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Managing sanctions risks

23 September 2014

News analysis: Managing sanctions risks - Read more

Due diligence is key to effectively mitigating risks posed by restrictions on conducting business with Russia and Ukraine.

As the West grapples with how to respond to the crisis in Ukraine it is critical to have a complete understanding of who controls prospective business partners in Russia and Ukraine. Corruption risk has always been high in Russia and most companies doing business there will carry out some level of due diligence. However, the strengthening of the sanctions regimes targeting the two countries represents a growing compliance risk for firms doing business in the region. Merely monitoring sanctions lists and notices will not be sufficient to steer clear of the potential hazards.

There are three key ways in which companies’ due diligence provisions need to adapt to weather the new regulatory climate: replace box-ticking with nuance; adapt proactive monitoring practices; and reject a one-size-fits all approach to risky counterparties.


Since the Ukraine crisis began six months ago, a series of lists have been published by the Office of Foreign Assets Control (OFAC) and the EU. These have blacklisted dozens of Russian officials and politically exposed individuals close to the Putin government. Most recently, new sectoral sanctions have moved from targeting individuals to specific entities and entire economic sectors – such as the arms trade.

In mid-July, fresh US measures came into place prohibiting Americans from providing financing for, or otherwise dealing in new debt of longer than 90 days maturity for a series of Russian banks and energy companies. Those include Gazprombank, the country’s third largest bank, and the world’s largest publicly traded oil company, Rosneft. The bans cover not just the companies themselves but also extend to property owned by them.

Perhaps the most important development, from a sanctions compliance perspective, has involved the so-called 50% rule laid down by the US Treasury. It stipulated that any company where a blacklisted individual held a stake of 50% or more should also be considered subject to sanctions. In August, this rule was reformulated and expanded to apply not just to individual shareholdings but also cumulative stakes.

This means that a company could still be banned if the minority shareholdings of several targeted people together add up to 50% or more. European rules are even more nuanced. The UK government considers that an individual does not need to be a majority shareholder in order to exercise control over a company. It is enough for them to have the right to appoint or remove a majority of the board or otherwise exercise dominant influence, including by making use of obscure provisions in the company’s articles of association. As a result, companies that are not themselves featured on OFAC or other blacklists may still be subject to sanctions. Clearly, for US or European-based companies, it is now more important than ever to fully understand who owns or controls a prospective business partner.

Due diligence

American and European officials advise increased caution when dealing with any company where a significant minority stake is held by a blacklisted individual or entity but such interactions are not necessarily proscribed. The subtlety of the new sanctions regime means that it is increasingly necessary to distinguish between those investments that merely cause one to ‘sweat a little bit’ – in the words of OFAC associate director John Smith – and potential sanctions breaches.

For example, US and EU-based companies are forbidden from engaging in direct dealings with Igor Sechin, the president of Rosneft. However, the company itself currently remains subject to only very narrow restrictions, which relate to its access to US capital markets. Billions of dollars in deals are at stake. Given the political exposure of major Russian companies, thorough due diligence procedures will help companies understand and assess the potential risks – from regulatory and reputational perspectives.

The best way companies can protect themselves from both undue skittishness and dangerous laxity is by adopting a much more focused approach to due diligence. For too long, many businesses have continued to regard due diligence as a box-ticking exercise; the new rules mean that simply running a shareholder name through a few databases is no longer a guarantee against sanctions-breach.

Potential counterparties must now be examined more thoroughly, and the various shareholdings carefully scrutinised beyond the obvious ’red flags’.

Lack of transparency

As the international regulatory noose tightens around Russian businesses, another key challenge for compliance professionals conducting due diligence is overcoming the lack of transparency of many corporate structures. Russian firms may redouble their efforts to stay one step ahead of sanctions regimes seeking to obscure their control over Western-facing subsidiary companies. As a result, the process of understanding whether a sanctioned individual is behind a potential business partner or investment will become increasingly complex.

Jurisdictions like Cyprus, the British Virgin Islands, Switzerland, Luxembourg and the Channel Islands continue to make it impossible to determine the ultimate beneficial ownership of many private companies. Russians targeted by sanctions routinely rely on offshore entities to disguise their stakes. However, efforts are currently under way in Washington, London and Brussels to oblige the disclosure of involvement by Ultimate Beneficiary Owners (UBOs). Although the process may take months or years to bear fruit, political pressure is growing on offshore jurisdictions to clamp down on corporate secrecy. Continual monitoring of the legislative and diplomatic climate by companies is essential to keep abreast of any developments in this direction.

Even more importantly, the internal reorganisations of Russian companies that are potential sanctions risks often yield clues about whether they might be engaged in hiding their ownership. Sudden board changes and sell-offs that may have taken place in recent months may indicate the past or enduring involvement of sanctioned individuals or entities behind the scenes. Such movements, which may not be caught by basic due diligence processes, will become increasingly crucial to the evaluation of risk.

Another difficulty created by the conflict concerns the changed corporate landscape. It is likely that the old, clearly delineated concepts of sovereignty will be replaced with shades of grey, as has already been shown by the uncertain regulatory status of businesses and investments in Crimea.

In the event that parts of eastern Ukraine gain greater autonomy as part of a newly federalised country or even, in an extreme scenario, become absorbed by Russia, a comprehensive re-examination of relationships with affected partners will be impossible to avoid. Companies registered in jurisdictions not recognised by Western powers, or ones subject to takeover or nationalisation by Russian or newly-created actors, will present novel compliance risks. Dealing with them will involve a highly sensitive, nuanced and creative use of all the available tools in the due-diligence arsenal.

The conflict in Ukraine remains unpredictable. As the scope of both the conflict and the sanctions regimes widens, a clear understanding of the ultimate ownership of their partners and investments will become a key prerequisite for companies to effectively deal with new developments.

Michael Boag is Managing Director and Vadim Nikitin is an Associate in the Due Diligence Practice of Stroz Friedberg

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