Over a barrel

A recent victory in The Hague has green-lit a record-breaking $100bn claim by Yukos’ majority shareholders against the Russian Federation. Legal Business investigates an arbitration that could change the face of international investment forever

On 31 May 2005, Mikhail Khodorkovsky shuffled into the spartan confines of Moscow’s Meshchansky courtroom for the last time, his hands and feet bound in shackles. Alongside co-defendant Platon Lebedev, he was placed inside a steel cage, flanked either side by armed militsiya guards. He was not facing trial for murder or some other violent crime, but for alleged fraud and tax evasion as part of a wider case against Russian oil giant Yukos, of which he was CEO.

After 12 days, the judges had finally finished reading from the 1,300-page judgment and delivered their verdict. Khodorkovsky was sentenced to nine years in a Siberian labour camp. He remains imprisoned to this day.

It was a ‘shameful conclusion’ to what the late US Democratic Congressman Thomas Lantos dismissed as ‘a political trial, tried before [a] kangaroo court’, and a sad end for one of Russia’s greatest corporate success stories.

Established during the country’s murky privatisation period of the early 1990s, the rampant profiteering of which saw the birth of a new ultra-rich ruling class – the so-called ‘oligarchs’ – Yukos at its peak was one of the world’s largest private oil companies. Already accounting for around 2% of global oil production, Yukos’ future seemed assured when in April 2003 the company agreed to a landmark $35bn merger with its main rival, Roman Abramovich’s Sibneft. The move was to herald a new dawn for Russian industry and commerce, with the combined company ranked as the world’s largest by oil reserves.

It was not to be. Less than six months later, a sustained assault by the Russian authorities led to the bankruptcy and eventual collapse of Yukos.

Beginning of the end

Although a hugely successful businessman, Khodorkovsky had fallen foul of the Kremlin due to his increasing political activity. As Russia’s richest man, he used his vast wealth to fund many of the country’s opposition parties in the 2003 parliamentary elections. Many believed he was even preparing to launch a challenge on the country’s presidency itself.

Such perceived posturing represented the breaking of an unwritten agreement that President (now Prime Minister) Putin is thought to have struck with the oligarchs when he came to power in 2000. Its terms were simple: stay out of the government’s affairs and it will stay out of yours. Other theories paint Khodorkovsky as a political martyr – a high-profile scapegoat for the unpopular oligarchs – or point to a desire within the Kremlin to renationalise Russia’s energy sector.

Whatever the motives behind it, the attack was both swift and devastating. It all began shortly after 5am on 23 October 2003, when Khodorkovsky’s private jet touched down at a Siberian airport as part of a planned pre-merger inspection of Yukos and Sibneft production facilities. As the plane taxied to the terminal, two vans filled with FSB (the post-Soviet successor to the KGB) operatives sped across the tarmac. The heavily armed agents stormed the plane and arrested Khodorkovsky at gunpoint.

‘Yukos was destroyed by the Russian Federation and expropriated with no proper compensation.’
Emmanuel Gaillard, Shearman & Sterling

The government froze Yukos’ shares eight days later, and the proposed merger with Sibneft fell through. (Sibneft was subsequently acquired for $13.1bn by state-owned Gazprom in 2005 and now operates as JSC Gazprom Neft.) Having been declared bankrupt after failing to meet a highly questionable $24bn tax bill, Yukos’ assets – including its chief production unit, Yuganskneftegaz – were seized and sold through a series of controversial state-run auctions.

Although Khodorkovsky himself acquired the majority stake in Yukos for just $350m in a similarly opaque ‘loans-for-shares’ auction in 1995 that was run by his own company, the Western world watched with horror as the events unfolded.

A 2005 Resolution by the Council of Europe’s Parliamentary Assembly was scathing in its assessment of Russia’s actions, stating that they went ‘beyond the mere pursuit of criminal justice, and includes elements such as the weakening of an outspoken political opponent, the intimidation of other wealthy individuals and the regaining of control of strategic economic assets’.

Turning point

It has given rise to the world’s largest ever arbitration: a $100bn claim against the Russian Federation by GML, which under its former Group Menatep guise was Khodorkovsky’s holding company and majority shareholder in Yukos.

One might reasonably assume that an instruction to advise the claimant in such a high-profile dispute would be hotly contested by the legal elite. However, a fight against the Russian state is not one to be entered into lightly. Indeed, Legal Business understands that several international firms with Moscow offices turned down mandates from GML in the run up to the arbitration.

‘When we were first approached, we knew that taking on a case like this would have certain downsides,’ admits Emmanuel Gaillard, who is leading the Shearman & Sterling team acting for GML. ‘We knew it would mean that we wouldn’t work for the Russian Federation or any of the major state-owned companies for the foreseeable future, but when I approached the management board the response was unanimous. It’s the largest arbitration ever – it’s well worth it.’

He’s not wrong. Sources close to the case indicate that both Shearman and the Russian government’s advisers, Cleary Gottlieb Steen & Hamilton, are billing in the region of $10m annually on the dispute, which is already in its fifth year. And without a presence in Moscow or any core clients that are active in the country, Shearman has been able to operate without fear of repercussions.

