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By John Helmer in Moscow

The Mechel steel and mining group — Russia’s largest producer of stainless steel and coking coal — is the only Russian metals and mining company to submit to the regulatory requirements of the US Securities and Exchange Commission (SEC). That began in 2004, when Mechel, then owned by Igor Zyuzin and Vladimir Iorikh, were the co-owners. Since then, Iorikh sold out, and moved his investment operations to Switzerland. He opted to jump. The New York Times and its reporter who published a different story were recently obliged to admit their mistake, and apologize to Iorikh.

Zyuzin has remained behind to borrow heavily and pay premium prices for ferroalloy and coal assets he is now having trouble affording. In retrospect, Iorikh’s calculation and timing gather wisdom.
In the meantime also, all the other Russian metals and mining proprietors, who wished to sell unsecured securities in their concerns to foreign investors, get an international market valuation, and borrow against it, have opted not to submit to the requirements of a US listing. Their debts, pledges, and loan covenants are probably just burdensome as Zyuzin’s. But they have been obliged to disclose much less to the market than the SEC has required of Mechel.

This week Zyuzin has had to fess up. And the New York Stock Exchange reaction was to cut his share price by 4% at the close of Wednesday trading. The day before, Mechel dropped 11% in Moscow trading.
On June 24, Mechel made public, through its SEC Form 20-F filing, its annual report for 2008 and auditor notes on its current financial position. Revealing and surprising though the new document is, at least for some investors, there is one tantalizing hint that the disclosure regime imposed by the SEC on Mechel has been anything but consistent. In its initial stock filing, ahead of the listing in the US in October 2004, the Mechel prospectus, and company auditor Ernst & Young, warned that an audit had turned up “material weaknesses in our internal control, and we may not be be able to remedy these material weaknesses or prevent future weaknesses…We may not be able to accurately report our financial results or prevent fraud.”
That was in the risks section of a prospectus that is today almost five years old.

This week, here is what Mechel’s chief executive Zyuzin has reported, at page 223 of the filing: “six material weaknesses were identified in our internal control over financial reporting. Exchange Act Rule 12b-2 (17 CFR 240.12b-2) and Rule 1-02 of Regulation S-X (17 CFR 210.1-02) define a material weakness as a deficiency, or combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of the registrant’s annual or interim financial statements will not be prevented or detected on a timely basis. As a result of the material weaknesses, our chief executive officer and chief financial officer have concluded that, as of December 31, 2008, the end of the period covered by this report, our disclosure controls and procedures were not effective at a reasonable assurance level.”
With Ernst & Young as continuing auditors and advisors, the six material weaknesses are reported in the Form 20-F as follows:

“We do not have sufficient resources in our Moscow-based International Reporting Department (IRD), to properly address relatively complex transactions and/or accounting and financial reporting issues that arise from time to time in the course of our operations. The high volume of work required on routine tasks also results in untimely identification of accounting issues;

• We did not have an adequate system of internal controls over period end financial reporting to ensure that the reporting packages received by the subsidiaries are properly reviewed at the subsidiary and group level, and that the U.S. GAAP transformation schedules and relatively complex and non-routine transactions are properly completed and reviewed;

• We did not design and operate effective controls over accounting for the business acquisition process;

• We did not design and operate effective controls related to the completeness of our recorded and disclosed commitments and contingencies. We did not establish effective controls over the completeness of the contracts management reviewed and used to prepare our commitments and contingencies disclosure;

• We did not design and operate effective controls over the calculation of the “lower of cost or market” valuation adjustment for inventories;

• We did not design and operate effective controls over the classification and timely accounting for transportation costs incurred by our subsidiaries.”

According to Mechel and Ernst & Young, there are the very best of intentions to remedy these problems, and the remedies are under way. Omitted is Mechel and Ernst & Young’s account of what has been happening since the internal control problem was first identified by the accounting firm in October 2004.

The US regulatory filing has also revealed for the first time a loan default obligation which has been demanded by June 30 by one of Mechel’s lenders, the German bank West LB. Until now, Mechel has been claiming in its public announcements and financial reports that it was confident of avoiding a default on $1.5 billion of loans, issued in March 2008, to finance Zyuzin’s takeover of Oriel Resources, a chrome mining and refining group.
In its Form 20-F filing, Mechel reports for the first time that “we have been in breach of certain covenants of certain of our loan agreements representing 78.9% of our indebtedness outstanding as of December 31, 2008. Certain of these breaches have been remedied and certain others, particularly relating to maintenance of financial ratios, are continuing. These agreements entitle our lenders to demand accelerated partial or full repayment of outstanding interest and principal. Certain of our loan agreements of which we are in breach contain cross-default provisions.”

