Committee for Russian Economic Freedom

Davos 2011

News out of Davos that the Moscow regime has struck mega mega oil and gas deals with BP and Exxon Mobil has heightened a sense among other potential investors that Russia may not be worth the risk. In their agreement with Igor Sechin’s state-controlled Rosneft, BP even turned its back on long-time Russian partners TNK, which took action yesterday in a London court to protect its interests.

Exxon Mobil also doesn’t seem to have a problem in doing business with Sechin and others who built Rosneft by stealing the assets of Yukos and sending its chairman Mikhail Khodorkovsky to a Siberian prison.

Despite an attempt by President Medvedev at Davos to promote investing in Russia, the corruption tax on investment flows directly to the Kremlin. As these two deals demonstrate, the Kremlin orchestrates deals to enrich themselves, adding resonance to Medvedev’s own words to Russian business leaders on December 29 that the country’s investment climate is “very bad.”

As Mikhail Khodorkovsky recently said to the International Herald Tribune and others,

It is obvious that those who can truly be called “oligarchs” – those who have combined state power and big business in one individual – were created by none other than Vladimir Putin and are his comrade-in-arms. The rest of the “Forbes faces” – and indeed a significant part of small business as well – have agreed to pay tribute to the bureaucracy in one form or another…Russia is a sovereign state, but to support deception to demonstrate respect for its corrupt officials, is amoral.

News of corruption-related crimes involving top government officials and large bribes increasing 100% in 2010 year-on-year in Russia comes as studies in geopolitical risk and economic opportunities reiterate Russia’s decline. Two notable studies on business risk came out this week, Heritage Foundation’s Index of Economic Freedom and Maplecroft’s Political Risk Atlas.

In the Heritage Foundation report, Russia remains in the bottom quintile and is only 0.6 points away from being in the “repressed” category of the index.

Russia scores very low in the categories Freedom from Corruption, Investment Freedom and Property Rights. From the summary report

Economic freedom is severely challenged in Russia. While strong returns from hydrocarbons have buoyed its economy, prospects for sustained, long-term diversification and growth remain dim…Pervasive corruption and limited respect for property rights hinder the development of economic activity that is free from government control or influence. Macroeconomic instability is a drag on economic growth.

In the Maplecroft report, the focus is widened to include political risks as well as emergins risk areas, notably structural risk affecting long-term infrastructure stability. Widening the scope of the survey seems to dampen Russia’s prospects further as Russia moved into the “extreme risk” category of their study for the first time. Russia is ranked 10th most risky country, sandwiched between Pakistan at number 9 and the Central African Republic at 11.

Political Risk Index 2011 (Dynamic) © Maplecroft, 2011

Russia’s extreme risk rating is exacerbated by the increased activity of militant Islamist separatists in the North Caucasus region. In 2010, terrorist attacks in this area doubled. Additionally, the business and investment environment in Russia is under a lot of pressure from the government. The Maplecroft study summarizes Russia’s business climate this way,

The country’s poor performance is compounded by its “extreme risk” ratings for its business environment, corporate governance and the endemic nature of corruption, which is prevalent throughout all tiers of government.

Challenges for companies operating in Russia also stem from an ineffective legal and regulatory system, which includes a lack of judicial independence from the government. This was most recently in the politicised case agained jailedYukos oil tycoon Mikhail Khodorkovsky, which most commentators dubbed a show trial.

Maplecroft also sees worsening stuctural issues for the BRIC countries and particulary Russia. In Ariel Cohen’s analysis of the Khodorkovsky verdict, he sees a “telephone” law at work where “a system in which punishments are triggered by phone calls from higher ups”

Given all this evidence, why risk Russia?

Russia started 2011 in the shadow of the Khodorkovsky trial. Judge Danilkin delivered a guilty verdict and the maximum sentence requested by the prosecutors, signalling to investors that Prime Minister Putin’s power vertical remained as strong as ever. Despite recovering from the lows of 2009, First Deputy Chairman of the Central Bank of Russia Alexei Ulyukayev recently told the press that total capital outflors will be in the $25-30 billion range. Russian investors took Putin’s retention of power seriously and looked for safer places to invest.

