Hypothetical Control’ in UK Sanctions: Nonsense on Stilts?

One of the most difficult issues in UK sanctions is their application to companies that are ‘owned or controlled’ by a designated person. In BCL’s response to the government’s call for evidence on an aspect of these provisions, John Binns makes the case for a broader review.

Background

Legal context

Since the days when the UK’s sanctions framework derived from its membership of the EU, HM Treasury (since 2016, through its Office for Financial Sanctions Implementation (OFSI)) has been responsible for the implementation of financial sanctions. This includes the administration of a regime to enforce financial sanctions by way of monetary penalties, the consideration of licence applications, and the receipt of various reports.

As part of the process of the UK’s exit from the EU, the Sanctions and Anti-Money Laundering Act 2018 (SAMLA) enabled the Foreign, Commonwealth and Development Office (FCDO) to make sanctions regulations, which were intended to replicate and build upon the EU’s equivalents.

Among other things, SAMLA enables the prohibitions created by regulations to apply not just to conduct in the UK but also to conduct overseas by a ‘UK person’ (which includes any UK citizen or UK-incorporated company). It also (in section 44) provides for an immunity from civil liability for any act 'done in the reasonable belief that [it] is in compliance with' those regulations.

Ownership and control

The standard financial sanctions provisions of these regulations enable the FCDO to designate persons according to certain criteria, which in turn refer to scenarios where an entity (C) is ‘owned or controlled, directly or indirectly’ by a person (P) (broadly, C can fulfil the criteria either in its own right, or because P can). They then go on to define that phrase with reference to two conditions.

The first condition (which broadly follows the equivalent concept in the EU) is where P holds (directly or indirectly) more than 50% of the shares or voting rights in C (in the EU it is 50% or more), or the right to appoint or remove a majority of its board of directors. The detail of how to define this condition is contained in interpretative schedule, which refers among other things to joint and nominee arrangements.

The ‘hypothetical test’

The second condition (which goes above and beyond the EU’s equivalent) refers to scenarios where ‘it is reasonable, having regard to all the circumstances, to expect that P would (if P chose to) be able, in most cases or in significant respects, by whatever means and whether directly or indirectly, to achieve the result that affairs of C are conducted in accordance with P's wishes.’

This is clearly a very broad test. The underlined words are what the Call for Evidence refers to as the ‘hypothetical element’ of the second condition (or the ‘hypothetical control’ test). The very narrow subject matter of the exercise appears to be the impact of this element on OFSI’s functions (it does not appear to refer to the second condition more generally, nor to the relevance of hypothetical control where the FCDO designates companies).[1]

Prohibitions and penalties

The impact arises because the standard provisions go on to prohibit dealings with funds or economic resources that are owned, held or controlled by (and making funds or economic resources available to or for the benefit of) either a designated person (DP) or an entity that is ‘owned or controlled, directly or indirectly’ by a DP (according to either of the two conditions).

The impact also extends to obligations to report assets caught by the ‘dealing’ prohibitions, and (for some firms) suspected breaches.

Importantly, requirements for the person to know or have ‘reasonable cause to suspect’ that the person or entity is a DP (or owned or controlled by one) do not apply for the purpose of monetary penalties.

For the regime relating to Russia and its invasion of Ukraine, there is also a specific prohibition on legal advisory services whose object or effect is a breach of sanctions (or an overseas act that would breach sanctions, but for jurisdiction). This could include, for example, advising on a transaction that involved an entity caught by the ‘hypothetical control’ test.

The test in practice

In practice, what all this means is that individuals and businesses caught by the jurisdiction of these regulations are at risk of monetary penalties where they deal with entities that meet either of these broad conditions, whether they have cause to suspect this or not. Those who are regulated (and/or subject to the additional obligations of money-laundering regulations (MLRs) will have additional causes to worry.

Conversely, if the individual or business acts in a way that would otherwise attract civil liability (for instance by breaching a contract), they will have the protection (in UK claims at least) of the immunity in SAMLA’s section 44 (subject to showing they had a ‘reasonable belief’ that sanctions applied).

In many cases, therefore, the balance of risks will prompt a UK business (regulated or not) to err on the side of refusing or ceasing business with (and, where appropriate, to freeze the assets of, and report suspected breaches involving) an entity that may be caught by sanctions. The question behind the Call for Evidence is what difference the ‘hypothetical control test’ makes to these judgement calls.

