Russian Roulette: Current Investment Risks in Russia, January 2010

Committee for Russian Economic Freedom Twitter @RusEconFreedom www.russianeconomicfreedom.org 1

RUSSIAN ROULETTE Current Investment Risk in Russia

January 26, 2010 Dear World Economic Forum Attendee: While at the World Economic Forum, keep in mind that in a cramped court room just a few blocks from the Kremlin a drama is playing out that will have profound implications for the future of economic and political freedom in Russia. That country’s former leading business leader, YUKOS Chairman Mikhail Khodorkovsky, is undergoing a bizarre second trial on fabricated charges after he criticized Vladimir Putin for failing to abide by the rule of law. Sentenced to eight years, Khodorkovsky now faces an additional 22 years in a Siberian prison camp. This Kafkaesque proceeding embodies everything that stands in the way of Russia achieving stability, growth, prosperity and Democracy for its people. GDP surges and plummets with oil prices, inflation and unemployment each exceed 10 percent, while the average salary is about $500 a month. Respected companies like IKEA, the Swedish home furnishings giant, have been forced to declare a moratorium on investment in Russia, frustrated by Russian officials’ disregard for contractual obligations and fair play. As a U.S. Senator, President Obama sponsored a bi-partisan resolution supporting Khodorkovsky after the first prosecution, stating that the case raises “troubling questions about the impartiality and integrity of the judicial system in Russia," and that the imprisonment represents "a violation of the norms and practices of Russian law." Other leaders from Italy, Germany, and European organizations joined in extending their support for Mr. Khodorkovsky. Courts from Switzerland, the United Kingdom, the United States, Netherland, Lithuania, and Cyprus, among others, have dismissed elements of the YUKOS affair. The Russian government’s contempt for the Rule of Law and the simultaneous proliferation of corruption remains a huge impediment to direct foreign investment for this key player in the world economy. Both US and Russian officials have publicly acknowledged Russia’s weak property rights and rampant corruption as reasons to avoid doing business in Russia. Russian First Deputy Prime Minister Igor Shuvalov said at an international conference on January 21, 2010, “Investment…is possible only with solid protection of private property rights. Therefore this problem is directly linked to the course of modernization.” On January 12, 2010 US Ambassador to Russia John Beyrle stated, “Russia is still a very tough place to do business. The combination of bureaucratic and administrative obstacles intertwined with pervasive


corruption in Russia still constitutes a pretty significant risk premium for American investors and American businessmen who want to enter the Russian market or grow their businesses.” Russian attorney Sergei Magnitsky was arrested in November 2008 after defending Hermitage Capital against expropriation by government officials. After being denied medical treatment during his year-long incarceration, Magnitsky died in Russian custody last November. If this can happen to Khodorkovsky and Magnitsky, what investor or corporation seeking to do business in Russia is safe? Why invest in Russia as long as Khodorkovsky is behind bars? According to Russian government studies and US State Department statistics, it’s estimated that corrupt officials rob the Russia people of an estimated $300 billion annually, a sum equal to 18% of the country’s gross domestic product. The response to the newly-adopted package of anti-corruption legislation initiated and promoted by President Medvedev and passed by the Duma in December 2008, has been tepid at best. Medvedev recently admitted publicly that corruption is still endemic in Russia. The excessive role of government in the economy and business sector, which spurs the supply side of corruption, aggravates the problem. As 2010 begins, signs of Russia’s complacency have become larger and the world stage is beginning to notice. The Khodorkovsky trial and continued politicization of the courts and trade illustrate the increasingly hostile nature of the Russian business environment. Kind regards, Pavel Ivlev Chairman Committee for Russian Economic Freedom


Contents

High Stakes ..................................................................................................................................... 4

Russian Economic and Investment Issues ...................................................................................... 4

Global Concerns over Russian Corruption ..................................................................................... 5

Selected Cases of Rule of Law Violations in Russia ...................................................................... 6

