YUKOS AFFAIR

YUKOS AFFAIR

In October 2003, Mikhail Khodorkovsky—by many estimates Russia’s richest man—was arrested for tax evasion, fraud and other charges. At the time Khodorkovsky was the CEO and largest shareholder of Yukos, one of Russia’s largest oil companies, and one of the most powerful oligarchs. Also arrested were Alexei Pichugin, former head of security at Yukos, and Platon Lebedev, former president of Yukos.

The arrest and trial of Khodorkovsky captured the imagination of the Russian public and the Western press and sent shivers down the spines of foreign investors. Many of the events unfolded during an election in which many think Putin wanted to make a point of cracking down on the largely reviled oligarchs. Khodorkovsky’s arrest also seemed to be a message to other oligarchs and business leaders not overstep their bounds.

Khodorkovsky is widely believed to have been arrested because he was an outspoken critic of Putin and he gave large amounts of money to liberal political parties that opposed him. In February 2003, he personally confronted Putin at a meeting between the President and businessmen and accused his government of corruption in regard to the sale of an oil company to the state-owned oil company. Khodorkovsky also angered Putin by suggesting a different pipeline route from Siberia to Asia than what the government proposed.

Putin was criticized for cracking down on one set of oligarchs only to create new ones. For example one company that benefitted the most from the Yukos affair was Rosneft, which was headed by Putin crony Igor Sechin.

Khodorkovsky

Khodorkovsky was one of Russia’s most well known oligarchs. A former Communist Youth League member, he became a billionaire while still in his early 30s and was known for his polite, deferential manner and the unscrupulous means he initially used to become so rich. At its highest point his net worth was estimated to be $15 billion when he was 40.

Khodorkovsky grew up in a communal apartment in Moscow. The only child of two engineers, he earned pocket money as a child by loading candy for a candy company. In college he worked on a railroad in Siberia, guarding payrolls with an ax. As a young man he allied himself with the Communist Party and rose to a senior position in Communist Youth League, quite an accomplishment considering his father is Jewish.

After graduating from Mendeleev Institute of Chemical Technology with a degree in chemistry Khodorkovsky launched a new company with support from the Communist Party. The company was called Menatap—an abbreviation for the Soviet sounding Inter-Industry Scientific Technical Programs. The company got started selling computers and doing currency exchanges and did well brokering deals between several government bureaucracies and industries. Khodorkovsky’s early success was the result of a combination of his party connections and his business acumen.

Yukos

Yukos was Russia's largest oil company and the 4th largest oil firm in the world.. At the time Khodorkovsky was arrested, it was ranked first in Russia in reserves and had a capitalization of $50 billion, annual sales of around $12 billion and was making profits of $1 billion every three months. It pumped 1.7 million gallons a day, 2 percent of the world’s total. Its proven reserves of 13.7 billion barrels was equal to the reserves of Algeria. It pumped more oil than Libya.

Yukos tapped oil from deposits in western Siberia, east of the Volga River, north of Kazakhstan and south of the Urals. Yuganskneftegaz, Yukos’s Siberia unit, accounted for 60 percent of its daily out output of 1 million barrels a day. Yukos also developed a remote site in eastern Siberia and the fields in Khanty-Mansiyak.

Yukos had 150,000 employees and was a major employer in a region with 30 million people. It operated gas stations throughout Russia. In 2003, it was the second largest tax payer in Russia, paying taxes that amounted to almost 5 percent of federal budget. Workers in European Russia were paid 7,000 rubles a month. Those in Siberia earned 30,000 rubles a month.

How Khodorkovsky Got Rich

In the early 1990s, Menatap was turned into a bank. At that time Russia had no treasury so it relied on banks to distribute money. Menatep became involved in this “authorized banking” and made a lot of money through it. In many cases its delayed payments and used the money to make investments, pocketing the profit.

After the collapse of the Soviet Union, Khodorkovsky set up an office in the Russian government building and made friends with powerful government officials. In 1993, he was appointed deputy to the energy minister at a time when that ministry was figuring out how to reorganize Russia’s oil industries into units that later become Russia’s oil companies. He was a key advisor to Prime Minister Victor Chernomyrdin, who organized the sale of the oil companies.

In the meantime Khodorkovsky began acquiring properties using dubious techniques to acquire millions of vouchers during the privatization auctions. In 1994, he obtained a stake in the fertilizer company Apatit, valued at several billion dollars, by making bids through fake companies that backed out at the last minute. Only four companies made bids for Apait—three fake ones and a real one controlled by Khodorkovsky. When the three dropped out only the company owned by Khodorkovsky was left. It then in turn failed to pay the amount of money promised and sold off the shares to other companies owned by Khodorkovsky.

