Bear Baiting – EU Sectoral Sanctions Against Russia

August 6, 2014

The European Union (the "EU") has over the course of the last two days adopted wide-ranging sectoral sanctions against the Russian Federation, which will apply throughout the EU’s 28 member states. These sanctions are a response to the ongoing crisis in Ukraine and in particular to the shooting down of Malaysian Airlines Flight 17. As a measure of the significance of this development, the only other states subject to sectoral sanctions are Iran, North Korea and Syria.

Since the EU first imposed restrictive measures in response to events in Ukraine on March 6, the sanctions have slowly but surely become progressively more stringent. What started with an asset freeze and travel ban imposed on 18 former Ukrainian politicians and officials has spread such that:

• 117 individuals have now been listed for an asset freeze and travel ban;
• 23 entities have been listed for an asset freeze;
• the EU has imposed  a ban on the importation of goods from Crimea or Sevastopol (unless certified by the Ukrainian authorities); and
• the EU has legislated for  widespread prohibitions relating to the defence, banking and oil sectors as well as further limitations on business in and with Crimea.

It is these last extensions to the EU’s sanctions that are the focus of this alert. Further detail on the other Russia/Ukraine sanctions may be found on our Mid-Year 2014 Sanctions Update webcast, or in our soon to be released written Mid-Year 2014 Sanctions Update.

The new sanctions were published in three separate regulations: Regulation 825/2014 (the "Crimean Regulation"), Regulation 826/2014 (the "Asset Freeze Regulation") and Regulation 833/2014 (the "Sectoral Regulation"). Each of these regulations apply within the territory of the EU, but also to the acts of any individual who is a national of a Member State, and to the acts of any legal person incorporated or constituted under the law of a Member State.   The Regulations also apply on board vessels or aircraft that are under the jurisdiction of a Member State. Finally they also apply to any legal person "in respect of business done in whole or in part within the Union." Thus those parts of a non-EU company’s operations that are conducted inside the EU are also subject to these, and other, sanctions.

This is the standard jurisdictional scope of EU regulations, but the potentially  extraterritorial scope of EU sanctions needs to be born in mind by non-EU companies that have operations in the EU. So, for example, if a Canadian company has operations in France, those French operations are subject to the EU’s sanctions.

The Asset Freeze Regulation

The Asset Freeze Regulation adds the latest set of individuals and entities to the sanctions lists of those subject to an asset freeze and travel ban and can be dealt with briefly. The new individuals are:

• Alexey Alexeyevich Gromov;
• Oksana Tchigrina
• Boris Litvinov
• Sergey Abisov
• Konstantine Valerevich Malofeev
• Arkady Romanovich Rotenberg
• Yuriy Valentinovich Kovalchuk
• Nikolay Terentievich Shamalov

The last three are what the Asset Freeze Regulation terms "long term acquaintance[s] of President Putin.".

The newly sanctioned entities are:

• JSC Almaz-Antey, a manufacturer of surface-to-air missiles;
• Dobrolet, an airline subsidiary of Aeroflot that has been running flights between Moscow and Crimea; and
• Russian National Commercial Bank, which is coming to dominate the Crimean banking sector and is owned by the so-called "Republic of Crimea".

The Sectoral Regulation

The prohibitions relating to "dual-use goods"

Article 2 contains a prohibition on the direct or indirect, sale, supply, transfer, or export of dual-use goods (i.e., goods that may have a military application, as well as a non-military application) as defined in Annex I to EU Regulation 428/2009  to a person or entity within Russia or for use in Russia if they are, or may be, intended to be for military use or a military end-user. There is a deeming provision that all goods sold to the Russian military are deemed to be of military use. The prohibition extends to goods originating from either within or outside the EU.

The competent authorities in each Member State (who are listed in an Annex) may allow such exports where they arise from a contract or agreement concluded before August 1, 2014.

Further, Article 4(1)(c) and 4(1)(d) contain prohibitions on  the direct or indirect provision of technical assistance or brokering services (both broadly defined, so that for example "technical assistance" includes repairs, maintenance and testing) in relation to dual-use goods or for the provision, manufacture, maintenance or use of such goods if they are, or may be, intended to be for military use or a military end-user. Further, the financing or financial assistance for any sale, supply, transfer or export of such goods or for related technical assistance is similarly prohibited.

These provisions place a premium on end-user and end-use certification when selling dual-use goods to Russia. The competent authorities in the Member States are likely to expect to see such certification before allowing any such exports to be authorised.

