“Non-fictitious transactions, and transactions with signs they are fictitious” is a little understood pun but, in fact, this is how we can describe yet another recommendation to commercial banks from the National Bank of Ukraine. In late May of this year, the NBU sent a letter to banks in Ukraine – Letter no. 25-0008 / 37888 “On the criteria for identifying clients, whose financial transactions are fictitious”, dated May 26, 2017 (hereinafter referred too as the Letter dated May 26, 2017). This document recommends that banks more thoroughly study the operations of their clients and identify them as looking fictitious. This does not only pertain to transactions carried out for the purpose of the so-called “withdrawal” of foreign currency by Ukrainian companies outside of Ukraine during a crisis period on the currency market – it also applies to transactions by any client of a Ukrainian bank, including transactions carried out in Ukrainian hryvnia.
The NBU sent all commercial banks in Ukraine the aforementioned Letter dated May 26, 2017 with the objective that they would properly fulfill the role of being the primary subjects of financial monitoring in accordance with the Law of Ukraine “On prevention and counteraction to legalization (laundering) of proceeds from crime, terrorist financing and the financing of the proliferation of weapons of of mass destruction” (hereinafter referred to as the Law on counteracting legalization). In particular, in order to prevent the laundering of criminal proceeds and the financing of terrorism, the chief banking regulator has created and provided banks with as many as 15 criteria, which should be used to draw the conclusion that a client’s operation looks fictitious, and consequently the servicing bank is obligated to investigate further and, if necessary, request that other banks exchange information.
Due to the fact that the required additional activities of banks to analyze clients’ transactions may be massive and also that this could potentially pertain to any company in future, we have carefully analyzed all of the criteria the NBU has specified for identifying those clients and financial transactions seen as appearing fictitious. Here we will quickly list our “TOP-3” for those that we deem the most controversial among them.
Third place on our list, which ranks as the sixth indicator in the NBU’s list, is the criterion that the “resources do not correspond to the volume of activities implemented”. According to the NBU, if a company has the following characteristics, this should be seen as suspicious:
- There is only one person or several people on the company’s payroll.
- The director, accountant and founder of a client company is one and the same person.
- Unformed authorized capital or minimum capital, for example, if the client’s authorized capital is less than USD 10,000.
- The client’s turnover of cash flows amounts to millions of hryvnia.
- There have been instances on the client’s accounts of financial transactions worth millions of hryvnia, which are identified as being for the “payment for the goods / services excluding VAT”.
- The purchase and sale of securities that are issued by a company included in a list of issuers that appear to be fictitious (“junk” securities), etc.
Without considering the latter ‘red flag’ characteristic, the first five could easily describe the activities of a regular IT company, which tends to involve self-employed professionals and have just one staff member (a director). Also, the provision of services for the development and testing of program software is genuinely not subject to VAT, in accordance with the tax laws of Ukraine. Therefore, according to this classical scheme, such a company would, at first sight, be considered by a servicing bank as carrying out fictitious business transactions.
Second place in our “hit parade” was the criterion of “Providing others the right to manage their own accounts”. This criterion is specified in the NBU’s list as number “13” and this is not surprising, since a company suspected by a bank should “provide the right to operate an account to a non-related third-party (who are not company officials and do not receive wages from the company), on the basis of the power of attorney”. Indeed, the situation looks ambiguous from the bank’s perspective when the person controlling a third party’s funds is not in an employment relationship with the entity.
Unfortunately, the NBU is, thus far, limited to an employment relationship as the legal basis for a company’s management, where the contract model, in practice, is also a quite common mechanism, and in this case, the bank will actually receive this same power of attorney from the client, which should be a “red” signal for him in terms of carrying out financial monitoring.
Finally, the top ranking particularity in our rating sees a tie between two criteria from the NBU’s list. These include the no. 1 and 2 criteria from this list, which are that “The main activity is wholesale trade” and “the period of the client’s existence” respectively.
The first on both our and the NBU’s list can be characterized as follows:
- The client’s main type of activity, according to its constituent documents, is non-specialized wholesale trade (i.e. 46.90 according to the Trade Classification System-2010) and/or it involves a wide-spanning list of registered activities, characterized by separate specific areas of activity.
- The client is often not the manufacturer of the goods it deals in, but instead acts as an intermediary. In particular, it carries out the purchase and sale of various product groups”.
We do not rule out the reality that, in practice, many fictitious companies choose Trade Classification number 46.90 as their main area of activity and also have a number of other classification numbers. However, in real life, there are many legitimate companies, for whom this is absolutely their sphere of registered activity. Thus, as a result of a quick and simple request for information search on the internet, we learned that such state-owned enterprises as the state-owned company “Ukrspetsexport” (code EDROPU 21,655,998) and its subsidiary “Promoboroneksport” (code EDRPOU 25662328) also have Trade Classification number 46.90 as their main registered activity, as well as a number of other classification numbers, the list of which is wide ranging. According to the second particularity, indicated by the NBU, such a company is often an importer of products manufactured by the parent company, rather than producing them itself.
The particularity ranking second on the NBU’s list, which is tied for first place in our own TOP-3 is the criterion, defined as “the period of the client’s existence”. It is also interesting that the NBU does not apply such a legal concept as a company’s period of registration, i.e. when it was legalized as a legal entity in accordance with the requirements of Ukrainian legislation. However, the particularity deemed as suspicious by a Ukrainian bank is that the client has “a short period of existence (of activity), which, as a rule, does not exceed the tax reporting period (e.g. one quarter), in order to avoid audits by the regulatory authorities”. We will not engage in polemics as to how companies that are newly established in Ukraine should conduct themselves, including with regards to foreign investment, but should only note that this criterion should carry no independent meaning or practical application. After all, every business, even those that are world famous, begins activity in a new country with its registration and so every entity ultimately does not have a long history of activity at some stage.
We would like to note that in no case does the analysis we have conducted and conclusions presented in this article deny or negate the role and purpose of servicing banks’ financial monitoring of clients’ transactions. At the same time, we hope that the perception of the NBU’s recommendations and their practical application by commercial banks will not put the Ukrainian business community in a strange situation, although they should be prepared to clarify that their activity is indeed not of a fictitious nature.
Author: Tatiana Prichepa