The banker occupies the pilot's cabin of the capitalist system. The banker is easily in position to know all, see all, hear all.

Description of U.S. economy circa 1900, The Robber Barons, 1934

The penal code should be amended so that it is a criminal offense if a manager fails to disclose financial information to all stockholders.

Russian Federal Securities Commission, 1999

We do contract work for foreign companies. But we could not just pay our employees from the proceeds of the contracts. We would lose most of the money to taxes. We set up a firm in Cyprus to handle financial transactions—a shell. We make sure that all of our employees have credit cards. Our firm in Cyprus is paid by the foreign companies for work performed under contracts, and we pay our employees by having the firm deposit money in each employee's credit card account. Our company in Russia gets just enough money to pay expenses.¹

This report from the director of an applied research institute in St. Petersburg shows how scientists are attempting to replicate offshore payment schemes pioneered for more than a decade by well-endowed Russian enterprises that export natural resources. While often distasteful and sometimes precarious, tax avoidance has become ingrained in the Russian approach to business. There is little hope of the government retrieving its fair share of Russian income through taxes in the foreseeable future.

Poor tax collection clearly has a braking effect on progress toward economic reform, reform that requires the government to have funds to do its job. Tax avoidance cannot be condoned. Nevertheless, why should Russian scientists be excluded from the national pastime of taking end runs around the tax authorities? In this case, as well as with other evasive approaches, the participants may in fact believe they are complying with ambiguous Russian laws.

The director has learned that the first responsibility of any research and development manager is to ensure that he or she has a program to manage. This means having income sources that enable the staff to practice their trade. For the St. Petersburg institute, foreign organizations were the only sources of income. Husbanding every dollar that these organizations were willing to pay was the director's top priority. He then faced crucial decisions as to how to divide a financial pie large enough to adequately feed only 20 percent of his staff. His response was to reward those who worked on foreign contracts with credit cards while distributing a small portion of the income among other employees. He claimed that he and his top managers did not receive excessive returns.

Russian organizations attempting to commercialize technology usually receive their funds in small droplets through many spigots. Overall, the largest income streams continue to flow from the federal government. Government support of research and development, however, has declined twenty-fold during the past decade. Also, there was a five-year hiatus of paychecks delayed for months or years.

Small payments for staffs of research and development organizations traditionally supported by the government began arriving on time in 1999. While not all researchers could report an end to delays, most could at least temporarily. This change has been attributed to the personal role of former Prime Minister Yevgeny Primakov who, after the financial crisis of August 1998, insisted on reliable salary payments—however small—to employees of all stripes who depended on governmental funds. Also, as we have seen, some firms found cash-paying customers for modern technological achievements following the devaluation of the ruble in 1998.

In addition to simply allocating financial resources to state institu-

tions on the basis of numbers of employees, the government has established a few special funds to support technological innovation activities. The money from these funds is distributed in various ways: on the basis of habit, on the basis of personal friendships, and sometimes on the basis of merit in competitions for funds. But the allocations are always at a low level.

The dreams of a large portion of the research and development community are pegged to success in obtaining grants and contracts from abroad. Innovators could then live from year to year rather than month to month, and they could boost their incomes from $50 per month up to $100 or even $500 per month. They are not particular as to their tasks, although they would like to participate in some level of innovation —whether modifying fighter aircraft for sales abroad, providing designs to enhance the safety of nuclear power plants in Russia, or developing stronger plastics, as is the case at the St. Petersburg institute.

In practice, few have such challenging jobs. Many accept assignments to provide rudimentary support of utility services or to maintain old and unreliable industrial equipment. While these tasks offer few technical challenges, they provide income to ride out the economic crisis, with the hope that in the future researchers can again become bona fide innovators.

For a decade, western governments have predicted that the only realistic sources of funds to revitalize Russian technological development would be from foreign, private-sector investments. Foreign equity investments will be important. But this narrow vision of Russia' s future can contribute to a neglect of development of internal Russian financial capabilities.

Of course, foreign signatories of contracts and grants are very sensitive to attempts to misuse their funds. They would like to pay for goods and services they have ordered when they take delivery and not worry about losing money in the interim. Russian organizations often argue, however, that they need up-front money to be able to carry out agreed-upon tasks. Thus, foreign organizations have developed a variety of approaches to help ensure that neither criminal elements, greedy

managers, nor the tax police become beneficiaries of their funds and thereby prevent Russian workers from completing their tasks.

Most ruble transactions, and many transactions involving foreign currency, wind their way through the Russian banking system. After a foreign contract involving an enterprise or institute is signed and money is deposited by the foreign entity, government authorities and financial institutions are eager to take their percentages before rubles arrive at the workplace. Thus, the number of rubles that are available to the enterprise or institute is hard to predict. The reasons given for reduced payments to the institutes—tax obligations, transfer fees, or other charges—are seldom, if ever, subject to appeal.

The reach of organized crime—into the banks, into the enterprises, and even into the pockets of the researchers—is omnipresent. Researchers themselves occasionally join the ranks of the corrupted, where they too can participate in siphoning off funds for their own use in preference to waiting for the eventual payoff from marketing of technology. For most entrepreneurs, protection against criminal activities has become a normal cost of doing business, a cost that technology innovators with dry income streams have difficulty absorbing.

