Hostile Takeovers: Russian StylePublished: April 20, 2009 in Knowledge@Wharton
On August 1, 2006, one headline dominated business news around the world: A Russian court had declared Yukos, one of the largest private oil producers in the world, bankrupt. Soon, its CEO and founder, Mikhail Khodorkovsky, saw his company's assets sold off for a fraction of their value to the state-owned Rosneft Oil Company and found himself behind bars, charged with tax evasion. The downfall of Yukos has unofficially become known as the most sensational example of high-end corporate raiding in the history of the post-Soviet economy.
According to some estimates, approximately 70,000 Russian companies a year become targets of raider attacks. Billions of dollars in assets are tied up in complex legal schemes, which some have dubbed "a new wave of property repossession." Despite certain similarities between corporate raiding and Western-style hostile takeovers, the unique Russian version of the phenomenon uses tactics that are possible only because of certain peculiarities of the Russian legal and administrative environments.
While the concept of corporate raiding in Russia has been around since Soviet economic liberalization began in the early 1980s, its methods have evolved continuously. In the mid-1990s, reports of AK-47 wielding masked men storming the headquarters of up-and-coming companies, seizing assets and forcing owners to sign a variety of property transfer documents were all too common. Since the financial default of 1999, however, tactics of raiders and their agents have become much more sophisticated. These days, the most common scenario involves an interested party placing an order with a raiding team for the takeover of a target company. Raiders typically start by acquiring a minority share in the target firm and using this share to initiate frivolous lawsuits against the target. The raiders then use a complex game of legal arbitrage to compromise the company's operations and drastically devalue its stock. These actions result in possible bankruptcy and almost certain takeover by the raider.
With the gradual sophistication of the raiding process, raider teams have become an institution of the Russian marketplace. Some raiding teams are independent intermediaries, similar to external consulting groups. Other firms originated as corporate division departments of the oligarchs' giant investment funds and currently cater to the entire marketplace. The most infamous are the raiding teams that are subsidiaries of large holdings and financial institutions. These teams possess operating knowledge and familiarity with the marketplace not unlike that of investment banking professionals in leading Western institutions. Their expertise highlights one of the end goals of the raiding process: to provide an alternative to legitimate M&A.
These raiding teams are commonly divided into "black," "grey" and "white" firms based on the degree of illegality of their tactics. "Black" raiders are known for the blatant use of criminal force, as was done in the mid-1990s. "Grey" raiders utilize milder forms of criminal activity, relying largely on judicial bribes. "White" raiders are most similar to their Western counterparts and use tools such as organized strikes and unplanned inspections by regulatory officials.
The legality of the raiding methods used in each instance is not clear-cut. Even if, in some cases, the particular tactics of Russian corporate raiders could be considered legitimate in the West (e.g., share buy-back), the manner of execution could be illegal (e.g., extortion of existing shareholders). The main methods of raiding include falsification, greenmail, forceful takeovers and share buyout.
Raider tactics differ greatly. Falsificationincludes the creation of fraudulent property ownership documentation, forgery of signatures and bribing of judges and governmental officials. This type of "grey" raiding occurs, for instance, when raiders bribe a court to file a lawsuit against a targeted company. While the lawsuit may be fictitious, it can result in a legal "arrest" of all outstanding shares of the company and deprive the executive board of its decision-making power. A company whose shares are "under arrest" cannot undertake significant business transactions or human resources decisions, or obtain financing. Galina Krylova, a Russian lawyer who has worked extensively with victims of raiding, states that the consequences often force "the owner to sell the operations to the attackers for a fraction of their actual value. Or, the lawsuits simply continue until the company is bankrupt."
"SMARTS" Group, for example, is a Russian telecom company that fell victim to raiders using falsification, among other tactics. The raiders obtained a minority share of the company and subsequently disrupted shareholder meetings. By filing legal claims against "SMARTS," the raiders succeeded in paralyzing the company's operations via the court system. In order to undermine the company's defensive measures, the raiders filed multiple identical lawsuits in regions far from the company's location. The raiders obtained jurisdiction in those regions by entering into false contracts on behalf of the company with local citizens. The legal proceedings have dragged on for two years and continue still.
Another victim, Hermitage Capital Management, was the largest international portfolio investor in Russia, with $4 billion invested. In a scandal that began in December 2005, Hermitage accused Russian police of attempting to defraud the company of hundreds of millions of dollars. Russian police confiscated key documents, which were later changed and falsified and used to file lawsuits against the company's subsidiaries.
Greenmailis a quasi-legal raiding method that utilizes psychological attacks. Similar in nature to greenmail used by Carl Icahn and others in the U.S. in the 1980s, this tactic employs a small group of raider-controlled shareholders who irritate the management until the latter agrees to repurchase the shareholders' stock at a significant premium. The means of concentrating these shares may not be entirely legal, and the tactics of influence are far less sophisticated than in the West. In one instance, a particularly reluctant board member of a targeted company received a coffin -- complete with flowers -- as a birthday gift, likely a quite persuasive gesture.
