• California company accused of sanctions violations challenges U.S. Treasury Department
  • Appeals court generally sides with government but remands because of arbitrary and capricious decision related to five alleged violations
  • Traditional interpretation of “inventory exception” is considered by Court

It is rare for companies to go to court to fight penalties imposed by the Office of Foreign Assets Control (OFAC) for violations of U.S. sanctions. It is even more rare for a court to make any sort of finding against the agency. Yet that is exactly what happened when the U.S. Court of Appeals for the District of Columbia Circuit (D.C. Circuit) recently considered OFAC’s imposition of penalties against Epsilon Electronics (Epsilon) for alleged violations of U.S. sanctions against Iran.

Background. Epsilon is a U.S. company that specializes in providing audio and video products for automobiles and homes. According to OFAC, between 2008 and 2012, Epsilon made 39 shipments of audio and video equipment to a company in Dubai, Asra International (Asra), that re-exports “most, if not all, of its products to Iran . . . ”

OFAC began its review of Epsilon in 2011, when it discovered a 2008 shipment from Epsilon’s California headquarters to an address in Tehran, Iran. After subsequently identifying multiple wire transfers from Asra, OFAC reviewed information related to Asra, including from the company’s website, that promoted the company’s business in Iran. Some of the photos from Asra’s website apparently appeared on Epsilon’s website in a photo gallery labeled “Iran” as late as 2012. (Just FYI, this is not a compliance best practice.) OFAC opened its official investigation into Epsilon in December 2011.

In July 2014, OFAC announced that it was assessing a penalty of $4,073,000 against Epsilon for violations of U.S. sanctions on Iran. OFAC claimed the violations occurred when Epsilon made shipments to Asra with knowledge or reason to know that Asra intended to re-export the goods to Iran.

Epsilon thereafter sued OFAC in federal district court. The district court granted summary judgment in favor of the government, and Epsilon appealed to the D.C. Circuit.

D.C. Circuit Opinion. As is commonly the case with court review under the Administrative Procedure Act, the D.C. Circuit evaluated only whether OFAC’s action was “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with the law.”

At appeal, Epsilon made two principal arguments. First, the company argued that the government had failed to show that the goods Epsilon shipped to Asra had reached Iran, and therefore failed to show that they had been exported or re-exported to Iran. The Court disagreed, finding that a violation occurs whenever an exporter knows or has reason to know, at the time goods are shipped from the United States, that the recipient intends to re-export them to Iran.

Second, Epsilon argued that the so-called “inventory exception” applied. As generally understood, the inventory exception creates a safe harbor for U.S. exporters who ship certain U.S.-origin products to general inventory in a third country – even if those products are ultimately re-exported to Iran – so long as the U.S. exporter does not know or have reason to know that the products are intended for Iran when exported from the United States.

The Court acknowledged the existence of the inventory exception. As the Court noted, Epsilon could not be held liable if it did not know or have reason to know that its third-country trading partner intended to re-export the goods to Iran.

But the Court concluded that Epsilon had the requisite knowledge. To reach its conclusion, the Court examined Epsilon’s course of dealing, Epsilon’s general knowledge of the industry and customer preferences, the working relationship between the parties, and other evidence. In particular, the Court highlighted information on Asra’s website, including information about its affiliate relationship with an Iranian company, its listed addresses, its own materials that referred to sales to Iran but no other countries, and its list of sales agents all located in Iran. The Court determined that this information was sufficient to establish that Asra conducted business exclusively with Iran; that correspondingly implied that Epsilon had reason to know that its products would be exported to Iran, i.e., the only place – according to the Court – in which Asra appeared to conduct business.

The Court also had the chance to consider whether knowledge that a customer deals predominantly (as opposed to exclusively) with Iran is, standing alone, sufficient for a finding of violation in this type of situation. The Court deferred, thereby casting some doubt on 2002 interpretative guidance in which OFAC suggested that “reason to know” can be established when a customer deals predominantly with Iran or the Government of Iran. It thus appears that liability premised solely upon a third party’s predominant dealings in Iran could be vulnerable to challenge.

Ultimately the D.C. Circuit largely sided with OFAC. Yet the Court remanded the case to the district court, with instructions to remand the matter to OFAC for further consideration of

  1. five findings of violation that occurred in 2012 (which the Court found arbitrary and capricious), and
  2. the total monetary penalty imposed.

Analysis. We think there are three key lessons from the Epsilon matter.

First, OFAC does not need to prove that goods, technology or services actually reach Iran in order to establish a violation of U.S. sanctions on Iran. The key regulatory provision at issue (31 CFR 560.204) prohibits exports that “are intended specifically for … Iran or the Government of Iran.” In focusing on the “intended” destination of a re-export, the Court rendered moot the actual destination of the re-export.

Second, egregious or evasive conduct tends to breed larger penalties. OFAC asserted that Epsilon failed to respond truthfully to an administrative subpoena requesting information about dealings with Iran. In addition, five shipments were made to Asra between February and May 2012, while OFAC’s investigation was ongoing.

Finally, it is important to remember that the courts can be an option for companies facing an OFAC penalty. Many companies feel as though they have little chance of successfully challenging determinations by U.S. agencies (particularly those involved in U.S. national security) in the courts. The Epsilon case is a reminder that U.S. agencies, while afforded significant deference, are nevertheless subject to checks on their power – and scrutiny of their decisions. If U.S. businesses do not hold regulators to the letter of the law, no one will.