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In the latest installment of Ropes & Gray’s ETF podcast series, asset management partner Brian McCabe and counsel Jessica Reece discuss the ongoing impacts of the Russia/Ukraine conflict on ETFs, including questions related to valuation and custody of Russian and Russian-related assets.

Transcript:

Jessica Reece: Hello, and thank you for joining us today on this Ropes & Gray podcast. I'm Jessica Reece, counsel in the Boston office of Ropes & Gray. Joining me today is Brian McCabe, a colleague in the asset management practice and a partner in our Boston office. In this podcast, which is part of a series of podcasts on issues related to exchange traded funds, we will discuss the ongoing impact of the Russia/Ukraine conflict on ETFs, including questions related to valuation and custody of Russian and Russian-related assets.

Brian, I think it might be helpful to quickly walk through the events of late February and early March resulting from the Russian invasion of Ukraine, and the immediate implications for global financial markets and, more specifically, ETFs.

Brian McCabe: Thanks, Jessica. ETFs are widely and appropriately hailed as resilient even in the face of crisis. For example, in 2011, Egyptian markets closed for almost two months, and still Egypt-focused ETFs continued to trade on the assumption that the markets would eventually reopen. Those ETFs continued to provide liquidity and serve as vehicles for price discovery until the markets did reopen. But the story in Russia and Ukraine is different.

As you’ll recall, in the last days of February, Russia executed a massive invasion of Ukraine, causing a humanitarian crisis. Without in any way diminishing the human suffering associated with this crisis, the focus of this podcast is on the impact on ETFs of the rapid series of changes to the Russian economy following the invasion, including the closure of the Russian stock market and the severing of Russia’s ties to central bank and financial systems around the world. The U.S. and other governments began imposing sanctions almost immediately, which have continued to ratchet up as the weeks go by.

In the days that followed the initial invasion, we saw Russia-focused ETFs suspend creations, citing significant share price volatility and liquidity concerns. By the end of the first week in March, exchanges globally had halted trading of Russia-focused ETFs, and by the following week, Russian equities had generally been removed from all indices at zero value. At the same time, there were reports of firms approaching the SEC about shutting off redemptions temporarily, but such relief was not granted (as of the date of this podcast, no ETFs have received relief to suspend redemptions, although one Russia-focused mutual fund was recently allowed by the SEC to suspend redemptions in connection with its liquidation subject to certain conditions).

Although the Moscow Stock Exchange reopened with limited capacity in March, foreign investors cannot sell on the exchange and the Central Bank of Russia has suspended all money transfers out of Russia by non-resident individuals and entities from states determined to be “unfriendly.”

Jessica Reece: This gets to some of the key characteristics of an ETF. ETFs are characterized by a creation and redemption process that provides APs (and their clients) with arbitrage opportunities designed to cause the ETF’s shares to trade at or near their net asset value. But in March, the scope of the economic fallout of the invasion impaired the arbitrage mechanism. Volatility in the Russian stock market caused share prices to swing wildly, and as sanctions imposed by governments worldwide restricted the normal flow of capital into and out of the country, valuing Russian holdings became much more challenging. In the first week of March, as tightening sanctions made it more difficult for Russia-focused ETFs to acquire certain Russian securities, they suspended creations. And then, as you mentioned, Brian, during the second week of March, index providers determined to remove Russian equities from indices at zero value.

With a now-limited supply of shares, by March 3, some Russia-related ETFs began to trade at a more than 100% premium to their NAV, which might be taken as an indication of investor belief the underlying holdings of the ETFs continued to have some value. When exchanges halted trading of Russia-focused ETFs the next day, however, such ETFs no longer had a daily closing price, and so, a premium or discount to NAV could no longer be calculated, preventing the ETFs from serving as the price discovery mechanisms that ETFs have previously provided in times of turmoil.

Brian McCabe: Can you talk a little more about what is so different about this crisis that the exchanges halted trading and ETF sponsors felt that they could no longer support creations?

