The Hermitage case and corruption in Russia

October 20, 2009

Foreign investors have come to accept that Russia is a pretty unforgiving place to put your money. Just ask BP, which was embroiled last year in a bitter feud at its joint venture TNK-BP, during the course of which BP endured a slew of questionable investigations and court cases. Or Norway’s Telenor, pressured recently into settling a dispute with its local partners under pain of seeing its stake at Russian mobile operator Vimpelcom confiscated by the government.

Such cases show how powerful interests seem able to use the legal process to extract money and concessions from foreign investors. But one foreigner’s tale makes even these well-known controversies look mild. Hermitage Capital Management, once the largest foreign investor in the Russian stock market, has become embroiled in a case that raises even more disturbing questions about the Russian justice system.

Hermitage claims to have uncovered evidence which shows that Russian gangsters conspired with bent cops and corrupt courts to steal three of its Russian subsidiaries, and subsequently used them to loot $230 million from the Russian budget by reclaiming taxes those companies had paid.

Meanwhile, Hermitage itself has become the focus of a criminal investigation in Russia, which the fund claims is retaliation for blowing the whistle on the corruption scam.

In the latest twist, Hermitage has written to the Russian State Audit Chamber with details of several other alleged tax frauds involving other companies, which Hermitage suspects may have cost the Russian budget an additional $240 million. In particular, it draws attention to an alleged scam involving two former subsidiaries of Renaissance Capital, Russia’s largest investment bank.

Hermitage believes that there may be a link between all these cases. In its letter to the government, Hermitage outlines many suspicious similarities between the alleged fraud involving former Renaissance subsidiaries, and Hermitage’s own case.

Hermitage alleges that the methods, courts, lawyers, tax authorities and recipient bank all coincided, as did individuals behind the litigant companies. Renaissance Capital has denied all knowledge of the alleged fraud, saying that neither the bank nor its investors were victims.

Hermitage’s letter also lists eight other instances of similar transfers from the Russian Treasury to Universal Savings Bank, an obscure Moscow bank (since liquidated) which Hermitage accuses of complicity in the fraud. It claims that the similarity of all these transfers “raise the substantial suspicion that all such payments were the result of systemic tax frauds”.

The government has yet to respond to Hermitage’s letter. A spokeswomen for the State Audit Chamber told Reuters that “no one will be able to comment until we study it properly because this letter mentions very serious things”.

Hermitage’s revelations are designed to pile pressure on the Russian government, which has hitherto largely ignored the fraud allegations, focusing its attention instead on accusations against Hermitage’s founder and CEO, William Browder.

Browder has been unable to enter Russia since 2005, when his visa was revoked by Russian authorities, supposedly on grounds of national security. Previously, his Hermitage fund had been the most active minority shareholder in Russia, loudly publicizing alleged cases of corruption, bad management and poor corporate governance at several large Russian companies.

Most outside observers have assumed that Browder’s activist tactics ended up antagonizing powerful people in Russia, leading to his expulsion from the country. On Oct. 9 the Russian Interior Ministry announced it had placed Browder on its international wanted list, claiming he was implicated in an unrelated tax evasion case. Hermitage has characterized the accusation as retaliation for Hermitage’s attempts to publicize the $230 million tax fraud.

Given Browder’s history, some investors in Russia have drawn the comforting conclusion that if you keep a low profile and “play by the rules”, then you will avoid the kind of problems that Browder is now publicising. But by uncovering a series of what may be similar cases, Hermitage is seeking to make the point that all foreign investors are exposed to such risks.

Whether there is substance to the new allegations by Hermitage is a matter the Russian authorities should investigate. Their response to date has been woeful. Although the authorities have acknowledged the existence of the original $230 million tax fraud and launched a criminal investigation, the only person brought to justice so far is an obscure ex-convict who worked at a sawmill in Saratov. No visible attempt has been made to recover the $230 million. Hermitage has long argued that the fraud required the collusion of senior police officers, tax officials and judges, as well as organized criminals.

Last month, President Medvedev himself made the astonishing admission that “corrupt officials run Russia”. And last week, Alexander Bastrykhin, the head of the Investigative Committee of Russia’s General Prosecutor, admitted that members of Russia’s police routinely assist crooked corporate raiders by falsifying corporate registrars and initiating bogus criminal cases. He made the comments in an interview with Rossiyskaya Gazeta, a newspaper closely linked to the Russian government.

The Hermitage affair offers the government an ideal opportunity to demonstrate that they aren’t just prepared to talk about such things. They should seize it, investigate thoroughly and act.

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