It has now been over a year since the United States and the European Union began imposing sanctions on Russian and Ukrainian individuals and entities in connection with the situation in Ukraine. The sanctions have major implications for private equity firms transacting and operating in the region and subject to U.S. law, and present unique challenges given Russia’s exposure to, and major presence in, the global market. After numerous rounds of sanctions imposed by the U.S. Government and sanctions legislation passed by Congress, it has become clear that the U.S. sanctions will not be removed soon even if the EU allows its sanctions to expire later this year, which is quite possible.
Many banks and U.S. corporations have taken a very conservative approach in complying with the Ukraine-related sanctions in expectation that they will continue to worsen and in order to be consistent with their global sanctions compliance programs. While understandable, such an approach does not take into account the distinct nature of the Ukraine- related sanctions, which are very targeted and may be distinguished from broader Iran-type sanctions. It is still very much possible for U.S. persons to carry out business with Russian parties and indeed the current situation may create strategic opportunities for funds in certain sectors where investment is badly needed and welcomed, such as agriculture, life sciences and technology. This article summarizes the sanctions and attempts to clarify a number of points which have created confusion for parties transacting with Russian parties and suggests what should be done to ensure compliance with sanctions and to mitigate risks of violation of sanctions while exploiting possible opportunities.
Overview of Ukraine-Related Sanctions
Specially Designated Nationalist List
Persons and entities targeted by the U.S. in response to the Ukraine crisis generally fall into either of the Specially Designated Nationals (SDN) or the Sectoral Sanctions Identifications (SII) Lists, both of which are managed and maintained by the Office of Foreign Assets Control (OFAC) of the U.S. Department of the Treasury. Executive Orders 13660 and 13661 of 6 March 2014 and 20 March 2014, respectively, provide the legal framework by which OFAC is given the authority to place individuals and entities on the SDN List.
Generally, SDN-type sanctions require the blocking of all property and interests in property of any listed person, and prohibit engaging in financial and trade transactions with, or for the benefit, of a person on the SDN List. The “blocked” property or “frozen” assets remain with the target; however, the exercise of powers and privileges normally associated with ownership is prohibited unless specifically authorized by OFAC. Entities that an SDN-listed person owns – defined as a direct or indirect ownership interest of 50% or more – are also blocked, even if that entity is not explicitly identified on the SDN List.
Sectoral Sanctions Identification List (SSI List)
The SSI List is a new type of sanction, the framework for which was established by Executive Order 13662. Under the order, the Secretary of Treasury, in consultation with the Secretary of State, may impose sanctions on certain sectors of the Russian economy. Thus far, such sanctions have been applied to companies in the financial services, energy, and defense related sectors in Russia. Although the executive order was issued on 20 March 2014, it was not until 16 July 2014 that OFAC made its first SSI List designations.
Designations to the SSI List are made pursuant to Directives 1 through 4. Directives 1 and 2, which target the financial and energy sectors, respectively, were introduced as part of the first SSI designations on 16 July 2014, whereas Directives 3 and 4, which target the military/defense and oil and gas exploration sectors, respectively, were issued as part of the designations of 12 September 2014. SSI List designations apply to U.S. persons or persons within the United States and prohibit engaging in transactions with respect to the provision of financing for, and other dealings in new debt of longer than 30 days maturity for entities listed pursuant to Directive 1 (90 days maturity for debt issued before 12 September 2014) and Directive 3, and 90 days maturity for those listed pursuant to Directive 2 with an added prohibition on dealing in new equity with respect to entities listed under Directive 1 (certain financial institutions). New debt, includes bonds, loans, extensions of credit, loan guarantees, letters of credit, drafts, bank acceptances, discount notes or bills, or commercial paper with a maturity of more than 90 days if issued between 16 July - 12 September 2014, and with a maturity of more than 30 days if issued after 12 September 2014. New equity includes stocks, share issues, depositary receipts or any other evidence of title ownership issued on or after 16 July 2014. Directive 4, which targets oil and gas exploration technologies, prohibits the provision, exportation or re-exportation of goods, services, or technology in support of exploration or production for deepwater, Arctic offshore or shale projects that have the potential to produce oil in the Russian Federation, or in the maritime area claimed by the Russian Federation and extending from its territory.
SSI-type sanctions were introduced to apply targeted pressure on the Russian Government without significantly affecting the Russian civilian population. It is important to note that the designation of entities on the SSI List does not constitute a blocking action (as an SDN designation would) and does not require U.S. persons to block the property or interests in property of the designated entities. Therefore, U.S. persons can continue to transact business with companies on the SSI List provided that such transactions do not violate the SSI sanctions (i.e. mainly providing financing, or facilitating financing to such SSI List entities beyond 30 or 90 days, as relevant). Moreover, it is possible to freely transact business with companies in such sectors (i.e., only certain transactions with certain companies are prohibited and not all transactions with all companies in the sector) provided that: (i) they are not acting as an agent for a sanctioned entity; and (ii) the U.S. person complies with U.S. export controls with respect to provision of equipment and materials to Russia in the energy and defense sectors.
