Economic sanctions – managing compliance requirements
September 2014 | TALKINGPOINT | RISK MANAGEMENT
FW moderates a discussion on compliance requirements arising from economic sanctions between Caroline Hobson, a partner at CMS – London, Charles Steele, an Advisory Managing Director at KPMG LLP, and Elizabeth Davy, a partner at Sullivan & Cromwell LLP.
FW: Can you provide a brief overview of key issues surrounding economic sanctions?
Steele: The US government and the governments of certain other countries, as well as the European Union and the United Nations, use economic and trade sanctions to advance foreign policy and national security goals by seeking to induce changes in the behaviour of sanctioned parties. Governments, especially that of the US, are increasingly using sanctions as a first response to geopolitical concerns, as recent events involving Russia, Ukraine and Iran demonstrate. Companies should expect this trend to continue. It is important for those engaged in international business to pay attention to, and to stay current with, sanctions developments, because the consequences for violating sanctions can be severe. In the US, for example, violations can be punished with large monetary penalties and, in serious cases, criminal penalties.
Hobson: Economic sanctions are targeted measures prohibiting transactions with sanctioned regimes, entities and individuals. They are primarily a political tool used by governments when diplomatic efforts have failed. Within the EU, sanctions are made possible through EU Council decisions and embodied in EU regulations which are binding on the EU Member States including the United Kingdom. The range of economic sanctions used by governments can be broad. Most commonly, sanctions have the effect of freezing the funds of those listed as sanctioned individuals and entities. Thus dealing with the funds and economic resources of such individuals and entities or making funds and economic resources available to them, even indirectly through third parties, is prohibited. A common difficulty is being able to identify if a sanctioned entity or individual is involved in a complex commercial transaction where identities are often masked by corporate structures.
Davy: Economic sanctions have been used as a foreign policy tool for a very long time. But it is fair to say that economic sanctions have never been a more important tool than they are today. That is true for a number of reasons. For one thing, the US government has been more willing in recent years to leverage the US financial system to deploy economic sanctions. Due to the relative importance of the US economy, the US dollar’s status as a reserve currency, and the use of the US dollar in international trade transactions, the application of sanctions to transactions in US dollars that clear through banks in the United States extends the reach and impact of US sanctions to non-US parties, including foreign financial institutions. In addition, there have been efforts to go beyond territorial jurisdictional limits. So-called ‘secondary sanctions’ have been employed, most prominently with regard to Iran – these measures provide for the possibility of sanctions against ‘any person’ who engages in certain conduct. The actor is thereby exposed to significant consequences under US law, including being frozen out of participating in the US financial system.
FW: What have been the most significant developments over the past year with regard to economic sanctions, particularly with regard to Russia and Ukraine?
Hobson: The situation in Ukraine and the imposition of sanctions on Russia has certainly attracted a considerable amount of attention on sanctions issues. With many UK companies operating in or making sales to Russia, we have seen a heightened concern about sanctions compliance with many clients now seeking advice on commercial transactions, and wanting to implement more developed sanctions compliance policies.
Davy: The most significant development is the sanctions that have been implemented, starting in March, to address the situation in Ukraine. At first, these sanctions were familiar targeted measures, requiring US persons to block the assets of certain designated persons and entities. From the beginning, the US measures have been closely choreographed with the European Union’s measures, and such close cooperation has not always been seen in respect of other economic sanctions programs. The Ukraine-related measures also saw the invention of a new type of economic sanctions called ‘sectoral sanctions’. In the current form, the ‘sectoral sanctions’ under Executive Order 13662 prohibit, among other things, US persons from providing new medium- and long-term debt and equity financing to designated Russian financial services, energy and defence and related materiel sector companies identified on the Office of Foreign Assets Control’s (OFAC’s) new Sectoral Sanctions Identification List.
Steele: For the US, ‘sectoral sanctions’ are a new type of sanction, in a number of ways. For example, the sanctions target particular sectors of Russia’s economy – the financial, energy and defence technology sectors – and prohibit certain specific types of investment activity, rather than imposing traditional blocking measures, which broadly prohibit all dealings with the sanctioned party. Also, while sanctions have traditionally targeted terrorists, drug traffickers, weapons of mass destruction (WMD) proliferators and countries seen to engage in unacceptable behaviour, these new sanctions target parties that have been engaged in mainstream commerce with other countries for years. This takes sanctions to a new level as a tool of foreign policy. Also, the sanctions will have a greater impact on the rest of the private sector, since the sanctioned parties are heavily integrated into international markets. Trends can also work in the opposite direction. Recently, for example, there has been a partial, temporary relaxation of certain sanctions against Iran, in return for Iran’s professed willingness to engage in negotiations over its nuclear program. This, too, shows how important sanctions have become as a tool of foreign policy.
FW: What have you seen by way of recent enforcement trends?