A list of the debt covenant violations, as of December 31, is presented in Appendix F of the filing.
According to Mechel, it has applied to its bankers for relief, time to pay, and waivers of these provisions. But Zyuzin has been turned down flat. As of June 1, 2009, the SEC filing says, “no such waivers have been received”. The listing of the financial problems (with numerical data in millions of US dollars) includes:

• The Group is not in compliance with certain financial ratios (specifically, “Shareholder’s Equity to Net Borrowings” ratio set at a level of 1.0:1.15 while the actual Group’s ratio as of December 31, 2008 was 1:1.29) and other operational covenants defined in the “Yakutugol” syndicated loan agreement with BNP Paribas, ABN AMRO, Calyon, Natixis, Sumitomo Mitsui Banking Corporation Europe Limited, Société Générale Corporate & Investment Banking and Commerzbank AG and “Oriel” credit facility agreement with the Royal Bank of Scotland;

• SKCC failed to meet the limit of $15,000 on overdue payables to third parties under the long-term credit lines agreements signed with Raiffeisenbank. The outstanding amount of such debt as of December 31, 2008 is $31,537. SKCC also breached a covenant relating to the level of guarantor’s equity requirements for the long-term U.S. dollar-denominated loan provided by Unicreditbank. The outstanding amount of such debt as of December 31, 2008 was $40,000;

• Izhstal was not in compliance with the financial ratios under the long-term loan agreements signed with Fortis bank and ABN-AMRO Bank, that had outstanding balances of $21,210 and $9,088, respectively. The “Shareholder’s Equity to Net Borrowings” ratio was set at a level of 1.0:1.10, while the actual Group’s ratio as of December 31, 2008 was 1.0:1.29;

• The Group and its subsidiary Oriel received a request from the lenders under the long-term U.S. dollar-denominated facility agreement with WestLB AG regarding the immediate repayment of the outstanding amount of $84,750 due to the breach of certain financial covenants. The amount of debt with loan covenant violations includes a current portion of $11,250 and $73,500 reclassified from a long-term portion due to such covenant violations;

• CMP breached a number of financial covenants under the loans provided by Fortis, ABN-AMRO and ING Bank in the total amount of $10,715 as of December 31, 2008. Fortis and ING banks set a “Shareholder’s Equity to Net Borrowings” ratio at a level of 1.0:1.0. The Group’s ratio as of December 31, 2008 amounted to 1.0:1.29 and was not in compliance with the agreement terms. CMP failed to meet the limit of $10,000 on overdue payables to the third parties and maintain agreed pledge level of $100,000 under the long-term credit agreement signed with ABN-AMRO;

• CMP breached a cash turnover covenant for short-term loans signed with Sberbank and Gazprombank. The outstanding balances under the mentioned agreements as of December 31, 2008 were $112,320 and $75,321, respectively. The covenants under the short-term loan agreement with Alfa-bank were breached due to violation of limits for the pledges and tax claims. The corresponding amount of the balance as of December 31, 2008 amounted to $149,321. The loans with Alfa-bank were subsequently fully repaid in March 2009;

• MTH and Mechel Service breached cash turnover covenants related to short-term loans provided by Gazprombank. The outstanding amounts of the loans as of December 31, 2008 were is $134,690 and $102,109, respectively.

The total amount of long-term debt with the breached covenants amounted to $1,563,613, which was classified as long-term debt with loan covenant violations within current liabilities as of December 31, 2008.”
In early 2009, Mechel now says, ” we have received a request from WestLB AG (“WestLB”) addressed to Voskhod Chrome in March 2009 for an early repayment of the outstanding amount of $84.8 million due to the continuing breach of change of control provision, which has not been waived by the lenders, and a number of other financial covenants. We have agreed with WestLB to repay the full amount outstanding on June 30, 2009, which we intend to do on that date. This request for early repayment received from WestLB has not so far resulted in cross-defaults under our other loans.”

The SEC filing also clarifies the legal and banking problem between Mechel and BNP Paribas, involving a Geneva trading account freeze over $52 million. “On March 17, 2009, Mechel Trading AG, Mechel International Holdings AG, Mechel Metal Supply Ltd, Monte Shipping Ltd and Littel Echo Invest Corp. appealed to the Geneva Court for preventive guarantee measures in respect to BNP Paribas actions to block the Group’s accounts with approximately the cash balance of $52,000. This was done by the bank in February 2009 to induce the Group to issue an additional guarantee for the loans issued to Mechel’s subsidiaries (MIH AG, Mechel Trading AG, Monte Shipping Limited)…”

Give credit where credit is due.

If Mechel has met its reporting requirements under the US market code, consider how much that is interesting that has yet to be disclosed by the Russian steelmakers, who have listed their shares under London Stock Exchange rules, and who are not bound by the same strictures.

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