June 2, 2005

June 2, 2005 | WebMemo on Russia, Russia and Eurasia

The Khodorkovsky Verdict: A Setback for U.S.-Russian Relations

A harsh, nine-year sentence meted out by a Russian court on May 31 against Mikhail Khodorkovsky, former owner of the YUKOS oil company, and his partner Platon Lebedev sends a chilling signal to Western and Russian investors and could disrupt U.S.-Russian relations. President George W. Bush, in an unusually blunt language, said that it seemed that Khodorkovsky "had been adjudged guilty prior to having a fair trial." Unfortunately, that is a fair assessment.

 

An Expensive Affair

It did not have to be this way. The Khodorkovsky trial, which followed the destruction of YUKOS, was aimed to address the real problem of Russia's powerful oligarchs, who were no strangers to tax evasion, political dabbling, and underhanded dealings during the 1990s. But the crackdown, in keeping with Russian history, threw the baby out with the bath water.

 

The lessons of the Khodorkovsky trial are just beginning to sink in. U.S. and international policy makers and business leaders now understand that the rule of law in Russia is deeply flawed. Justice there is selective. Many oligarchs likely committed the kind of crimes of which Khodorkovsky and Lebedev were accused, but no others were prosecuted.

 

Few in Russia deny that Khodorkovsky may have nurtured political aspirations; after all, his company did support Duma members from the two liberal opposition parties-Yabloko and Union of Right Forces-and even some Communists. However, the Kremlin's abuse of tax authority and the criminal justice system is a massive display of force against a political foe that raises questions about separation of powers in Russia.

 

President Vladimir Putin's chief of staff, Dmitry Medvedev, has admitted that the prosecution was intended to "make an example" for Russian business, which will now be chastened to pay its taxes dutifully and stay away from politics. During the trial, Putin initiated a retroactive amnesty for privatization violations of the kind Khodorkovsky was found guilty. Further, in his annual State of the Federation address, Putin criticized tax authorities' "terrorization" of business-seemingly the same terror that brought down YUKOS with a $30 billion tax liability.

 

The legal proceedings against Khodorkovsky were deeply flawed, with retroactive application of the tax code, harassment of Khodorkovsky's lawyers, and violations of criminal procedure.

 

In short, the prosecution of Khodorkovsky was legally arbitrary and politically capricious, and the economic response has been predictable. Russian and Western investors have voted with their feet. Capital flight quadrupled in 2004, reaching somewhere between $9 and $12 billion, according to the Russian Finance Ministry. According to Putin's own economic advisor, Andrey Illarionov, a critic of the crackdown on YUKOS , it may be as high as $24 billion.

 

The government's heavy-handed behavior also has consequences for Russian civil society. The authorities' assault on Khodorkovsky and YUKOS led to a crackdown on Khodorkovsky's charity, Open Russia, which supported a slew of non-government organizations promoting democracy, human rights, Internet-based education, and study abroad. The rhetoric of the Russian secret services against Western and foreign-funded NGOs has been harsh. Some were publicly accused of ties to Western intelligence services, and others have been harassed.

 

Squandered Opportunity

The crackdown on YUKOS and the government's subsequent steps have destroyed the notion that Russia may develop a privately owned and financed oil sector. Such a model, if it had been allowed to flourish, would have helped Russia integrate into the global economy and brought Western investment and know-how into the Russian energy industries on a scale which is inconceivable today, with the government being the dominant player in oil and gas.

 

YUKOS was among the champions of privately developed oil pipelines to Murmansk and Daikin, in Northeast China. Now the Murmansk pipeline seems to be dead in the water, and Daikin has morphed into a branch off a primary pipeline projected to be built across Siberia to the Pacific port of Nakhodka. Controlling the project is the government owned pipeline monopolist Transneft.

 

The government has quickly consolidated power in the energy sector. Yugansk, the main production asset of YUKOS, was auctioned off in an opaque procedure in December 2004 to a fly-by-night corporate shell and then quickly transferred to Rosneft, a government-controlled oil company. This spring, tax authorities initiated a $1 billion tax claim against TNK, the Russian partner in a $6 billion joint venture with British Petroleum called TNK-BP, so far (and perhaps for some time) the largest Western investment in Russia. Exxon has announced that it will freeze investments in the Sakhalin island oil projects after Russian Ministry of Energy requested the company to pay an additional $1 billion. Natural Resources Minister Yurii Trutnev announced in February that a number of attractive mineral projects will be closed to Western investors. He was seconded by Putin, who called for a "strategic sectors" law to bar foreign investment from selected industries. Finally, the Russian government now plans to acquire over 10 percent of the gas monopoly GAZPROM, which will give it formal control of the gas sector, as well. In this context, the YUKOS affair and the Khodorkovsky verdict are only part of of the Russian state's re-consolidation of the "commanding heights" of the economy-a troubling trend.

 

Currently, foreign investment in the Russian energy sector is falling, efficiency in the sector is declining, and production, which until 2003 grew by leaps and bounds, has plateaued.

 

Conclusion

The U.S. and the West need to recognize that Russia has changed. The U.S. and Russia still have important joint interests, such as preventing Iran from becoming a nuclear armed power, joint efforts to secure Russian nuclear materials and other weapons of mass destruction , the war on terrorism, and economic cooperation. But the lack of transparency, deficiencies in the rule of law, and threats to property rights and political diversity are making the U.S.-Russian relations increasingly strained-and economic cooperation ever more difficult.

 

Ariel Cohen, Ph.D., is Senior Research Fellow in Russian and Eurasian Studies in the Douglas and Sarah Allison Center for Foreign Policy Studies, a division of the Kathryn and Shelby Cullom Davis Institute for International Studies, at The Heritage Foundation.

About the Author

Ariel Cohen, Ph.D. Visiting Fellow in Russian and Eurasian Studies and International Energy Policy in the Douglas and Sarah Allison Center for Foreign and National Security Policy, a division of the Kathryn and Shelby Cullom Davis Institute for International Studies, at The Heritage Foundation
Douglas and Sarah Allison Center for Foreign and National Security Policy