U.S. Sanctions – Tips and Traps for Lenders

Mark Herlach, Sutherland, Asbill & Brennan LLP Jeanine McGuinness, Davis Polk & Wardwell LLP

American Bar Association Business Law Section 2015 Spring Meeting San Francisco, CA

Overview – What is OFAC?

Purpose is to achieve U.S. national security, foreign policy, or economic goals Sanctions generally prohibit U.S. persons from directly or indirectly engaging in or

facilitating business with target countries, individuals, or entities Sanctions may be imposed against geographical areas and all persons within those

areas, or against designated governments, organizations, individuals, and entities wherever they may be located There are currently more than 20 sanctions programs, although some overlap Frequently change in response to world events

The U.S. Treasury Department’s Office of Foreign Assets Control (“OFAC”) is the primary federal agency administering and enforcing U.S. economic sanctions programs against countries, governments, groups, and individuals

2

U.S. Sanctions Programs Building Blocks

Asset Freezes (Blocking) – Bar transfer of or dealing in property, e.g., assets, liabilities, services, securities, and all contracts in which a sanctions target has any interest (a blocked property interest often is less than legal title or ownership)

Trade Embargoes – Bar imports and/or exports of goods, services, and technology (or some combination) “Services” include financial services

New Investment Prohibitions – Bar contributions or commitments of funds, loans or credits, and development of economic resources Scope varies depending on definition of “new investment”

Sectoral Sanctions – New tool used in the Russia/Ukraine sanctions; impose less comprehensive sanctions on specified parties in certain industries

Miscellaneous Prohibitions – May bar entry into or the performance of contracts supporting government, commercial, industrial or public utility projects; dealing in goods or services originating in certain countries; may limit travel or entry into the United States

3

Who Is Targeted by U.S. Sanctions?

Territorial (Country) Sanctions: Crimea, Cuba, Iran, Sudan, Syria, and, for certain transactions, North Korea (“Target Countries”) Territorial sanctions on Burma/Myanmar have been suspended

List-Based Sanctions: Individuals or entities (“Target Persons”) whose property is blocked. Generally placed on OFAC’s List of Specially Designated Nationals and Blocked Persons (“SDN List”):

Individuals and entities involved in narcotics trafficking, terrorism and terrorist financing, transnational crime, proliferation of weapons of mass destruction (WMD), piracy

Designated individuals and entities in or related to, at April 13, 2015, former regimes in the Balkans, Côte d’Ivoire, Iraq, Liberia, Libya, and Ukraine and current regimes in Belarus, Burma, the Democratic Republic of the Congo, North Korea, Russia, South Sudan and Zimbabwe; specific acts in the Central African Republic, Darfur, Lebanon, Somalia and Yemen

Sectoral Sanctions: Defense, Energy, Financial Services

Individual and entities designated in OFAC’s Sectoral Sanctions Identifications Lists (the “SSI List”) and conduct described in Directives 1-4 of the Russia/Ukraine-related sanctions

4

Who Must Comply with OFAC Regulations?

“U.S. Persons”:

U.S. citizens and permanent resident aliens (“green card” holders), wherever in the world they are located

Entities organized under U.S. law, including their non-U.S. branches

Persons (including entities) actually located in the United States (even temporarily – on vacation or at a meeting)

U.S. branches of non-U.S. companies are U.S. Persons

For Cuba and Iran – Entities owned or controlled by U.S. Persons, wherever organized or located (e.g., foreign subsidiaries), must also comply

5

Iran Sanctions – Recent Developments

Significant Acceleration of Sanctions through 2013 Gradual trend toward secondary sanctions: denying third-country companies access to or benefits of

U.S. market if they trade with Iran Significant ramping up of secondary sanctions from 2010-2013 Recent Pause in Imposition of Additional Sanctions January 2014: P5+1 and Iran began to implement the Joint Plan of Action (“JPOA”); extended in July

2014 and again in November 2014 Freezes key elements of Iran’s nuclear program in exchange for temporary, limited, reversible sanctions relief and

repatriation of certain blocked funds held outside of Iran

During the “JPOA Period”, as extended – January 20, 2014 through June 30, 2015 – non-U.S. persons engaging in certain transactions with Iran will not be targeted for secondary sanctions under U.S. law