Forceful takeoversare frequently combined with fraud tactics. For example, a group of armed mercenaries may storm into the offices of the target company and set up a fictitious CEO. Police often provide fraudulent paperwork; judges, acting on bribes, validate those documents. Violent takeovers, prevalent in the mid-1990s, have become less common due to both changes in law enforcement and further development of anti-takeover laws.
Togliatti Azot, a victim of a forceful takeover, is a giant chemical factory in Russia's Samara region, 600 miles east of Moscow. According to deputy director Sergei Korushev, in September 2005, dozens of men dressed in camouflage and carrying automatic weapons stormed into the administration building. The attackers were members of OMON, Russia's paramilitary police, and detectives from Moscow. They seized financial documents that they claimed were evidence of crimes committed by the management. The police later charged the general director and CEO with tax evasion and fraud. The company supposedly owed $150 million in back taxes. The head of the plant, Yuri Budanov, claimed that the police investigations were instigated by rival companies with influence over local politicians.
Another, less sophisticated, forceful takeover involved Specialist Electrical Equipment, a small Moscow company that manufactures fire-safety equipment. One day in November 2004, the raiders used their muscle to simply lock the employees out of the premises and take over the company. The owner was ousted, and the company's valuable property in Moscow was sold off. All that is known about the raiders is that they were linked to a firm registered in the British Virgin Islands.
Share buyout, the most Western of the tactics used by raiders, often uses "grey" methods. In the U.S., a hostile takeover occurs when an acquirer buys out a company, often at a premium, despite management's opposition. In Russia, a raiding syndicate that obtains a controlling share of a target company typically forces a secondary equity offering without the consent of the other shareholders. In this way, the raider dilutes minority interests and retains majority control of the company and the newly issued shares. The dilution of the minority stake reduces the bargaining power of the remaining shareholders, often forcing them to sell off their shares.
Many unique factors in the post-Soviet environment have enabled asset-acquisition via raiding. The legacy of decades of a planned economy is the lack of an established framework for private-property ownership. In the late 1980s, most of the Soviet Union's industrial capital was sold off in closed auctions at prices hundreds of times below market value. These auctions concentrated a vast amount of capital in very few hands, thereby laying the foundation for oligarchic industrial ownership at a time when Russia lacked a legal framework for the protection of property rights. Due to the widespread familiarity with -- and contempt for -- the nature of these first-wave acquisitions, the notion of private property in today's Russia enjoys little respect. This, in turn, facilitates corporate raiding.
Another factor that enables raiding is the lack of sophistication in Russia's emerging financial markets, which produces two effects. First, local investors' inexperience with complex financial instruments clears the way for schemers to manipulate stockholders and illicitly acquire their financial assets. Second, inexperience limits local investors who could otherwise purchase adequate financial instruments in more mature markets. In part owing to the financial crisis of 1999, the Russian stock market trades primarily on the blue chip stocks of the country's corporate giants and not on the stocks of mid-cap companies. Moreover, since the notion of transparent and accountable corporate governance remains in its infancy in Russia -- a situation perpetuated by operating inefficiencies and complex tax evasion schemes -- potential buyers are deprived of the ability to accurately gauge the value of firms. Given the low level of corporate transparency, raiding offers a quicker, cheaper and more effective alternative to legal M&A processes.
In addition, the legal environment has helped clear the way for corporate raiding. Sergei Volfson, a lawyer at Dewey & Leboeuf's Moscow office, confirms that Russian legal judgments are not based on precedent, and judicial opinions are not made publicly available. The few legal decisions that have been published recently have been too laconic to offer much guidance to lawyers or contribute meaningfully to the predictability of the law. As judges who have no legitimate legal reason for their rulings are not forced to reveal their thinking, it is much more difficult to identify judicial corruption. Corporate raiders use corruption to their advantage in order to obtain favorable court decisions and falsified legal documents.
Forum shopping, the strategic selection of a forum for a lawsuit based on favorable law and judges, is commonplace in Russia and enables raiding teams to compromise their targets more easily. In the U.S., legal forum availability is limited by jurisdictional requirements. In Russia, plaintiffs can bring the same lawsuit simultaneously in multiple -- often remote -- local courts in the hope of obtaining at least one favorable verdict or injunction. For the defendant firm, the barrage of identical lawsuits represents an enormous cost and greater exposure to potentially unfavorable decisions, damaging its operations and thereby forcing it to capitulate to the raiders' demands.
The practice of law itself in Russia remains largely unregulated. Russian lawyers do not face the same rigorous examination requirements as their Western counterparts prior to commencing their practice. Furthermore, the Russian legal system lacks effective methods for reprimanding attorneys engaging in malpractice. In the U.S., for example, Rule 11 of the Federal Rules of Civil Procedure sanctions lawyers who turn in false documents to the court or initiate frivolous lawsuits. In Russia, no such similar sanctions exist.
