The EU has again strengthened sanctions against Russia, including further restrictions directly impacting the energy industry. It is vital that everyone involved in the Russian energy industry is aware of these restrictions to finance and trade.
In response to the on-going developments in Eastern Ukraine, on 12 September 2014 the EU expanded its “Stage III” sanctions against Russia (Council Regulation (EU) No 833/2014) by issuing Council Regulation (EU) No 960/2014. These “Stage III” sanctions are aimed at specific sectors of the Russian economy, as well as identified individuals and entities. Russia’s capital markets, energy and defence sectors have all been targeted by these sanctions, which are currently due to expire on 31 July 2015.
What impact the expanded EU sanctions might have on the energy industry, as well as the steps that can be taken to mitigate the risk of being in breach of the sanctions, and the possible consequences of violating them, are set out below.
Read more in our more general client briefings on the EU, US and Canadian sanctions against Russia.
To whom do the sanctions apply?
The Regulation applies:
- To nationals of EU Member States (wherever located).
- To any legal person, entity or body, established in an EU Member State or otherwise constituted under the law of a Member State (including the subsidiaries of non-EU persons, entities or bodies).
- To any legal person, entity or body in respect of any business done in whole or in part within the EU (including the branches of non-EU persons, entities or bodies).
- Within the territory of the EU (including airspace) and on board any aircraft or vessel under the jurisdiction of a Member State.
How do these sanctions affect the energy industry?
The latest rounds of EU sanctions have taken direct aim at the Russian energy industry in two ways. Firstly, by prohibiting the supply into Russia of certain oil and gas related equipment, technologies and services for use in specified future Russian oil projects. Secondly, by restricting the access of a small number of partially state-owned Russian energy companies’ to EU sources of capital.
Specified equipment, technology and services
EU companies now require prior authorisation for the “sale, supply, transfer or export” of specified equipment and technologies to a Russian entity, or to any entity which intends to use the equipment or technology in Russia (Council Regulation (EU) No 833/2014, Article 3).
Such authorisation will be administered by the competent authority of each EU Member State (a list of the competent authorities for each Member State is annexed to the Regulation) and authorisation will not be granted if the relevant authority has reasonable grounds to determine that the “sale, supply, transfer or export” is for deep water oil exploration and production, Arctic oil exploration and production, or shale oil projects in Russia.
The applicable equipment and technologies are set out in a list annexed to the above Regulation and largely consist of pipes and casings used for drilling and constructing pipelines, drilling and pumping equipment, floating or submersible production platforms and associated items. The origin of the equipment and technologies is irrelevant. It is the export of that equipment or technology by a business falling within the scope of EU sanctions that is restricted.
In addition, there is a direct prohibition (as opposed to restriction by way of an authorisation procedure) on providing certain services necessary for deep water oil exploration and production, Arctic oil exploration and production, or shale oil projects in Russia (Council Regulation (EU) No 960/2014, Article 1(3)). The specified services are drilling, well testing, logging and completion services and supply of specialised floating vessels. The sanctions allow for an exception to this restriction in the event of an emergency (Council Regulation (EU) No 960/2014, Article 1(5), 3).
Capital market access
The most recent EU sanctions expanded the list of entities that are subject to EU capital market restrictions relating to transferable securities and money-market instruments, to include Russian energy-related companies Rosneft, Transneft and Gazprom Neft. This list had previously been limited to Russian financial institutions. In summary, it is now prohibited to trade in new bonds, equity or similar financial instruments, with a maturity exceeding 30 days, with these entities, after 12 September 2014. Subject to some limited exceptions, it is also prohibited to provide new loans or credit, with a maturity exceeding 30 days, to these entities after 12 September 2014. Read more in our detailed briefing on the EU capital market restrictions.
It should be noted that these EU sanctions are similar, but slightly different, to the energy related restrictions in the latest round of US sanctions. The US sanctions do prohibit the provision, exportation, or re-exportation of goods, services (not including financial services), or technology in support of exploration or production for deepwater, Arctic offshore, or shale projects that have the potential to produce oil in Russia (or its claimed territory), however the restrictions only apply when the dealing involves one of five Russian energy companies - Gazprom, Gazprom Neft, Lukoil, Surgutneftegas and Rosneft. The latest round of US sanctions has also imposed capital market restrictions on Gazprom Neft and Transneft (in addition to Rosneft and Novatek, which were already restricted).
This briefing is an analysis of EU sanctions. In the context of all sanctions issues, the United States’ framework is extremely significant and should be considered at the earliest opportunity. We work closely with our colleagues in Washington, DC who have significant experience of advising global corporates and financial institutions in connection with the impact of US economic and trade sanctions. Read more in our detailed briefing on US sanctions.
Limitations of EU sanctions
The EU measures are not designed to curtail current oil production projects, but to restrict future access by Russia to technology, hardware, services and expertise when developing new oil sources.
There are two aspects of these sanctions which will limit their impact. First, the relevant competent authority may grant the authorisation described above if the transaction concerns the execution of an obligation from a “contract or agreement” concluded before 1 August 2014. Similarly, the latest prohibition on specified services does not apply to the execution of obligations arising from a “contract or framework agreement” that was concluded prior to 12 September 2014 or ancillary contracts necessary for the execution of these contracts. Otherwise prohibited dealings will therefore seemingly be authorised or allowed, provided they can be firmly linked to an agreement which was entered into prior to the relevant cut off dates, including the numerous agreements already in place between oil majors and Russian oil companies to develop new Russian oil sources, to enable companies to carry out their contractual obligations. Further, there is little constraint on the meaning of “contract”, “agreement” or “framework agreement”, and therefore a provisional agreement, entered into before sanctions were introduced, could potentially be relied upon to allow subsequent (otherwise prohibited) dealings to occur.
