Since March 2014, the United States and European Union have imposed multiple rounds of sanctions restricting certain activities with Russian and Ukrainian individuals and companies as a result of the ongoing crisis in Ukraine. The most recent round of sanctions came into effect on September 12, 2014.

The nature of these sanctions differs markedly from typical measures used by the United States and the European Union in the past, as sanctions previously involved freezing all assets of designated companies and prohibiting all transactions with such entities. The obligations for U.S. and EU companies under traditional sanctions measures are relatively clear – they cannot engage in any dealings with the sanctioned entity.

In contrast, the United States and EU have imposed targeted measures with respect to Russia that prohibit dealings in specific types of debt and equity instruments of certain Russian entities in specific sectors, but do not broadly prohibit all commercial activities with such entities. These measures present special challenges for the financial industry generally – and for asset managers in particular – as such institutions must ensure that any of their activities that involve Russian companies subject to these financing restrictions are not connected to any prohibited debt or equity instruments targeted by U.S./EU sanctions.

Overview of Measures Affecting Transactions in Equity and Debt Instruments of Sanctioned Russian Companies

For the financial services industry, the most relevant measures in this respect involve the creation of the Sectoral Sanctions Identifications (SSI) List by the U.S. Government, which imposes certain restrictions on equity and debt instruments of specified Russian entities in the financial, energy and defense industries. The EU also has imposed similar, but not identical, measures affecting certain Russian companies in those industries. Other U.S./EU measures impose specific restrictions on transfers of certain oil/gas technology, equipment and services to Russia and/or to specified Russian entities, and also impose asset freezes on a number of Russian individuals and companies. This article focuses on restrictions regarding certain equity and debt instruments of specified Russian companies due to the unique challenges these restrictions pose to the global financial services sector.

The specific companies, and related equity and debt instruments, covered by U.S. and EU measures against Russia are summarized below.

Russian Financial Industry

The companies targeted by EU measures are: Gazprombank, Sberbank, Rosselkhozbank (Russian Agricultural Bank), Vnesheconombank (VEB) and VTB Bank. The EU restrictions are imposed on: (i) new equity or new debt with a maturity period of greater than 90 days issued by, on behalf of, or for the benefit of these Russian financial institutions on or after July 31, 2014; or (ii) any new debt with a maturity period of greater that 30 days issued by, on behalf of, or for the benefit of these Russian financial institutions on or after September 12, 2014.

The companies targeted by the U.S. measures are: Bank of Moscow, Gazprombank, Sberbank, Rosselkhozbank (Russian Agricultural Bank), Vnesheconombank (VEB) and VTB Bank. The U.S. restrictions are imposed on: (i) any new equity or new debt with a maturity period of greater than 90 days issued by, on behalf of, or for the benefit of these Russian financial institutions on or after July 16, 2014 (except for Sberbank); (ii) any new equity or new debt with a maturity period of greater that 30 days issued by, on behalf of, or for the benefit of all of these Russian financial institutions on or after September 12, 2014; and (iii) new equity issued by, on behalf of, or for the benefit of Sberbank on or after September 12, 2014.

Russian Energy Industry

The companies targeted by EU measures are: Rosneft, Transneft and Gazprom Neft. The EU restrictions are imposed on: (i) new equity or new debt with a maturity period of greater than 90 days issued by, on behalf of, or for the benefit of these Russian energy companies on or after July 31, 2014; or (ii) any new debt with a maturity period of greater that 30 days issued by, on behalf of, or for the benefit of these Russian energy companies on or after September 12, 2014.

The companies targeted by U.S. measures are: Gazprom Neft, Novatek, Rosneft and Transneft. The U.S. restrictions are imposed on: (i) any new equity or new debt with a maturity period of greater than 90 days issued by, on behalf of, or for the benefit of Novatek or Rosneft on or after July 16, 2014; (ii) any new equity issued by, on behalf of, or for the benefit of Gazprom Neft or Transneft on or after September 12, 2014; and (iii) any new debt with a maturity period of greater that 30 days issued by, on behalf of, or for the benefit of all of these Russian energy companies on or after September 12, 2014.

Russian Defense Industry

The companies targeted by EU measures are: OPK OBORONPROM, United Aircraft Corporation and Uralvagonzavod. The EU restrictions are imposed on any new equity or new debt with a maturity period of greater that 30 days issued by, on behalf of, or for the benefit of these Russian defense companies on or after September 12, 2014.

The company targeted by U.S. measures is Rostec. The U.S. restrictions are imposed on any new equity or new debt with a maturity period of greater that 30 days issued by, on behalf of, or for the benefit of Rostec on or after September 12, 2014.

Instruments and Companies Covered

Under U.S. sanctions, “new debt” covered by relevant measures includes bonds, loans, extensions of credit, loan guarantees, letters of credit, drafts, bankers acceptances, discount notes or bills, or commercial paper issued after the date sanctions were imposed against the relevant Russian entity. U.S. sanctions define covered “new equity” to include stocks, share issuances, depositary receipts, or any other evidence of title or ownership issued after date sanctions were imposed against the relevant Russian entity. Under EU measures, “transferable securities” subject to restrictions include shares or other equivalent securities in companies, partnerships or other entities; bonds or other forms of securitized debt; depository receipts in respect of such securities; and any other securities giving the right to acquire or sell any such transferable securities.

