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MOSCOW – Andrei lllarionov is a coward, but President Vladimir Putin isn’t strong enough to say so. This makes the lllarionov case the very opposite of what Putin’s enemies in the media are claiming.

lllarionov is one of the leftovers of the laissez-faire, free-for-a-few economics of the Boris Yeltsin era (1991-99). Married to an American studying for a Harvard PhD, the combination of Harvard economics faculty and Russian privatization ought to have long ago disqualified lllarionov from any public office funded by the Russian taxpayer, let alone one at the invitation of the Kremlin. However, since lllarionov hasn’t been invited to speak to the president for a very long time, his function has been that of a cheap lightning rod – to deflect attacks on Putin himself; to unsettle Anatoly Chubais, the electricity boss and another leftover from Yeltsin privatization schemes still in office; and to confound the doctrinaire policymakers in Washington, who still have influence on American public opinion toward Putin.

Accordingly, lllarionov has served as the president’s official economic adviser, and also his emissary to the Group of Eight (G8) countries dominated by the US. These are sub-ministerial assignments in which protocol is more important than power. But without the protocol he has enjoyed, lllarionov would be one of dozens of Russian chatterers seeking a perch in the Western media. No one would pay him attention. In none of the governments of the other seven G8 countries would it be honorable for a man who advised the head of government to stay in his post if he opposed his leader. A ranking adviser in those seven governments who finds himself at odds with the policies and decisions of his superiors and colleagues would resign, lllarionov, who has repeatedly attacked President Putin’s policies, doesn’t have the gumption to do that.

After Putin’s end-of-the-year press conference, lllarionov gave several media interviews and took himself to a Moscow courtroom to watch proceedings in the trial of Yukos bosses Mikhail Khodorkovsky and Platon Lebedev. He was there, said Khodorkovsky’s lawyer, as an “ordinary visitor”. In his interviews, lllarionov did not cover much economic policy ground. Instead, he publicly condemned Putin’s handling of the oil company affair, calling Yukos “the best company in Russia”, and the dismantling of its shareholding and corporate structure the “swindle of the year”. He added: “This entire affair regrettably demonstrates that any of the official or semi-official explanations given to the public regarding the Yukos affair does not have a leg to stand on.” That remark included Putin; lllarionov knows only too well that it was the president who was the principal decision-maker in the Yukos case.

lllarionov even went on to encourage US intervention in the Yukos case. He endorsed what he called the “victorious revolution” of Ukrainian opposition leader Victor Yushchenko, warning that Putin’s policies are leading “unavoidably” to a comparable revolution in Russia itself, lllarionov said that on a Moscow radio station on December 30. On January 3, a presidential decree was released, announcing that lllarionov had been relieved of his position as Russia’s G8 emissary and replaced by presidential assistant Igor Shuvalov. There was no mention of lllarionov’s post as economic adviser, which he retains, by default.

For this performance, lllarionov has been treated as a hero in the anti-Putin press at home and abroad, not because he has enlightened anyone with the contents of his economic portfolio or said anything that hasn’t been said dozens of times before. Rather, he is the hero of the moment for having bitten the hand that feeds him. Ekho Moskvy, a radio station that used to be former US president Bill Clinton’s Moscow favorite, conducted a purported four-minute poll, in which 9,200 listeners called in -that’s 38 per second – indicating that 86% believe lllarionov should stay in his job to influence the president. The Anglo-American media then judged lllarionov’s removal as the G8 representative as a fresh example of Putin’s refusal to be influenced and of the president’s dictatorial tendency.

If 38 Muscovites per second believe lllarionov should keep his post, it would behoove lllarionov to expose a little more of his economics portfolio than the fistful of issues on which he has expressed himself so plainly. Why, for example, has he remained so conspicuously silent – why indeed has the entire Russian government, parliament, the judiciary, and the press – been so indifferent to the privatization auction of the state’s shares in Russia’s leading steelmaker, Magnitogorsk Metallurgical Combine (MMK), which took place the week before lllarionov launched himself on behalf of Yukos and Ukraine. Can lllarionov be a hero because he defends the corrupt privatization of Yukos but as an adviser to the president, has nothing to find fault in the mysteriously under-priced privatization of Magnitka?

