Khodorkovsky & Lebedev Communications Center

As the crowd waited patiently in the stairwell, a small group of journalists was ushered in to film inside the courtroom. Meanwhile, Mr. Demchenko was back, first seen trying to enter the courtroom then changing his mind and leaving.

Morning Session.

The trial resumed with an immediate 5 minute break as the court attempted to fix the malfunctioning audio feed into the press-room on the second floor. These attempts were unsuccessful and those who were unable to find a seat in the packed courtroom ended up watching on mute as Mr. Khodorkovsky resumed his testimony. About 30 minutes later the sound reappeared.

Meanwhile, Mr. Khodorkovsky, prior to returning to the theses he introduced during the last hearing, briefly returned to addressing prosecutor Lakhtin's assertion that the transfer of crude oil ownership rights from YUKOS production subsidiaries to YUKOS did not exclude the possibility that crude oil was stolen by an organized group. As a slide depicting the transfer of crude oil from Yuganskneftegaz to Transneft and the transfer of crude oil ownership right from Yuganskneftegaz to YUKOS appeared on the courtroom's was, Mr. Khodorkovsky told the court that, based on what he learned from numerous legal treatises and Supreme Court commentaries, ownership right remains with victims if property was stolen by means of embezzlement. Mr. Khodorkovsky told the court that he knew the properties of crude oil and that theft of crude oil was not possible without the physical taking of the object of theft. The exchange of papers and documents was not enough to conduct the theft. As Mr. Khodorkovsky explained previously, the practice of the oil industry separates the liquid's movement from transfer of ownership rights. The liquid and the ownership rights could be transferred together or separately, usually to different entities.

Explaining the diagram, Mr. Khodorkovsky told the court that after entering the Transneft pipeline crude oil could arrive at a refinery or a sea port. Meanwhile, ownership rights, through documentary exchange, could change several times between traders. According to Mr. Khodorkovsky, the worldwide volume of crude oil ownership rights transfers is ten times larger than the actual volume of crude oil delivered.

Mr. Khodorkovsky reminded the court that commercial courts established that ownership rights of the crude oil that went into the Transneft pipeline belonged to YUKOS, not to its crude oil trading subsidiaries. While he still did not agree with that interpretation, he could not contest it in this trial and had to follow those decisions which established that rights of ownership, use and disposal were all transferred to YUKOS. According to Mr. Khodorkovsky, under these facts the mythical organized group would have had nothing to take. "I know your honor that crude oil has no holy spirit, only smell! If the prosecution thinks that crude oil in addition to liquid and ownership rights has some other third something that went to the organized group - let them explain it! Then I can properly defend me! For example ‘the organized stole smell!'" Mr. Khodorkovsky was speaking directly to prosecutor Lakhtin, while the latter was intently staring into his notebook's screen.

Mr. Khodorkovsky told the court that he will continue to explain that legality of transferring crude oil to Transneft and the legality of transferring ownership rights to YUKOS, meaning the legality of civil transactions between parties. According to Mr. Khodorkovsky, the criminal aspect of theft of crude oil by physical persons was already barred by court decisions and facts, neither of which is being denied by the prosecution.

Mr. Khodorkovsky returned to his fourth thesis, which was that competitive trade between subsidiaries within vertically-integrated oil companies was technologically and economically impossible.

Mr. Khodorkovsky told the court that vertical integration means unification on financial-economical basis of a number of technologically interconnected production operations. In the oil industry these include exploration, production, refining, transportation and sale of crude oil and petroleum products. According to Mr. Khodorkovsky, the Russian government's realization that competitive sale of large volumes of crude oil and petroleum products on the domestic market was impossible was the principal reason for creation of VIOCs.

Mr. Khodorkovsky went into a detailed explanation of why VIOCs were created. First, he mentioned that, as witnesses testified, crude oil producers never had the expertise and the practical experience in selling their product, nor specific divisions to do so.

