Heyday of investing in Russia ends in scandal for U.S. bank; Economy suffers in dealings abroad


Just three years ago, financial publications buzzed with news of the eye-popping returns available to intrepid investors in Russia. A Russian oil company's stock had jumped 40 percent in a week. Russian government bonds were paying as much as 200 percent interest. The value of the Moscow Times stock index had tripled in a year.

No U.S. company moved more aggressively into the promising but volatile Russian market than the Bank of New York. Despite its conservative reputation and 18th-century pedigree -- it was founded by none other than Alexander Hamilton -- the bank elbowed out competitors to seize Russian business.

It opened U.S. accounts for Russian banks, which were not permitted by U.S. banking regulators to open branches here. It moved swiftly to dominate the market in Russian stock offerings, assisting such Russian businesses as Inkombank, a major commercial bank, and Sibneft, a Siberian oil company. A bank officer boasted that the Bank of New York had been midwife at the sale of $10 billion worth of Russian stocks in just six months.

Since those heady days, the collapse of the ruble and the taint of corruption have cast a shadow over Russian business and its foreign partners. Inkombank was wiped out in last year's ruble devaluation amid rumors of missing millions. Sibneft was accused of using a detective agency to eavesdrop on Russian public figures, including the daughter of President Boris N. Yeltsin.

And now the Bank of New York is itself the target of a criminal investigation into money laundering. As much as $10 billion from Russia passed through the bank, and federal investigators believe that at least some of that money is linked to a well-known Russian crime boss.

"Here we have a very venerable institution that has a black eye, a very big black eye," said Jim E. Moody, former deputy assistant director of the FBI, who launched the bureau's fight against Russian organized crime. "Something happened, and the bank apparently didn't exercise due diligence."

The Bank of New York, which has fired two Russian-born employees and suspended another, says it is cooperating with the federal investigation, first reported Aug. 19 in the New York Times.

Banking analysts in the United States and Russia suggest that most of the money that churned through the Bank of New York accounts was revenue diverted from a broad array of businesses rather than proceeds from such crimes as prostitution, drug-dealing or extortion.

The tentacles of the Russian mob reach into many places, but probably can't extract $10 billion, some analysts say.

The bad news is this: Capital flight is probably more pervasive and more damaging than the Russian mob.

Russian businesses understandably want to protect their earnings by placing them in havens abroad. But in doing so, they are likely to violate Russian currency laws, cheat stockholders and employees, illegally avoid taxes, and deprive Russia of cash badly needed for investments.

It is only by working with foreign banks that such maneuvers are possible. And even in the heady days of Western optimism about investing in Russia, American and European banks were being used to get money out of the country.

Dominating ADRs

The Bank of New York, for example, worked with Russian businessmen to issue "American depository receipts," essentially a vehicle to allow foreign investors to buy Russian stocks. The ADRs, traded on U.S. stock markets, offer investors convenience and confidence that they really own shares in a real company in Russia. The bank quickly dominated the business.

But while their purpose was to steer money into Russia, the ADRs proved to be an efficient way to circulate money abroad, according to banking analysts in Moscow.

Someone could walk into a brokerage in Moscow, put down $500,000 in cash, and purchase some ADRs, which are more liquid than ordinary Russian stocks.

Later on, the ADRs could be sold abroad, with the proceeds being paid into a foreign account. "When you sell it, there's no way for the Russian Central Bank to track it," said Margot Jacobs, an analyst with United Financial Group in Moscow.

No evidence exists that the Bank of New York's ADR program is linked to the money-laundering allegations. But Russia's Federal Securities Commission announced last week that it was launching an investigation into companies that listed ADRs through the Bank of New York.

Getting money abroad

There are all sorts of ways, of course, to get money abroad. One common method is to divert money through subsidiaries. A publicly held Russian oil company, for instance, sells oil at below-market prices to a subsidiary -- often outside Russia -- controlled by oil company insiders, which then resells it on the world market. The result is that shareholders are cheated, and company officers enriched.

Or, a foreign company might be set up to receive payments. Aeroflot's overseas receipts reportedly all go to a Swiss firm controlled by tycoon Boris Berezovsky, with none of the money making it back to the airline.

Such schemes would violate many laws in this country, where business is watched over by an elaborate regulatory system that took decades to evolve. In Russia, regulations are few, and the government officials charged with enforcing them are often in on the deal.