In this way Khodorkovsky was able to snatch 20 percent of the fertilizer company at a fire sale price ($225,000 instead of the $283 million he promised to pay). The move would later come back to haunt him. It was the basis of tax evasion and fraud charges that led to his arrest in 2003.

By 1995 Khodorkovsky was so rich his bank, Menatep, gave Yeltsin a $168 million loan to cover a budget deficit. But just as quickly his fortunes turned. In 1998, during the collapse of the ruble, his bank along with other Russian banks collapsed and he lost it.

In the meantime, however, he had acquired other assets. By 1998 Khodorkovsky owned 1) Yukos Oil (then Russia’s largest oil company, ranked first in reserves); 2) Menatep holding company (ranked third in capital in 1998); 3) Rosprom (a holding company with chemical, textile, mining, petrochemical and food industries) 4) 10 percent of Independent Media (publishers of the Moscow Times, St. Petersburg Times and the Russian versions of Playboy, Cosmopolitan and Good Housekeeping.

Khodorkovsky Takes Control of Yukos

Khodorkovsky obtained Yukos at a privatization auction in 1996. He and his partners obtained 78 percent of Yukos for the incredibly cheap price of $310 million (with 45 percent going to Khodorkovsky for $159 million) apparently with approval from Chernomyrdin. The Yukos deal was part of the “loan for shares” scheme in which the nearly broke Russian government decided to swap its oil companies for loans. The whole scheme was devised by future oligarchs and helped create the bond between them and Yeltsin. Menatep organized the Yukos auction, and it was no surprise that a Khodorkovsky front company won.

When Khodorkovsky took over Yukos it was losing money and it had not paid its workers for six months. It was $3 billion in debt and pumping only 40 million tons of oil a year, with production falling despite huge reserves. Two years later Yukos was listed on the Moscow stock exchange at a value of $7 billion, which was considered highly undervalued, with proven reserves of 13.2 billion barrels. Yukos doubled in value between 2000 and 2001 based on high growth rates and low production costs. The reserves it controlled were roughly equal to those of France-based TotalFinaElf yet its market capitalization was only a tenth of the European company.

Khodorkovsky ran the company with a close eye on the bottom and little tolerance for slacking off or opposition. He laid off thousands of workers, fired lazy managers and pitted the ones who staid on against each other. He banned smoking and fined workers caught drinking—tea.

Khodorkovsky used a number of underhanded business practices to secure his assets and hold on to them. At stockholder’s meetings he locked out minority shareholders and diluted their stakes by issuing more shares. Foreign investors were muscled out with physical intimidation and dirty tricks. Once he secretly changed the location of shareholders meeting so no one would be present to object to the dilution of their stocks. One foreign investor called Khodorkovsky’s people “bullies”. Khodorvosky later said, “At the time Russian law allowed us to do things that were unthinkable in the Western business world.”

When the Russian government agreed to OPEC demands to cut oil production Khodorkovsky announced a 20 increase in production. When the government tried to audit his bank, a truck carrying records mysteriously fell in a river. Large amount of money were reportedly squirreled away in places like Cyprus, the Isle of Man and the South Pacific island of Niue.

Khodorkovsky Makes Yukos Into a World Class Company

Khodorkovsky began to change his style in the early 2000s and acted more responsibly as a corporate leader. After Western transparency was adopted foreign investors arrived in swarms and the value of the company skyrocketed. Khodorkovsky stake became worth $8 billion, making him Russia’s richest man. At that juncture he owned 40 percent of Yukos (he owned 60 percent of Menatep and Menatep owned 56 percent f Yukos). Khodorkovsky courted Western investors and used the money to help modernize his company along the lines of a Western oil company.

Khodorkovsky built Yukos into a large oil company through a series of mergers. In the late 1990s Yukos was merged with Eastern Oil Company, ranked ninth in Russia in terms of reserves. Yukos was earmarked to become Russia’s largest oil company through a proposed merger with Sibneft, Russia’s 5th largest oil producer, that began in October 2003. At that time Exxon Mobile and Chevron Texaco expressed an interest in obtaining large stakes of company.

When Khodorkovsky was arrested, Yukos was in the process of completing the $13 billion merger with Sibneft. If the deal had happened the resulting company it would have been the world’s 4th largest private oil producer and the largest private oil company in Russia. Its worth was estimated $45 billion. Investors salivated when reports surfaced that ExxonMobile was interested in buying 40 percent of the merged company. ChevronTexaco is said to have wanted 25 percent.

The Yukos-Sibneft deal fell a part at the last minute when many thought it was a done deal. Some described it as a divorce. Already months of preparations had been made. Yukos obtained 92 percent of Sineft, paying a down payment of $3 billion for 20 percent, and then swapped 26 percent of the combined company for the remaining 72 percent of Sineft. Sibneft owner Roman Abramovich had already been paid $3 billion. All that was left to do was figure out how the staff of the two companies would be merged. Working out the details of unraveling the deal was took months.