Second, crude oil exports were limited by quotas imposed on the use of the Transneft pipeline system, with only 25-30% of all crude oil allowed to be shipped for export. Mr. Khodorkovsky told the court that YUKOS was allowed extra exports to Cuba, but was paid in sugar. He asked the court to imagine how a production company would have dealt with that headache. Mr. Khodorkovsky noted that export quotas were allocated based on the volume of crude oil transferred into the pipeline system, while the transfer could not be made without indicating where the same volume of crude oil was to be transferred out of the system - the pipeline had a finite capacity. He knew this from frequent meetings with former Deputy Prime Minister Khristenko, who, beginning in 2000, headed a commission on crude oil exports. Mr. Khodorkovsky told the court that he knew with 100% certainty that no one exported 100% of their crude production.

Third, crude oil production companies did not have their own capacity to transport the crude oil. Furthermore, their storage capacity was limited to 2-3 days of production.

Fourth, crude oil and petroleum products exports were dependent on meeting mandatory domestic obligations, such as during crop planting and collecting seasons, when the government demanded no shortages of crude oil going to domestic refineries. According to Mr. Khodorkovsky, this was material enough to have been included in the draft of SEC Form F-1 when YUKOS considered listing on the NYSE.

Fifth, Mr. Khodorkovsky explained that if 30% of every ton of crude oil was being exported, to sell the rest of it domestically required major refining capacities within VIOCs, which in turn needed the means to distribute and sell the petroleum products. An independent refinery had no way to sell the gasoline it refined, while a VIOC had a chain of gas stations.

Sixth, refineries and retail stations required guaranties of continuous deliveries, demanding large investment of capital - regardless of whether payments were coming in. The latter was the state of the industry from 1992 to 2001. Even if there was no purchaser who could pay for petroleum products, refineries had to receive crude oil in order to continue to operate. Stopping refineries meant a loss of operational capacity, with almost no hope of later recovery. And Mr. Khodorkovsky asked the court to imagine the kind of scandal that would erupt if gasoline and heating fuel deliveries were terminated to non-paying regions. This was the VIOC's responsibility. Mr. Khodorkovsky testified that until 2001 Russian crude oil companies, including YUKOS, operated through cross-financing - when proceeds from crude oil exports paid for all crude oil production costs, including what for what was marked for domestic consumption. Mr. Khodorkovsky added that the sole reason for low cost of refining was because the holding allocated all necessary funds to cover all expenses, including maintenance and repair.

Seventh, technological reasons demanded guaranteed sales, transportation and deliveries, which meant pre-payment of all related expenses one month in advance, regardless of when, or if, the final purchaser paid. At the time when Russian banks charged 150% annual interest - as they did in 1998 - the VIOC took on responsibility for pre-financing.

Eighth, Mr. Khodorkovsky explained that domestic prices on petroleum products did not cover production costs at each lever of the VIOC. This was in addition to the fact that some petroleum products bartered, while others weren't paid for at all. Mr. Khodorkovsky reminded the court about financing production for domestic market from export proceeds. Mr. Khodorkovsky explained that if domestically crude oil was sold at what it was sold for in Rotterdam, than gasoline cost would have at least tripled, resulting in a severe blow to the society. At the same time, he would have been criminally charged with a pricing conspiracy.

Ninth, as a slide depicting various domestic and export costs appeared on the wall, Mr. Khodorkovsky explained, that constantly changing market conditions and severe time constraints simply did not allow for negotiation of market rates for services provided by affiliates within VIOC - it took 40 days alone to call a General Shareholders Meeting necessary to approve transactions between interested parties. According to Mr. Khodorkovsky, every division would have bargained for profits - not just the production companies alone. Mr. Khodorkovsky noted that prosecution and its experts argued that only the production companies were allowed to have any profit - which is simply unexplainable. He showed the court a slide depicting an excerpt from a newspaper article, explaining that in 2009 average profit margin of gas station operators was 36%. "The prosecution thinks that the distribution chain should have a profit margin of zero! I have no idea how they came up with this! My professional experience does not support existence of charitable distribution centers!" Mr. Khodorkovsky exclaimed to the court.

