RUBEUS. Rubeus Report 26 November Seeing the Monster The impact and internationalisation of Brazil s Petrobras scandal

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1 Rubeus Report 26 November 2015 This brief represents the latest in a series of concise Think- Pieces from Rubeus LTD. Seeing the Monster The impact and internationalisation of Brazil s Petrobras scandal

2 Scope As part of our on- going analysis of large- scale corruption scandals with international dimensions, Rubeus Ltd has conducted in- depth investigation of the Petrolao, the largest corruption scandal in Brazilian history. This piece draws on our research to communicate the scandal s size and complexity. It also sheds light on the nature and development of the Brazilian and international inquiries. We examine the investigation s internationalisation, the legacy for Brazil and the significant risk of dangerous revelations yet to come for international businesses associated. 1 Executive Summary: The inquiry into corruption around Petrobras will continue for years not months. Petrobras and the main players in the scandal s rogues gallery are going to have another very tough year managing reputational risk in Multiple international entities, private and governmental, have initiated investigations and legal proceedings. Brazilian prosecutors have specifically warned foreign companies that they are turning their attention overseas. Plea bargains will be offered; companies who refuse to talk, or talk late, will receive significantly harsher sanction; those who cooperate earlier will be incentivized to reveal as much information as possible. As the first manifestation of an increasingly independent judiciary in the post- military government era the inquiry is a positive indicator for Brazil s democracy. The Petrolao may topple the government, but this could be just one positive development that results from the scandal, alongside a new more market friendly government, improved infrastructural works and a less corrupt business environment. Perhaps the most historically significant result of the scandal s fallout will be a significant undermining of the Continent s much- discussed leftward shift. Brazil s incumbent Workers Party, the flagship left- wing progressive movement that presided over boom years in Latin America s largest economy now suffers an indelible stain of corruption; it is difficult to see it regaining the electoral appeal it enjoyed during the boom years of the early 2000s. 2

3 2 Brazil and Petrobras: The Fall from Grace God is a Brazilian pronounced former President Lula in 2009, following huge finds of deep salt oil off the booming BRIC s coast. Petrobras would safeguard the resource s development and channel the profits to Brazil s health and education budgets. To President Lula, the company was the prettiest girl at the jamboree; everyone wants a dance, 1 and a year later, in 2010, Petrobras raised USD310bn on the New York Stock Exchange. It was the fourth- largest company in the world and had completed the largest share sale in history. At this time, Petrobras is now the 39 th largest company in the world with a USD26bn market capitalization, less than a tenth of its 2010 achievement. It is the world s most indebted oil company and been awarded the title King of corporate junk bonds. 2 Once a national treasure but now despoiled, Petrobras faces cost and investment- cutting, asset sales, partial privatisation, the worst industrial action in decades, and years of media punishment until its reputation recovers. Meanwhile the scandal threatens to unseat the President, as seen in on- going protests and media reporting, and has snared two former Presidents and a swathe of the political elite, including the Head of the Senate, the leader of the Coalition Government in the Senate and the Speaker of the Lower House. It has also seen untouchables of the corporate aristocracy jailed, such as the highest profile figures in Brazilian finance and construction and inflicted unquantifiable but very significant damage on the economy. 3 Seeing the Monster Evidence suggests that a large proportion of Brazil s political elite (over 50 lawmakers) and the sixteen top infrastructure and engineering companies, 3 otherwise described as the cartel of Brazil s biggest builders exploited Petrobras and its annual USD20billion capital expenditure as an ATM 4 for their personal enrichment. Excessive political interference in Petrobras is a central theme in this tale of decline, as seen in all the reports emerging thus far. It would appear that key politicians /brazil- fixated- as- human- bomb- revelations- rock- elections /petrobras- crowned- new- king- of- junk- bonds- after- rating- downgrade 3 These are the same companies whose vast public works projects underpinned Brazil s growth in the Lula years post chief- resigns- brazil- corruption- scandal 3

