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By John Helmer in Moscow

It’s fashionable in trade these days, especially when delicate consumer sensitivities are involved, to call a slaughter-house a meat-packing plant, as if what goes in the front-door can be made to seem as tasteful as what goes out the back. The German slogan, “Arbeit Macht Frei”, tried the technique on human beings. For the livestock concerned, the smell is always the giveaway.

In Russian business, it’s the prospectuses which release the tell-tale odour. What’s remarkable about this tell-tale prospectus is who is doing the telling – one of the largest and most powerful of Russian state companies, accompanied and advised by the state-controlled bank, VTB, pointing the finger at the Prosecutor-General.

A multi-million dollar loan prospectus just issued by JP Morgan, Barclays Capital and Vneshtorgbank (VTB) for the Russian Railways admits that a legal loophole used three years ago by Russian government officials to destroy Volgotanker, once Russia’s largest oil tanker fleet operator, may be used again.

Russian Railways (RZhD) is 100% state-owned. It is the country’s largest employer, with 1.3 million on the payroll as of December 31 last. It is one of the largest single contributors to Russia’s economy, adding 2.4% to the Gross Domestic Product last year, according to RZhD data. The new prospectus reports that in 2008, RZhD’s group of companies generated revenues of Rb1,203 billion ($48 billion); earnings (Ebitda) of Rb218.8 billion ($8.76 billion); tax payments of Rb48.7 billion ($2 billion); and net income of Rb76.4 billion ($3.1 billion).

Its debts are also gargantuan – Rb197.1 billion ($7.9 billion) in short-term borrowings as of June 30, 2009, and Rb200.9 billion in long-term borrowings ($8 billion). These debt numbers grew bigger in the second half of 2009. The prospectus reports that on top of the June 30, 2009, obligations:

“the Company’s significant long-term borrowings obtained in the second half of 2009 amounted to approximately RUR 75.05 billion (excluding a RUR 22 billion loan discussed immediately below), EUR 27.6 million and US$500 million. These borrowings included new issues of Russian domestic bonds for a total of RUR 55.0 billion, the sale back into the market of RUR9.2 billion Russian domestic bonds held by the Group as at 30 June 2009, the drawing of EUR27.6million under an existing facility agreement with Deutsche Bank in connection with the purchase of high-speed trains from SiemensAG, a US$500 million loan from the European Bank of Reconstruction and Development, a RUR 5 billion loan from Standard Bank plc, and three loans from Alfa Bank in a total of RUR 5.85 billion. In addition, during that period, other significant borrowings of Group members included a RUR 2.9 billion loan from Vnesheconombank to TransCreditBank, a RUR 3 billion credit-line from Alfa Bank to TransContainer, and a RUR 3 billion loan from Alfa Bank to Freight One…. In addition, in the second half of 2009, the Company borrowed RUR 22 billion from the State Corporation Deposit Insurance Agency and subsequently loaned that amount to OJSC KIT Finance Investment Bank (“KIT”), an associate of the Group, as part of a recovery plan for that financial institution. That amount was provided to KIT by the Company by way of subordinated loans of RUR 10 billion and long-term loans of RUR 12 billion. The State Corporation Deposit Insurance Agency also provided a loan of RUR 46 billion to finance KIT’s mortgage portfolio in the second half of 2009.”

For some unaccountable reason, the RZhD prospectus fails to tot these debt numbers up. The sub-total of new debt for the second half of 2009 appears to be $4.8 billion. So, the grand total now owed by RZhD is about $21 billion. This appears to be a bigger debt than the state-owned energy companies Gazprom or Rosneft, and bigger than the biggest of the state-protected oligarch debtors, Oleg Deripaska.

Worse even, these numbers may be inaccurate, as RZhD acknowledges in the prospectus. “The Group’s independent auditors have noted a number of material weaknesses in the system of internal control over the preparation of the consolidated IFRS financial statements, including an insufficient number of qualified personnel in the Group’s IFRS department and a lack of an integrated information system supporting preparation of the consolidated IFRS financial statements. International Standards on Auditing define a material weakness as a weakness in internal control that could have a material effect on the financial statements.”

The chief executive of RZhD is Vladimir Yakunin (left figure in the picture), once a presidential candidate to succeed Vladimir Putin as president. The 9-man RZhD board of directors is appointed by the prime ministry, and chaired by Deputy Prime Minister Alexander Zhukov. It includes two senior state banking appointees – Andrei Kostin, chief executive of VTB, and Nikolai Kosov, deputy chief executive of VEB, the bail-out bank chaired by Putin. Among those reported to be independent directors, Alexander Ryazanov, once from the Gazprom management, now works for the energy oligarch, Gennady Timchenko’s group of companies; and Andrei Sharanov, who was a deputy trade and economic development minister, and now runs the Chinese-financed Troika Dialog investment group.