Secondly, and most importantly for the energy sector, these sanctions do not apply to gas exploration and production. By way of example, much of the listed oil-related equipment, technology and services are also commonly used in gas exploration and production, and therefore may be authorised or allowed on this basis. Further, many of the oil projects which the sanctions are designed to target will involve both oil and gas, and gas project equipment, technology and services are not prohibited. However, equipment, technology and services which are labelled as for the gas sector but which in fact will used in the oil sector will fall foul of the sanctions.
Although these potential limitations exist, by structuring the sanctions in this manner the EU has left open the possibility of tightening up or expanding the prohibitions at a later date. Accordingly, the energy sector should be prepared for further measures, depending on how the situation develops.
Precautions that should be taken
In light of this new round of EU sanctions, there are certain measures that entities doing business in the energy sector should take to ensure they do not fall foul of the provisions.
Firstly, in terms of the product and services sanctions, it must be determined whether the relevant equipment, technology, product or service is one which may be captured by the sanctions. Any company involved in the sale, supply, transfer or export of any goods or technologies to Russia should verify whether the items in question appear in the lists annexed to the relevant EU Regulation. In relation to the capital market restrictions, entities should re-screen all Russian counterparties, and counterparties with relevant business or investments in Russia.
More than ever, thorough due diligence of counterparties is key. A review of company structures, shareholdings and management, including of the end user (which often will not be the contracting party) should be carried out before entering into any new agreements. Importantly, an inquiry into the intended use of relevant equipment, technology or services is vital to ensure that EU entities do not breach the sanctions.
Issues that are raised through due diligence may require further investigation, for instance, a contracting party who is situated in a jurisdiction which is not subject to EU sanctions, and who refuses to sign up to sanctions provisions in the contract. Appropriate sanctions wording should be included in contractual documentation; parties should agree how risk is to be allocated between the parties and the contractual consequences of a sanctions breach. Consider what procedures the parties need to have in place during the contractual term to monitor any potential risk. Consider all the jurisdictions that may be involved in the transaction, including in relation to the assets involved or the parties to the transaction. Such other jurisdictions may have their own, possibly different, sanctions regime that could have an impact on the transaction. Consider what may happen if sanctions are further strengthened and if it makes the contract difficult or impossible to perform, including the contractual consequences and where the inevitable loss will lie.
The EU sanctions provide for a limited defence if the EU person or entity did not know, and had no reasonable cause to suspect, that its actions would infringe the sanctions. There may be contractual (or other) steps an innocent entity can consider to maximise its ability to rely on this defence, however this will depend on all the circumstances of the transaction. A failure to carry out sufficient due diligence, a failure to have in place adequate systems and controls to detect such a breach, or the wilful turning of a blind eye to breaches of sanctions is unlikely to meet the required standard to defend allegations of breaches of EU sanctions. It is also important to note that any intentional attempt to circumvent the sanctions is strictly prohibited.
Where Member State authorisation is required, the Regulations state that the applicant must supply the competent authority with all relevant information required for that application. The form and content of such an application is likely to differ depending on which Member State is involved. Further, in certain circumstances, it may be that the competent authority of one Member State is more likely to grant authorisation of a particular transaction than that of another Member State. It is also important to note that, in relation to oil related technology and equipment, authorisation records will be shared amongst the Member States, and where authorisation has been denied by one Member State, a second Member State cannot grant authorisation of the same transaction without consultation with the Member State that issued the denial.
EU energy companies may also be affected by the asset freeze and visa bans which have been placed on specified individuals and entities. There are further, specific sanctions in relation to Crimea and Sevastopol which are likely to affect any energy entity doing business with some connection to that area. These are covered in our general briefing.
Finally, it is vital that energy companies are aware that the sanctions regime is constantly changing at a rapid pace. Businesses should have appropriate procedures and policies in place to avoid a sanctions breach which may in turn result in contractual breaches.
Consequences of being in breach of EU sanctions
Although the EU Regulations are directly applicable in all Member States without further national legislation being required, the EU leaves it to each Member State to legislate what the penalties are for breach of the sanctions.
In the UK, it is a criminal offence to breach the prohibition on dealing with transferable securities and money-market instruments. The penalties include a possible jail term of up to 2 years for individuals and/or a fine (The Ukraine (European Union Financial Services) (No. 3) Regulations 2014, section 6). These penalties are the same as those imposed for breaching the asset freeze on specified individuals and entities (The Ukraine (European Union Financial Services) (No. 2) Regulations 2014, section 12).
In the UK, the penalties for breaching the above Regulations in relation to products, technology and services include a fine and/or a jail term for individuals - The Export Control (Russia, Crimea and Sevastopol Sanctions) Order 2014 (the 2014 Order), which came into force on 26 September 2014). Sentences range from 6 months to 10 years depending on the offence. Note that the 2014 Order has not yet criminalised breaches of the latest trade sanctions under Regulation 960/2014. Amendments to the 2014 Order in this regard are currently being considered by the Export Control Organisation.
EU sanctions are drafted in wide and sometimes imprecise terms with limited associated guidance. This means that there is often uncertainty as to how European courts will interpret the restrictions set out in the EU sanctions legislation.
In light of the on-going expansion of the EU sanctions in connection with events in Eastern Ukraine, energy companies should undertake on-going risk assessments to ensure they are not contravening the EU sanctions regime. This includes bearing in mind potential future risks, as any broadening of the sanctions could significantly impact transactions.