Book ideas #13: The Oligarchs
Ponzi schemes, shady privatization deals, and other tales from 1990s Russia
In his book The Oligarchs, David E. Hoffman portrays the lives of 6 men who played a crucial role in Russia’s transition to a market economy. Four of them were oligarchs, while the remaining two were architects of the post-Communist system.
Privatization was one component of the market transition. It is, by definition, a form of redistribution from the state to private actors. The resulting (private) distribution of assets can take any shape, ranging from a single person amassing all the state's wealth to every citizen receiving an equal share.
The architects of Russia’s privatization must have had their distributional preferences. The fact that they decided to give every Russian citizen a voucher, which could then be used to buy state assets, reflected the idea that every citizen should benefit from privatization. But whatever distribution they envisioned, it was most likely quite different from the actual distribution a couple of years later.
We can think of the gap between the desired and the actual distribution of wealth as the sum of unintended redistributions. In a perfect universe, state assets would be privatized exactly as planned, resulting in the intended private distribution of assets. In an imperfect universe, things don’t work out as planned, resulting in a different distribution of assets.
Viewed through this prism, The Oligarchs is a collection of stories about unintended redistribution. What’s common to all these stories is how assets typically flowed. The direction of the redistribution was predictable. When oligarchs were involved, assets flowed toward them, and away from their counterparts—the state, Russian individuals, and foreign investors.
The victim is the state
Plain old theft
The oldest form of redistribution is stealing. The larger the target asset, the bigger the opportunities for stealing. Few things have grown larger in already vast Russia than the AvtoVAZ car factory in Tolyatti, churning out hundreds of thousands of Zhigulis a year. When the Soviet system unraveled, criminals (some of whom were the factory’s own managers) stole whole containers of spare parts, occasionally even bringing production to a halt.
Theft took place at every level, not just at the top. Stealing rates might even have been similar across the board. But even with identical stealing rates, a container-load of spare parts represented a much larger redistribution in absolute terms than stealing a handful of tools or other small things.
Authorized banks
Only certain commercial banks were allowed to handle state-owned funds. These banks would receive money from the state and send it to the final recipient. In an ideal world, the banks would forward this money to the recipient without delay. Instead, what happened was that they would sit on the money. Or, more precisely, they would invest it for their own benefit, forwarding it only weeks later. In other words, they appropriated the time value of money, which was very valuable in high-inflation, high-interest Russia.
It's unclear whether the victim was the state (which could have used the money longer) or the recipient (who received less valuable rubles due to the delay). Whichever party it was, authorized banks benefited at their expense.
Loans-for-shares
Loans frequently come with collateral. In a typical market transaction, the lender wants to get their money back, and they are not interested in taking possession of the collateral. In post-Soviet Russia, this logic was frequently reversed.
The Russian state needed money. Some private entities had money and wanted a good return on their investment. So far, there is nothing unusual in the story. What’s unusual is what the state offered as collateral for these loans: shares in large, profitable companies that were state-owned at the time. The oligarchs wanted to get their hands on these companies and do so as cheaply as possible. This gave rise to the loans-for-shares model: the oligarchs would lend money to the state, knowing the state wouldn’t (or couldn’t) pay it back. They would then get the shares they had wanted all along.
Acquiring shares of highly profitable companies at a fraction of the market price required two things.
The first element was that the collateral (i.e., the share) needed to be much more valuable than the money lent. Otherwise, they could have just bought those shares directly. Normally, if a debt is not repaid, the collateral is sold, and the amount exceeding the outstanding debt is paid back to the borrower (i.e., the state in our case). The oligarchs wanted to keep this surplus for themselves, which meant they had to sell the shares at cost, at least on paper. The second element was retaining ownership of the shares.
There is one easy way to meet both requirements: selling the shares to yourself. The oligarchs did just that through shell companies.
51% of shares to insiders
Both the authorized banks scheme and the loans-for-shares program were implicitly about excluding competition that could reduce profits. Exclusion was sometimes an explicit program feature. The original idea of Russian privatization was that anyone could bid for the shares of large public companies. This version was discarded and replaced by a different version, which then became the most widely used privatization method: instead of all shares being up for grabs, 51% of a company’s shares could only be bought by insiders, such as the company’s former directorate and workforce.
The victim is the ordinary citizen
MMM Ponzi scheme
Ponzi schemes have been common in history, and they thrive in environments like the Russia of the early 1990s. The country had a population with no experience with financial markets and investments. At the same time, people saw their neighbors become rich overnight. These two factors created the preconditions for the false inference that anybody could get rich by participating in financial markets. Seeing one’s neighbor get rich also had another effect. Few things activate people’s fear of missing out more than a neighbor making a windfall overnight.