Davy: Twenty years ago, enforcement of economic sanctions was relatively simple. OFAC generally took unilateral action and fines were relatively low. Now, although OFAC remains of primary importance, other governmental authorities have entered the arena. The US State Department has an important role under many of the Iran-related programs, especially under the so-called ‘secondary sanctions’ programs. Criminal charges are more frequent, under both federal and state law. The US Department of Justice and the New York County District Attorney’s Office have been on the front lines of many enforcement matters. The Federal banking regulatory agencies, such as the Board of Governors of the Federal Reserve System and the Office of the Comptroller of the Currency, have made OFAC enforcement a focus of their examination process and have joined in enforcement actions against the banks under their jurisdictions, and OFAC screening and other compliance mechanisms have become important requirements of an effective anti-money laundering program. State authorities, especially the New York State Department of Financial Services, which occupies a unique place among state regulators due to the dominant presence of banks in New York City, have been aggressive about using state laws to reach conduct that also constitutes a violation of US economic sanctions.
Steele: The US tends to enforce its sanctions more aggressively than other countries do, by heavily penalising those who violate the rules. In the US, OFAC brings several enforcement actions each year. The actions usually involve the programs that are a higher priority, such as those targeting Iran, Sudan and Cuba. Over the past few years there have been several large actions brought against a number of banks, including cases involving global resolutions with several federal and state regulators, for transferring money on behalf of Iran, Sudan and other countries that face US sanctions. Companies in other industries that have been recently targeted by the US government for sanctions violations include an aerospace manufacturer and an oilfield services company. The oilfield services case was an example of multiple US agencies coordinating their enforcement actions. In that case there was a global resolution of civil and criminal actions by five US government agencies involving both sanctions violations and violations of the US Foreign Corrupt Practices Act.
Hobson: The US has tended to be the more visibly active regulator in recent years when it has come to sanctions enforcement. Within the EU, enforcement is a matter for national authorities and thus there are differences between EU jurisdictions in terms of enforcement penalties and approach. Thus at EU level, there is relatively little published enforcement, with many cases settled with the authorities out of the public eye. However, with recent political events, and increasing cooperation between authorities, we anticipate that companies can expect stricter enforcement in the short to medium term.
FW: Do some industries and sectors present greater sanctions risks than others? If so, which industries and sectors carry greater risk, and how?
Steele: Generally, the greater the amount and frequency of international business, the greater the sanctions risk. Since sanctions generally outlaw all dealings with targeted parties, without regard to the types of services provided or goods exported or imported, all international industries and sectors – even those involving benign products – carry some degree of risk. In 2012, for example, OFAC brought an enforcement action against a cosmetics company for doing prohibited business in Iran. That said, there are certain industries and sectors with higher risk than others. The financial sector, for example, carries a high degree of risk as a result of the massive numbers of transactions executed every day. This is especially true of large international banks, but it can also apply to smaller financial institutions, such as money services businesses that operate in high-risk markets that have large numbers of sanctioned parties. International industries that service core infrastructure sectors of the economies of sanctioned countries also face big risks. These include the oil and gas and international shipping industries. And commerce that tends to involve certain controversial parties, such as conflict minerals sourced in central Africa, also carries a heightened sanctions risk.
Hobson: It is misleading to assume that only certain sectors are affected by sanctions rules. Any sectors which involve cross-border transactions with individuals and entities in jurisdictions affected by sanctions regimes can be at risk of breach. However, due to the complexity and cross-border nature of financial transactions and the very nature of financial instruments, the financial services sector is a high risk area and one that has been the focus of recent enforcement activity. The recent imposition of EU sanctions on Russia which have particular emphasis on energy activities, illustrate how the energy sector is used to target economic sanctions. With exploration and production taking place in those parts of the world subject to sanctions, then it is important that energy companies have robust compliance programs in place.
Davy: This is a tricky question, as sanctions risks can be present in any sector or industry. That said, in various ways, it is fair to say that certain industries and sectors present greater risk. Financial institutions are on the front lines of sanctions compliance, and for that reason generally bear the greatest risks of non-compliance. Also, companies engaged in exportation or re-exportation of US origin goods, particularly electronics, chemicals and aviation equipment, are often the target of OFAC enforcement. Some industries are specifically targeted by sanctions. For example, with regard to Iran, US laws provide for so-called ‘secondary sanctions’ for activities in the energy sector of Iran, the shipping sector of Iran, and with regard to weapons and weapons delivery systems. Other US laws target the automotive sector of Iran. Other programs, such as the Ukraine-related ‘sectoral sanctions’ are in the same vein, targeting Russia’s financial services, energy and defence and related material sectors.
FW: What are the rules with regard to successor liability in the sanctions area? If a company acquires a target and then learns that the target committed sanctions violations prior to the acquisition, what steps does the company need to take?
