13 2015 Elena Ignatyeva/AP/SIPA Elena Sanctions against : Evasion, compensation and overcompliance by Cameron Johnston

In the popular imagination, sanctions are akin only displace it onto others, exacerbating ten- to arrows at an archery range: fired by archer sions between competing factions. Therein lies A, they fly in a regular arc to hit ‘target’ B with the danger. varying degrees of accuracy. Attractive as this model may be, however, it does scant justice Some sanctions hit the bull’s-eye, others go to the reality of how sanctions work. For tar- astray. Sanctions also sometimes overshoot gets are less like static archery butts than live their mark or veer off in crosswinds to hit in- game, ducking and weaving to avoid projec- dividuals and companies which are innocent of tiles. In Russia, these feints have taken a variety any wrongdoing. These companies may find it of forms, including exploiting loopholes, alter- more difficult to access capital markets, struggle ing share structures and using tax havens with to recapitalise their debts and cut back on in- the aim of concealing beneficial ownership. If vestment, hampering economic growth. These sanctions do not change direction in the course three themes, evasion, compensation and over- of their flight, they will miss their target or sim- compliance, are all visible in the case of Russia. ply deliver glancing blows. Evasive measures But the archer is no sadist. Inflicting pain on the target is a means to an end, the end being Bank Rossiya offers a case study in how compa- a change of behaviour on the part of a third nies close to the Kremlin succeeded in evading player, the state. If close allies of an autocratic sanctions, at least for some time. Bought in 1991 leader see their fortunes endangered by erratic by close allies of , including Yuri behaviour, they might apply pressure to change Kovalchuk, it expanded rapidly in the 2000s by his foreign policy. The problem, of course, is buying state assets at knock-down prices to be- that he too is a dynamic actor. As fast as the come the 17th largest bank in Russia at the start sender can inflict pain, the leader can deliver of 2014. Described by the US Treasury as ‘the analgesics in the form of new contracts, thereby personal bank for senior officials of the Russian buying his allies’ continued loyalty. If his econ- Federation’, it was the first Russian entity to be omy is not growing, however, the autocrat can- blacklisted when the US introduced sanctions not make the pain disappear altogether: he can on 20 March 2014.

European Union Institute for Security Studies May 2015 1 As an investigation by The Economist showed, The answer is that it concealed beneficial own- the bank protected its subsidiaries by exploit- ership. Since RNCB was sold in March 2014 ing loopholes in the sanctions legislation. and changed hands again in early 2015, it ap- Until March 2015, it held a controlling stake peared to be independent of Bank of . (51%) in the insurance company, Sogaz. But In reality, the two banks were as connected as with sanctions looming, it transferred 2.5% they ever were, since Bank of Moscow’s direc- of its shares to a newly created subsidiary. As tors continued to negotiate on behalf of their a result, Sogaz was not listed, because, under erstwhile subsidiary. the rules as they then stood, a firm owned by multiple targets could not itself be listed unless Keeping it in the family one of those targets individually held a 50% stake. The US Office for Foreign Assets Control As well as altering share structures and conceal- (OFAC) closed this loophole in August 2014, ing beneficial ownership, targets may protect so that the combined shares of targeted entities their assets by passing them on to family mem- became the deciding factor, but before it could bers, with the hope, perhaps, of resuming con- do so, Bank Rossiya acted again. trol when sanctions are lifted. Hartwall Arena, a music venue in , was one such asset. On 11 August 2014, just before the new rules Until 2014, it was half owned by Timchenko took effect, Bank Rossiya transferred a por- and half by the Rotenberg brothers, childhood tion of its shares in Sogaz to a subsidiary of friends of President Putin. Since all three of , a company which is not subject to them were soon to be blacklisted, the venue’s full sanctions. The stakes of fully sanctioned future appeared to be in doubt. In the event, entities therefore added up to less than 50% Arkady and Boris Rotenberg saved it by trans- and Sogaz avoided sanctions. ferring all of their shares to Boris’s son, Roman, and arranging for Timchenko to sell Roman a Second, Russian targets have sought to shield 0.5% stake. Sanctioned individuals now owned their subsidiaries by relinquishing (or at least only 49.5% of the arena, allowing it to continue appearing to relinquish) ownership. Half of the operating unimpeded. shares in , one of the world’s largest oil trading firms, were until March 2014 owned by repeated the trick later on another Putin loyalist, . On in 2014. Bloomberg reported in October that the very day that he was blacklisted by the US, he had transferred TPS Real Estate Holding, a however, Timchenko company that builds sold all his shares to shopping malls, to his his Swedish business ‘...although Putin’s inner circle became son Igor. He also an- partner. He is also re- nounced that he had ported to have sold his poorer in absolute terms, they grew disposed of his stake stake in the Finnish stronger in relative terms as the in OAO Mostotrest, airliner Airfix and in Russia’s largest builder airport business termi- president rewarded loyal acolytes with of roads and railways, nals in St Petersburg a larger slice of a shrinking pie.’ only for the very same and Moscow. The sus- Igor to appear on com- picion, of course, is pany documents as a that although ownership changes on paper, the 26% shareholder. Because the family members previous owners continue to control the com- of sanctioned individuals are legally obliged to pany in practice. The case of Russian National declare that they are related to ‘politically-ex- Commercial Bank (RNCB) shows how this posed persons’, however, and banks often give might be achieved. them a wide berth, it is not clear whether this tactic always works. At the start of 2014, RNCB was a small sub- sidiary of the Bank of Moscow and the 587th Despite all this ducking and diving, however, largest bank in Russia. But it took advantage of Russia’s wealthiest men incurred stinging loss- Russia’s annexation of Crimea to expand rap- es in 2014 due to the combined effect of fall- idly, to the extent that by January 2015, it had ing oil prices, structural economic problems 200 branches on the peninsula and was pro- and Western sanctions, with the twenty rich- viding financial services to the regional author- est losing a combined total of $62 billion. But ities. How did it evade sanctions, then, after its although Putin’s inner circle became poorer in parent company was blacklisted in July 2014? absolute terms, they grew stronger in relative

