the charter capital of its suppliers and users of its products, the external auditor, and the management company). It is also imperative to consider the positions held by the target enterprise in financial and industrial groups, its impact on the conduct of business by its subsidiaries, and the extent of the influence exercised by state agencies and local administrations on the company and its officials.

All this reflects the gamut of specific risks associated with investments in Russian ventures. A company's rating mirroring its corporate governance situation should help identify and account for such risks.

Therefore, the Institute has developed a Corporate Governance Rating Methodology making it possible to obtain an objective idea about a company's corporate governance structure and practices and to compare different enterprises from the standpoint of their corporate governance quality.

The Methodology has been designed under the supervision and with the direct participation of members of the Blue Ribbon Panel, an expert council comprising leading Western and Russian specialists in corporate governance, senior executives from major investment funds, and experts from such international financial organizations as the World Bank, International Finance Corporation, and the European Bank for Reconstruction and Development.

Corporate governance assessments are carried out primarily on the basis of information disclosed by the companies under review both in accordance with applicable requirements and additionally on a voluntary basis. Queries addressed to a company by minority shareholders help conclude whether it offers equal treatment for all shareholders.

The Methodology makes it possible to evaluate a company's corporate governance situation and identify problems that may be encountered by investors. As a result, the latter are provided with a product representing a competent opinion on the company's corporate governance, which they can use as a basis for making balanced and substantiated investment decisions and for evaluating the non-financial risks posed by corporate governance problems.

In addition, corporate governance ratings are also useful for issuers, by enabling their senior executives to weigh up the adequacy of the existing corporate governance arrangements and to chart ways for improving them.

2. Methodology Elaboration

a. Object of assessment

When elaborating the Corporate Governance Rating methodology, its authors proceeded from the need to evaluate the entirety of relations coming to exist between a company's shareholders, members of its board of directors and management council, and other parties concerned regarding the governance of the company.

b. Assessment techniques

For the results of companies' corporate governance assessments to be understandable to a broad circle of their Russian and foreign users, the Methodology is based on the OECD Principles for Corporate Governance, which are generally recognized standards in the given field.

The Methodology was designed with due regard for the following:

• A company's rating is an indicator advising investors of its corporate governance situation. Among many other parameters, the rating should reflect the readiness of the company's management to cooperate with all shareholders (equal treatment of shareholders) and the objective possibility for investors to obtain full and accurate information about the company. Therefore, ratings should be computed regardless of issuers' wish to be made part of such rankings and irrespective of direct orders, which may be placed by companies for this kind of evaluation.
• Russian corporate governance practices are fraught with a number of risks likely to be faced by investors. Therefore, as ratings are compiled, special attention should be paid to detecting those potential risks, which emanate, inter alia, directly from issuers' foundation documents.
• A company's non-transparency increases any risks confronted by shareholders. Therefore, its corporate governance rating should be based, in the first instance, on that information which is disclosed by the company itself, both by way of complying with the relevant obligatory requirements and voluntarily outside the scope of such requirements, including in response to queries sent by the Institute as a shareholder.
• Ratings should be calculated in a manner making it possible to minimize subjective attitudes. Therefore, the relevant questions are formulated so that in most cases the responding experts should simply confirm or deny a certain statement rather than expressing their own opinions on the issue concerned.

The Methodology focuses not only on establishing how strictly a company observes applicable legislative requirements. Obviously, a formal semblance of compliance with legislation does not yet guarantee unfailing respect for shareholder rights, which is why a company's rating takes account of such of its acts as, though formally being consistent with legislation, effectively entail shareholder right restrictions. In addition, a look is taken at the measures being taken by the company to improve its corporate governance standards.

In order to be able to identify the company's practical problems with corporate governance or, on the contrary, its strongpoints in this area, the issues to be analyzed as part of working out its relevant rating are subdivided into the following categories reflecting different aspects of corporate governance:

-        information disclosures;

-        ownership structure;

-        board of directors and management structure;

-        shareholder rights;

-        expropriation risk;

-        corporate governance history.

