Ban on Co-Operation with Shell Arrangements — Myths and Reality

The Finance Sector Development Council in its meetings held on 21 March 2018 and 3 April 2018  approved amendments to the Law on the Prevention of Money Laundering and Terrorism Financing (hereinafter – the “Law”), stating that the amendments aim at improvements the risk-based monitoring measures and require urgent implementation. The amendments have been drafted to strengthen the financial system and ban high risk transactions with especially risky clients, i.e. shell arrangements. The amendments also aim at promoting information exchange between the obliged entities and law enforcement institutions to combat financial crimes. The present publication is solely devoted to the ban on co-operation with shell arrangements.

The amendments to the Law have gained a lot of attention in mass media, and the comments regarding them have been contradictory. For example, on  10 April 2018 mass media wrote that about “20 000 Latvian companies will have to terminate their co-operation with shell companies” stating the following: currently the general public is under a false assumption that the new amendments to the Law for strengthening the financial system are going to apply solely to the banking sector of Latvia. They went on to emphasize that apart from the banking sector the amendments would apply to a number of other companies, e.g. tax consultants, law offices, accountancy service providers, etc. Thus, according to the media information about 20 000 companies would have to disclose their clients and terminate cooperation with shell companies. [1]

This information stated in the mass media is not correct and may lead to false perceptions.

What are “shell arrangements”?

Recently, the term “shell arrangements/companies” has been increasingly used in Latvian mass media.

The Financial Action Task Force (FATF),which is an independent intergovernmental body that develops and promotes policies to protect the global financial system from money laundering, terrorist financing and the financing of the proliferation of weapons of mass destruction, has defined that the shell companies are considered to be companies that are incorporated but have no significant economic operations or related assets [2].

According to Wolfsberg group - a non-governmental association of 13 international banks, that develops financial industry standards for the prevention of money laundering and terrorist financing, Glossary issued on 22 February 2018 - a shell company is a company that either has no operations, or has assets consisting solely of cash and cash equivalents and nominal other assets [3].

The US Financial Crimes Enforcement Network defines a shell company as a company without active business operations typically representing an instrument for the business activity of another company, and indicates that the term “shell company” refers to non-publicly traded corporations, limited liability companies (LLCs), and trusts that typically have no physical presence (other than a mailing address) and generate little to no independent economic value [4].

Since 9 November 2017, a definition of a shell arrangement is also provided in Section 1, paragraph151 of the Law stating that it is “a legal person characterised by one or several of the following indications:

    a) it has no affiliation of a legal person to an actual economic activity and the operation of a legal person forms a minor economic value or no economic value at all, and the obliged entities has no documentary information a its disposal that would prove the opposite;

    b) the laws and regulations of the country where the legal person is registered do not provide for an obligation to prepare and submit financial statements for its activities to the supervisory institutions of the relevant state, including the annual financial statements;

    c) the legal person has no place (premises) for the performance of economic activity in the country where the relevant legal person is registered.”

Most shell companies are formed by individuals and business for a legitimate purpose, such as to hold stock or intangible assets of another legal entity or to facilitate domestic and cross-border currency and asset transfers and corporate mergers. However, as noted in the US Money Laundering Threat Assessment, shell companies have become common tools for money laundering and other financial crimes, primarily because they are easy and inexpensive to form and operate [5].  According to the FATF, shell companies and nominees are frequently misused by bribe donors and recipients to facilitate their illicit transactions. For example, French oil company “Elf Aquitaine” was alleged to have funnelled bribes to Gabon president El Hadj Omar Bongo through his Swiss bank accounts opened in the name of offshore shell corporations [6].  Not infrequently shell companies are used for money laundering purposes and to circumvent sanctions.  For example, in the Russian Laundromat case the Russian, UK, Cyprus and New Zealand based companies were used to launder 20.8 billion  US dollars [7],  in turn North Korea has created a network of shell companies to “circumvent” the restrictions imposed by international sanctions [8].

Since shell companies pose a higher risk with regard to money laundering and terrorist financing, the Law even in its present wording sets particular obligations and restrictions for co-operation with such arrangements:

• if a particular customer is a shell arrangement and the total credit turnover of this customer or several customers sharing one beneficial owner during the past 12 calendar months exceeds 10 million euros, an obliged entity shall, no later than within 45 days from the moment when the abovementioned limit is exceeded, obtain a confirmation signed by the beneficial owner of the customer that he or she is the beneficial owner of the customer (Section 18, Part 4, paragraph2 of the Law);
• An obliged entity is prohibited from executing transactions of any kind with shell banks; furthermore, it is prohibited to create or operate shell banks in the Republic of Latvia (Section 21 of the Law).

The above restrictions apply to all obliged entities as defined by the Law.

Proposed restrictions on interacting with a shell arrangement

The intended amendments propose to supplement the Law with Section 211: “Prohibition of co-operation with shell arrangements” stipulating that credit institutions, payment institutions, electronic money institutions, investment brokerage companies and investment management companies when managing individual portfolios of clients or distributing open-end investment fund certificates shall be prohibited to start or continue business relationships or conduct any occasional transaction with a shell arrangement, if it concurrently meets the criteria specified in Section 1,  paragraph 151 (a) and (b) of the Law.