Abitare ........................................................................................................................................ 6

BP Plc ......................................................................................................................................... 6

Carrefour ..................................................................................................................................... 6

DeBeers ....................................................................................................................................... 6

Hermitage Capital ....................................................................................................................... 6

IKEA ........................................................................................................................................... 7

Motorola ...................................................................................................................................... 7

Open Society Institute/George Soros .......................................................................................... 7

Peter Hambro Mining ................................................................................................................. 7

PriceWaterhouse Coopers ........................................................................................................... 7

Royal Dutch Shell ....................................................................................................................... 8

Starbucks ..................................................................................................................................... 8

YUKOS/Mikhail Khodorkovsky ................................................................................................ 8

Zoloto Resources ........................................................................................................................ 9

Who Is Mikhail Khodorkovsky? ..................................................................................................... 9

Arrest and Trial ............................................................................................................................... 9

New York Times - Ikea Plans to Halt Investment in Russia .......................................................... 10


High Stakes

The recent initial public offering of the Russian aluminum giant Rusal is just the latest example of how lawlessness threatens companies investing in Russia. The $2.5 billion in proceeds from the Rusal IPO would go to repay part of its $4.5 billion loan largely held by the Russian state-run Vnesheconombank (VEB) (controlled by Prime Minister Vladimir Putin), also Rusal’s biggest single creditor. Nevertheless, during the due diligence process, the Hong Kong Stock Exchange listing the shares raised concerns and requested more information from Rusal. Goldman Sachs was dropped as a book runner after the investment bank expressed reservations about sponsoring the deal. More doubts surfaced when allegations emerged in offering documents that controlling shareholder Oleg Deripaska is tied to organized crime and was refused a visa to enter the United States on those grounds and has received millions in government money funneled through Vnesheconombank (VEB),. On the one hand, the Russian authorities keep Mikhail Khodorkovsky in prison, while rewarding Mr. Deripaska for his cooperation and collaboration, stating publicly that he would transfer Rusal back to the government at any time saying, “If the state says we need to give it up, we’ll give it up.” The Rusal IPO highlights the political and institutional challenges that arise when Russian companies tap into international capital markets. Headed by someone close to the Kremlin, Rusal benefits from regulatory and financial support in the form of advantageous loan refinancing and investment in the IPO.

Russian Economic and Investment Issues

The Financial Times reported on January 10, 2010, that Russian companies intend to seek $90 billion over the next two years to finance debt restructuring and capital improvements and resupply the coffers of politically connected Russian business owners, who saw their fortunes collapse during the 2008 financial crisis. Russia’s economic and financial outlook remains cloudy at best:

• Russia expects to see a steeper drop in economic production this year than initial forecasts, with the country now preparing for a continuation of the economic crisis long into 2010.

• Russia suffers from minimal domestic financial intermediation because inept state banks dominate the financial market.

• President Medvedev announced in May wide-ranging budget cuts previously put on hold, and conceded that Russia was far from out of the economic crisis.


• For the Russian government, investor perception of Russia as a high-risk country is a very serious issue, especially as Mikhail Khodorkovsky remains behind bars. One of President Dmitry Medvedev's key programs is to create a diverse economy and to encourage a higher level of foreign investment. In July 2008, he urged the government to put an end to the bureaucratic practice of creating "nightmares" for businesspeople, such as needless inspections and various extortion schemes to force businesses to pay bribes to bureaucrats to stay in business.

• In October 2009, Carrefour, the world’s second largest retailer withdrew from Russia, citing an absence of growth prospects in the short- and medium-term just months after opening its first store in June 2009.

• IKEA, in June 2009, declared a moratorium on investment in Russia after the CEO declared that he refused to be extorted.

Global Concerns over Russian Corruption

Recently, two widely cited surveys on economic freedom, Transparency International’s Corruption Index and the Heritage Foundation’s Index of Economic Freedom ranked Russia close to the bottom and in the case of the Index of Economic Freedom, barely above “repressed.”

