Lending to Russian and Ukrainian borrowers: Financial Sanctions
The Wealth Finance Brief - 20 June 2014
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The current crisis in Ukraine and worsening relations between the West and Russia make it timely to review how the financial sanctions recently imposed may affect finance transactions. While, at the time of writing, there has been a slight easing in tensions, the position remains highly volatile.
In this note we outline the sanctions imposed by the EU and US, consider what steps might be available to lenders, and what effect the sanctions may have on existing facilities and on documentation. With financial sanctions, however, "the devil is in the detail". It is important to establish exactly which sanctions are applicable, who is affected by them, and their exact terms.
Sanctions arising from events in the Ukraine
EU sanctions were first imposed on 6 March 2014 against former President Yanukovych and a number of former ministers and senior officials identified with his regime. On 17 March the EU imposed sanctions against a number of Russian and other officials deemed by the EU to be directly associated with events in Ukraine.
The sanctions require funds and economic resources of those named to be frozen, and prohibit their being made available to them or for their benefit, whether directly or indirectly, without a licence from the relevant authority. This extends to assets owned, held or controlled by these individuals and EU guidance indicates that an interest of 50% or more amounts to ownership. The restrictions apply to steps taken both within the EU and elsewhere, and an EU institution may find that this conflicts with its legal obligations outside the EU, causing potential difficulties. Breach of these sanctions is a criminal offence, but liability is not strict: it is a defence if the institution or person concerned did not know and had no reasonable cause to suspect that it was dealing with a designated person. Institutions acting in good faith and without negligence when freezing assets will not face civil claims from parties affected.
A number of other jurisdictions, including a number heavily exposed to investment into Russia, have followed suit, or are within the scope of these sanctions. Cyprus and the BVI, for example, are reported to have been, respectively, the first and third largest foreign direct investors into Russia in 2012, with Cyprus much favoured by high-net-worth Russian and Ukrainian clients. Both jurisdictions are subject to the EU sanctions, Cyprus as a member state, and BVI as a British dependency.
A US executive order of 6 March 2014 authorised an asset freeze and visa ban on individuals and certain entities associated with the situation in Ukraine, and sanctions have followed. The latest regulations were published on 8 May and Ukraine-related sanctions currently (as at 14 May) list 45 individuals and 19 entities (including Bank Rossiya) on the Office of Foreign Assets Control (OFAC) list.
Among other restrictions, US banks are unable to process payments to or from those on the OFAC list, or entities 50% or more owned by them. Relevant funds in their possession or control, or in that of related entities, must be blocked and sequestered. As with the EU, there is a licence regime. Liability for breach of these US sanctions is strict: unknowing or unintentional breach may result in liability.
Financial institutions outside the US will bear in mind that while US sanctions may not be directly applicable to them, the issues become more complex if they have US operations, or in relation to their US national employees. The same applies when payments in US dollars are involved, given that most such payments are routed through the US, and so across the books of institutions subject to the US sanctions.
Particular issues arise when transactions involve assets or businesses in Crimea. Under Ukrainian law it remains part of Ukraine. Under Russian law it is part of Russia, subject to transitional measures applying until 1 January 2015. Under the "accession agreement", however, the laws of the Russian federation are stated to have immediate effect in Crimea. Similar issues are likely to arise with any other part of Ukraine that joins Russia or assert greater autonomy.
In addition to financial sanctions, if individuals (whether or not subject to sanctions) are held to have misappropriated public assets, that of itself is likely to have generated criminal property potentially subject to anti-money laundering rules. Currency controls imposed by Ukraine may also prevent Ukrainian entities acquiring funds required to settle obligations falling due in a foreign currency.
What can lenders do?
Immediate concerns are questions such as: can we make the facility available or make additional advances, and can we cancel or call default under an existing facility or realise security? These are considered further below, while this section looks at the position of lenders in broader terms.
Financial institutions will already have undertaken due diligence to identify if they are dealing with individuals (or related entities) subject to Ukraine-related sanctions, and if so what payments and other steps are prohibited, or prohibited without first obtaining a licence from the appropriate authority. Particularly in a wealth management context, the necessary information should have been obtained at client inception stage for anti-money laundering and other reasons, although tracing the beneficial ownership of entities can be challenging. The situation must also be kept under review, as the sanctions lists continue to grow, and lenders should consider not just borrowers, but also owners, security providers and other obligors. Credit approval for making facilities available to potential sanctions targets should be subject to similar considerations and due diligence.
Lenders should review facility documentation, focussing on representations and events of default, and any specific terms relating to financial sanctions, illegality or unenforceability. This may require a careful analysis of the documents, and the relevant place of performance of particular obligations. Given that the EU sanctions apply to actions taken by EU persons (including companies) anywhere in the world, the scope to structure payments and arrangements so as to avoid breach of those sanctions is restricted.