Jessica Reece: Sure. In early days of the conflict, Brian, Russia-focused ETFs continued to trade in the U.S., but they grappled with complicated questions about how to value the underlying assets of those funds—on the one hand, the Russian equity market closed right away, and by the first week in March, brokers had stopped accepting trades in depositary receipts of Russian and Ukrainian companies. Yet at the same time, investors’ willingness to continue to trade in ETFs with Russia-linked holdings (initially on the exchanges and then in the over-the-counter market) seemed to indicate that those underlying securities still had some positive market value. ETFs have surmounted similar obstacles before, but this time, the use of economic sanctions by the governments of the United States and many other countries on certain Russian individuals and Russian corporate and banking entities muddied the waters. The issue is that, even if Russian markets open, sanctions prevent the ETFs from buying, and potentially from selling, certain Russian assets.

Brian McCabe: And we are seeing similar effects in the markets for depositary receipts. On April 27, a Russian law went into effect requiring Russian issuers to delist existing depositary receipts by May 5. As a result, holders of depositary receipts would either forfeit their economic interest in the underlying Russian securities, or be required to maintain a local custody account in Russia in which to hold the underlying shares. However, that’s easier said than done. While taking receipt of the underlying shares could potentially preserve value for ETFs and other holders of the depositary receipts if the underlying securities eventually have value, it may raise issues under the current U.S. sanctions.

Jessica Reece: That’s right. Executive Order 14071, issued on April 6, prohibits “new investment in the Russian Federation by a United States person, wherever located.” Unfortunately, the U.S. Department of the Treasury’s Office of Foreign Assets Control (or OFAC) has not yet provided any clarity on the scope of the new investment prohibition. With that said, OFAC has in the past defined “new investment” broadly as any “transaction that constitutes a commitment or contribution of funds or other assets or a loan or other extension of credit to” the sanctioned entity, which is in this case, the entire Russian Federation.

Based on prior practice, it’s possible that OFAC will take the position that maintenance of existing investments that predated the April 6 Executive Order will not qualify as “new investment,” and so, the receipt of shares for depositary receipts held prior to April 6 may be permissible. However, new infusion of capital into Russia-related entities or other new investments in Russia would presumably be captured by the restrictions, and so, the key questions from a sanctions perspective would appear to be whether the conversion of depositary receipts to local shares can be characterized as maintenance of a current investment, and whether the creation of the new Russian accounts to hold the local shares would itself implicate the U.S. sanctions. Unfortunately, these questions cannot be answered with certainty in the absence of OFAC guidance.

It’s worth noting in this regard that many Russian financial institutions are subject to comprehensive sanctions, and payments of custody fees may also be restricted (and subject to time limited wind down authorizations). Finally, it’s also worth noting that on May 8, OFAC also prohibited U.S. persons from providing certain categories of services to Russian entities—including accounting, trust, and corporate formation, as well as management consulting services. As a result of this new restriction, U.S. persons may be prohibited from supporting necessary restructurings and other activities (though there is an exception if the Russian entity receiving services is ultimately owned or controlled by a U.S. company).

The answers to the questions posed by the unwinding of depositary receipts of Russian securities are complex and will likely depend to a significant extent on the particular facts and circumstances of each situation as Russia-focused ETFs seek to answer the question of, “What next?”

Brian McCabe: That brings us to the end of the podcast. Jessica and I want to thank all of you for joining us on this discussion of the impact of the crisis in Ukraine on ETFs. For more information about the topics we’ve discussed or other topics of interest to asset managers, please visit our website at www.ropesgray.com, where we have links to additional materials regarding these topics. To help you better understand the current ETF landscape, we’ll be issuing additional podcasts designed to provide greater depth of analysis on important and timely issues. If you have any questions regarding the topics we addressed or anything else, please don't hesitate to get in touch with one of us or whoever you have a working relationship with at Ropes & Gray. You can also subscribe and listen to the series of podcasts wherever you regularly listen to podcasts, including on Apple, Google and Spotify. Thank you again for listening.