Who is Covered by Sanctions?
U.S. sanctions apply to “United States persons”, which, pursuant to the Executive Orders establishing the framework for designating entities to the SDN and SSI Lists, means “any United States citizen, permanent resident alien, entity organized under the laws of the United States or any jurisdiction with the United States (including U.S. branches of foreign companies), or any person in the United States.” U.S. sanctions, generally do not apply to non-U.S. subsidiaries of U.S. companies (although non-U.S. branches of U.S. companies are covered), except to the extent that the U.S. company controls the subsidiary’s decisions; and non-U.S. companies whose shares are publicly listed on a U.S. exchange. This is in contrast to other broader sanctions imposed by the U.S. Government.
Control Over SDN/SSI Entity
Both SDN- and SSI-type restrictions extend to entities that are 50% or more owned by a designated person.
Furthermore, pursuant to a new OFAC rule issued in August 2014, the 50% rule also extends to persons that are 50% or more owned in aggregate by designated entities.
In defining whether an entity is “controlled” by a sanctioned entity OFAC looks to both ownership and control together, when determining whether to block an entity. As OFAC has clarified, in cases where an entity is controlled, but not 50% or more owned by one or more designated persons, it is not considered automatically blocked. OFAC, however, has cautioned against doing business with such entities, warning that they may constitute targets for future designation. Companies dealing with entities that may be controlled – but not 50% or more owned – by a blocked person should also be wary of violating EU sanctions, which stipulate that funds and resources controlled by a listed person would also be frozen (in addition to those “owned” and “held”). While the EU provides general criteria for determining whether an entity is controlled by another entity or person, it allows its member states to interpret control on an individual basis.
Carrying Out Due Diligence on Russian and Ukrainian Persons
While transacting business in Russia and with Russian parties is still very much possible, U.S. persons, especially those based in the U.S. or with operations in the U.S., dealing with Russian persons should take steps to ensure that their business activities do not violate U.S. sanctions.
All transactions with Russian counterparties should be carefully analyzed to determine compliance with relevant sanctions and export controls. Careful assessments should be made for transactions in sectors targeted by U.S. and EU sectoral sanctions, such as banking, defense/military and energy (including oil and gas exploration). Furthermore, shareholders, directors, customers, and business partners or other key persons in a relevant company should be screened to determine whether any of them are subject to sanctions (expressly or as persons controlled by sanctioned persons); or if there are any ongoing or expected transactions with the blocked persons or companies controlled by blocked persons, and whether such transactions involve dealing with, or exporting to, entities in Crimea (trade with Crimea is generally prohibited by a separate executive order issued at the end of 2014).
Contracts concluded with Russian counterparties in high-risk sectors should provide for the possibility of termination due to sanctions, as well as liability for violating sanctions provisions. Companies subject to U.S., as well as EU, law should also identify and include provisions allowing for the instant termination of agreements and obtain end-use statements for contracts, purchase orders, or agreements, including representations by Russian counterparties affirming that they are not acting as an agent or otherwise on behalf of a sanctioned person or engaging or facilitating in the export or re-export of restricted goods for military-use of certain energy operations, as well as to Crimea in general. Contracts should be updated or drafted to include penalties for breaching sanctions-related provisions and clauses.
Transacting with Debt and Equity of SSI-Designated Entities
As mentioned before and as confirmed by OFAC, U.S. persons may conduct business with SSI-designated entities as long as they do not violate any of the prohibitions imposed by the relevant Directive. However, caution should still be exercised when dealing with such entities, especially when determining whether an instrument in the secondary market constitutes prohibited “new debt” or “new equity” of the SSI-designated entity in question. While providing loans and other types of financing after the date on which an entity was designated on the SSI List are obvious examples of “new debt”; companies should also strive to make sure that payments for services or goods delivered to a designated entity does not exceed 30 (entities subject to Directives 1 and 3) or 90 (entities subject to Directive 2) days, as such payment may be considered as credit beyond the acceptable maturity date.
U.S. sanctions imposed on Russian and Ukrainian entities over the last year are complex and evolving in form as the situation in Ukraine develops. For instance, at the end of last year, the U.S. Congress passed the Ukraine Freedom Support Act, thereby codifying sanctions related to Ukraine. However, while the law mandates sanctions on Russian parties to some extent, it also largely continues to allow the President considerable discretion in applying such sanctions.
While the geopolitical uncertainty creates real challenges for companies doing business in the region, it is possible to continue to successfully operate and/or pursue new business opportunities in Russia provided proper due diligence is carried out and compliance measures are pro-actively applied.