Russia’s Latest Effort to Encourage Domestic IPOs: A Supply-Side Solution to a Demand-Side Problem?
January 2006
In a move that appears directed at capturing a larger piece of the hot Russian IPO market for domestic securities exchanges, the Russian State Duma recently amended the Russian securities and stock company laws, and the Russian securities regulator followed suit by amending related securities regulations, governing offerings by Russian issuers on international and domestic markets. While the streamlining of the domestic offering process is a positive step for capital formation by Russian issuers, increased burdens on international offerings is a more precarious step. In particular, it is unclear whether the supply-side stimulus driving more Russian shares onto the domestic securities market will enhance domestic market liquidity, or, in the absence of demand-side reforms to address insider trading, market manipulation and other issues affecting investor confidence, merely depress domestic share prices and take some of the steam out of the hot Russian IPO market.
Russian IPOs: The Goose that Lays Golden Eggs
In 2005, a dozen Russian issuers and their shareholders raised approximately US$5 billion in initial public offerings, with most of that money being raised and most of those offerings being conducted outside Russia
1. The number of deals and the amount of money to be raised in 2006 is estimated by various market professionals to be double that.
Accordingly, this is a high stakes game – and not just for the Russian issuers and shareholders seeking to tap into the capital markets. It is also of singular importance for the Russian securities regulator, the Federal Service for the Financial Markets, or FSFM, which in numerous public statements has set itself the objective of improving the international competitiveness of the Russian domestic capital markets. Time and again, FSFM has identified the outflow of liquidity in Russian shares to foreign markets, principally the London Stock Exchange, as the principal obstacle to achieving this objective.
To this extent, FSFM is on target – illiquidity in the domestic market has pernicious effects on the efficiency, level and volatility of share prices. Low trading volumes imply a limited number of valuation opinions, rendering price discovery unreliable. It also means potentially longer holding periods, greater risk exposure and higher transaction costs, which issuers and investors alike bear in the form of systematic discounting of share prices. Finally, the market may be more likely to overreact to news and therefore share prices will be more volatile.
All of these factors make foreign markets more attractive for IPOs by Russian issuers seeking to maximize valuations and offering proceeds, as well as enhance secondary market liquidity for their shareholders – which in turn contributes to the kind of liquidity drain that FSFM is concerned with. Hence the impetus for legislation to bring Russian shares back to the Russian market.
Lure It or Trap It?
The recent amendments to the Stock Companies Law
2, the Securities Market Law
3 and certain FSFM acts
4 reduce obstacles to conducting a domestic IPO of newly issued, or primary, shares. By making the domestic IPO process more compatible with investment bank marketing practices, the amendments encourage Russian issuers to use a mechanism that they might otherwise have shunned in favor of a foreign IPO.
The following aspects of the reformed open subscription process are particularly noteworthy:
Shareholders of a Russian issuer have pre-emptive rights in both closed and open subscriptions. In the case of an open subscription, all existing shareholders have pre-emptive rights in proportion to their percentage shareholding in the company. Historically, pre-emptive rights could be exercised by existing shareholders during a minimum period of 45 days, and only after that would third party investors be permitted to participate in the offering. The pre-emptive rights exercise price effectively had to be set in advance and could not be lower than 90% of the public offering price. Accordingly, the price range for the offering was fixed too early, and the number of shares available for allocation to the public was determined too late, in the typical marketing process for international capital markets deals.
By contrast, the amendments permit the offering price (including the price at which primary shares are to be placed to persons having pre-emptive rights, if different from the offering price) to be determined
after the expiration of the pre-emptive rights exercise period, and the minimum exercise period to be reduced in such case to 20 days. Accordingly, while some uncertainty as to public offering size remains built into the pre-emptive rights process, that process is now less obstructive of marketing and pricing an offering of primary shares.
