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Journal of Business Studies Quarterly

2013, Volume 4, Number 4 ISSN 2152-1034

Hermitage Fund: Shareholder Activism and Corporate Governance

Amir Manzoor

Hamdard Institute of Management Sciences, Hamdard University, Pakistan

Abstract

In countries with weak judicial systems that can easily be hijacked by influential, investing and

safeguarding the interests of investors is not easy. One such example is Russia. This case focused

on application of shareholder activism and corporate governance besides traditional strategies

of stock picking and timing maximize the returns and safeguard investors. This case is about

Hermitage Fund, an investment fund focused on investing in Russia. The case begins by

describing the Hermitage Fund, the country background of Russia, followed by the corporate

governance crisis in Russia and Hermitage Fund response to this crisis. The last part of the case

discusses the use of activist strategy in response to the corporate governance crisis. The strategy

worked in part by impacting Russian companies' reputation abroad and in part by forcing

regulators into action. However, continuation of such strategy required a rethinking about the

long-term sustainability of the activist strategy.

Keywords: Activism, Shareholders, Corporate governance.

The Hermitage Fund

Hermitage fund was founded in April 1996 as an investment fund focused on investing in

Russia. The Fund was started by William Browder in partnership with Edmond Safra, Chairman

of National Republic Bank. Browder had an MBA from Stanford and prior experience as

management consultant for BCG1 and investment banker for Salomon

2. He was the master mind

behind Hermitage strategy. Browder had distinct advantages over other fund manager operating

in Russia. He had proprietary knowledge about the oil companies operating in Russia which no

else knew. He was one of the very few people who had knowledge about how to invest in Russia.

Browder’s compensation was tightly linked with fund’s success. Hermitage focused on equity

market of Russia and did not engage in other investment services such as investment banking.

The fund had always concentrated on oil and gas sector (see Exhibit 11)

1 Boston Consulting Group. A diverse and global business consulting firm in USA. 2 A global investment banker in USA.

©JBSQ 2013 27

Country Background

Russia went through a wave of economic reforms during 1990’s. Initial focus of reforms

was to decentralize economic power and decision making. Macroeconomic reforms were

followed by microeconomic reforms with a privatization policy (See Exhibit 2). Voucher scheme

received little public attention.3 Loans-for-Share scheme dramatically increased importance of

so-called financial industrial groups.4 Privatization did provide financial supporters for Russian

government in the elections and broke the power of bureaucracy which could have thwarted the

reforms. Privatization was expected to increase efficiency and stimulate financial sector

development. Scholars emphasize that country with deeper financial sector witness high growth

rate of nation. With more developed financial systems, firms dependent on external finance see

high growth.5

Corporate Governance Crisis

But concerns mounted about the decline of government effectiveness and rampant

corruption (See Exhibit 1). A significant source of this concern was the lack of functioning

corporate governance system and institutions. These institutions, such as company laws,

accounting principles, securities regulations, and financial intermediaries (e.g. audit firm and

equity analysts) are present in developed markets to address conflicts between insiders of the

firms and investors. But these institutions either didn’t work as intended or developed slowly in

Russia (See Exhibit 3). Laws and their enforcement proved to be weak. Insiders in the firms e.g.

managers who achieved control through voucher scheme or oligarchs who achieved control

through loan-for-shares scheme took advantage of the situation and used their powers to enrich

themselves. This situation contributed to weakening of other corporate governance mechanisms

(e.g. company charter, company board) because insiders often had the power to change charters

and dominate the corporate boards. Abuse of rules became common practice by insiders of firm.

They manipulated judges to order in their favor or ignored entirely the legal rulings against them.

The toothless Scurrilities and Exchange Commission was unable to enforce compliance with

their rulings and relied upon Russian courts which often ignored or threw out these rulings.

Though litigation in Russian courts was inexpensive but had little prospects for success. Courts

were easily corruptible and, as a result, corporate governance violations were extreme, very

common, and very visible. 6 There was political involvement in corporate cases where

government officials likely took actions against interests of minority shareholders as to support

insiders of firms. The weaknesses in economic and political environment, together with

institutional weaknesses produced a challenging environment for Russian firms. GDP fell and

poverty increased (See Exhibit 12). The situation demanded immediate response from Hermitage

as the largest public equity fund in Russia and for its strong returns in spite of these problems

(See Exhibit 11).

