Screening Investments for Kleptocracy Risk at the Local Level

National governments have stopped mergers and acquisitions with foreign industries, citing security. Should local governments play a role? What about the public?

Open Government Partnership

Published in

OGP Horizons

6 min readAug 27, 2024

By Joseph Foti and Corina Rebegea

Overview

How can local governments identify investments from foreign kleptocrats looking to launder money or undermine security? In this post, the OGP Support Unit and National Democratic Institute (NDI) review the risk from some foreign investment and explore how local governments can start screening for potential risks. In the coming months, NDI and OGP will be looking to support solutions, including a potential paper.

Here are some key takeaways.

Foreign kleptocrats are investing at the local level. Autocratic governments are investing at the local level where they may evade scrutiny. This money, often the proceeds of crime, may compromise local integrity and independence.

Local governments have a special role in safeguarding their communities. Local governments have a big role in attracting foreign investment. They should consider how to safeguard their communities from strategic corruption by kleptocrats. Some of their work is at high risk of capture by foreign governments.

The number of governments screening investments is growing. National governments already screen for security and strategic issues. They have rejected major investments through direct parliamentary action and existing statutes. This screening takes place as part of the processes of approving major mergers and acquisitions. Risk of corruption, especially from foreign autocrats, should be a part of investment considerations, but has not been so far.

Local governments need to take a different approach. Local governments are different. They do not usually regulate mergers and acquisitions (M&As) as national governments do, and rarely regulate transboundary trade. Officials may not have the awareness of the risks of foreign corruption or the capacity to detect and respond to such issues. Therefore, the solutions need to be different. They need to work across parts of society and jurisdictions.

The problem

National and local governments attract investment to improve employment, wealth, and revenue. Most of the time, investment is of significant public benefit. Yet, in some cases, local communities risk taking on tainted investments. In particular, money may come from foreign kleptocrats posing as legitimate investors.

Investment screening is a process that helps ensure that foreign investment is clean. It considers whether an investment would compromise national security, strategic industries, or protected data. To date, screening has not taken into account illicit finance or corruption.

Local government’s unique roles and risks

Local governments have different roles in attracting foreign investment than national governments. This creates unique exposure for them. The following actions have some risk.

Offering tax breaks and credits to investors: Such investors may pose risks of bribery, intellectual property theft, or misappropriation.
Attracting and subsidizing investment through land use policy, workforce development, and infrastructure development: If a corrupt foreign actor benefits from these activities, it may amount to transferring wealth from the local public to kleptocrats. In some cases, as in the case of a US steel plant, such investment also runs the risk of being a vehicle for money laundering.
Overseeing utilities and awarding public-private partnerships: In Ukraine, for example, local governments will play a big role in rebuilding infrastructure. Continued European dependence on Russia for nuclear fuel is not only a security risk. It also raises the threat of corruption, when sole-source suppliers experience little oversight.
Maintaining state-owned enterprises (SoEs), including universities: The OECD has found that SoEs are twice as prone to foreign bribery as typical businesses. Universities are also enterprises likely to see reputation-laundering activities by foreign kleptocrats.
Coordinating with national governments: Often, local governments coordinate with national counterparts to jointly attract investment.

These actions need to be subject to democratic oversight. Representatives, independent inspectors, relevant agencies, and the public each play an oversight role.

The growth of national investment screening

National governments have increasingly introduced processes that filter out risky foreign investment, through a group of practices called “investment screening.” High-profile cases show that they are willing to reject major M&As where they have a conflict with the national interest. Investment screening includes rules for inspection, transparency, and direct regulation. Understanding the national approach is essential to understanding how it would differ from and support subnational processes.

The global picture of national investment screening

M&A rules. As of 2020, 62 countries have M&A investment screening rules. This includes many OGP members.
A growing practice. Some countries have expanded screening on national security grounds. The US, Canada, and Australia now screen the critical minerals sector, worried that China is trying to dominate supply chains. Even in the absence of regulation, the US has warned tech companies of growing strategic vulnerability.
Missing corruption? The main grounds for such screening have either been national security or on the basis of “strategic industries.” They may choose to expand this approach to corruption and other democratic values as well. The UK Joint Money Laundering Steering Group recommended examining sovereign wealth fund investments.
Special considerations: In some cases, there may not be specific laws that allow for investment screening, but governments exercise a “functional equivalent” in excluding companies where sanctioned individuals have control. In countries without a strong rule of law, investment screening mechanisms may themselves be subject to corruption or arbitrary decision-making. These special cases require additional oversight and investments.

A different approach

Local governments range from large provinces to small towns. The term may also include special authorities like ports, bridges, or utilities. They are different from national governments, which affects how these bodies can manage the risks of foreign direct investment.

Two areas where local governments differ from national governments are in terms of their mandate and capacity.

Mandate: First, they usually have different powers constitutionally. Local governments rarely regulate M&As. In most countries, they are usually barred from regulating transboundary trade.
Capacity: Second, they may not have the awareness of the risks or the capacity to detect and respond to such issues.

Implementation thus requires innovative approaches to tackling this issue. Potential lines of research to better understand how to limit risk from foreign investment are as follows.

Basic rules and roles: Local governments have different roles for regulating investment. Which offices may already have the mandate to guide foreign investment? Which mandates are missing? For example, in Spain, there are local investment agencies.

Inter-level coordination: National governments already help one another and industry. How can they share their expertise with other levels of government? How can they help detect risks that may fly under the radar — not only for big infrastructure like ports, but also at universities? When and how should local governments be the first line of defense?

Pooling of resources: Sometimes national governments are not leaders in this area or lack resources. Other times, intelligence and regulatory capacity requires work across jurisdictions. Where should jurisdictions coordinate with one another? In federal systems, do local governments challenge national governments to protect their interests?

Capacity: Local investment planners need training to access and use financial intelligence data. What are the successful examples?

Open government: Transparency, participation, and public accountability can lower risks of foreign investment. Some areas for action may include:

Beneficial ownership transparency: Establishing clear reporting requirements on ownership and control of firms.
Public standards for due diligence: Such standards could include screening for investors using the proceeds of kleptocracy, violations of human rights, or the rule of law.
Public information protocols. Publish the justifications of review body investment approvals or denials. Information should be systematic and provide the public with as much information as possible.
State-owned enterprise transparency: Increased transparency of shareholders in local government-owned enterprises.
Trusted flaggers. In some cases, governments establish expert groups that are able to submit areas of concern. These may be general bodies or they may be specific to a certain set of investments or industries.
Citizen participation in audits. In some jurisdictions, auditors and independent inspectors ask for public opinion on key risks.
Local media and civil society: Independent organizations and actors may spot problems before authorities do. Local governments can ensure that they can carry out investigations independently.

What’s next

NDI and OGP are looking to expand research on this issue to enable guidance for local and regional governments. Please contact research@opengovpartnership.org and gov_team@ndi.org if you are interested in collaborating.