Over the past few years, the United Arab Emirates has witnessed an increase in awareness and significance of environmental, social and governance (ESG) issues. While businesses in the UAE have begun to acknowledge that conscious efforts towards ESG compliance is imperative for growth and longevity of their business, the question remains whether ESG compliance can truly be said to now form a part of the UAE compliance ecosystem.
ESG significance on the rise: Key Factors
M&A has been on a steady rise in the MENA region (with the UAE continuing to demonstrate resilience despite global headwinds). ESG compliance has become a point of concern for investors, who are frequently concerned to fully investigate and understand the nature and extent of ESG compliance by UAE targets.
In cases where such compliance can be successfully demonstrated, investors derive comfort regarding sustainable financial performance and the ability of the management to identify and account for long term business risks. On the other hand, a lack of transparency concerning ESG compliance often results in questions regarding the sustainability of the business and management’s lack of sensitivity to an issue that is increasingly important to investors and stakeholders.
As a consequence, ESG rating agencies are often engaged by potential investors for the purposes of conducting an ESG diligence which has led to the “ESG Score/Ratings” becoming increasingly significant in evaluating, and to an extent negotiating certain contours of an investment. In most cases, the ESG score/rating will have a direct impact on the valuation of a target.
Good-to-have or must-have: Where do we stand?
While the UAE business ecosystem awaits further and more granular regulation of ESG matters, the question arises whether UAE businesses should of their own initiative, take cognizance of an issue that is now at the core of many investment mandates. Improved capability of risk management, higher brand value, advantage over non-compliant competitors and potentially reduced business costs resulting in higher valuation are only a few of the factors that influence the decision-making process. ■
The UAE introduced the Economic Substance Regulations in April 2019 (later amended by Cabinet Resolution 57 of 2020 (ESR) and Ministerial Decision 100 of 2020).
The relatively new regulations have imposed a number of reporting requirements for virtually all private companies in the UAE. Despite this relative infancy, the Ministry of Finance has already started issuing heavy fines for companies which are not compliant with the regulations.
In applying these fines, the Ministry of Finance will apply the Economic Substance Test set out in Article 6 of the ESR. In essence, a company must demonstrate that:
(a) it conducts the necessary core income-generating activity within the UAE;
(b) the relevant activity is directed and managed in the UAE; and
(c) there is an adequate presence (employees, assets) within the UAE.
The regulations specifically require an entity to show that the relevant activity is “directed and managed” in the UAE. In order for a relevant activity to be “directed and managed” in the UAE, an adequate number of board meetings must be held and attended by directors in person in the UAE. The ESR does not specifically set out what would constitute an “adequate” number of board meetings for the purposes of the “directed and managed” limb. The only guidance provided is that what is adequate will depend on the relevant activity being carried on as well as the level of income earned by the company in question.
The Ministry of Finance has recently fined a company tens of thousands of dirhams for failing to meet the “directed and managed” test, apparently due to the lack of evidence of the company (a subsidiary of a larger group) holding substantial board meetings. It appears that “cosmetic” board meetings held in view of satisfying this test may not be sufficient to convince the Ministry of finance that a company was being directed and managed in the UAE.
A subsequent appeal on the issue was also rejected. Penalties for subsequent failings can be hundreds of thousands of dirhams.
In order to avoid such pitfalls, it is recommended that companies genuinely attempt to direct their businesses from within the UAE rather than becoming satellite holding companies for businesses conducted in other countries. The UAE Ministry of Finance is expected to increase their supervision on companies situated in the UAE as it becomes a global financial hub in line with international reporting standards. ■
Now, more than ever, sanctions lists are growing daily, and therefore navigating the challenges related to compliance is becoming more complex. In the region, prominent US sanctions already exist with respect to Iran, Syria and Yemen. There has been talk of US sanctions against Iraq and Turkey.
