Lessons from Naftogaz

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By Gian Piero Cigna – Associate Director, Senior Counsel & Svyatoslav Sheremeta – Corporate Governance Advisor at the Legal Transition Team of the EBRD

 

In December 2014, the European Bank for Reconstruction and Development (EBRD) – an international financial institution, based in London – signed a €150million sovereign loan with Ukraine to upgrade and repair part of the Ukrainian gas transmission system, the main artery to transport Russian gas to Europe, which accounts for 40 per cent of the total European gas storage capacity.

The transmission system is managed by Ukrtransgaz (UTG), a subsidiary of Naftogaz – one of the largest and most strategic companies in Ukraine. The signing followed many years of negotiations – and many failed attempts – to work with the Naftogaz group, which employs more than 75,000 people and is Ukraine’s largest natural gas producer responsible for around 80 per cent of gas production in Ukraine, importer (accounting for approximately 74 per cent of imports) and wholesale trader (with roughly a 70 per cent share of Ukrainian gas trading). The group has been historically loss making. In 2014, Naftogaz sustained losses of about £3.6billion, the equivalent of 5.7 per cent of the country’s GDP.[1] George Soros defined the company as ‘a black hole in the budget and a major source of corruption’.[2]

In 2014, Ukraine was facing a severe crisis. In February, the ‘Revolution of Dignity’, also called Maidan Revolution, culminated in a series of violent events in the capital Kiev, resulting in the ousting of the Ukrainian President Viktor Yanukovych and the formation of a new interim government.

In October 2014, the Ukrainian elections consolidated the reformist forces, opening the way to decisive steps, but also highlighted the urgency to deliver change on a broad scale and scope, in an extremely difficult situation both in the short term and in the medium term. Reforming the gas sector and ensuring financing for critical investments to rehabilitate the UTG transmission network and to increase energy supply reliability through, for instance, gas purchase financing support for Naftogaz, are priorities for the Ukrainian Government and the EBRD. The latter, together with the EU, the World Bank, the International Monetary Fund (IMF) and the European Investment Bank (EIB), has been actively engaged in joint policy dialogue with the Ukrainian Government for a number of years with the aim to provide technical and financial assistance to reform and restructure the gas sector and modernise the gas infrastructure, based on market-based principles and liberalisation. Reform of Naftogaz is one of the key objectives of the joint international financial institutions’ action plan in the energy sector.

One of the key conditions of the EBRD loan was to require Naftogaz and UTG to undertake a comprehensive reform of their corporate governance practices, under EBRD supervision and guidance.

The corporate governance review – aimed at identifying the main issues of concern and securing agreement to an improvement action plan – started in early 2015. State-owned enterprises are usually heavily regulated – Naftogaz is no exception – and all their governance practices are meticulously regulated either by a law, decree, regulation, order or instruction. The initial review therefore, assessed both the practices in place at the companies and the legislative framework governing those practices. The review was completed in June 2015. A comprehensive report was issued, highlighting the major issues of concern on the practices in place at the companies and the legislation that should have been amended in order to allow the reform to take place.

The review flagged several priorities that should have been tackled to align Naftogaz group’s practices to international standards – essentially, the OECD Corporate Governance Principles and the OECD Guidelines for Corporate Governance of State-Owned Enterprises (SOEs). Among those were to:

■  Reduce the inconsistent state interference within the company’s management

■  Clarify the group’s ownership structure – at that time divided between the cabinet of ministers as ‘company founders’ and the Ministry of Energy as ‘company shareholder’

■  Separate the ownership, regulatory and policy-making functions affecting Naftogaz commercial autonomy and raising conflict of interest

■  Develop a ‘state ownership policy’, defining the state vision and rationale for state ownership[3]

■  Establish an independent and qualified supervisory board – which was until then present only ‘on paper’ as it had held no meeting in the previous 24 months – with clear authority and responsibilities

■  Empower such independent and qualified supervisory board to develop a group strategy, anchored to a defined budget and risk appetite, with clearly defined commercial and social goals

■  Create an internal control framework servicing corporate objectives and not only political purposes, as well as strengthen the group’s transparency and disclosure

Three-phase action plan

In order to tackle the issues highlighted above and allow the reform to take place, a complex set of legislation – including more than 80 laws, decrees, instructions, orders, often conflicting with each other – was to be amended.