3. Ratings

Ratings resulting from the analytical processing of the corresponding information obtained are customized digital indicators of the companies' performances in the field of corporate governance on a scale whose maximum value corresponds to a business ideal in this respect, i.e. one that not only abides by legislation, but also employs such procedures as do not pose any potential threats of shareholder rights being breached and one that works continuously to upgrade its corporate governance standards so that in practice its shareholders face no related risks.

A reply to each corresponding question adds between zero and 200 points to a company's combined rating, depending on how important the matter is for assessing corporate governance practices.

In addition, sub-ratings are calculated for various aspects of corporate governance (information disclosures, ownership structure, board of directors and management structure, shareholder rights, expropriation risk, corporate governance history).

4. Information Disclosures

Information disclosures constitute a fundamental principle of corporate governance. They are especially indispensable to the Russian capital market where so-called external corporate governance mechanisms are not as yet engaged. Therefore, issues related to information disclosure practices make a separate part of the corporate governance rating assessment process.

They serve as the basis for computing a special information disclosure sub-rating as a tool for judging the company's transparency. The latter's lack of transparency, as well as irregularities in the way the business complies with information disclosure requirements, may attest to its improper corporate governance practices.

A company's information disclosure performance is evaluated by analyzing its readiness to provide its shareholders with corporate documents and to respond to their queries, including written requests and telephone calls. The company's willingness to provide information to the Institute as a minority shareholder points to its adherence to the principle of equal treatment for all shareholders.

The relevant category of issues includes those connected with the company's conformity to legislative requirements concerning information disclosures on the securities market and its supply of additional information on a voluntary basis so as to keep interested parties better informed about the issuer.

4.1. Obligatory information disclosures

The lists of data to be at all times made available by joint stock companies and that to be provided at the request of shareholders are established by Federal Laws No. 39-FZ "On the Securities Market", dated April 22, 1996, and No. 208-FZ "On Joint Stock Companies", dated December 16, 1995.

The Securities Market Law obliges an issuer of publicly traded securities to disclose information about such securities, as well as its financial standing and business performance in the following two forms:

(1)       through quarterly reports; and

(2)       through reports on material facts and events affecting the company's finances or business undertaking.

Therefore, the research done in this field includes determining whether the issuer under study submits its quarterly reports on time and whether the information included in such reports is full enough and meets the requisite requirements made by applicable regulatory acts. The contents of quarterly reports are further analyzed to establish whether they are sufficient for investors to be able, on their basis, to derive an idea about the company's activities.

The Joint Stock Company Law lists documents which a company must provide to shareholders upon their request.

Therefore, a company under review is forwarded a request for copies of its corporate documents, including, but not limited to the following:

• its charter;
• internal company documents approved by the general shareholders' meeting or other governing bodies (regulations on the procedure for the conduct of general shareholders' meetings, regulations on the board of directors, regulations on the internal audit commission, regulations on executive authorities, regulations on compensation payable to members of the board of directors and the management council, etc.); and
• minutes of proceedings at general shareholders' meetings, as well as meetings of the board of directors or supervisory board and the internal audit commission or internal auditor, and lists of the company's affiliates, including the numbers and categories or classes of their shares.

Such documents lay the foundation for the company's corporate governance. Therefore, the possibility for shareholders to gain access to such documents is a crucial aspect of corporate governance practices and the provision, or refusal to provide, or any interference in attempts to obtain, the documents concerned is duly taken into account for rating calculation purposes.

4.2. Voluntary disclosures of additional information

The information disclosure sub-rating is also influenced by a company's willingness to disclose more about itself on a voluntary basis so as to provide interested parties with a fuller briefing on its activities.

This includes determining whether the company provides its shareholders with any information in addition to that required by law or any explanations regarding its operations, whether the company reveals any data about its strategic operating guidelines, etc. It is also analyzed if shareholders have opportunities to put questions to the company and to receive appropriate replies. For this purpose, the Institute sends letters to the companies being rated, asking them about practical steps taken to deal with this or another problem.

