Corporate Raiding Underlines Dismal State of Russia's Legal System

By Philip P. Pan
Washington Post Foreign Service
Thursday, August 13, 2009

MOSCOW -- When three of Russia's finest lawyers agreed to represent the investment fund Hermitage Capital, they thought they were taking on a routine tax case.

Then they uncovered evidence of a breathtaking crime: Top police and tax authority officials appeared to have quietly seized ownership of Hermitage firms and used them to arrange a $230 million tax refund.

Now, the lawyers themselves are in legal trouble. One has been jailed. The two others have fled the country. All three face charges that seem intended to discredit Hermitage and divert attention from the enormous theft.

Their plight highlights the hazards of practicing law in Russia's corruption-ridden courts despite nearly two decades of reforms supported by hundreds of millions in U.S. and European aid. Prosecutors and police continue to dominate the judiciary as they did in the Soviet era, but unrestrained by the institutions of the old Communist system or the checks of a genuine democracy, the opportunities for abuse have grown.

No crime illustrates the state of the legal system better than what is known as "reiderstvo," or raiding -- the takeover of businesses through court rulings and other ostensibly legal means with the help of crooked judges or police. The practice is so widespread that local media have reported what raiders charge: $10,000 to alter a corporate registry, $50,000 to open a criminal case, $300,000 for a court order.

Hermitage, once Russia's largest foreign shareholder with more than $4 billion in holdings, says it encountered a bold variation on reiderstvo: When raiders failed to seize its assets, they looted the Russian treasury instead, then went after the lawyers who caught them.

President Dmitry Medvedev, a lawyer himself, has called "legal nihilism" the main obstacle to growth in Russia and has condemned raiding as "shameful." But neither he nor his government has responded to Hermitage's pleas for help or the protests of the Moscow bar association and international legal groups.

In a statement last month, the Interior Ministry touted its success in solving the tax theft. But the money has not been recovered, nor have any officials been arrested. Prosecutors have charged only a convicted killer named on documents as Hermitage's new owner.

Courts in Cohorts

For years, Hermitage targeted corruption in the state enterprises in which it invested. In 2005, it upset someone in power, and its British chief, William Browder, was barred from entering Russia. As a precaution, the fund sold its Russian assets and moved most employees overseas.

Then, in June 2007, police raided its Moscow offices and those of its Moscow-based law firm, Firestone Duncan. Brandishing warrants for material about a Hermitage affiliate suspected of tax evasion, they confiscated much more. When one lawyer objected, police beat him so badly that he was hospitalized for two weeks, said Jamison Firestone, the American head of the law firm.

Three days later, Hermitage hired the prominent Moscow defense lawyer Eduard Khayretdinov.

A taciturn former cop and judge, Khayretdinov, 50, was among a pioneering generation who joined the bar in the early 1990s as lawyers first began to operate independently of the state. It was a hopeful move, he recalled, made as then-President Boris Yeltsin's reformers were trying to build an impartial judiciary.

Nearly two decades later, Russian lawyers are the embodiment of that incomplete task. Some are corrupt middlemen, pulling strings and delivering bribes. Others risk arrest and violence in pursuit of justice. Most try to avoid trouble, though figuring out how is more difficult than ever. If the party once controlled the courts, now the highest bidder often does.

Khayretdinov tried to make a difference. In a nation with a conviction rate near 99 percent -- higher, some say, than under Joseph Stalin -- he managed to win the release of five clients in 15 years. "I understood that our system was getting worse, but every time I prepared to speak in court, I honestly believed the court would hear me," he said.

In October 2007, he discovered that lawsuits had been filed in St. Petersburg against three Hermitage firms that once held shares of Gazprom, the state energy giant. Without telling his client, judges had issued more than $400 million in rulings against the firms.

Photographing each page of the court files, Khayretdinov realized that lawyers representing the firms had essentially pleaded guilty in every case. But Hermitage had never hired them.