Finally, Mr. Khodorkovsky told the court that all VIOCs work with a single profit-forming center, by means of consolidated shares. YUKOS went through consolidation process from 1998 through, sooner than all of its industry peers.

Mr. Khodorkovsky summarized the fourth thesis and told the court that regardless of how prosecution wanted to portray it - crude oil production companies could sell at "market prices" with a VIOC and certainly could not export all of its crude oil production to sell in Rotterdam. Furthermore, there was never a time when crude oil production companies sold their crude oil domestically or for export, barter and regional needs being an insignificant exception.

Turning to the fifth thesis, Mr. Khodorkovsky testified that he formalized the business practice of using intra-company pricing in accordance with strategy put in place by the Russian government. Mr. Khodorkovsky testified that, after he joined YUKOS in 1996, he saw that the difficult financial situation at the company was caused by the fact that 30% of crude oil produced wasn't even paid for, while the rest was paid for 6-9 months late or through barter. This was typical for other peers in the crude oil industry. For YUKOS, the result was lack of fiscal discipline and debts of more than $2 billion USD.

Mr. Khodorkovsky testified that his personal research showed that production companies did not have trading, logistics, refining, customs and other departments necessary to support a full distribution chain. They did not have to, because during the Soviet era this was a function of another Ministry.

Mr. Khodorkovsky testified that his discussions with local managers in different regions revealed that they were under continuous pressure from criminal elements - contracts were signed, crude oil would be offloaded, but everyone knew that no payment was forthcoming. He told the court that these managers were literally sitting on hundreds of millions worth of crude oil and had no way to protect themselves.

Mr. Khodorkovsky cited Gazprom's experience, as well as Rosneft President Mr. Bogdanchikov's, explanation that intra-company pricing was determined at the top of the holding to ensure particular financing needs of specified segments, both mid- and long-term. Mr. Bogdanchikov was quoted in Vedomosti in 2000 as saying that Rosneft stringently controlled all expenditures by centralizing product and finance flows.

Mr. Khodorkovsky testified that once the general agreements were concluded with YUKOS production subsidiaries, there were several law suits - with YUKOS winning all of them. The lawsuits were motivated by corrupt motives - everyone who was feeding off the side agreements was immediately shut-out. Mr. Khodorkovsky noted that purchase by parent company of most of its production subsidiary's product remains the industry practice today - a slide showed that Rosneft purchases between 92-99.9% of crude oil and gas condensate produced by Purneftegaz.

Mr. Khodorkovsky testified that at the behest of regional governors YUKOS began conducting monthly auctions, all in an attempt to mollify the governors. Those auctions were a sign of good faith, although YUKOS knew that there were no independent purchasers who could have refined, transported and sold the quantities that were being auctioned off. Mr. Khodorkovsky told the court that the governors continued to insist on these auctions, despite explanations that no one could off-take the quantities of crude oil that was being produced in their regions. Independent purchasers could take 2 -5% of the volumes, at best.

Mr. Khodorkovsky moved on to his sixth thesis. YUKOS' intra-company pricing was comparable to pricing of other producers within the same region, for similar transactions and similar volumes. Mr. Khodorkovsky noted to the court that the absence of a competitive domestic crude oil market was recognized by no less than the Audit Chamber of the Russian Federation. He cited to a 2003 bulletin issued by the Chamber.

Mr. Khodorkovsky testified that YUKOS' pricing policy was written in a company document and was based on "cost plus." This policy used the same principles enunciated in Russia's Tax Code. Mr. Khodorkovsky read a brief passage from the Tax Code, then showed a slide depicting the process for determining the intra-company price. Mr. Khodorkovsky, while explaining the slide, noted that YUKOS could not just call the neighboring production company in the region and ask how much their crude oil was being sold for - that would have gotten the anti-monopoly authorities to start an investigation. The company used independent appraisers whose function it was to predict what the price in a particular region would be about a month later.

Mr. Khodorkovsky faulted the prosecution from concealing from the court that most important fact - the crude oil price paid to production companies always started with production costs and went up from there, not down.

