1 Mikalkree

Asset Stripping Case Study

"I'm going to tell you a war story-my war story," opened Browder. " It's one that involves Gazprom, Itera, and PricewaterhouseCoopers. But I'm not a diplomat so this won't be diplomatic," he cautioned. As an investor, he says he looks to find companies whose stock is cheap, and Gazprom is "by far the cheapest oil and gas company in the world," if one divides the value of the company by its total reserves.

Because the market discounts virtually the entire value of Gazprom with the assumption that 99% of its assets are stolen, Gazprom's reserves trade at 10 cents for energy equivalent to one barrel of oil. (Exxon Mobil's reserves, by way of comparison, trade at $13.80 per barrel.) Eighteen months ago, deciding he needed a better understanding of the factors underpinning Gazprom's undervaluation, Browder dug around a bit using public information and found that the stealing was "so brazen" that Former CEOs Rem Vyakhirev and Viktor Chernomyrdin and others transferred assets openly to members of their family. "The arrogance was so extreme that there was no cover-up whatsoever," Browder remarked. "But that was helpful to us, because it enabled us to paint a very accurate picture of what had been stolen."

In October 2000, Browder's investigation pinpointed seven dubious transactions that stripped enormous value away from Gazprom. These seven companies - Purgaz, Rospan, Tarkosaleneftegaz, Sibneftegaz, Achimneftegaz, Vostokgaz, and Severneftegazprom - were worth $5,805 million to Gazprom, but were sold away for a total of $325 million between 1997 and 2001, a lost value of 5,480 million dollars. In losing these assets, Gazprom lost just under 10% of its total reserves, a quantity comparable in size to Exxon-Mobil's entire reserves worldwide.

So, Browder discovered that though the markets perceived that 99% of Gazprom's assets had been stolen, in reality only 10% had been. Browder said he was impatient "for perception to catch up with reality," since the good news was likely to increase Gazprom's share value and decided to speed along the process. His findings were published and shared with other Gazprom shareholders, with members of the Gazprom board, as well as with journalists from five publications [Business Week, The New York Times, Financial Times, The Wall Street Journal, and The Washington Post], each of whom went on to run stories between October 2000 and February 2001 exposing large scale graft by the company's managers and their relatives.

Mobilized by the ensuing public outrage, Gazprom investors in December 2000 called for an independent audit to examine the evidence of asset stripping and to assess the murky relationship between Gazprom and Itera, a Florida-registered gas trading company. The investors further proposed that an outside firm, Deloitte and Touche, be given the task, rather than Gazprom's internal auditor, PricewaterhouseCoopers (PwC).

Incensed, Gazprom management rejected the call for an independent audit and consented only to a confidential PwC audit. That audit was presented to the company's board alone in June 2001, though the report was subsequently leaked. Using excerpts from that report, Browder gave five examples to illustrate the patent misconduct by Gazprom executives for the benefit of Itera, whose assets ultimately must have accrued to the executives themselves, as well as the absurdity of PwC's economic evaluations.


1. The Purgaz Joint Venture
Gazprom, in 1998, had put 381 billion m3 of reserves into Purgaz, a joint venture with Itera, which received a 49% stake in return for nothing concrete, only the promise to contribute future funding. The next year, Gazprom sold an additional 32% in Purgaz to Itera for the ridiculously low price of $1,200. In its report, PwC valued Purgaz at $1,768 million, meaning 32% of that would be worth $566 million--exponentially more than the price Itera paid.

PwC, however, concluded on page 32 of its report that it was "difficult to evaluate the [Itera purchase of Purgaz] transaction from a commercial point of view due to the absence of comparative information regarding the acquisition of Russian gas fields, noted Browder incredulously. Earlier in the report, PwC says it was "significant cash shortages" that forced Gazprom to let Itera and other companies obtain stakes in the companies holding licenses for gas reserves. But that avoids the more revealing, fundamental problem: transfers from Gazprom to Itera, totaling $616 million in 2000, caused the cash shortages. "Gazprom was a poor company only because it was making Itera rich," explained Browder.