Another idiosyncratic aspect of the Russian statutory offering regime is that, historically, a report on results of a new issuance of securities must be filed with, and registered by, FSFM after the closing of the offering. If such report is not registered, the issuance is cancelled, all primary shares are annulled, and the monies paid for such primary shares must be returned to the subscribers. Moreover, until registration of a report on results of the issuance, not only can the primary shares can not be traded, but also the holder cannot enter into a contract for their sale. In practice, registration of the report on the results of the issuance takes place no earlier than one month after the subscriber (the investor) has paid for the primary shares. Finally, where old emission shares are listed on a Russian stock exchange, the exchange may decide not to permit the newly issued shares to trade thereon until some 3 months after registration of the placement report, when the old and new emissions are consolidated by FSFM.
The post-closing placement report registration requirement increased the risk of all participants in a domestic primary offering. All of these features would tend to reduce the interest of short-term speculative investors in an open subscription, thereby reducing liquidity in the secondary market immediately after closing, and deterring an important class of investors from making their capital available for domestic IPOs.
The amendments to the Securities Market Law and the Issuance Standards have addressed all of these issues. An issuer may now elect to provide to the FSFM, in lieu of the report, a notification on the results of the issuance if the aggregate of the following three criteria are met: the primary shares were placed through an open subscription; a Russian broker was involved in the placement process; and the shares have been listed
5. Secondary trading in the placed primary shares can commence immediately upon filing with the FSFM of such notification on the results of the issuance. Moreover, shares can now be listed temporarily (up to three months) in a low-level quotation list ("C" list) with the least onerous (save the seasoning) eligibility criteria, specifically created for listing the shares that are being placed for the first time by open subscription with the involvement of a broker or are offered for the first time for public circulation through a stock exchange or through a broker. Upon expiration of three months from the moment of placement through the stock exchange, shares must be transferred to more stringent "A" or "B" lists, or to the list of non-listed securities admitted for trading.
Another significant drawback of the open subscription process had been the nature of investor allocations. Unlike an internationally accepted bookbuilding procedure, which generally affords underwriters broad discretion to accept or reject subscriptions in whole or in part, shares placed by means of open subscription effectively had to be allocated on a first-come-first-served or pro-rata basis. Accordingly, the open subscription process suffered the drawback of not allowing the issuer, in consultation with its underwriters, to exercise sufficient control over the shape its post-closing investor base. By contrast, the amendments to the Issuance Standards suggest that if primary shares are placed by means of open subscription, the issuer may have discretion to select, from among the persons who have offered to subscribe for such shares (other than persons exercising statutory pre-emptive rights), those persons whose offers will be accepted.– Even if you build it, will they come?
Nevertheless, it remains to be seen whether the new open subscription rules gain market acceptance and supplant the commonly used Тback-to-backУ international or domestic underwritten public offering by a core shareholder that uses the proceeds of its offering (in whole or in part) to fund its participation in a closed subscription for primary shares of the Russian issuer, or to an offering of Russian primary shares in the form of depositary receipts abroad. Perhaps with this in mind, FSFM sought to put additional restrictions on international offerings by Russian issuers.
In addition to the securities and stock company law amendments discussed above, FSFM has adopted new regulation governing the procedure for granting permissions to circulate Russian shares abroad in the form of depositary receipts
6 . Pursuant to such regulation, in addition to obtaining a listing on a Russian stock exchange, the following conditions must be satisfied before FSFM will permit a Russian issuer to access the international capital markets.
Primary shares to be offered outside Russia in the form of depositary receipts must also be "offered for placement" domestically in a concurrent offering of the shares themselves though a Russian stock exchange or a broker, such that no more than 70% of the primary shares are placed abroad in the form of depositary receipts.
On the one hand, most of the recent international IPOs by Russian issuers of their shares in the form of depositary receipts involved a concurrent offering of shares domestically through the facilities of a Russian stock exchange. On the other hand, the domestic tranches of those offerings have typically represented substantially less than 30% of the global offering. Accordingly, there is an important interpretive issue as to whether 30% of the primary shares must be
offered for placement, or must actually be
placed, domestically. Recent public pronouncements by FSFM tend to suggest that it may be the latter, since FSFM has indicated that if the Russian broker fails to place the full 30% to other investors, one way to satisfy the requirement would be to take the remainder of the domestic tranche into its investment account. Of course, for an underwriter, to take shares into its investment account is the very definition of a failed underwritten offering – so the new 30% requirement may yet have a significant deterrent effect on primary offerings in the form of depositary receipts.
