Hermitage and Russia's Vulture Capitalism

Last month Dmitry Medvedev set out his bold new vision of a "more civilized" Russia, no longer prone to the "legal nihilism" that has rotted the fabric of Russian capitalism and turned the courts and police into tools for settling private business disputes. Many hoped that such a powerful signal from the president would set Russia on course to establish the rule of law. Now, a high-profile test case will show who runs Russia—crooks with official connections, or the state itself. This week a criminal suit filed in a Moscow court details a scam in which senior bureaucrats, judges, and police defrauded the Russian taxpayer of half a billion dollars—and then used the courts to persecute the scam's victims when they tried to blow the whistle.

Right now the nihilists appear to have the upper hand. The plaintiff, American money manager Bill Browder, who once defended Vladimir Putin for playing hardball with Russia's business oligarchs, now lives in London, barred from Russia in 2005 as "a threat to national security." His Hermitage Fund, once the biggest foreign investor in Russia, has closed its Moscow operations. Hermitage's new lawsuit does not attempt to recoup the fund's money: it charges that a shadowy group of corrupt bureaucrats and police stole companies from Browder and others and used them to claim fake tax rebates from the Russian state. It seeks no redress for Hermitage other than the release of one of its lawyers, arrested nine months ago in an apparent bid by criminals with police ties to silence the company. Yet as of last week, the alleged crooks sit in police and government offices, while one of the apparent victims is in jail and other Hermitage lawyers and managers have fled abroad. Since Hermitage began complaining about the theft of its companies, Russia officialdom has done little to investigate—but it has placed Browder on an international wanted list for alleged tax irregularities. "We're trying to expose half a billion dollars stolen by officials from the government," says Browder. "I cannot imagine any other country which would take no action except to attack those who exposed it."

In recent years, many big foreign investors felt they have been harassed by questionable law-enforcement actions in Russia. Russian courts and ministries have slapped Shell with crippling fines for alleged environmental violations, mysteriously revoked the work permits of British oil executives from BP, diluted the holdings of Norwegian telecom firm Telenor. The fear is that anyone who runs afoul of the state is fair game—which is one reason why an estimated $7 billion in foreign capital has left the country in the second half of 2008. Foreign investment is down 22.9 percent since last year, according to the Noviye Izvestia newspaper. The Hermitage complaint is the most detailed anatomy of the state of Russian corruption to appear in years. The story is so outrageous—even by Russian standards—that a video summary posted by the plaintiffs has become the most viewed YouTube clip in Russia.

To understand why this case is so important to the future of Medvedev's Russia, we need to go into a little background. Browder, grandson of Earl Browder, one of the leaders of the Communist Party of America, started Hermitage Fund in 1997. His strategy: buy shares in big, inefficient Russian companies like Sberbank and Gazprom, and campaign for them to clean up their books and make their ownership structure and revenues more transparent. As they did so, their share prices went up.

That strategy worked well until Hermitage began asking questions about the ownership stake of a senior Kremlin apparatchik (whom Browder prefers not to name) in an oil company in which Hermitage was a minority shareholder. With no warning, in December 2005, Browder found himself on the Federal Security Service visa blacklist, and the Hermitage operation started winding down. Soon, vultures began circling in the form of a group of criminals with apparent deep ties to the tax inspectorate, according to court documents.

The basic idea of their scam was simple: acquire companies that had paid tax on their profits to the Russian government, then create fake losses, and use the adjusted balance sheet showing a zero profit to claim the taxes back as a rebate. "Fake tax refunds have become a popular scam," says Larisa Mave, a Moscow lawyer who has become an expert on Russian corporate raids. "Obviously, such a crime would not be possible without tax police getting a share."

The scammers first targeted companies set up by Renaissance Capital, one of Russia's largest investment houses, in order to buy shares in Gazprom for various international clients. After the shares had been bought and sold and taxes paid on the profits, the companies were left empty of funds. At that point, Renaissance says, they sold off the companies to a group of investors and heard no more about them. The purchasers—using a convicted murderer as their front man—then faked losses in order to retroactively claim back the tax money paid by Renaissance. The only loser, on paper, was the Russian taxpayer. Renaissance made no complaint about the fraud, saying that the companies were no longer theirs and they had suffered no loss. Browder cites the silence as evidence that Renaissance colluded with the fraudsters, a claim that a Rencap spokesman describes as "unsubstantiated allegations based on speculation and hearsay."

Next, the scammers set their sights on a series of investment companies created by Hermitage, only these weren't for sale. The scammers' solution offers a startling insight into the way law and order works in modern Russia. In June 2007, citing an alleged tax violation by Hermitage, a group of 25 masked police raided the offices of Hermitage and of Firestone Duncan, Hermitage's lawyers. After beating up a lawyer who questioned the officers (he was hospitalized for a week), they confiscated two vanloads of documents—including the founding charters of three Hermitage-owned holding companies. While the documents were in the possession of the police, new charters transferring the companies to new owners were drawn up, signed and certified, all unbeknown to Hermitage. "No one can dispute that the change of ownership of the companies happened while the documents and stamps were in police custody," says Jamison Firestone of Firestone Duncan.