2. A Siberian Scam
The Gazprom/Itera Yamal-Nenets tax scam, whereby Itera drained even more cash--on the order of $5.53 billion--from Gazprom between 1997 and 2000, is another example of flagrant impropriety on the part of Gazprom's managers. It worked in this manner: Gazprom owed significant back taxes in the Yamal-Nenets region in northeastern Siberia and gave gas valued at $2-$4 per 1000 m3 to the tax authorities there as payment in kind for its arrears. Yamal-Nenets, needing something to do with such huge quantities of natural gas, then contracted to transfer the gas at that same price to gas trader Itera, which sold the gas on the CIS market at the going price, between $30 and $90 per 1000 m3.

Had Gazprom sold the gas on the market in the first place, revenues from just 5% of the gas it ultimately gave to Yamal-Nenets would have covered the $341 million in taxes it owed. The remaining 95% could have been sold for a profit of $5,527 million, which begs the question of why the company would deny such a profit opportunity, if not for the managers' personal financial interest.

In the face of this compelling information, PwC, incomprehensibly in Browder's mind, again equivocated, concluding that Gazprom actually benefited from this arrangement because they saved scarce cash resources and would have been forced to raise debt financing when the interest rate reached 50%. But that defies basic economics, said Browder. Interest rates would have had to reach 1600% to justify selling gas at $2-$4 per 1000 m3 instead of borrowing money.

3. Negotiations with Niyazov
In Browder's third illustration of Gazprom's misdealings and PwC's misjudgment, Gazprom CEO Rem Vyakhirev negotiated in December 1999 with Turkmenistan's president Niyazov on behalf of Itera. Under their agreement, Itera bought Turkmen gas at $35.4 per 1000 m3 and resold it to Gazprom at $45 per 1000 m3, reaping an $87 million profit. PwC determined that this was roughly equal to Itera's transportation costs, and thus Itera's profit was negligible. The truth, Browder stressed, was that Gazprom reimbursed Itera for its transportation costs by a separate agreement so Itera simply pocketed the money.

4. Exports to Belarus
Itera, furthermore, was the recipient of two gifts from Gazprom, for which it gave no compensation whatsoever. The first, 35% of the Belarusian gas market-the third largest in the CIS, one worth $500 million a year-accounted for a $99.7 million annual loss to Gazprom. PwC declared that the profit margins for operations in Belarus were of little significance, making this an inconsequential gift, but Browder, using Audit Chamber information, claimed that Itera sold its exports to Belarus at a staggering 57% margin.

5. Diluted Ownership
The second gift, the gift of Tarkosaleneftegaz, worth between $247 million and $896 million took place over the course of several years, during which time Gazprom, reluctant to ante up further funds, allowed its ownership stake to be reduced by almost 40% by non-participation in all but one in a series of new share issues. [For more information, please see Browder's graphs, by clicking here] Those rights issues that Gazprom opted out of would have cost a total of about $8 million. The sole one in which Gazprom did choose to participate cost the company $65.5 million, or eight times more. Gazprom sold 16.2% of its share, ostensibly to avoid future obligation of financing for the project, though despite the massive inflow of capital that occurred with each share issue, Tarkosaleneftegaz executives say they don't have sufficient capital to operate successfully. Said Browder, "This is shocking stuff, even to jaded, post-Enron eyes."


In light of this evidence, Browder had the following recommendations for the Russian government, which could exert considerable influence through its 38% controlling stake in Gazprom:

1. Immediately reopen a forensic audit of Gazprom's transactions, using an auditor other than PwC and including non-Itera asset stripping;
2. Sack PwC as Gazprom's official auditor at the upcoming annual general meeting and replace the firm through a transparent tender procedure;
3. Launch an international lawsuit against PwC for malpractice;
4. Improve audit legislation by introducing better rules governing auditors' behavior and by strengthening regulatory bodies;
5. Set up an interdepartmental government task force to retrieve Gazprom's (i.e. the state's) lost assets, fire Gazprom managers found to be accountable for the losses, and/or prosecute them.