A prime example of prominent sanctions are those that the United States on November 5, 2018 fully re-imposed on Iran. These sanctions had been previously lifted or waived under the Joint Comprehensive Plan of Action (or ‘Iran deal’). Given the recent tensions between the US and Iran, the US is aggressively continuing its campaign of maximum financial pressure on the Iranian regime and intends to strenuously enforce the sanctions that have come back into effect as well as newly announced sanctions.
While historically enforcement actions have been more prevalent in the financial services sector, regulatory bodies are increasingly turning their attention to other industries which have recently been subjected to significant fines. The US Department of the Treasury has issued 22 enforcement actions along with a record of USD1.3 billion in total penalties in 2019 alone.
Consequently, sanctions and compliance continue to remain critical factors for businesses across all sectors.
While not exhaustive, the following are some proactive measures which should be taken by companies to mitigate the risk of violating sanctions:
- Understanding international sanctions regimes: Companies should obtain an appropriate level of understanding of international sanctions regimes, seek information from professionals to the extent necessary, and conduct research to make a determination as to the legality of their transactions under the relevant sanctions’ laws. Entities should check with their regulators regarding the suitability of specific programs to their unique situations. For example, the US Office of Foreign Assets Control (OFAC) issues public advisories on important issues related to sanctions, and while these documents may focus on specific industries and activities, they should be reviewed by any party interested in OFAC compliance.
- Due diligence: It is important for companies to conduct continuous due diligence on their entire supply chain, including customers and clients (and their respective partners and affiliates) to ensure the continued sanctions compliance of all stakeholders so that none of them become subject to sanctions or penalties. All stakeholders should be subject to periodic KYC checks.
- Risk assessment: The assessment may include risks posed by clients, customers, products, services, supply chain, intermediaries, counterparties, transactions, and geographic locations. For example, an anti-bribery/anti-corruption risk assessment, may be a good foundation for a sanctions risk assessment.
- Sanctions compliance officer: Companies should designate an individual with the primary responsibility for integrating the company’s policies and procedures into the daily operations of the company or a dedicated “sanctions compliance officer”. The sanctions compliance officer should be charged with assisting in the development of a compliance program and to monitoring and verifying that procedures are being followed.
- Formulate a sanctions compliance program: Companies should develop and implement a sanctions compliance program and policy manual in order to understand what actions can and cannot be taken. There is no single compliance program suitable for every company. It is further recommended that the sanctions compliance program be subject to regular review and, when necessary, routinely updated.
- Internal controls: The purpose of internal controls is to clarify expectations, define procedures and processes pertaining to sanctions compliance (including reporting and escalation chains), and minimize the risks identified by the company’s risk assessment. Policies and procedures outlining the sanctions compliance program should be easy to follow, capture the organization’s day-to-day operations, and designed to prevent employees from engaging in misconduct.
- Training: The training program on the company’s sanctions compliance program should be provided to all appropriate employees and personnel (and, in particular, business units operating in high-risk areas) on a periodic basis, and at a minimum, annually.
- Use of Technology: Invest in software or update sanctions screening software to comply with sanction regulations.
- Reporting: Companies should put appropriate procedures in place to identify, escalate, and report transactions that are in violation of sanctions regulations (voluntary self-disclosure).
- Contractual safeguards: Companies should include contractual exit rights in all agreements with their counterparties whereby, should enforcement action be taken against a counterparty, the company has the right to remove itself from the transaction.
- Snap-back safeguards: Measures taken by companies should include specific sanctions-related force majeure provisions and sanction termination and wind-down provisions which can provide contractual protection in the event that sanctions are re-imposed in the case of snap-back.
- Documenting: It is imperative for corporates to document and report all sanctions compliance efforts (for example, keep a written record of their screening policy and be able to justify the timescales and frequency of screenings). Their systems and checks should ensure a documented trail of all actions taken in such matters.