In Moscow, Hermitage checked the government's corporate registration database and was astonished to discover that it no longer owned the subsidiaries. A business in Kazan, 400 miles from Moscow, was listed as the proprietor.

Complex Maneuvering

Raiding, a mix of extortion, identity theft and simple thuggery, has emerged as major problem for the Russian economy, where property rights remain clouded by the chaotic privatizations of the 1990s. A U.S. Justice Department official in Moscow has described it as "a new and sophisticated form of organized crime" that "poses a serious threat to foreign investors" and has even spilled into American courts.

In one high-profile case, the Norwegian telecom giant Telenor is battling an attempt to seize its stake in a Russian mobile operator after a Siberian court issued a $2.8 billion ruling against it. But smaller domestic firms are usually the victims. One veteran police official has estimated that as many as 10,000 takeovers occur annually but that fewer than 100 are prosecuted and result in convictions.

Raiding is difficult to investigate because it relies on police and judicial corruption and often involves complex legal maneuvering. Hermitage turned to Sergei Magnitsky, 37, a specialist in tax law at Firestone Duncan who was also a licensed auditor. "The best I ever saw," Firestone said.

To take ownership of the firms, Magnitsky concluded, the thieves would have needed original corporate seals and founding documents -- items that police had seized in the raids.

The lawyers suspected the involvement of Lt. Col. Artem Kveuznetsov, an Interior Ministry official who supervised the raids and had been poking around Hermitage bank accounts. He had no clear link to the lawsuits, but raiders often use criminal cases to smear their victims and obtain key documents.

On Nov. 29, 2007, Hermitage confronted Maj. Pavel Karpov, the officer supervising the tax probe, with its findings. The company says he blanched and motioned one of its attorneys to his desk. Apparently worried that his office was bugged, he typed a message: Kuznetsov had pressured him to open the inquiry.

Kuznetsov and Karpov referred a reporter's queries to the Interior Ministry, which did not respond to faxed questions.

Only one law enforcement agency opened a probe into Hermitage's allegations. But when Magnitsky showed up 10 minutes early for a meeting with its investigator last summer, Kuznetsov was in the office.

Looting the Treasury

Why would anyone go to the trouble of obtaining multimillion-dollar judgments against companies that no longer hold any assets?

The mystery stumped Vladimir Pastukhov, 46, a longtime Hermitage adviser and a law professor at the Higher School of Economics. "No one knew what the crime was, but it was clear that if we didn't immediately argue our case, Hermitage would be blamed for something," he recalled.

He and the others filed a series of court motions. Prosecutors responded by indicting Hermitage executives in absentia and disclosing that the powerful Federal Security Service, the domestic successor to the KGB, had initiated the tax inquiry.

It was Browder, the company's British chief, who first suggested that the raiders might be using the court rulings to erase profits on paper and apply for a huge tax refund. The lawyers were skeptical. Magnitsky noted that it often took years to get a refund in Russia.

But then they discovered that the firms had opened accounts at two banks that reported a spike in deposits afterward. With more digging, they confirmed that $230 million was deposited days after the companies applied for a tax refund. The money quickly disappeared overseas.

When Hermitage reported the fraud in July 2008, police went after the lawyers, summoning them to Kazan.

After speaking to police, Pastukhov concluded that he would be arrested if he went. "I used to believe that if you were persistent and targeted, you could get results, even in the Russian courts," he said after fleeing to London. "But I've changed my mind. I'll never step into another courtroom again as a Russian lawyer."

Khayretdinov was sure he could prove his innocence and hid in Russia for months. But then police accused him of improperly representing the stolen firms because Hermitage no longer owned them. He decided he had no hope in court and flew to London.

Magnitsky never considered leaving because he didn't believe he could be jailed for nothing, colleagues said. But in November, police charged him with helping a Hermitage firm evade taxes in 2001. His attorney said he didn't even begin working with the firm until 2002.

"They've told him that if he says bad things about Hermitage, they'll let him go," Firestone said. "But Sergei told them no. . . . He believes the only way that Russia gets better, the only way the law starts to work here, is if good people stand up for it."