International chain reaction: local businessmen gain lessons from Russian crime Saga.

WITHIN weeks of its opening, the first Subway restaurant in Russia was selling more sandwiches than any other store in the chain, and David J. DiTomaso, a Simi Valley-based Subway franchise operator here in the U.S. who had invested in the Subway Russia LLC venture, was figuring his ship had come in.

"We were the happiest gays thinking this is going to be sweet," recalled DiTomaso, who has since become a partner in Subway Russia.

But the euphoria did not last long. Five months after opening, the venture's Russian partner stormed the restaurant with submachine guns blazing, the partners said.

The first Subway in Russia had, for all intents and purposes, been hijacked.

It has taken 10 years and millions in legal fees, but DiTomaso and his partners, Jim Gansinger and David Worrell, finally got their store back in April, and the team is well on its way to opening a network of about 20 company-owned and franchised stores in Russia this year and next.

But the struggle to recapture their first store offers some stinging lessons to small businesses that venture into emerging countries.

"There have been major bumps in the road for us," said Gansinger, who is a business litigation attorney with Gibbs, Giden, Locher & Turner in Century City: "But if you're going to turn and go home when you hit a bump in the road, you probably ought not to be there. Patience is a virtue if you're doing business in strange places."

Subway Russia's experience is not unusual, experts on trade with Russia say, even today.

"Organized criminal activity in the business realm remains a significant problem in Russia, although exact figures are difficult to come by," said Ben McTernan, managing editor of The PRS Group, a Chicago-based research group that provides information on investment and risk in international markets. "... It is an open secret that many local government administrators are actively cooperating with criminal elements, which not infrequently are the same people, having determined that cooperating with crime bosses in the shared interest of maintaining order is preferable to stirring up trouble by attempting to bring legal action against them."

Indem, a Russian think tank, in a report in 2002 estimated that about $35 billion was paid annually in bribes to public officials. Liberal Mission, another think tank in Moscow, estimated that small businesses in Russia alone paid out about $6 billion in bribes and protection money, figuring cooperating with officials and mobsters is cheaper in the long run than the price of paying taxes and licensing fees.

But in the early 90s, few knew what to expect when they crossed the newly lifted Iron Curtain.

The U.S.S.R. had just broken apart. Some 140 million people in Russia were so starved for consumer goods, lines for McDonald's wound around an entire city block. Then-presidents Bill Clinton and Boris Yeltsin were shaking hands on a $750 million financing package to encourage investment in the new Russia. And by 1994, foreign money was pouring into the region at the rate of $500 million a month.

By 1992, OPIC, the Overseas Private Investment Corp., a federal agency set up to help encourage investment in high-risk emerging countries by providing financing as well as risk insurance, was fielding requests from more than 300 American companies. Among them were multi-million dollar projects by companies like Texaco and Pratt & Whitney along with a tiny company that hoped to build a chain of Subway sandwich shops in the region.

Needing a partner

Back then, a foreign company seeking to do business in Russia needed a Russian partner, and Subway Russia, through an associate of Boris Yeltsin, had been introduced to a businessman named Vadim Bordug who was to be the company's partner in a 50-50 joint venture and help to identify locations for the restaurants.

The St. Petersburg Subway opened in December 1994 at a cost of more than $2.5 million. Although that is quite a bit more than the cost of opening a Subway restaurant in the U.S., on average about $150,000, the Russian launch involved development costs and reflected the much larger size of the these restaurants in Russia--St. Petersburg's first Subway had seating for 150 people.

Besides, early indications were that the partners would recoup their investment in the first year.

But in May, while the Russian managers hired by Subway Russia were on vacation, Bordug took over the store. According to local Russian newspaper accounts, guards posted at the store tried to attack the manager upon his return from vacation and made threats against his life.

Gansinger believes Bordug was a member of the Tombovski crime group in St. Petersburg.

"The mistake we made was that we assumed that since this guy came to us as a direct referral from the president's office that was all the vetting we needed to do," Gansinger said.

Trade experts point out that such occurrences are not necessarily tied to organized crime in Russia.

