Wednesday, February 4, 2015

The Browder Affair and the Death of Russian Economic Reform 1/3

by Nomad

Here's a three-part post on the investor who led a crusade to clean up corrupt newly-privatized companies in Russia. The Browder affair ended up leading to an international crisis, the death of one man, another man in fear for his life. 

Meet William Browder, once the head of a London-based investment fund called  Hermitage Capital Management. In his prime, Browder became the poster child for a new kind of investor, one that was ready to seize the moment and jump into the emerging Russian market.  At one time, it was considered where bold investors went.

Today, Browder is  reportedly in fear of being kidnapped by Russian criminal syndicates working with the Kremlin. His story may sound like a thriller novel but it also serves as a warning to any foreign investor thinking about doing business in Russia. 

The Backstory

The story William Browder, it has been said, reads like a real-life LeCarre novel. It is, in fact, much more than that. In many ways, the Browder case reflects everything that went wrong with the hope and promise of Russia in the post-Soviet era. 

Browder is, without question, a complex character. It's in his genes. He is the grandson of Wichita-born Earl Browder. (Another biography made for film) Earl was certainly a man of strong political beliefs when to be a Communist was a dangerous thing to be.

During World War I Browder served time in federal prison as a conscientious objector to conscription and the war. Later he became a union organizer and later in 1927 went to Moscow, married a Russian woman named Raissa. Afterward, upon his return to the US, Earl became the head of the Communist Party in the United States.
Around 1933, Earl was already warning.
"There is little doubt that Hitler will rearm Germany and, with the help of the Western capitalist powers, unleash war against the Soviet Union."
Felix Browder, Earl's son, and father of the subject of this story became a noted Princeton mathematician.
From those roots, Earl's grandson, William Browder, drew his impeccable credentials as a hybrid communist-capitalist for the post-Soviet age.

William Browder was raised in Chicago and attended the University there and later Stanford. He joked about growing up in a family of Communists. How does one become a rebel in such a family? By putting on a suit and tie and becoming a businessman, of course!

Just as the Berlin Wall was collapsing, Browder was getting his MBA degree. How could an idealist American Communist with a degree in Business resist the temptation of the opportunity in post-Soviet age?
Working for US firms, like Boston Consulting Group (BCG) - Mitt Romney's old stomping ground- and later with the Wall Street investment bank, Salomon Brothers,

It was about this time, Browder realized that newly-privatized state-run companies in the Soviet Bloc were being sold are ridiculously low prices. It seemed too good to be true.
And it was.

By the 1990s, foreign investment was already huge. In the early and mid-1990s, during the presidency of Boris Yeltsin, Russia was in the painful process of privatization

Browder and Edmond Safra set up Hermitage Capital Management in order to invest initial seed capital of $25 million.
In the first years, the business was very successful and things were expanding rapidly at Hermitage.
About three years later, the ground began to shake under Browder's feet.

The Meltdown and the Melt Away

The Russian Financial crisis of 1998 changed attitudes for many foreign investors. It was around this time that things began to look a little less rosy for investors like Browder. That summer, the nation was in an economic crisis much like the one we are seeing now. 

In July of 1998, President Boris Yeltsin, blocked by the Duma, was able to keep the government anti-crisis going by presidential decree. Indeed, the government seemed unable to deal with the problems facing the nation, unable to implement a coherent set of economic reforms. This, in turn, set off a chain reaction of investors in flight, and that too led to a sell-off of the ruble. 

By August of 1998, the Russian Central Bank was forced to devalue the ruble, to default on domestic debt, and to declare a moratorium on payments to foreign creditors. 
(Incidentally, it was at this very time that President Yeltsin replaced his Federal Security Service Chief Nikolay Kovalyov with a former KGB officer, Vladimir Putin, his first major step of his political career.)

Corruption in Russia was quickly becoming a deterrent to progress. International loans from various institutions were being siphoned off as fast as they were negotiated. The only question was how much actually disappeared.

As reported at the time, it was not pocket change:
A study by the Institute of Economics of the Russian Academy of Sciencesand the Centre for the Study of International Economic Relations at the University of Western Ontario, published this May, suggested that up to $70 billion disappeared in 1992 and 1993 alone. Other specialists argue that total capital flight in 1994–98 amounted to more than $140 billion and currently is running at more than $15 billion a year.
U.S. News and World Report reported that, according to intelligence, some $350 billion in he capital left Russia and were never used for their intended purposes.