According to Russia analyst James Beadle:

[Russia's] economic development is the innocent victim in this domestic power play. Russia’s business leaders may understand this message but international investors don’t. They observe a distrubing dichotomy between words and actions. Putin has demonstrated that his arbitrary word is the law and that Russia’s legal system remains feudal…Russia’s popularity as a target for investment of all forms will be hindered by insecure political structures. Foreign direct investment will be the biggest victim.

Russia also faces pressure to reduce corrpution and President Medvedev has put that at the top of his agenda. Despite Medvedev’s efforts at combating corruption, Russia continues to fail to comply with the Council of Europe’s Group of Statees Against Corruption (GRECO). Out of 26 recommendations made, Russia completed only a third. Accoring to Alexei Volkov, head of the State Duma’s commission on anti-corruption legislation, change in the area of corruption requires “deep” analysis to see if “they will work in Russia taking into account our culture and tradions.” Would that be the culture of corruption Mikhail Khodorkovsky mentioned in 2010?

Tony Avelar/Bloomberg News

News that Goldman Sachs engineered a major stake in Facebook, the world’s most popular social networking website, by Moscow-based investment firm DST Global offers more evidence to support Mikhail Khodorkovsky’s observation in the Washington Post last year that corruption ranks as a leading Russian export.

“The source of the funds used to make the Facebook investment merits further investigation,” said Pavel Ivlev, chairman of the Committee for Russian Economic Freedom. “It’s increasingly clear that money stolen by corrupt Russian officials is being spirited out of the country and invested in legitimate Western businesses.”

Created in 2005, DST is owned by oligarch Alisher Usmanov and Yuri Milner, founder of Russia’s most successful Internet ventures, including Mail.ru.

Usmanov, a native of Uzbekistan, spent six years in an Uzbek prison on a conviction of fraud and embezzlement in the 1980s, charges he says were politically inspired. A Soviet court later dismissed the charges and Usmanov eventually made billions of dollars in the post-Soviet era by managing steel mill subsidiaries for Gazprom before they were spun off as his own businesses.

The record shows that Usmanov’s relationship with Vladimir Putin and other Kremlin leaders has made him one of Russia’s wealthiest men. From his lead role at Gazprom, the state-controlled energy giant that absorbed assets stolen from Khodorkovsky’s Yukos in 2003-2004, to his current company Metalloinvest, Usmanov has made the money he used to invest in Facebook by capitalizing on what former Prime Minister Mikhail Kasyanov calls “Putin’s capitalism for friends.”

Milner got his start in business working for Khodorkovsky’s bank Menatep, setting up a brokerage and investment arm before leaving in 1997, the Financial Times reported. Officials aligned with the regime later prosecuted former Menatap financial executives and tried to force them to testify falsely against Khodorkovsky. But not Milner, who shifted into investing in the Internet with the backing of Usmanov and others tied to Putin.

Following Khodorkovsky’s conviction last month a second round of trumped up charges, Russian Foreign Ministry spokesman Andrei Nesterenko dismissed protests from leaders in Washington and EU capitals, saying “we expect everyone to mind their own business, both at home and in the international arena.”

Investors in Russia have done just that, “minding their own business” by pulling assets out of the country at an accelerated pace, according to Pavel K. Baev in a post-verdict analysis.

The conviction of Khodorkovsky proves that Prime Minister Putin and not President Medvedev controls Russia and “translates into a re-evaluation of business and personal prospects in a country of self-serving bureaucracy – and into capital flight that increased sharply in the last months of 2010 and is set to reach $25 billion to $30 billion,” Baev wrote.

“Medvedev tries to explain away this worrisome trend by emphasizing the need to improve the investment climate, which in his view “leaves something to be desired; it is bad.” Medvedev has also initiated a package of reforms in economic legislation that should take effect in 2011-12, and quite probably he simply does not understand that the Khodorkovsky case is not a minor setback for the markets, as it was five years ago, but the irrefutable verdict on his “modernization” strategy.” Yet the verdict renders hollow Medvedev’s statements supporting the rule of law and enforceable contracts in Russia.