• The 2009 Corruption Perception Index from Transparency International ranked Russia 146th out of 180 countries, falling behind the likes of Libya, and Pakistan and Honduras. By comparison, the data shows that in 2009 Georgia posted a score of 4.1 up from 3.9 in 2008, illustrating that that country’s corruption reform efforts continue to be highly effective in earning domestic and international confidence and improving the country’s image. Brazil, China and India, part of the BRIC emerging markets block, consistently score higher than Russia as well.

• In the 2010 Heritage Foundation’s Index of Economic Freedom, Russia’s overall rating

in this measurement of economic openness, regulatory efficiency, the rule of law and competitiveness, decreased to 50.3 this year, ranking it only 0.3 points away from being a repressive economic business environment. Russia ranked 143rd out of 179 countries. Ten different components make up the overall score and Russia’s three lowest scores are in the Investment Freedom, Property Rights and Freedom from Corruption categories. Not surprisingly, foreign investment in Russia continues to be challenging for investors given the capricious nature of Russia’s investment process, rampant expropriation of property and extensive government controls on international capital flows.

• Russia’s weak score of 25 on property rights was echoed this week by Russia’s First

Deputy Prime Minister Igor Shuvalov, who said, “Investment in high technology is possible only with solid protection of private property rights. Therefore this problem is directly linked to the course of modernization.” The same court system that is prosecuting Mikhail Khodorkovsky, is so inefficient and corrupt that property rights are difficult to enforce, a major deterrent to foreign investment.


Russia’s future in the community of nation’s rests in the balance. During your discussions in Davos, please consider the fate of Mr. Khodorkovsky and its impact on investment and the Russian people’s economic future.

Selected Cases of Rule of Law Violations in Russia

Abitare

February 2005 U.S. businessman Frank Neuman, who owned a furniture chain, Abitare, was denied entry to Russia; shortly thereafter armed gangs forcibly closed his stores; business is re-registered to new owners upon forced "sale."

BP Plc

2004 to present BP Plc has faced numerous regulatory and legal issues in Moscow since forming its joint venture with Russian oil company TNK, including back tax claims, espionage allegations, immigration disputes and licensing fights. In March 2008, armed police raided the Moscow offices of BP and its local joint venture, TNK-BP in an attempt to persuade TNK-BP's Russian shareholders to sell their 50% stake in the company. The Kremlin has ratcheted up pressure on foreign energy companies in recent years as part of its effort to consolidate control over the country's largest and most important hydrocarbon deposits. Robert Dudley, who served as CEO of TNK-BP after it was formed in 2003, left Russia in July 2008 citing “sustained harassment” amid court battles and labor and tax inspections.

Carrefour

October 2009 Citing an absence of growth prospects in the short- and medium-term, the world’s second largest retailer withdraws from Russia, just months after opening its first store in June 2009. Among industry analysts, Russia is known to have investment challenges, including bureaucratic inconsistency, corruption and restrictions on lucrative sectors like energy. Corruption weakens the rule of law and increases the fragility of property rights.

DeBeers

January 2009 De Beers, the world’s largest diamond company, withdrew from a mining joint venture after talks with the Federal Anti-Monopoly Service.

Hermitage Capital

2005 to present In 2007, Russia's Interior Ministry raided the corporate offices of Hermitage Capital Management, one of the largest portfolio investors in Russia, and stole documents that allowed them to install new executives. The new executives forged contracts that allowed them to create nearly $1 billion in liabilities, which cleared the way for them to apply for the $230 million in fraudulent tax refunds. In July 2009, a U.S. judge ordered that


attorneys for Hermitage may subpoena JP Morgan Chase Bank and Citibank NA for testimony and records relating to wire transfers that Hermitage said will aid its four pending cases in Russia. Hermitage contends in court documents that other Western investors in Russia had colluded with the authorities to steal the money through the tax refunds and then launder it through New York banks. Russian authorities had stopped Hermitage's chief executive, William Browder, at a Moscow airport in 2005 and deported him on national security grounds. In November 2009, Hermitage lawyer Sergei Magnitsky died under suspicious circumstances while in Russian custody.