The United States does not require further reductions in purchases of Iranian crude by China, Japan, South Korea, India, Turkey, and Taiwan during the JPOA Period

Virtually no impact on U.S. persons and their subsidiaries, which remain subject to the prohibitions in the Iranian Transactions and Sanctions Regulations

April 2014: Parties to the JPOA reached an understanding on the framework for a Joint Comprehensive Plan of Action for containing Iran’s nuclear program (the “JCPOA”) Iran and the P5+1 are working to complete the final text of the JCPOA by June 30, 2015

6

Russia/Ukraine Sanctions – Recent Developments

March and April 2014: The United States, the European Union and other nations, including Canada and Switzerland, imposed sanctions on certain Persons in response to threats to the peace, security and stability of Ukraine, including actions taken by the Russian Federation involving Ukraine and Crimea March 2014: President Obama signed three new Executive Orders, including Executive

Order 13662, which authorizes a new type of sanctions – “sector-related” sanctions – on parties operating in sectors identified by the Secretary of the Treasury, such as financial services, energy, metals and mining, engineering, and defense and related materiel; not yet applied; sectoral sanctions first applied in July 2014 December 2014: Ukraine Freedom Support Act of 2014 enacted

Authorizes the President to impose additional economic sanctions against entities in the Russian defense sector that engage in specified activities

Also authorizes, but does not mandate, the imposition of sanctions on non-Russian persons that knowingly engage in targeted activities involving certain Russian parties or sectors, including the imposition of sanctions on non-Russian persons knowingly investing in certain Russian crude oil projects

President Obama issued a new Ukraine-related Executive Order (13685) that imposes territorial sanctions on the Crimea region

7

Who Owns What?

In August 2014, Treasury published revised guidance on treatment of entities owned by blocked persons (OFAC’s 50 Percent Rule)

SDN interests will now be aggregated to determine whether interests in an owned entity are also blocked

Guidance has not eliminated ambiguity

Anomalies of ownership rule

What diligence is “due”? Lack of transparency remains an issue

Restructuring by blocked persons to avoid sanctions

8

What is “Support” under Directive 4?

Directive 4 prohibits activities “in support of exploration or production” for projects with the potential to produce oil in the Russian Federation

Unclear how far the concept of “support” extends

What is the scope of the exclusion for “financial services”? Clearing transactions

Providing insurance

How much of a link is required?

Interaction with other Directives

9

Russia/Ukraine Sanctions – Energy Sector Export Controls

New export restrictions target Russian development of “long-term, technically challenging future projects.” Russian energy sector sanctions restrict the export of certain items used directly or

indirectly for Exploration for or production of oil and gas from Russian deepwater (greater than 500 feet) Arctic offshore Shale projects in Russia to product oil or gas

All exports of energy-related items to Russia should be subject to special review Lending for international energy activities involves new risks because of the export

control sanctions administered by the Department of Commerce

10

Cuba Sanctions – Recent Developments

Cuba Assets Control Regulations (the “CACR”) were amended in January 2015 to implement policy changes announced by President Obama in December 2014, in order “to further engage and empower the Cuban people” by facilitating certain authorized commerce, authorized travel to Cuba by U.S. persons, and the flow of information to, from, and within Cuba, including by: Increasing remittance levels to Cuba by U.S. persons; Expanding travel to Cuba by issuing general licenses for the 12 existing categories of travel to

Cuba authorized by law; Authorizing expanded exports and imports between Cuba and the United States; and Authorizing credit/debit and correspondent account transactions between Cuba and the United

States.

OFAC noted that the Cuba embargo remains in place and that most transactions between the United States, or persons subject to U.S. jurisdiction, and Cuba continue to be prohibited OFAC continues to enforce the prohibitions of the CACR

11

What Are the Penalties for Violating U.S. Sanctions?