“Investors in PepsiCo, Morgan Stanley, Facebook should closely question their board members about the prudence of those companies risking capital with the Putin regime given the growing list of major Western companies that have been defrauded by corrupt Russian officials,” Ivlev said. “But more telling are the latest statistics which show that Russian businesses that have benefited from the regime are now eschewing further investments in the country given the lawlessness that they themselves helped promote.”

Verdict Destroys Hopes for the Rule of Law, Independent Courts, Protection of Property Rights and Government Anti-Corruption Drive in Russia

Defense Slams “Charade of Justice”

Reuters

New York, December 27, 2010 – Today a Moscow court found Mikhail Khodorkovsky and Platon Lebedev guilty of embezzling a staggering two thirds of the total production of the Yukos Oil Company over a six-year period. The conviction in this 22-month mock judicial process confirms the subservience of the judicial system in Russia to corrupt officials who continue to view Khodorkovsky as a threat and who seek to prevent his scheduled release in 2011. Khodorkovsky is already serving an 8-year sentence, handed down in 2005, but dating from his arrest in 2003. Had he been found not guilty he would have been released in 2011, a few months before Russia’s 2012 presidential elections. The new unlawful prison term will be announced either this week or shortly after the Khamovnichesky Court reconvenes from holidays in mid-January. Prosecutors have asked for 14-year sentences for Khodorkovsky and Lebedev.

According to lead defense lawyer Vadim Klyuvgant: “The trial was a charade of justice, the charges were absolutely false, but I fear the sentencing will be very real.”

The behavior of the prosecutors and of the judge turned the trial into a fiasco. Despite filling time by reading from a 188-volume case file, and parading numerous witnesses into court, prosecutors were unable (and did not even try) to prove how it was possible that Yukos covered its operating costs, invested heavily in capital expenditures and acquisitions and paid taxes and dividends when the entire oil production of Yukos over a six-year period was being stolen, as alleged in the indictment. At the end of the trial, prosecutors further confused their case when they attempted to save face by reducing the volume of oil allegedly stolen by approximately one third.

“This verdict diminishes Russia’s legitimacy in the world stage and signals to policy makers and investors that Russia’s political leaders apply the law as they see fit,” said Pavel Ivlev, former corporate counsel to Khodorkovsky.

The authorities misleadingly attempted to portray the process as legitimate. The defendants were permitted to speak in court almost without restrictions, but the judge blocked their lawyers from introducing exculpatory documentary evidence and refused to hear many witnesses and experts. Illusions of adversarial process and legitimacy were created by allowing the defense to file motions and objections to serious procedural violations, however the judge routinely quashed the vast majority of these motions and failed to react to the objections. The defense and the defendants persisted to the end in doing anything they could to document the full extent of the mistrial, and have publicly released online all submissions rejected by the court.

The verdict in this trial is based on patently false allegations that are incompatible with the first case against Khodorkovsky and Lebedev and with the enormous tax claims that bankrupted Yukos to the benefit of persons controlling state-run Rosneft. The conviction is also impossible to reconcile with numerous decisions of Russian courts that have recognized the tax claims against Yukos. Today’s ruling also contradicts Russia’s official position as it attempts to defend its treatment of Khodorkovsky, Lebedev and Yukos before the European Court of Human Rights. There, the Russian authorities allege that it was lawful to impose grossly punitive taxes on proceeds from the sale of oil owned, sold and accounted for by Yukos. On the other hand, in the Khamovnichesky Court the prosecutors allege on behalf of the Russian Federation that the same oil was stolen from the company by Khodorkovsky and Lebedev, and therefore could not have been sold by Yukos. The court supported the slanderous allegations of oil theft despite the fact that the so-called “injured parties”, production subsidiaries of Yukos, received not only full compensation for their production costs but also 2 billion USD profits from sales.