The negotiations lasted for about three months and on 21 October 2015, the Cabinet of Ministers approved the Naftogaz Corporate Governance Action Plan, a comprehensive plan for reform, including improvements in corporate governance practices and legislative amendments to be implemented according to a well-defined timetable.[4]

The action plan was divided in three phases: the first was to start immediately to insulate Naftogaz from political inference and allow it to start operating as a company. This involved the clarification of the ownership structure, the approval of a new charter, defining the role of shareholders, supervisory board, committees, internal audit, compliance, anti-corruption, risk management and the introduction of a transparent nomination policy for the supervisory board, based on qualifications and expertise. These actions were the basis for a second phase – to start after one year – involving legislative and regulatory reforms, to align Naftogaz governance structure to the OECD Corporate Governance Principles and OECD Guidelines for Corporate Governance of State Owned Enterprises (the final third phase).

The phasing was necessary due to the complexity of the situation. These kinds of reform cannot be implemented from day to night. The company’s commitment to the reform was strong and in May 2015, Naftogaz published its first ever annual report, titled Changing For The Future, providing a vision for reform.[5]

Most of the priorities included in the first phase were implemented quite swiftly. In December 2015, the company’s shares were transferred to the Ministry of Economy, so clarifying the entity in charge of the exercise of the ownership function, with no responsibility in policy-making and regulation of company’s activities. At the same time, a revised charter of the company – along with the terms of reference of the supervisory and management board – were approved.

This paved the way for the EBRD to sign a second operation with Naftogaz: a $300million loan to allow the company to purchase more than one billion cubic metres of gas (bcm) and so support Ukraine in reaching its target of having 19 bcm of gas in storage, thus also helping the country to diversify its sources of gas supply by financing purchases from its interconnections with Europe through the so-called reverse flow. Under the terms of the loan, Naftogaz was required to tender and contract any gas purchased with EBRD funds under procedures in line with best European practices and to comply with the agreed action plan.

“State-owned enterprises are usually heavily regulated – Naftogaz is no exception – and all their governance practices are meticulously codified by a law, decree, regulation, order or instruction”

In January 2016, the search for independent and qualified directors to serve on the supervisory board of Naftogaz was launched and in April a new supervisory board was appointed. For the first time ever, the board of a state-owned enterprise in Ukraine was made up of a majority of well-qualified and independent directors.

However, reforming a country’s energy sector is not a walk in the park and things can turn ugly. In February 2016, Aivaras Abromavicius – the Minister of Economy and one of main promoters of the reform – resigned. In his resignation letter, the Minister referred to Naftogaz corporate governance action plan and cited ‘pressure to appoint questionable individuals to key positions in state-owned enterprises’. [6]

In April 2016, a new government was formed, but the reshuffle slowed down the reform process. In April 2017,  Naftogaz supervisory board chair Yulia Kovaliv resigned, mentioning the clash of opinions on further development of Naftogaz and lack of consensus regarding the implementation of the corporate governance reform according to the initially envisaged plan.[7]In the same month, the independent board members sent a letter to the Vice-Prime Minister of Ukraine indicating their concerns over the situation in the company. “Without material progress it would be inappropriate and untenable for us to continue as supervisory members” they said in the letter.[8]

Less than five months later, the Naftogaz supervisory board resigned.