The penalties for violations can be substantial. Depending on the program:

Criminal penalties for willful violations can include fines ranging from $50,000 to $10,000,000 and imprisonment ranging from 10 to 30 years

Civil penalties can range from a maximum of $65,000 to $1,075,000 per violation

Most cases are covered by the International Emergency Economic Powers Act, as amended, authorizing a civil penalty that is the greater of $250,000 per violation or twice the value of the transaction

Obvious franchise and reputational risks exist for U.S. companies that are investigated or deemed to have violated the regulations and sometimes even for those that engage in lawful transactions which have some nexus to sanctions targets

One enforcement action often attracts the attention of other agencies

12

Key Trends in Sanctions Investigations

Overview of key sanctions-related cases involving financial institutions from 2005-2015: Substantial fines and criminal penalties imposed – aggregating more than $14 billion

Multi-year, worldwide investigations and comprehensive analysis of USD payments with links to sanctioned jurisdictions

Scrutiny by multiple federal and state civil and criminal regulators OFAC

U.S. Department of Justice

Manhattan District Attorney’s Office

Federal Reserve Bank

New York State Department of Financial Services

Office of the Comptroller of the Currency ("OCC")

Senate Permanent Subcommittee on Investigations

13

Fines in Large Sanctions Investigations

14

*The ABN AMRO settlement was first announced in April 2007.

BANK DATE AGGREGATE FINE

ABN AMRO* 2005, 2007 $580,000,000

Lloyds 2009 $350,000,000

Credit Suisse 2009 $536,000,000

Barclays 2010 $298,000,000

JPMC 2011 $88,300,000

ING 2012 $619,000,000

Standard Chartered 2012, 2014 $967,000,000

Fines in Large Sanctions Investigations (cont.)

15

BANK DATE AGGREGATE FINE

HSBC 2012 $1.9 billion

Bank of Tokyo – Mitsubishi 2012-2014 $574,000,000

Royal Bank of Scotland 2013 $100,000,000

Clearstream Banking 2014 $151,902,000

BNP Paribas 2014 $8.97 billion

Commerzbank 2015 $1.45 billion

Overview and Key Trends in Sanctions Investigations

Financial institutions have been charged with “stripping” that occurred outside the United States “Stripping” refers to removing or altering sanctioned-country identifiers, or inserting misleading

information, in payment messages

Examples of alleged “stripping” practices: Use of a special ex-U.S.-based internal payment processing unit to manually review messages from

sanctioned-country banks and remove country references

Marketing to clients in sanctioned countries the capability to manually alter payment messages

Creating a special manual to instruct employees to remove references

Routing payments through internal account to hide connection to sanctioned entities

These practices largely involved acts outside of the United States that impacted transaction activity in the United States Many of the banks had U.S. offices; only three used their own branches to clear payments on behalf

of sanctioned entities

Increased involvement of state regulators (i.e. NYDFS)

16

U.S. Sanctions Risks and Risk Mitigation in the Credit Agreement Context

Main Prohibitions of Concern for U.S. Persons in Connection with Lending Transactions

Prohibition on the exportation of services by U.S. Persons to Target Country or Government or to Target Persons

Test: Is any benefit received by Target Persons or Persons in a Target Country or by its government in any location?

Prohibition on the “facilitation” by U.S. Persons of non-U.S. persons’ actions that the U.S. Person could not perform directly

Approval, guarantee, financing, brokering, or other assistance

This type of facilitation is the key concern for U.S. lenders – they need to ensure that their loans are not being used by the borrower to finance business with Sanctions Targets

Changing policies to allow non-U.S. Person to act in place of U.S. Person normally responsible for approval of such transactions

Referral to non-U.S. person

Delegation of job responsibility to non-U.S. colleague

18

OFAC Facilitation Violation Risks for Lenders

U.S. Persons generally may not: Play any role in deals on behalf of Target Countries or Target Persons directly or indirectly;

Engage in transactions involving companies or persons that have business with or investment in Target Countries or Target Persons unless the targeted business is de minimis (discussed further below); or

Transfer any property or property interest to or on behalf of an individual, entity or group that is acting for or is designated as a Target Country or Target Person. This may include: Providing financing to a foreign borrower

Underwriting for a foreign issuer

U.S. Persons may not participate in many transactions that are entirely legal for non-U.S. Persons

19

OFAC De Minimis “Rule”

U.S. Persons may, in general, make loans to non-target companies or parties that engage in business involving Target Countries or Target Persons, provided that: The financing does not involve or relate to the borrower’s business with the Target Country or Target

