Sanctions: The new ‘Deripaska Rule’ – a twist to regulation?

The U.S. Office of Foreign Assets Control (OFAC) recently removed three companies from its Specially Designated Nationals (SDN) List, where they had been each designated under two Executive Orders as part of OFAC’s Ukraine-/Russia-related program.

The delisting process for these firms, which was elongated due to the Congressional oversight mandated by the 2017 passage of the Combating America’s Adversaries Through Sanctions Act (CAATSA), seems to show that OFAC has failed to heed its own guidance, and the leveraging of a loophole in OFAC’s 50 Percent Rule.

What Happened

In April 2018, a number of Russian oligarchs and firms they owned and controlled, as well as a number of government officials and state-owned enterprises were sanctioned by OFAC under Executive Orders 13661 and/or 13662. Among these were a number of firms associated with Oleg Deripaska, including United Company Rusal PLC (“Rusal”), which is responsible for approximately seven percent of global aluminum production.

At the same time, a number of General Licenses were issued to allow for maintenance and wind-down of existing contracts, and divestment of securities investments in the designated firms. The General Licenses related to Rusal, its corporate owner EN+ Group PLC (“EN+”), and JSC EuroSibEnergo (“ESE”), also owned by EN+), were amended to extend their expiration dates numerous times, the most recent versions expiring in January 2019.

This was in response to efforts by these firms to restructure Deripaska’s ownership and control of these firms so the resulting structure would be acceptable to U.S. regulators. On December 19, 2018, Congress was notified, as per the requirements in CAATSA, of OFAC’s intention to remove the three firms from the SDN List.

The Senate narrowly failed to block the removals and they were removed from the sanctions restrictions on January 27th.

The Deal

Prior to the April sanctions designations, Deripaska owned approximately 70% of EN+, as well as an insignificant stake (0.01%) in Rusal and none whatsoever in ESE. Under the deal as reported by multiple news outlets, he reduced his stake to 44.95% by essentially tendering his shares to the state-owned VTB Bank PJSC (“VTB”), which already had an ownership stake in EN+.

Deripaska’s $800 million in debt to VTB was effectively extinguished as part of the transfer, as news reports indicate that VTB will soon sell the shares and assign the debt to the new owners.

In the interim while VTB holds the shares (raising its stake to 24% of the firm from 10%), 2 independent directors will control their voting rights. In addition, Glencore, implicated in money laundering and corruption scandals and one of Rusal’s largest customers, will receive over ten percent of EN+’s shares through a share swap of its Rusal shares.

Finally, the shares held by Deripaska’s former wife and father-in-law, which represents 7.5% of EN+ shares, will now be controlled by an independent third party, while some additional Deripaska shares will be donated to a charity he founded, but which he agrees to step down from as part of the overall deal.

Deripaska’s remaining stake was made illiquid as part of the deal, as he will not be able to sell shares. Any dividends he receives will be placed in a blocked account, making them off-limits to him as well.

Additionally, as a letter sent from the Treasury Department to Senate Majority McConnell notes, Deripaska’s level of control over these firms has been significantly reduced.

The voting stake that he controls is limited to 35% of shares, with the remaining being required to follow the will of the majority of the remainder of the shares. The EN+ board is being reconstituted, with Deripaska only appointing four of the twelve members.

However …

There are a number of elements of the Terms of Removal (“TOR”), as the deal is referred to in the letter to Leader McConnell) that are still disturbing. While Deripaska’s stake in, and control of, EN+ has been significantly reduced and he likely lost a significant amount of money on the shares proffered to VTB, he still will be able to realize significant economic benefit from the ongoing ownership stake in EN+.

While the shares cannot be sold for cash, nothing in the letter indicates that they can’t be swapped for shares in other companies (which then could be sold for cash).

Additionally, there appears to be no restriction for using the shares as collateral for additional loans; the $800 million in VTB debt being extinguished under the TOR was, in fact, a collateralized loan against Deripaska’s EN+ holdings due to the financial strain that sanctions had placed on him.