The Hellard typology

Inevitably, the definition of ‘owned or controlled, directly or indirectly’ in sanctions regulations has been considered in various reported court judgments, including that of Deputy Judge Nicholas Tompsell in Kevin Hellard & others v OJSC Rossiysky Kredit Bank and others [2024] EWHC 1783 (Ch)[2]. This suggested a typology of control in four categories (de jure control; ‘actual, present’ de facto control; ‘potential, future’ de facto control; and ‘potential, future’ de jure control). (For those with less Latin than judges or law students, de jure means ‘based on a legal right’; de facto just means ‘in fact’.)

Broadly, it might be said that the first condition in the regulations refers primarily to de jure control (both ‘actual’ and ‘potential future’), and the second to de facto control. The ‘hypothetical test’ (as defined in the Call for Evidence) refers specifically to ‘potential, future’ de facto control. 

Our Response

Why we are responding

BCL is responding to the Call for Evidence as a law firm that is regularly consulted for advice on whether entities are caught by sanctions. Our clients may be advisers, counterparties, customers or suppliers. In some cases, we may be instructed by a DP or someone (said to be) associated with one, or by the entity itself. As the detail of the information we receive and the advice we give is subject to legal professional privilege (LPP), our responses are necessarily at an aggregate level and cannot go into specific examples. We do not provide transactional services and are not subject to the MLRs, but we are subject to reporting obligations under sanctions regulations (except for information covered by LPP).

The questions

2.11 How often does a DP’s hypothetical ability to exercise control feature in your sanctions casework? In what proportion or volume of cases does this consideration materially affect the outcome, such as resulting in the test being met?

BCL is often asked for opinions on whether companies are caught by sanctions. While the ‘hypothetical control test’ necessarily always features in the analysis, it is rarely if ever significant, still less determinative. In part this is because of the inherently nebulous nature of the second condition (broadly, de facto control) generally, which will almost certainly not be possible to determine based on documentary evidence (or even, except in rare cases, by suitably qualified witnesses who are prepared to provide evidence in writing). In a scenario where the available facts comfortably rule out actual, current de facto control (and any de jure control), the question of hypothetical control is likely to be determined largely or entirely by inference or supposition.  

In practice, this element of the test is one of several factors that lean heavily towards a presumption, whenever the question is raised, that a company linked to a DP is caught by sanctions. Based on our experience, hypothetical control is unlikely ever to weigh more heavily than (for example) the prospect of criminal offences (for individuals or corporates), including circumvention, strict-liability monetary penalties, regulatory or reputational risk, and/or the immunity from civil liability provided by SAMLA section 44.

In some cases, clients will also be influenced by the prospect of secondary sanctions (that is, the risk that by associating with the company, they will themselves come within the criteria for designation), the likely perspectives of other stakeholders (such as banks or auditors), and/or risks arising from sanctions regimes in other jurisdictions (including the EU, US, and offshore jurisdictions whose regimes derive from the UK).

2.12 In which sanctions regimes does hypothetical control most commonly arise? Are there particular regimes where it appears more frequently?

Since the vast expansion in the scope of designations under the Russia sanctions regime in 2022, the volume of enquiries relating to DPs under that regime has vastly increased. The fact that ownership and control queries arise most frequently in this context cannot therefore be considered an indication of any meaningful relationship between the test and those designated under that regime.

It should also be recognised that this scope has deliberately extended beyond those in or associated with government roles to individuals whose designations are often based on (alleged) interests in one or more significant sectors of the Russian economy, and in a context where the UK (and related offshore jurisdictions) had a very different perspective on Russian wealth prior to 2022. This will necessarily bring parties subject to UK (and UK-derived) sanctions into more regular contact with corporate-held wealth and business vehicles that may well be entirely legitimate, and where the difficulty of disproving hypothetical control has substantial adverse impacts (disproportionate to any benefits achieved by the regime).

2.13 Are there discernible sectoral or structural trends in the cases involving hypothetical control, for example, the use of trusts, proxies, complex corporate structures or cross-jurisdictional arrangements?