3 Hilary Appel, 1997, “Voucher Privatization in Russia: Structural Consequences and Mass Response in the Second

Period of Reform”, Journal of Europe-Asia Studies, Vol. 49, No. 8, 12, pp. 1433-1449 4 “Political Environment for Global Business - Course Guide- Chapter 5: Privatization in Russia, Poland”

http://www.mega.nu:8080/ampp/PEGB/chap05.htm 5 Ross Levine, 1997 “Financial Development and Economic Growth: Views and Agenda” Journal of Economic

Literature, Vol. 35, No. 2, 6, pp. 688-726 6 Alexander Dyck et al., 2006, "The Corporate Governance Role of the Media: Evidence from Russia"

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Hermitage Response

Hermitage had early success by following a traditional investment approach of choosing

stock. In Browder’s words:

“In these early years, my investment strategy was relatively straightforward and my main

skill was picking stocks. I put together a list of the most important companies as a percent

of GDP and a list of the most important companies on the stock market. When a company

was on the GDP list but not on the market list I saw an opportunity because I believed an

important economic player would eventually become an important stock market player.

The companies that weren’t important stock market players often traded at massive

discounts to Russian companies that were well researched by the brokers.” 7

But the current Russian crisis diminished these returns. Hermitage changed its strategy to activist

strategy (See Exhibit 7). Browder provided some perspectives on activist strategy.

“We take large long-term positions in companies, which are highly undervalued on a

fundamental basis, but often have corporate governance problems. Instead of waiting for

the world to change, we launch our own corporate governance initiatives to unlock their

intrinsic value.” 8 “We use two strategies. If the company acts in blatant violation of

shareholder rights, we embark on a media campaign exposing the problem. We also

conduct thorough research to see if the company is diverting money. These are often

complex questions, but when we relate them we will provide an easy-to-understand

presentation of the facts. We have the expertise and resources to conduct research that

would be beyond most people’s budget. We also have money at stake, and so it makes

sense for us to perform this research.” 9

Hermitage also contacted leading western financial newspapers such as Financial Times and

Wall Street Journal. Hermitage often combined its legal campaign with high-profile lawsuits,

designed to maintain the high profile of the issue in the press as to redress shareholder rights

abuses in the courts. With this new strategy, Hermitage again gained significant increases in its

share price (see Exhibit 11).

The Rise of Activist Strategy

In pursuit of its activist strategy, Hermitage launched campaigns against several

companies in which it had invested. UES (Unified Energy System) announced a restructuring

plan whose primary hidden goal was to sell assets of the company at lower value in a series of

non-transparent auctions. Hermitage launched a public campaign to draw the attention of the

Russian government to potential losses which both the government and minority shareholders

would incur should the initial plan go through. As a result, the Russian government established a

special commission to prepare a new restructuring plan. Hermitage was become member of this

commission (See Exhibit 9).

7 “Media and Corporate Governance in Russia” HBS Case # N2-703-010 8 Media and Corporate Governance in Russia” HBS Case # N2-703-010 9 “Russian Activism and the Press: Is There a ‘Hermitage Effect?’”

http://hermitagefund.com/index.pl/news/download/891/hedgeworld%20june%202007.pdf

©JBSQ 2013 29

In 2001, Sberbank (The Savings Bank of the Russian Federation) management decided to

proceed with a new share issue without granting pre-emptive rights to existing shareholders.

Hermitage together with other minority shareholders initiated a campaign to stop dilution. In the

end, the Russian parliament approved amendments to the Joint-Stock Company Law that

introduced the concept of pre-emptive rights to protect minority shareholders from dilutive share

issues (See Exhibit 8).

The case of Gazprom was the latest. Gazprom was accused of massive asset stripping.

Gazprom largest shareholder was Russian government. Hermitage, together with other minority

shareholders, launched a campaign to address governance problems at Gazprom (See Exhibit 10).

Hermitage also sought a court ruling to invalidate the PricewaterhouseCoopers‘(Gazprom

auditor) audit reports in order to pave the way for a new forensic audit at Gazprom by an

independent auditor.