In his new letter of resignations, Paul Warwick – the chair of the board – wrote: “Despite assurances from senior politicians, deadlines have passed and commitments have not been delivered, with an environment of government control not envisaged in the corporate governance action plan. Essentially, no material change has occurred over the last five months despite the assurances we received to the contrary.”[9]

The resignation of the supervisory board was a shock to the whole reform process – especially in a moment when Ukraine managed to raise $3billion in its first sovereign bond issue since restructuring its debt in 2015. However, it sent a strong and clear message. The resignation of all independent directors is undoubtedly a dramatic event in the life of a company, but it is also a clear signal of the integrity that is to be expected from independent directors. A complete novelty for Ukraine.

Independent directors play a crucial role and if they are unable to do their job, they must resign, rather than carry on with business as usual. Such a move – albeit extreme – sends a strong message to the market that there are serious concerns. In turn, the market should understand the seriousness of this signal… and the message was well received.

In November 2017 – thanks to the coordinated effort of the Government and Ukraine’s partners from international institutions, including the EBRD – a new supervisory board, composed of a majority of highly professional and reputable candidates, was appointed by the Cabinet of Ministers.[10] At its first meeting on 22 December 2017, Clare Spottiswoode was unanimously elected as the chair.[11] Expectations are again high.

As SOEs corporate governance reform can be successful only if practices are backed by sound legislation, significant efforts have been paid to the legislative reform. A number of cabinet of ministers decrees – developed with financial and technical assistance from international organisations and development institutions – were approved to allow for the selection of independent supervisory board members of large SOEs and to define the nomination and selection procedures.[12] A very important and difficult test was the approval of several laws by the Verkhovna Rada, the Ukrainian Parliament.

In April 2015, the law of Ukraine on joint stock companies was amended, introducing the concept of independent directors and requiring supervisory boards of public companies and SOEs to have at least two independent directors.[13] In June 2016, another law required boards of SOEs to have at least a majority of independent directors.[14] In January 2018, a new law introduced a key provision, stipulating that the general meeting of shareholders cannot decide on matters reserved to the supervisory board.[15] The bypassing of the board – and its independent directors – by shareholders in key strategic decisions has historically been a key problem in Ukraine, causing the state’s direct meddling into company matters. The law also introduced new independence requirements for supervisory board members, extended the scope of activities of the supervisory board and detailed the powers of supervisory board committees – i.e. audit committee, nomination committee and remuneration committee – also introducing a completely new (for Ukrainian corporate practice) concept of a succession plan.

In March 2018, another law became effective, accelerating state divestment from some large and most medium and small SOEs, leaving only SOEs strategically important to the state’s economy and security.[16] In addition to intensifying privatisation, it is planned that a large amount of small loss-making, state-owned companies will be liquidated under a streamlined procedure.[17] This is another way of tackling the inefficient SOE sector – in Ukraine, about 3,500 companies still belong to the state, many more than in any Western country.

Board responsibility

A cornerstone piece of legislation is now under discussion at the Parliament. The Draft Law 6428 aims at empowering the supervisory boards of SOEs with the key authority to approve the SOE’s strategy and budget and to appoint and remove management.[18] Indeed, the approval of the strategy – anchored to a clearly defined budget and risk appetite – is the key board responsibility and it establishes the benchmark upon which the board can then strategically guide, challenge and oversee management. Without such authority, together with the power to appoint and remove management, the board cannot function well.

“There are lessons to be learned from the Naftogaz saga. The main one is that corporate governance reforms need both ‘pressure’ and ‘culture’”

The draft law also reinforces the concept of fiduciary duties of supervisory board members, requires SOEs to establish an internal audit function and introduces a ‘reference’ to the state ownership policy, which should define the main objectives of state ownership over SOEs, the expected results of SOEs’ operations and the corporate governance mechanisms to be adhered by the state and SOEs.

As the draft law envisages a serious shift of authority, it is encountering some fierce resistance. Disappointingly, on 21 March 2018, following several months of discussions at the Government and endorsement by the Parliamentary Committee on Economic Policy, the draft law failed to collect the required amount of support votes in its first hearing and is now waiting to appear on the Parliament’s agenda for another session. We hope it will be soon.