The prohibitions relating to the oil sector

Annex II to the Sectoral Regulation contains a lengthy list of equipment and technology that is used in the "deep water oil exploration and production, Arctic oil exploration and production, or shale oil projects in Russia". It is noteworthy that the word "gas" is omitted from this description (particularly since, as discussed below, the Crimean Regulations refers to "oil and gas"). Under Article 3 it will now be necessary for any EU exporter to seek prior authorisation for the direct or indirect sale, supply, transfer or export of such items to a person or entity within Russia or for use in Russia. The prohibition extends to goods originating from either within or outside the EU. This authorisation is to be sought by the organisations responsible for financial sanctions, rather than those who would more normally deal with export controls. In the United Kingdom this means that requests for authorisation go to HM Treasury, rather than the Department for Business, Industry and Skills.

Under article 3(5) the competent authorities "shall not grant any authorisation" for such an export if they have reasonable grounds for determining that the equipment or technology "is for projects pertaining to deep water oil exploration and production, Arctic oil exploration and production, or shale oil projects in Russia." The request for authorisation is to be made in the Member State where the exporter is established and, under Article 3(2) will treat these goods as if they are dual-use military items.

There is discretion as to whether the competent authorities may grant an authorisation where the export is under a contract concluded before August 1, 2014.

Under Article 3(6), "[u]nder the conditions set out in paragraph 5, the competent authorities may annul, suspend, modify or revoke an export authorisation which they have granted." This is unlikely to mean that already-existing export authorisations may now be revoked as this equipment would not previously have needed such an authorisation. Rather, it suggests that the EU has reserved to the competent authorities in each member state the ability to change their minds as circumstances develop or new information comes to hand.

Further, under Article 4(3) authorisation will also be required (and only given under the same circumstances as in Article 3) for the provision of technical assistance or brokering services in relation to the equipment in Annex II, and the provision, manufacture, maintenance and use of that equipment to either a Russian entity or person, or (if the equipment is to be used in Russia) to an entity or person in any other country.

Finally, the financing or financial assistance related to these same technologies will also require prior authorisation. This is said to include, "grants, loans and export credit insurance, for any sale, supply, transfer or export . . . or for any provision of related technical assistance" to either a Russian entity or person, or (if the equipment is to be used in Russia) to an entity or person in any other country.

The prohibitions relating to military goods

Contrary to what was included in a press release issued by the EU on July 29, the Sectoral Regulation does not contain "an embargo on the import and export of arms and related material from/to Russia." See the press release here. It is open to question whether this reflects a last minute change in policy. There is in fact no restriction at all on the importation of military goods and equipment from Russia into the EU.

Further, the limitations on the export of military goods to Russia, do not extend to the prohibition of such exports. Rather, under Article 4(1), the prohibitions are limited to the direct or indirect:

(i)      provision of technical assistance related to: the goods on the EU’s Common Military List (available here); or to the provision manufacture, maintenance or use of such goods by an entity or person in Russia or for use in Russia;

 (ii)      provision of financing or financial assistance related to goods on the Common Military List "including in particular grants, loans and export credit insurance or guarantee" for any sale, transfer or export of such goods, or for the provision of related technical assistance, to an entity or person in Russia or for use in Russia.

The prohibitions on the EU’s capital markets

It was widely publicised that the Sectoral Regulation would include restrictions on access to the EU’s capital markets for majority state-owned Russian banks. The EU has not, however, applied these limitations to all such banks but rather to a specified list of such banks contained in Annex III. While this may be added to in the future, for the moment the Central Bank of Russia, for instance, is not included. Even so, Russia’s four biggest commercial banks have been included along with its "Bank for Development and Foreign Economic Affairs" (VEB).

The banks are:

• Sberbank
• VTB Bank
• Gazprombank
• Vnesheconombank (VEB)
• Rosselkhozbank (Russian Agricultural Bank)

Further, under Article 5(b), the capital markets exclusion includes entities "established outside the Union whose proprietary rights are owned for more than 50% by" one of these banks.