One defensive approach taken by Russian organizations trying to innovate for profit through hard work is to build financial fire walls around their activities—referred to in Russia as “roofs.” Then they attempt to operate as normal business endeavors. Also, as noted, a few institutes have mastered the intricacies of safeguarding their funds in foreign subsidiaries in Cyprus and other remote havens. The remainder have grappled with less sophisticated schemes to minimize risks of losing their funds before they themselves can use them.

Despite the uncertainty of sources of funding and the many hands reaching for any money that appears on the scene, innovating for profit has sometimes been possible in Russia. A number of Russian scientists and engineers, having honed their skills in the Soviet military-industrial complex are determined to turn their technologies that produced high-tech swords into lucrative market shares. More recent entrants into the world of technology innovation increasingly look to the West for new ideas that Russian talent can develop and sell at home and abroad.

As suggested above, there are many hazards in seeking a profit from almost any legitimate activity in Russia. It would seem that only the foolhardy would risk long-term investments in innovative technologies with uncertain payoffs even in the best of times. But the Russian government is willing to assume at least some of the risk.

For decades, the Soviet and then the Russian Ministry of Science and Technology have provided funds to support enterprises and research institutes in developing technologies with industrial potential. In recent years, the scope of such efforts has declined. At the same time, no longer do manufacturers have funds in reserve to apply the latest developments. Today, Russian companies—state-owned and privatized alike—must be convinced that they will find almost instantaneous payoff if they are to incorporate new products or processes into existing production lines. Nevertheless, the ministry is accustomed to providing funds for pushing technologies that it considers promising. And old habits change slowly.

The money available to the ministry is pitifully small by any measure. The research and development kitty has declined precipitously during the past decade from hundreds of millions to tens of millions of dollars annually for nationwide efforts. Still, ministry support sometimes demonstrates small-scale positive returns from investments in technology projects.

A centerpiece of the ministry's effort is the Fund for Development of Small Firms in the Scientific and Technical Sphere. The fund, established in the mid-1990s by a dynamic and effective Russian director, has combined technological and financial acumen in support of hundreds of Russian firms. The fund has played an important role in finding relatively safe workplaces for its clients in technoparks and innovation centers in Moscow, St. Petersburg, and Nizhny Novgorod—even in an abandoned defense complex in Kazan—away from the grips of the mafia.

With a budget of $6 million in 1999, the fund emphasizes support of technology-oriented firms that already have small market niches and are attempting to develop broader customer bases. The fund usually

provides interest-free loans of up to $200,000 for 12-18 months. In 1999, the repayment rate was over 50 percent. There have been several keys to the success of the fund. Proposed projects are carefully screened, taking into account “all” aspects of doing business in Russia —from uncertainties regarding suppliers to changing government regulations to difficulties in collecting payments from customers. The fund operates in a transparent fashion. It recognizes the importance of publishing detailed annual reports about its activities so as to dampen suspicions over the possibility of corrupt practices. Finally, the staff of the fund is in tune with what is happening in the country at the micro level, particularly with regard to handling financial assets and dealing with organized crime. The staff gives special attention to the integrity of the financial systems that support projects chosen for financing.²

In 1992, the ministry established another fund, the Russian Fund for Technological Development, to support larger projects proposed by researchers in strategic industries formerly associated with the military-industrial complex. This fund emphasizes financing of improved technologies in telecommunications, transportation, computers, and petroleum. Russian companies are doing reasonably well in these fields. Therefore, projects that are financed have a good chance of catching the attention of these companies.³

The Ministry of Economics maintains a related fund to support initial production runs for new or improved items. Manufacturing enterprises that desperately need new product lines to stay alive are sometimes beneficiaries. To avoid interagency quarrelling, the Ministry of Science and Technology does not participate in these activities, despite its expert knowledge of the innovation process in Russia. Instead, the latter ministry concentrates on individual entrepreneurs, even though they represent but a small portion of the country's technological potential, and on the State Scientific Centers discussed in Chapter 2. ⁴s

The foregoing funds are well known throughout the Russian research and development community, but they tell only a small part of the story. In 1998, a Russian official handed me a list of 81 other government funds set up to support industrial development. While some are limited to specific regions of the country, and almost all are directed to narrow industrial sectors, in the aggregate they cover almost

all branches of industry. None of the funds have much money to distribute, but they keep alive the hope that at some future date the government will again be a reliable source of resources for industrial development. ⁵

Many government agencies in the United States, Europe, and Asia also support research and development in Russia, although no one has a reliable list of such programs. Several western companies also fund research and development in Russia. One compilation identifies over 50 foreign sources of financing of technological and related commercial activities not including individual foreign companies. At least a dozen venture capital funds have been established in Russia, usually with financial contributions from abroad. Something about Russian industry, despite its weakened state, continues to hold the world in suspense.⁶

Few of the foreign venture funds are investing significant amounts in technology development. The St. Petersburg Technology Fund is a promising exception. A handful of foreign investors have pooled resources to establish a fund that takes equity positions in well-managed Russian high-tech firms. With western management philosophy and direction, the fund has invested several million dollars in small companies; and expansion of activities is a high probability. ⁷While several million dollars may seem small, a good track record with limited resources is preferable to the many false starts of much larger, past investors.

