By Allen Maggard

Due diligence – the process of investigating prospective counterparties for potential risk  – is a core principle of responsible commerce. Successful due diligence hinges on an enterprise’s ability to gather information about possible business partners, whether in order to minimize risk to themselves or to maintain compliance with regulatory statutes. While counterparties may supply some of this data, due diligence investigations generally rely on a variety of public records and media in order to capture additional information. In this respect, due diligence is an open source activity that thrives on transparency.

Though most people might scoff at the idea of it being a “transparent” jurisdiction, Russia does possess an extensive collection of online public records. The Federal Tax Service, for example, operates the Unified State Register of Legal Entities,  a nationwide corporate registry that allows users to pull up the corporate records of each and every company, non-profit, and state entity operating in Russia. Want to know who owns a particular trademark or trade name? The Federal Institute of Industrial Property has got you covered. One can even study data for state procurement contracts – a known means of revenue for Putin’s closest associates – through clearspending.ru and zakupki.gov.ru. These resources – all of which are currently free and open to the public– make performing thorough due diligence on Russian counterparties fairly straightforward.

Yet over the past several months, the Russian government has proposed measures that could make the work of due diligence significantly more difficult. These measures would enable the Kremlin to allow certain enterprises to withhold financial information about transactions involving strategically significant economic players. The Kremlin maintains that these measures are a retaliation to the U.S. sanctions regime – a way to frustrate information-gathering by Western governments in support of new sanctions. However, it is likely they will further isolate Russian markets from foreign investors, who conduct due diligence based on the same open source materials used by Western governments to target firms and individuals close to the Kremlin. Worse still, it will likely result in extensive collateral damage to independent Russian firms enjoying far fewer protections from sanctions-related risks than their state-owned peers.

The abovementioned initiative gained momentum after the US Treasury Department’s announcement on 6 April 2018 of new sanctions against Oleg Deripaska and several other members of the infamous “Oligarchs list.” Three days later, Prime Minister Medvedev instructed his government to develop measures to support companies affected by US sanctions. Around the same time, the Ministry of Economic Development (Minekonomrazvitya) reportedly began developing a program that promised to protect prominent Russian businessmen from Western sanctions if they re-registered their offshore assets in one of two “onshore” tax havens located in Kaliningrad and the Russian Far East. Medvedev himself has since confirmed the existence of this plan, which noticeably aligns with the Kremlin’s “deoffshorization” campaign.

Among other incentives, the proposal guarantees anonymity for onshore companies’ shareholders and principals, requiring that individuals seeking the corporate records of specific companies first obtain permission from the very enterprises they wish to examine. This may be advantageous for companies who operate within Russia, but as Yekaterina Lazorina of PricewaterhouseCoopers Moscow points out, most foreign banks will not open accounts for firms that do not disclose their shareholding structure or identify their ultimate beneficiaries. Those Russian businessmen who do end up transferring their offshore assets back “onshore” will likely struggle to conduct business abroad going forward. But this has not dissuaded Deripaska from considering the possibility of re-registering En+ in Russia in order to take advantage of the onshore scheme.

Minekonomrazvitiya has also advanced legislation that would allow the Kremlin to restrict the dissemination of financial information concerning enterprises of “systemic” importance to the Russian economy. This legislation builds on a December 2017 law that allows the government to exempt firms involved in “major deals” and/or transactions related to state defense orders from publishing relevant financial and shareholder information. Minekonomrazvitiya’s bill further expands the list of firms subject to these redactions to include an array of private and state-owned enterprises (SOEs) outside the defense industry, including Gazprom and Rosneft.

Russian legal experts believe that allowing the government to regulate the disclosure of financial statements and shareholder information will do more harm than good to the country’s business climate.  Elena Zhukova of Coleman Legal Services Moscow warns that adopting measures like those developed by Minekonomrazvitiya “will doubtlessly influence economic indicators.” By revoking guaranteed access to comprehensive corporate and financial records, Zhukova suggests, the Russian government will impede firms’ ability to vet their Russian counterparties and will scare away potential foreign investors who are obliged to comply with “know your client” (KYC) standards and other best practices or suffer stiff regulatory penalties. This will not affect Russian SOEs that are already subject to direct or indirect sanctions. However, it does place Russian small and medium sized enterprises (SMEs) at a comparative disadvantage.

Russian SMEs are relatively unrepresented within the government procurement market: according to Minfin’s estimates, SMEs accounted for around 12.7% of all government procurement contracts awarded in 2017. The Putin administration has made a developmental priority of increasing the share of SMEs involved in government procurement as well as supporting Russian SMEs overseas. The specter of Western sanctions, however, will compel the Kremlin to sacrifice one of these goals for the sake of the other. After all, private firms that have been contracted to provide services for local Crimean authorities over the past four years should not expect easy access to foreign capital. By increasing the share of SMEs participating in government procurement contracts, the Russian government risks undermining these firms’ ability to transact business with foreign clients.

The Kremlin has nevertheless so far exhibited greater concern for shielding so-called “systemic enterprises” from sanctions-related risks than for SMEs. Last December, for example, the State Duma approved a set of reforms that would require SOEs to transfer most information about public procurements from SMEs online beginning in 2019. Notably exempt from this provision were transactions with affiliated companies in which the contracting SOE maintained a 25 per cent stake. This loophole outraged many deputies, who felt that it would effectively allow SOEs to buy out SME suppliers and thereby make the bidding process for government procurement contracts less competitive as well as less transparent. Minfin intervened late last month when it proposed a compromise measure that only allowed SOEs to withhold information about transactions with affiliated entities in which they maintained a 50 per cent or greater stake.

Will the abovementioned measures work as intended and hinder the formulation of new sanctions? While these policies may affect access to corporate records and financial documents, they are unlikely to significantly complicate due diligence analysis that would implicate politically-exposed persons close to the Kremlin. These records are not the only references used in due diligence investigations, which also rely on prior news reports, local experts, and even social media. One could say this corporate and financial data is like the corner pieces in a jigsaw puzzle. They make it easier to put the rest of the pieces together, but they are ultimately just one part of a much larger pool of sources.

One can assemble a more or less comprehensive open source profile of a counterparty without corporate and financial records given enough time and resources. Western governments possess the necessary institutional and technical capacities to formulate sanctions on the basis of other open sources. One need only comb through news media and the various online archives offering compromising information on Russia’s economic and political elites to understand their personal networks and financial interests. Assuming that the Kremlin makes good on its promise to shield them and their assets, these same elites should have little to fear from sanctions. But the same cannot be said for the vast majority of Russian SMEs and individual entrepreneurs, many of whom face considerable risks of their own as a result of the Kremlin’s aspirational sanctions-busting.