It is unclear what the phrase "proprietary rights are owned for more than 50%" means – this is not an expression which has been used before in EU sanctions legislation. Further, not all of the different language versions (each of which is of equal force) have this same formulation. Thus while the French and Italian versions speak of "droits de proprieté" or "diritti di proprietà", and the Dutch of "eigendomsrechten", by contrast the German version speaks only of shares – "Anteile" – rather than "proprietary rights", and the Spanish simply of a company being more than 50% owned ("propiedad en más del 50 %"). This variety makes it unclear whether it is intended that this element of the prohibition should be limited to subsidiaries directly held by the parent bank, or whether it may be intended to extend to indirect subsidiaries which are in fact directly owned by companies not listed in Annex III. In a banking group such as that underneath VTB Bank these different interpretations result in significantly different results. If only directly held subsidiaries are included this would (according the bank’s own structure chart) cover the various VTB Banks in Angola, Armenia, Azerbaijan, Belarus, Georgia, Ukraine, as well as RCB Bank and VTB-24, but would not include Bank of Moscow OJSC as this is held through VTB Pension Administrator Limited and nor would it cover Leto Bank OJSC as that is held by Bank VTB 24 CJSC.

The same uncertainty as to the breadth of the provision in Article 5(b) means that the exact holding structure for Sberbank’s ownership of the Turkish bank DenizBank AS and Gazprombank’s subsidiaries in Armenia and Switzerland, may determine whether these banks fall within or outside the EU’s sanctions. It is to be hoped that the EU clarifies the meaning of this provision as a matter of some urgency. Until any such clarification is provided it would be prudent to assume that the prohibition extends to all indirectly held non-EU subsidiaries of the specified banks.

What EU persons and entities are prohibited from doing in relation to the sanctioned banks, or anyone acting on behalf of those banks or at their direction, is to "directly or indirectly purchase, sell, provide brokering or assistance in the issuance of or otherwise deal with transferable securities and money-market instruments with a maturity exceeding 90 days, issued after 1 August 2014."

The key terms of "money market instruments," "transferable securities" and "brokering" are each defined in the Sectoral Regulations.

"Money market instruments" is defined as: "those classes of instruments which are normally dealt in on the money market, such as treasury bills, certificates of deposit and commercial papers and excluding instruments of payment."

"Transferable securities" is defined as: "those classes of securities which are negotiable on the capital market, with the exception of instruments of payment, such as:

(i)      shares in companies and other securities equivalent to shares in companies, partnerships or other entities, and depositary receipts in respect of shares;

(ii)     bonds or other forms of securitised debt, including depositary receipts in respect of such securities;

(iii)    any other securities giving the right to acquire or sell any such transferable securities or giving rise to a cash settlement."

While "brokering" is defined as:

"(i)     reception and transmission of orders in relation to one or more financial instruments,

(ii)     execution of orders on behalf of clients,

(iii)    dealing on own account,

(iv)    portfolio management,

(v)     investment advice,

(vi)    underwriting of financial instruments and/or placing of financial instruments on a firm commitment basis,

(vii)   placing of financial instruments without a firm commitment basis,

(viii) any service in relation to the admission to trading on a regulated market or trading on a multilateral trading facility." 

These are purposefully broad definitions, intended to stop the banks and their subsidiaries from accessing the EU’s capital markets. It is to be imagined that they will be successful.

As has been noted in the press, however, the exclusion from EU’s capital markets itself excludes the EU subsidiaries of the sanctioned Russian banks. Subsidiaries inside the EU include: VTB Bank (Austria) AG, VTB Bank France S.A., VTB Capital Plc in the UK, VTB Bank (Deutschland) AG, VTB Bank Belgrade JSC, or Sberanks’s subsidiary Volksbank International AG.

The Crimean Regulation

The Crimean Regulation is actually a series of amendments to Regulation 692/2014 of June 23, 2014 which had imposed a ban on imports of goods from Crimea or Sevastopol to the EU. It should be noted that under Article 1(c) of Regulation 692 a definition of "goods" contained in another piece of EU legislation was adopted. This gives a very broad definition, as follows:

(a)   mineral products extracted within that country;

(b)   vegetable products harvested therein;

(c)    live animals born and raised therein;

(d)   products derived from live animals raised therein;

(e)    products of hunting or fishing carried on therein;

(f)    products of sea-fishing and other products taken from the sea outside a country’s territorial sea by vessels registered or recorded in the country concerned and flying the flag of that country;

(g)   goods obtained or produced on board factory ships from the products referred to in subparagraph (f) originating in that country, provided that such factory ships are registered or recorded in that country and fly its flag;

(h)   products taken from the seabed or subsoil beneath the seabed outside the territorial sea provided that that country has exclusive rights to exploit that seabed or subsoil;

(i)    waste and scrap products derived from manufacturing operations and used articles, if they were collected therein and are fit only for the recovery of raw materials;

(j)    goods which are produced therein exclusively from goods referred to in subparagraphs (a) to (i) or from their derivatives, at any stage of production.

