Better in their words…

Russia 2006
In December of 2006, Gazprom, the Russian energy monopoly, “accepted” control of Sakhalin-2 from Royal Dutch Shell. Sakhalin-2 is a drilling venture off Sakhalin Island in Russia’s North Pacific. Shell negotiated the offshore drilling rights with the Russian government to be Sakhalin-2’s owner and operator along with its two Japanese partners. In return, Shell agreed to invest $8 billion. Shell’s deal was unusual because it included no Russian partner, but it was approved at the highest levels in 1994. As the end of 2006 approached, Sakhalin-2 was ready to go into production. Shell’s investment had grown to $20 billion.

Then came trouble. Russian environmental regulators suddenly discovered a number of violations that endangered Sakhalin Island’s “delicate ecostructure.” They ordered the project closed down and gave no instructions for remedying the presumed violations. In effect,

Sakhalin-2 was placed on permanent hold.

President Vladimir Putin, however, offered a solution. If Shell would sell fifty percent plus one share of Sakhalin-2 to the Russian state gas monopoly, Gazprom, perhaps a solution to the environmental holdup could be found.

Shell, faced with an indefinite delay during which its license might lapse, caved in. Shell gave up its controlling interest to Gazprom at a price well below market value.

At the signing ceremony, Putin announced that the environmental issue could be considered “resolved.” He cited Shell’s and Exxon’s (which had also been squeezed by regulators) participation in Russian energy development as proof of the open investment climate. Shell executives put on their happy faces and declared how much they looked forward to working with their new Russian “partner,” the state-owned Gazprom.

Shell would be a fool to return to Russia for another major project, although BP did recently with similarly bad results.

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China 2011
In its most recent regulatory filing, Yahoo disclosed that Alibaba Group, 43 percent owned by Yahoo but under Chinese management, transferred Alibaba’s on-line payment service, Alipay, to a company owned by its Chinese CEO. Yahoo learned of the transfer only after it was completed and without approval of Alibaba’s board. The Chinese Alibaba chairman’s excuse: He had to transfer ownership because of “Chinese regulatory rules.” In the wake of this disclosure, Yahoo’s share price plummeted. Alipay represented the most valuable single asset of the company’s Chinese operations.

The Chinese CEO of Alibaba, Jack Ma, is a major businessman, Internet pioneer, and celebrity. Although he is not a fabled “Princeling,” he is well connected with Chinese party leaders and bureaucrats. If not, he would not be a billionaire. In a legal battle in China between him and Yahoo, Ma would be the winner.

In late July, Ma and Yahoo reached an “agreement.” Alipay remained the property of Ma, but, in the event that Alipay goes public, Alibaba will receive at least $2 billion but no more than $6 billion.

Like Shell in Russia, Yahoo executives smiled as Ma announced the agreement “that serves the interests of all parties. He left the best for last: “We have secured the license needed to operate.”

Upon hearing this news, an influential fund manager dumped his company’s entire stake in Yahoo because of the de facto loss of one of its most important assets.

United States 2009
In Spring of 2009, a group of Chrysler’s secured lenders threatened to fight in bankruptcy court what they termed the “illegal” sale of Chrysler to a union-aligned trust. Under the government-brokered plan, Chrysler assets would be transferred to a new company owned 55 percent by a union health-care trust. The rest would be owned by Fiat and the U.S. and Canadian governments.

Under established bankruptcy law, secured creditors are first in line in the distribution of assets. They are supposed to get a better deal than unsecured creditors, such as the union fund, in this case. Instead, the secured creditors were told they would get about 29 cents on the dollar

– a return well below others in line.

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Unsurprisingly, the four large banks, that held the bulk of Chrysler’s secured debt, agreed to the proposed “hair cut.” They also happened to be among the recipients of billions of dollars of government bailouts under the TARP program. As such, they had already received their payoffs; so why raise a fuss about their Chrysler losses?

Secured lenders, who did not receive TARP funds, could not agree to “unfair and illegal payment schemes.” They complained: “We went into this investment thinking normal bankruptcy laws developed and refined over decades were to be upheld.” Obviously, they were disturbed to learn that they were wrong.

As the Non-TARP secured lenders prepared for battle, they found their numbers dwindling. President Obama, in a press conference, labeled them as “speculators,” whose refusal to play ball forced Chrysler into bankruptcy. Within days, the Non-TARP group dwindled to nine companies representing only $295 million in Chrysler debt. The group was so afraid of a public backlash that its members unsuccessfully asked the court to remain anonymous. The Non-Tarp secured lenders caved in to government pressure. They understood “you cannot fight city hall.” The President’s vitriol could have been followed by Congressional hearings, IRS visits, or other unpleasant things.

The American public remained blissfully unaware that something untoward had even happened.

These three stories tell us a great deal about forces that hold economies back.

In the Russian case, the Putin regime openly blackmailed one of the world’s largest and most visible corporations by unleashing its regulators for the express purpose of extortion. Shell invested $20 billion and its technology. Putin decided it was time for the Russian state and its oligarchs to cash in. When the state itself extorts, newspapers and reporters avoid plain talk. But in my book extortion is extortion, even if the government, not Tony Soprano, does it.

In the Chinese Alibaba case, a Chinese insider ignored all established rules of corporate governance to transfer the most valuable asset of a company he presided over as CEO to another company he owned. In so doing, he violated his fiduciary responsibility to all owners, including the largest shareholder, Yahoo. His excuse was again state regulation.

He had to take over the asset because Chinese regulatory rules forced him to do so. He had no choice, but that choice made him an even richer man.

The Chinese case is only slightly less blatant than the Russian one.

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When the abuse became known to the investment community, the Chinese parties backtracked somewhat, and pretended to reach an amicable deal, but it was still a losing deal for Yahoo.

China is very dependent on foreign direct investment for technological progress. Its domestic innovation machine is overblown and ineffective.

Yahoo’s Alibaba experience is probably only the tip of the iceberg. If that is the case, China will eventually have to kiss foreign investment goodbye despite its vaunted high growth and large consumer market.

Chrysler follows the same pattern but is more subtle. The secured debtors clearly had the law on their side, but they could not withstand the threats and accusations that the administration brought to bear against them. The Obama administration decided that the established rule of law was trumped by political considerations. They strong armed those with the law on their side. They could argue that they set aside normal legal procedure for the good of the country (or for labor allies), and only a few lenders were hurt.

These cases show that Russia has no rule of law and is not particularly concerned about this fact being made quite obvious. Russia therefore has little chance of economic progress and is sustained only by its vast energy and mineral resources. China also does not have a rule of law, but China participates in world markets and needs Western technology and direct foreign investment. In the long run, its lack of a rule of law will severely retard its economic progress when the international business community better understands China’s investment climate.

The United States has prospered so far by having a well established rule of law. Apologists for the Chrysler action shrug and note that only a few investors and the rule of law were sacrificed for the sake of the national good (or the administration’s labor allies).

But the Chrysler case could have far reaching implications. Currently lenders are sitting on trillions of dollars. As one of the Chrysler secured debtors warned: “Why should we lend money when we do not know if our legal rights will be upheld?” Similar thoughts must be going through the minds of mortgage and other lenders. Perhaps some government agency will require us to change the terms of the loan. Maybe the President will brand us as evil and drive our depositors away.

Is this one of the reasons why all that money is sitting on the sidelines and holding back our recovery? The presumed denial of the rule of law to a few may affect the behavior of the many.

Paul Roderick Gregory is a Hoover Institution research fellow.

Forbes.com – Magazine Article.