Khodorkovsky’s Political Activities

An enlightened Khodorkovsky began condemning the very system that made him rich. He also began throwing a lot of money around to support different political parties and candidates. On top of this he made a number of overseas trips, acting more like a diplomat than an executive. Many analysts believed that Khodorkovsky was positioning himself for a run at the presidency.

Khodorkovsky founded a youth organization called New Civilization that some said aimed to be the Young Pioneers for the post-Soviet era. As of 2003, it had 100,000 members and ran camps and computer clubs. Its biggest program was a game in which children created model states that involved writing constitutions and starting businesses. Many New Civilization clubs were based in old Young Pioneers headquarters.

Yukos money also funded the Russian State Humanitarian University and the Federation of Internet education. Khodorkovsky also was widely engaged in philanthropies, setting up orphanages, providing Internet access to schools and establishing libraries through his charity the Open Russia Foundation. In 2003, he provided $157 million for his various projects, including $1 million to the Library of Congress and $500,000 to the Carnegie Endowment of International Peace.

Khodorkovsky challenged Putin at a meeting over the corrupt sale of an oil field. Putin responded sharply, reminding Khodorkovsky how he had obtained his own company. A man associated with the oligarchs told the Washington Post, “The whole thing came loose after that. It was clear to me that we had signed our own death warrants.” Earlier Khodorkovsky had angered by Putin showing a meeting not wearing a tie, a move that Putin interpreted as a sign of disrespect.

Arrest and Imprisonment of Khodorkovsky

Khodorkovsky was arrested and his plane was raided by armed and masked commando while it was making refueling stop in the Siberian city of Novosibirsk. The commandos kicked on the door of the plane and warned its occupants not resist or they would shoot. Khodorkovsky was then flown to Moscow and placed in Matrosskaya Tishina prison. He spent his first night in jail in a cell with five other inmates. He was denied bail and changed to a cell with two other cell mates and allowed out of his cell for an hour each day to go jogging.

Khodorkovsky was imprisoned for almost two years while he awaited trial and while he was on trial. He was not freed on bond. While in prison Khodorkovsky learned to speak English pretty well. Yukos executive Alexei Pichugin was charged with murdering a married couple. He claimed that while he detained he was injected with mind-altering drugs and tortured. In July 2004, top Yukos shareholder was arrested on charges related to the same murder. Yukos President Platon Lebedev claimed he was roughed up.

While in jail the government began taking stabs at Khodorkovsky’s enterprises. One subsidiary of Yukos was accused of harming cows and rabbits. According to an agriculture ministry document: Among the rabbits “coupling take place unsystematically and no zoological-technological monitoring records are kept.:

Other oligarchs did things just as bad as Khodorkovsky or worse. Khodorkovsky seemed to have been singled out because he complained publically and, opposed legislation to raise corporate taxes and because he had political ambitions and financed candidates running against Putin. The arrest of Khodorkovsky served Putin by eliminating a potential rival, sending a message to others that dared to challenge him and showing the public he was capable of reigning in the reviled oligarchs. Some speculated that Khodorkovsky might run for President while in jail.

Khodorkovsky’s Trial

Khodorkovsky was charged with fraud, embezzlement, tax evasion of $1 billion and other charges. He faced a prison sentence of 10 years. There is no denying that Khodorkovsky engaged in some pretty shady practices. For example, Yukos avoided paying million of dollars in taxes by selling oil on paper to shell companies at discount prices and then paying with promissory notes instead of cash. The main question was did he break any laws with such schemes, and most cases he didn’t because of various loopholes and other problems with the laws.

Many of the charges leveled against Khodorkovsky were in connection with the acquisition of the Apatit fertilizer company (See Above). It is not clear why prosecutors zeroed in on Apatit when hundreds of companies, maybe thousands of them, were acquired in a similar fashion and Khodorkovsky had already agreed to pay a $15.5 million penalty to bring the episode to a close— a deal which was signed off on by the same man who later headed the case against him.

The trial began in June 2004. Like defendants in other cases, Khodorkovsky sat on a hard bench, chained in cage in the court room. The trial is itself was abominably boring. Much of the time was taken up by prosecutors reading and rereading documents without even bothering to explain what they meant. Some people tried to figure out what they meant to fight off sleep. The judges yawned and stared blankly like everyone else. One day a guard had to be roused because he was snoring so loudly he woke everyone else up. Khodorkovsky spent much of his time reading detective novels. Lebedev did crossword puzzles. [Source: Peter Baker. Washington Post]

In May 2005, Khodorkovsky was sentenced to nine years in jail for tax evasion and fraud. Three months before he dismissed the charges against him as “the fantasies of a pulp fiction writer” meant to cover the government’s attempts to seize his assets and damage him politically.