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A company in noncompliance may be opening itself to adverse publicity, fines, and even criminal penalties (if violations are other than inadvertent). Taking preemptive actions would enable a company to show that it has proactively taken steps to structure its operations to ensure that it is compliant with sanctions in an open and transparent manner. Such preventative measures would significantly reduce the potential risks of costly sanctions violations and provide a company with a competitive advantage of being in a better position to navigate sanctions. ■
Further to our previous inBrief dated 7 July 2019, which discussed UAE Cabinet Resolution 31 of 2019 Concerning Economic Substance Regulations (the UAE Economic Substance Regulations or the Regulations), and inBrief dated 10 October 2019, which discussed the Guidance on UAE Economic Substance Regulations issued by the UAE Ministry of Finance, Cabinet Decision No. 58 of 2019 has now designated the regulatory authorities (the Regulatory Authorities) to regulate compliance with the UAE Economic Substance Regulations.
Under the Regulations, a Licensee engaged in any one of the nine Relevant Activities listed therein must meet an Economic Substance Test in relation to each Relevant Activity carried on by such Licensee. This includes but is not limited to demonstrating that its State Core Income-Generating Activities are carried out in the UAE.
The Regulations contemplated that a yet-to-be designated Regulatory Authority (the Regulatory Authority under the Regulations is different from the Competent Authority) would regulate compliance with the Regulations. The Regulations read as if there would be a single Regulatory Authority for the entire UAE; however, the Guidance on Economic Substance Regulations, in certain places, contemplated the possibility of more than one Regulatory Authority.
Cabinet Decision No. 58 of 2019 has appointed a number of different authorities as the Regulatory Authority, depending on the nine Relevant Activities and where these Relevant Activities are undertaken.
The concerned Regulatory Authorities are as follows:
– UAE Central Bank for banking activities regulated by the Bank.
– Competent authority in the Financial Free Zone for banking activities exercised in the latter.
– Insurance Authority for the insurance business regulated by the Insurance Authority.
– Competent authority in the Free Zone for the insurance activities exercised in the latter.
– Competent authority in the Financial Free Zone for the insurance activities exercised in the latter.
Investment Funds Management
– Securities and Commodities Authority (SCA) for the investment funds management regulated by the SCA.
– Competent authority in the Free Zone for the activities of investment funds management exercised in the latter.
– Competent authority in the Financial Free Zone for the activities of investment funds management exercised in the latter.
Financial Leasing Activities
– UAE Central Bank for the financial leasing activities regulated by the bank.
– Competent authority in the Free Zone for the financial leasing activities exercised in the latter.
– Competent authority in the Financial Free Zone for the financial leasing activities exercised in the latter.
– Ministry of Economy for the headquarters’ works and activities regulated by the Ministry.
– Competent authority in the Free Zone for the headquarters activities exercised in the latter.
– Competent authority in the Financial Free Zone for the headquarters activities exercised in the latter.
– Ministry of Economy for the shipping activities regulated by the Ministry.
– Competent authority in the Free Zone for the shipping activities exercised in the latter.
– Competent authority in the Financial Free Zone for the shipping activities exercised in the latter.
Holding Company Activities
– Ministry of Economy for the holding company activities regulated by the Ministry.
– Competent authority in the Free Zone for the holding company activities exercised in the latter.
– Competent authority in the Financial Free Zone for the holding company activities exercised in the latter.
Intellectual Property Activities
– Ministry of Economy for the intellectual property activities regulated by the Ministry.
– Competent authority in the Free Zone for the intellectual property activities exercised in the latter.
– Competent authority in the Financial Free Zone for the intellectual property activities exercised in the latter.
Distribution and Services Centres
– Ministry of Economy for the distribution and services centres activities regulated by the Ministry.
– Competent authority in the Free Zone for the distribution and services centres activities exercised in the latter.
– Competent authority in the Financial Free Zone for the distribution and services centres activities exercised in the latter.
The appointment of the Regulatory Authorities means that businesses licensed in the UAE should fast track an assessment to determine if they are subject to the UAE Economic Substance Regulations. It remains to be seen what approach such Regulatory Authorities will take in enforcing the UAE Economic Substance Regulations. ■
Charles Laubach shares his professional opinion on the current issues on anti-corruption compliance in the UAE.