Why hasn't foreign equity investment become a more significant factor in the revitalization of Russia's industrial base? Western firms had less than satisfactory experiences with joint ventures in the early 1990s —often coming to impasses with Russian partners over both management and financial issues. Most large western companies became disillusioned about the joint venture approach, although a few small western entrepreneurs investing on the order of $500,000 to $1.5 million have enjoyed significant returns despite the economic downslide throughout the 1990s.⁸In general, foreign companies—and even some Russian companies—are more attracted to short-term contracts with much less risk involved. For example, the Russian organization NPO Mashinostroenie, the Central Aerohydrodynamics Institute, and

the Research Institute of Aviation Systems have been reluctant to give up equity or to provide cash as required in joint-venture arrangements. ⁹Yet, growth in foreign equity investments remains an important near-term goal for Russia if sustained income streams are to be developed.

Much of the lack of interest in the West in foreign equity investment can be traced to the uncertain legal framework and the associated risks. Among the specific concerns are:

• Taxes should be based on profits not on turnover, as is now the case, and should never be retroactive, a constant worry.

• Minority shareholder rights need to be strengthened and legally binding.

• Venture funds should have the right to extend loans as well as provide equity, but now only banks can extend loans.

• Registration and approval requirements for many types of activities need to be simplified.

• A reliable banking system is essential.¹⁰

While foreign investors are increasing in number, they are becoming more chary in their willingness to take chances. They want good projects. But what is a good project? To most investors, a good project equates with a good business plan—a plan that emphasizes a realistic customer demand for the product and an approach that avoids entanglements with criminal elements. Unfortunately, proposals for good projects are in short supply. Support of Russian organizations as they develop candidate projects should be an activity for western organizations interested in a stronger technological infrastructure in Russia.

A European Union report issued at the end of 1999 concludes that with minor improvements in the Russian legal and taxation system and with modest economic growth, up to $4 billion dollars could be available from European venture capitalists for Russia, if good projects were developed. The report underscores the importance of investment by both public and private sectors in innovative activities and the financial systems which support those activities. Such measures can realistically boost international competitiveness of Russian industry, according to the report.¹¹

Russian specialists attempting to develop and market newly found technologies consider funding pursuant to western contracts and grants more reliable, as well as more lucrative, than payments from Russian sources. Foreign payments usually arrive on time. They are generous, given the low average salary levels in Russia. Also, they usually are denominated in dollars, which provides some protection from devaluation of the ruble.

Russian and foreign partners have successfully used a variety of mechanisms for transferring money into Russia. A principal objective is to avoid payments to customs and tax officials, to pension and social funds, and to bottomless overhead accounts of Russian organizations. Some end runs of “authorized” payment channels are within the laws of Russia while others unambiguously violate the laws. Many are on the edge of legality, with Russian law enforcement officials making arbitrary decisions every day as to whether to block financial flows that do not follow regular patterns.

A simple route to avoid diversions of funds is for the intended recipient simply to receive stacks of one hundred dollar bills handed directly to him or her in Russia by the foreign funder rather than having the money deposited in a bank account. The recipient can then direct the funds to research and development activities or other uses as he sees fit without an obligation to pay bank fees or to hassle the accountants working at his organization. At the same time, the western partner must have an astounding amount of trust in the integrity of the recipient of the bills to engage in such a practice. Also, Russian authorities may be poised to question the legality of such transactions.

Occasionally, directors of institutes arrange such payments. They cherish the flexibility of unencumbered hard currency, since they seldom receive real cash owed to them by Russian institutions. Indeed, financial transactions between Russian entities show up as entries in the bank accounts of the payer and the payee. The paper trail complicates development of concocted stories about cash histories to avoid payments to the government of one type or another.

Most foreign partners know that if they place money into the bank

account of an institute rather than the account of an individual researcher, greedy hands will be reaching for a percentage for “ personal supporting services,” for institute overhead, or simply for paying impatient creditors who threaten to close the institute. Adding overhead, pension, health care, and income tax deductions, the researchers are lucky if they receive one-quarter of the funds earmarked for salaries after the garnishments are deducted. While western scientists are accustomed to such deductions at their home institutions, they are confident that pensions will be real, that health care will be adequate, and that overhead charges will benefit their work. Such confidence is difficult to imagine in present-day Russia.

In 1993, the International Science Foundation established in Russia by George Soros began handing funds directly to individual researchers, with the approval of the Russian government, to avoid diversion of research stipends to questionable activities such as purchases of new Mercedes automobiles for directors. In 1994, the International Science and Technology Center in Moscow adopted similar procedures. By 1999, more than two dozen western organizations were making direct payments to Russian specialists.¹² These legally sanctioned transfer routes circumvented most opportunities for either the government or an institute's management to take a cut.

Initially, institute directors hated schemes for direct payments of foreign funds to individual researchers. To them, not having personal control over salary funds meant losing control of their employees. Also, the directors feared that employees who did not have an opportunity to share in a portion of the income from foreign contracts and grants might soon revolt over the higher salaries of their favored colleagues.

In time, the directors adjusted. First, they too became participants in western projects, at least on paper. They were added to the lists of recipients of direct payments from abroad. Also, western organizations provided modest cash payments for overhead to be used at the discretion of the directors. The level of overhead funding was usually no more than 20 percent of total project costs. This was free money for the directors. While 20 percent is a very small percentage in comparison with the overhead charges of 500 percent or more to which the

institutes had been accustomed during the Soviet era, guaranteed payments of even small amounts of overhead were welcomed.