Lessons learned

There are lessons to be learned from the Naftogaz saga. The main one is that corporate governance reforms need both ‘pressure’ and ‘culture’.

In Ukraine, the ‘pressure’ is mainly exercised by the international community, backing the Revolution of Dignity by the Ukrainian people. International support is tangible and delivers results. Lastly, the word of international financial institutions and friendly countries still carries weight, especially when they speak with one voice and adds wind to the sails of these courageous women and men. It emboldens a remarkable civil society to speak up and demand change.[19]

The creation of the corporate governance ‘culture’ is a long process. Naftogaz was possibly the starting point. At the time of the first EBRD deal’s negotiations, there was not much understanding in Ukraine of what ‘corporate governance’ meant. It was often confused with ‘corporatisation’, which many read as corporate governance ‘on paper’. After years of discussions and negotiations at all levels, there is finally an understanding of what good governance is and a growing consensus for reform.

Following the Naftogaz experience, the EBRD is now working with a number of SOEs in Ukraine.[20] Consultants carrying out corporate governance reviews are developing good skills – also drawing from international expertise – and contributing a lot to the culture creation. A few years ago, it was hard to find a good Ukrainian corporate governance expert, even at the largest consultancy houses. Nowadays, firms are creating and are continuously developing corporate governance practices. New corporate governance-oriented educational initiatives appear, and the Ukrainian Corporate Governance Academy is a very good example, able to stimulate the Government in addressing corporate governance-related discussions, both within corporate governance reviews of individual SEOs or as stand-alone processes, which was unthinkable just a few years ago.

It would now be a good time for this culture creation revolution to reach the Verkhovna Rada.

The contents of this publication reflect the opinions of individual authors and do not necessarily reflect the views of the EBRD.

 

About the Authors:

Gian Piero, who is an Italian qualified attorney, is the corporate governance specialist in the EBRD Legal Transition Team. Prior to joining the EBRD, he worked on company law, corporate governance and capital markets related issues at the European Commission and at the Italian Ministry of Economy. He practiced law in an international law firm in Italy, Albania and Romania and acted as consultant to international organizations and various state institutions and ministries in Eastern Europe. In Albania he was advisor at the Ministry of Economy for the privatization of state owned enterprises in strategic sectors. In the Czech Republic he worked as “Pre Accession Advisor” at the Ministry of Justice and the Securities Commission for the approximation of the Czech legislation with EU standards.

Svyatoslav Sheremeta is a Corporate Governance Advisor at the Legal Transition Team of the EBRD, based in Kyiv, Ukraine. Svyatoslav is focused on Bank’s corporate governance projects in Ukraine and other countries of operation, and particularly on SOE sector. Svyatoslav was a Partner and Head of Corporate and M&A Practice Group in one of the Ukrainian law firms. Before that, Svyatoslav headed legal departments of one of the largest Ukrainian investment firms and of a large agri company. Svyatoslav is a graduate of Ivan Franko Lviv National University in Ukraine, and earned his LL.M. degree in International and Comparative Law from University of Iowa College of Law in the US.

Footnotes:

1.See 2014 Naftogaz Annual Report, available at: http://www.naftogaz.com/www/3/nakweben.nsf/0/386A5C4407B5195BC2257EDD006E9E90?OpenDocument&Expand=2&

2.See: “Wake Up, Europe” by George Soros. Available at: http://www.nybooks.com/articles/2014/11/20/wake-up-europe/

3.See OECD Guidelines for Corporate Governance of State Owned Enterprises, Guidelines I and II. Available at: http://www.oecd-ilibrary.org/governance/oecd-guidelines-on-corporate-governance-of-state-owned-enterprises-2015_9789264244160-en