European Union Institute for Security Studies May 2015 2 terms as the president rewarded loyal acolytes It would appear, then, that sanctions have sped with a larger slice of a shrinking pie. up the concentration of resources in the hands of a coterie of Putin loyalists. Bloomberg reports Let the good times roll… that between March and December 2014, firms connected to Gennady Timchenko and Arkady Bank Rossiya once again exemplified the trend. Rotenberg won 309 billion roubles (around On 10 April 2014, an obscure body called $8.1 billion) in government contracts, 12% the Market Council voted to transfer financial more than in the whole of 2013. In a country business related to Russia’s wholesale electric- in which the state can make or break a person ity market from Alpha Bank to Bank Rossiya at will, a businessman’s absolute wealth matters in a deal that promised rich rewards for the less than his position in the pecking order. By sanctioned bank. The business is worth 4 bil- cementing his allies’ position at the top of the lion roubles a year, only slightly less than Bank food chain, Putin calculated correctly that they Rossiya’s total net profit in 2013. All the evi- would swallow sanctions without demanding dence suggests, meanwhile, that the decision a change of course. Whereas a few public fig- was taken at highest state levels. Igor Sechin, ures have openly criticised government policy, head of Rosneft and long-time friend of Putin, most notably former Prime Minister Yevgeny is chairman of the board, while the loser in this Primakov and former Finance Minister Alexei deal, Alpha Bank, is headed by an oligarch who Kudrin, no one at the top has voiced any op- has made no bones about his desire to diversify position. his portfolio away from Russia. But although Putin’s strategy has been effective Putin has bought the loyalty of sanctioned oli- in the short term, it might prove dangerous in garchs by channelling existing business in their the long run. In times of growing scarcity, Putin direction but his ‘foreign adventures’ have also will try to feed his followers by starving their opened up new opportunities for faithful aco- rivals. Last October, the state expropriated lytes, not least in Crimea. The departure of vir- Vladimir Yevtushenkov’s oil company Bashneft tually all Ukrainian banks from the peninsula amid rumours that it would be transferred to after March 2014 opened up a vacuum, which Rosneft. Yevtushenkov was placed under house Bank Rossiya helped to fill. It opened the first arrest and saw 90% of his wealth evaporate in four of thirty projected branches in June 2014, the space of twelve months. while Timchenko’s Volga Group announced last May that it had bought a further 17 branches If Russia’s economic crisis deepens, as now from a European bank. seems likely, Putin might be tempted to carry out further expropriations, alienating some oli- Rossiya was not the only bank to benefit from garchs and stoking tensions between compet- the state’s growing involvement in tenders and ing clans. takeovers. SMP bank, which is majority owned by the Rotenberg brothers, was invited in May Overcompliance and its effects 2014 to take over three struggling competitors, Mosoblbank, Investment Republican Bank If sanctions (and the Kremlin’s responses to (Inresbank) and Finance Business Bank. To that them) mean different things for different oli- end, it secured a large loan at a very favourable garchs, their effects on lending and business rate of interest and later appealed to the Deposit deals have been more clear-cut. The recent Insurance Agency for further funding. contretemps between and the UK government reveals the potential for sanc- And although the much-vaunted pivot towards tions, like errant arrows, to damage the inter- China is unlikely to materialise any time soon, ests of businessmen who are not beholden to the grand infrastructure projects required to sanctioned parties. bring it about will line the pockets of Putin’s inner circle. Arkady Rotenberg is set to ben- Meanwhile, the steep decline in Western lend- efit most from the construction of the Power of ing to Russian businesses, including ones that Siberia gas pipeline to China, just as his com- are not subject to sanctions, is likely to slow pany cashed in on the annex- down economic growth in the medium to long ation of Crimea. It recently won a huge con- term. tract to build a 19km bridge across the Strait, which separates Crimea from mainland Sanctions alone cannot explain why Western Russia. lending to Russia has dried up but they certainly