On December 22, the government’s privatization agent, the Federal Property Fund, put up for auction the state’s 17.8% shareholding (equal to 24% of the voting shares) in the steel plant. Though there were 11 nominal bidders, there was, in fact, no competitive bidding and the auction was declared over as soon as it started, with a sale price of US$790.15 million – this was the government’s starting price. This can be estimated to represent a price of $0.42 per share. The winner of the stake was a company called UFGIS Structured Holdings Ltd, which represented the management of the steel plant, headed by its chief executive, Victor Rashnikov. The Rashnikov group already controlled about 57% of Magnitogorsk through a secretive web of onshore and offshore companies that also manages the trade of the plant’s annual production of 10 million tonnes of steel worth about $4 billion at current prices. A report to Prime Minister Mikhail Fradkov by the Tax Ministry in September indicated that Magnitogorsk paid just 12% its revenues in taxes in 2003, a fraction less than its steelmaking peers Severstal and Novolipetsk, but well below the tax rates of the major Russian oil companies. The report suggested that various tax minimization schemes, including transfer pricing between units of the same group, were at work.

Even if the Tax Ministry suspected Magnitogorsk of paying the state less in taxes than it should have, officials in other ministries thought the state should receive even less in value from the privatization than the balance sheet suggested. In July, for example, an official of the Ministry of Economic Development and Trade announced that the sale of the Magnitogorsk shareholding should fetch at least $275 million. At that time, the plant management was still trying to defer a date for the privatization to enable them to accumulate enough cash to ensure that they would be the highest bidder. In August, Putin signed a decree removing the plant from the list of strategic federal property barred from privatization without express Kremlin approval. Magnitogorsk had been thus listed as part of the delaying tactics; its de-listing signaled that Rashnikov was ready to bid. Then on September 30, Prime Minister Fradkov signed a decree, adding the sale of the Magnitogorsk stake to the privatization schedule for 2004.his was the sign that Rashnikov was keen to get the sale over with as quickly as possible, before his rivals had time to raise the cash for a counter-bid. After years of red tape, the paperwork was rushed through to fix the auction date on December 22.

There was one last question the federal government had to decide. That was the valuation of Magnitogorsk, and the reserve price for the sale. It seemed that $275 million was a visibly small number and had to be increased, not least to keep it out of the hands of Rashnikov’s rivals. The price would have to be just enough to deter speculators, but not too high to create financing problems for the Rashnikov group. On November 20, the Federal Property Fund announced that the auction would start at $790.15 million. This was small enough: for the first six months of 2004, Magnitogorsk had declared a pre-tax profit of $710 million on revenues of $2.1 billion; after-tax income for the period was $524 million. Most Russian investment banks and brokers believed that rival bidding would drive the auction to a figure of not less than $950 million and perhaps as much as $1.5 billion.

What happened next is the tale of how Rashnikov’s rival, the Mechel Steel Group controlled by Igor Zyuzin and Vladimir lorikh, was persuaded to abandon a challenge it had been publicly preparing for more than a year. Mechel, whose principal steelmaking asset is the Chelyabinsk steel mill, but which also controls rich iron ore and coal mines, generated $2.1 billion in revenues in 2003 and $1.6 billion in the first half of 2004. Its annual steel output is just under 6 million tonnes.

