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Case Briefs 7.1, 7.2 From Text Book Business(Its Legal Ethical And Global Environment )By Marianne M Jennings

FACTS: Yukos is a Moscow-based joint-stock company whose shares trade on the Russian stock

exchange. Yukos shares also trade indirectly on multiple European exchanges and over-the-

counter in the United States.

Allegedly, Khodorkovsky was part of a select group of Russian business leaders known as

“oligarchs” who supported former Russian President Boris N. Yeltsin, but were politically opposed

to current Russian President Vladimir V. Putin.

The Tax Code of the Russian Federation prescribed a maximum income tax rate that incorporated

two components: a tax payable to the federal budget and a tax payable to the budget of the

taxpayer's local region. For example, in 2004, the statutory maximum rate was 24%, of which up

to 6.5% could be collected by the federal government and up to 17.5% by regional governments.

The Tax Code also prescribed a minimum rate for taxes payable to regional governments. In 2004,

that rate was 13.5%. However, the regional governments could offer tax benefits to reduce or even

eliminate the regional budget liability of certain categories of taxpayers. Because of this regional

variance in the effective income tax rate, taxpayers in the metropolitan regions of the Russian

Federation, such as Moscow, paid higher taxes than taxpayers in remote regions, or “ZATOs.”

The complaint alleges that from 2000 through 2003, Yukos grossly underpaid its taxes to the

Russian Federation by illegally taking advantage of the ZATOs' preferential tax treatment.

According to the complaint, Yukos booked oil sales at “well below” market prices to seventeen

trading companies, all of which were registered within ZATOs. Without taking physical

possession, the trading companies sold the oil to customers at market prices and claimed the tax

benefits of their ZATOs. However, the profits were “funneled ... back to Yukos and Yukos paid

taxes only on the initial below-market sales while reaping substantial profits from the low-tax

market-price sales.

The complaint alleges that the regional trading companies received the benefits of ZATO

registration illegitimately because “[n]o business was actually conducted by the sham companies

in the ZATOs.” This Yukos tax strategy presented enormous risk because it violated Russian law

and because the Russian Federation had prosecuted other companies that had acted similarly.

Nonetheless, the risk was not disclosed in any of the Yuko’s filings with the SEC. Also, what was

filed with the SEC was allegedly not prepared in conformity with U.S. GAAP or other standards

of financial reporting.

At a secret meeting with Khodorkovsky and other oligarchs in 2000, Putin promised not to

investigate potential wrongdoing at their companies if the oligarchs refrained from opposing Putin.

Nearly three years later, at another such meeting, Khodorkovsky allegedly voiced his opinion that

high-level officials in Putin's government should be ousted. According to the plaintiffs, Putin

reacted negatively and intimated to Khodorkovsky that the Russian Federation might investigate

Yukos' methods of acquiring oil reserves. Despite Putin's warnings, Khodorkovsky publicly

criticized Putin and financed opposition parties.

On October 25, 2003, Russian Federation authorities arrested Khodorkovsky and charged him with

fraud, embezzlement and evasion of personal income taxes. Days later, the Russian Government

seized control of Khodorkovsky's 44% interest in Yukos as security against the approximately $1

billion he owed in taxes. Concurrently, the Tax Ministry revealed that it had been investigating

Yukos' tax strategies. The Department of Information and Public Relations of the General

Prosecutors Office then announced charges that accused Khodorkovsky and others of fraudulently

operating an illegal scheme at Yukos to avoid tax liability through shell company transactions.

On December 29, 2003, the Tax Ministry concluded its audit of Yukos for tax year 2000, issued a

report that Yukos had illegally obtained the benefit of the ZATOs’ preferential tax treatment, and

owed $3.4 billion to the Russian Federation in back taxes, interest, and penalties for tax year 2000.

As a result, Yukos defaulted on a $1 billion loan from private lenders and the Russian Government

confiscated Yukos' assets, including its main production facility and billions of dollars from its

bank accounts. The price of Yukos securities “plummeted” in response to these events.

Shareholders in Yukos (Plaintiffs) filed consolidated class actions against Khodorkovsky and

others (defendants) on July 2, 2004. The U.S. plaintiffs had purchased Yukos securities between

January 22, 2003, and October 25, 2003. They allege that Yukos, its outside auditor, and certain

of its executives and controlling shareholders knowingly concealed the risk that the Russian

Federation would take action against Yukos by failing to disclose: (1) that Yukos had employed

an illegal tax evasion scheme since 2000; and (2) that Khodorkovsky's political activity exposed

the Company to retribution from the current Russian government. The plaintiffs based their claims

on the fraud provision, Section 10(b), of the Securities Exchange Act.

ISSUE: Does the act of state doctrine prohibit the court from taking the case?

DECISION: No. The court dismissed the case on other grounds, but found that the act of state

doctrine did not prohibit the court from hearing the case. The case was not one that involved

invalidating Russian actions; it was a case to decide whether the company should have been more

transparent and forthcoming about the risk of its strategy as well as the political risk in Russia.

Questions:

1. Describe how Yukos is alleged to have saved significant amounts in taxes.

2. Explain what act of the Russian Federation is in question.

3. What are the plaintiffs asking the court to decide? Does that decision require revisiting what

the Russian Federation did, and why or why not?