After a short break, Mr. Khodorkovsky continued. He told the court that the indictment spends a lot of time on discussing Rotterdam prices, although it wasn't clear what allegations of embezzlement had to do with prices. Mr. Khodorkovsky told the court that during the 7 years he worked for a crude oil company he was unable to base pricing on mythical market prices. He wasn't alone - the Russian Federation has been unable to do so for the past 18 years. As another slide was projected on the wall, Mr. Khodorkovsky explained to the wall what the process of determining a market price for a shipment of Yuganskneftegaz's crude oil would look like.

Mr. Khodorkovsky told the court that after the crude oil was extracted and the production company was paid, the price that was paid was widely known to tax and anti-monopoly authorities. He explained to the court that it wasn't difficult for anyone to check what the production companies were paid.

Mr. Khodorkovsky showed to another court another slide, depicting a table of average crude oil prices for Yuganskneftegaz and two nearby production companies - Sibneft's Noyabrskneftegaz and Rosneft's Purneftegaz. Some years Yuganskneftegaz's average price was lower than its neighbors, some years it was higher. However, in almost every case it closely tracked the Khanty-Mansiysk regional average. In addition, all three companies' averages were several times lower than the "average world market price" found in the indictment.

Mr. Khodorkovsky stressed, once again, that production companies' financial statements prove that the price they were paid for their crude oil covered all costs associated with crude oil production. Mr. Khodorkovsky told the court that if prosecution was acting in good faith, the prices would be compared to minimum prices in production regions. Instead, without deigning it important enough to explain, the prosecution chose to compare it to minimal prices 4000 kilometers away, in Rotterdam.

Mr. Khodorkovsky used another slide to explain to the court how YUKOS analyzed economical effectiveness of its transactions. Mr. Khodorkovsky explained that the company used "netback pricing" methodology. Going from the top of the slide, containing boxes for crude oil exports, petroleum products exports and domestic petroleum products sales all the way down to production companies, Mr. Khodorkovsky explained that at each stage every division - trader down to refinery - had costs of its own.

Mr. Khodorkovsky reminded the court that CAPEX was allocated to profits and not to production costs, because these expenditures were investment into future crude oil production. That was why the Board of Directors decided where to spend in order to allow for future increase in crude oil production. According to Mr. Khodorkovsky, the more developed a particular oil field was, the less capital investment was required, even in a place like Samara, where they were able to ramp up the falling production numbers without investing too much.

Mr. Khodorkovsky told the court that it should be obvious that the very fact that production costs were covered destroyed allegations of gratuitousness and losses. The fact that YUKOS intra-company pricing was in many cases higher than that of its peers further showed the falsity of the allegations. Mr. Khodorkovsky asked the court to imagine what YUKOS shareholders would say if he was the only one paying production subsidiaries 5,000 Rubles per ton, when Sibneft and Rosneft were paying 700-1000 Rubles nearby.

Mr. Khodorkovsky summarized the fifth and sixth theses, and went on to the seventh, which was that tax optimization - as a lawful strategy of any company - was used to determine trading strategies.

First, Mr. Khodorkovsky explained that the practice of buying wellhead liquid directly at the well had nothing to do with tax optimization. Mr. Khodorkovsky told the court that in the 90s a common strategy for local criminal elements was to force a company to sign fictitious contracts for production services, which were later used to file law suits and to arrest the crude oil. Once the crude oil was offloaded from the pipeline into train cars, it was sold by the local criminal element. However, when the ownership rights to well-head liquid were transferred at the well, the criminals had nothing to arrest. According to Mr. Khodorkovsky, one could not do anything with the well-head liquid, while the crude oil processed and transferred to the pipeline system at the counter node could not be arrested because the ownership rights belonged to YUKOS. Once the problem with the criminal elements was resolved around 2000, the companies began to transfer crude oil ownership rights at Transneft's counter nodes.