"Overnight, Russia was supposed to transform from a Communist dictatorship to a capitalist market society," Moody said. "But they did not have and still do not have the necessary infrastructure. They just don't have rules."

So the money has just flowed out of Russia -- and into Western bank accounts.

An estimated $300 billion in this decade has fled the country -- more than 10 times the federal budget in Russia this year. Some of the money might represent prudent safekeeping of incomes from legitimate businesses.

But, says Vladimir Ispravnikov, a Moscow economist, as much as half the economy is "in the shadows" -- not properly supervised and not accountable to anyone.

Much of that, he said, has to do with wrong-headed policy, mistakes and mismanagement on the part of the government. Nevertheless, Western banks have proted from funds whose origin is murky at best -- the proceeds of various schemes involving everything from government bonds to oil sales, often with the connivance of corrupt corporate or government officials.

Under Russian law, many of the schemes are perfectly legal.

"There are a lot of things that we consider illegal that are not illegal in Russia," Moody said.

Indeed, said Alexandre P. Konanykhine, a former Russian banker granted political asylum in this country earlier this year, the move from Russia to the United States can be eye-opening. Only after he settled here did he fully understand what is wrong with insider trading, nepotism and other conflicts of interest.

'Smart plays'

"In Russia, many of these things are simply considered smart plays," he said. "If you grew up in the Soviet Union, you had no idea what other standards there might be."

It was in this context that the Bank of New York pursued its Russian business, starting in the mid-1990s.

"Folks were optimistic and excited about Russia," said David S. Berry, a banking analyst at Keefe, Bruyette & Woods Inc. in New York. "There were market reforms and undervalued assets. American corporations were opening offices, and there was a feeling that there was a lot of business to be done."

At the same time, however, plenty of evidence existed that corruption and organized crime were powerful forces across the emerging Russian business world. In 1996, the CIA estimated that at least half of the 25 largest Russian banks had ties to organized crime. Bribery flourished at every level of government.

Moody, then with the FBI, testified to Congress that year about mob penetration of Russian business and government, naming as one crime boss Semyon Mogilevich, the man now linked to the alleged money laundering at the Bank of New York.

The Clinton administration played down such reports, determined to preserve relations with the Yeltsin administration. Former diplomats at the U.S. Embassy in Moscow have said they were discouraged from reporting to Washington on the extent of official corruption, for fear the information would be leaked and undermine administration policy.

Despite the hazards of doing business in Russia, the Bank of New York moved boldly to open "correspondent accounts" for Russian banks. "They could have opened those accounts at any bank in the U.S.," said Igor Fyodorov, an emigre Russian businessman who worked with several Russian banks in the mid-1990s. "But they all used the Bank of New York."

The bank should have been more careful about its dealings, some analysts say, even when the letter of the law was being obeyed.

'Know your customer'

"When employees told top management, 'We have quite a bit of money coming in from people in Russia,' someone should have asked, "Which people?' " said Bill Gearin, a consultant who advises banks on how to avoid money laundering. "It's an age-old axiom in banking: Know your customer."

Andrew B. Collins, a banking industry analyst at ING Barings in New York, said the Bank of New York might be bearing more than its share of blame for an industrywide problem. The questionable billions mounted, he noted, partly because the FBI asked the bank to keep the suspect accounts open for months while agents tracked the money.

Moreover, by definition, money laundering involves the transfer of illicit funds from account to account and business to business to obscure their criminal origins, he said. So it is likely that a string of banks around the globe handled the suspect money that passed through the Bank of New York accounts.

"I think there are some other shoes to drop as far as international banks that handled this money," Collins said.

Holding the Bank of New York or other institutions accountable for any suspicious transfers might be difficult.

To prove the crime of money laundering under U.S. law, investigators must show that a "specified unlawful activity" produced the money. But it might be difficult to prove what activities produced the funds -- or that those activities were illegal in Russia.

Money to be made

Meanwhile, there's still money to be made there for those with steely nerves. The ADRs issued by the Bank of New York for Russian oil giant Lukoil Holding are up 90 percent since the beginning of this year -- but down 66 percent since their peak July 6.

The money-laundering scandal is likely to slow, not stop, U.S. banks from doing business with Russia, said John Byrne, senior counsel at the American Bankers Association.

"It's a warning sign, sure," Byrne said. "It's not a do-not-touch sign."

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