Hobson: It is critical for any company acquiring a target to consider, as part of its due diligence, whether there is a risk that the target has committed sanctions breaches. Clearly, sanctions risk may not be relevant in all circumstances, but a target which conducts commercial activities with parties based in any jurisdiction subject to sanctions should be subject to enhanced due diligence in this regard. If the acquirer continues with a contract previously entered into by the target which involves infringing activity or the appearance of infringing activity, the authorities or a court may assume that the acquirer has persisted in the breach and may invoke considerable powers of investigation conferred by the UK regulations in order to establish whether that is the case. Any violations therefore need to be properly investigated and the arrangements ceased, and disclosure should be made to the appropriate authorities. Failure to make such disclosure can result in further criminal offences being committed.
Steele: In the US, successor liability principles apply in the sanctions arena. If a party acquires a company, and then learns that the acquired company committed sanctions violations prior to the acquisition – and within OFAC’s five-year statute of limitations – then the new owner is liable for the violations. This puts a premium on thorough pre-acquisition due diligence. If an acquirer learns of prior sanctions violations, and it nonetheless wishes to proceed with the acquisition, it should do a careful internal investigation and, if necessary and appropriate, disclose any violations to OFAC and work to resolve the matter. US law does not require voluntary self-disclosures to OFAC, but it will usually be in the company’s best interest to self-disclose. Among other things, self-disclosures result in a substantial mitigation of OFAC’s enforcement action.
Davy: In any acquisition context, the acquirer could be inheriting sanctions liabilities. In addition to inheriting liability for past actions in violation of law, the fact of the acquisition itself may make conduct that was lawful pre-acquisition unlawful post-acquisition. For example, if a US company acquires a non-US company with long-term supply contracts with a Cuban purchaser, as soon as the acquisition is completed, the non-US company will be owned or controlled by a US company and, under the terms of the Cuban sanctions program, no longer permitted to trade with Cuba. Protection against liability in connection with acquisitions begins with due diligence – an acquirer will be in the best position and will have the greatest range of options if it identifies problems well in advance of closing. A variety of tools are available to address problems, and what is right in any particular case will depend on the facts and circumstances.
FW: What are the consequences for non-compliance with sanctions requirements?
Steele: In the US, the consequences for violations can be severe. OFAC can impose substantial monetary penalties for violations. For most of its programs, including Iran, Sudan and Russia, the maximum penalty for each violation is the greater of twice the monetary value of the transaction constituting the violation, or $250,000. In serious cases involving wilful violations, the US Justice Department can bring parallel criminal actions, with maximum penalties of 20 years in prison and a fine of $1m per count of conviction, alongside OFAC’s civil action. If the case involves controlled items, the US Commerce Department can also bring a separate but parallel civil action. In addition, violators suffer reputational harm, over and above the criminal and civil penalties, that may make other businesses reluctant to deal with them.
Davy: The so-called ‘secondary sanctions’ may mean that even if civil or criminal penalties are not available, significant consequences nevertheless may attach. For example, foreign financial institutions that engage in sanctionable activities under the Comprehensive Iran Sanctions, Accountability, and Divestment Act of 2010 (CISADA) or the National Defense Authorization Act of 2012 (NDAA) may be subjected to strict conditions or the prohibition of opening or maintaining a correspondent account in the United States at a US financial institution. Engaging in sanctionable conduct under the Iran Sanctions Act of 1996 can lead to a range of penalties, from the loss of eligibility to receive US government contracts to designation as a blocked person. Parties that provide material support or assistance to blocked persons also could be designated as blocked persons.
Hobson: Enforcement of EU sanctions regulations is left to the relevant agencies of the individual EU Member States with national legislation setting out the penalties for breach. In the UK, breaches of the sanctions rules can lead to criminal prosecution leading to imprisonment and/or a fine. Prosecutions can be brought against individuals and corporate entities. Where a body corporate is guilty of an offence, and that offence is proved to have been committed with the consent or connivance of or is attributable to any neglect on the part of any director or manager, that person as well as the body corporate is guilty of that offence and can be prosecuted.
FW: What are the greatest challenges facing companies in terms of compliance efforts?
Davy: OFAC’s modification of its 2008 guidance – providing a presumption that blocking would extend to situations where one or more blocked persons own, individually or in the aggregate, directly or indirectly, a 50 percent or greater interest in an entity, even if those blocked persons were not acting in concert – has created a compliance challenge for companies. It has the potential to expand the class of ‘shadow targets’ – parties with whom it is unlawful for US persons to deal, but who cannot be identified other than through the exercise of due diligence – especially those owned by designated Russian nationals. This has created significant possibilities of unintentional violations where ownership information is difficult or impossible to obtain under the circumstances and ‘shadow targets’ therefore go undetected. Although OFAC has indicated that it will not hold banks responsible for due diligence on entities in the same way as it will hold someone responsible that has a direct relationship with a party, it is our understanding that OFAC expects, as a general matter, that companies will apply reasonable due diligence measures to all parties with which they are doing business in order to reduce the risk of dealing with a person or entity that is blocked pursuant to the OFAC guidance. Consequently, the challenge of companies identifying beneficial ownership in order to comply with the guidance is a difficult problem.
