Ben Aris in Berlin -

The three leading international rating agencies have got Russia's sovereign rating wrong: it shouldn't be investment grade but default.

So says the Association Fédérative Internationale des Porteurs d'Emprunts Russes (AFIPER), a French pressure group that represents the interests of over 300,000 investors who bought Russian Tsarist-era bonds at the end of the 19th century.

The French government did a deal with Prime Minister Viktor Chernomyrdin in 1996 to settle the obligation and the Kremlin paid out $400m over four-years, but AFIPER claim that the deal did not cover individuals. After waiting over 100 years, AFIPER says its members are owned between $80bn and $100bn, or about a fifth of Russia's entire hard currency reserves.

And this is not ancient history; the bonds were listed on the Euronext bourse in Paris until about 18 months ago, when the French government lent on the exchange to discreetly remove them, says AFIPER's president Eric Sanitas.

The Russia government has refused to pay up and is untouchable, thanks to its sovereign immunity, so now AFIPER is attempting to get the leading ratings agencies to rescind Russia's investment-grade rating, granted in 2003. If AFIPER is successful the change would completely cut Russia off from the international credit markets and end the country's prospects for continued strong growth overnight. "If we can get [the rating agencies] to downgrade Russia, the government would be knocking at our door within one hour asking to pay," says AFIPER's president Eric Sanitas.

AFIPER's story raises more thorny questions about the way rating agencies judge a creditor's creditworthiness, which were already under scrutiny following the collapse of the US housing market last summer.

Imperial gold

The story starts at the end of the 19th century when European politics were in flux. Germany signed a mutual defence agreement with Italy and the Austro-Hungarian Empire called the Triplice, or Triple Alliance, in 1882. Berlin was worried that Paris, the grande dame of Europe at the time, wanted to recover Alsace-Lorraine, which it lost to Germany in the 1870 Franco-Prussian war.

France, keen to form a military alliance on Germany's eastern flank, approached its long-time friend Russia and asked if it wanted to form a counter alliance. Moscow was only too happy to sign up, but wanted financial help as part of the bargain. Russia had been shut out of the German financial markets as the German Chancellor thought Russia was ripe for bankruptcy. So Tsar Alexander III signed a military-financial Franco-Russian alliance in 1893. "The key to this deal was the Russians wanted money in exchange for their military support. The French government was also broke, so it proposed to tap the population by selling bonds," says Sanitas.

The Russian alliance was a key part of France's national security strategy so the government threw itself feet-first into marketing the bonds. "Lending to Russia is lending to France" was the advertising strapline on the Russian bonds. Only two Russian bonds had ever been issued in France before in 1822 and 1867, but now bonds were issued in 1889, 1890, 1891, 1893, 1894, 1901, 1906, 1909, 1910, 1912, 1913 and another on the eve of the first World War in 1914; some 1.5m Frenchmen plonked their life savings into what was supposed to be a rock-solid investment. By 1917, three-quarters of Russia's external debt was held by the French public.

At the time, some questioned the wisdom of lending Russia money, but in an ironic twist to a familiar story, the Russian government handed out large bribes to French journalists and killed the story. So much money was spent that the Russian Ministry of Finance agent at the Parisian embassy, Arthur Rafalovich, who paid the bribes to Le Temps, Petit Parisien, Le Figaroand Matin among others, is on record complaining about the, "abdominal venality of the French press."

The French government was right about Germany's aggression, but the chancellor was also right about Russia's creditworthiness. France got Alsace-Lorraine back in the subsequent war, but not its money; one of the first things the Bolshevik government did following the 1917 revolution was default on its French bonds.

Government dealings

Today, AFIPER says it counts 316,000 bonds still in existence, owned by the children and grandchildren of the original unlucky investors. They were sold with a face value of 500 francs and backed by a gold standard. "The bond holders have been deprived of the use of this money for 100 years and the Russian government has profited from it," says Sanitas. "We are claiming $100bn from the Russian government."

