Russian roulette: the sanctions-compliance challenge

June 2022  |  COVER STORY | GLOBAL TRADE

Financier Worldwide Magazine

June 2022 Issue

Russia’s invasion of Ukraine burst the balloon of fragile coexistence between the two Slavic nations and sent major shock waves around the world – a conflict that, in the words of Ukrainian president Volodymyr Zelenskyy, is “one of the greatest threats to international peace and security”.

Countermeasures by the West were all but inevitable, particularly in the context of Russia’s annexation of the Crimean Peninsula from Ukraine in 2014 and the occident’s flimsy response. However, direct military intervention – i.e., boots on the ground and a no-fly zone over Ukraine – is a red line that cannot be crossed for fear of nuclear escalation, leaving covert activities (i.e., provision of weaponry) and the imposition of economic sanctions as the only real multilateral options.

In the event, the sanctions route is the one generally being pursued by the West. Described by president Biden as “devastating”, the sanctions imposed on Russia, Russian government officials and Russian companies, as well as their associates, are the most coordinated and severe in recent memory, with approximately $1 trillion in assets having been frozen.

The West’s sanctions are also encouraging many leading companies to reduce or exit their Russian operations. Across a range of sectors, including automobiles (Ford, GM and Volkswagen), aviation (Airbus and Boeing), energy (BP and Exxon), entertainment (Disney and WarnerMedia), shipping (Maersk and MSC) and technology (Apple), companies have moved swiftly to reassess their trade with Russia – action in tune with the consensus that Russia will remain an undesirable place to do business for the foreseeable future.

With evasion out of the question, the longer the West’s sanctions are in place, the greater the economic cost for Russia. So, as the country increasingly heads toward a state of unsustainable autarky, the Russian economy, in the long run, will have lower income, productivity and growth.

“The West’s sanctions on Russia have been unprecedented, both in terms of their scope and the speed at which they have been implemented,” says Mike Casey, a partner at Wilson Sonsini Goodrich & Rosati. “In less than a month, the European Union (EU), the US and the UK transitioned from administering relatively discrete Russian sanctions programmes to adopting very expansive sanctions regimes.”

According to Shahab Wahdatehagh, vice president of global trade intelligence EMEA at Descartes, the sanctions, while indeed wide-ranging, focus on three key areas: (i) business and financial transactions with few exemptions, such as the energy and oil & gas industries; (ii) individuals such as oligarchs or otherwise politically exposed individuals; and (iii) the export of certain goods that fall under additional export controls limitations, such as products that may have dual-use applications (e.g., civil and military).

“President Putin and Russian foreign minister Sergei Lavrov have been designated by the majority of western governments,” affirms Charles Delingpole, founder and chief executive of ComplyAdvantage, “along with a variety of oligarchs and Russia’s largest commercial banks, including the state-owned Sberbank and VTB, both of which have had their assets frozen.”

Mr Delingpole also notes efforts to reduce Russia’s access to the global financial system, with bans on trade in Russian sovereign debt, the removal of major Russian financial institutions from the SWIFT international payments messaging system, and US, EU and UK prohibitions on dealings with the Russian central bank, finance ministry and wealth fund.

Moreover, a significant offshoot of the West’s sanctions measures is that companies conducting business internationally need to be prepared to act quickly and review their links to any sanctioned individuals or companies and their suppliers, third parties, investments, funds and clients.

“Sanctions have broad economic impact, not only on the sanctioned entities but also for businesses that have operated successfully in Russia and are now confronted with the challenge of finding new sources of supply or markets to serve,” asserts Mr Wahdatehagh. “The West’s range of sanctions requires companies to remain constantly up to date due to changes that are often made on a daily basis.”

In order to ensure compliance, companies need to have a tight due diligence process in place to protect their business from potential penalties and associated reputational risk in the event that sanctions are breached.

Red flag due diligence

In the current environment, any company with operations, customers, clients, investors or counterparties involved with Russia would be well-served to assess how sanctions could impact their business, with comprehensive due diligence essential in identifying red flags.

However, because of the particular complexities and peculiarities of the latest Russia sanctions programmes, diligence is not as simple as it may be for other sanctions programmes.

“Prior to the Russia sanctions, there was only one ‘flavour’ of prohibited party: the specially designated national (SDN),” explains Judith Alison Lee, a partner at Gibson, Dunn & Crutcher LLP. “Once it was established that a counterparty was an actual SDN – that is, not a ‘false positive’ – then the rules were pretty clear: companies could not deal with that person or entity without specific authorisation from the Office of Foreign Assets Control (OFAC),”

“But with the Russia sanctions programme, all of a sudden we have a completely new type of restricted party: the sectoral sanctions identifications (SSI) entity,” she continues. “For this type of entity, not all transactions are prohibited, but only certain transactions that are specifically delineated in one of OFAC’s directives. So now, you not only have to do the diligence to determine whether your party is an SSI, you also have to do additional diligence to determine whether the particular transaction itself is prohibited.”

In the view of Mr Wahdatehagh, unless the type of business being conducted is specifically excluded, sanctions adherence must be seen as a crucial piece of code of business and ethics. “Areas to be assessed are actors in the supply chain, such as suppliers, customers and partners,” he says. “Red flags need to include the assessment of at least majority ownerships. It is not enough to screen business partners, but their ownership structures need to be screened to ensure there are no sanctioned parties involved.”

Overcoming opacity

Understanding a counterparty’s ownership and management is critical for ensuring sanctions compliance, but what can often hinder the due diligence process is opaque ownership structures, such as shell companies – a significant barrier to establishing a complete and accurate picture of a potential business partner.

