ADRs: Recovery by Remote?

Western fund managers are tired of hearing that Russia's equity market is "a golden opportunity," "a boom waiting to happen," "the most promising emerging market in the world." On the one hand, say industry experts, large institutional investors -- pension and insurance funds -- are increasingly opting to invest in emerging markets. During 1995, the emerging market exposure of these financial giants ballooned to 8 percent of their total investments. But on the other hand, a mere 0.5 percent of all their emerging-market investments hit the market on everybody's lips -- namely, Russia.


Western fund managers are also tired of explaining the apparent anomaly. The Russia mantra has grown stale because Moscow's stock market infrastructure -- facilities for trading equity and recording changes in ownership -- remains painfully underdeveloped. Although 1995 saw considerable progress, most Western investors have never been convinced they can hold onto the shares they have bought.


Warsaw and Prague boast formal stock exchanges, with legislation modeled on the Paris bourse. Moscow is different. Transaction costs are high and there are few formal regulations. The tight Moscow trading community protects itself mainly by self-selection: A reputation for not honoring your prices can be fatal.


Local unwritten rules may work for a time, but formal regulations have to be satisfied before Western regulatory agencies -- such as the U.S. Securities and Exchange Commission, or SEC -- will allow institutional investors to sink big money directly into the Russian market. Since November 1994, constantly ducking political shrapnel, Russia's Federal Securities Commission has worked to establish international standard "settlement" and "custody" procedures -- so share purchasers can be sure to both receive and maintain their equity. Huge steps have been taken, but the speed with which Russia's market has developed has meant that huge legislative holes remain.


The pension and insurance funds, meanwhile, have been growing impatient. Everyone is talking about Russia's undervalued blue-chip bargains. And only the most powerful investors can hope to extract the necessary "no-action" letter from the SEC, allowing them to take the plunge.


This is why the use of "synthetic" equities has emerged in Russia -- known as American Depositary Receipts (ADRs) or Global Depositary Receipts (GDRs), depending on your geographic preference. ADRs are a "derivative" -- that is, an investor does not make actual share purchases, but buys a claim on a fund which brings the exact dividends and losses as the underlying shares which it represents. ADRs allow foreigners to invest in Russia by remote control. The shares stay where they are, avoiding the hassle of Russia's unreliable settlement procedures. Yet by using at least one -- and often several -- reputable Western intermediaries, Russian companies can tap into the savings of Moms and Pops from Manhattan to Missouri by issuing ADRs.


In September 1995, with a nod from the SEC, the electricity monolith Mosenergo became the first Russian company to issue ADRs. The company raised $22 million by selling 2.5 million ADRs -- accounting for 3 percent of its total equity. Since then, such sought-after stocks as LUKoil and Seversky Tube Works have followed their example. And Inkombank, Unified Electricity Systems, Chernogorneft and Norilsk Nickel, among others, have ADR issues in the pipeline.


The benefits to the issuing company are obvious. LUKoil shares jumped from $4.10 to $5.90 on their ADR issue. Although Russian firms have so far only succeeded in issuing Level One ADRs -- allowing them to trade existing stock, rather than issue new equity -- ADR issues still bring immediate financial benefits. And Russian companies providing accounts to international standards may soon be able to float Level Two and Level Three ADRs, allowing new issues of equity overseas.


ADRs represent an early step by Russia's corporate elite to full multinational status. A similar process is happening in Latin America -- Mom and Pop investors are well used to buying ADRs issued by Telemex, Mexico's largest telephone company. Certainly, in the words of one of Moscow's most experienced traders: "ADRs break the Russia taboo."


But ADRs are still only as good as the underlying shares they represent. Although they get around local settlement problems, they do nothing to deal with instances of share dilution -- where new shares are issued without permission, devaluing the stakes of existing investors -- or other types of "minority bashing." Despite using ADRs, many of the big institutional investors -- and the Moms and Pops they carry with them -- still fret, and probably with good reason. Horror stories about share revocations linger in the collective memory. A colleague of the trader above said of ADRs: "same problems, different packaging."


There are other, more hidden, problems with ADRs, relating to that ever-present Russian headache -- tax. Russia's securities market is a taxation quagmire. Faced with settlement and custody obstacles, taxation risks do not come into the banter of most Muscovite traders. But holders of ADRs could find themselves presented with large capital gains liabilities. Because capital gains are treated as profit in Russia, this puts the bill at 15 to 25 percent of the upside. In the past, investors have been charged 15 to 25 percent not of the gain, but of the price of the entire trade. Thankfully, this official malpractice seems to be on the decline.


But another tax-time bomb awaits. If the Russian government gets serious about raising revenue from the stock market a "retroactive capital gains" effort could land financial intermediaries with huge tax liabilities. Not only would institutional investors be liable for their capital gains, but also for those of all the investors who had held a share since it was first issued. Driving this danger of "pooled risk" is that lack of a clear audit trail in Russian security trading. Powerful Western investors would be loathe to cut into their profits by paying the extra tax themselves. This would mean, presumably, a shock for Mom and Pop.