1 3rd Eurasian Corporate Governance Roundtable Shareholder Rights, Equitable Treatment and the Role...

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3rd Eurasian Corporate Governance Roundtable

Shareholder Rights, Equitable Treatment and the Role of the State

April 17-18, 2002

hosted bySecurities and Stock Market State Commission of Ukraine

State Property Fund of UkrainePFTS

with the support ofThe Government of Japan

The GlobalCorporate Governance Forum

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Gazprom gifts to ITERAReview of PWC Audit of Itera

By

Mr. Vadim Kleiner Hermitage Capital Management

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Outline of PresentationIntroduction of the problemAnalysis of PWC conclusion Recommendation

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Introduction to the Problem

In October of 2000, Hermitage Capital Management investigated and discovered a number of dubious transactions that stripped value out of Gazprom:

G a z p ro m

C o m p a n y D a teM a rk e tV a lu e ,

m ln U S D% lo s t

P ric e p a id ,m ln U S D

V a lu e o fs ta k e ,

m ln U S D

L o s t v a lu eto G a zp ro m ,

m ln U S D

% o f to ta lG a zp ro mre s e rv e s

P u rga s 1 9 9 8 -1 9 9 9 2 ,5 3 5 * 8 1 % 2 7 5 2 ,0 5 3 1 ,7 7 8 1 .2 5 %

R o s p a n 1 9 9 7 -2 0 0 1 9 5 4 5 1 % 2 6 4 8 7 4 6 1 1 .6 2 %

Ta rko s a le n e fte ga s 1 9 9 7 -2 0 0 1 7 8 0 3 8 % 1 6 2 9 8 2 8 2 1 .3 3 %

S ib n e fte ga s 1 9 9 9 5 3 0 3 5 % 0 .3 1 8 6 1 8 5 1 .0 4 %

A c h im n e fte gas 2 0 0 0 5 9 6 4 9 % 2 9 2 2 9 2 1 .1 6 %

V o s to kga s 1 9 9 9 5 0 3 4 9 % 2 4 7 2 4 7 0 .9 8 %

S e ve rn e fte gas p ro m2 0 0 0 -2 0 0 1 2 ,5 2 3 * 8 9 % 1 0 2 ,2 4 5 2 ,2 3 5 2 .2 6 %

T otal 1 9 9 7 -2 0 0 1 3 2 5 5 ,4 8 0 9 .6 5 %

Source:Weighted estimates of PWC and reserve-based valuations.

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Hermitage Investigation

The findings were exposed to a number of shareholders, board members and international and domestic media organizations:

Media Date Key Facts Exposed

Business Week October 2000 "Gazprom has sold shares at below market prices,as well as $1 bln in annual contracts to Stroytransgaz,…owned by Gazprom managers and their relatives"

New York Times October 2000 "..there are indications that company assets are being transferred to subsidiaries,… for the benefit of management" "Gazprom transparency is close to zero. How long can this continue?" " .. Company owned by Mr.Vyakhirev's brother, Gennadi I. Vyakhirev bought 5 persent [in Sibneftegas], for a price equivalent to less than a penny for a barrel of oil [reserves]"

Financial Times November 2000 "Gazprom has been awarding large contracts to a company which is majority owned by the relatives of Gazprom's …management"

Wall Street November 2000 "In the past two years, Gazprom has quietly shuffled roughly two trillion cubic meters of gaz reserves into ventures … owned by Itera"

Washington Post February 2001 "Gazprom … has transferred hundreds of millionsof dollars in assets while signing … deals with a firm largely owned by Gazprom's directors…"

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Origination of Audit of those transactions

Step 1 Step 2 Step 3 Step 4 Step 5

As a result of public outrage, investors pushed for an explanation of those transactions

Analysis and

Exposure of dubious

transactions

10.11% shareholders of Gazprom called for independent audit of

assets stripping using new auditor (Deloitte & Touche instead of

PWC)

Gazprom management

rejected call for independent

audit by Deloitte &

Touche

Board of Directors of

Gazprom appointed PWC to audit alleged

relationship with ITERA

Oct-Dec Dec Dec Jan Jan-Jun 2000 2000 2000 2001 2001

Audit undertaken

by PWC

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PWC was asked to look at number of issues

The basis for business between Gazprom and Itera:

• Did Itera pay a fair price for assets?• Analysis of Yamal-Nenetsk and Nadym tax payments• Justification of Gazprom - Itera business dealings• Analysis of alleged asset stripping for Itera benefit

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Highlights

1. Gazprom ‘gift’ of Purgas to Itera

2. Yamal-Nenetsk & Nadym tax scam

3. Vyakhirev negotiating with Turkmenistan on behalf of Itera

4. Gazprom ‘gift’ of Belorussian market to Itera

5. Gazprom ‘gift’ of Tarkosaleneftegaz to Itera

6. Summary of lost reserves

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Background Itera purchase of Purgas:

• In 1998 Gazprom put 381 bln. m3 of reserves into joint venture with Itera named Purgas (51% vs. 49%);

• Itera received 49% without any meaningful consideration;

• In 1999 Gazprom sold another 32% in Purgas to Itera for $1,200 only;

• PWC valued Purgas at $1,768 mln. (PWC report: p.30), which implied a value of $566 mln. per 32%.