In Russia, the largest Ponzi scheme, MMM, was orchestrated by a man named Sergei Mavrodi. On the surface, MMM was presented as a legitimate investment: people could go to an office and buy a “share” (similar to the AVVA bearer certificate mentioned in the next section). Every day, a buyback price would be set single-handedly by Mavrodi. People would see this price increase day after day.
In reality, MMM was nothing more than a Ponzi scheme: early members had their astronomical returns financed by new memberships. When new memberships dried up, the whole scheme imploded. The buyback price dropped to practically zero overnight, wiping out the savings of many of the 5 to 10 million people who participated in the scheme.
AVVA
Boris Berezovsky, one of the oligarchs portrayed in the book, wanted money to buy shares in the AvtoVAZ factory when it would be privatized. He devised what we could call a Soviet-style equity crowdfunding model.
The equity crowdfunding part was that people could buy shares in a company that wasn’t yet operational. When the company became profitable, shareholders would get dividends. AVVA, the company in question, wouldn’t just be a money-making enterprise. Its promise was that it would construct a large factory to produce a people’s car, akin to Germany’s Volkswagen. In car-hungry Russia, this message found a willing audience.
Around 2.6 million people bought AVVA shares. That’s what they thought, at least. Despite featuring the word “share” prominently, the piece of paper they bought was a bearer certificate. Its only use was that it could be converted into a share.
Most people didn’t realize that their share was not actually a share. Those who saw through this trick were disincentivized from converting their worthless certificates into shares: AVVA organized lotteries in which certificate holders (but not shareholders) could win cars. In any case, converting the certificate was difficult (e.g., there was a narrow conversion window), leaving many with useless certificates.
This was the Soviet-style part of the model: people were promised dividends and an ample supply of new cars, but they got neither.
The victim is the foreign investor
Share dilutions
In the 1990s, Russia slowly became a place where foreigners could invest. Some foreign investors acquired minority shares in companies. One example of this was US investor Kenneth Dart, who owned shares in oil extraction companies. The majority shareholder in these companies was Yukos, largely owned by oligarch Mikhail Khodorkovsky. In Russia, having majority ownership allowed one to do almost anything, as protections for minority shareholders were largely non-existent.
For example, Yukos (the majority shareholder) decided to issue new shares in the extraction companies. To be clear, issuing new shares has many legitimate uses, like raising capital or bringing in strategic investors. In this case, however, the reason behind the move was different—to dilute the shares of minority shareholders like Kenneth Dart. After some time, Dart sold his shares to Khodorkovsky for an undisclosed sum.
Share dilution cases were not unusual. Minority shareholders typically came out behind. Sometimes, however, they fought back successfully. One of these was the case of Bill Browder, a minority shareholder in Sidanco, another important oil company. As documented in detail in his book Red Notice, the same share dilution tactic was tried against him, but the maneuver was eventually blocked by the Russian financial regulator due to a combination of media pressure and a bureaucrat who took his job seriously.
Transfer pricing
Share dilution works by reducing someone’s ownership in a profitable company. Another way to deprive minority shareholders of profit is by making a profitable company unprofitable on paper. The minority stakeholder still owns the same number of shares. The only difference is that these shares now represent claims to the (non-existent) profits of an unprofitable company.
Consider a profitable oil extraction company. The oligarch, who is the majority shareholder in the oil extraction company, creates a separate trading company. He now controls two companies: the oil extraction company and the trading company. He then uses transfer pricing to generate profits for the trading company and losses for the oil extraction company.
His trading company serves as the middleman between the oil extraction company and the final buyer. But unlike a regular middleman that charges a markup and does some actual work, the point of the trading company is merely to shift profits.
The trading company buys oil very cheaply from the extraction company and then sells it at world prices. It has no costs and makes a windfall. On the other hand, the extraction company has almost no income from its oil sales to the trading company but bears all the costs of extracting oil from the ground, such as paying wages and servicing equipment.
Conclusion
Reading about Ponzi schemes, share dilutions, transfer pricing, and other redistribution strategies is rewarding in itself. But we shouldn’t lose sight of the bigger picture. People respond to incentives and operate within the constraints of their legal, social, and institutional environment.
In this sense, the loans-for-shares program or transfer pricing (or the identities of the oligarchs) were replaceable elements of the system. It’s tempting to think that if these things had been better regulated, or if some implementation detail had been different, or if an oligarch had followed a different life path, everything would have turned out just fine.
I think that’s the wrong conclusion. All the unintended redistributions were the result of the existing incentive structure and environment. Had it not been the loans-for-shares program, there would have been a different scheme with largely equivalent outcomes.
Details do matter, and it’s important to get them right. But it’s more important to have the right incentive structure and environment in place. If these are dysfunctional, we should expect the same outcome in each new iteration, even if the concrete policies, stealing methods, monopoly-creating actions, and other details differ from one cycle to the next.