4 effectively appointed senior Petrobras employees and this cronyism was key to understanding how the rot set in. 5 These personnel were the politicians point men and richly repaid them for their support. They seemingly used their positions to conspire with the contractors to inflate and rig the award of the contracts within the cartel. The plunder was then shared out between the cartel, Petrobras employees, money- men and the political patrons. 6 Meanwhile the cartel formalised its operations in a light- hearted but coherent manner. With a nod to Brazil s sporting heritage, it called itself the club, drew up rules of the game, referred to its fake bidding process as the sports tournament and the contract award as the trophy. 7 Reports show that shell companies, dubious consultancy fees, offshore accounts, middlemen, money launderers and mules were all vital to the illicit money flow. Sources state that one of these figures, Alberto Youssef, a convicted money- launderer; co- ordinated the flight of USD444 million to foreign accounts and his role has been central in the scandalous revelations that have so angered many Brazilians. On his first night in captivity Yousseff warned his lawyers: Guys, if I talk the Republic will fall and produced a list of names that shocked his legal team. Describing that moment, his lawyer said: We were shocked in Brazil, we know that corruption is a monster this was like seeing the monster. 8 Numbers released by Brazil s Finance Ministry underline the scale and complexity of the scheme; federal police are scrutinising 267 transactions that involve 27, 579 people and which are linked to the suspicious movement of over USD16 billion companies are under investigation, including at least eighteen foreign companies, principally, but not exclusively, in the oilfield services market. 10 In February 2015, computers were taken from 2000 Petrobras employees and 150 senior personnel placed under investigation These substantial kickbacks, (often between 1-3% of vast seven figure awards) were wryly known as political adjustments. 7 of- petrobras- scandal- leave- brazilians- lamenting- a- lost- dream.html?_r=0 8 Yousseff s job chasing executives for the bribes and placating impatient politicians was complicated and tense, a nightmare of logistics and diplomacy in a realm of big egos and outstretched palms ; he is heard on tape swearing bitterly about the complexity of the illicit money flows, saying No- one here knows how to do the math. of- petrobras- scandal- leave- brazilians- lamenting- a- lost- dream.html?_r=0 9 suspicious- activities- could- involve- as- much- as- 16bn- dollars petrobras- scandal- britains- rolls- royce- cooperates- investigation- into- corruption- scandal Open sources report that around a dozen foreign companies are under investigation but we have been able to compile a list of eighteen foreign companies linked to the scandal by the Brazilian judiciary in press reporting scandal employees- under- full- scale- investigation- corruption

5 Although press reports do not reveal the extent to which most projects have been prejudiced the number under investigation has been reported as being as high as The Abreu e Lima refinery is often cited as the most egregious example. Inaugurated in 2005 by President Lula, 13 it was forecast to cost USD2.5bn. However, as of December 2014, when the refinery finally opened three years late, Petrobras estimated the cost to be to USD18.5bn, seven times its original budget. 4 The first manifestation of an independent judiciary? The scale of the corruption surrounding Petrobras has incensed the Brazilian street but it is also energising a highly determined and talented group of prosecutors. Their tight- knit eleven- strong group is now known as The Workforce, (although it was formerly known as The Nine Horsemen of the Apocalypse ) 14 and is responsible for the aggressive prosecution of the investigation and the revelatory shock waves that have accompanied it. They have 90 staff and recently moved into bigger offices, an indicator that speaks to the scale and trajectory of the investigation. Several of The Workforce have postgraduate degrees from Harvard and the London School of Economics and Political Science and senior members have travelled to Washington in order to progress the investigation with American counterparts in the Department of Justice 15. This American relationship will become increasingly important in the context of the FCPA and as the SEC civil investigation and the Department of Justice s criminal probe develop. American assistance has been requested by Brazil and specifically in the context of unlocking corrupt money secreted abroad. The Workforce s methodology is as modern as it is effective. Each member has specific expertise in areas such as wire fraud or money laundering. They keep their communications private, avoid and message each other using encrypted apps. They visit and interview suspects and witnesses in person, avoiding the phone and mail services corruption- debt/ 13 The flagship refinery was intended to be a joint venture with Venezuela although President Chavez never put a cent into it c7c- 11e4-98d feabdc0.html 14 brazils- nine- horsemen- cracked- petrobras- bribery- scandal of- petrobras- scandal- leave- brazilians- lamenting- a- lost- dream.html?_r= brazils- nine- horsemen- cracked- petrobras- bribery- scandal

6 Judge Sergio Moro, 43, spearheads the probe and admits to being inspired by the Italian Clean Hands anti- corruption operation of the 1990s. 17 Although he is described as a humble man with a reluctant celebrity status, he has handed out some of the longest sentences seen in Brazil since the end of the military dictatorship. Observers keen to identify a silver lining for Brazil point to The Workforce, viewing it as the first manifestation of an increasingly independent judiciary in the post- military government era How much longer for the investigation? The Workforce believes the probe could continue for years; the prosecutors are stubborn - almost messianic - in their determination. One senior prosecutor recently provided an insight into their mind- set with a quote from Mohatma Gandhi, There have been tyrants and murderers, and for a time, they can seem invincible, but in the end, they always fall. 19 Such resolution goes some way to explaining why The Workforce enjoys massive popular support, despite the economic damage associated with the investigation 20. Judge Moro himself notes the policeman who discovers a crime is not to blame for the corpse and Brazilians agree. One recent poll asked 20,006 respondents in 144 cities whether the federal investigation should continue despite the economic consequences in a country already suffering recession. A very large majority of 88% agreed it should Is the inquiry too successful, or too political? Analysis suggests the greatest threat to Judge Moro s inquiry is its own success. Defence lawyers are challenging Moro s competence, stating the investigation is too 17 One Italian associate has suggested that Judge Moro s fate will mirror that of the Italian Judge Falcone, who was murdered by the Sicilian Mafia in However, Moro denies having received any concrete threats. We assess that Brazil in 2015 is neither Colombia in the 1980s or Sicily in the 1990s. Moreover Judge Moro is not specifically challenging the interests of an armed criminal group. Were he focused on one of Brazil s notorious armed criminal groups, the threat to his life would be significantly more grave /brazil- s- massive- corruption- scandal- has- bitterness- replacing- hope 19 cita- gandhi- em- denuncia- e- afirma- que- tiranos- sempre- caem, Three large firms have been bankrupted, multiple firms have lost credit lines, projects have been frozen, certain Petrobras suppliers unpaid and thousands of workers laid off brics/2015/09/16/brazils- rousseff- is- this- the- beginning- of- the- end- a- new- poll- suggests- it- is/ 6

