Bank Warranties: The Other Sanctions Regulations

Imagine, for a moment, that your company has achieved a state of compliance nirvana. Through the diligent efforts of compliance personnel and counsel, the company has assessed its economic sanctions and export control risks, implemented policies and procedures to prevent unlawful activity, and provided compliance training to employees.  With those measures in place, the company has mitigated much of its legal risk, and has identified a subset of activity with sanctioned countries—such as Iran and Russia—that is perfectly lawful, and stands to be profitable. Full speed ahead? Not quite. Many companies looking to engage with sanctioned countries find that, even when the contemplated activity is lawful, representations and warranties set out in the company’s loan agreements restrict the activity. This can be particularly jarring for non-US companies, which are authorized to engage in a broad range of activity with US sanctioned countries such as Iran (subject to certain limitations), but risk running afoul of provisions in loan agreements that prohibit even lawful business with those countries. In a sense, these representations and warranties are a set of regulations unto themselves that pose compliance challenges and can carry severe risk in the event of an infraction. This raises a few key questions:

• Why do these provisions exist?
• What representations are required?
• What types of restrictions do such warranties impose?
• Are there any ambiguous provisions that can pose challenges?

Why?  Financial institutions tend to be risk-averse when it comes to sanctions compliance, and understandably so. First, US banks are strictly prohibited from engaging with embargoed countries and sanctioned companies and individuals.  Furthermore, in recent years, the United States has imposed nine- and ten-figure penalties on non-US financial institutions for violating US sanctions, including Commerzbank AG (2015, $1.45 billion), BNP Paribas (2014, $8.973 billion), Clearstream Banking, S.A., (2014, $150 million), Royal Bank of Scotland (2013, $100 million), and HSBC (2012, $1.9 billion), among others. Non-US banks face US sanctions risk because of the ubiquity of the United States in global commerce, as all funds transfers and dollar clearing that traverse the US financial system are subject to US jurisdiction.  Therefore, financial institutions are keen to avoid sanctions violations, whether committed by themselves or by their borrowers. Representations. Typically, a loan agreement will require the borrower to confirm that it is not a sanctioned entity, and that it has not been the subject of a government investigation regarding potential sanctions infractions.  Some representations may go farther, requiring the borrower to confirm this information with regard to subsidiaries, affiliates, joint venture partners, officers, directors, and agents.  As a representation gets broader in scope, the use of a knowledge qualifier—typified by the phrase “to the best of the borrower’s knowledge” at the beginning of the representation—may be appropriate.  Furthermore, with regard to previous sanctions investigations, a five-year lookback period often is appropriate. Warranties. Sanctions-related warranty provisions in a loan agreement govern future conduct, and are of paramount importance both for the bank seeking to mitigate risk and for the borrower seeking latitude to engage in lawful activity.  Some key points:

• Most sanctions-related warranties restrict the borrower from using the borrowed funds to engage in activity for the benefit of a sanctioned individual or entity, or in a manner that would violate sanctions.
• Some warranties can go even further, and flat-out prohibit any use of the funds for dealings with a sanctioned country, full stop.
• Other warranties can go yet further, and prohibit the borrower from using its own assets to fund activity involving restricted parties and/or countries.
• Breach of a sanctions warranty usually constitutes a breach of the agreement, which can trigger severe consequences, such as acceleration of the loan.

Ambiguous provisions/key interpretational points. Warranties, in particular, can include ambiguous provisions with far-reaching consequences for performance under the agreement.  Careful drafting is essential to ensure mutual understanding and mutual benefit under the agreement.  Such potentially ambiguous provisions, or provisions that otherwise warrant close attention and detailed drafting, can include:

• Which sanctions regime(s)? Warranties usually define “sanctions” to include sanctions as set out in laws, regulations, and orders issued by a “sanctions authority,” which can include the United States, European Union, United Nations, and whatever national authority might have jurisdiction (e.g., an agreement for a Swiss bank may refer to the Swiss Financial Market Supervisory Authority). One key question is the extent to which export control restrictions are considered “sanctions” in this context. 
• “Sanctions” vs. “applicable sanctions”. Warranties often purport to restrict activity that would violate sanctions, but one key question is whether this refers to activity that would violate any sanctions specified in the agreement, sanctions applicable to the bank, or sanctions applicable only to the borrower.
• Sanctions violations. Most warranties will restrict borrowers from engaging in activity that violates sanctions (applicable or otherwise, as discussed above). Some warranties seek to prohibit borrowers from engaging in activity that would constitute a violation if engaged in by the bank directly, or in activity that would “result in” a violation by the bank. These provisions call for detailed analysis.
• Countries “subject to” sanctions. A warranty may seek to restrict dealings with countries “subject to” sanctions, but this term can be open to interpretation. The United States and European Union have imposed sanctions targeting more than 25 countries. However, the term “countries subject to sanctions” typically is understood to cover only the countries/regions subject to a comprehensive US embargo, which at this time are Cuba, Iran, North Korea, Sudan, Syria, and the Crimea region of Ukraine. (The United States has suspended sanctions against Sudan, but Sudan technically remains an embargoed country.) Careful drafting should make this clear.
• “Sanctions list.” Most warranties restrict dealings with restricted parties, typically defined to include individuals and entities set out on a “sanctions list.” However, there are different types of sanctions lists, including lists that “block” persons, such as the US Specially Designated Nationals List and EU Consolidated List of Persons, Groups and Entities Subject to Financial Sanctions, and lists that impose less severe financial restrictions, such as the US Sectoral Sanctions Identification List targeting Russian entities. Another wedge issue in this area is the US “Executive Order 13599 List” targeting the Government of Iran, which is applicable to US persons, but not non-US persons. Furthermore, there is a question as to whether non-sanctions restricted party lists, such as the US Entity List in the export control context, constitute “sanctions lists.” These issues warrant close attention during the drafting stage.

Overall, financial institutions and borrowers bring different, complicated sets of incentives to the negotiating table. US financial institutions are strictly prohibited from violating US sanctions, while non-US financial institutions, although subject to fewer restrictions, are keen to avoid processing sanctionable transactions through the US financial system, and may want to avoid reputational injury even with respect to perfectly lawful business.  Overlaying these factors can be other complex issues, such as the sanctions-related impact of denominating transactions in dollars, or the impact of a non-US bank including US banks in a syndication of a loan.  Borrowers, on the other hand—in particular, non-US borrowers—seek the freedom to engage in lawful activity without restrictions on the use of the borrowed funds, or even more severely, their assets. So what can be done to address these concerns? More than anything else, attention to detail and careful drafting should carry the day.  There is no “one size fits all” approach to sanctions-related representations and warranties.  Financial institutions that are particularly concerned with sanctions risks will seek out the farther-ranging provisions described above.  Meanwhile, borrowers—especially non-US borrowers—seeking to conduct lawful business in higher-risk countries (e.g., Iran, Russia, etc.) must carefully consider the contours of sanctions warranties, especially with regard to whether restrictions apply only to “applicable” sanctions, which sanctions lists apply, and whether restrictions apply to the use of the borrower’s own assets.