Trading with certain countries or in issues from certain companies is forbidden, period. The black and white requirements are clear to understand so they are easy to follow.
Not so, when it comes to the new sanctions imposed by the U.S. government against Russia. The White House was heavily lobbied by trade associations representing buyside firms before the final rules were issued. It appears that a well-intentioned regulatory concession to ease potential losses by investors and fund managers has turned into a knotty compliance problem. “The regulators did a great job in making the sanctions easier for fund managers to handle from an investment management perspective,” says Thomas Bogle, a partner at Dechert in Washington DC. “However, down the road it may be difficult to determine whether certain investments in sanctioned companies are permitted.”
The US sanctions are part of international initiative among Western nations, seeking to seeking to punish Russia for annexing the Crimean peninsula and for allegedly backing pro-Russian insurgents in eastern Ukraine. Among the sanctions imposed by the US government — more specifically the US Treasury — are prohibitions against acquiring certain Russian investments. The list is not only specific, naming Rosneft, Noratek, VTB, Bank of Russia, Russian Agricultural Bank and United Shipbuilding Corp. as targeted companies, but also contains a twist that narrows the focus. The prohibition applies only to equity — such as stocks or depositary receipts — and long-term debt that is issued on or after the effective date of the sanctions, either July 16 or July 29 of this year.
In a second twist, the same prohibitions apply to another. less well-defined class of companies — those directly or indirectly, at least 50-percent owned by the named Russian companies.
Investors can legally keep what they already owned before effective date of the sanction, and can legally purchase other issues of the sanctioned companies, as long as the instruments were issued prior to the effective date of the sanction. The European Union has implemented similar policies, effective August 2. While excluding Rosneft and Novatek from its list of sanctioned companies, the EU sanction included Sberbank.
Portfolio managers and traders are certainly breathing a sigh of relief at sanction terms that minimize damage to their portfolios. Clearly, the industry lobbying for the narrowest interpretation of sanctions succeeded in avoiding a fire sale in Russian holdings as liquidity dried up fast.
But what’s good for financial performance isn’t necessary easy for everyone else. In fact, internal monitoring of compliance with the sanctions may turn out to be harrowing in firms that continue to invest in exempt instruments issued by the sanctioned companies. Fund managers could need to follow either US sanctions, European sanctions or both depending on whose jurisdiction they fall under. Despite the threat of hefty financial penalties violations, and no matter how committed the firm may be to compliance, there may be no simple method to identify compliance breaches before or after the trades. Such a compliance dilemma could be why so many — more a dozen IT, operations, and investment compliance specialists — not only refused to discuss the topic with FinOps Report, but many demanded reassurances that the names of their firms not appear it this article.
It doesn’t appear that any of the named Russian companies have issued new debt or equity since the effective date of the sanctions. When they do, the compliance problem challenge emerge. With other sanctions, order management or portfolio management systems have been programmed to automatically reject trades or issue breach alerts. With the Russia sanction, the software-based compliance strategy may not be dependable, as new issues may have the same instrument identifier as the old ones.
Market data associated with the issues will likely contain the issue date but issue date is not ordinarily found in trade order or portfolio systems. The closest automated systems are likely come to compliance is to issue a caution if attempts are made to invest in certain companies. At that point, manual scrutiny of the market data will be the only option. Once the risk of human error comes into the picture, compliance oversight will have to be ratcheted up.
Thanks to regulatory concessions, the compliance scenario differs from other country-related sanctions in two critical ways. With sanctions aimed at other countries, all US dollar investment is banned. That has been the case in countries such as Iran, Sudan and Cuba for some time. Not so with Russia, where there is no requirement to divest billions of dollars in assets already held in by US investors and asset managers, unless they meet narrow sanction rules. Investors continue to have the freedom to pursue legal investment opportunities in non-sanctioned investment opportunities in Russa.
In this murky framework, proactively monitoring what is legal and what is not becomes another kind of challenge. Obviously the simplest, but most extreme solution is to avoid any new purchases of shares or debt in sanctioned companies, or companies that might be sanctioned due to ownership stakes by the named sanctioned companies.
There are two more ways to determine whether or not to trade shares or debt of sanctioned Russian companies besides checking on the public float each day. If index providers such as MSCI eliminate them from indices, then there should be concern about whether some of the securities in the market are subject to sanctions, says Bogle. Another tactic is to monitor new issues of any Russian company that may possibly be subject to sanctions, watching prices in the secondary market for evidence of international demand or lack of it.
” I suspect many fund firms would not risk the chance of unintentionally acquiring sanctioned securities, and therefore would avoid new purchases in the secondary market,” explains Bogle. Operations specialists at two US fund managment firms with allocations in Russia tell FinOps they have been informed by portfolio managers they will either slowly divest their current holdings in some of the companies targeted by the sanctions or they will begin buying shares in unaffected Russian companies on the notion they are now undervalued.
Jim Slear, a partner with the law firm of Thompson Coburn in Washington DC, recommends portfolio managers have a serious discussion with their compliance directors about just how they will evaluate the risks and the rewards of attempting legal investments in the targeted companies. “It’s a balancing act and the compliance departments need to rely on internal sanctions specialists to clearly interpret the new rules,” he says. “Investors need to develop risk mitigation procedures that are directed at countering the risk. ” Those who don’t have such expertise obviously should obtain external legal counsel to do so.
Of course, a broad divestiture policy carries its ow significant risks. “The sanctions implemented by the US Treasury will clearly have a chilling effect on trading because there might not be a market to sell the shares or debt of those companies issued before July 15, if fund managers are concerned about buying them,” says Erich Ferrari, a sanctions attorney at the law firm of Ferrari & Associates in Washington DC, calling reaction to the sanctions consternation.
Custodians in the Crosshairs
His last word of advice: Fund managers need to also consult with their custodian banks as to whether or not they will settle a particular trade. “They [fund managers] might think they can buy more shares or more debt, but the custodian bank might have a different viewpoint and if the two don’t reconcile their opinions the fund managers might not be able to use the custodian to safekeep and settle the shares,” says Bogle.
Apparently, fund managers won’t be the only ones on the hook for violating the sanctions. Custodians — some of the world’s largest banks — also can’t afford to slip up. They might be handling only the safekeeping and settlement of transactions, but the concept of strict liability applies to custodians even for just holding the investments.
Several custodian banks contacted by FinOps declined to comment for this article, as did the Moscow Exchange-owned National Settlement Depository in Moscow, and international securities depository Euroclear in Brussels, which has established an automated link with the NSD to allow its bank and broker-dealer members to settle transactions in Russian debt instruments.
Euroclear rival Clearstream in Luxembourg, which also allows its participants to settle trades in Russian debt instruments and even equities, did respond to emailed questions from FinOps Report with a prepared statement. “It is our objective to comply fully with both sets of sanctions [EU and US] imposed and to show that we apply appropriate and diligent measures as a financial infrastructure provider. Clearstream takes its responsibilities very seriously.” The statement went on to refer FinOps to a stern letter to participants outlining their own responsibilities which is posted on Clearstream’s webite.
US legal experts tell FinOps that both international securities depositories could be viewed as custodians. Clearstream declined to elaborate on its own liability in the event it settled or safekept transactions in prohibited securities or how it would avoid falling afoul of the sanctions.
With all of the worry about how to avoid violations, being prepared for extra measures to be safe rather than sorry appears to common thread. “When in doubt, call your legal counsel and regulator such as the US Treasury to find out if your transaction would violate the sanctions rules,” says Ferrari.