7 big for a single judge to oversee. Moro s supporters worry that the defence lawyers are seeking to cripple the investigation by splitting it off from the Curitiba HQ in order to bury it under more amenable judges in other jurisdictions. Others suggest the inquiry is a political tool controlled by centre- right politicians seeking to remove President Rousseff, of the left wing Workers Party, and her Coalition from power. Indeed, all but one politicians implicated have been from her Coalition. These voices state that when and if this soft coup has been achieved the new government will quietly close down the probe 22. However, research suggests that the inquiry is not under the control of a political entity and therefore could not be shut down by one. The tone and content of the prosecutors language used by the Prosecutors in describing their work, what we know of their backgrounds, their standing in the eyes of the press (even in press from the left spectrum), and their massive popularity amongst the public, all suggest they are non- partisan. Further, no credible evidence has been seen linking the opposition to the prosecutors; many supporters of the President, who see the damage the Petrolao is doing to her government and her party, criticise the opposition s exploitation of the probe s political capital, but do not allege politicization of the prosecutors themselves. Even if a political interest were in charge of the probe would they seek to shut it down? We assess they would not and could not. Anyone seen to be shutting down the investigation would risk a toxic association with the corrupt interests the probe has revealed. With widespread support for the investigators, as evidenced above, such a move would surely be politically disastrous. 7 A scandal in metastasis; where will the contagion spread and what does it mean for foreign investors? The scandal has continued to widen in Brazil; August 2015 saw investigators announce a new direction, focusing on corrupt activity at Eletrobras/Electronuclear 23 in a phase called Operation Radioactivity. In a news conference heralding this new direction, Prosecutor Athayde Ribeiro Costa told reporters Corruption is endemic, 22 This is a view expressed in conversations between the author and associates with business interests in Brazil. 23 The probe has a tendency to pull in the most senior figures, be they ex- Presidents, the most prominent industrialists or, in this case, a veteran of the military- industrial complex, such as, in this case the CEO of Eletronuclear Rear Admiral Othon Luiz Pinheiro da Silva, a key figure behind Brazil s secret nuclear program in the 1970s. petrobras- eletrobras- idusl1n1080on #yumz4tmzqamm7olv.99 7

8 and there are signs it is spread over various institutions in Brazil we live in a state of metastasis. 24 How the metastasis will develop is difficult to determine. Certainly the investigators are effective and have shown no reserve thus far; to the contrary, one of the most notorious phases of the investigation (which saw the detention of the untouchable Marcelo Odebrecht, scion of the dynasty controlling Latin America s largest company) was called Erga Omnes, Latin for Towards Everyone. Their message: No- one is too powerful to be spared their attention. It is however already clear that the state of metastasis has expanded internationally, transporting contagion very far from Brazil. Multiple entities, private and public, in multiple jurisdictions are spinning up their Petrolao- related investigations. To give just a few of many possible examples, from state law enforcement bodies alone, in the UK the Serious Fraud Office is looking into alleged bribery from Rolls Royce, in Milan the prosecutor is looking into Saipem, in Peru a congressional inquiry is investigating links between Petrobras and former Presidents Garcia and Toledo. Holland has already completed a USD240 million settlement with SBM Offshore. In America, the US DOJ and SEC are conducting their own investigations. On a global level, in the private sector, dozens of investors involved in the share sale of 2010 are pursuing legal action, some independently, and some within the Class Action scheduled to open in New York City in February With so many threats from so many different quarters Petrobras and the main players in the rogues gallery are going to have another very tough year managing reputational risk in It will not just be the Brazilian entities exposed to the contagion. Most recently The Workforce itself has explicitly warned foreign companies that the Brazilians are turning their attention overseas. In early November, lead prosecutor Deltan Dallagnol stated, We will focus on international companies in a second step and the sooner they come to co- operate the better for them. Referring to the plea bargains that have so successfully uncovered evidence fuelling the investigation in Brazil, Dallagnol added. We will not make agreements with all of them we are going to make agreements with the ones that arrive sooner. Companies who refuse to talk, or talk late, will receive significantly harsher sanction; those who cooperate earlier will be incentivized to reveal as much information as possible. This carrot and stick approach means that significant evidence trails will be revealed, increasing the risk of association for companies linked. Notwithstanding this, within Brazil itself, there is pragmatism at play. The prosecutors acknowledge the vital economic role of the businesses involved and 24 petrobras- eletrobras- idusl1n1080on