"I think small investors from the States or elsewhere, their problem is they just don't know the market," said Ariel Cohen, research fellow at The Heritage Foundation, a Washington, D.C.-based research and educational group, who advises Russian and American businesses in crisis management. "They don't know the mores and the rules, and one of the rules is you find something called the roof. The roof is whoever provides you protection, and everyone has one."

Sometimes, said Cohen, the roof is the Federal Security Service (the KGB of the post-communist era) and sometimes it is the local organized crime group and sometimes those two groups are the same.

Bordug's claims

Publicly, Bordug claimed the manager had abandoned the store and he was stepping in to correct what he said was a case of mismanagement.

In the U.S., a partner who tries to elbow the others out of a venture would be hit with an injunction, stalling any moves until the matter could be hashed out in court.

"That's not how it worked in Russia in 1994," said Gansinger. "The authorities wouldn't know a business dispute from a shooting star. They had no experience in white collar crime. Plus they were being bribed."

Gansinger tried to work with the Russian authorities to get back control of the store. He even met with Vladimir Putin, who was then deputy mayor of St. Petersburg. But when Putin was defeated in an upset election, Subway Russia was on its own.

The partners and other trade experts say that many small business owners facing similar situations in Russia simply walk away from their enterprise, but Subway Russia was unwilling to do that.

"We just basically refused to let the crooks get away with what they tried to do," Gansinger said.

Subway Russia petitioned the International Arbitration Court in Stockholm, the body set up to hear trade disputes between the foreign partnerships that were being set up at that time. Gansinger tried the case himself, and Bordug showed up to defend his actions.

It took about a year, but the court ultimately ruled unanimously in favor of Subway Russia.

"We went to the officials in the city of St. Petersburg and said, 'we won,' and they didn't do anything," said DiTomaso.

Subway Russia turned to OPIC, which had underwritten an insurance policy for the company. The controversial agency provided a cadre of lawyers who painstakingly guided the case through Russia's complex appellate system, a process that took another five years.

When it was over, Subway Russia became the first company to get a foreign arbitration award confirmed in post-Soviet Russia, Gansinger said.

"We tend to forget how much regulation there is of business in the U.S.," Gansinger said. "There is a uniform commercial code that has developed over a couple hundred years. We have all these regulatory agencies and all the rules and regulations overlaying it to make our free economy system work smoothly. Russians didn't have any of that stuff."

Reopening

The St. Petersburg store finally reopened in April at a gala that included as many high-powered Russian officials as the group could muster in hopes that by raising the profile of the small company they could prevent any future incidents.

Meanwhile, Subway Russia had already begun opening new stores, these through selling franchises to Russians, and one store had opened in Moscow in 1998.

Six more franchise stores are slated to open in coming months and another 14 franchises are expected to open next year. Plans are also underway to build additional stores which Subway Russia will continue to own.

Many of the company's current obstacles now revolve around more traditional marketing issues.

Russians are not familiar with Subway as a brand, and the company has to find ways to get locals to understand what the restaurant offers.

And the market for potential franchise owners is different in Russia. Most Russians do not have access to bank financing as a U.S. franchise owner might, so the company has to identify and appeal to those who already own businesses or who own property in which to house a store.

"That makes our growth difficult," said DiTomaso, whose 3H Network Inc. owns 17 restaurants in the Conejo Valley and other parts of Ventura County and is opening two more in the next two years.

But even after their long journey through Russia's legal system, and the more recent economic turmoil and the devaluation of the ruble in the country, the partners are undaunted, mostly they say because Russia offers staggering opportunity for development, and Subway Russia owns the exclusive right to develop those franchises in the region.

"I was sitting in the audience when (former U.S.S.R. President Mikhail) Gorbachev gave his 'we're open for business' speech," recalled Gansinger, who began his efforts to open restaurants in Russia even before the breakup. "on the last day of my first trip (to Russia) we went to see McDonald's near Pushkin Square, and there was a line that went all the way around the block. There must have been 5,000 people in line and that McDonald's had been open for a year. It was astonishing. We looked at it and went, holy mackerel, how can you miss in a place like this?"