IKEA

June 2009 In 2004, building licenses and construction permits were disputed by the Moscow authorities, delaying opening of stores and increasing project costs; IKEA's Russia head said that he feared for his life after refusing to pay bribes to local authorities. In June 2009, IKEA declared a moratorium on investment in Russia.

Motorola

2006 Between March and April 2006, Motorola shipped 167,500 mobile phones to Moscow. Upon leaving customs they were immediately seized by Moscow Interior Ministry officials as "contraband." In another incident that year, RussGPS, a small high tech company supplying the Russian military, persuaded the Interior Ministry to bring a claim for patent infringements against Motorola in Russia, circumventing the normal procedure of protecting intellectual property via courts.

Open Society Institute/George Soros

November 2003 George Soros' Open Society Institute’s Moscow office was raided at midnight by private security forces. The cause of the raid was not clear, but suspicion is that it was retaliation for Soros' criticism of the arrest of Mr. Khodorkovsky.

Peter Hambro Mining

2006 Oleg Mitvol, Deputy Minister of Rosprirodnadzor asserted breaches of license agreement against Peter Hambro Mining and threatened asset seizure and penalties, effectively wiping £300 million from the market capitalization of the company.

PriceWaterhouse Coopers

2007 Russia’s Interior Ministry raided the firm’s offices allegedly in connection with the YUKOS affair; the Interior Ministry opened a tax evasion case against PwC, widely seen as a deliberate effort to discourage PwC from supporting the defense of the new charges brought against Mikhail Khodorkovsky. Ultimately in June 2007, PwC announced the withdrawal of its YUKOS audited financial statements. Two days after PwC announced its withdrawal of the YUKOS audited financial statements, the


General Procurator’s Office advised PwC that it found no evidence of wrongdoing by PwC in its audits of YUKOS. Less than two weeks later, an appellate court overturned a lower court’s judgment against PwC for tax evasion and returned the matter to the lower court for reconsideration on nearly the entire assessment.

Royal Dutch Shell

2006 Gazprom, the Russian energy monopoly, seized control of the world's largest combined oil and natural gas development after a highly publicized campaign of pressure on its foreign operator, Royal Dutch Shell. Before the seizure, Shell came under pressure for alleged cost overruns, delays and environmental violations at its Sakhalin-2 project. Shell was forced to sell half its stake in the Sakhalin-2 project to Gazprom for $7.45 billion, far below its value and the Shell investment. Relations between Shell and the Russian government have thawed, with Putin welcoming Shell to participate in two upcoming natural gas projects in Russia in June 2009. Shell partnered with Russian gas giant OAO Gazprom to launch Russia's first liquefied natural-gas plant in February 2009.

Starbucks

2002 to 2005 Starbucks trademark was appropriated by Russian squatter, delaying market entry by three years and after extensive legal fights. Starbucks prevailed in Russian court; the victory was seen as a sign that Moscow may realize that defending intellectual property rights must be recognized. Starbucks opened its first store in Russia in September 2007.

YUKOS/Mikhail Khodorkovsky

2003 to present A circle of businessmen and politicians initiated legal proceedings against the oil mogul Mikhail Khodorkovsky and his partner Platon Lebedev based upon alleged illegality in connection with Group Menatep Limited’s acquisition of assets during privatization and the subsequent alleged abuse of these entities and tax evasion. Lebedev and Khodorkovsky were arrested and convicted in a show trial. YUKOS was systematically dismantled through, first, a sham tax auction wherein its largest asset was auctioned off at a fraction of its market value to an ad-hoc shell company which promptly transferred its assets to state-owned Rosneft. Second, there was a contrived bankruptcy wherein YUKOS’s remaining assets were sold at deflated prices to, among others, Rosneft and state-dominated Gazprom. Since then, YUKOS former shareholders have filed claims for damages worth more than $30 billion as a result of the Russian government's expropriation of their investments. Meanwhile, U.S. shareholders have lost from $4 billion to $6 billion as a result of the Russian government's attack on YUKOS and Khodorkovsky. Today, Khodorkovsky and Lebedev are now on trial on criminal charges, inter alia, of embezzling all of the oil produced by the YUKOS production subsidiaries and money laundering that widely regarded as baseless.