Finally, many directors decided to withhold for the institute's general fund the salaries that foreign-supported researchers would have received from the institutes if they did not have western income. For example, if a researcher received the equivalent of $50 per month as an institute employee and then was awarded a foreign grant that provided $300 per month, he or she would receive a total of only $300. The institute retained $50 for overhead that in principle should benefit all researchers in some small way.

The Russian government approved the scheme for western funders to pay unencumbered salaries directly to researchers only for nonprofit organizations and international organizations that transfer funds to Russia for “technical or humanitarian assistance.” Governments and private companies have no comparable payment route unless they first transfer their funds to an intermediary nonprofit organization for conveyance. To circumvent this limitation, representatives of some western companies become money mules, carrying large amounts of cash into Russia every time they make visits, and then handing the money to the designated recipients. Also, foreign governments often rely on diplomatic pouches for shipping cash for local expenses, with the embassies seldom concerned about the propriety of diplomatic dodges around the tax structure.

Another approach to circumventing Russian government claims on foreign payments is for a foreigner to hand over cash to a Russian partner for “expenses” during the latter's travels abroad. The foreigner can rest assured that the acquaintance will figure out some way to use the money without having a substantial portion skimmed off. Western scientists are small players in this game, however, transferring only hundreds or possibly thousands of dollars in individual transactions. Western companies interested in buying Russia's natural resources sometimes transfer tens of millions of dollars to Russian businessmen in transactions at overseas locations, a practice clearly outside Russian law.

For their part, Russian customs officials seem unconcerned about cash coming into the country from the West, apparently assuming the

dollars spent in Russia are a plus for the economy. On only one occasion has a customs official ordered me or any member of groups travelling with me through Sheremetyevo Airport to produce the dollars indicated on an entry declaration. My wad of new $100 bills added up to $9,500 on that one occasion, the amount needed for legitimate lodging and transportation expenses for a group of visitors. The customs agent simply glanced at my bulging fist and immediately waved me through the checkpoint.

Leaving the country is a different story, however, reflecting Russian determination to cap one route for capital flight. The traveler who overestimates his financial needs in Russia and plans to go home with more than $500 in cash should beware. If he or she has more foreign currency in pocket than was originally noted on the entry declaration, the excess could be taken at the exit point. Customs officials are instructed to prevent the outflow of foreign currency, although they may not always be attentive to their jobs.

During one trip, an attractive young American friend was carrying $9,000 out of the country, cash she had forgotten to declare on her customs form during entry. When I asked her at the airport how she would get the money past the customs desk, she replied, “Just watch. ” After loosening the top button of her blouse, she leaned over the customs official's counter, blinked, and said in perfect Russian, “I have only $500 dollars which I don't need to declare.” A grin ran off the edge of the uniformed official's face. His eyes froze in a downward stare toward his work space, temporarily hidden. After a few blinks and a long hesitation, he waved her through and wished her a pleasant flight.

Not surprisingly, the extraordinary measures associated with money transactions in Russia often distract Russian research and development managers from their primary focus on ensuring the sustainability of research and development programs at their institutes. They must pay a “time tax” of 10-20 percent of the work week for coping with financial flows. Indeed, the focus on money has forced many researchers into technical support services for people with cash-in-hand, even though these activities result in a slow erosion of research competence.

Research and development is subsidized in all countries, and research and development organizations traditionally receive tax breaks. But, in Russia, there is a large cadre of impoverished specialists unable to benefit directly from either approach. They must push the envelope of legality to make ends meet. Let us hope that their unorthodox approaches are short-term measures and that in time they will be able to concentrate on technology innovation rather than on money manipulation.

Several Russian acquaintances, in addition to Gennady who was introduced in Chapter 2, have tried their hands at becoming entrepreneurs, each determined to set up a business independent of the shackles of any existing Russian organization. Their logic was that ties with old-line Russian organizations would simply siphon away portions of the earnings of new businesses. Instead they would find working spaces, hire their own employees, and set up their bank accounts. Then their businesses would take off. If necessary, they would hire security guards for their premises. From time to time, they would consult Russian acquaintances to help file the proper papers with the authorities and generally stay out of legal entanglements—so was their game plan.

But it wasn't so simple. The first problem was work space. Well established organizations or simply squatters seem to have claims on all desirable working spaces in most cities of the country. Even the independent-minded “gang of four” physicists encountered in the Prologue retained an affiliation with Moscow State University so they could be assured of space with guarded entrances.

A second problem is heating, water, electricity, telephone services, and waste collection. These services are not always easy for an individual to organize for business purposes. New businesses are viewed with suspicion by municipal officials who issue the necessary authorizations. Some officials are genuinely concerned about mafia links. Others ponder how they can benefit from a new business moving into their territory.

The list goes on. Fire and health inspections may require modifi-

cations of premises, acquisition of nonflammable carpets, or eradication of pests that will not go away. Parking places for personal and customer vehicles may not exist. By the time a potential entrepreneur has a suitable place to work, he or she is so shaken by the many uncertainties of maintaining the premises that little energy remains to devote to the business. And the mafia hasn't even arrived at the doorstep yet.