Strangely enough, nearly a third of that ended up in banks in the United States. Following the crash of the ruble in 1998, that flow became a flood. Incompetence, entrenched corruption, a lack of oversight and capital flight all worked to undermine whatever confidence foreign investors might once have had in the Russian economy.

For example, in that summer of 1998, as the Russian economy was in free fall, International Monetary Fund loans to Russia were reportedly were hijacked. International loans to Russia's Central Bank were aimed at building up capital reserves, help finances the budget, or pay international obligations.

Refusing Reform

From 1992 until 1998, the IMF had lent about $ 20 billion to Russia. Now rumors were circulating that the money, as much as $10 billion, was allegedly laundered through an asset-holding bank in the United States.
Economists placed the blame on IMF miscalculation but also Russia's inability to implement much-needed reforms:
Russia's fault lies in the government's chronic refusal to reform. The Russian government has been aware of the problems in its economy and what is needed to fix them for at least five years. Because of mismanagement, inertia, and outright corruption, such vital changes as trimming the budget, overhauling the tax code and tax collection, land reform, and otherwise providing conditions to stem capital flight and attract foreign investment have not been implemented.
An audit by PricewaterhouseCoopers showed that Russia’s central bank funneled $1.2 billion in IMF money in 1996 to a firm it controlled called Financial Management Co., or FIMACO, on the Channel Island of Jersey.

According to one expert on the Russian economy, Professor Marshall Irwin Goldman, the people with access to FIMACO included senior officers of the Communist Party, Komsomol, state banks, KGB, and the military.

The full truth about the Jersey bank and its purpose will probably never be known, despite some intriguing clues. Everybody had a theory. A Yeltsin re-election slush fund, an illegal source of capital for foreign investment, a tool to drive down interest rates, a means for insiders to capitalize on the expected default, nobody knows for sure. 

One thing that was certain was that because of institutionalized internal corruption, Russia had little chance of successful economic reform. 
It was all going nowhere fast.

The Crusader Investor

By that time, most financiers were coming to a grim conclusion. It wasn't worth investing in Russia. 

Incompetence, entrenched corruption, a lack of oversight legality all worked to undermine whatever remained of foreign investor confidence in the Russian economy.

While many foreign investors were packing their suitcases, Browder was not ready to leave just yet. He shrugged off the crisis as a sign of growing pains and he remained committed to investing in Russia. He did, however, realize that passive investment in the Russia was as good as throwing money away, or more precisely, throwing into somebody's pocket.
He reportedly explained,
"You had to become a shareholder activist if you didn’t want everything stolen from you."
What exactly is a shareholder activist?

There are many reasons why a company can be undervalued. In Russia, two of the usual causes are either gross incompetence or corruption. Therefore, anybody who exposes and removes these hindrances to corporate growth can turn around an otherwise failing business.

This is something capitalized on. One of Browder's unique trademarks was to drive up share prices of a company by exposing corporate malfeasance and mismanagement. A corruption house-cleaning, so to speak.
One source reports:
His widely publicized campaigns for shareholder rights and corporate governance helped propel the Hermitage Fund from $25 million in 1996 to $4 billion a decade later.
Browder's Hermitage Capital Management became a shareholder in various partially state-owned companies, such as Russian gas giant, Gazprom, the large oil company Surgutneftegaz, RAO UESSberbank, Sidanco, Avisma, and Volzhanka. Despite the occasional economic crises, between 1995 and 2006, Hermitage rose to become one of the biggest foreign investors in Russia.

Navigating through the Byzantine system of laws and practices, Browder succeeded in playing the Russian game, amassing a significant fortune. Hermitage was proof to outside investors that Russia could be the place to make money. You just had to play by a different set of rules. 

However, these good times for Browder were soon to come to an end. The reason was simple and it had to do with Browder's unique trademark. 
Hermitage's novel technique was to drive up share prices by exposing corporate malfeasance and mismanagement. The idea was based on the notion that a corruption house-cleaning would make the corruption more profitable. As a principle shareholder in the companies, Browder had every right to demand things be done on the up and up.

There was but one problem- a serious and fatal flaw woven into Browder's activist shareholder business model. It made certain naive assumptions about the Russian state.
He had grossly underestimated the degree in which corruption was (and is) an institutionalized and irreclaimable way of life in Russia. Admittedly the same can be said for the majority of countries in the world but, in Russia, the sheer scale puts that country into a different class.
It was not merely the level of lawlessness. The political muscle of those who were involved in the corruption formed a wall that was every bit as impenetrable as the one in Berlin.
That wall too was, as Browder was just about to learn, granite hard.

Russia's largest oil company, Gazprom, however, was where this shareholder crusader went badly wrong.