EU sanctions and Euro denominated securities

EU sanctions against Russia and Belarus

Following the Russian invasion of Ukraine, the Member States of the European Union (EU) adopted a series of new sanctions against Russia and Belarus. The necessary speed at which these were introduced and the complex nature of the matters with which they deal mean that, inevitably, there will be challenges in interpreting the exact scope and intention of the measures brought in.

In particular, a new EU Regulation prohibits the sale of euro denominated transferable securities issued after 12 April 2022 or units in collective investment undertakings which provide exposure to such securities, to

• any Russian national or natural person residing in Russia; or
• any legal person, entity or body established in Russia.

Nationals and residents of EU Member States are excluded from the scope of the prohibitions.

A separate Regulation imposes the same provisions in respect of Belarus.

In a further Regulation issued on 8 April the restrictions were extended to all official currencies of the Member States, including those issued by Bulgaria, Croatia, the Czech Republic, Denmark, Hungary, Poland, Romania and Sweden.

We have received a number of questions from asset manager clients regarding the scope and requirements under the Russian and Belarusian provisions (together referred to as the Regulations) and our current views are set out below.

Please note, though, that this a fast-moving area and interpretation of the various rules can be highly nuanced and impacted by local guidance and implementing legislation - this note does not purport to convey legal advice and for specific queries you should speak to your usual contact at Simmons.

What securities does this affect?

From the wording of these provisions, the prohibition relates only to sales of securities denominated in Euros or any other official Member State currency and issued after 12 April to Russian and Belarusian nationals, residents and incorporated entities (i.e., it should not affect securities issued before that date).

Similarly, as the Regulations only apply to the sale of new units in collective investment schemes to such persons and not to the on-going holding of them, funds with existing Russian / Belarusian investors should not be restricted from trading in the affected securities (provided the fund documentation does not give the investor an ownership right in the securities held by the fund) and such investors should not need to be compulsorily redeemed.

There is, though, an argument that a party who sells a relevant security to a non-Russian / Belarusian entity owned by Russian / Belarusian residents, nationals or entities - and by extension to a non-Russian / Belarusian fund with Russian / Belarusian investors - could be circumventing the prohibition on selling securities directly to those persons (which is itself an offence).

In particular, an FAQ published by the European Commission notes that:

Euro-denominated securities - Version as of 20 March 2022

Does Article 5f of Regulation (EU) 883/2014 allow an entity which is wholly owned by Russian citizens or entities but registered in a country other than Russia to invest in euro-denominated securities issued after 12 April 2022?

The prohibition set out in Article 5f only applies to the sale of such transferable securities to Russian nationals or natural person residing in Russia or any legal person, entity or body established in Russia.

It does not apply to an entity established in the EU owned by Russian citizens but registered in a country other than Russia. However, the provisions should be read in conjunction with Article 12 which prohibits EU operators from knowingly and intentionally circumventing the measures in the Regulation.

[Emphasis added]

The purpose of the measure is to limit access to Russian entities and persons in Russia and to avoid circumvention of other refinancing prohibitions which are set out in the same Regulation.

Any enforcement risk associated with such a breach, if made out, is likely to be heightened for a party selling to a fund which has a large number of Russian / Belarusian investors, and/or Russian / Belarusian investors which hold significant stakes. This would not, though, appear to be a breach by the fund as buyer of the securities.

Which funds/managers does this affect?

The EU sanctions apply to EU nationals and incorporated entities wherever they are in the world.

EU funds and/or EU managers will therefore be subject to the Regulations, but, since the above restrictions are limited to the sale of new units in funds which trade in affected securities, these will only need to ensure that new investors into such funds are not Russian/Belarusian nationals, residents or entities. If the fund does not trade in the relevant securities, then it seems unlikely that this step would be required.

