Russian oil giant Lukoil’s attempt to buy out the minority shareholders of Chaparral Resources, Inc. (CHAR.OB) raises serious concerns about shareholder rights and the treatment of outside investors by the first Russian company to list on the London Stock Exchange — one that claims to be a model for openness and transparency.
Over the last few years, Lukoil, described by many observers as an extended arm of the Kremlin, has tried repeatedly to expand its operations in Kazakhstan, which it views as strategically important for its vast oil reserves. Last year, it lost the $4.2 billion takeover battle of Canadian PetroKazakhstan to the Chinese National Petroleum Company. In the heat of that fight, it bought another player in Kazakhstan’s oil industry, Nelson Resources, and thereby acquired a stake in CHAR, which it eventually raised to a 60% majority. Following its defeat in the PetroKazakhstan saga, Lukoil has taken on an easier target: the minority shareholders of CHAR.
While it is not surprising that Lukoil seeks to consolidate its presence in Kazakhstan, it is the tactics it employs that raise eyebrows among U.S. investors. Minority shareholders have a tough stance anywhere in the world, but when U.S. minority shareholders and a Russian company are involved, two extremes come together. Shareholders would not even know the whole story, had it not come to light through a class action lawsuit against the buyout. Lukoil’s managers seem to have been unaware of the remarkable powers enjoyed by plaintiffs in the U.S. to compel the release of internal documents during discovery, as they left an extensive paper trail. Frank Quattrone’s infamous e-mail instructing employees to ‘clean up’ their files sounds harmless and innocent compared to the unambiguous and direct language in documents released through Chaparral’s proxy materials.
During the preparation of the 10-K in early 2006, a Lukoil executive instructed Chaparral in internal e-mails to “add something a little negative to the report” and complained that it conveyed a “positive impression” and used “positive words.” To make sure that investors got a negative impression, he also suggested the deletion from a press release of production data that showed growth. In fact, production had been a major drag on CHAR’s stock price for a few months, because drilling of new wells had been suspended at the end of 2005 when the lease on the CHAR’s only drilling rig on the Karakuduk oil field expired. The field is operated jointly by Lukoil and CHAR. However, the expiration of that lease was caused deliberately by Lukoil, which refused to renew the lease contract, even though the rig’s owner kept urging a renewal. The suspension of drilling had the desired effect: CHAR’s stock price dropped by more than 23%. Investors were told neither that two new rigs had already been lined up, nor that drilling and production would be accelerated later in the year.
With the stock price depressed artificially, Lukoil made a lowball offer for the shares of CHAR’s minority shareholders. Lukoil’s initial bid of $5.50 per share was soon raised to the final price of $5.80 when it became clear that this was a level at which one institutional holder was willing to sell. While CHAR and Lukoil were debating whether $5.50 or 5.80 was the right price, CHAR’s financial adviser indicated that the value of the firm in the $8-$11 range.
Even though it exploited the Karakuduk field jointly with CHAR, Lukoil executives regarded it as theirs. In an email, the CFO of CHAR talks of Lukoil’s regional director for Kazakhstan, Boris Zilbermints, making “noises” about payments from the oil field to CHAR, which “is letting the minority shareholders receive funds.” Presumably, this is an example of what a CHAR director describes in another email as “the Russian way of doing business.” So are some of the other scare tactics used by Lukoil.. It threatened to shut-in the Karakuduk field if no deal were reached, or to cease development or fire the board of directors.
This is not to say that firing the board of directors would have been a bad outcome. A committee of two independent directors had been created to lead the negotiations with Lukoil, as is standard practice in mergers, with a mandate to represent shareholder interests. At least one of the two directors on the committee, however, appears to have had more concern for Lukoil’s interests than for those of shareholders. He leaked the valuation range that CHAR’s financial adviser had calculated to Lukoil, so that CHAR was negotiating with a buyer who knew the price range of the seller. The two directors appear to have been well aware of the problematic nature of the buyout, as they negotiated a highly unusual clause in their indemnification agreement: if there is a lawsuit in connection with the merger, they will be paid $300 per hour for time spent defending themselves. In other words, the less they represent shareholders, the longer the lawsuits will be, and the more they get paid.
The big question is: why does Lukoil bother going to such great lengths to strongarm minority shareholders? Chaparral is a $200 million company of which Lukoil owns 60%, so that the buyout is costing a mere $80 million. This is small change for the world’s second largest oil company by reserves, which posted net profits of approximately $1.7 billion in the first quarter alone. Clearly, it could afford to pay fair value if it wanted, without the need to squeeze outside shareholders to the bone.
Lukoil’s actions can only be explained by culture. As in many other emerging markets, Russian companies have an appalling record of treating minority shareholders, and Lukoil is exporting this standard to the U.S. market. Add to this a few ambitious regional and divisional managers seeking to impress their superiors with clever financial maneuvering. In a 2003 presentation posted on Lukoil’s website, Lukoil’s regional management for Kazakhstan boasts of its skill at buying assets low and selling high – they are sure to get top grades in that subject due to their Chaparral dealings.
For any large corporation, it is easy for top executives to tout their firm as a modern, shareholder-friendly company with good governance. But it is much harder to get B and C-level executives to act in that spirit. In Lukoil’s case, middle management actively torpedoes the tone set at the top, and sooner or later it will lose any credibility with investors. And it is a mystery how exactly Lukoil intends to build a brand name for its gas stations in the Mid-Atlantic while establishing a reputation of abusing shareholders. What money they save on the CHAR purchase today will not be enough to fix their reputation in the future.
With Lukoil guaranteed to vote its 60% stake at the September 29th shareholder meeting in favor of selling CHAR to itself, the fate of Chaparral’s minority shareholders is now in the hands of the Delaware courts. Class action lawsuits are often vilified, but if you are a holder of Chaparral, it is your only shot at getting a fair price for your shares.