In late May, The Russian Federation issued its first sovereign bond since the Ukraine crisis in 2014. The sole organizer of the bond is VTB Capital, an arm of VTB Bank, Russia’s second largest financial institution. Both VTB Capital and VTB Bank are subject to sectoral sanctions.

According to published reports, the 10-year bond is being offered at yields of 4.65-4.9 percent. Russia’s goal was to raise $3 billion to help with its budget deficit caused by weak oil prices. Reportedly, the bond generated $7 billion of demand, though the Russian finance ministry announced only $1.75 billion in sales. Foreign investors constituted more than 70% of the bond purchasers. According to media reports, large global banks declined to participate, partly due to sanctions compliance risks. But as we will see, the compliance risks aren’t very clear. We will examine the exact risks and evaluate the question of why banks might be over-complying.

Background:

In response to Russia’s annexation of Crimea and its use of force in Ukraine, the U.S. government imposed targeted sanctions against Russia’s financial and energy sectors, among other sanctions. The sectoral sanctions are unique because two elements are required to constitute a prohibited transaction: (1) prohibited transaction type plus (2) designation.

Under Directive 1 of the Sectoral Sanctions, issued in 2014, U.S. persons are prohibited from transacting in, providing financing for, or otherwise dealing in new debt with a maturity of longer than 30 days or new equity with entities on the Sectoral Sanctions Identifications (SSI) List. All other transactions with SSI entities are permitted. The SSI List under Directive 1 primarily consists of Russian banks, including VTB Bank. Thus, U.S. persons are prohibited from transaction in, dealing in new debt of longer than 30 days or new equity with VTB Capital. Guidance from the U.S. Department of Treasury, Office of Foreign Assets Control (OFAC) is clear that the sectoral sanctions do “not require U.S. persons to block the property or interests in property of the entities identified in the Directives, nor will persons identified in Directives 1 and 2 be added to the Specially Designated Nationals (SDN) List.”

Further, OFAC guidance has clarified that purchasing new debt is permitted in which the SSI entity is not the borrower. OFAC’s Frequently Asked Questions, FAQ 405 states:

405. Does the prohibition on “otherwise dealing in new debt” of longer than 30 days maturity (for persons subject to Directives 1 and 3) or 90 days (for persons subject to Directive 2) of SSI entities, their property, or their interests in property prohibit dealing in debt with maturity that exceeds the applicable authorized tenor in which the SSI entity is not directly or indirectly the borrower?

Directives 1 and 3 prohibit U.S. persons from dealing in debt of longer than 30 days maturity and Directive 2 prohibits U.S. persons from dealing in debt of longer than 90 days maturity issued on or after the sanctions effective date in cases where the new debt is issued by an SSI entity subject to these Directives. Directives 1, 2, and 3 do not prohibit U.S. persons from dealing with an SSI entity as counterparty to transactions involving debt issued on or after the sanctions effective date by a non-sanctioned party. For example, U.S. persons are not prohibited from dealing in a loan exceeding the applicable authorized tenor that is issued after the sanctions effective date of sanctions provided by an SSI entity to a non-sanctioned third-party, dealing with an SSI entity who is the underwriter on new debt of a non-sanctioned third party exceeding the applicable authorized tenor, or accepting payment under a letter of credit with terms exceeding the applicable authorized tenor that is issued, advised, or confirmed by an SSI entity, so long as the SSI entity is not the borrower. [9-12-2014]

As a sovereign borrower, Russia is not a sanctioned entity. But according to many media reports, large U.S. and non-U.S. banks have declined to participate in the Russian bond offering, citing compliance risks. In February and March of this year, some reports suggested that officials at the State Department and Department of Treasury cautioned banks against participating in any bond sale, that helping finance Russia would be counter to U.S. foreign policy and the objectives of the sanctions.

But does it make sense for the U.S. government to expect private commercial entities to refrain from legitimate transactions when U.S. policymakers have determined to not sanction the conduct in question? The whole point of targeted sanctions is that they are targeted. If the U.S. government wanted to block Russia’s access to the U.S. financial system, it could have done so through imposing standard sanctions. But it didn’t. That doesn’t mean there are no risks in purchasing Russian debt, or that a bank might not independently determine that dealing with Russia constitutes an unacceptable reputation risk (as discussed below), but should banks be required to determine and adhere to the spirit of the sanctions even when the laws say otherwise?

We have seen this phenomenon in the context of Iran as well. European banks are so burned by the gargantuan penalties in cases related to sanctions violations (see BNP Paribas, Commerzbank, Credit Suisse, HSBC, Standard Chartered, the list goes on) that they are wary of dealing with Iran even when it is perfectly lawful. That creates an outcome directly contrary to stated U.S. foreign policy under which sanctioned parties should be rewarded for the behavior the sanctions are designed to produce.

Sanctions can be extremely effective. Targeted sanctions are measured and innovative. But businesses must be permitted to follow the law and not fear getting in trouble.

Ok, so what are the risks?

To some cautious investors, the risks in buying Russian bonds might outweigh the potential rewards. So let’s discuss some of considerations that must be evaluated if participating in the bond sale.

  • Dealing with Russia. Even though Russia itself is not sanctioned, the reputational risk of dealing with Russia might be too high for the tolerance of some investors. And U.S. officials warned about returning to “business as usual” with Russia so long as its actions to destabilize Ukraine continue. The fact is Russia is unpredictable. And because U.S. foreign policy toward Russia is continually shifting, the risk of investing there may just be too high for the risk-averse.
  • Dealing with SDNs. While the bond’s prospectus states that proceeds will not be used to finance sanctioned entities, it’s hard to really determine where the money goes. Much of Putin’s inner circle and many other Russian entities have been placed on the SDN List. U.S. persons are prohibited from any dealings with SDNs, so there is a risk that funds might end up in the wrong hands.
  • Compliance Costs. Many investors might find the opportunity appealing, but the cost of compliance and due diligence might not be worth the penny. Even though buying the bonds from an SSI entity is legal under the regulations, investors would still need to implement careful due diligence procedures to ensure that SDNs were not benefitting. Further, because of OFAC’s 50% rule, any entity owned 50% or more by an SDN is also sanctioned. Those entities are not on the SDN List. So, you can see how compliance costs would add up if the investor wanted to ensure that no SDN or SDN-owned entity was funded by the transactions.
  • Settlement. At the end of the day, the investment needs to pay off. Many might be unpersuaded of Russia’s ability to settle its debt. It is, after all, an oil dependent country subject to Western sanctions.

According to media reports, one Russian banker said that he could sell the bonds just to American investors if he wanted to. “There are enough people there who hate the government and want to make money.” The latter part may be true. But for now, many U.S. investors and international banks seem to be avoiding the risky business of investing in new Russian debt.