Trusts often feature in BCL’s sanctions matters and have a complex relationship with the hypothetical aspect of the control test. Formally, the test is only relevant where a legal entity (such as a company) is involved in the trust structure. Informally, questions about a DP’s role (hypothetical or otherwise) feature in trust scenarios via other routes, typically in addressing whether assets are indirectly held or controlled by a DP, or provisions of funds or resources bring them an indirect benefit.

With respect to proxies and corporate structures, while these do feature, they are more naturally addressed by other aspects of the ownership and control test, for instance, the provisions in the interpretive schedule about nominee arrangements, and the inherent nature of assessing ‘indirect’ ownership or control (which necessitates a tracing exercise through levels of corporate ownership).

2.14 Have you observed any patterns in the way that DPs structure their interests or relationships that complicate the assessment of the hypothetical element of the control test?

The implication of this question is that DPs (or even potential DPs, before they are designated) may structure their interests in deliberate attempts to complicate assessments of ownership and control. BCL has seen very limited evidence of this. Where there are examples of (for example) shares being transferred to connected third parties, the resulting assessment is easily covered under the interpretive provisions of the first condition, with reference to joint or proxy arrangements; the hypothetical control test adds nothing to the analysis in practice.

Conversely, the cumulative effect of the various provisions (including on circumvention, immunity, monetary penalties, regulatory and reporting obligations, secondary sanctions, etc) is such that legitimate efforts by individuals, trustees and others to divest or donate assets are inevitably seen as suspicious if, and when, those individuals are designated. Again, the hypothetical control test adds nothing (positively or negatively) to this in practice, and its removal would not by itself undo the collateral damage caused to legitimate property rights (eg of family members).

2.15 Without the hypothetical control element of the control test, how would you or your organisation identify and respond to potential circumvention by DPs through complex or opaque arrangements intended to obscure a DP’s influence?

The first condition and its interpretative schedules in practice cover a great deal of scenarios of indirect control (de jure or de facto). For instance, they provide that ‘where a person controls a right, the right is to be treated as held by that person’, and that the arrangements for such control (and for holding shares jointly) can include ‘any scheme, agreement or understanding, whether or not it is legally enforceable’. This in practice covers many scenarios where a DP has sought to obscure their (current) influence, even before the second condition (let alone its hypothetical element) is engaged.

Taking the reference to ‘circumvention’ literally, if a counterparty suspects the company they are (potentially) dealing with, and/or its owner, of a circumvention offence under sanctions regulations (or an equivalent act overseas) then this has a potential impact under proceeds of crime laws, which may make it unlawful to transact without consent from the National Crime Agency (NCA). If an AML-regulated firm has reasonable grounds to suspect the same, it may also have an obligation to report these grounds to the NCA in a separate report. The hypothetical control test adds nothing to these provisions and arguably distracts from them.

2.16 What impact, whether positive or negative, does the assessment of hypothetical control have on legal risk and administrative burden?

For all the reasons already considered, the hypothetical control assessment is unlikely to have a substantial impact on the legal risks for someone subject to the jurisdiction of UK sanctions; the surrounding provisions will invariably be sufficient to determine the extent of the risk. For an individual or a business that seeks to be thorough, however, there may well be a significant additional administrative burden from having to spend time examining and seeking evidence or reassurances with respect to an issue that is likely to be impossible to resolve in practice.

3.8 Do you find that in practice, there is enough evidence to substantiate the hypothetical element - “P would (if P chose to) be able” - in the control test when dealing with hypothetical control? Why/why not?

What evidence or information is most/least persuasive in these cases?

The nature of the arrangements by which a person would retain the de facto option to control a company (in circumstances where there was no de jure option, at least via a right to appoint or dismiss a majority of its board of directors) is likely to mean that it is undocumented and/or clandestine, especially where the person is designated (or had been anticipating designation). It is hard to imagine a scenario where the company concerned would voluntarily provide evidence (in whatever form) to confirm such an arrangement, in circumstances where a (continued) business relationship depended on the opposite.

Conversely, the lack of existence of such an arrangement is impossible to prove definitively. A company can (in theory) provide substantial evidence to describe how it is currently owned or controlled; it may even be able to describe controls that would in practice prevent a DP from gaining control of it. But the fundamental absurdity of the task (to refute an inference or a supposition, absent any direct evidence) is obvious. Even the most extensive (and expensive) package of evidence aimed at proving the negative could not definitively do so, such as to reduce the risk to zero. In practice, some attempt to show the detail of how the company is run (and could be run, in hypothetical scenarios) will likely be preferable to a ‘tick-box’ approach that simply states (as some companies do) that the hypothetical control test is not met.