Zoloto Resources

2008 Zoloto Resources, a Canadian gold exploration company stopped investing in Russia after the strategic deposit legislation designed to protect domestic producers became law.

Who Is Mikhail Khodorkovsky?

Prior to his arrest, Mikhail Khodorkovsky was known throughout the world as Russia's most successful businessman and leading philanthropist. He actively promoted civil society, fought corruption, encouraged foreign investment, and sought to integrate Russia into the world community. Mikhail Khodorkovsky is a patriot whose continued imprisonment is a scar on the Russian political and economic landscape. Mikhail Khodorkovsky built YUKOS into one of the most successful businesses in Russia by combining the best talent and best practices known in the oil industry. He, along with Platon Lebedev, introduced modern technology and management skills into what had been a nearly bankrupt Soviet-style energy producer. Wishing to share his success with his country, Khodorkovsky became a leading philanthropist, contributing millions of his own for civil society foundations, education programs, and student scholarships. Mikhail Khodorkovsky was born on June 26, 1963, in Moscow. His parents, Boris and Marina, worked as chemical engineers, earning modest salaries. Deciding to follow in his parents' footsteps, Khodorkovsky chose to study chemical engineering and graduated in 1986 from Moscow's Mendeleev Institute of Chemical Technologies. Khodorkovsky has also studied at the Plekhanov Institute of Economy - Russia's top economic management school - as well as at the Institute of Law. In 1987, at the age of 24, he founded the Youth Center for Scientific and Technical Development to conduct market research for large manufacturers and introduce them to new technologies. In 1989, Khodorkovsky together with his business partners founded one of the first commercial banks in Russia - later known as Bank MENATEP. In 1994, Bank MENATEP's board of directors decided to expand its business model to form a diversified industrial group called ROSPROM, which managed the transition of more than 100 large manufacturers from the Soviet economic model to free enterprise. In 1997, Group MENATEP Limited was established as a holding company, which later acquired majority interest in YUKOS. At the end of 2001, Mikhail Khodorkovsky established the Open Russia Foundation, a non-governmental organization dedicated to the principles of freedom and democracy.

Arrest and Trial

The arrest of Khodorkovsky's key associate, Platon Lebedev in July 2003 was widely interpreted as a warning sign aimed at the YUKOS chief. Against the advice of many, Khodorkovsky chose not to leave Russia because he was determined to refute the charges against him. He also considered leaving Russia a betrayal of Lebedev, his employees, and his homeland.


On October 25, 2003 Khodorkovsky was arrested at gunpoint in the city of Novosibirsk. After an unfair trial on trumped-up charges believed by many to be politically motivated, Khodorkovsky was sentenced on May 16, 2005, to nine years in prison. This sentence was reduced by the Moscow City Court to eight years.

