Dual-Use Items on Investment Funds: What are they? Why are they important and why should you, as MLRO/RC, handle them with care?

In an era where geopolitical tensions are at a peak, with events like the ongoing war in Ukraine, the persistent Israel-Palestine conflict, which has escalated dramatically since the beginning of the October, investment funds with exposure to dual-use items are under the microscope by facing an increasingly scrutinized by national authorities. This article will explore into the complexities of dual-use items, focusing on their impact on Luxembourg investment funds. It will also discuss various controls performed by the MLRO/RC, more in general of Compliance Officers, and mitigation measures that must be implemented to effectively manage the associated risks in this dynamic sector.

Given the current climate of geopolitical tensions, it is reasonable to expect an increase in surveillance by national authorities over investment funds dealing with dual-use items. In this context, establishing a robust compliance framework and being able to show the evidence of the controls to an authority is crucial.

“Items … that can be employed for both civilian and military ends”

Let start by the definition, what is a Dual-use Item? Per EU Regulation 2021/821, Dual-Use Items are defined as goods, software, and technology that can be employed for both civilian and military ends. As a explanatory examples, we identify: drones, robotics, Satellite Technology, Cryptography, Nuclear technology, etc...
It can be deduced that the duality of military and civilian uses inherently increases AML/CFT risks. The same items have legitimate commercial uses can also be repurposed for military applications, including terrorism. For this specific reason enhanced due diligence is required and additional controls must be put in place.
Upon reviewing EU law, it becomes clear that the definition includes items used in designing, developing, producing, or using nuclear, chemical, or biological weapons, or their means of delivery, as well as items that can assist in the manufacture of nuclear weapons or other nuclear explosive devices. The definition should be further extends to items that can assist, in any way, in the manufacture of nuclear weapons or other nuclear explosive devices and therefore even components and technologies that indirectly contribute to the production of such weapons are considered dual-use. I personally believe that the definition of Dual-Use Items might be enlarged to emerging technologies, for example artificial intelligence and machine learning, quantum computing, and facial/biometrics recognition.

“Compliance officers must ensure these companies hold the necessary export licenses issued by national authorities”

The first task of a MLRO/RC/Compliance Officer is to assess whether an investment fund actually invests in unlisted assets exposed to dual-use items. We are explicitly referring to unlisted assets. Unlisted assets, unlike their listed counterparts on public stock exchanges, are not traded in open markets and this distinction is significant, especially in the context AML/CFT risks. For instance, consider a RAIF or SIF acquiring or lending money to a company not listed in a stock-exchange dealing with Dual-Use items.
Within the due diligence report, Compliance Officers are required to clearly explain why the items sold by a specific company are classified as dual-use items, and therefore placing the company under this category.

During the forthcoming Financial Crime Questionnaire, the Commission de Surveillance du Secteur Financier (CSSF) inquires whether investment funds under management include Dual-Use Items. If affirmative, fund managers should be prepared for potential scrutiny by the CSSF, as well as potential queries during external audits.
In this article, our focus shifts from the usual procedures of Due Diligence, Identification, and Verification of counterparties and Ultimate Beneficial Owners (UBOs). Instead, we'll concentrate on the additional documentation that MLRO/RC, Compliance Officers, should take into account over the initial and periodical Due Diligence on the investee.
First of all, Compliance officers must ensure these companies hold the necessary export licenses issued by national authorities, aligning with stringent international sanctions and Money Laundering/Terrorist Financing (ML/TF) regulations. Exporting dual-use items without proper licensing can lead to violations of international sanctions, which is a key concern in ML/TF risk assessments. A copy of the license must be obtained by the RC over the Due Diligence process. We also remind that the European Banking Authority highlighted the increase of ML/TF risks associated with goods that require export licenses, such as dual-use items.

The risk of the item being diverted for unauthorized use should be evaluated, especially if it can be used for the development of weapons of mass destruction or has military applications. The requirement for an export license is a control mechanism to prevent such diversion, but the inherent risk of diversion itself contributes to the higher ML/TF risk and this aspect should take into consideration while performing risk assessment and assigning the final risk score. Special attention must be given to the export of non-listed cyber-surveillance items, which are subject to controls especially if intended for use in connection with internal repression or serious violations of human rights and international humanitarian law.

In my view, it is beneficial to consider the development of a tailored-made Due Diligence Questionnaire, seek for written confirmation, and collect the necessary additional documentation. As the EBA advised, compliance officers are advised to adopt a holistic risk assessment approach, where individual risk factors are not isolated but viewed in the context of the overall relationship.