Politically it is notable that in the most high-profile trial in Russia, closely-watched by the public and media all over the world, the court could so openly ignore applicable procedural and substantive laws as well as basic notions of fairness. This is testament to the power of those corrupt officials who zealously seek to justify their seizure, control and ownership of Yukos assets and to isolate Khodorkovsky and Lebedev from Russia’s business and public spheres – and to keep them in jail as long as possible to achieve these goals. Prime Minister Vladimir Putin’s most recent (but far from the first) public intervention in the case and undisguised pressure on the court came in televised remarks on December 16, 2010, one day after a last-minute postponement of the reading of the verdict to December 27, 2010. With the judge still deliberating on the case, the Prime Minister directly mentioned the current charges and stated that Khodorkovsky’s guilt had been proven in court and that he must stay in jail.

The trial and its verdict are an open challenge – and indeed an affront – to President Dmitry Medvedev’s highly-publicized efforts to ensure the rule of law and to reform Russia’s criminal justice system and to fight government corruption. If upheld on appeal, this verdict shall be a triumph of corrupt officials controlling Russia’s law enforcement and judicial bodies, and a setback for an entire country that aspires yet continually fails to modernize.

Alrosa, world’s second largest diamond producer, is considering a stock market flotation in 2012. Currently majority-owned by the Russian government, Alrosa is closed to outside equity investors. Despite some optimism that greater foreign investment would translate to better corporate governance, Alrosa is preparing for their float by restricting the ownership structure. This is standard operating procedure at Kremlin Inc. As we have noted before, the Russian government keeps tabs on its investments even as it looks for fresh sources of capital outside its border by restricting percentage of shares a Russian company can list abroad.

With state capitalism firmly entrenched in Russia, Alrosa maintained its production volume even as other diamond producers have scaled back. Alrosa sells its excess diamonds to the Russian government, which owns a $1 billion diamond stockpile. This indicates that Kremlin officials might have other uses for Alrosa besides the float on a foreign exchange, as another channel for top-level corruption.

The verdict for the Khodorkovsky trial has been postponed until next Monday, December 27th and it looks like the market has already priced in his continued conviction. Russian stocks remain at a 30% discount to other emerging market stocks based on forward price/earnings multiples. That the government or oligarchs own 44% of Russian equities may indicate a not just a strong government influence in business but also a lack of enthusiasm among foreign investors for Russian companies. And since 2005 the 24 stock offerings of Russian companies have returned 13%, but remove gas producer Novatek and the return falls to less than 1%. No wonder investors are in no hurry to allocate capital to Russia.

Today the postponement of the verdict for Mikhail Khodorkovsky was announced by Judge Danilkin without much fanfare. Already a strong litmus test for President Medvedev’s commitment to end legal nihilism, the Khodorkovsky trial has become a bellwether for the future of Russia. Moving the verdict to December 27th, the traditionally quiet period between Christmas and the New Year seemed to some like the Russian government wanted to reduce the world’s focus on Russia’s most famous prisoner.

US Senator John McCain recently said at a speech at John Hopkins University,

And then there is the sad ongoing saga of Mikhail Khodorkovsky, whose company was stolen from him, and who has languished in jail for seven years.  When his sentence expired recently, new charges were manufactured against him. He is not being tried by a jury, just a single judge, and the political fix has been in for a long time. He could now face up to 12 more years in prison. If ever there were a case of ‘legal nihilism’ – of an affront to the very values of equal justice that we hold dear – the case of Khodorkovsky is it.

David Remnick, editor-in-chief of the New Yorker, wrote the lead Talk of the Town article this week when he addressed the issue of the Khodorkovsky trial and what it means for Russia’s future

Khodorkovsky exploited the lawlessness of the era no less than his fellow-oligarchs did, but he was more reserved than the rest…Over time, he also displayed unusual signs of independence from his Kremlin patrons. And, for Putin, there was the rub. Khodorkovsky began to see the necessity of playing a less sleazy game—not least in order to attract foreign investors…
The Khodorkovsky affair long ago erased any notion in Russia of an independent judiciary; it made plain that the courts do the bidding of a corrupt hierarchy that will stop at little to enrich itself.
Russia undermines its pretense to modern statehood with such an appalling abuse of state power. Putin’s ruthlessness is apparent. President Dmitry Medvedev ostensibly has the power to pardon, and he has shown some small measure of independence from his patron, speaking of the “legal nihilism” that prevails in Russia today. Does he have the capacity, much less the courage, to release Mikhail Khodorkovsky?