The conspirators appeared to have allies everywhere in official Russia. Their next move was to sue the stolen companies in Moscow, St. Petersburg, and Kazan for breach of various contracts—also forged. Lawyers for the new owners pleaded no contest, and judges in all three cities awarded damages that amounted to the exact sum of the previous year's profits. Result: the companies now no longer showed a profit for the previous tax year, but only broke even.

The new owners quickly claimed a tax rebate totaling $230 million, the biggest tax refund ever made in Russian history—yet was approved the day after it was filed and paid out the following day. Officials from the tax departments involved are named in Hermitage's lawsuit as key players in the fraud. So far, so neat. Hermitage had suffered no loss because the holding companies had only existed to trade Gazprom shares, and were empty of funds by the time they were stolen. Only the Russian state had lost out. But unlike Renaissance, Hermitage decided to go public, filing 35 complaints to Russian officialdom, from the Federal Security Service to the tax police.

Retaliation came quickly. Clearly, the conspirators hadn't reckoned on publicity and so decided to cover their backs. In January, Sergei Magnitsky, one of Firestone Duncan's top lawyers, was unexpectedly arrested as he arrived to give evidence to a prosecutor assigned to investigate the case. Imprisoned without bail and denied permission to see his family, Magnitsky told his boss, Firestone, that he hadn't been seriously questioned, but instead that police and investigators had repeatedly made offers to free him if he gave evidence against Hermitage. Magnitsky has refused to do so. Freeing Magnitsky has become Hermitage's main priority, which is why it's doggedly investigated the scam, uncovering eight more companies targeted and a further quarter-billion dollars in stolen tax money. Hermitage has passed its evidence to the Russian government's Audit Chamber, which has a mandate to investigate official malpractice. "The whole story shows the level of corruption in the country," says Browder. "One leader—Medvedev—at least acknowledges the problem, but he seems to be unable to do anything. The state is incapable of protecting its own interests."

Top Kremlin reformers such as presidential economic adviser Arkady Dvorkovich and deputy chief of the Kremlin staff Igor Shuvalov are aware of the problem and even sympathize with Hermitage, says one senior Western diplomatic source in Moscow not authorized to speak on the record. But it's clear that they lack the power to act. Many Russian officials just shrug off the case. Gennady Gudkov, a former KGB colonel who heads the Duma's Security Committee, says Browder should have followed Russian rules—that is, by employing the right security company, known in Russian as a krysha, or roof. "Browder was too greedy, he should have spent more money on security," says Gudkov, who himself runs a major private security company. "If he dealt with us, we would have protected him." Alexander Dubrovinsky, a lawyer for the Arbat Prestige cosmetics retailer whose CEO was jailed last year in a corporate raid, says, "Browder's tactics could make sense in some other country—but here he had no chance of winning. Back in 2002 I told Mr. Browder that his struggle was hopeless." Some colleagues believe Browder courted disaster. "Browder's style was to shout about corruption from the rooftops; that's a good way to get yourself into trouble in Russia," says one top Western banker in Moscow who requested anonymity, fearful of damaging his business in Russia. "Most foreign investors try to play by Russian rules, which means staying quiet and sharing your profits with people who can look after you"—like top officials and secret policemen.

In the end the real loser is Russia. Russian stocks sell at a 40 percent discount to other emerging markets, largely because of the uniquely high risk that companies can be stolen by well-connected hoods. Foreign bank credits come at a premium, for the same reason. Since 2002, Russia has fallen 30 places to number 147 on Transparency International's ranking of the world's most corrupt nations, based largely on investor surveys. Russia's own Interior Ministry reports that the "average bribe" for a range of bureaucratic services has risen 10-fold in the past decade. "Who is going to give Russia money when the court system does not work, everybody ignores the law, both government and society think it is OK that thousands of private businesses are stolen every year in Russia and that raiders are paid 30 percent of the companies' assets, which comes to hundreds of millions of dollars?" says Kirill Kabanov, an adviser to Medvedev and the head of the National Anticorruption Committee, an NGO.

Good question. On Nov. 7 the Russian government will hold a road show in London, trying to sell $17.8 billion in sovereign Eurobonds to the world. Officials of Medvedev's government have forecast an "enormous appetite" for Russian bonds, based on "the gradually improving, stabilizing financial situation." To justify that optimism, Medvedev needs to do more than criticize legal nihilism. He needs to show that his country's police and tax services aren't run by criminals, and that his country's courts and prisons aren't for sale to the highest bidder. If he fails, then it's only a matter of time before Russia becomes too toxic for even the most swashbuckling investor. And without the flow of foreign capital, there's next to no chance that Russian business can develop—or for Russia itself to realize Medvedev's dream of becoming truly "civilized."