“Given the severity of sanctions, opaque ownership structures should be a non-starter in the current environment,” contends John E. Katsos, associate professor of business law, business ethics and social responsibility at the American University of Sharjah. “Information about ultimate beneficial owners (UBOs) is the critical piece of information that companies must demand when facing opaque ownership structures.

“Cross-referencing UBOs with sanctions lists and politically exposed persons (PEPs) is an important first step toward building an accurate picture of a potential partner,” he continues. “Banks already do this, but other companies will be under pressure to meet similar criteria, either by law or by consumers and shareholders. Plus, if a potential partner does not want to provide this information, it is a massive red flag in the current environment.”

Also problematic is the prevalence of ‘circular ownership’ structures in Russia, which are unlawful in many other countries. “In Russia, the circular ownership structure can be used to consolidate control of different companies or obfuscate the beneficial ownership,” explains Ms Lee. “In both ‘open’ and ‘closed’ loop structures, it is important to conduct due diligence to understand circular ownership loops when conducting investigations in Russia.

“Moreover, because they are legal in Russia, these structures can be used to obscure ownership of companies that are owned by sanctioned companies or individuals,” she continues. “Identifying cases where this happens and taking the time to parse through the noise of the circular ownership structure is an essential part of ensuring compliance with sanctions when dealing with Russian counterparties.”

Building an effective SCP

With the stakes surrounding sanctions compliance having multiplied significantly in recent months, companies need a programme that can effectively address the necessity of sanctions adherence throughout their operations and ensure strong buy-in, while, at the same time, avoid violations carrying major penalties.

“The specific risks a business faces in relation to Russia will vary significantly depending on the industry it operates in, the products and services it offers, and the profile of its customers,” says Mr Delingpole. “Every company will need to determine what level of risk it is comfortable taking, and base its systems, controls and risk mitigation approaches around that.”

To that end, Mr Delingpole advises companies to evaluate the five components listed below as part of maintaining an effective Russia sanctions compliance programme (SCP).

First, systems and controls. Are companies’ client and payment screening platforms able to detect relevant risks? Once detected, are they able to manage these risks, for example blocking transactions or freezing funds when required?

Second, training. Provide appropriate training and guidance for compliance staff to help them understand the latest sanctions measures, how to handle affected clients and transactions, along with updated communications as the situation changes. In a highly volatile situation, companies should aim to minimise the number of ‘false alarm’ alerts that are raised when these could have been discounted with the right training.

Third, exposure. Companies should consider how they go about understanding their exposure, not only to sanctioned entities, but also the wider nexus around them. For example, do they have systems in place to do this, or will it be a manual exercise?

Fourth, continuous monitoring. Compliance staff need a mindset similar to that adopted by traders watching the stock markets. It is critical to monitor the latest news and alerts in real time.

Finally, holistic understanding. As well as understanding what sanctions are in place, compliance staff should be keeping up to date with geopolitics, trade, commerce and wider world events simultaneously. These are all likely to converge, with potential for cross-over sanctions risks.

Furthermore, technology can help companies to effectively evaluate these components. “In the US, online, subscription-based tools, such as Dow Jones Risk and Compliance and Kharon, which include detailed ownership information, are available,” notes Ms Lee. “However, sometimes it can be cost prohibitive and time consuming to use these screening modules for every international transaction. Therefore, in developing a risk-based approach, it is important to identify the transactions with the most risk, and to devote the most resources, including technology resources, to those areas.”

At the same time, Mr Wahdatehagh reaffirms that potential fines for breaking sanctions and the associated business and reputational risks more than outweigh the cost of solutions and in-house processes.

No backsliding on sanctions

With Putin seemingly unlikely to withdraw his forces from Ukraine unless the Ukrainian government is removed and the country realigned within Russia’s ‘sphere of influence’, the conflict is likely to become a drawn-out war of attrition – a war that will certainly last for months, perhaps even years.

“It is very difficult to predict with any certainty what is going to happen with Russia sanctions in the future, with so much depending on developments on the ground in Ukraine,” suggests Ms Lee. “It is possible, however, to identify some possible candidates for sanctions escalation.

“Additional sanctions could be in the form of new designations to SDN and entity lists, the termination of existing wind-down periods in existing general licences, additional prohibited imports, additional sectors in the Russian economy designated for prohibited investment and a further expansion of export controls,” she continues. “Other possibilities include special tariffs, such as the tactic the Trump administration used against China.”

Also expecting an escalation in sanctions is Mr Casey. “Russian sanctions have not yet reached a settled state,” he says. “My expectation is that the EU, the US and the UK will continue to unveil new sanctions – and refine existing sanctions programmes – over the coming weeks and months. In addition, Russia almost certainly will continue to push forward various countermeasures designed to blunt the effectiveness of Western sanctions.”

Aside from expanding military action in Ukraine, Russian retaliation could include cyber attacks – indeed, the US Cybersecurity and Infrastructure Security Agency (CISA) has issued a ‘Shields Up’ warning to all organisations “to be prepared to respond to disruptive cyber activity” – and limiting the activities of non-resident owners of Russian assets.

How, when and why the conflict will conclude is anybody’s guess, but given his proven predilection for posturing and promises written in smoke, any suggestion by Putin to end hostilities in Ukraine must be treated with extreme caution by the West.

For the moment, however, with the sanctions screw expected to be turned tighter on Russia, one thing is virtually certain: there will be no backsliding on sanctions.

© Financier Worldwide

BY

Fraser Tennant