In his article, “What now for Russia? Part Three” Anthony Harrington argues that not only does the Khodorkovsky trial blatantly flaunt the rule of law, the actions of Khodorkovsky and his business associates indicate that he was getting Yukos in financial shipshape for a possible sale to foreign investors and listing on the New York Stock Exchange.
Which leads us to the question of what does the postponement mean? While reading into the nondecision is a little like reading tea leaves, it is probably safe to say it indicates a neutral or negative final outcome. With the delay, the authorities may try to mitigate negative public reaction to a guilty verdict. Alternatively, it could be that the judge, who obviously had made his own opinion so far, was unable to get approval from his supervisor. Or it could be something else more germane, such as needing more time to write the decision. Ultimately, the postponement demonstrates to the world that Russia’s judicial system is far from independent.

On Russia’s Constitution Day, December 12^th, demonstrations in support of Mikhail Khodorkovsky and against the Russian government will take place in Moscow, St Petersburg, New York, Chicago and London.

The protests are against Russia’s failed judicial system, and the government system that is corrupted to the core. In New York, the demonstration will be held at noon ET by the Permanent Russian Mission to the UN at 136 East 67 Street.

For more information, click here.

Boris Nemtsov at an event hosted by Columbia University's Harriman Institute and the Institute of Modern Russia

On November 17, 2010, Boris Nemtsov, a leader of the Russian democratic opposition and a former Deputy Prime Minister of Russia, spoke at Columbia University’s Harriman Institute on the current political situation in Russia and his perspective for its future. Echoing his thoughts and research in his recently published pamphlet, “PUTIN: What 10 Years of Putin Have Brought,” Mr. Nemtsov equated Prime Minister Vladimir Putin’s economic policy with Russia’s corrupted state. “If you break corruption, you will break Putin,” Mr. Nemtsov said.

The symbol of corruption in Russia remains the imprisonment of Mikhail Khodorkovsky. Mr. Nemtsov speaks in this video at length about how Khodorkovsky’s imprisonment is an impediment to foreign direct investment and perhaps even more importantly, how freeing Khodorkovsky allows President Dmitry Medvedev the opportunity to break free of Putin’s vertical power chain.

Allegations of corruption on a grand scale continue to dog the Kremlin. Transneft was accused by minority shareholder Alexey Navalny of embezzeling $4 billion during the construction of the East Siberia-Pacific Ocean pipeline. Some of the materials that support his allegations come from mid-level civil servants in the Audit Chamber, perhaps implying that vertical power is most profitable at the top.

Although much is written about the corruption in Russia, estimated by Russian authorities to be between $200 and $300 billion annually, the main indicator for investors is their return on investment.

There was another call today, to remove Russia from the group of emerging market powerhouses, BRIC and replace it with Indonesia. Although a fabricated group of emerging market countries, the allure of BRICs remain and companies from BRIC companies dominate indexes. Indonesia has a younger, growing population, maturing social and political institutions and commitment to education and public health and make it more attractive to foriegn investors. Above all, investors seek growth on their investment, as long as the Kremlin continues to siphon off working capital to grease their vertical power structure, Russia will only continue to be less productive and become less attractive to investors.

PUTIN: What Ten Years of Putin Have Brought

Our recent participation in the Global Macro Investing and Geopolitical Risk Forum in New York helped us focus attention on the challenges and potential rewards of investing in Russia. We are asking supporters of free markets, free ideas and free people to show support for the rule of law, transparency and secure profits by requesting a symbolic share in Russian Economic Freedom today.

By becoming a shareholder in Economic Freedom you will send a message to Russia’s leaders that direct foreign investment will increase only if they stem corruption, increase transparency and enhance corporate governance. Owning a share will cost you nothing more than the courage of your own convictions, yet it will yield tremendous social and financial rewards for asset managers and the Russian people alike. Hedge your position – short Russia’s current regime and go long Russia’s economic future.