Even if this is the case, it may be possible to structure the international offering of depositary receipts as a secondary offering by a core shareholder along the lines discussed above, while a back-to-back placement of primary shares to the core shareholder is made to satisfy the Russian issuer’s corporate financing needs. But it remains to be seen whether such a structure, though in technical compliance with FSFM rules, would be viewed by FSFM as constituting an evasion of the new offering.
The maximum number of a Russian issuer’s shares that the FSFM can authorise for placement or circulation outside of Russia has been reduced from 40% to 35% of the total number of the issuer’s placed shares of the same class.
It appears that such percentage should be computed based on a figure that includes shares which are in the process of issuance. Although it is unclear from the wording of the new regulations whether the FSFM permit is to be re-issued to cover a lower number of shares if not all primary shares within the new issuance are placed, we are aware of the FSFM reissuing a permit in this manner under the old regulations, and it seems consistent with FSFM’s continued focus on a percentage cap that they would follow this practice in the future.
While the overall intent of the above limitations is clearly to re-direct liquidity from the international capital markets back into the domestic securities market, what is somewhat puzzling is that the approaches described above are so different from those adopted by UK regulators for the London capital market, which FSFM (quite rightly) believes to be the principal competitor for Russian IPOs.
Another Idea: Make it Want to Stay
The UK, of course, does not impose requirements on domestic issuers to list domestically, yet not only do they, but also issuers from around the world, seek to offer and list their shares in its capital markets. One might postulate that it is because the UK creates favourable conditions for valuation and liquidity: first by getting information to the market through rigorous enforcement of disclosure rules and transparent governance, and second by ensuring a level playing field through rigorous enforcement of insider dealing and market manipulation rules. In other words, it creates the conditions for investors to be able to trust the price discovery mechanism in its markets and to be willing and able to trade freely. In short, it is a demand-side solution.
FSFM has market abuse legislation on its agenda. The sooner such legislation – and appropriate funding, monitoring and enforcement mechanisms – can be implemented, the more likely domestic demand will rise to meet the supply of Russian shares which FSFM and the State Duma have sought to foster through the measures discussed above, and the more likely that the result will be not a glut of undervalued shares, but the robust domestic capital market that this country deserves.
Endnotes:
1 The PBN Company: ТRussia’s IPO PioneersУ.
2 Federal Law "On Stock Companies" No. 208-FZ dated December 26, 1995, as amended.
3 Federal Law "On the Securities Market" No. 39-FZ dated April 22, 1996, as amended.
4 Standards of Issuance of Securities and Registration of Securities Prospectuses, approved by FSFM Order No. 05-4/pz-n dated March 16, 2005, as amended (the "Issuance Standards"); Regulation on Organisation of Trade in the Securities Market, approved by FSFM Order No. 04-1245/pz-n dated December 15, 2004 (the "Trade Organisation Regulation"). The amendments to the Issuance Standards and Trade Organisation Regulation approved by the FSFM Orders No. No. 06-7/pz-n and 06-4/pz-n, both dated January 12 2006, have been registered with the Ministry of Justice and, as of this writing, are expected to be published in the near future and to take effect in April 2006.
5 This exemption does not apply to securities issued by credit organizations.
6 Regulation on the Procedure for Granting by the Federal Service for the Financial markets of a Permission for Placement and (or) Circulation of the Issue Securities of Russian Issuers outside the Russian Federation, approved by FSFM Order No. 06-5/pz-n dated January 12, 2006.
Authors: Mark M. Banovich, Yulia A. Cherkassova and Kirill D. Ryurikov
The Russian language version of this article is due to be published in Edition No. 4 (April 2006) of the Russian legal journal “Corporate Lawyer”.