The annotation of the proposed amendments states that the subparagraphs referred to above set out the most essential criteria for identifying the risks of money laundering and terrorist financing deriving from shell arrangements. Namely, a legal person that is not affiliated to any economic activity and does not prepare and submit any financial statements may potentially enable financial transfers for money laundering.

Who is going to be restricted

Section 3, Part 1 of the Law states that the obliged entities under the Law are persons performing economic or professional activity, namely:

• credit institutions;
• financial institutions;
• tax advisors, external accountants, sworn auditors and commercial companies of sworn auditors;
• sworn notaries, sworn lawyers, other independent providers of legal services when they, acting on behalf and for their customers, assist in the planning or execution of transactions, participate therein or carry out other professional activities related to the transactions for their customer concerning the following:

        - buying and selling of immovable property, shares of a commercial company capital;

        - managing of the customer's money, financial instruments and other funds;

        - opening or managing of all kinds of accounts in credit institutions or financial institutions;

        - establishment, management or provision of operation of legal persons or legal arrangements, as well as in relation to the making of contributions necessary for the establishment, operation or management of a legal person or a legal arrangement;

• providers of services related to the establishment and provision of operation of a legal arrangement or legal person;
• persons acting as agents or intermediaries in immovable property transactions;
• organisers of lotteries and gambling;
• persons providing encashment services;
• other legal or natural persons trading in vehicles, cultural monuments, precious metals, precious stones, articles thereof or other goods, and also acting as intermediaries in the abovementioned transactions or engaged in provision of services of other type, if payment is made in cash or cash for this transaction is paid in an account of the seller at a credit institution in the amount of EUR 10 000 or more, or in a currency the amount of which in accordance with the exchange rate to be used in accounting in the beginning of the day of the transaction is equivalent to or exceeds EUR 10 000 regardless of whether this transaction is carried out in a single operation or in several mutually related operations;
• debt recovery service providers.

The degree of risk for laundering criminal proceeds and for terrorist financing is not the same in all cases. Therefore, a comprehensive risk-based approach is required. It means that when the legislators define the anti-money laundering and counter-terrorist financing requirements and also the measures for ensuring that these requirements and activities are proportionate to the risk level inherent in the obliged entity activities, the size of the entity and the nature of its economic activity, they must take into account the differences between the obliged entities, including the nature and size of their services, as well as the risk level inherent in each sector. Therefore, it is not valid to conclude that the requirements of the Law equally apply to all obliged entities as defined by the Law. Certain requirements set by the Law apply, for example, only to those obliged entities that are legal entities (for example, the obligation to appoint a staff member responsible for complying with the requirements of the Law is binding only for those obliged entities that are legal entities) or only on credit institutions and financial institutions (for example, the prohibition on maintaining anonymous accounts). It may, thus, be concluded that the requirements of the Law apply to all obliged entities as defined by the Law only unless it is specifically indicated that a requirement applies only to certain obliged entities.

Consequently, the prohibition provided in the amendments does not apply to all the obliged entities. The prohibition to co-operate with shell arrangements that meet the two criteria set by the Law has been imposed on credit institutions, payment institutions, electronic money institutions, investment brokerage companies and investment management companies when managing individual portfolios of clients or distributing open-end investment fund certificates.

As indicated before, the prohibition is applicable only if both criteria set out in Section 1, paragraph 151 (a) and (b) of the Law are met. Therefore, the prohibition contained in the amendments to the Law does not apply to the legal entities registered in the Republic of Latvia that are clients of credit institutions and the abovementioned financial institutions, since the regulatory framework of the Republic of Latvia states that they have to prepare and submit financial statements, including annual financial statements on their activities, to the relevant state supervisory bodies. Consequently, a legal person registered in the Republic of Latvia does not meet the criterion set out in Section 1, paragraph 151 (b) of the Law.

It should be noted that the amendments to the Law have been found to be urgent. They were adopted in the first reading on 19 April 2018, whereas the final wording was adopted by the Parliament (Saeima) on 26 April 2018. The changes will take effect on the day following the day when the amendments are announced.

[1] http://www.db.lv/zinas/lursoft-sadarbiba-ar-caulu-kompanijam-bus-japartrauc-apmeram-20-000-latvijasuznemumu-473879

[2] FATF Guidance: Transparency and beneficial ownership, October 2014, pg. 6.

[3] The Wolfsberg Correspondent Banking Due Diligence Questionnaire (CBDDQ), Glossary, 22 February 2018, pg. 14. 

[4] Department of the Treasury, Financial Crime Enforcement Network: Guidance FIN-2006-G014, issued on November 9, 2006, Subject: Potential Money Laundering Risks Related to Shell. 

[5] Ibid.

[6] OECD: Behind the Corporate Veil: Using corporate entities for illicit purposes, 2001, pg. 35.  

[7] https://www.occrp.org/en/laundromat/the-russian-laundromat-exposed/

[8] http://uk.businessinsider.com/north-korea-why-un-sanctions-not-working-2017-9