The Future Direction

The activist strategy was unusual for an institutional investor. In the words of Robert

Chappell, chair and CEO of Penn Mutual Life Insurance Co.:

“Once we lose faith in the management or the trajectory of that company, we sell it. We

are strictly passive. We don’t feel so much engaged or wedded to (a stock) that we’re

going to spend time trying to change its behavior … Is that the right thing to do? It’s a

debate.” 10

Hermitage strategy gained some appreciation. At the same time this strategy was criticized as

well. Not everyone was convinced that this strategy was good for Hermitage investors or for

other minority shareholders. Among the criticisms Browder encountered were concerns about

showboating for his own personal interest, using the media campaigns as advertisement for his

funds, and that returns could be higher without this using this strategy. Alternatives to activist

managers emerged soon. The Russia's Investors Protection Association (IPA) was founded in

April 2000. IPA had support of many fund managers including Hermitage. It was dedicated to

minority shareholders' interests against the predations of Russia's business oligarchs. Headed by

former head of the Russian Securities Commission, IPA had its own members to take up seats in

corporate boards. 11

In the aftermath of Gazprom case Browder needed to rethink his approach.

While Hermitage returns had increased significantly after Gazprom case settlement his strategy

was showing some weaknesses. Browder failed to win seat at Gazprom board. Russian courts

dismissed lawsuits against PricewaterhouseCoopers. There were daily stories of corporate

scandals in USA. It was becoming increasingly difficult to make these Russian corporate

governance issues newsworthy in western media and this could cause decline in his leverage.

Should he continue his activist strategy? If yes, what policies should he follow, and would it

continue to work? Time was running out and he had to quickly come up with the answers to

these questions.

10 “Institutional Investors as a Force for Change” Knowledge@Wharton;

http://knowledge.wharton.upenn.edu/article.cfm?articleid=655 11 RUSSIA - Profile - Igor Kostikov; http://www.allbusiness.com/mining/oil-gas-extraction-crude-petroleum-

natural/617610-1.html , Accessed 15 August, 2007.

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Exhibit 1: Corruption and Government Response in Russia

Source12

12 Hermitage Capital Management (HCML)

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Exhibit 2: Summary of Russian Economic Reforms

Year Event Outcome

1992 Price

Stabilization

Reforms

Price stabilization took longer. Inflation was finally under control by

1995. Government increased reliance on debt to cover its

expenditures. Government’s inability to collect tax revenue led to

budget imbalance, default on domestic debt and massive devaluation

of ruble.

1992-

1994

Privatization-

Stage I

15,000 firms employing more that 60% of industrial workforce were

privatized using voucher method. Later, government sold through

cash sales to domestic and foreign investors as well.

1995 Privatization-

Stage II

Strategic industries e.g. oil and gas were privatized through loans-

for-share scheme. Shares of strategic industries were transferred to

investors as government did not make its loan repayments.

1996 Privatization-

Stage III

A new privatization law was passed. More emphasis was placed on

competition in privatization.

Source 13

Exhibit 3: Development of Corporate Governance Institutions

Year Event

1993 Bankruptcy law was passed

1995 Securities law was passed

1995-

1996

Securities and Exchange Commission(FSRC) was established.

A civil law was passed.

Source 14

13 Privatization in Russia: Scope, Methods and Impact available at http://www.bbk.ac.uk/polsoc/staff/academic/bill-

tompson/privatisation-in-russia1992-2002 14 A Survey of Corporate Governance in Russia; http://www.cefir.ru/download.php?id=988

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Exhibit 4: Hermitage Strategy and its Impact on Corporate Governance

Source15

Exhibit 5: Russian Macroeconomic Indicators

15 Hermitage Capital Management (HCML)

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34

Source16

Exhibit 6: Russian Firms Microeconomic Indicators

16 Hermitage Capital Management (HCML)

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36

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Source: Hermitage Capital Management (HCML)

Exhibit 7: Hermitage Investment Approach

Source

17

Exhibit 8: Sberbank Initiative and Outcome

17 : Hermitage Capital Management (HCML)

38

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Source18

Exhibit 9: UES initiative and Outcome

18 Hermitage Capital Management (HCML)

40

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Source19

Exhibit 10: Gazprom Initiative and Outcome

19 Hermitage Capital Management (HCML)

42

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Source20

Exhibit 11: Hermitage Performance

20 Hermitage Capital Management (HCML)

44

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Source21

21 Hermitage Capital Management (HCML)

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Exhibit 12: Russian GDP by Expenditure 1990-1999

Source22

22 IMF Staff Country Report: Russian Federation, No. 00/150, Nov. 2000, page. 29.