Particular difficulties are likely where security is held over assets in Crimea, since Crimea has been cut off from the relevant Ukrainian registers of real and personal property and security. Realistically, future security will need to treat Ukraine as part of Russia, while the continuing effectiveness of existing security subject to Ukrainian law will have to be considered carefully. The Parliament of Crimea has indicated that Ukrainian law adapted after 21 February this year will not apply to Crimea, which suggests that, in theory at least, contracts and security in place before that date should remain effective.
Russian customers are an important part of the business jet market. If a borrower is made subject to sanctions, an application may have to be made for consent to receive payments that would otherwise be prohibited on loans and leases. In the UK this would be by application to HM Treasury. But consent will not, of course, be forthcoming to allow funds to be shifted to jurisdictions outside the scope of existing sanctions, which would defeat the purpose of the freeze.
It might appear that the operation of valuable movable assets such as corporate jets will not be directly affected by the sanctions, given that the EU sanctions principally seek to freeze "funds" and "economic resources". The latter are widely defined to include assets of every kind that may be used to obtain funds, goods or services. Freezing economic resources means preventing their use to obtain funds, goods or services in any way, including by selling, hiring or mortgaging them. But while the operation of such an asset may not be affected, servicing a related loan facility and any realisation of security clearly could be, and may also fall within the provision affecting the making of economic resources available "for the benefit" of a designated person.
The individuals currently designated as sanctions targets are in general politicians and officials, unlikely to own such assets. Many are likely to be on the boards of companies that charter or own business jets, although at present that seems unlikely to make such companies subject to sanctions. Nonetheless, the position needs to be kept under review, and the US sanctions, at least, include the executive chairman of one major state owned enterprise in the Russian oil and gas sector.
In a trade finance context, banks will be unable to pay out under a letter of credit if prohibited under sanctions legislation, even if presented with compliant documents. Widely worded sanctions clauses, expressly excusing payment if sanctions are imposed or threatened, should be closely reviewed by beneficiaries.
Overview of existing documentation and issues
The Loan Market Association forms of document do not currently make express provision for financial sanctions, although the LMA advises that, in appropriate transactions, additional representations may be applicable to cover sanctions, bribery or other deal-specific issues. They do, however, include standard illegality provisions by which if it becomes unlawful in any applicable jurisdiction for a lender to perform its obligations or to fund or maintain its participation in a loan, its available commitment will, on notice to the agent, be cancelled, and the borrower (or any affected borrower) must prepay the participation of each affected lender. Whether or not the imposition of sanctions will trigger an "unlawfulness and invalidity" event of default will depend on the particular wording used and circumstances, but in general it appears unlikely that sanctions would be held to make it unlawful for a borrower to perform its obligations (it would instead make it extremely difficult for it to do so).
It is becoming common, however, particularly in certain markets, for lenders to include an express borrower undertaking to ensure that loan proceeds are not used for a transaction in breach of applicable sanctions, or for the benefit of a person on the SDN List, and also an event of default to cover political and economic risk, which are perhaps more likely to be triggered by the imposition of sanctions, again depending on the terms of the particular provision.
A further question is whether the imposition of sanctions on a borrower will trigger a material adverse change (MAC) event of default. MAC clauses are often heavily negotiated and the analysis will depend on both the wording used and the factual position. It may be challenging to establish a MAC, but if the borrower's business or secured assets are located in Crimea (or perhaps in an affected area of eastern Ukraine) it is possible that such a provision might be triggered, particularly if the wording extends to political and economic risk.
The imposition of sanctions could, in theory, also result in the performance of obligations under a loan agreement being held to have been frustrated. It appears, however, from the Libyan Arab Foreign Bank case ( 1 QB 728), concerning a proposed payment of US dollar funds in London that might result in the paying bank breaching US sanctions, that whilst it is possible for a banking contract to be frustrated in this type of situation, had performance been impossible without an act that was illegal, the obligations of the paying bank would have been suspended rather than discharged.
The possibility of obtaining a licence to advance funds may also be relevant to the analysis set out above. An illegality or force majeure provision may not, in any event, excuse performance where, for example, a restriction is imposed by the EU but performance is to be undertaken outside the EU.
Whether or not exercising a right of set-off or to combine accounts breaches a restriction on the payment of funds is likely to depend on the exact terms of the relevant restriction or sanction (In re K (Restraint Order)  2 QB 298).
In summary, the situation requires continuing vigilance as to those affected by sanctions, and a careful consideration of both the relevant documentation and the legal issues.
This briefing is intended only as a guide and does not constitute legal advice. We will be pleased to provide more detailed advice if required.