Person, and

Due diligence confirms that the borrower’s activities involving sanctions targets are de minimis

Always conduct diligence to ensure that loan proceeds provided by a U.S. bank are not intended to finance activities in a Target Country or with a Target Person

If a non-U.S. borrower’s business involving sanctions targets is limited, it may be legal for U.S. banks to lend money to the borrower

No prescribed rule or bright line test for what is “de minimis” Up to 10% of assets, revenues or profits may be acceptable, depending on the circumstances

Current relations between U.S. and Target Country or developments pertaining to counterterrorism or nonproliferation may result in OFAC applying lower than 10% threshold (lenders seem more comfortable with a 5% limit) Currently, Iran and WMD are of particular concern

20

Other Potential OFAC Risks (Iran and Russia)

If non-U.S. borrower engages in certain transactions involving Iran or Russia, the borrower risks being sanctioned by the U.S. Government If the most extreme sanction – blocking of its property within U.S. jurisdiction –

were imposed, then U.S. banks would be unable to conduct business with the borrower and could not receive repayment for the loans (any repayment funds would have to be “frozen”)

Therefore, if there is an indication that the borrower conducts any business with Iran or Russia, the banks must conduct additional due diligence

21

Steps to Mitigate OFAC Risk: Due Diligence

Sample OFAC diligence questions: Does a transaction involve or relate to a Target Country or Target Person?

Does a transaction involve or relate to a non-target entity with substantial business interests involving Target Countries or Target Persons?

Will U.S. citizens, permanent residents, or individuals located in the United States be involved in or supervise the transaction?

Describe the company’s sanctions compliance program, if any

Provide details about the borrower’s and its affiliates’ business with Sanctions Targets, including the percentage of their assets, revenue, and net profits attributable to business with Sanctions Targets

22

Steps to Mitigate Risks: Protection Through Contractual Undertakings

When engaged in a credit transaction, you can preserve the understandings reached in due diligence by representations and covenants

No “one size fits all” - should be tailored to the risk profile of the company

“Status Under Sanctions” Obtain assurance that neither the non-U.S. borrower nor any of its group members who may receive

loan proceeds are themselves Target Persons or located in a Target Country

“Use of Proceeds” Obtain undertaking that borrower will not use loan proceeds to finance business with Target Person or

in Target Countries

Designed to protect the banks against a claim that the proceeds of the loans were used to finance business of or with targets of sanctions, i.e., to guard against a facilitation violation

In an acquisition financing, if the proceeds are all going to purchase stock of the target, and there are no red flags about the seller and no revolver, banks can consider forgoing use of proceeds covenant

23

Steps to Mitigate Risks: Protection Through Contractual Undertakings (cont.)

General considerations Whether to permit a “knowledge qualifier” In “status under sanctions” representations, it may be acceptable to include

knowledge qualifier for directors, officers, employees, affiliates, or agents but not for the borrower and its subsidiaries If employees, agents, and affiliates are so numerous that the knowledge qualifier

would make any of these categories meaningless, they can be deleted if, after conducting due diligence, there are no red flags

Whether to permit a “materiality qualifier” Unacceptable in sanctions use of proceeds covenant

24

Steps to Mitigate Risks: Protection Through Contractual Undertakings (cont.)

Some banks require representations and/or covenants regarding the borrower’s compliance with all applicable sanctions

Some include representations and covenants as to the maintenance of sanctions compliance policies and procedures Are compliance with sanctions provisions necessary? What are the risks? Minimal legal risk

Credit risk?

Reputational risk If borrower is not a U.S. Person, may be of limited utility to the lenders

Covered by general compliance with laws representation and covenant (although such representation is often subject to materiality or MAE qualifier)

If included, should lenders permit a materiality qualifier? Avoid having a minor sanctions violation trigger an event of default

25

When is Forgiveness not a Good Thing?