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PWC conclusion on Itera purchase of Purgas :

• It is difficult to evaluate those transaction from the commercial point of view due to the absence of comparative information regarding the acquisition of Russian gas fields (PWC report: p.32)

• Significant cash shortages forced Gazprom to let Itera and other companies to obtain stakes in the companies which held licenses for gas reserves (PWC report: p.21)


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Economic Analysis: Cash shortages were caused by transfers from Gazprom to Itera

Receivables$386 m

Receivables$104 m

Loans $22 m

Loans $35 m

Guarantees$140 m

Guarantees$195 m

$0

$100

$200

$300

$400

$500

$600

$700

1999 2000

MillionUSD $266 m

$616 m

up 132% or

$350 m

Total amount of financing provided by Gazprom to Itera

Source:PWC investigation of Gazprom - Itera relationship; PWC 2000 audit of Gazprom; Audit Chamber report on Itera, 2001.


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2. Yamal-Nenetsk and Nadym tax scam

Background: The tax “scam” Gazprom entered into with Itera drained even more cash from Gazprom

Year Gazprom closed its tax arears in

kind

Gasprom would get at average

CIS price

Foregone profit

1997 $16 mln $143 mln $127 mln

1998 $160 mln $1,847 mln $1,687 mln

1999 $92 mln $2,006 mln $1,915 mln

2000 $73 mln $1,872 mln $1,799 mln

Total $341 mln $5,868 mln $5,527 mln

G azp ro mY am al-

N en e tsk taxau th o r itie s

Ite ra M arket$ 2 - $ 4 p er1 ,0 0 0 m 3

$ 2 - $ 4 p er

1 ,0 0 0 m 3 $ 3 0 - $ 9 0 p er1 ,0 0 0 m 3

Source:PWC investigation of Gazprom - Itera relationship; Audit Chamber report on Itera, 2001.

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PWC conclusion: Gazprom benefited from this arrangement because they saved scare cash resources. Otherwise Gazprom should raise debt financing when the interest rate reached 50% (PWC report: p. 51, p. 2)

Economic Analysis of PWC conclusions:

Interest rate should have had to be 1600% to justify selling gas at $2-4/ thousands m3 vs. borrowing money

2. Yamal-Nenetsk and Nadym tax scam

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T u r km e n istan

G a zp rom

G as G as

$ 3 5 .4 p er1 0 0 0 m 3

$ 4 5 p er1 0 0 0 m 3

Background: • In December 1999 after tough negotiations of CEO of Gazprom

Rem Vyakhirev with President of Turkmenistan S. Niyazov Turmenistan agreed to supply about 10 bln. m3 of gas at about $36 per 1,000 m3

• It turned out that Mr.Vyakhirev was negotiating on behalf Itera which bought Turkmenian gas at $35.4 per 1,000 m3 and further resold it to Gazprom at $45 per 1,000 m3

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PWC conclusion: The price is roughly based on the price paid by ITERA to the Turkmenistan government plus transportation costs (PWC report: p.14)

Economic Analysis of PWC conclusions:• Itera earned about $87 mln. on the transaction negotiated by Gazprom

• Transportation costs were reimbursed by Gazprom by separate agreement

T u r km e n istan

Itera earned

$ 8 7 .4 m

G azp r o mG as9 .1 b ln m 3

$ 4 5 pe r

1 0 0 0 m 3

$ 3 5 .4 pe r

1 0 0 0 m 3

Se pa ra te tra n spo rta t io na g re e m e n t with Ite ra


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Background: Belarus occupies the third place among CIS countries in terms of gas consumption

• Belarus consumes about 16 bln. m3 of gas

• ...valued at about $500 mln. per annum

• Gazprom granted to Itera 35% of Belarus market without any compensation

B ela ru s

4.Gazprom ‘gift’ of Belarussian market to Itera

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PWC conclusion: Profit margins of these operations were hardly of any significance (PWC report: p.61, p.4)


• According to information from reports of PWC and Audit Chamber gas was exported to Belarus at 57% margin

Exploration $2

Transportation$11

price received by Itera

$0

$5

$10

$15

$20

$25

$30

$35

Costs Sale price

USD per 1,000 cubic m

57% margin

$30

$ 99.7 mln annual loss to

Gazprom

4.Gazprom ‘gift’ of Belarussian market to Itera

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Background: Tarkosaleneftegaz intrinsic value is between $112 mln. and $896 mln.

5.Gazprom ‘gift’ of Tarkosaleneftegaz to Itera

Tarkosaleneftegaz valuation

$58.5 mln$112.0 mln

$896.3 mln

0

100

200

300

400

500

600

700

800

900

1000

Last dilutive issue (Apr 2000)

Based on Gazprom $/boevaluation

Based on average Russian$/boe valuation

MillionUSD

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Background: Gazprom being one of two founders of Tarkosaleneftegaz decreased its stake in Tarkosaleneftegaz through a set of controversial new share issues.