“Compliance Officers must ensure that investees do not export to restricted countries”

Companies dealing with such items need to be diligent in adhering to international sanction lists and export controls. In accordance with EU Regulation 2021/821, Annex IV, Part 2, Compliance Officers must ensure that investees do not export to restricted countries such as Iran, North Korea, Russia, Myanmar, Syria and concerning software and technologies related to cryptography and secure communications ensure that investees do not export to restricted countries under the Union General Export Authorisation No EU008, which includes a list of countries such as Afghanistan, Egypt, Qatar, and Russia, Saudi Arabia, among others as detailed in the regulation. These restrictions are part of the regulatory measures to control the export of dual-use items, ensuring that they are not used in ways that could contribute to international security threats or conflicts. Moreover, confirmation should be seek by the Compliance Officer if the company's activities comply with any arms embargo imposed by the Council, OSCE, or the United Nations and that these assets are not sold to certain countries, entities, or individuals with international sanctions and embargoes. It is also essential to include a control mechanism in the Due Diligence Questionnaire to ensure these items are not resold to entities in prohibited countries, as part of the compliance process.
Over the Due Diligence Questionnaire the RC should ensure that the company considers the risk that these items might be used for unauthorized military applications or by entities involved in the proliferation of weapons of mass destruction and that the company makes sure that end-users are legitimate and the intended use complies with international security standards is a significant aspect of the ML/TF risk assessment.

“Sanction and name screening tools play a crucial role in managing compliance, particularly for Investment funds dealing with dual-use items.”

Sanction and name screening tools play a crucial role in managing compliance, particularly for Investment funds dealing with dual-use items. Sanction and name screening tools help identify individuals, organizations, and entities that are on government-issued sanction lists, including those maintained by the EU, UN, OFAC, and other international bodies. Dealing with parties on these lists can be prohibited or require special authorization, especially when it involves dual-use items. The AIFM and RCs should make sure that their internal tool is actually configured to screen against these lists. I also remind the requirement to immediately notify the Luxembourg Ministry of Finance in case of dealings with an entity subject to international financial sanctions, in line with the Art. 6 of the Law 19 of December 2020.

In addition to the regulatory measures discussed, investment funds in the EU must also incorporate media adverse screening into their compliance strategies. This involves monitoring and assessing negative news or media reports related to the companies they invest in, particularly those dealing with dual-use items. The significance of adverse media screening lies in its ability to uncover potential reputational risks, unethical practices, or illicit activities that might not be evident through traditional financial audits or regulatory reports.

Last but not least, The Compliance Officer should make sure if the company/exporter has an effective Internal Compliance Program. An Internal Compliance Program should include policies and procedures for complying with the regulation's provisions, including due diligence measures for assessing risks related to the export of items to end-users and end-uses and due diligence and risk assessments are routinely conducted. This is to guarantee that Dual-Use Items are not used in ways that could support the spread of Weapons of Mass Destruction (WMDs) or human rights violations.

Where We Stand Today:

In the EU, especially with rules about dual-use items, there's a clear move to more careful control by government authorities. Over 2024 is also expecting an update on the dual-use items list by the EU, and a better alignment with international export regimes. Investment funds, especially those with exposures to such items, must prioritize robust due diligence processes. This includes strong Due Diligence questionnaires, rigorous sanction screening, and adverse media monitoring. These steps are essential not only for regulatory compliance, and authority controls but also for navigating a difficult and evolving international environment. By prioritizing robust due diligence, including sanction screening and adverse media monitoring, investment funds can not only adhere to regulatory mandates but also contribute to global efforts in maintaining international security and preventing the misuse of dual-use technologies. The changing EU regulations, especially with expected updates in 2024, mean that funds need to be constantly ready to adapt. In summary, the complex situation of investment funds that handle dual-use items, especially in Luxembourg's financial sector, shows how important it is to have strict compliance and strong due diligence procedures.

If you arrived until here, it means that you potentially enjoyed this article. I personally thank you and I invite you to subscribe to the newsletter. Also, feel free to get in contact and suggest any particular topic for the next release.

The views and opinions expressed in this article are my own and do not reflect the official policy, position, or opinions of any financial institution, or other organization.
The content of this article is based on personal research of the author and understanding of AML (Anti-Money Laundering) and compliance topics.