New York Times - Ikea Plans to Halt Investment in Russia

June 24, 2009

By Andrew E. Kramer

MOSCOW — Ikea said Tuesday that it was suspending further investment in Russia, apparently because of pervasive corruption and demands for bribes. The announcement came after a rare statement by Ikea’s 83-year-old founder in a radio interview that Ikea had decided not to solve problems by slipping money under the table. Russian President Dmitri A. Medvedev has acknowledged that corruption is a national problem, and curbing official corruption is one of the goals of his tenure. Mr. Medvedev has signed a law prohibiting surprise inspections from fire and health authorities of the type often used to extort companies, and has required bureaucrats to disclose not only their own income and assets but their spouses’, a once common conduit for bribes. Beyond embarrassing Mr. Medvedev’s administration, the Swedish retailer’s public stance could mark an economic turning point if it leads to more Western businesses speaking out against corruption here. The decision is particularly damning for Russia because Ikea runs outlets in dozens of countries around the world and is hardly thin-skinned when it comes to dealing with bureaucracies. “We all support the anticorruption policies of President Medvedev,” Elena A. Panfilova, Russia director of Transparency International, the anticorruption group, said in a telephone interview. “But people need to see real results. And if companies like Ikea don’t see results in their daily business practices, it’s sad news for Russia.” In a statement, Ikea’s Russia director cited the “unpredictability of administrative processes” in Russia as the basis of the decision. Outside experts said that was the company’s way of describing a pattern of bribe-taking and shakedowns by Russian officials that had become intolerable. “Ikea as a major shopping center developer wishes to invest in Russia to serve our customers and bring jobs and growth,” the director, Per Kaufmann, said in the statement. “Yet, as long as the principal issues being crucial for Ikea development in Russia remain pending, we have to put all new investment plans on hold.” Ikea’s announcement came after a series of public complaints, including from the company’s founder, the secretive billionaire Ingvar Kamprad, who went on Swedish radio to complain that


the company had been cheated out of millions of dollars by overcharging for electricity. Mr. Kamprad linked the problems to Ikea’s decision not to pay bribes in Russia. Western business executives have complained privately for decades that bribery is an integral part of Russian business culture, often tolerated or silently rebuffed. In fact, foreign companies retain legions of lawyers so they can adhere scrupulously to regulations in hopes of avoiding providing an opening for bribe-seeking officials. Russia has fared badly on the group’s corruption perception index, tying with Bangladesh, Kenya and Syria for 147th place, out of 180 countries. The traffic police routinely take cash bribes, and in popular lore, their large motorcycle gloves are especially designed to store wads of bills. However, it is the next level of official venality, so-called administrative corruption, that is most harmful to business as fire, sanitary, tax, customs and other authorities with the power to halt business activity demand bribes. “It becomes a choice of businesses either to pay or get involved in years and years of paperwork exchange,” Ms. Panfilova said. Ikea operates both as a furniture retailer and a developer of malls in Russia, with its stores as anchor clients. Since the first store opened in 2000, the company said it had become the target for corrupt officials in Moscow and the provincial towns where it operated. In a recent interview, Mr. Kaufmann, the Russia director, told The Associated Press that the inspectoral assault sometimes gave him the feeling that “someone somewhere does not like us.” The company had been growing more vocal about its troubles this spring. Mr. Kaufmann went public with a threat to halt investment throughout Russia — the decision taken Tuesday — unless authorities allowed a store in the southern Russian city of Samara completed some months ago to open. Inspectors had said that the building was not sturdy enough to withstand hurricane-force winds; Ikea pointed to historical records showing that such winds have never occurred in central Russia. Regional officials in Samara have said they were ensuring the safety of the store, and that Ikea’s public statements were attempts to pressure inspectors. This dispute at the Samara store fits a pattern. Authorities have consistently blocked openings at the last moment, when a company is most vulnerable to delays because of the capital it has already invested. Days before the first opening of an Ikea store on the outskirts of Moscow, authorities declined to connect the electricity; Ikea resorted to renting generators, and since then has made a practice of having them on hand. In 2004, officials halted an opening ceremony at a separate Moscow store minutes before it was to begin, saying the parking lot was too close to a natural gas pipeline.


An outlet in Nizhny Novgorod was closed for its opening holiday season in 2006 on the grounds of fire-code violations; the opening of an outlet in Novosibirsk was postponed over demands to rebuild a road. In his statement, Mr. Kaufmann said Ikea would complete stores already under construction in Omsk, Ufa and the Moscow region but suspend future investment. The central government in Moscow has made no comment.

Russian Roulette: Current Investment Risks in Russia, January 2010

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