European Union Institute for Security Studies May 2015 3 played their part. Russian businesses secured Sea supplies. This explanation struck many ob- $38 billion in dollar-denominated loans in servers as odd because, although Fridman is 2012, and $52 billion in 2013, but only $9.5 Russia’s second richest man, he is fiercely in- billion in 2014. It is not only sanctioned firms dependent and has resisted Putin’s calls to in- that are feeling the freeze. ING bank pulled out vest the proceeds from the sale of TNK-BP in of a loan to Techsnabexport JSC, a nuclear fuel Russia. exporting company in September, even though this subsidiary of Rosatom (State Atomic Energy Large state-owned behemoths like Rosneft can Corporation) is not included on any blacklist. weather the economic storm for a while by tapping into the National Welfare Fund – but Where Russian companies nevertheless did suc- smaller companies in Russia’s shrinking pri- ceed in finding funding, they often had to sign up vate sector have no such luck. And although to more stringent conditions. Techsnabexport financial cooperation with China is on the rise, later secured a loan from Deutsche Bank, but Sinologist Alexander Gabuev argues that ‘in the only for $150 million, not $500 million, and short term, China cannot become a real alter- for three, not five years. In May 2014, - inter native to Russia to replace the West as a source national creditor stipulated that Russian firms of capital’. Sanctions therefore act as a brake would have to repay their debts immediately if on future economic growth and may change they or their shareholders fell under sanctions. the Kremlin’s calculus in the medium to long term. But why did Western banks turn off the tap so indiscriminately in 2014, when sanctions are Dynamic targets, dynamic instruments? supposed to be precise, targeted instruments? Lower growth prospects were no doubt a factor These complex patterns of evasion, compen- but fear of the US Treasury’s Office for Foreign sation and overcompliance serve as useful re- Assets Control (OFAC) played a part as well. minders that sanctions often work differently Under so-called ‘extraterritoriality clauses’, in practice than in theory. States that are likely OFAC has the power to prosecute any firm to be hit by Western sanctions will not allow with a US branch that trades, wittingly or un- individual targets to suffer and become critics wittingly, with a sanctioned entity. It does not of government policy. But the measures such hesitate to wield this power, as the prosecution states take to compensate targets may well of BNP Paribas demonstrates. open up new divides among ruling elites and store up problems for the future. Multinational firms doing business in Russia therefore have to invest in the complex due Moreover, the example of Russia shows that diligence required to ensure that their Russian so-called ‘targeted sanctions’ are less targeted counterparts are not linked to sanctioned enti- than senders might acknowledge them to be. ties. Even if they find that a deal is technically This is not necessarily a bad thing. Sanctions legal, they might still hesitate. ‘If you’re dealing have indirectly harmed Russian companies that with a company that may be 33% owned by are not included on any blacklist – lamentable designated parties, I would sweat a little bit’, perhaps, but a small price to pay if they help to said OFAC’s Deputy Director at a Dow Jones rein in Putin in Russia’s near abroad. conference in April 2014. Such veiled threats may well have worked. Kroll, a corporate in- vestigations company, reported in December Cameron Johnston is a Junior Analyst at the that requests for due diligence work were tail- EUISS. ing off, suggesting that many firms had decided to avoid the Russian market altogether. And individual companies have been tainted by their association with Russia, despite having few links to the Kremlin. In March 2015, the UK government announced that it would try to block Mikhail Fridman’s takeover of Dea, the oil and gas arm of the German company RWE. Dea extracts oil and gas from the North Sea and the UK authorities voiced concern that future sanctions against Russia might endanger North

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© EU Institute for Security Studies, 2015. | QN-AK-15-013-2A-N | ISBN 978-92-9198-269-1 | ISSN 2315-1110 | DOI 10.2815/27414