Waivers and amendments to credit agreements with an SSI entity can be problematic

Delay of payment is not specifically authorized

Numerous different factual situations will arise

OFAC guidance on this is sparse

26

Sample Sanctions Representations and Covenants

OFAC: “Not a Sanctions Target” Representation

Neither the Borrower nor any of its subsidiaries nor, to the knowledge of the Borrower, any director, officer, employee, agent or affiliate of the Borrower or any of its subsidiaries, is an individual or entity (“Person”) that is, or is owned or controlled by, a Person that is:

(i) the subject of any sanctions administered or enforced by the U.S. Department of Treasury’s Office of Foreign Assets Control (“OFAC”) or the U.S. State Department[, the United Nations Security Council (“UNSC”), the European Union (“EU”), Her Majesty’s Treasury (“HMT”), or other relevant sanctions authority] (collectively, “Sanctions”), nor

(ii) located*, organized or resident in a country or territory that is, or whose government is, the subject of Sanctions** (including, without limitation, Cuba, Iran, North Korea, Sudan and Syria).

* Could substitute “has a place of business” or “operating”

** Borrowers may request the addition of language such as “comprehensive territorial” to modify “Sanctions,” which should be acceptable

Note that there are other acceptable formulations of this representation, including those that define “Sanctioned Person” and “Sanctioned Country”.

28

OFAC: “Not a Sanctions Target” Representation (cont.)

Commonly seen problems with “Not a Sanctions Target” representations: Example A: “The [foreign] Borrower, its subsidiaries, and its and their directors, officers,

employees, agents, and representatives are not Persons described or designated in [OFAC's] Specially Designated Nationals and Blocked Persons List.”

Too narrow – only covers a portion of a U.S. Person’s obligations not to deal with sanctions targets, omits prohibited territories

Example B: “None of the [foreign] Borrower, its subsidiaries, or its or their directors, officers, employees, agents, or representatives is subject to U.S. economic sanctions administered by [OFAC].”

Ambiguous – the phrase “none of [the relevant parties] is subject to U.S. economic sanctions” could be interpreted as a representation that the Borrower [etc.] is not subject to the jurisdiction of OFAC, which will almost universally be true of a non-U.S. individual or entity.

Need representation that the Borrower [etc.] is not “the subject of U.S. sanctions” or “a target of U.S. sanctions”

29

OFAC: “Use of Proceeds” Covenant

(b) The Borrower will not, directly or indirectly, use the proceeds of the Loans, or lend, contribute or otherwise make available such proceeds to any subsidiary, joint venture partner, or other Person:

(i) to fund any activities or business of or with any Person, or in any country or territory, that, at the time of such funding, is, or whose government is, the subject of Sanctions; or

(ii) in any other manner that will result in a violation of Sanctions by any Person (including any Person participating in the Loans, whether as lender, advisor, investor or otherwise).

30

OFAC: “Use of Proceeds” Covenant (cont.)

Commonly seen problems with “Use of Proceeds” covenants: “The [foreign] Borrower . . . will not knowingly directly or indirectly use the proceeds of

the offering . . . for the purpose of financing the activities of any person currently subject to any U.S. sanctions administered by OFAC.” Too narrow – limited to any “person” subject to sanctions, thus excluding prohibited jurisdictions

Knowledge qualifier Possible compromise “will not, directly or, to the Borrower’s knowledge, indirectly…”

Same ambiguous “subject to any U.S. sanctions” language as in sample representation

“Currently” freezes covenant as of the closing date rather than at the time of the funding

31

Questions & Discussion

32

Jeanine McGuinness is counsel in Davis Polk’s Corporate Department, practicing in the Washington DC office. She concentrates in U.S. trade and investment laws applicable to cross-border transactions, focusing on U.S. economic sanctions, anti-money laundering laws, anti-boycott laws, the Foreign Corrupt Practices Act and transaction reviews by U.S. national security agencies, including the Committee on Foreign Investment in the United States (CFIUS). Her clients include major U.S. and foreign financial institutions, and pharmaceutical, technology, telecommunications, energy and natural resource companies.

Mark Herlach is an international lawyer in Sutherland’s Washington office with a practice focus on energy and international business. With deep experience in Asia, Europe and North and South America, Mark represents a broad range of clients, including corporations, governments, and high-technology companies. He has guided clients in a broad range of complex matters, including mergers and acquisitions, and export control, import relief, and Foreign Corrupt Practices Act investigations. Mark advises on cross-border transactions, foreign investment, government policy, international trade, and privacy matters.

33