While debate may continue regarding the exact causes of corporate raiding, its effects on the Russian economy are clear and negative. The widespread extent of raiding, which harms thousands of successful businesses every year, significantly compromises the overall economic growth of the Russian economy. Often, raiders dismantle the targeted companies and sell off their assets. As a result, any long-term economic value from the target company's operations is lost. Even if the firm survives, the crippling effect of the raiding process may render it unprofitable.
The threat of raiders significantly impedes future business growth by undermining the incentive structure for business development in Russia. As Galina Krylova notes: "There is no pattern by which companies get targeted [for raiding]. Any successful, well-functioning company will get targeted, sooner or later." An environment in which businessmen have to worry about developing an operation that is tooprofitable simply does not promote growth, especially in an emerging economy such as Russia.
Moreover, corporate raiding significantly reduces foreign investment flows into Russia. The chief economist of the Moscow branch of a major international investment bank stated that it is his "distinct impression from conversations with international clients that corporate raiding in Russia is a concern that adds to the overall murkiness of the Russian market." Public Joint Stock Offering regularly warns investors that the Russian legal system and legislation, as well as "inconsistencies between federal laws ... gaps in the regulatory structure ... [and a] lack of an independent judiciary" create an uncertain environment for investment and business activity.
The consequences of raiding and the publicity that raiding has garnered have raised awareness of the need for effective defensive methods. A carefully designed corporate structure remains one of the most effective tactics. Daniel Coppel, also an attorney at Dewey & LeBoeuf's Moscow office, argued that creating offshore holding companies for Russia-based entities can be a useful measure to evade attacks because such a move introduces judiciary precedent and increases the difficulty of becoming a minority stockholder and obtaining company documents. Moreover, designing joint venture agreements between Western and Russian partners that include an anti-dilution provision -- to ensure that the original investments are unchanged over time -- can protect a company from raiding attacks.
Nicolai P., a small business owner in Moscow, acknowledged that raiding has spurred companies to adopt creative defenses, such as obtaining multiple registrations for the same company. "When you begin to suspect a raider attack, the assets of the company can be quickly transferred to a parallel company under a different registration," said Nicolai. One long-term approach advocated by others is to take the company public and make it as transparent as possible. Greater transparency makes it more difficult for raiders to raise false charges against the company.
None of these strategies is foolproof. Indeed, raiders have taken over companies with every one of the aforementioned defenses in place. Krylova states that, in the end, "the only real preventative measure is to have very good political connections." The last few years have witnessed the rise of a variety of anti-raiding firms in Russia that offer protective services. However, because no individual method of protection can guarantee security, Russian businesses are looking to the government for more systematic solutions to raiding. Many believe that the eradication of corruption is a prerequisite to successfully combating corporate raiding. Possible government measures include the development of an investigative unit specifically dedicated to tackling corporate raiding and the establishment of a government agency that would inventory all outstanding shares of public companies and record changes in their ownership.
Others place hope in recent legal reforms, particularly those addressing jurisdictional issues. Three years ago, the Supreme Court of the Russian Federation proclaimed that courts of common jurisdiction cannot rule on cases of corporate arbitrage, many of which are raider-instigated lawsuits. The requirement that arbitrage cases be filed only in the location where the defendant company is incorporated will deprive raider firms of the ability to file multiple identical suits, a key tool in the takeover arsenal. Many experts claim that coupling these measures with reforms establishing effective punitive measures for legal and judicial malpractice may prove a highly effective method of preventing frivolous litigation.
Nevertheless, many remain skeptical about the proposed reforms and the changes already adopted. "Increased political will" is the only long-term solution to the raiding problem, according to Krylova. She and several other lawyers state that Russia has adequate corporate laws, but that they are not well-enforced: "[W]e have wonderful laws but they only apply to a select few." Only strong support on behalf of the government for the anti-raiding laws and campaigns can put a stop to this profitable business activity.
Over the last 20 years, the Russian economy has experienced large fluctuations. The unique combination of post-Soviet infrastructural loopholes and rapid market liberalization has spawned widespread corruption and made activities such as corporate raiding extremely profitable. Proponents of anti-raiding measures currently focus on engaging the government in ending corruption. However, the future of raiding remains unclear. Many believe that bribery has engrained itself so deeply in the Russian mentality that the development of independent and accountable agencies to support an efficient market will remain impossible. Others, however, continue to be optimistic that soon Russians -- including raiders -- will seek greater stability in the market in order to protect their rights and "rightful" property.
This article was written by Brenden Carbonell, Dimitry Foux, Vera Krimnus, Ed Ma, and Lisa Safyan, members of the Lauder Class of 2010.