The tax minimization was accomplished by choosing traders located in regions with tax incentives, as was done by other companies in the oil industry. Mr. Khodorkovsky read an excerpt from an analytical report which Mr. Gref addressed to Mr. Putin in 2000. Mr. Gref wrote that crude oil companies like any other tax payer sought ways to optimize their tax obligations. The two most common strategies were a self-contained product-finance flows chain and concentration of profits in regions with tax incentives. Mr. Khodorkovsky noted that everyone knew about the two and did not consider these as violating the law. Mr. Khodorkovsky did not deny that YUKOS sought to register trading companies in regions it found to be most advantageous. Mr. Khodorkovsky explained that with the volumes of crude oil sales involved no one could hide where the companies were registered. He personally discussed this with people from the Ministry of Tax, and even with Mr. Kudrin, the Minister of Finance.

Mr. Khodorkovsky used the next two slides - one containing an article excerpt from Kommersant-Vlast' the other a table comparing taxes paid per ton of crude oil by YUKOS, Sibneft and Rosneft - to demonstrate to the court that YUKOS consistently paid more into the treasury than its peers. As a percentage of revenue, YUKOS paid 34%, while Sibneft 23% and Rosneft 22%. In dollars per ton, in 2003 (excluding penalties and interest) YUKOS paid over $68.18 per ton, compared to $51.10 for Sibneft and $42.14 for Rosneft.

Mr. Khodorkovsky asked the court to pay particular attention to the next assertion made by the prosecution - that ownership rights were purchased by companies who never physically took possession of the crude oil. Mr. Khodorkovsky told the court that he continued to be puzzled by this assertion. Mr. Khodorkovsky explained that there are no crude oil pipelines going to Moscow, Geneva or New York. A crude oil trader has no storage facilities and no refining facilities. Mr. Khodorkovsky told the court that companies are registered where it is convenient to do so. He added that none of the cities where YUKOS production subsidiaries are registered have any crude oil pipelines going through the city, as well.

Mr. Khodorkovsky testified that incorporation of traders in specific regions and ownership through various structures was done based on PwC consulting advice, in order to ensure that all US GAAP requirements were complied with. At the time no judicial precedent existed which would have found these arrangements to violate the law. "It wasn't only backdated to help steal YUKOS, but went further and determined that these traders "were YUKOS," which allowed to levy 7-10 times more in additional taxes."

Mr. Khodorkovsky told the court that "now the prosecution alleges that traders were not YUKOS, at all, acting, instead, for Khodorkovsky and the organized group, by embezzling crude oil with a previously undiscovered method - ‘moving to balance sheet.'" Mr. Khodorkovsky asked if YUKOS was the beneficiary of all transactions, as determined by the courts, but now prosecution asserts that it was really Mr. Lebedev and he, than why additional taxes, interest and penalties were levied against YUKOS. "Put a representative of YUKOS at the table next to you, let [YUKOS] become a victim. And return not only what you added in 2004, but everything that YUKOS paid until 2003, because it should not have paid any taxes at all, since you argue that [it] did not have anything to pay taxes with. [YUKOS] did not get any crude oil! I stole it!" Mr. Khodorkovsky exposed the absurdity of what the prosecution argued in court.

Mr. Khodorkovsky, after summarizing the seventh thesis, returned to the slide he already showed before - YNG transfers crude oil into Transneft pipeline, YNG transfer crude oil ownership right to YUKOS, the organized group left with a question mark - and told the court that he thought of this slide as representing the crux of the matter being examined at the trial. Mr. Khodorkovsky told the court that no one contested that YNG transferred in a specific volume of crude oil at one end and the other end the same volume was transferred out. Ownership rights went to YUKOS. No one had a problem. So the question remained - what was left for the organized group? "Lakhtin said that transfer of ownership rights did not exclude that the organized group took the crude oil. It's as if we are involved in a theoretical dispute! I'm asking, for a year now - what did the organized group get? Crude oil? No, it's in the Transneft pipeline, no one contests that. Ownership rights are with YUKOS. That was established by the court. What did the organized group get? A question without an answer to this day," Mr. Khodorkovsky stressed to the court distilled basics of the trial.