It didn't take long for aspiring Russian entrepreneurs to recognize the advantage of locating fledgling businesses on premises maintained by someone else. It made sense for the new entrepreneur to find an organization that could provide a “roof” (or krysha) for the business. Some preferred institutions in similar lines of technology development in order to ease access to supplies and supporting services that were already available on the premises. However, the chosen institution could not be so similar as to be a competitor. A few decided to take advantage of sites offered by technoparks and incubators. Most have preferred to find roofs maintained by old acquaintances. Tens of thousands of small businesses of all types have been set up on the premises of enterprises, institutes, and other established organizations. Technology-oriented businesses are often located inside the premises of research institutes, where institute employees can be engaged by the firm on a part-time basis (see Chapter 2).

To some western experts on Russia, the notion of a roof has strong criminal overtones. They consider the concept an outgrowth of the communist system: one variant of corrupt patronage, confiscation, and dispensation has merely supplanted another. From their viewpoint, the roof includes the following elements:

• connections to a financial institution,

• penetration into government structures—nationally and locally—and

• availability of an armed force when necessary.¹³

However, a roof for a small innovative firm with limited cash flow seldom rests on a credo of destruction of property, beatings, and murders. More often it relies on lawyers and accountants who wend their way through the labyrinth of government bureaucracies to assist the

business in moving forward. Sometimes, as has been noted, the primary purpose of a roof is simply to provide safe working space and supporting physical infrastructure.

Roofs of various types have become a permanent feature of the changing Russian economic scene where protection of assets commands the highest priority. As organized crime becomes more aggressive, a new firm without a roof can be in trouble. When threatened with annihilation, some new firms simply have no choice but to engage organizations that maintain close contacts with criminal gangs to provide roofs.

The acceptance of the roof concept is not limited to Russian entrepreneurs. When western companies establish operations in Russia, some recognize the importance of a roof. Others are determined to do business as if they were in California—and they soon return to California. A few decide to pay for favors on a case-by-case basis.

The smartest accept as the only sensible path to follow a relationship with a Russian organization that can provide a roof (e.g., Monsanto 's laboratory at the Institute of Bioorganic Chemistry and Westinghouse 's office at the Institute of Power Engineering). In a large city, it is often expeditious to enter into a joint partnership with the city administration (e.g., McDonalds' arrangements with the mayor of Moscow, which not only embrace hamburgers but also provide rental space for Boeing and other western companies). Russian organizations of all types are providing roofs for western firms.

Roof maintenance is clearly a cost of doing business in Russia. And the 10 percent or so of profits needed to maintain a roof simply becomes an unwritten entry in the business plan. Those who decide that such insulation from financial and other types of predators is not necessary may in time have difficulties avoiding far more costly confrontations.

Money manipulations within research institutes and small firms have been modest compared to the elaborate get-rich schemes that accompanied the privatization of large state enterprises. Much ad-

vanced technology from the Soviet era still resides in these firms. While some technology may be completely out of date and other capabilities may be rusting, they nevertheless could offer springboards for economic revitalization in important fields.

As the Soviet Union splintered into 15 independent states, thousands of Soviet government officials knew they would soon be out of their government jobs. They ceded to themselves and to their friends de facto ownership of the assets of many state enterprises. The majority of the capital and perhaps 80 percent of the voting shares of the privatized companies ended up under the control of people who have milked these assets for their own ends.

At the height of privatization in 1996 more than 2,000 privatization crimes were registered. Given the notoriously weak government enforcement when powerful Russians are involved, many times that number of unregistered crimes undoubtedly took place. Government officials were themselves often involved.¹⁴

Key participants in privatization schemes have been enterprise directors who remained in place from Soviet times like “fixed post agents of the old regime, sentries left behind, unrelieved and forgotten by a hurriedly retreating army.”¹⁵ A considerable number are engineers. Many personally developed technologies that were critical to successful Soviet production efforts. Understandably, they believe that they should be among the beneficiaries of their contributions.

Initially, directors found themselves answerable to no one. They maintained a type of hypnotic control over workers. The workers, through their shareholdings, were supposed to become owners of the enterprises, but they often considered their paper shares worthless and turned them over to management.

Even prior to privatization, some directors took advantage of a government decree permitting the establishment of cooperatives at state enterprises. This new form of private activities, largely unnoticed among the many smokestacks throughout the country, provided cash cows for directors and their close associates, who used them as personal sales outlets for goods contributed almost free of charge by the enterprises. The transactions of the cooperatives set the stage for more extensive diversions of assets that, during the privatization process,

had suddenly been put up for taking by the best-informed parties—namely, plant managers.

Reports abound as to how profits were diverted into accounts controlled by directors, how companies were allowed to enter bankruptcy after directors stripped them of their assets, and how directors arbitrarily declared illegal any shareholder meeting that criticized management. Even in cases when individual directors were painstakingly removed by the government for unseemly behavior, their successors frequently offered more of the same. Sometimes they conspired with the deposed directors.

Now barter and promissory notes are important currencies of enterprises. Legitimate owners of privatized firms and government officials responsible for state-owned firms have even more difficulty gaining control of the assets, since there are fewer financial levers to grab. Further, with increased reliance on non-cash transactions, the interest of management in investing money in activities that will result in technological advancements in the long term is at an all-time low.

Stories about the theft of enterprise assets are often connected with firms exporting natural resources—the Krasnoyarsk aluminum plant, the Norilsk nickel combine, the large oil companies. While firms engaged in aerospace, computer, nuclear, and other advanced technologies may have fewer cash assets, they too are targets of financial swindles. Indeed, by 1999 any firm with significant assets that had cash value, directly or indirectly, was on the hit list of dishonest forces in Russia.