The Diplomatic Service of the European Union further mentions that:

- "EU sanctions apply within the jurisdiction (territory) of the EU; to EU nationals in any location; to companies and organisations incorporated under the law of a Member State - including branches of EU companies in third countries; on board aircraft or vessels under Member States' jurisdiction. The EU refrains from adopting sanctions having extra-territorial application in breach of international law."

Therefore, on the face of it, a non-EU manager of a non-EU fund would fall outside of the scope of the Regulations. As such, it would appear that shares in their funds could continue to be offered to Russian/Belarusian investors even if the fund is investing in securities denominated in Euros or any other official Member State currency (provided such investment activity is not being conducted within the territory of the EU).

However:

• any EU nationals employed by the manager or otherwise involved in relevant activities on behalf of the fund would fall within the scope of the Regulations and would be exposed to the risk of breach
• any EU issuer or seller of such securities might require the fund to represent that it has no Russian/Belarusian investors before proceeding with the sale in order to protect itself against any risk of circumventing the sanctions
• where the fund's administrator is an EU entity, it may refuse to assist in the sale of fund units in those circumstances.

Which investors does this affect?

The European Commission FAQ referred to above indicates that EU funds and/or EU managers that take the view that all non-Russian / non-Belarusian entities purchasing fund units automatically fall outside the scope of the prohibition could be exposed to the risk of circumventing the sanctions if those entities are ultimately owned by Russian or Belarusian nationals, residents or entities.

However, it is unclear how far funds and managers who fall within the scope of the Regulations need to go in seeking to identify any Russian or Belarusian underlying beneficial owners (UBOs) of the investing entities, and crucially whether they need to identify persons who hold a less than 25% interest who would not be considered as UBOs for AML compliance processes (a factor which will heavily influence existing KYC and investor due diligence procedures).

On one view, there is a risk of circumvention in allowing any entity with a Russian / Belarussian UBO to invest in a fund with exposure to affected securities. However, another FAQ published by the European Commission on steps that may be taken to identify UBOs who may be subject to an asset freeze is instructive, and may provide a basis for a more flexible approach:

4. It can be very tricky for companies/investors to identify owners of companies in order to check whether any of these are sanctioned. This is especially relevant for Russian companies or funds as ownership is often hidden in holding companies, owned by other holding companies etc. Will the Commission provide guidance on what constitutes reasonable efforts on part of companies to identify sanctioned parties in a company structure?

Assessing the beneficial ownership of a business counterpart is a due diligence duty. There is no one-size-fits-all model of due diligence. It may depend - and be calibrated accordingly - on the business specificities and the related risk exposure. It is for each operator to develop, implement, and routinely update an EU sanctions compliance programme that reflects their individual business models, geographic and sectoral areas of operations and related risk-assessment. Such sanctions compliance programmes can assist in detecting red flag transactions that can be indicative of a circumvention pattern.

Our view, then, is that there is some latitude in how to conduct due diligence of non-Russian / non-Belarusian entities investing in affected funds and that an approach based on identifying UBOs with shareholdings of over 25% may, in the context of the overall risks faced by the fund, be reasonable and proportionate.

Funds and managers, though, should ensure

• that the approach they take meets any regulatory obligations they owe, including express requirements to have sanctions systems and controls in place (such as those under the FCA's Financial Crime Systems and Controls); and
• that they take a risk-based approach to their due diligence of potential fund investors, including by:
  • responding appropriately to the information available about those investors and parties related to them; and
  • making further enquiries and/or taking further steps to verify the information provided in circumstances which present higher risks of breach.

In particular, given the guidance referred to above, firms should be particularly responsive to any patterns of behaviour which indicate that a prospective fund investor or its UBO(s) are seeking to circumvent the relevant prohibitions.

Where can I find out more?

For the latest information on the EU sanctions, please see the webpage here

For further information or advice, please see our online resource here or speak to our Financial sanctions and trade controls team; Alexandra Webster, Etienne Kowalski, Sascha Kuhn and David Schreuders.