Any provisions in the charter that impose restrictions on information disclosures are subjected to scrutiny. Efforts are also made to study the company's information disclosure practices during preparations for general shareholders' meetings.

5. Ownership Structure

When sizing up the possibilities of disposing of their equities in a company and in order to make the right decisions, shareholders need to have an objective picture demonstrating the actual extent of influence which other shareholders are in a position to exercise on corporate decision-making. The tactics and strategies chosen by different categories of shareholders for the disposal of their shares are substantially dependent on what they think of the type of share capital and the role played by controlling, blocking or major shareholders. The set of related issues makes it possible, upon their analysis, to determine the degree to which a shareholder can find its bearings in the structure of the company's share capital and gauge risks arising out of the possibility for certain decisions to be taken in the interest of isolated groups of shareholders.

Share capital structure assessments are made proceeding from the following. The privilege to receive information about the ownership pattern in a company, as well as about the scopes of rights enjoyed by its co-owners and the correlations of such rights, is a basic entitlement of every investor. Corporate governance practices prevalent at Russian companies indicate the reluctance of major shareholders and other parties in control over or which may control a business to make any such revelations about themselves.

Therefore, share capital structures are assessed on the basis of information provided by the corresponding companies about their shareholders, with special pains taken to determine whether such disclosures are sufficient for drawing sound conclusions about the composition of the companies' shareholders, whether the information made available is about actual shareholders or nominee shareholders, and if anything and how much is allowed to be known about the controlling shareholder.

6. Board of Directors and Management Structure

The board of directors is allotted an important role within the corporate governance system as a mechanism to ensure a company's management in the interest of shareholders. The board of directors is expected to be liable for planning the company's development strategy, oversee the performances of its managers, and to support the operation of the system in place for the internal regulation of the company's activities in order to protect the investments made by its shareholders, as well as the company's own assets. Conflicts of interest between shareholders and the board of directors are quite likely.

Assessments of a company's board of directors and its management council are performed by reviewing the relevant provisions of its charter and corresponding regulations. A number of questions analyzed as part of the Corporate Governance Rating Methodology concern independent directors. A study is also carried out of the board of directors' role in the management of the company and other matters pertaining to the distribution of powers between the board of directors and the company's executive authority.

In order to evaluate the roles of a company's governing bodies, it is important to know the percentages of shares owned by members of its board of directors and its executive authority, whether the positions of the board chairman and the individual executive authority are separated in practice, how extensively the management council is represented on the board of directors, whether the charter or other internal regulations make any specific requirements for directors, and what such requirements are, considering that the charters of some companies formulate such requirements for candidates to serve on the board of directors as violate shareholder rights.

The requirements to be met by those nominated for the board of directors or supervisory board may be set out by the charter or by another internal document of a company if approved by its general shareholders' meeting. In some companies, governing, controlling shareholders abuse this legislative provision in order to bar any undesirables from the board. The charter may stipulate, for example, that only a company's employees may be elected to serve on its board of directors.

Other questions to be answered include whether the board of directors has formed any special committees, for example, an audit committee empowered to review and monitor the preparation of financial statements and internal oversight arrangements and to cooperate with the external auditor, and whether such committees include so-called independent directors.

The regularity of meetings held by the board of directors is also analyzed, as are issues deliberated at such meetings and whether all board members take part in voting.

The charter and other documents governing the activities of executive authorities are used as the basis for reviewing issues falling within their competence.

In the case of ADR issuers, it is checked whether depository banks have granted the management of such companies’ powers of attorney to vote at general shareholders' meetings.

7. Shareholder Rights

Corporate governance arrangements should be such as to ensure protection for shareholder rights and equal treatment for all shareholders, including minority and foreign shareholders.

The relevant research is geared to establishing whether a company’s corporate governance system is adequate for upholding such shareholder rights as are defined as basic by the OECD Principles of Corporate Governance. This covers, but is not limited to, issues relating to shareholders’ exercise of their fundamental right – the right to vote/to participate in general shareholders' meetings – and to dividends.