What can be done to restore confidence of potential investors in privatized companies with strong technological capabilities? As one step, the Russian Federal Securities Commission—which has power to investigate alleged abuses—should be able to refer documented abuses to the procurator general for prompt punitive actions. The commission should approve public offerings of securities only for companies with satisfactory records in dealing with shareholders. Also, the government should embed protections for minority shareholders, as well as transparency requirements, in the corporate charters of state-owned companies before any more are privatized.¹⁶

The financial situation in most enterprises is incredibly complex

and confused. Inter-enterprise debts and credits have accumulated for years. Unpaid bills for utilities and supplies are commonplace. Tax payments, however calculated, are held in abeyance as long as possible. Bank accounts are drained at the end of each month as inflation degrades the ruble's buying power. And personnel turnover clouds efforts to determine where assets have gone in the past. While many uncertainties will never be resolved, more rigorous accountability to the shareholders and to the tax authorities is a priority requirement for governmental action.

As Russia began to move toward a market economy in the early 1990s, the banking system immediately took on new responsibilities as the conduit for flows of money into, out of, and through Russia. Twenty-five hundred banks were established. By 1999, many had folded voluntary or had gone bankrupt, and 1,500 remained. While small transactions regularly take place outside the banking system and large deals are frequently consummated abroad, the banks handle most of the nation 's financial assets. Without reliable banks, a technology-based industry that draws on both foreign and domestic capital has little chance of succeeding.

Beginning in 1992, I spent two years searching for a bank in Moscow that could handle $70 million of available western funds for Russian scientists and engineers. We had two requirements. The money was to be deposited in personal bank accounts of several thousand individuals or handed to the individuals, with “reasonable” transaction fees being charged by the banks. The relevant bank records showing the money trails were to be available to western auditors. Every bank claimed it could easily handle the first requirement, although most of the banks underscored that since such small sums of money were involved, the transaction fees would be between 5 and 10 percent. Only one bank—Konversbank, which was controlled by nuclear specialists who were to be beneficiaries of the funds—agreed to the audit requirement and would accept reasonable fees. The other bankers simply wanted to take care of the transactions their own way with

no one peering into their internal processes. I soon became convinced that their way was both risky and illegal.

Throughout our discussions, specialists from the Central Bank provided advice to us. These specialists knew the details of every applicable regulation and the legal limits of banking practices. At the same time, they did not know—or did not admit to knowing—the details of practices of the commercial banks.

Against this background, I was not surprised when the banking scams of the mid-1990s came to light. Nor was the deep involvement of banks in facilitating off-shore capital flight unexpected. Even the contract killings aimed at banking officials were not a surprise. As elegant bank buildings appeared, as Russian artists found bankers eagerly purchasing their most expensive paintings to decorate bank offices, and as armored car sales to the banks boomed, it became clear that a disproportionate share of Russia's wealth was supporting extravagant tastes of Russian bankers.

The banking system became a nesting area for illicit activity. Criminals were often employed by banks, sometimes unknown to bank management, while other criminals manipulated bank decisions from behind the scenes. Banks and bank customers were targets for extortion. Russian organized crime even placed moles in banks around the world with tentacles into Russia.¹⁷

Already in 1993, the Central Bank had transferred $50 billion of its financial reserves to a shell firm registered on the Channel Island of Jersey, reserves that should have been used to stabilize the ruble-dollar exchange rate. Instead, the firm invested, successfully, in the Russian bond market. The recipients of the profits from the successful investments, as well as the exorbitant fees that were charged for each transaction, remain a mystery. Also, Central Bank officials illegally sold federal property, used bank credit cards for personal purchases, and established a $20 million social fund for bank employees. Such practices by the regulator do not send a good signal for establishment of reliable banking institutions.¹⁸

The antecedents to current bank frauds go back more than a decade. In 1988, the first so-called “zero banks” were established as hideaways for funds taken from the communist treasuries by officials who

were soon to lose their positions of influence. Much of the money was transferred abroad. Also in 1988, “pocket banks” were established to serve heavy industry. Such banks were in the pockets of enterprise directors.

One bank set up in Moscow simply to bilk its depositors was named Nazhebanye. If the spelling is reversed, the resulting Russian word means “screw you.” During its few weeks in existence, it attracted a number of customers. It then closed, and the founders simply disappeared with the deposits. All that was needed to set up such a bank were three board members and capital of $80,000. Even if a bank were not established to take advantage of unwary customers, its management team could use it as a laundering operation for illegally obtained income.¹⁹

With this recent history, in all likelihood the banking system will continue to be vulnerable to counterfeit, manipulation, and fraud. ²⁰Still, commercial banks are critical for the functioning of a Russian economy in transition. Russian criminal elements will strongly resist any expansion of services currently authorized for western banks operating in Russia, but only a greater role for such banks can provide the necessary competitive pressure for Russian banks to clean up their act.

Turning to capital flight, 1999 estimates had up to $2 billion leaving Russia every month for offshore havens, primarily in western Europe, with Russian bankers frequently involved in these transactions. Russian specialists define capital flight as transfers of assets denominated in rubles into assets denominated in a foreign currency, either at home or abroad, in ways that are not part of normal commercial transactions. ²¹Both legal and illegal behaviors are included. For example, keeping money abroad due to a lack of confidence in Russian banks may not violate any laws. Sending money abroad to avoid taxes is probably an illegal practice. And laundering money derived from the narcotics trade through various bank accounts should be a ticket to jail. Also, the propensity of Russians for hoarding cash at home in dollars rather than rubles is considered internal capital flight although, in most cases, illegal behavior is not the motivation.

