We have been following the sanctions landscape closely over the past few months. In March we covered sanctions imposed by the United States and other jurisdictions in response to Russia’s invasion of Ukraine. The sanctions impede Russia’s ability to access the international financial system and are designed to have a severe and lasting effect on Russia’s ability to finance the war in Ukraine and other similar initiatives.
Sanctions are serious business and can result in strict liability, which means that a financial institution or other lender may be liable for a sanctions violation even if there is no knowledge or intent to commit a violation. breach. When it comes to managing risk, most financial institutions consider the risk of sanctions based on the parties with whom they interact directly. For commercial lenders, sanctions risk assessment and mitigation has focused on the borrowing parties. Banks and other lenders exercise caution when it comes to complying with sanctions and are very careful when dealing with a borrower who has a level of direct or indirect ownership by a sanctioned person or entity.
In fund financing, we see a connection to sanctioned limited partners (“LPs”) that may not be found in other types of financing arrangements. Numerous individuals and entities that are LPs in various borrowers of funds have been blocked for sanctions purposes, either directly or indirectly by virtue of designating their beneficial owners under applicable sanctions. Over the past few weeks, we have seen a number of borrowing funds report to their lender that an LP in the fund has become a sanctioned person.
These fundraising-sanctioned LP issues are real developments, as opposed to theoretical risks. While each sanctions designation and deal structure is nuanced and government guidance specific to sanctions risks in funding funds is limited, we will break down some of the key concepts and provide a general overview of the issues that arise when a fund notifies its lenders that an LP has been identified as subject to sanctions.
Sanctions create real risk for lenders in financing transactions
When grappling with sanctions issues in a lending transaction, some borrowers have taken the position that they are the party that bears the risk. It is true that the risks of sanctions tend to be more immediate for the fund, but the potential risks for the lender are also very real. In a fundraising transaction, a lender’s ability to call capital from a borrower’s LPs is a potentially direct touchpoint with inherent sanctions risk. There is also a risk that an instruction from the lender to a fund? for example, calling capital, exiting an investor, or even excluding a sanctioned LP from a future capital call? could inadvertently cause a fund to breach sanctioning rules and potentially lead to a breach of facilitation by the lender. OFAC has not provided detailed public guidance on how lenders should manage the risk of fundraising sanctions. With this lack of regulatory clarity in mind, the parties are cautious and conservative.
Funds should take immediate action in response to an LP becoming a sanctioned person
Under OFAC’s 50% rule, lenders are generally not prohibited from dealing with borrower funds provided that no person sanctioned by OFAC owns, directly or indirectly, 50% or more of the fund. The holdings of most LPs do not approach this threshold. But while a lender may be permitted to deal with a fund in which a sanctioned LP has a small stake, the fund itself must take appropriate action when dealing directly with its LP.
For example, funds generally freeze distributions to any sanctioned LP and freeze funds held in connection with the LP’s interest in the fund. Typically, frozen funds are placed in an “escrow account”, which the sanctioned person cannot access without an appropriate license from OFAC.
In addition to freezing assets and payments, the funds are also considering whether other actions could constitute a prohibited service or other transaction. For example, a fund may consider that exempting a sanctioned LP from a fund call would grant a prohibited benefit to a sanctioned LP; in such a scenario, the fund may instead choose to make the capital call to the sanctioned LP and immediately place the funds received in an escrow account.
Exiting the fund’s LP may not be a simple solution
Generally, when an investor is identified as being sanctioned, the parties are prohibited from dealing with both the property of the sanctioned investor and with the sanctioned investor himself. Allowing funds to flow to or from a sanctioned LP without proper blocking would almost certainly be a violation; sign a new agreement that is countersigned by a sanctioned LP? whether to take the LP out of the fund or for other purposes? may also be prohibited unless an appropriate license is granted. Obtaining such an OFAC license can be a long and expensive exercise. There is also uncertainty as to whether it would be granted.
Further, sanctions laws would generally not require a fund to leave a sanctioned investor; sanctions laws generally prohibit only new transactions and require the blocking and reporting of sanctioned interests. Thus, a fund and its lenders may take the position that exiting a sanctioned investor, rather than simply locking in the investor’s ownership, goes beyond what is required by law and thus incurs risk. reputation for the fund.
Some fundraising lenders are moving forward with conditional waivers
Under a typical fundraising credit agreement, the presence of an investor who is a sanctioned person is an exclusion event that results in the removal of the LP in question from the borrowing base. Generally, at the time of each drawing, a borrower must make a statement that neither he nor any of his investors is a sanctioned person or otherwise subject to sanctions. But when the LP of a fund is actually subject to sanctions, the borrower cannot make this declaration and the fund, by effect of contract, is unable to borrow. Lenders and borrowers have explored how to approach this scenario.
As noted above, exiting the sanctioned LP from the fund is far from straightforward. One solution the parties use is a waiver process. For example, the agent and the lender(s) may agree to waive a default under the credit agreement due to the failure of the borrower to make the required declaration regarding a particular sanctioned limited partnership. . The waiver is granted on the condition that the fund and the other parties to the credit agreement undertake to take appropriate, often carefully specified, measures, such as blocking all property connected with the sanctioned LP, to ensure that all the parties remain in compliance with the sanctions laws. . These disclaimers are specific to each transaction and party and, depending on the facts and circumstances and the risk tolerance of the different parties, can be quite complex. Nevertheless, with the advice of an attorney, some lenders may determine that such a waiver process provides a reasonable avenue when a borrower’s limited partnership is under sanction.
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.