The core internal document determining the rights and obligations of parties to corporate relations is a company’s charter. In order to form a notion of the company’s policy vis-a-vis shareholders, reviews are performed of both the charter and other internal regulations open to shareholders, for example, that prescribing a procedure for the conduct of general shareholders' meetings, to see if they contain any provisions threatening potential shareholder right abuses.

The company’s charter and internal documents are also scanned for provisions requiring compliance with any supplementary procedures or any extra terms in order to be able to buy or sell shares in addition to the respective wish of the purchaser or seller of such securities.

Analysts professionally involved in monitoring the company’s operations are interviewed so as to elucidate whether any artificial barriers exist to its shareholders’ participation in general shareholders' meetings, whether such analysts are aware of any shareholder complaints about the procedure employed to give notice of general shareholders' meetings and, where the company has announced dividends, whether there have been any delays with their payment or refusals to pay such dividends.

8. Expropriation Risk

The practical experience of investor right protection efforts in Russia has revealed a number of considerable risks inherent in the creation and re-allocation of property on emergent markets in general and on the Russian market in particular. Financial crises amid imperfect legislation have engendered specific ownership re-distribution schemes infringing upon the rights of small-time and non-controlling shareholders to various extents.

Corporate governance rating calculations in this field are based on evaluations of such risks as are associated with equity dilution, transfer prices, asset withdrawals, reorganization and other possible changes to a company’s corporate structure (incomplete holding company consolidation), and the absence of representatives of minority shareholders on the board of directors.

The existence of a group of minority shareholders coordinating their actions and together representing a blocking parcel of shares makes a palpable impact on a company’s corporate governance practices, as such shareholders may well block decisions which are desired by “controlling” shareholders, but are contrary to the vetoing group’s interests.

Concerted action by minority shareholders may affect corporate governance practices regardless of whether their holdings, in aggregate, constitute a blocking equity. Should minority shareholders’ rights be breached, for example, their coordinated response may well win them a redress through court.

Therefore, one aspect of risks given special attention in the course of corporate governance reviews envelopes all matters relating to minority shareholders.

Another important factor for risk analysis purposes is whether a company’s board includes any so-called independent directors. It needs to be noted that independent directors are still rare in Russia, but trends showing in the evolution of corporate governance arrangements indicate that the practice of appointing such people to serve on boards of directors is eventually going to prevail.

The reason why investors’ proxies are nominated for boards of directors is the need to represent minority shareholders and stand up for their interests.

By their joint efforts, minority shareholders are in a position to be able to get their representative elected to a company’s board of directors and in certain instances also to secure that an extraordinary general shareholders' meeting is convened. The inclusion of such a representative on the board of directors enables minority shareholders to obtain information about company activities and resolutions made and, if necessary, to take prompt action to defend their rights.

Shareholder risk assessments also involve exploring the possibility for the board of directors to make decisions in the interest of only an isolated group of affiliates, and determining whether the charter requires that directors report possible conflicts of interest during the board’s deliberations of certain issues, whether the charter includes any provisions which may entail shareholder right abuses or clauses giving preferences to some shareholders over others, and whether internal documents regulating the activities of the company’s governing bodies prohibit transactions based on insider information.

Since the State’s equity participation is, in the peculiar conditions of the Russian market, fraught with certain risks to other shareholders who cannot, for example, foresee how the government-owned stake will eventually be disposed of and have to put up with the inefficiency ordinarily demonstrated in its management, companies’ corporate governance assessments cannot but take account of such risks.

Special attention is paid to considering possibilities for equity dilution through additional share offerings. It is established who is competent to decide to increase the company’s charter capital and whether the issuer is obliged to make such an increase and transfer shares to the winner of a specialized privatization tender. Where a shareholding was sold off by investment bidding in the process of privatization, checks are made to determine whether the period reserved by the bidding rules for the fulfillment of investment terms in respect of the company concerned is now over (until such terms are met, the charter capital may not be increased, meaning that as long as the investment terms still have to be satisfied, there is no risk of charter capital increases).