At Gazprom's next annual general meeting, Browder said he intends to make use of Russia's joint stock law which gives him, as a shareholder with at least a 2% stake, the right to add any item to the agenda. He would like to see the Board of Directors:

1. Adopt Russia's new Corporate Governance Code as the code for Gazprom itself;
2. Amend the Charter to give Board of Directors oversight of asset transactions;
3. Further amend the charter to allow the Board to initiate any audit of any transaction it chooses and create a subcommittee to supervise all audits;
4. Give the Board purview over all of Gazprom's financial activity - all lending, all borrowing, all encumbrance;
5. Replace PwC with a new auditor chosen by a transparent tender procedure.

Browder told the audience in Washington that later that day, he hoped to encourage U.S. government officials he was meeting with to implement these recommendations:

1. Cease to fund-and thereby condone-Itera. (The U.S. Trade and Development Agency has given a $868,000 grant to Itera.)
2. Pressure PwC to withdraw from the Gazprom account, leveraging the USAID funding PwC receives for technical assistance programs in India, Morocco, and elsewhere;
3. Launch an SEC investigation into misleading financial statements affecting U.S. American Depositary Receipts (ADRs) for which PwC's accounting failures are responsible;
4. Open a Justice Department investigation into Itera's activity in the U.S. on the basis of the Foreign Corrupt Practices Act;
5. Pressure the Russian government to bring transparency to Gazprom, using Russia's membership in the pro-transparency organizations like the World Bank, IMF, European Bank for Reconstruction and Development (EBRD), etc.

Despite the unflattering publicity generated by Browder's better-corporate-governance campaign, Gazprom's share price has risen steadily, he maintained, to about $6 a share, and will only continue to climb as greater transparency is achieved.

Q & A

Asked how to quantify for the Russian government the benefit of positive changes and thus motivate it to take action, Browder said that, were Gazprom to be valued properly, the government's 38% share would be equivalent to all the debt it owes to creditors. Though it is an economic actor by virtue of its position on the Gazprom board, the Russian government doesn't behave as such, responding instead to political incentives not to rock the boat. Officials worry that if they do, they'll lose their jobs.

This is where media exposure and American influence can help, he thought. If Putin, whom Browder characterized as "risk-averse," can tell Gazprom managers, "Look, sorry, I don't have any choice here," he can deflect some of the resentment for the changes away from himself personally. Browder recounted that German Gref, the Trade and Development Minister, seemed "glad to have the Business Week article ["Russia's Enron? Gazprom and PricewaterhouseCoopers Are Under Fire," February 18, 2002] to wave around in meetings." And Alexei Miller, whom Putin appointed last May to replace former CEO Rem Vyakhirev, "is a good guy with a gigantic [restructuring] task that dwarfs him and needs all the help he can get." The markets will "absolutely reward" Gazprom for greater transparency, Browder argued.

On the Europeans' role and ability to exert influence, Browder gave the example of the German company Ruhrgas, which gets approximately 25% of its gas from Russia. Browder said he was told by a German diplomat that Germany cares about nothing other than the safe supply of gas to the country and sees no interest in shaking matters up.

Browder agreed with CSIS's Sarah Mendelson that Western governments have been aware of this, yet have done nothing about it, calling it a maddening "conspiracy of silence." PwC accountants in London "whitewashed" the audit, likely in order to keep its client happy, and in so doing, keep the $13 million in Gazprom fees it receives each year--a story parallel to Arthur Andersen and Enron. "All accounting firms do the same," said Browder, and will continue to until the rules are strengthened to the point that firms are scared to sign off on anything shy of the full truth for fear of the consequences. There is no incentive, currently, for accounting firms to stand up to company executives.

On Itera, Browder said its grant from the U.S. Trade and Development Agency confers upon it a certain legitimacy and never should have been given, especially when the EBRD had previously refused a loan to Itera until the company's ownership was clarified. Having recently lost Purgaz, whose acquisition is detailed above and which accounted for 70% of Itera's production capacity, Itera lost a key cash flow asset and is "on the ropes right now," said Browder, "but they still have a lot that they stole."

In terms of facilitating better corporate governance, Browder thought that the teams of international specialists sent to Russia by international organizations like the International Finance Corporation (IFC) and EBRD would have a much greater ripple effect if they were assigned to work with Gazprom rather than with myriad small, $10 million companies. Russia and the international community could-and should, contended Browder-use Gazprom as a very visible demonstration of their commitment to transparency reforms.

