Ben Aris in Berlin -

The privatization of Russia's power sector is one of the few triumphs Prime Minister Vladimir Putin can claim during his eight years at Russia's helm. Billions of dollars in badly needed investment were raised in one of the biggest privatizations the world has ever seen. Now it could all blow up in Putin's face as Kremlin-favourite Mikhail Prokhorov blithely ignores mandatory buyout laws to stitch up minority investors in what investors are calling, "the worst corporate governance abuse since Yukos."

The rule of law has never been strong in Russia, but faith in the courts could be destroyed completely over what is arguably the worst corporate governance row in a decade. Worse is that the controversial "strategic investment law," which precludes foreign investors from certain sectors, has been twisted and could now be applied to any sector. And a mockery has been made of the financial guarantees that underpin deals. Unless the row is resolved, Russia's development could be set back by 10 years or more, argue the victims.

The privatization of the power sector is almost at an end and only a handful of problematic auctions are left. The state-owned utility holding United Energy Systems (UES) was dissolved last summer and an open market for power is being phased in. The sector is currently undergoing a consolidation and restructuring process that should leave Russia with a functioning and profitable power sector that will suck in billions of dollars to build new capacity. The reason the whole process has gone so smoothly is because the Kremlin went out of its way to involve potential investors from the start.

In 2000, Alexander Branis, chief investment officer at Prosperity Capital Management, then still only 23 years old, got a call from the Kremlin and found himself in a meeting with then president Putin and Economic Development and Trade Minister German Gref, who masterminded much of Russia's liberal reforms. Putin quizzed Branis about how best to privatize the sector: "How should we unbundle the assets? What do we need to do to make sure investors come in?" Putin peppered Branis with questions and was so impressed with the answers, not only was much of the advice adopted, but the following year he appointed Branis, just 24 years old, to the advisory board of UES.

The privatisation was hailed by investors as a huge success and should have been (one of the few) big feathers in Putin's cap; UES CEO Anatoly Chubais was boasting at the European Bank of Reconstruction and Development's annual meeting in Kazan two years ago that the sell-off had raised way more cash than they had dared hope for.

Now it has all gone horribly wrong. Last year, top Russian businessman Mikhail Prokhorov and Leonid Lebedev bought majority stakes in Territorial Generating Company 4 (TGK-4) and TGK-2 respectively, as the privatization of the sector has proven to be as attractive to the locals as to the foreigners.

Prokhorov's investment vehicle Onexim Holdings (Cyprus) bought a 50.6% controlling stake in TGK-4 at an auction. At the same time, Kores Invest, controlled by Lebedev, a member of the Upper House of the Russian Parliament representing Chuvashia, bought a 45.4% stake in TGK-2 in an auction. The offer from Kores Invest was backed by a RUB19.9bn (€468m) guarantee from Sberbank, while the Onexim offer enjoyed RUB25.6bn of backing from Rosbank.

Under Russian law, any investor that buys more than 30% in a company is obliged to offer the remaining investors the opportunity to sell their shares at a fixed average price. Prokhorov and Lebedev duly made these offers at the start of September and most of the 300,000-odd minority shareholders took them up. Between September and October, the minorities transferred their shares to the two businessmen and settled back to wait for their money - hundreds of millions of dollars.

It never arrived. By the middle of September, the Russian stock market has gone into freefall and most businessmen suddenly found themselves fighting for their corporate life. Within weeks both Prokhorov and Lebedev began to issue a blizzard of lawsuits trying to back out of the mandatory buyout offers.

Analysts say in Lebedev's case, he would probably bankrupt himself if he were to meet the obligations of the buyout offer, but Prokhorov is sitting on several billion dollars after selling his stake in metals giant Norilsk Nickel earlier in 2008. "It seems that Prokhorov has decided the money is better spent elsewhere," says Mattias Westman, founder and co-manager of Prosperity. "Thanks to the crisis, cash is king and for anyone with cash at the moment, there are some amazing bargains on offer."

Legal blizzard

Investors were shocked in September when Onexim suddenly announced its mandatory offer couldn't be completed because it had broken the terms of the newly minted "law on foreign investments into strategic sectors." Since then, Onexim has issued dozens of lawsuits, most of which are pending and will be heard over the next six months or so.

The strategic law put 39 sectors like defence and oil off limits to foreign investors, who have to apply for special permission to invest. TGK-4 owns a gas pipeline that was leased to another company until August 30. But as the financial crisis wrought its damage, the lease was cancelled and the pipeline returned to TGK-4. Gas is one of the 39 strategic sectors. Onexim has brought a legal case arguing that because the company is technically a "foreign company" and TGK-4 is in the gas business, thanks to the pipeline, the auction that Onexim won for TGK-4 should be cancelled. This is despite Onexim's owner being Russian and all its assets are in Russia. As for the pipeline, it supplies a mere 10 buildings in Ryazan and accounts for less than $10,000 of TGK-4's revenue, according to the company's own accounts.

The twist of the knife came in October when Onexim itself applied to the Federal Tariff Service (FTS) to have its investment in TGK-4 re-classified as a "natural monopoly" because of the gas pipeline, and so ban itself from making the investment in the first place. "If this is how [the strategic law] works, then you can turn your strategic status on and off on a whim. It destabilizes all investments into Russia, as investors can no longer say what is a strategic investment and what isn't. People will be worrying about this for years if it's allowed to go ahead," says Westman.

