After six months of incubation, the proposal put up by a consortium of Russian banks for a "loans-for-shares" deal with the government has finally become flesh and blood.


The first packet of shares, a 40 percent stake in Surgutneftegaz, a very big Siberian oil company, is due to go on the auction block in November. In the next few weeks, the state's shares in 29 of Russia's biggest and best firms are to follow.


Anatoly Chubais says this selloff will raise 3 trillion rubles ($665 million) by the end of November to fill a few of the holes in this year's budget.


At my first reading, the terms of the sales are not excessively corrupt or unfeasible, which is at least an improvement on the initial proposal made by a consortium of nine banks earlier this year.


Still, the haste of the deal and the eye-glazing complexity of the terms have left little time for scrutiny. The basic shape of the deal has only been clear for a month and the terms of each sale will be hard to control.


What is the "loans-for-shares" deal? Well, it has evolved into something like a futures contract on Russian government shares which operates in two stages.


In Stage 1, the government auctions the right to manage a given parcel of shares to the highest bidder. In return, the winner makes a loan to the state, guaranteed by the shares.


In Stage 2, between six months and three years from now, the winner in Stage 1 sells the shares outright. The Stage 1 winner will have his loan repaid plus a moderate fixed interest rate, and, in addition, will receive 30 percent of the price rise on the shares between Stage 1 and Stage 2.


For example, say you buy the right to manage the Surgutneftegaz shares for $100 million in Stage 1 next month and then in Stage 2, a year later, you sell the shares for $200 million.


You would get back $100 million (your loan) plus $30 million of capital gain plus say $5 million in interest (assuming a 5 percent rate).


Your profit on the deal, $35 million. The Russian government would get to keep your initial payment ($100 million) plus the other $65 million from the sale. Investors will want to study the fine print: The government is not actually guaranteeing the principal or the interest. If the shares drop to $70 million between Stage 1 and Stage 2, the investor loses.


The first question is, why does the government need all this hocus-pocus? Why not just sell the shares at a public auction?


Part of the problem is that, under existing legislation and decrees, shares in many of the companies cannot be sold for specified periods ranging up to three years.


More importantly, almost all the companies are undervalued, and they will be worth a lot more once they are restructured, or at least properly audited. The two-stage process means the investor will have a year or two to make the company ready for sale.


Investors, however, are not happy with the 30/70 profit split which ensures the government will get the lion's share of the upside when the shares are sold. They will presumably reduce their bids at Stage 1 accordingly.


But the government does not seem likely to accept bargain-basement bids. Judging from the minimum price set for the Surgutneftegaz auction, it expects the value of the "loans" advanced at Stage 1 to be close to the current market price. If that is the case, the winners in Stage 1 auctions will probably need to double the value of shares in their companies before they see real blue sky in Stage 2.


Whether they can do this will depend partly on how much power they are given over the companies and their management to do restructuring.


At first glance, the answer is not that much. They can vote on issues like sacking directors and undertaking audits. But they have been prevented from using their shares to vote on issues like liquidation or reorganization of the company, changes to its charter capital or on the sale, mortgage or lease of major assets.


Because of all of these difficulties, some brokers say the most likely way to make money is not in Stage 1 or Stage 2 but in the unofficial Stage 3. Investors will not bother trying to increase the sale price in Stage 2 since they will only get 30 percent of the capital gain. Instead, they will use their insider information to sell the shares at around the Stage 1 price plus interest to a related company. The real profit will come when their buddies resell these shares for the market price. This is a risk but it is not a certainty, providing the government maintains open, fair auction conditions at Stage 2.


In summary, two basic and contradictory risks. Either the terms are too stringent and no one bids, or the terms are an invitation to insider trading and corruption. One group of people likely to do very well out of this deal is the current shareholders in auctioned companies. The government has offered them a very nice incentive. As part of the Surgutneftegaz auction, the winning investor in Stage 1 must make a promise to wipe out Surgutneftegaz's 1 trillion rubles in back taxes.


The government should be prudent, but it cannot expect to squeeze every last cent out of these sales. Government must expect to give investors some reasonable incentive to take part in purchases of state property.


The more serious problem for the whole scheme is that a new president could come to power in July who fundamentally opposes privatization and will overturn all the rules of these very hastily organized schemes. That could throw a real damper on investment.





Geoff Winestock is a Moscow-based correspondent for the Journal of Commerce.