Though the Rashnikov group was favored to win the Magnitogorsk sale because it already held a controlling interest that others were reluctant to challenge, Mechel -which had acquired a 17.1% stake for itself – announced that it intended to bid against Rashnikov, either alone or with another Russian steelmaker. But a challenger, Iskander Makhmudov’s Ural Mining and Metallurgy group, claimed that it could break up Rashnikov’s shareholding control in court and then buy up the pieces to achieve control with the state stake. But Makhmudov’s bid failed. Mechel pressed on and in October, Zyuzin and lorikh sold almost 12% of their own stock on Wall Street in the form of American Depositary Shares (ADS) to raise just over $330 million. “In our view,” reported Rob Edwards, steel analyst for the Moscow investment bank Renaissance Capital, “Mechel is gathering as much cash as possible to take part in the auction for a 17.8% stake in Magnitogorsk Iron and Steel Works.”

It was obvious that by itself, Mechel didn’t have enough cash to make the government’s reserve price, let alone compete against the heftier cash pile of the Rashnikov group. If Mechel were serious, then it would have to recruit a more powerful partner than itself. Various alliances between Russian steelmakers were rumored. The Evraz group, with three Russian steel mills, commands the largest steel production and earns the largest revenues; but it decided to bow out of the Magnitogorsk bidding when the Makhmudov challenge failed. Severstal, ranked third in output after Evraz and Magnitogorsk, had ample cash to buy the Magnitogorsk stake from the government. But the priority for Severstal’s spending, according to Alexei Mordashov, the controlling shareholder, was pursuit of foreign steel assets far from the reach of the Kremlin or the Tax Ministry in Eastern Europe and North America. Just one cash-rich Russian steelmaker was left -Vladimir Lisin, who controls the Novolipetsk Metallurgical Combine. For much of 2004, he had been spending an estimated $1.5 billion in free cash to take control of strategically vital assets such as coking coal supplies to his plant and ports that handle his steel exports.

It was Lisin, then, whom lorikh meant when he announced on December 9: “It is most likely that we will join up with someone.” Without saying exactly who, he had added: “We expect to conclude an agreement on joint participation in the auction in the very near future.” Over the next 10 days, Lisin made his own moves, securing permission from the Federal Anti-Monopoly Service to attempt to acquire up to 42% of Magnitogorsk’s shares with up to $2.5 billion in cash. If this was the partnership lorikh had unveiled, it appeared that Mechel was very much the junior player, if at all. According to the detailed prospectus Mechel had presented to US investors in October, the company’s strategy included a plan to expand its steel production by up to 40% in the next three years. Among the asset acquisitions planned, Mechel said it wanted to “make selective acquisitions of coal and other mining enterprises”, and “to continue to selectively acquire value-added downstream businesses such as hardware, stampings and forgings producers to help us reach our customer base, including in new markets”. Not a word was said about Mechel’s bid for control of Magnitogorsk. Was lorikh putting up a smokescreen for Lisin? Or was Lisin trying to soften up Rashnikov on Mechel’s behalf?

According to Mechel, during the weekend of December 4-5 and for several days that followed, its offices in Moscow were the target of an investigation by officers from the Ministry of Interior. The federal Tax Ministry said it wasn’t involved and so did the federal headquarters of the Interior Ministry. Regional officials in Chelyabinsk added to the denials. According to Mechel spokesman Alexei Sotskov, the purpose was obvious: “Somebody is insisting on checks at Mechel Trade House to prevent its bid for Magnitogorsk Metallurgical Combine,” he said. A few days later, Edwards of Renaissance Capital reported that Mechel had been hit with a fresh charge that the valuation of the company’s key assets – the Chelyabinsk steel mill, Beloretsk Metallurgical Plant, and Yuzhuralnickel – had been intentionally understated in order to limit the amount of cash subsidiary companies were obliged to subscribe to the group’s capital. “We believe that the likely source of this allegation is one of Mechel’s main competitors in the auction for the government stake in Magnitogorsk steel mill,” said Edwards. “We also think Mechel still has a good chance of winning.”