‘Yukos was destroyed by the Russian Federation,’ Gaillard says bluntly, as if to reinforce the point. ‘Russia has expropriated the Yukos shareholders by wiping out the value of their shares through the phoney auction of Yuganskneftegaz and other actions taken to renationalise [the company] with no proper compensation.’

The arbitration is based on the offer to arbitrate that is found in the Energy Charter Treaty (ECT), which gives substantive protection against issues such as expropriation and governmental interference, and ensures that parties receive fair and equitable treatment in any subsequent disputes.

While this allowed GML to commence proceedings under the Permanent Court of Arbitration in The Hague in February 2005, Russia argued that it wasn’t actually bound by the ECT.

Although the Russian Federation became a signatory state of the Treaty in 1994, it did not ratify it. This, it claimed, rendered it exempt, as signing is just a declaration of intent and therefore has no legal value. Even the ECT’s definition of Russia’s status at the time was inconclusive. Its website stated that the absence of ratification ‘does not present an obstacle to the practical and technical work of the Energy Charter process’, but that it does ‘leave ambiguity about the extent of Russia’s legal rights and obligations under the Treaty’.

GML’s argument centred on Article 45 of the ECT, which states that the Treaty is immediately applicable upon signing, unless the country specifically opts out. Some countries, such as Norway, did make such a declaration when signing. Russia did not.

On this front, the claimants had precedent on their side. In July 2007, a Skadden, Arps, Slate, Meagher & Flom team acting for Greek national Ioannis Kardassopoulos achieved the first provisional application of the ECT, in a $350m ICSID (International Center for Settlement of Investment Disputes) arbitration against Georgia. Interestingly, the panel was chaired by renowned Canadian QC Yves Fortier, who is also presiding over the GML tribunal.

‘The Dutch decisions show that, outside of Russia, no one believes that the forced bankruptcy of Yukos was anything other than a manipulated sham to steal the company’s assets.’
Tim Osborne, Wiggin Osborne Fullerlove

Russia’s obligation to adhere to the ECT was finally confirmed in December 2009, with the arbitral tribunal ruling that the country is indeed bound by the Treaty and that Yukos shareholders are entitled to its protection. An attempt by Russia to exercise Article 17 – which allows states to deny ECT investment protection benefits to companies declared as being owned or controlled by foreign nationals – was also dismissed, with the tribunal ruling that this clause can only be implemented prospectively, not retroactively, and not without notice.

The landmark ruling means that the arbitration is finally able to proceed to the merit stage, where the three GML subsidiaries – Yukos Universal, Hulley Enterprises and Veteran Petroleum (the Yukos employee pension fund) – will attempt to prove that the Russian Federation illegally expropriated the company’s assets. Gaillard is under no illusions as to the challenge of the task ahead.

‘It will take a few years,’ he sighs. ‘Russia will try to argue that their actions were simply part of a legitimate tax claim. We think we have a very strong case, but it’s hard to see with motives that are so politically driven.’

Enforce to be reckoned with

However, victory in this stage of the arbitration may only lead to the start of another battle. Even if GML is awarded compensation for the expropriation of Yukos, it will then have to rely on the Russian Federation to enforce it.

‘That’s a problem I’m looking forward to having, as it would mean we’ve been successful,’ says GML director Tim Osborne (see boxout, ‘The man in the middle’, page 28). ‘More seriously, Russia has participated fully in this arbitration – it has appointed serious lawyers and has dealt with it in a serious manner. We expect them to continue in that vein, and if they do lose, to fully comply with any order of the tribunal.’

If that turns out not to be the case, and Russia declines to honour any arbitral award, GML would be faced with the unenviable prospect of fighting in the local courts. Gaillard is realistic about GML’s chances in such a situation.

‘We’d be dead,’ he says emphatically. ‘If your opponent is the state, then you don’t want to appear before the organs of that state. In the local courts in Russia you have zero chance, as we have seen – Yukos has litigated in local courts and lost every time except for one, after which the judge was sacked in the following months. It was a clear signal. Judges in Russia understand. There is no independence.’

The judge he refers to is Natalya Cheburashkina, who agreed to accept Yukos’ appeal against the tax authorities, thereby suspending fulfilment of the tax bill while the case was considered. This stance was seen as too sympathetic by the Tax Ministry, whose request that the judge be removed was agreed to by the court. An official statement by a court official claimed that Cheburashkina ‘has an interest in the outcome and is biased against the Tax Ministry’.

This is no isolated incident. Judge Vlada Bliznets lost her job after twice making favourable decisions to structures closely connected with Yukos. Svetlana Bakhmina, Yukos’ legal executive, and a number of independent lawyers acting for Yukos in criminal cases have even been imprisoned.

The other, much more favourable option would be to pursue the non-diplomatic assets Russia holds outside its borders under the 1958 New York Convention.

