Russia sanctions bring new wave of compliance risks

On 31 July 2014, as part of a coordinated effortwith the US, the EU escalated its Russian sanctions regime to ‘phase three’. These wide-ranging sectoral sanctions against Russia apply throughout the EU’s 28 member states and are a response to the ongoing crisis in Ukraine and in particular the downing of Malaysian Airlines Flight MH17.

Since the EU first imposed restrictive measures in response to events in Crimea on March 6, 2014, the scope and nature of the restrictions have become progressively more stringent. What started with an asset freeze and travel ban imposed on a small number of former Ukrainian politicians and mid-ranking civil servants has increased to more than 100 Russian and Ukrainian individuals being subject to an asset freeze and travel ban; 23 Russian and Ukrainian entities being subject to an asset freeze; a ban on the import to the EU of unauthorised goods from Crimea or Sevastopol and further restrictions on business and investment in that region; a Russian arms embargo; and widespread Russian sectoral sanctions relating to the financial services and oil sectors.

To put matters into context, other states subject to similar EU sectoral sanctions include Iran, North Korea and Syria. In parallel, the US has imposed similar measures, with its sectoral restrictions going further than those of the EU in some respects. Around the world, other countries including Canada, Australia, Japan, Liechtenstein, Switzerland and Norway have also imposed restrictive measures to varying degrees in a bid to isolate Russia further from the wider international community.

The finance industry is dealing with restrictions that have been placed on access to capital markets by state-owned Russian banks – Sberbank, VTB Bank, Gazprombank, Vnesheconombank and Rosselkhozbank. In response, private equity houses, which may be subject to sanctions compliance covenants from lenders and investors or liable themselves in the event there is a sanctions breach, are having to take immediate steps to understand and ensure compliance within portfolio companies.

The extension of sanctions restrictions to what are mainstream Russian banks and the energy sector, and perhaps just as importantly the threat of further restrictions, has meant that companies that have not had to consider sanctions in the past are having to address what are complex, technical and high-risk compliance questions for the first time.

While many larger financial institutions are likely to have an advanced understanding of sanctions issues, particularly given their prominence in Iran and across north Africa and the Middle East in the wake of the Arab Spring, the speed at which the current crisis has developed and the scope and extent of the restrictions means that many other businesses are dealing with what are novel and unfamiliar issues.

In response, prudent financial institutions, asset managers, investors and corporates are having to carefully assess whether their business has a direct (or indirect) Russian nexus, whether through customers, suppliers, investors, finance, joint venture partners or otherwise. This risk assessment is aimed at determining what aspects of the business are vulnerable to the current situation and/or future developments. Ideally, this process will then feed into properly documented and implemented risk-based policies, including screening/due-diligence systems and controls designed to ensure compliance. Currently, many businesses simply do not have such procedures in place and now may well be the time to take stock and invest accordingly.

As part of these processes, businesses should assess the requirement for initial and ongoing sanctions screening of counterparties against the list of sanctions targets. The broadly drafted legislation also requires consideration to be given to whether counterparties are “owned or controlled” by designated parties and thereby subject to sanctions themselves.

Sanctions clauses

More generally, caution should be exercised when investing in or dealing with counterparties that operate in sectors of the Russian economy that have been targeted by sanctions. There has been an increase in so-called ‘sanctions clauses’ which contain contractual language that provides comfort that counterparties are not subject to sanctions and mitigates counterparty risk in the event that performance becomes subject to sanctions.  

As a minimum, potential purchasers of Russian interests or businesses are now requiring warranties with regards to sanctions compliance to limit the exposure to latent sanctions liabilities and conditions to allow parties to exit and would-be purchasers to be reimbursed if sanctions in any way impact the proposed transaction. And assurances are being sought as to the subsequent use of purchase funds to limit the potential exposure should they be used to finance a sanctioned activity. Many of these principles and the issues raised are also relevant
to lenders and insurers who are particularly exposed to sanctions risk given the nature of their businesses.  

Generally, sanctions issues can give rise to complex legal issues. For example, when determining the scope of an asset freeze in relation to Russian high-net-worth individuals holding assets in offshore trust structures, questions must be asked relating to whether those jurisdictions have implemented similar sanctions restrictions, the terms of the trust instrument or arrangements and precisely how the assets are held. None of this is straightforward and the implications in the event of breach may be severe, with record-breaking fines for sanctions busting being imposed by the US authorities in recent months. 

Shaistah Akhtar is a partner and Darren Roiser a managing associate at law firm King & Wood Mallesons SJ Berwin.