Hobson: The need to check commercial transactions with ever-changing sanctions regimes, including regular changes to the list of sanctioned individuals and entities, presents a significant challenge for many companies. This is compounded by the complex nature of many commercial transactions, as well as the lack of transparency in many corporate structures making it difficult for companies to know who they are dealing with, or whether their dealings may indirectly breach the sanctions rules. Our experience is that there is a lack of understanding within many companies of economic sanctions, but also considerable concern about the applicability of other sanctions regimes, particularly that of the US, to transactions. These elements can make it difficult to communicate internally an easy to understand and practical compliance policy.
Steele: Certainly one of the most significant compliance challenges is posed by OFAC’s ’50 percent rule’, particularly in the context of the recent Russia/Ukraine ‘sectoral sanctions’. Under the rule, if a designated/blocked person owns 50 percent or more of another company, then the latter company is also blocked, even if it does not appear on OFAC’s list. What is more, ownership interests of blocked persons are aggregated for purposes of this rule – so, for example, if two blocked persons each own 26 percent of another company, then that company is blocked. Also, ownership can be direct or indirect. The rule therefore presents a great compliance challenge, especially with respect to the Russia/Ukraine sanctions, in light of the fact that many of those parties are integrated into international markets.
FW: What advice can you offer to firms on building a comprehensive sanctions compliance program?
Hobson: A one-size fits all approach does not work to achieve sanctions compliance. Thus the most essential step for any company when it comes to sanctions compliance is to conduct an internal risk assessment by understanding the commercial activities that the company is participating in and where those may be impacted by sanctions rules. Using the results of such an assessment allows you to achieve a focused compliance program. Any program should include robust and appropriate screening, as well as thorough training for commercial personnel. Importantly, it should also include policies and procedures to ensure that an assessment of sanctions risks is built into commercial decision making.
Davy: The best compliance programs start with strong corporate governance and the commitment and support of senior management, as well as a compliance function that is independent of the business. Equally important is an enterprise-wide approach that addresses sanctions risk across the organisation and is based on a comprehensive global assessment of sanctions risk. A company should also make sure it has competent and well-trained personnel responsible for sanctions compliance and systems and controls that keep pace with improving technology and incorporate state of the art sanctions screening systems.
Steele: Every company engaged in international business should have a proper sanctions compliance program in place. Such a program should be integrated into an enterprise-wide compliance effort that includes regulations pertaining to conflict minerals, anti-bribery and corruption, and so on. But care should be taken to ensure that any comprehensive program does, in fact, meet sanctions requirements. And, in light of the new ‘sectoral sanctions’ and the implications of the 50 percent rule, there is a heightened premium on third party due diligence. It is necessary, of course, for companies to screen customers, vendors, suppliers and other business partners against OFAC’s list to ensure that they don’t do business with parties that are already on the list or are at risk of being placed there. But companies also need to undertake further efforts to ensure a prospective business partner that is not itself on the OFAC list is not owned by other parties who are. And, the fact that third parties who present sanctions risk could also be engaged in other problematic conduct, such as corrupt practices or money laundering, is all the more reason that sanctions compliance should be part of an integrated company-wide compliance program.
Caroline Hobson is a partner in the London office of CMS, specialising in trade and competition matters. Ms Hobson regularly advises on the application of EU and UK economic sanctions and export control rules to clients including those in the energy, IT, financial services, insurance and property sectors. She can be contacted on +44 (0)20 7367 2056 or by email: firstname.lastname@example.org
Charles Steele is a managing director in KPMG’s Forensic practice, focusing on economic sanctions, anti-money laundering, and anti-bribery and corruption. Before joining KPMG he served for more than 25 years in the US Treasury and Justice Departments. From 2011 to 2013 Mr Steele was the Associate Director for Enforcement in the Office of Foreign Assets Control (OFAC). He can be contacted on +1 (202) 533 8007 or by email: email@example.com.
Elizabeth Davy is a partner in Sullivan & Cromwell LLP’s Financial Services Group and is particularly active in the areas of banking regulation, supervision and enforcement. She advises clients on numerous bank regulatory and compliance issues, including issues relating to anti-money laundering and OFAC sanctions compliance. Ms Davy has represented banking clients in numerous public and non-public enforcement actions by bank regulatory agencies, FinCEN and OFAC. She can be contacted on +1 (212) 558 4000 or by email: firstname.lastname@example.org.
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