Mechel had already admitted in its October 4 ADS prospectus that it could face tax problems. The company’s lawyers had warned US investors that Mechel might face “significant losses” if the Russian tax authorities “challenge our prices and propose adjustments”. According to the consolidated financial data presented in the prospectus, the Mechel group paid income taxes of $74 million in the first half of 2004, reflecting a rate of 4.5% of revenues totaling $1.6 billion. In 2003, according to the US data release, the income tax payment rate was 2.3%, and in 2002, 0.2%. According to the prospectus, there was a risk that the financial statements might be subject to revision. Mechel’s accountant, Ernst & Young, the prospectus stated, “reported material weaknesses in our internal control and we may not be able to remedy these material weaknesses or prevent future weaknesses … We may not be able to accurately report our financial results or prevent fraud.”

In a listing of risk factors associated with the offer of the group’s shares, Mechel said that Russian transfer pricing rules, which took effect in 1999, empower the tax authorities to impose additional tax on companies when transfer pricing between related entities or in foreign-trade transactions is found to differ from market pricing by more than 20%. The rules, according to Mechel, “are vaguely drafted, leaving wide scope for interpretation by the Russian tax authorities”. Acknowledging the risk of a challenge, the prospectus said: “If such price adjustments are upheld by the Russian courts and implemented, our future financial results could be adversely affected. In addition, we could face significant losses associated with the assessed amount of prior tax under-paid and related interest and penalties.” According to the prospectus, “widespread tax evasion” is noted as a general factor in Russia’s economic instability. Mechel also suggested that the Tax Ministry’s “crackdown on certain Russian companies’ use of tax optimization schemes” may be “selective”.

But when the crunch came, and officers of an anonymous government agency fanned out through the Moscow offices of its trading subsidiary, Mechel claimed it was Rashnikov, not the Tax Ministry, at work. As the value of his newly minted ADSs started falling in New York, lorikh announced that he would fight off the challenge with a heavyweight for a partner. This corrected the fall in the value of Mechel’s shares and led the Russian market to anticipate a fierce and expensive bidding contest on December 22.

But they were mistaken. On December 21, Mechel announced that it had sold its 17.1% stake to the Rashnikov group. Lisin’s bid evaporated as if it had never been, and by the time the sun came up on auction day, there was no longer any competition for Magnitogorsk. Rashnikov, according to the Mechel disclosures, had paid lorikh and Zyuzin $870 million, which amounted to a price of $0.52 per share. This was 10 cents, or 24%, higher than the government’s starting price for its stake – a small premium for Rashnikov to avoid what industry analysts had been expecting to be a final price of at least $300 million more.

Renaissance Capital, which has been an adviser to Lisin in the past, said it smelled a rat. According to analyst Edwards, “The recent probings by government organs into Mechel may have caused the sudden transformation of Mechel from a keen buyer of MMK, seemingly at any price, to a willing and happy seller”.No one spoke up for the Russian government, which had every reason to believe that if the price Mechel had received for its shares on December 21 was a fair one, the Federal Property Fund had been badly short-changed by the failure of the December 22 auction to raise any money above the minimum price. Had lllarionov the hero been focusing on his portfolio, he might have advised the president or told the media that by elementary calculation the privatization of Russia’s most famous steelmaker had failed to realize a fair market price. All the extra value in the Magnitogorsk shares had been quietly transferred to the Rashnikov group, without a murmur.

And who benefits? According to a report by Alfa-Bank’s Moscow brokerage after the share sale, “We expect Magnitogorsk to consider the listing and sale of its shares on a foreign exchange (New York or London) as soon as 2005.” It has been difficult enough for Putin to manage the process of retrieving the ill-gotten proceeds of the Yukos privatization. Had Khodorkovsky not challenged Putin early in 2004 by proposing to sell a large stake of his company to the US, he might just have got away with it. If lllarionov remains the economic adviser, the process by which Magnitogorsk has just been privatized and is about to be sold to Wall Street will be just dandy – so long as Putin doesn’t learn what happened and doesn’t interfere once again.

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