The new prohibitions, on the other hand, relate to investment in the key sectors of transport, energy, telecommunications, oil, gas and minerals in Crimea and Sevastopol. Under the new Article 2a(1)(a) the granting of a loan or credit specifically relating to the "creation, acquisition or development of infrastructure" in the transport, telecommunications or energy sectors is prohibited. Article 2a(1)(b) prohibits the acquisition or extension of a participation in a company established in Crimea or Sevastopol that is itself engaged in the "creation, acquisition, or development of infrastructure" in these same sectors in Crimea and Sevastopol, and Article 2a(1)(c) prohibits the creation of (but not the investment in) joint ventures that are so engaged. The term "joint venture" is not defined. Note that the acquisition of such an interest in a non-Crimean or Sevastopol company (say a Russian company) is not prohibited.

These provisions are then mirrored by Article 2a(2)(a) to (c) in prohibiting the granting of finance, the acquisition of a participation, or the creation of a joint venture "relating to the exploitation of oil, gas or mineral resources in Crimea and Sevastopol." The contrasting inclusion of "gas" in the Crimean Regulation compared to its omission in the Sectoral Regulation is to be noted.

Under Article 2b the provision of technical assistance or brokering services in relation to any of the prohibited investments is itself prohibited.

The prohibitions in Article 2a and 2b as against investment, have a short term exception in Article 2d for contracts concluded before July 30, 2014. Please note that as drafted, this exception does not cover a wholly new acquisition. These may be performed until October 28, 2014, so long as the competent authority in the relevant Member State is given 10 days’ notice of this performance.

Mineral resources are defined by way of a long list of minerals contained in Annex II. This contains many precious and non-precious metals, chemicals and other minerals, but also includes surprising items such as "Electrical Energy." It should be closely consulted.

The term "exploitation" is also defined and covers "exploration, prospection, extraction, refining and management . . . and provision of related geological services." Unless covered by the term "management," it might appear from this that the transportation of oil, gas and mineral resources is not included within the prohibited activity such that investment in oil and gas pipelines or shipment, for example, is currently unrestricted. Such an investment would, however, be captured by the energy sector infrastructure prohibitions contained in Article 2a.

The new Article 2b prohibits the provision of technical assistance or brokering services in relation to the investments prohibited in Article 2a.

Annex III to the Crimea Regulation lists equipment and technology said to be related to infrastructure in the transport, telecommunications, energy, oil, gas and mineral resources sectors. Other than two items it is, however, entirely identical to the list contained in Annex II to the Sectoral Regulation which was for "deep water oil exploration and production, Arctic oil exploration and production, or shale oil projects in Russia." This suggests that despite the six sectors being listed, the real focus of the prohibition on the equipment listed in Annex III is the oil and gas sector and specifically the many oil fields contained in the newly claimed territorial waters of Russia in the Black Sea.

Under Article 2c(1) "it shall be prohibited to sell, supply, transfer, export, directly or indirectly" any of the listed equipment to a person or entity in Crimea or Sevastopol or for use in Crimea or Sevastopol. Article 2c(3) applies the now familiar prohibitions on technical assistance, brokering services and financing relating to sales of this equipment to Crimean companies or persons or for use in Crimea.

Existing contracts concluded before July 30, 2014 may be performed until October 28, 2014, so long as the competent authority in the Member State is given 10 days’ notice of this performance.

It should be noted that although Regulation 692/2014 had included a prohibition on the insurance or reinsurance relating to the importation of goods of Crimean origin, and although the EU had indicated in its press release that this would be extended to the new export bans to Crimea, the Crimean Regulation contains no reference to insurance or reinsurance, with the existing reference in Regulation 692 not capable of being extended to cover the inserted amendments. It is unclear whether this is another late policy change, or whether this is an oversight which will be corrected in due course.

Conclusions

Subject only to a change of policy by the Russian Federation, these sanctions are likely to remain in place for the short and medium term. Further, it is likely that additional individuals and entities will have their assets frozen, further banks and other entities excluded from the capital markets, and additional items of equipment will be added to the banned lists, and perhaps additional sectors of the Crimean economy excluded from EU investment. Businesses can expect both diligent enforcement and perhaps little leniency when it comes to the exercise of any discretion on the granting of authorisations to export. Rigorous due diligence and compliance should become the new normal when doing any business connected to Russia.