9 have been ready to agree leniency deals reflecting the mantra punish the executives and preserve the business. This pragmatism will apply to foreign companies whose activities support Brazil s economy; SBM, for example, has already been allowed to tender for Petrobras contracts even though its judicial status viz the scandal is unresolved. The same principle cannot be expected to guide the US Securities and Exchange Commission, the US Department of Justice and/or multiple financial institutions seeking compensation from Petrobras. In a bid to see justice done and penalties or compensation achieved they will likely seek to expose any and all details required, without such consideration of the consequences for the business involved. 8 Not just the contractors Crucially, in terms of risks of association, the Petrolao s foreign protagonists are not just engineering and oilfield services providers. The role played by numerous international banks, many with accounts in Monaco and Switzerland has recently come under the spotlight. Even PriceWaterhouse Coopers WC is being sued alongside Petrobras by the Bill & Melinda Gates Foundation, whose suit summarizes the investors case very clearly: The depth and breadth of the fraud within Petrobras is astounding. By Petrobras' own admission, the kickback scheme infected over USD80 billion of its contracts, representing approximately one- third of its total assets, the lawsuit said. Equally breath- taking is that the fraud went on for years under PwC s watch, who repeatedly endorsed the integrity of Petrobras internal controls and financial reports. This is not a case of rogue actors. This is a case of institutional corruption, criminal conspiracy, and a massive fraud on the investing public Conclusion In terms of the life cycle of this scandal, there is much ground still to be covered, both in terms of how long the investigation lasts and the geographies involved will see the scandal travel from Brazil to become a media issue in other jurisdictions. The international legal processes are going to add a new character to the reporting on the Petrolao, potentially increasing the headline and reputational risk for associated parties. Within Brazil the scandal and associated opposition maneuverings will pose an enduring threat to the workings of President Rousseff s government, prejudicing its 25 and- melinda- gates- foundation- sues- petrobras- auditor- for- fraud

10 ability to defend itself or to enact required reforms. It may contribute directly or indirectly to an impeachment process, forming the pretext or shaping the atmosphere in which impeachment becomes inevitable. It might be argued that a change of government ahead of the 2018 elections could be positive for Brazil, provided due process is followed. This could be the circuit breaker the country needs but has not yet been able to implement. We assess that such an event might be just one of various positive developments for foreign investors that arise from the Petrolao. Firstly, if the inquiry is left to run its path, Brazil s corporate environment will surely be less corrupt (although a huge improvement in its rankings in the corruption index would be unrealistic) and Brazil s economy will benefit. As Judge Moro has noted, the alternative is overpriced, graft- ridden public contracts and infrastructure projects often left unfinished. 26 Secondly, an unfettered inquiry demonstrates to the markets that Brazil s institutional strength and democracy has evolved. Former President Cardoso has observed, In the past, in similar circumstances, we would be talking about names of generals Now we are discussing names of judges, nobody that I know is proposing a coup, except a few crazies who talk about the return of the military [to power], which the military do not want. 27 Thirdly, if the PSDB succeed Rousseff, as looks likely, a more pro- business government will improve terms for engagement of foreign companies, opening up opportunities for investment on more pro- market terms. Ultimately hindsight may well show that the Petrolao acted as a force that curbed the power of the state, reducing political influence over Petrobras and inflicting a reversal of fortune on Brazil s Worker s Party, one of Latin America s flagship left- wing political movements. They rode the boom years with Brazil, but now, in a deep recession, with the plunder of Petrobras so indelibly associated with their tenure in the eyes of many, it looks like they may well, for the time being at least, be ushered from power with a deeply stained reputation. Latin America s much- discussed shift to the political left will therefore have been partially reversed and corruption at Petrobras will have played a significant role in that sea change in the continent s largest economy. Rubeus Report This analysis represents a brief Think-Piece from Rubeus Ltd. Please contact us for 26 petrobras- judge- idusl1n0zj0vw #06a8wlsu7tirxaas sotero/crisis- in- brazil- leads- to- gridlock_b_ html 10

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