Perhaps the most common type of illegal capital flight involves western buyers of Russian products who place a portion of the real

payment for sales in offshore Russian bank accounts. The Russian seller then pays taxes on the much lower declared payment that is remitted to Russia. Another approach is for a Russian organization to invest illegally obtained funds abroad and let the interest accumulate there.

Capital flight is draining the country of investment capital and aggravating the balance of payments problem on a large scale. High-tech activities require such investment capital which, unfortunately, has moved offshore. Also, foreign partners are discouraged by their governments to invest in Russia when the Russian government has inadequate income due to tax evasion.

What can be done to cap capital flight? Improvements in the investment climate and financial infrastructure are fundamental requirements. Stricter laws are needed to control international transactions. Taxes on barter arrangements and requirements for immediate repatriation of revenues associated with exports will also help reduce incentives for capital flight.

One bold and sensible proposal of leading Russian economists calls for a program of amnesty for Russians with bank accounts in western Europe that contain income from illegal activities. The owners of bank accounts in some countries are having difficulty withdrawing their money as local authorities ask questions about the sources of that money. These authorities frequently turn to the Russian government for information prior to permitting further money transactions in their countries. The scheme of the Russian economists calls for the Russian government to certify the legitimacy of funds being held hostage in foreign banks, whatever the source, in exchange for a return of 50 percent of the funds to the Russian government as overdue taxes.²²

The growth in economic crime intersects with many aspects of technology development. As to the large enterprises, illegal trade in natural resources is the dominant form of economic crime, while small entrepreneurs are constantly confronted with property theft and bribery. One chilling report in 1997 said that:

Organized crime controls 40 percent of private businesses, 50 to 85 percent of banks, and 60 percent of state-owned companies. In Moscow, organized crime is believed to control 50 percent of commercial real estate and 80 percent of all shops, warehouses, and service industries.²³

This situation evolved in several stages, as suggested by the following timeline:

• 1985-92: Perestroika: criminal groups sprouted deeper roots than ever before, with protection rackets encompassing embryonic joint ventures and cooperative restaurants in providing a financial base.

• 1992: Vacuum: large and sophisticated criminal groups moved in, establishing banks and solidifying their financial base.

• 1993-95: Privatization: a flea market for deep-pocketed criminal groups to take over much of the technological prowess of the country developed, with a massive wave of murders that peaked in 1995.

• 1998-?: Consolidation?: With thousands of criminal groups having become active, consolidation will be the byword of the future. And competition will lead to new conflicts among kingpins.²⁴

A particularly nasty aspect of economic crime is contract killings. Common targets include officials in government, banks, or large companies who make illegal business dealings difficult. Also at risk are businessmen who either fail to pay their debts or who are reluctant to share their profits with criminal elements. Some cynics contend that contract killings are an alternative means of enforcing business contracts that are not enforceable through the judicial system.

Often, contract killings are double hits. The first killer is hired to assassinate a designated victim; a second killer is hired to kill the first assassin as soon as he kills his victim. Thus, the costs of hiring the first killer have doubled from the $5,000 price tag for assassinations in 1995.²⁵ This chain of events complicates the tracing of the perpetrators. And the plotters of assassinations are seldom, if ever, captured and convicted.

Bank-related crimes have included bombing of the car of the deputy finance minister, who reduced the number of banks authorized to deal with the government, and an attack on the home of the president of the Central Bank after revocation of licenses of several commercial banks. The president of a trade union bank was assassinated for refusing to launder money for Chechen rebels. Finally, a speaker at

the funeral of a bank president involved in the takeover of aluminum assets was poisoned.²⁶

What can be done to reverse the upward surge in crime, so banks can become more responsible and entrepreneurs can reduce their protection payments? Fortunately, in January 1997 the government and parliament adopted a new criminal code which, together with the constitution, provides a good paper framework for the development of the rule of law within the country. Many Russians still shake their heads in disbelief that the criminal code made it through the Duma. Many deputies simply were not paying attention, even those surrounded by advisers with close ties to organized crime.

What is needed now is enforcement muscle. But the law enforcement agencies are plagued with corruption, and the courts have yet to emerge as a force in combating crime. Edicts are regularly issued by the government to challenge the crime lords. They call for additional police on the streets, more and better paid judges, a federal protection program for witnesses, and removal of officials from office as soon as they are charged with corruption.²⁷

These measures target the manifestations of crime, but not underlying organized crime structures. Investigations are frequently thwarted by mediocre police performance—the result of poor recruitment procedures, low morale resulting from irregular pay checks, and reliance on inadequate law enforcement technologies. Sometimes, the police, lacking vehicles, jump into taxis in pursuit of criminals leaving crime scenes.²⁸Nevertheless, partially effective measure are better than no response at all.

While deeply concerned about crime and corruption in the country, neither Russian nor western reformers have considered the situation serious enough to be a show stopper for economic recovery. But with organized crime having touched every facet of the economy, often conferring a sense of legitimacy to illegal activities, they are wrong. Fear of crime and corruption has discouraged many potential entrepreneurs from undertaking legitimate activities that could lead to financial ruin. A turnaround is essential if legitimate business is to begin approaching its potential.