3.9 What are the main challenges when forming an assessment of whether a DP would be able to exercise control if they chose to? How do these challenges affect due diligence burdens, resource allocation, the risk of litigation against your assessment or inconsistent outcomes?

Companies subject to assessment may resist attempts to gather extensive evidence, in part because the exercise of proving the positive case (that the company is owned or controlled by others) is necessarily intrusive, and due diligence may sometimes be misconstrued as a straightforward ‘tick-box’ exercise. In the presence of grounds (even if weak) to suspect ownership and control by a DP, the ‘burden of proof’ is effectively on the companies suspected (or on those within the organisation pressing to commence or continue business).

3.10 Is it costly to investigate hypothetical control and to implement financial sanctions on this basis? If yes, please provide monetary estimates. Would removing the clause offer tangible savings on your implementation and/or compliance costs?

It is difficult to isolate the costs of this specific aspect of the control assessment. Arguably the biggest cost is in undermining the credibility of the due diligence exercise by including a question that is virtually impossible to answer.

3.11 Are there any best practices or internal procedures your organisation has developed for managing issues associated with the assessment of the hypothetical element? Conversely, are there any procedures that you disregarded as being ineffective?

BCL has not developed procedures specifically for the hypothetical element of the test. As above, while every case is different, there is usually little value in a simplistic ‘box-ticking’ exercise that simply states that the test is not met.

3.12 How, if at all, could [the government] better support firms in making an independent assessment of hypothetical control (without providing a determination)? For example, through access to additional public sources of information, the publication of control typologies, and/or facilitating dissemination of industry-produced best practice?

Guidance on best practice may be helpful but equally could serve to confuse by layering additional levels of ambiguous phrasing and case studies on top of an already difficult combination of legislation and case law. The government should consider a process for obtaining binding (though not necessarily final) determinations through an impartial (judicial) process.

4.8 Do you find that in practice, the way hypothetical control… presents in sanctions casework typically corresponds with ‘potential future de facto control’ or ‘potential future de jure control’ as given in Mr Justice Thompsell’s control typology [from the Hellard case]?

It may be unhelpful to require too strict a demarcation between the four categories identified in the Hellard case. Notably, the case study provided in the Call for Evidence (figure 2A), as an example of (de jure) potential or hypothetical control, refers to a deed between the shareholders granting a DP the right to nominate and remove the majority of the directors. The existence of this right means the scenario is caught within the first condition rather than the second, which would nevertheless be considered (rightly, in most cases) to be concerned with actual (current) control.

As ever, where difficult legislative drafting has given rise to voluminous case law and guidance, the starting point must remain the wording of the law itself. Scenarios where ‘it is reasonable to expect that [the DP] would, if [they] chose to, be able… to achieve’ control of the company are caught. The real point about potential, future de facto control (as made clear in Hellard) is that the evidence for it will almost certainly be lacking.

4.9 Are there any examples from your casework that do not fit neatly in the four categories given in Mr Justice Thompsell’s control typology, or which reveal gaps or ambiguities?

The typology in Hellard is logically comprehensive, insofar as it deals in two binary questions: is the nature of the control de facto or de jure; and does it exist currently, or could it exist in the future. There may be scenarios where the answers to the questions are unclear, but this does not mean an amended typology is needed.

4.10 Do you identify types of control in your sanctions casework when conducting assessments of control? Are there other typologies or conceptualisations of control not mentioned in this chapter that you consider practically relevant?

No. As above, in practice the assessment of whether to take the risk of dealing with a potentially sanctioned entity is taken based on various interacting factors, and the question of typology is secondary (if it is needed at all). Insofar as there is a category of ownership or to control that ought to be considered more relevant, it is the scenario where a company was formerly, but is no longer, owned or controlled by a DP. Arguably, the main impact of the ownership and control exercise is to ensure that this kind of asset is frozen in practice, notwithstanding that (as a matter of law) it should not be. This includes the hypothetical control test, but only as the most absurd example of a set of provisions that is far broader than it needs to be. It is this broader issue, rather than the narrow one of hypothetical control, that ought to be the subject of further consideration.