Summary by Caroline McGregor, Junior Fellow, Russian and Eurasian Program.

End of document

About the Russia and Eurasia Program

The Carnegie Russia and Eurasia Program has, since the end of the Cold War, led the field of Eurasian security, including strategic nuclear weapons and nonproliferation, development, economic and social issues, governance, and the rule of law.

Section 2 of Chapter V of the AIFMD imposes obligations on AIFMs managing AIFs that acquire major shareholdings in, or control of, non-listed companies and issuers, such as notification of acquisition, disclosure requirements, annual reporting requirements and restrictions on asset stripping. In particular, Article 30 imposes restrictions on distributions by EU portfolio companies during the first two years following acquisition of control. These asset-stripping provisions may potentially cause deal-structuring issues and are the focus of this analysis.

More specifically, if an AIF acquires control of a non-listed EU company, for a period of 24 months following the acquisition it cannot facilitate or support any dividends, capital reduction, share redemption or share buy-backs which:

  • reduce the net assets of the company below its subscribed capital plus its non-distributable reserves; or
  • exceed the amount of the company’s cumulative realised profits plus other distributable reserves, less the aggregate of any cumulative losses and other non-distributable reserves.

These restrictions are subject to some limited exceptions. In particular, the asset-stripping rules do not apply if the controlling influence is acquired in a small or medium-sized company (defined as companies which employ fewer than 250 people, have an annual turnover not exceeding EUR 50m and/or annual balance sheet not exceeding EUR 43m). Exceptions also apply to vehicles involved in purchasing, holding and administrating real estate. Also, these rules do not apply to any distribution, capital reduction, share redemption or acquisition of own shares made by a non-listed company that has its registered office outside of the EU.

Practical impact

From a practical standpoint, the asset-stripping rules would be relevant if a transaction such as a dividend recapitalization, refinancing, merger or reorganisation of a portfolio company took place within two years following the date of acquisition of that company by AIFs. This is because such transactions often involve, or are shortly followed by, a distribution, capital reduction or acquisition of own shares by the portfolio company.

What is important though is that the AIFMD rules do not contain a blanket prohibition on such transactions per se. But these new asset-stripping rules should always be kept in mind by AIFMs managing AIFs and their legal advisors when planning and structuring the above-listed transactions. With the proper planning, we believe it should often be possible to structure and implement a proposed transaction without contravening the asset-striping rules. For example, a distribution of cash/assets to the shareholders should not be caught by the rules if it is implemented by means of the repayment of the shareholder loan. Thus inserting a shareholder loan into a company’s financing structure is likely to provide more flexibility than the standard equity instruments (such as preference shares).

Furthermore, there is no statutory definition of the term “capital reduction”. Thus it is currently unclear whether such term refers only to a reduction in the nominal value of a company’s registered share capital or would also include a reduction in a company’s share premium account (or similar accounts such as account 115 in Luxembourg). Therefore relevant analysis, including the legal analysis of the domestic company law of the portfolio company’s jurisdiction, is necessary.

Last but not least, the rules provide that AIFs must use their “best efforts” to prevent any prohibited transaction from taking place during the requisite period and do not provide that such obligation ceases to apply upon the private equity firm disposing of its shares in the relevant company.


To conclude, while we do not expect that the asset-stripping rules will limit the freedom of AIFMs managing AIFs in any significant way, it is important that such rules are kept in mind when planning and structuring an acquisition of the target. This is simply to avoid the situations where portfolio companies are prevented from carrying out a proposed transaction that, with the appropriate preparation, would have been otherwise feasible.

It is important to point out that a breach of these rules should generally have an impact on the validity of a distribution, capital reduction, share redemption or acquisition of own shares from a company law perspective. Nevertheless, failure to comply with the asset-striping provisions can result in the variation or cancellation of an authorised person’s permission to carry on regulated activities or the imposition of additional requirements. Theoretically, this could lead to the AIFM losing the required permissions to manage the AIF or have additional requirements placed on their conduct. Last but not least, it could also lead to significant reputational damage for a given AIFM.

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