After another short break, Mr. Khodorkovsky turned to his eighth thesis, that trading methods, pricing and company profit were available [for examination] to the shareholders, the government and the public. Furthermore, the unity of shareholders' interests was accomplished through share consolidation program, which was completed from 1997 through 2001.

Mr. Khodorkovsky testified that he personally presented reports on YUKOS trading to shareholders and even in the Duma, the lower chamber of Russian Parliament. Some shareholders liked the system, some did not, but everyone knew what it was. In addition to citing case materials, Mr. Khodorkovsky showed a slide depicting a diagram published in an article by the head of Orlov office of the Anti-Monopoly Ministry, depicting movement of petroleum products within YUKOS. The diagram showed details on movement of petroleum products and funds, including tax payments to various regions, and even identified YUKOS as a "vertically-integrated oil company."
Mr. Khodorkovsky went over additional publically available information, including published financial statements, newspaper articles and mentioned that even the annual average intra-company pricing was reported to the government. He described how YUKOS switched to a majority of independent members of the Board of Directors, even before SEC made it mandatory in 2003 for all companies trading on US stock exchanges. Furthermore, beginning in 1999, YUKOS formed an independent corporate finance department, run by Michel Soublin, on loan from Schluberger. Mr. Khodorkovsky named some of the independent directors and explained their involvement in company activity.

Mr. Khodorkovsky told the court that he did not know how prosecution could argue with a straight face that transactions were being concealed and that someone was deceived. Mr. Khodorkovsky, looking over at the prosecutors, told the court that when he heard that investigators were going to amend the indictment, he thought that some of the most fantastic passages would be removed - as did the investigators who were in Chita. But that did not happen.

Mr. Khodorkovsky moved on to the ninth thesis, that the oil produced by the company, and the petroleum products manufactured from it, were at the disposition of authorized representatives of the company and, pursuant to an instruction of the Ministry of Finance, were reflected on the balance sheet in the form of production costs until they were sold. Mr. Khodorkovsky showed a slide depicting the process of crude oil production, refining and sales, and which management company controlled which stage. YUKOS-EP stage ended when crude oil was transferred to Transneft, with YUKOS-RM managing the following stages. Mr. Khodorkovsky once again emphasized that physical movement of oil was different from crude oil purchase agreements.

Mr. Khodorkovsky, explaining the various stages in great detail, told the court that in this trial he wasn't interested in entering into discussions with non-specialists. He added that he was explaining how things happened, not how they could have been organized theoretically. "When Mr. Lakhtin begins to manage his own oil company, let him run his business the way he likes. We'll see what the result would be!" Mr. Khodorkovsky quipped. Mr. Lakhtin, who hadn't uttered a word during the hearing, continued to stare at his notebook.

After showing a slide with an excerpt from Yuganskneftegaz's accounting statement, identifying production costs as being lower than revenue, Mr. Khodorkovsky detailed how crude oil was delivered from production subsidiaries for export or to refineries. He explained the planning involved in getting appropriate volumes of crude to be produced and shipped. Mr. Khodorkovsky explained that all transactions were "futures contracts," selling crude oil that was to be produced in 1-2 months and delivered in 2-3 months, all while not knowing what the actual price would be. He showed another slide, depicting crude oil price variations in 2000. He asked the court to note that within a month the price per barrel went from $22 to $38, then dropped as suddenly.

Summarizing this thesis, Mr. Khodorkovsky told the court that YUKOS-EP employees caused crude oil to be transferred to Transneft; second, no one could gain access to that crude oil, but even if someone did - YUKOS crude oil would have been impossible to identify, because the liquid inside Transneft was a mixture of crude oil from all crude producers; third, storage facilities were impractical for the volumes that were produced and everyone kept a current count of how much crude oil was inside the system at any time. Mr. Khodorkovsky told the court that he was certain Transneft could pinpoint the volume down to a thousand tons, so when the question was being raised about 350 million tons it sounded more like a joke - if so much crude oil disappeared from the system, the prosecution should be able to show where it happened.

As the clock approached 14:30, the trial was adjourned.

The trial will resume on Monday, April 12, 10:30 Moscow Time.