Is it any wonder that the entire population is focused on money? Much of the focus is on ways to safeguard money obtained through legitimate activities. At least for now, few investors will risk long-term investments in technologies with the hope that in a few years there will be a positive return on their investments.

Raising investment capital, protecting financial and other assets, and finding and retaining paying customers for new products are talents in high demand in Russia. There are occasional successes of innovating for profit. The Russian government can help in all of these areas, as we have seen. Steady efforts of Russian leaders and western institutions to promote good government and rewards for efforts to overcome illicit activities are needed.

Transparency should become the hallmark of transactions involving money, particularly government funds. Banking laws, trading laws, and a host of other money-influencing laws need to be strengthened to provide legal pressure for such transparency. A rewards-for-reporting program could encourage whistleblowers to report illegal transactions under conditions that would not jeopardize their safety. The establishment of nongovernmental organizations, with anit-corruption as their theme, should be encouraged. As transparency evolves, corruption should subside. Then, in time, funds will gravitate toward projects that stand on their technical merit, the foundation of the innovation process.

Western governments can play a strong supportive role, both by repeatedly imploring the Russian government to clean up its act and by supporting Russian organizations with good records of integrity and responsibility. The schemes for direct payments of salaries to individual researchers work well and avoid many problems. Other innovative schemes are needed, particularly in encouraging innovation at large enterprises.

Finally, when transferring large resources to Russia, the IMF, the World Bank, and other major financial institutions must be vigilant as to how their resources flow through the Russian system and where they end up. It is not acceptable to simply say that management of

these resources is a Russian responsibility. Without close oversight from abroad, few Russians in desperate economic straits can resist temptations to develop their own interpretations of what is legal and what is not. If illegal activities are permitted by western institutions, the likelihood of Russian institutions following a straighter path is low indeed.

1. Richard Dulik, “Legal Issues of Special Concern to Technology Commercialization,” Technology Commercialization: Russian Challenges and American Lessons (Washington, D.C.: National Academy Press, 1998), p. 16.

2. Discussions with American and Russian officials knowledgeable about the activities of the Fund for Development of Small Firms in the Scientific and Technical Sphere that updated earlier discussions with fund officials, April 1999.

3. Discussion in Moscow with officials of the Ministry of Science and Technology, June 1998.

4. Ibid.

5. “Register of Branch and Interbranch Extra-Budgetary Funds for Scientific-Research and Experimental Design Work,” Ministry of Science and Technology, April 1998.

6. J.E. Tumarkin and J.F. Kraus, Sources of Financial Assistance for the Environmental Restoration of Former Military Lands (Washington, D.C.: Institute for Defense Analysis, January 1998).

7. Discussions in Moscow with science and technology experts from St. Petersburg who participate in activities of the St. Petersburg Technology Fund, November 1999.

8. Discussions in Monterey, California, with a Seattle-based representative of a large number of small American firms that invest in companies in the Urals and Siberia, December, 1999.

9. David Bernstein, Commercialization of Russian Technology in Cooperation with American Companies, Center for International Security and Cooperation, Stanford University, June 1999.

10. “White Paper—Priorities for Private Equity in Russia,” released by European Union TACIS program, Moscow, November 1999.

11. Ibid.

12. Meeting in Moscow with a representative of the Ministry of Finance, November 1998. See also “Order No. 315,” Government of the Russian Federation, April 12, 1994; “Decree No. 426,” President of the Russian Federation, April 27, 1992; and “Instructions No. 120,” Ministry of Science and Technology, November 13, 1997.

13. Russian Organized Crime, CSIS Task Force Report (Washington, D.C.: The Center for Strategic and International Studies, 1997), p. 30.

14. Ibid., p. 3.

15. Albert Sperensky, “The Red Directors,” released on the Internet by The Jamestown Foundation, HtmlResAnchor www.jamestown.org, October 1996.

16. E. Michael Hunter, “The Russian Financial Crisis,” conference in Washington, D.C., at the Carnegie Endowment for International Peace, June 8, 1998.

17. “Moles at Banks,” CNN broadcast, September 2, 1999.

18. See, for example, Bill Powell and Yevgenia Albats, “Follow the Money,” Newsweek, March 29, 1999, pp. 38-39. See also OMRI Service of Radio Free Europe, February 5, 1999.

19. Timothy M. Burlingame, “Criminal Activity in the Russian Banking System,” Transnational Organized Crime, Vol. 3, No. 3, Autumn 1997, pp. 46-72.

20. Ibid.

21. “The Problems of Capital Flight from Russia,” Task Force Report, Institute of Economics, Moscow, September 1998.

22. Discussions in Moscow with Russian economists, November 1998.

23. Nicola J. Lowther, “Organized Crime and Extortion in Russia: Implications for Foreign Companies,” Transnational Organized Crime, Vol. 3, No. 1, Spring 1997, pp. 23-38.

24. See “Four Waves of Russian Crimes,” Russia Review, March 13, 1998, p. 20.

25. Discussion in Moscow with Russian criminologists, November 1998.

26. Burlingame, “Criminal Activity in the Russian Banking System.”

27. Russian Organized Crime, p. 69.

28. Ibid., p. 70.