46.0%

28.0%

40.0%

23.7%19.0%

7.7%

47.0%

28.6%

40.8%

40.8%

22.0%

9.0%

45.2%

48.0%

29.7%

10.3%

14.1%

7.0%

43.4%

4.6%

0.0%

19.7%14.6%

5.8%3.6%

1.4%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Mar-94 Nov-97 Feb-98 Aug-98 Jun-99 Apr-00

OtherNovafininvestIteraTNG Holding GMBHPurneftegasgeologiaGazprom

Source:FSCM website.


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Background: Gazprom is selling cheap and buying expensive


0.09

9.57

(1.61) (1.26)

(2.61)

(0.04)

-8

-6

-4

-2

0

2

4

6

8

10

12

Mar-94 Nov-97 Feb-98 Mar-Oct-98 Jun-99 Apr-00

Cen

ts $

per

bbl

of r

eser

ves

Gazprom bought Tarkosaleneftegaz

Gazprom sold Tarkosaleneftegaz

Source:FSCM website.

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PWC conclusion: Gazprom allowed its share to be reduced by non-participation in new share issues and direct sale of 16.2% to Itera to avoid taking future obligations on financing this project (PWC report: p. 36, p. 2)


• Gazprom passed five rights issue required $7.9 mln. and participated in one rights issue where they contributed $65.5 mln.

• The new owners lack financing and have been making roadshows to raise capital for last three months with no success


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Background: Gazprom gave up control over 2.9 trln. m3 of its reserves, which comprises 10% of Gazprom total reserves

Yamal-Nenetzk region

ITERA share

Gas reserves, bln m3

Purgas 77% 381Rospan International 51% 493Tarkosaleneftegas 61.6% 403Sibneftegas 51% 315Achimneftegas 49% 354VostokGas 49% 299Severneftegasprom 89% 688

Total ITERA reserves 2,933


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A $325 mln. compensation was paid for control over the total of 2.9 trln. m3 of gas reserves in 7 companies ($0.11 per 1,000 m3 of reserves)


• At the same time, PWC estimated the fair price for Purgas (381 bln. m3) at $1,768 mln. which implies $4.6 per 1,000 m3 (PWC report: p.30);

• Based on this valuation, the total of 2.9 trln. m3 of gas reserves should have cost $13,340 mln., not $325 mln. Itera paid for it.

..the squirrel cannot overweigh the rhinoceros


$ 1 3 ,3 4 0 m ln .

$ 3 2 5 m ln .

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Conclusions

• PWC confirmed assets diversion from Gazprom to Itera

• PWC identified Itera compensation for former Gazprom assets, but did not find anything wrong with it, despite an enormous discount to the fair value of these assets

• PWC did not make any conclusion on whether relations between Gazprom and Itera had commercial nature or resulted in the losses for Gazprom

• PWC failed to address an involvement of Gazprom management and its family members in ownership of Itera

• PWC investigated Gazprom tax payments in kind and did not find anything wrong with it

PWC report mislead the government

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Government Actions

1. Reopen forensic audit of transactions immediately:•new auditor;•include non-Itera asset stripping.

2. Sack PWC as official auditor at AGM and replace with a new auditor under a transparent tender procedure.

3. Launch international lawsuit against PWC for malpractice.

4. Improve audit legislation: •introduce rules and liabilities for auditors’ malpractice;

•strengthen regulatory body overviewing auditors activity.

5. Set up inter department government task force to:•retrieve lost assets;

•fire responsible Gazprom managers;

•prosecute responsible executives.

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Shareholders Actions

Hermitage Capital Management has made the following proposals for

Gazprom AGM to improve the value of the Company:

1. Adopt FSCM Corporate Governance Code of Gazprom

2. Various Charter amendments in order to implement Board of Directors oversight of assets transactions;

3. Charter amendments to allow Board of Directors instigate any audit of any transactions using any audit;

3. Boards oversight over financial activity of Gazprom (lending, borrowing, encumbrance);

4. Set up Audit sub-committee of Board of Directors to control all auditing process in Gazprom;

5. Sack PWC as official auditor at AGM and replace with a new auditor under a transparent tender procedure;

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Recommendations for FCSM

1. Reopen forensic audit of transactions immediately:•new auditor;•include non-Itera asset stripping.

2. Sack PWC as official auditor at AGM and replace with a new auditor under a transparent tender procedure.

3. Launch international lawsuit against PWC for malpractice.

4. Improve audit legislation: •introduce rules and liabilities for auditors’ malpractice;

•strengthen regulatory body overviewing auditors activity.

5. Set up inter department government task force to:•retrieve lost assets;

•fire responsible Gazprom managers;

•prosecute responsible executives.

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Disclaimer

The information is based on data obtained from publicly available sources, which have not been verified by Hermitage Capital Management Limited, or any of its respective associates or affiliates. As a result of the difficulty in obtaining reliable data in Russia, we do not represent this information to be accurate and complete and we do not accept any responsibility for the reasonableness of any conclusions based upon such information.

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