As you know, hope for an improved investment climate in Russia surged after President Dmitry Medvedev’s tour of Silicon Valley in June and California Governor Arnold Schwarzenegger’s October visit to Skolkovo, the new business and research hub started by Medvedev to encourage high tech innovation. Despite intense words of support by the Russian political and business elite, it’s become even more apparent that incubating entrepreneurs in Russia face massive bureaucratic hurdles to success.

As part of President Medvedev’s push to diversify the economy, he has launched an anti-corruption campaign, but the results have demonstrated the systemic nature of corruption in Russian society. The Prosecutor General Yury Chaika announced that the average bribe increased 30 percent to 30,500 rubles ($1,015) from 23,100 rubles last year. At a meeting of the heads of the law enforcement agencies, Chaika exhorted his colleagues, “In 2008 and 2009, we saw a significant revival of work in this area, but the results of the activities of law enforcement agencies in the first half of this year confirm complacency and a decrease of effectiveness and quality of work.”

At the capital markets level, a disappointing performance for Russian IPOs this year reflects the lack of progress in strengthening enforceable contracts, scaling back government intervention in business and allowing greater political expression. So far, the Russian IPO market has totaled only $3 billion this year, of which $2.2 billion is made up of the Rusal IPO on the Hong Kong Stock Exchange in March. This is only a tenth of the $20 billion IPO market predicted earlier this year by sell-side analysts.

The Russian stock market is posting gains along with increases by other emerging powerhouses China and India. However, volatility reigns as valuations on the RTS Index are trading at an average multiple of seven times 2010 earnings while other emerging markets are changing hands at an average of 13 times earnings. This represents an inherent risk premium for Russian businesses as investors seek safer harbors for their assets.

Transparency International’s recently released 2010 Corruption Perceptions Index ranked Russia as the world’s most corrupt major economy, falling to 154th of 178 countries. (Russia placed 146th in the 2009 index of 180 countries.) Russians now pay bribes totaling $300 billion a year, equivalent to almost a quarter of the nation’s GDP, according to Kirill Kabanov, head of the National Anti-Corruption Committee.

Jailed Russian businessman Mikhail Khodorkovsky and Hermitage Capital’s Bill Browder know all about doing business in Russia and how successful businesses can be run aground by the capricious whims of government officials. Khodorkovsky’s second trial is approaching its end and despite the trappings of a functioning judicial system, the ultimate decision maker of his fate rests within the Kremlin.

“A guilty verdict would damage President Medvedev’s reputation and his drive for modernization,” Mark Urnov, a political scientist at the Higher School of Economics in Moscow, told Bloomberg News. “Though Medvedev has never said that he’d like Khodorkovsky to be freed, his acquittal would be seen by many as Medvedev’s achievement.”

James Beadle, a U.K.-based consultant for investors in Russia, echoed that “a negative outcome for Khodorkovsky is likely to reinforce investor skepticism toward the fairness of the Russian business climate … I don’t think that any foreign company is under any illusions that things have changed; they remain hesitant.”

Investors should also heed the fate of Sergey Magnitsky, Hermitage Capital’s attorney who refused to give in to corrupt tax officials only to pay with his life. Recently, both US houses of Congress introduced the “Justice for Sergei Magnitsky Act of 2010”, which is not only symbolic but hits his perpetrators in their pocketbooks. The bill prevents Russian officials implicated in Sergey’s murder from entering the United States and freezes their assets here.

When introducing the bill, US Senator Benjamin Cardin said,

Nearly a year after Sergei’s death, the leading figures in this scheme remain in power in Russia. It has become clear that if we expect any measure of justice in this case, we must act in the United States…At the least we can and should block these corrupt individuals from traveling and investing their ill-gotten money in our country.

Although Russia is a tempting place to invest in new business with their highly educated population and large reserves, you should be cautious about the exhortations offered by President Medvedev. He has promised much but delivered little during his term and with the 2012 presidential elections coming up, the winds are blowing against his direction and even his meager declarations of modernization, transparency and accountability may come to an end.

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