If the charter provides for any authorized shares, their number is clarified. Obviously, the risk of equity dilution is the greater, the larger the amount of authorized shares is if the board of directors is empowered to increase the charter capital by its own decisions.

It is also found out whether there is a ban on shares being paid for other than in cash and if there any other provisions effective to prevent dilution, whether the charter lacks a provision granting preemptive rights of purchase to shareholders or the general shareholders' meeting has resolved to abstain from the exercise of such rights for one year, and if any securities convertible into common shares are in circulation.

Other risks assessed include those of a decline in share prices as a result of dubious transactions (asset withdrawals, transfer prices, etc.).

Corporate governance rating calculations are take due account of evaluations of risks arising out of possible company restructuring (the possibility of measures that are effectively designed to alter the company’s corporate structure, for example, a switchover to uniform shares).

9. Corporate Governance History

This category of issues subject to analysis includes those related to the roles of the external auditor and the internal audit commission, and any penalties administered against a particular issuer by the FCSM. An assessment is made of the company’s record of preparing financial statements according to international standards.

The internal histories of Russian companies having had relatively short corporate existences need to be studied in each case in order to evaluate the quality of their corporate governance arrangements. Answers obtained to questions prepared to ascertain the situation in this field facilitate conclusions on how closely a company’s policies have conformed to the principles of due corporate governance.

Such questions include whether the company maintains a set of accounting records in accordance with international standards (GAAP or IAS), whether its external auditor is a member of the Big Five, whether the company’s external auditor has been replaced over the preceding two years on shareholders’ initiative, who the new auditor is if such replacement did take place, and whether any unscheduled external audits have been initiated by shareholders since 1999.

Related analysis extends to determining whether the internal audit commission is an active, working body, how often it holds its meetings and if such meetings deal with any issues other than checks on the company’s financial standings and business performances upon the results of each year.

The corporate governance system should provide investors with dependable ways of registering their title. Protection for shareholders’ ownership rights is ensured by delegating responsibility for the maintenance of the company’s share register to a specialized independent registrar. It is clarified, in the latter case, if the outside registrar is a member of the signature guarantee program and whether, if the company is a shareholder in its registrar, its respective equity there exceeds 5 or more percent of the latter’s charter capital.

Since securities issues by joint stock companies directly affect the rights of their shareholders, corporate governance evaluations cannot do without finding out whether the FCSM has ever denied state registration to any of such offerings, mounted probes prompted by complaints about shareholder right violations, or imposed any fines against the company for having breached investor protection legislation, or if any share issues over the preceding two years been paid for with securities floated by the company’s subsidiaries or affiliates (for example, veksels).

The possibility for shareholders to “vote with their feet” where they are unhappy with what a company’s management has achieved through their work is an external mechanism to make for more efficient corporate governance. This is why issuer assessments also include studying matters connected with the free circulation of such companies’ outstanding shares.

10. Sources of Information

Corporate governance rating calculations are based on the following two categories of source data:

-        information required to be disclosed and additional information publicly revealed by a company; as well as such information disclosures as are made by regulatory authorities (FCSM).  Acting lawfully, shareholders can base their decisions on only such information as is publicly disclosed by the company or is otherwise available from sources in the public domain such as the press or market analysts’ reviews. Therefore, rating computations do not take account of any information that is inaccessible to investors.

 -        company's replies to written queries and telephone calls from the Institute as its shareholder.  Life demonstrates that small shareholders encounter real problems, coping with which calls for both time inputs and financial expenses, when they attempt to obtain information about their company. In order to assess the company’s actual attitude to shareholders, the Institute, which is itself one of such shareholders, sends various queries to the company. Significantly, such questioning is not a one-time measure only undertaken for the purposes of initial rating calculations, but will continue from time to time in the future as well so as to monitor the company's performance in this respect continuously.

© Institute of Corporate Law and Corporate Governance, 2000

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