Notably, these sanctions apply not only to the companies identified above, but also to any entities that are owned 50 percent or more (in the aggregate) by one or more of the listed entities. It should also be noted that, notwithstanding these specific debt and equity-related prohibitions, U.S. and EU financial institutions generally may continue to maintain correspondent accounts and process general commercial transactions for the Russian entities targeted under these specific measures, so long as those activities do not involve transacting in, providing financing for, or otherwise dealing in any prohibited debt or equity instruments.

Specific Sanctions Compliance Considerations for Asset Managers and Other Financial Institutions

The measures detailed above represent the first time that U.S. and EU sanctions regulations have narrowly targeted activities of asset managers and financial institutions that involve a sanctioned entity. As a result, these institutions must carefully consider novel challenges when engaging in any activities that involve a Russian entity targeted by these measures. The primary considerations in this regard are set forth below.

Determining Whether an Instrument in the Secondary Market is Prohibited “New Debt” or “New Equity” of a Sanctioned Entity

The most important consideration for a financial institution is to determine whether it is dealing in “new debt” or “new equity” of a sanctioned Russian entity, which was issued after the date on which sanctions were imposed against that specific entity. For example, a U.S. financial institution would be permitted to trade in any shares of Sberbank that were issued prior to September 12, 2014, but would be prohibited from transacting in any shares of Sberbank offered after this date. For companies such as Rosneft that have been targeted by multiple rounds of financing-related restrictions, the specific obligations that apply may vary depending on when certain debt instruments were issued and/or the maturity period of such debt – for example, there are no prohibitions related to new debt of Rosneft with a maturity period of between 30 and 90 days if such debt was issued prior to September 12, 2014, but any such debt issued on or after September 12 would be covered.

The United States Government has specifically stated that it is the responsibility of the financial institution to determine whether it is dealing in “new debt” or “new equity” issued after the effective date of sanctions imposed against a particular entity. This could pose substantial challenges when investing in secondary markets. International Securities Identification Number (ISIN) codes do not include information about securities issue dates. As a result, any new equity issues by a sanctioned Russian bank could stress the market for the sanctioned bank’s existing shares, since it would be difficult to determine whether a buyer was purchasing existing, pre-sanction equity or new, sanctioned equity. If sanctioned securities find their way into the secondary markets, it is anticipated that most financial intermediaries will prohibit new purchases of securities on those markets. In addition, the sponsors of major financial indices have indicated that they may remove SSI-listed companies as index components if asset managers are unable to readily determine whether or not shares outstanding are subject to sanctions.

Beyond strict compliance, there is a question about the liquidity and value of existing investments in SSI-listed entities. Rather than dealing with the administrative burden of determining whether a particular investment in an SSI-listed entity is subject to sanctions, it is possible that some financial institutions will simply choose to divest themselves of any shares of the sanctioned Russian entity. As other U.S./EU institutions would be reluctant to purchase such shares due to their own sanctions compliance considerations, the market for buyers of the shares is likely to decrease. Therefore, the company seeking to divest may be required to sell its holdings at a significant discount.

It is important to note that the vast majority of securities of SSI-listed entities were issued prior to the effective date of sanctions, and thus are not subject to sanctions. To the extent that a financial institution knows that a sanctioned Russian entity has not yet issued any prohibited new debt or new equity at all, then that institution can continue to trade in all debt/equity of the sanctioned entity in the secondary market, as such instruments would have pre-existed the date on which any sanctions were imposed and therefore not be subject to any restrictions.

Transactions Involving Derivative Instruments Linked to Prohibited New Debt or New Equity

A financial institution may have the opportunity to engage in transactions that involve derivative products whose value is linked to debt or equity of a Russian entity targeted by the U.S./EU financing restrictions discussed above. If subject to U.S. or EU sanctions laws, the financial institution generally would be prohibited from dealing directly in any underlying assets that may be considered to be prohibited new debt or new equity of the Russian entity (depending on the specific restrictions imposed against that entity). However, the United States Government has issued a “General License” that explicitly permits U.S. financial institutions to engage in transactions involving derivative products whose value is linked to an underlying asset that constitutes prohibited new debt or new equity of a sanctioned Russian entity. The European Union does not have a similar explicit carve-out, but transactions involving such derivative products also may be permitted to the extent that they do not involve dealings in the underlying assets themselves.

Conclusion

The recent U.S. and EU sanctions targeting debt and equity instruments of certain Russian entities are complex, and raise many issues for asset managers and other financial institutions that have not been considered previously in any other sanctions-related context. Beyond compliance considerations, asset managers and other financial institutions should be mindful of market and potential liquidity risks associated with investing in listed Russian entities. Finally, the United States and EU are continuing to assess the effectiveness of current sanctions policies, and are likely to modify or impose additional sanctions in the near future. Accordingly, asset managers and other financial institutions should continuously monitor sanctions developments and assess the impact of sanctions measures on their business operations.