When a group which is as close to the government as this admits to the risks they run, what they say is worth quoting verbatim. According to the 286-page document for investors, RZhD says it is vulnerable to the Russian criminal charge of unjust enrichment, if “intrusive and aggressive” action by the Russian tax authorities disputes VAT rebates for the export transportation of oil and petroleum products through Russia’s seaports. The transportation charges should be charged zero VAT, the prospectus says. But RZhD also says it is “aware of recent cases” where VAT rebates have been challenged by the Russian taxman.

The best known of these cases was the action between 2005 and 2008 by the Samara tax inspectorate, followed by the federal authorities, to imprison Volgotanker managers, and seek the extradition of its shareholders, after claiming Volgotanker had illegally taken Rb3.3 billion ($110 million) in VAT rebates. Although the government owned a 20% in Volgotanker, and the civil courts did not uphold the VAT rebate interpretation by the Samara taxman, the fleet was laid up, and the company’s operations halted. This then allowed competitors to take over the lucrative oil transportation business. Some Volgotanker executives are still in jail; others fled abroad.

State officials have never admitted before, as RZhD now claims, that the customs clearance documents provided for oil exports “are not sufficient to prove the right to apply 0 percent VAT.” But it is unprecedented for RZhD, and by the co-author of the prospectus VTB, to suggest that what happened to Volgotanker was contrived, probably illegal, and unconstrained by the state authorities, which RZhD’s board should represent. “The Company,” says RZhD, “does not exclude the possibility that the state authorities would deny the tax refund based on an inability of the Company to present sufficient documentary support for the 0 percent VAT rate.”

Foreign police and courts have gone further than that, in order to test the evidence compiled by the Russian Prosecutor-General, Yury Chaika (right figure in the illustration), to charge the executives and shareholders of Volgotanker who fled to the UK and Denmark. The charges against Ilya Katsnelson in Denmark, for example – filed by Chaika’s men in August of 2006, eight weeks after Chaika had taken office – include the type of VAT fraud, which RZhD now disputes; abuse of authority; unjust enrichment; and money-laundering. Katsnelson, a US citizen of Russian origin, headed Volgotanker’s offshore fleet operations until they were halted by the regional and federal prosecution.

In response to the charges against Katsnelson and the Volgotanker executives, the UK and Danish authorities have already ruled there is no substance to the “unjust enrichment”, VAT, and other charges lodged against Volgotanker. The Danes have been more methodical than the British in investigating the charges; the police and the Danish Ministry of Justice took three years, and did not finally rule on the evidence until July 29, 2009, when the extradition request for Katsnelson was finally dismissed. In rejecting the evidence and the constructions of law, on which the Russian Prosecutor-General had relied, the Danish government reply said the charges could not be sustained by the evidence submitted. It hinted that it was refraining from taking a position on the context in which Volgotanker had been destroyed with the VAT rebate weapon. The implication is that the attack on Volgotanker had been an asset raid, employing administrative methods and political influence, for the gain of Volgotanker’s rivals.

There is nothing remarkable about public acknowledgement in the financial markets of the legal bias and corruption of the Russian administrative and judicial system. The rulings of the UK High Court and the UK Court of Appeal in the current case of Michael Cherney against Deripaska — the man who is facing trial on charges of stealing his business — have already demonstrated that this is the consensus of the British judiciary. In the Russian transportation sector, the extent of the corruption in the management of the shipping company, Sovcomflot, and of state officials and commercial rivals, has been on trial in the High Court in London since last October. A ruling by Justice Andrew Smith on half a billion dollars in claims and counter-claims is due by mid-year.

Sovcomflot is a wholly-owned state company, like the railways company. But Sovcomflot and the General Prosecutor have been on the same side, according to thousands of pages of court testimony and documentary evidence.

What is novel about the RZhD prospectus is that one of the state’s most powerful companies is saying it too may be victimized by the system. Yakunin, the state appointee, is pointing his finger at Chaika, the state prosecutor, when the prospectus declares: “The independence of the judicial system and the Prosecutor General’s office and their immunity from economic and political influences in Russia are subject to doubt. The court system is understaffed and underfunded. Judges and courts remain inexperienced in certain areas of business and corporate law, such as international financial transactions. Russia is a civil law jurisdiction where judicial precedents generally have no binding effect on subsequent decisions. Not all Russian legislation and court decisions are readily available to the public or organized in a manner that facilitates understanding. The Russian judicial system can be slow and court orders are not always enforced or followed by law enforcement agencies. Additionally, the press has often reported that court claims and governmental prosecutions are influenced by or used in furtherance of political aims or private interests. The Group may be subject to such claims and may not be able to receive a fair hearing…”

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