And these bonds are not family heirlooms gathering dust on the family mantelpiece of Parisian saloons: until 2007, the bonds were still listed on the Paris Stock exchange, now part of the Euronext pan-regional exchange. "This is a highly regulated bourse and one of the leading markets in Europe. The quotations [of the bond prices on the exchange] were suspended in the run-up to the 1997 Franco-Russian agreement and never resumed. But the French government didn't dare remove them from the lists. They waited until October 2007 when they were very discretely removed from the exchange," says Sanitas.

The association was leaderless at the time, after the previous head of the association Pierre de Pontbriand, was forced to retire in 2005, due to old age. The association was only reformed this July, under Sanitas.

In 1996 Russia's Foreign Economic Relations Minister Oleg Davydov and France's Finance Minister Jean Arthuis signed an agreement to repay $400m of the Tsarist-era debt over four-years. The goal was to improve Russia's rating and also help along Russia's application to join the so-called Paris club of sovereign debtors. The trouble is, the individual bondholders were not included in the settlement - a fact that got little attention at the time. "The agreement was signed in the name of the French government and relieved the state's claim on the Russian government. But it is only binding on the French state and not on the individual bondholders. However, the Russian government regards the agreement as covering all the outstanding bonds," says Sanitas.

The fact that the Kremlin paid some of the debt off is a tacit acknowledgement that the bonds obligation is still in effect. AFIPER followed up by winning a decision from the Conseil d'Etat, France's highest court, affirming the rights of French individual bondholders against Russia are not extinct. However, Russia is hiding behind its sovereign immunity and has ignored the decision.

In a similar case earlier this year, the French bank Noga managed to get a French court to seize Russian state money deposited in bank accounts on French soil. However, in the agreement with the bank signed in the 1990s with the Russian government, the Kremlin explicitly waived its sovereign immunity. French courts are powerless to act in AFIPER's case.

AFIPER tried to impound a Russian ship moored in Marseilles in 2002 (which skipped port after the captain was tipped off) and in 2003 it tried again to impound 240 paintings on loan to Paris from the Hermitage, but French courts have repeatedly rejected these suits.

Unable to get satisfaction through the courts, AFIPER has changed tactics and is now trying to pressure the Russian government by attacking its sovereign rating. The argument is a simple one: if the Russian state has defaulted on a valid obligations, then the sovereign rating should not be the investment grade, but default. "The Conseil d'Etat decision means that despite all claims to the contrary, and despite the investment-grade sovereign ratings attributed to Russia by the leading credit rating agencies, Russia is in fact in default on its sovereign debt," argues Sanitas.

AFIPER has hit a sensitive spot. Rating agency methodology has already come under close scrutiny following the collapse of the US sub-prime market last summer when the main agencies were called into the White House to explain why their ratings hadn't reflected the danger of the collapse of the market.

Sanitas levels a now common complaint: "There is a conflict of interests here, as these agencies make their money from the same people they rate. If they were to market Russia's sovereign rating down to default, then they would market the entire country down to default - as companies can't have a higher rating than the country - and so end their entire business in Russia," says Sanitas.

But AFIPER is unlikely to have much joy with this line of attack either. In the US, the rating agencies are hiding behind the constitution's first amendment, which entitles them to say what they like. In Europe, the association has been lobbying the European Parliament, but it not clear what lawmakers in Brussels can do, as there is no law against guessing the quality of an investment incorrectly.

bne contacted all three of the main ratings agencies. Fitch and Moody's declined to comment. But their methodology says ratings are supposed to be an indication on the "probability" of an issuer defaulting on current debt. Does Russia's refusal to pay the Tsarist bonds say anything about the likelihood it will default on the debt it has issued since 1991? The Kremlin would certainly say no. The Russian Finance ministry also failed to return calls. "If there is a repudiated debt issued by a previous government that is not considered amongst the current government liabilities, then we remove the default status if there is no resolution of the issue over time," says John Piecuch, director of communication at Standard & Poor's in Paris. "The credit rating is a forward-looking opinion after all and after a certain time the disputed debt ceases to have any relevance for market participants."

Ignored by the Russian government and abandoned by the French government, which had encouraged people to buy these bonds in the first place, it looks like the Tsarist-era bonds will become a family heirloom gathering dust on the mantle piece. A $100bn family fortune that might have been.

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