Finally, the other companies which Deripaska controls (which were also designated in April 2018) operate wholly within Russia and will continue to provide him liquidity and wealth not subject to asset freezes, as long as they avoid transactions over which OFAC could claim jurisdiction.

It is unclear what effect the control restrictions on Deripaska are intended to, or will, have. As a businessperson, it is logical to assume that Deripaska’s shares, and the board members he appointed previously, would act in a manner consistent with producing better business results, and not necessarily for any nefarious purposes.

Nothing in the designations of EN+ and its subsidiaries implied any involvement in anything other than normal business activities. Perhaps this action is to head off any attempt, for example, to punish U.S. and E.U. countries through price increases or supply restrictions on Rusal aluminum products? It should also be noted that, while the TOR appears to require that the ultimate owner of the shares transferred to VTB not be on the SDN List, the shares could, in theory, end up in the hands of other Russian oligarchs, officials or state-owned companies that are not currently designated.

Even so, as both VTB and Deripaska are closely linked with Russian President Vladimir Putin, the pair would still control – even after VTB sells off the shares it received under the TOR – 45% of the voting rights which, while not a majority, still allows them to exercise a significant amount of control. And it would not require much of a stretch of the imagination to see Glencore vote in concert with Deripaska and VTB.

Not Half Full?

If one were to do the math and realize that the Deripaska and VTB stakes exceed fifty percent, one might wonder if the OFAC 50 Percent Rule applied. Unfortunately, it does not – the 50 Percent Rule imposes the same restrictions on a firm that applies to its sanctioned owners.

While Oleg Deripaska’s assets were frozen when he was placed on the SDN List, VTB is “only” subject to the capital markets restrictions imposed by Executive Order 13662’s Directive 1. Since the restrictions are different, the 50 Percent Rule does not apply. And yet, OFAC seems willfully blind to what its own guidance says:

U.S. persons are advised to act with caution when considering a transaction with a non-blocked entity in which one or more blocked persons has a significant ownership interest that is less than 50 percent or which one or more blocked persons may control by means other than a majority ownership interest.

Given his control of one third of the new EN+ board, and his control of 35% of the voting rights, one has to ask: why was Deripaska not forced to relinquish significantly more of his ownership stake in return for the lifting of sanctions on EN+, Rusal and ESE?

In an emailed statement to KYC360 regarding concerns about the Deripaska deal, a Treasury spokesman said:

Time for New Rules

The fact that EN+ and its subsidiaries are not sanctioned under the 50 Percent Rule, once the revised ownership and control structure imposed by the TOR has been put in place, seems inherently unfair. While there are no formal ties between VTB and Deripaska, especially after his loans are paid off, it is clear that they are both vital elements of the machinery of the Russian state.

A simple change to the 50 Percent Rule might make it more just in cases such as this. The current guidance refers to blocking (aka “asset-freezing”) sanctions only, while OFAC’s FAQ 373 states that it also applies to entities on the Sectoral Sanctions Identification List (“SSI List”).

One could make the 50 Percent Rule more effective by stating that if the 50 Percent Rule does not apply solely on the basis of ownership by those subject to blocking sanctions, or solely on the basis of ownership by SSI List entities, but the combined ownership of both categories of sanctions targets meets or exceeds 50 percent, the owned firm is subject to sanctions. There are multiple options for which sanctions could apply in such a case: the sanctions on the category of owner (blocking or SSI List) with the larger percentage, the more severe sanctions, or the less severe ones, for example.

Which of those choices (or others) is somewhat immaterial; the important element of this change is to make sanctions apply in such cases. There will always be cases where one might not want such an enhanced 50 Percent Rule to apply. However, it would be easier for OFAC (although more burdensome for compliance officers) to issue General Licenses for such exceptions than to start designating specific firms that one would like the restrictions to be applicable for.

Of the oligarchs and officials designated in April, Deripaska was unique in that he controlled companies with significant international ties. Still, despite the unease that many feel of the terms of the TOR, if this proposed “Deripaska Rule” is implemented, it may have been worth it, long-term.

– By Eric A. Sohn, CAMS, global market strategist and product director, Dow Jones Risk & Compliance, New York, NY, USA, eric.sohn@dowjones.com