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Compliance alert: Fly-by-Night companies in Russia pose special risks

A major risk for inbound investors in Russia is inadvertent exposure (often under the aegis of third parties) to a type of shell entity called a Fly-by-Night company.

While some maintain a partially legitimate business purpose, many Fly-by-Night entities aid fraudulent activities, including the generation of slush funds. As seasoned compliance practitioners know, fraud and off-book accounts are enablers for bribery, theft, embezzlement, tax evasion, money laundering and other illicit activities.

Compounding the in-country corruption risk is an increasing level of in-country enforcement. Russian regulators are becoming progressively interested in investigating and prosecuting bribery and tax fraud. Their authority rests on a quickly changing legislative landscape — one which may fall below the radar of most incoming players or foreign companies doing business in Russia.

Ignorance of the law is no defense. When local enforcement issues are tripped by exposure to these fictitious Fly-by-Night entities, they may also trigger U.S. and other international enforcement actions.

Considering the many economic crime touchpoints connected with Fly-by-Night companies, it’s easy to see why an association with one, no matter how unintentional, could expose companies and their executives to a world of hurt. The real question is how do these risks manifest — and how to steer clear of them.

A number of Russia-based FCPA investigations have involved bribes that were paid from slush funds generated by payments made to such fictitious vendors. The mechanism typically involves making payments to dummy companies under contracts and invoices for services that were never actually rendered, or for which the reported cost was substantially higher than the fair market value. Off-book funds generated from such schemes are then commonly used for other illicit purposes.

One common scheme employed by Fly-by-Night companies is fraudulently collecting Value-Added Tax (VAT) on services rendered to a company and not remitting it to the government. This may be viewed as an act of defrauding Russian tax authorities. And it gets worse. When Russian authorities inform a company that they’ve conducted business with a Fly-by-Night and that they owe taxes, the next question is often, “And where did the money go?”

Unfortunately, if a company’s compliance program and internal controls did not detect that they were doing business with a Russian Fly-by-Night company, they may then also be at risk of not meeting the standards of their home country’s anti-money laundering regulators. A transaction with a Fly-by-Night company may also lead to exposure to the FCPA’s books and records and internal controls provisions. A company that learns of a compliance breach only from a regulatory inquiry (e.g., a subpoena) is also robbed of the opportunity and benefits of self-disclosure.

Here are a few tips from the field on how to help your organizaiton stay ahead in the compliance game in Russia:

1) Make sure your compliance house is in order. See that your governance and compliance protocols are robust and in line with regulatory expectations. Conduct corruption risk assessments to help identify and mitigate hiring and third-party risks. Make your whistleblower hotlines serve as canaries in the corruption coalmine. Hire ethical people — a must — and incentivize personnel in compliance-sensitive positions.

2) Double down on due diligence. Given the risks involved with Fly-by-Night companies in Russia, it’s even more critical to dive deep on due diligence of third parties. So in addition to the usual baseline due diligence reviews (sanctions, watch lists, denied parties list, etc.) — identifying and weeding out third parties that are closely related to government officials, or ones with links to organized crime — in Russia it’s essential to conduct more specialized third-party analysis. Consider analyzing a population of minor contacts with one-time or limited-time vendors. Such vendors can typically be identified during discussions with company personnel and through analysis of the master vendor file. Engage in deeper layers of scrutiny, such as researching a company’s incorporation date, Web presence (or lack thereof), taxpayer status and general business reputation. We have found that many red flags reside herein. 

3) You don’t know what you don’t know. The special combination of elevated corruption risk and growing enforcement within Russia (not to mention AML and tax fraud prosecutions in Russia and other countries) points to the need to be on top of compliance issues at all times. While all sophisticated compliance professionals know that compliance is never a one-solution-fits-all exercise, it’s essential to keep in mind that Russia has its own, unique risk profile. Vigilance in your compliance program set up in Russia may generate the best return on investment of all: peace of mind.

4) Take a look under the hood, especially outside your ’hood. While the importance of auditing and monitoring for compliance cannot be understated in any jurisdiction, this is especially true for Russia.

5) Mind your P’s and Q’s. Managing the risks of corruption in Russia goes hand in hand with managing the risks of non-compliance with the Russian Competition Law. Russian courts have recently opined that third parties’ actions may not create liabilities for their principals with the same level of certitude that is generally acknowledged by Western courts, particularly those in the U.S., and that creating onerous or vague requirements for third parties may be in violation of Russian Competition Laws. To that end, caution should be exercised, particularly in the areas of due diligence, compliance requirements, third party audits and termination.

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Sulaksh A. Shah is a partner in PwC’s Forensic Services Practice in Washington D.C. His practice focusses on anti-corruption/FCPA matters, including internal investigations, compliance programs, and due diligence.  He has represented clients before the United States Department of Justice as well as the Securities and Exchange Commission.

James Gargas is a director with PricewaterhouseCoopers’ Forensic Services Practice with eight years of specialized anti-corruption experience and forensic accounting experience. He has led internal investigations, anti-corruption compliance, anti-corruption due diligence, and other compliance engagements spanning multiple locations and in several countries on six continents.

Tatiana Vostrova is a Director with PricewaterhouseCoopers’ Forensic Services Practice in Russia. She has over ten years’ experience of the investigation and remediation of compliance related issues including fraud, corruption and other breaches of internal and external regulatory requirements. She led the teams on fraud and corruption investigations in Russia and CEE countries.

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