No one objected when Onexim won the auction. According to TGK-4's own list of affiliated parties, published at the end of September, Onexim held 50.4% of the power company's shares after the auction, but the most recent company report says it now owns 50.00%. Clearly, some of TGK-4 shares have been sold or transferred. But selling or moving shares before making the payment to minority shareholders puts Onexim in breach of the shareholder agreement that it signed with the Russian government at the time of the auction, says Prosperity.

And the problems are widening to touch others. Onexim has also launched legal cases against all the leading international custodians in Russia - including the likes of Deutsche Bank, Citigroup, Morgan Stanley and Goldman Sachs - to try and get them to return the shares they are holding to the minority shareholders. If this legal attack is successful, then it will also undermine Russia's custody laws, making investments even riskier.

The story with TGK-2 is similar, albeit not quite as sophisticated. When it came time to pay, Lebedev refused and his holding company Syntez filed a lawsuit against Kores Investment, saying it was not entitled to buy the shares in TGK-2. "Syntez owns 99% of Kores and claims Kores is incompetent and should not be allowed to buy the shares, so the deal should be undone," says Westman. "But this is a risible excuse. He is effectively suing himself for incompetence. If we all did this every time we made a mistake, no one would be doing anything."

Despite the laughable legal arguments, in both cases Russian courts have granted injunctions on making the payouts to minority investors until about May.

Financial guarantees

Taken together, all these legal cases will at worse seriously undermine Russia's already shakey legal foundations, and at best introduce new risks to doing business in Russia by weakening property rights. However, in the short term, significantly more damaging is the refusal of the two banks involved to honour their guarantees that backed the mandatory payments to minority investors.

The Kores mandatory offer enjoyed a financial guarantee from Sberbank, which pledged to promptly pay minority shareholders if Kores doesn't have the means to do so. Kores has also taken Sberbank to court in an attempt to get an injunction that blocks Sberbank from paying out to minorities.

Onexim is playing a similar game. Its buyout offer was also backed by a financial guarantee, in this case by Rosbank (until recently partly owned by Onexim). No money has been forthcoming. Onexim has successfully applied for an injunction preventing the guarantee payments, while another Cyprus-based company tries to sue Rosbank in order to invalidate the bank guarantee altogether.

The whole point of these guarantees is to make sure that the minorities get paid come what may if the majority shareholders fail to pay. "It looks very much as if the Kremlin is playing for time in the hope that the two sides will find a compromise and the problem will go away," says one banker who declined to give his name.

Lobbying

Onexim didn't return calls for this article and the Russian press has made little of the case so far. Indeed, Vedomosti voted Prokhorov "businessman of the year" in January and only referred to the row over TGK-4 with a few lines. The only thing Prokhorov has said publicly was to accuse Prosperity on his blog of "selling out."

"What astonishes me is the fact that Prosperity Capital Management, which was being always positioned itself [sic] as the long-term investor into Russian power engineering and believes in the bright long-term future for both the sector as a whole and for TGK-4 in particular, is thanks to the crisis behaving as speculators," Prokhorov wrote.

Speculators buy low and sell high. Prosperity and the other investors would like to behave like speculators, but the fly in the ointment is that the person they are trying to sell to won't pay them, despite the fact that the shares have been transferred.

Westman is one of Russia's best-known investors in Russia and since Hermitage Capital's Bill Browder was ousted from Russia, Prosperity has become the biggest foreign investor into the country. But the row has caught up many other big funds that were also minority shareholders in the two TGKs.

As these investors' patience has frazzled since the start of this year, they have moved onto the offensive and gone from lobbying the government to mounting a more public campaign. "There has been no reaction from the government. No replies to our letters and no state support," says Denis Kulikov, chairman of the Investors Protection Association. "Investors have been cancelling projects because of the crisis, but this case will make a bad situation worse."

In October, the funds bought a full-page ad in Vedomosti calling on Russian President Dmitry Medvedev to intervene, which was signed by the biggest TGK shareholders, including: Jochen Wermuth of Wermuth Asset Management; Seppo Remes of EOS Russia; and Aivaras Abromavicius of East Capital; as well as Brandis and Kulikov. The letter they published threw the president's words from his inaugural speech back in his face by starting with a quote from it: "A mature and effective legal system is an essential condition for economic and social development, supporting entrepreneurship and fighting corruption."

"Russian President Dmitry Medvedev complained about Russia's legal nihilism in his inauguration speech. Now we are facing a test case and it looks like they have fallen at the first fence," says Westman.

Prosperity has been to see the Arbitration Court, the Federal Service on Financial Markets (FSFM), various ministries and even got into see Prime Minister Putin to press their case. They have also won the support of several large state-owned companies like RusHydro, which was also a minority shareholder in the TGKs. While they have been given reassurances from many of these people, there has been no action, the legal cases continue and no one has received any money.

"Everyone is expressing support. We met with [Deputy Prime Minister Igor] Shuvalov, the head of the Moscow Arbitration court, the head of the FSFM; even Chubais has come out in our support. But no one is doing anything," says Westman.

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