Here, Gaillard has already secured an important, precedent-setting victory for GML subsidiary Moravel Investments. In September 2005, Moravel triumphed at the London Court of International Arbitration (LCIA) against Yukos over outstanding payments under a $1.6bn loan provided by Société Générale to Yukos in September 2003. However, the Russian Federation refused to recognise the LCIA’s $847m award and declined Moravel’s application as a creditor in Yukos’ bankruptcy. Gaillard therefore took the case to the District Court of Amsterdam, which in March 2008 ruled that Moravel was entitled to recover its claim in full from the sale of Yukos’ foreign assets.

‘The stark contrast in the treatment of the LCIA award in Russia and in the Netherlands is yet another illustration of the complete lack of independence of the Russian judiciary with respect to the Yukos affair,’ Gaillard commented after the hearing. ‘The Dutch decisions show that, outside of Russia, no one believes that the forced bankruptcy of Yukos was anything other than a manipulated sham to steal the company’s assets,’ Osborne added.

In 1998, German entrepreneur Franz Sedelmayer also successfully used the New York Convention to force the sale of Russian property in Cologne, after the Kremlin had failed to uphold an earlier award from the Arbitration Institute of the Stockholm Chamber of Commerce.

However, the size of GML’s claim means it would be a gargantuan task. Chasing $850m in foreign assets is one thing, trying to recover $100bn is quite another.

‘Yes, it could take a while,’ Osborne laughs, ‘but if we had the judgment in our back pocket, then under the New York Convention we’d get there in the end. We haven’t really looked at this, as enforcement is still a long way down the road, but if forced we’d go after what we can, wherever we can.’

They wouldn’t be short of prospective targets – a number of Russian corporates with government stakes, such as Gazprom and Aeroflot, have large portfolios of international assets. They could even potentially go after state-owned oil major Rosneft.

When Yuganskneftegaz was sold in December 2004 during the state-run auctions of Yukos assets, it was picked up by the previously unknown entity Baikalfinansgrup for what was widely regarded as a heavily discounted price of $9.7bn. It subsequently emerged that Baikalfinansgrup – whose sole bid for Yuganskneftegaz was uncontested by the auction’s only other participant, state-owned Gazprom subsidiary Gazprom Neft – had been established just two weeks prior to the auction. Three days after it closed, Baikalfinansgrup – and therefore the Yukos assets – was acquired by Rosneft.

‘When you’re negotiating new energy structures, you have to make sure there’s a legally binding dispute resolution mechanism. Without that, anybody who invests in Russia is taking one hell of a gamble.’
Tim Osborne, Wiggin Osborne Fullerlove

Yuganskneftegaz is one of the core assets at the heart of GML’s expropriation claims. Indeed, before Rosneft’s London listing in July 2006, which at $10.7bn remains Russia’s largest IPO, Khodorkovsky wrote a letter to the UK Financial Services Authority requesting that it block the transaction as it contained assets obtained ‘under unlawful proceedings which would not be recognised or enforced by the English courts’.

His attempts to scupper the deal ultimately failed, but the issue was flagged – in bold – on page one of the IPO prospectus. It states that ‘investors should be aware that if any of these risks materializes (including in relation to litigation arising out of the acquisition of the Company’s subsidiary Yuganskneftegaz…), they could lose all or part of their investment.’ It later warns that ‘if the ECT claimants were to obtain one or more arbitral awards on the merits against the Russian Federation… they may seek to enforce such awards against Rosneft.’

Fight the power

Regardless of whether GML wins or loses, the case has had a significant impact in more ways than one.

Most serious of all was Russia’s decision to terminate its provisional application to the ECT with effect from 19 October 2009.

‘It’s a major setback,’ explains Brian Zimbler, managing partner of Dewey & LeBoeuf’s Moscow office. ‘It’s really shaken up foreign investors and will definitely put some people off. Those that do wish to invest will have to think about other investment treaty protection.’

This will primarily involve bilateral investment treaties, or ‘BITs’, which ensure non-discriminatory treatment for direct investments between two nations. According to the International Centre for Settlement of Investment Disputes, Russia currently has such agreements in place with 50 countries.

However, as Zimbler says: ‘Not all BITs are equal – some are better than others.’ Take Cyprus, for example. Many Russian deals are structured using investment through a Cypriot holding company, so it comes as some surprise that the two countries no longer have an effective BIT in place. A deal was originally signed in 1997, but delays in Russia’s ratification eventually saw Cyprus pull out. Russia’s BITs with Sweden and Denmark, on the other hand, offer investors relatively broad protection.

The good news for international investors already operating in the country’s lucrative energy sector is that their assets are covered for the next 20 years under Article 45.3 of the ECT, which is designed to stop states from what is known as ‘pulling the rug’. Those that are considering entering the market, on the other hand, will now do so at their own risk.

Osborne’s message for such intrepid investors is clear. ‘When you’re negotiating new energy structures, you have to make sure that there’s a legally binding dispute resolution mechanism,’ he warns. ‘Without that, anybody who invests in Russia is taking one hell of a gamble.’

After five years of fierce legal struggle, it seems that GML’s gamble might be about to finally pay off. LB