Harvard Submits Claim Against Oil Co.

Harvard submitted a demand for class arbitration to the American Arbitration Association last week, alleging that the Russian oil company Surgutneftengaz (Surgut) has cheated the University out of at least $3.7 million through illegal accounting practices.

In the arbitration claim, Harvard accused Surgut of submitting annual profit figures to shareholders as much as 79 percent lower than those it submitted in tax reports to the Russian Federation—a practice Harvard said is illegal.

In a company statement, Surgut denied any wrongdoing and questioned Harvard’s motives.

“Most probably, the information on the action brought by minority shareholders is just an attempt to heat the market,” the statement said.

Surgut is the fourth-largest oil producer in Russia. Harvard owns over three million American Depositary Receipts (ADRs) in Surgut, which it purchased between June 2002 and May 2004.

An ADR is a certificate of ownership interest in a foreign company. In this case, each ADR represents 100 shares of stock in Surgut—or approximately $130 million in all—according to Harvard’s arbitration claim.

Because Harvard holds “preferred” shares of Surgut, it is entitled to a yearly dividend payment based on Surgut’s net profits, said Megan Kelleher, a spokesperson for Sowood Capital Management, which is handling the case on behalf of Harvard.

According to Harvard’s claim, the University and Surgut agree the rate for each ADR is 10 percent of the company’s net profits, divided by the total preferred shares.

Harvard has accused Surgut of misreporting its net profits to preferred shareholders, leading to considerably smaller payments.

In the claim, Harvard argues that net profits should be calculated as total revenue minus total costs. The claim said Surgut accurately reported its net profits to the Russian Federation for taxation purposes.

But Harvard said Surgut used a different calculation when reporting net profits to preferred shareholders. In this formulation, Surgut calculated net profits to be total revenue minus total costs and capital investment—leading to much smaller reported profits.

In 2003, for example, Harvard said Surgut reported a 51.042 billion Russian rubles ($1.755 billion in the U.S.) profit to the government, but only a 17.371 billion Russian rubles ($597 million) profit to shareholders.

Harvard said in the claim that Surgut violated Russian law with its reports to company investors.

But Surgut asserted that such accounting practices were necessary to protect shareholder interests.

The company’s statement said Surgut is forced to heavily invest in capital because, unlike the U.S. tax code, the Russian Federation tax code does not allow tax reductions for exploration, drilling and construction. Surgut said it would suffer huge tax losses that would harm shareholders if it chose not to make capital investments.

Surgut added in the statement that deducting capital investment from net profits is legal in the Russian Federation, and that it had a nearly decade-long history of deducting the cost of capital investments before declaring net profits to shareholders.

“Why did the Harvard minority shareholders disregard this fact at the moment when they were buying the shares?” Surgut asked in the statement.

This is not the first arbitration case brought against Surgut, Kelleher said.

But she added that Harvard is the first party to bring action against Surgut in the United States.

In its statement, Surgut said that Russian law makes Harvard’s attempt to arbitrate the case in America—rather than in the Russian Federation—illegitimate.

Harvard, on the other hand, asserted in its claim that the Deposit Agreement signed by Surgut in 1998 that enabled it to sell ADRs mandates that the arbitration must be conducted in the United States.

Harvard holds four percent of the preferred shares of Surgut. In total, 25 percent of Surgut is owned by preferred shareholders.

Kelleher said Harvard is attempting to gain leverage against Surgut in negotiations by applying for class-action status. If granted, class-action status would enable Harvard to act on behalf of all preferred shareholders. Harvard argued in its claim that all preferred shareholders suffered similar losses.

But in its claim, Harvard said it would pursue arbitration even if its request for class-action status is denied.

—Staff writer Alan J. Tabak can be reached at tabak@fas.harvard.edu.