Break up Yukos After Khodorkovsky’s Arrest

After Khodorkovsky’s arrest he resigned as the head of Yukos and was replaced by a pair of Americans. The government froze 44 percent of the company’s shares. Khodorkovsky’s arrest and the moves that took place afterwards made foreign investors jittery and the stock market tanked after just reaching all time highs. As the drama unfolded there were concerns that Yukos might have to stop producing oil. This sent oil prices to an all time high.

The Russian government effectively created an “artificial bankruptcy” by giving Yukos an absurdly large tax bill that it could never pay off. Yukos was ordered to pay $3.4 billion in back taxes and fines. When Yukos paid that amount the total bill was raised to more than $27 billion. Authorities froze Yukos’s accounts and prohibited the company from selling assets to pay off the bill. As Yukos operated in financial limbo the government took half the company’s revenues to pay the bill. Siberneft used the same tax shelters that Yukos did but was not punished. Lukoil used them too and paid the government $200 million in compensation to avoid being targeted.

Finally the court said that it would sell Yuganskneftegaz, Yukos’s Siberia unit, which accounts for 60 percent of its daily out output of 1 million barrels a day, if the bill was not paid. It was not paid and Yuganskneftegaz was sold off in 2004 to an unknown company Baikal Finance Group for $9.4 billion, a deal believed to have been made with the Kremlin’s blessing. Analyst estimate that Yuganskneftegaz’s true value was $12 billion to $20 billion. A short while later Baikal Finance Group was sold to Rosneft.

In January 2005, Khodorkovsky transferred his stake in Yukos to his partner and largest Yukos shareholder Leonid Nevzlin, who was living in Israel and had been charged with murder in Russia. What initially seemed like a drive to punish Khodorkovsky ended up leading to the dismantling of Yukos. As of May 2005, Yukos still controlled two units, producing 500,000 to 600,000 barrels a day, and five refineries. It shares had lost 97 percent of their value, and were worth only 19 cents each. The Kremlin maneuvered to seize Yukos assets, which were largely taken over by state oil firm Rosneft. In May 2005, Rosneft won a ruling against Yukos that allowed it to become Yukos’s largest creditor. The plan then was for Rosneft to declare Yukos bankrupt and size its remaining assets.

Foreign investors shuddered at the thought that private property could be taken so easily by the government. Foreign investors in Yukos lost all or much of the money unless they were able to get their money out early. Future investors in Russia were scared off. Who was to say the companies they invested would not be dismantled too.

Fall Out of the Yukos Affair

Khodorkovsky has said he expected to lose everything. From prison he wrote: “Parting with my wealth will not be unbearably painful for me...I have already realized that wealth, and especially vast wealth, does not make a person free...I had to make enormous effort to protect this wealth. I had to limit myself in everything that might harm this possession. ...I avoided saying many things, because speaking candidly could harm my possessions...I controlled my possession; they controlled me....I have no intention of becoming a Count of Monte Cristo. To breath the spring air, to play with children study at an ordinary Moscow school, to read good books—all this is much more pleasant than multiplying wealth and settling scores.”

With the Yukos cases, the Kremlin seem to say that the days of Wild West capitalism were over; that their were limits to what the oligarchs could get away with; and perhaps first and foremost don’t cross the Kremlin. It also demonstrated how the justice system was used selectively to go after people deemed as enemies of the Kremlin.

The Kremlin asserted itself more in business, especially over the energy sector. A liberal member of the Duma told the Washington Post, “It’s clear that the state is strengthening its control over the economy. Business today is facing a lot of trouble. They’re under attack from all sides. These are black days for Russian capitalism.”

Some saw the Yukos case as a kind of justice to make of for the injustices that took place in the privatization and loans for shares era. Plans for further privatization were put in hold. Rather than liberalize the economy the Kremlin moved to impose more rules and control. Many foreign investors were scared off at a time when many of them were starting to get up the courage to invest. Those that tried to invest complained of more red tape and double crosses than before. Some foreign investors welcomed the crackdown on Yukos, viewing at as a measure to bring stability.

Image Sources:

Text Sources: New York Times, Washington Post, Los Angeles Times, Times of London, Lonely Planet Guides, Library of Congress, U.S. government, Compton’s Encyclopedia, The Guardian, National Geographic, Smithsonian magazine, The New Yorker, Time, Newsweek, Reuters, AP, AFP, Wall Street Journal, The Atlantic Monthly, The Economist, Foreign Policy, Wikipedia, BBC, CNN, and various books, websites and other publications.

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© 2008 Jeffrey Hays

Last updated May 2016

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