William N. Goetzmann Matthew Spiegel Andrey Ukhov Yale School of Management

1. Modeling and Measuring Russian Corporate Governance: The Case of Russian Preferred and Common Shares William N. Goetzmann Matthew Spiegel Andrey Ukhov Yale School of Management

2. A Misleading Opening Quote ...Russia has a strategic goal – to become a country that makes competitive goods and renders competitive services. All our efforts are committed to this goal. We understand that we have to solve questions pertaining to the protection of owners' rights and the improvement of corporate governance and financial transparency in business in order to be integrated into world capital markets. Vladimir Putin's speech at the World Economic Forum in Moscow (10/30/01)

3. Share Classes and Their Prices • Typically find two similar share classes in the same firm selling for dramatically different prices. • Corporate governance to the rescue! • Price difference represents the value of control.

4. But Does It? • Russian common and preferred shares sell for very different prices. • Can corporate governance issues explain the price difference and its variation over time? • Obviously, I do not think so! Why else would I put up this slide! 

5. Corporate Governance – The Explanation that Never Fails • Corporate governance CAN explain ANY price discrepancy. • Just assert that as of next week all future cash flows will only go to the security with votes. • Is this realistic? • How about testing whether the implied value of the votes corresponds with the potential future cash flows?

6. Russian Common and Preferred Shares: Background • Russian preferred shares are NOT related to those in the U.S.. • In Russia “preferred” shares came into existence with the privatization of the economy. • The government created these shares to give to the company employees. • Designed to protect their current and future interests.

7. Preferred Share Payout Rules • Minimum dividend set equal to a fraction of the firm’s earnings. Typically 10%. • Minimum dividend must at least equal that paid to the common shareholders. • Protection against splits, and similar actions.

8. chad Voting • At the very least preferred shareholders are allowed to vote on . . . modifications or amendments to the Charter may affect the rights and interests of the first issue Preferred Stock owners . . . the decision has to be ratified by those owning two thirds of the Preferred Stock . . . Surgutneftegaz Charter • Other firms pool votes from the common and preferred.

9. Data Source • Moscow Interbank Currency Exchange (MICEX) • Trading begins in March 1997. • By December 1997: Listed 50 stocks from 33 different companies.

10. MICEX Growth Over Time • Equity trading on MICEX accounted for 53% of all equity trading in Russia in 1999. • By December 1999 MICEX listed 174 stocks by 112 issuers. • In 2000, transactions on MICEX reached 472 billion Rubles a six-fold increase against 1999.

11. Russian Trading System (RTS) • The RTS Stock Exchange is an electronic trading floor established in 1997. • Presently, RTS lists and trades all Russian blue chips and many regional firms.

12. The Puzzle • Why do Russian preferred shares typically sell for substantially less than the common? • The preferred are guaranteed cash flows at least equal to the common. • The preferred are guaranteed at least 10% of the firm’s profits. • The preferred get to VOTE.

13. How Important are Preferred Shares in Russia?

15. Russian Exchanges Dominated by a Few Large Firms 1. Unified Energy System (EESR), 2. Lukoil Holdings (LKOH), 3. Norilsk Nickel (NKEL), 4. Rostelecom (RTKM), and 5. Surgutneftegas (SNGS). All have preferred and common shares on both the Russian and U.S. stock exchanges (the latter via ADRs). As of October 25, 2001, common and preferred shares of these firms accounted for over 53% of the RTS index’s market capitalization.

16. Can Liquidity Explain the Price Discrepancy?

17. Liquidity Continued

18. Can Corporate Governance Explain the Price Discrepancy? • Paper builds two simple models of expropriation and calculates the parameters needed to explain the current observed price discrepancies. • General Properties: Perpetual growth models, with a constant discount rate.

19. An Aside on Control • Perhaps the preferred should have a control premium? • The following appears to be perfectly legal: • Buy up all of the preferred. • Buy up 50% of the common (25% for some companies). • You now have 50% of the votes • Vote all future dividends to the preferred. • Score One for the Preferred!

20. Model 1: Value Expropriation • At some date T the common will take some fraction α of the preferred’s value. • Free parameters: • r = interest rate • α = level of expropriation • g = growth rate • T = expropriation date. • Fix r and α to reasonable values and then see if reasonable values of g and T will fit the data.

23. Expropriation via Takeovers • In year T a takeover of the company will occur. • The bidder will offer the common shareholders a premium m times the value of the future cash flows. • The preferred shareholders will earn none of the premium. • Free variables: T, g, m, and r. • Table lists fitted values of T and g, given m and r.

24. Historically How Frequent are Mergers in Russia? • 1995 0 • 1996 1 • 1997 1 • 1998 2 • 1999 4 • 2000 0 • 2001 1 • 2002 5 • -------- • TOTAL 14

29. Conclusions • Differences in common and preferred share prices unlikely to be explained entirely by either: • Liquidity • Corporate governance • Possible additional explanations: • Law of one price (a conjecture) may not hold. For example – Spiegel (RFS 1998). • Behavioral model of some type.