4 Naftogaz Corporate Governance Action Plan is available at: http://www.naftogaz.com/www/3/nakweben.nsf/0/9D3499C093EF79EBC2255F38004FA269?OpenDocument&Expand=1&

5.Naftogaz Annual Report for 2015 is available at: http://www.naftogaz.com/files/Zvity/Naftogaz_Annual_Report_2014_engl.pdf

6.http://www.naftogaz.com/www/3/nakweben.nsf/0/3A86AF063F9E0B33C2258102003C60DF?OpenDocument&year=2017&month=04&nt=News&

7.http://www.naftogaz.com/www/3/nakweben.nsf/0/B40E58E66D187E58C22580FA003FB3B8?OpenDocument&year=2017&month=04&nt=News&

8. The resignation letter is available at: http://www.me.gov.ua/News/Detail?lang=en-GB&id=f13fa574-3e1b-4eca-b294-f9e508910e01&title=StatementByTheMinisterOfEconomicDevelopmentAndTradeOfUkraineAivarasAbromavicius

9. The resignation letters are available at: http://www.naftogaz.com/www/3/nakweben.nsf/0/6D7C544D5F376866C22581A0006883A0?OpenDocument&year=2017&month=09&nt=News&

10. The composition of the supervisory board of Naftogaz as of March 2018 is available at: http://www.naftogaz.com/www/3/nakweben.nsf/0/C05E55FE9F457547C2257F9D003C672C?OpenDocument&Expand=4&

11. https://economics.unian.info/2343167-clare-spottiswoode-heads-naftogaz-supervisory-board.html

12. Regulation of the Cabinet of Ministers No. 142 “On Certain Matters of Managing State Enterprises and Companies Where the State Holds Over 50 per cent in Share Capital”, dated 10 March 2017; Regulation of the Cabinet of Ministers No. 143 “On Certain Matters of Managing State Owned Assets”, dated 10 March 2017; Regulation of the Cabinet of Ministers No. 469 dated 4 July 2017, amending the Cabinet of Ministers Regulation No. 777  “On Carrying Out Competition for Appointment of Key Officers of State-Owned Enterprises”.

13. Law of Ukraine “On Amendments to Certain Legislative Acts of Ukraine on Protection of Investors’ Rights”, adopted by the Parliament on 7 April 2015, No. 289-VIII.

14 Law of Ukraine “On Amendments to Certain Legislative Acts of Ukraine on Managing State and Municipal Assets”, adopted by the Parliament on 2 June 2016, No. 1405-VIII

15. Law of Ukraine “On Amendments to Certain Legislative Acts of Ukraine on Simplification of Doing Business and Investment Attraction by Securities Issuers”, adopted by the Parliament on 16 November 2017, No. 2210-VIII. Certain provisions of Law 2210 will become effective gradually over the year, at the very latest on 1 January 2019.

16. Law of Ukraine “On Privatization of State and Municipal Property”, adopted by the Parliament on 18 January 2018, No. 2269-VIII.

17. As set forth in the memorandum between Ukraine and the IMF, dated 1 September 2016 , which is available at: https://www.imf.org/external/np/loi/2016/ukr/090116.pdf

18. Draft Law “On amendments to certain legal acts of Ukraine on improvement of corporate governance of legal entities where the state is a shareholder” No. 6428 (Draft Law 6428).

19. https://www.ft.com/content/6f478418-e4e8-11e7-97e2-916d4fbac0da

20. Energoatom (a nuclear energy generator, which operates 4 nuclear power plants, holds an approx. 60 per cent share in country’s electricity generation, and employs about 34,000 employees), Ukrainian Railways (the company operates a 22,000 km rail network which is the fourth largest in Europe as measured by both passenger and freight turnover, and employs about 270,000 employees), Ukrposhta (a postal service operator, which operates about 11,500 postal offices and employs about 76,000 employees), and Ukrenergo (an electricity transmission system operator, which operates 21,000 km of backbone and interstate overhead power transmission lines and employs over 13,000 employees).