Russia’s invasion of Ukraine sparked international outrage, and sanctions aimed at crippling the Russian economy were swiftly imposed by authorities across Europe, North America and Asia. Unfortunately, this meant some trade finance transactions that predated the aggression potentially became illegal overnight. John Basquill examines the compliance clash facing western banks, and a pivotal lawsuit from parties caught in its midst.
Western powers’ sanctions regimes have evolved considerably in the last two decades. In April 2000, Kofi Annan, then-secretary general of the UN, touted the introduction of “smart sanctions” to an audience of policymakers and researchers, warning that sweeping restrictions on a country’s economy are a “blunt instrument which hurt large numbers of people who are not their primary targets”.
Annan’s proposal was to make sanctions more precise, targeting specific individuals or institutions by limiting their ability to access wealth, move funds and travel across international borders, and that concept remains at the heart of the US, European Union and UK sanctions regimes to this day. However, unintended consequences continue to come to light.
When Russia invaded Ukraine on February 24, lawmakers around the world were quick to respond. By the start of March, the governments of the US, UK, EU, Japan, Singapore, South Korea and Australia had imposed or vowed to impose some form of sanctions on the Russian economy, including against the Central Bank of Russia and state-owned banking giants such as Sberbank and VTB.
Janet Yellen, US secretary of the Treasury, said the “serious and unprecedented action” would deliver “severe consequences to the Kremlin and significantly impair their ability to use the Russian economy and financial system”.
But some companies have been caught in the legislative crossfire, with the introduction of sanctions creating a scenario where businesses had pre-existing agreements that effectively became outlawed overnight. In trade finance, details emerged of transactions that had been agreed before controls were introduced, but where payment was still outstanding.
“We are seeing a conflict of law situation arise around the sanctions against Russia,” says Aline Doussin, a partner at Hogan Lovells who specialises in both UK and EU sanctions law.
“If you look at an irrevocable letter of credit (LCs), parties have to comply when the documents are submitted to them, but there might have been sanctions put in place since that contract was agreed,” Doussin tells GTR. “That means the party is at risk either of breaching sanctions or of being sued by the other party for not complying with their contractual obligations.”
Part of the issue is the unpredictable nature of Russia’s aggression, which made it difficult for institutions to prepare for the potential introduction of sanctions. Though Russia had been building up troops at the Ukrainian border since November 2021, it had undertaken a similar exercise nine months previously that did not lead to full-scale military action.
As a result, policymakers had to react quickly. Lists of sanctioned entities were updated frequently as the war escalated, meaning financial institutions had to work hard to keep up.
“The speed with which sanctions were introduced did catch some people by surprise, and part of the difficulty is that because sanctions are a political tool, it is hard to predict exactly what their scope will be even if you know they’re on the horizon,” says Sam Fowler-Holmes, a partner at law firm Sullivan, speaking to GTR.
“But another factor was how quickly we saw additional sanctions being introduced after the first wave. I’ve seen situations where institutions have run sanctions checks, and then within a couple of days, what was previously a valid transaction has suddenly become one that can’t proceed.”
Legal battles
The aviation sector quickly emerged as a battleground for sanctions. One of the first retaliatory actions taken by authorities in North America and Europe was to prevent Russian planes from entering their airspace, and that was soon followed by bans on providing goods and services linked to aircraft used by Russia.
“With the EU’s initial sanctions targeting the aviation sector, there was no exception allowing parties to perform obligations that predated the sanctions, or any option to go to a regulator and ask for a specific licence to carry out that transaction,” says Hogan Lovells’ Doussin. “That created a major problem for some parties.”
In March, Celestial Aviation Services – an Irish subsidiary of Netherlands-based aircraft leasing giant AerCap Holdings – filed a lawsuit against the London branch of Munich-headquartered UniCredit Bank AG in the High Court in London.
Between 2005 and 2014, Celestial had entered into agreements to lease planes to two Russian airlines, AirBridgeCargo and Aurora. The leases were underpinned by seven irrevocable standby LCs, issued by Sberbank and confirmed by UniCredit between 2017 and 2020.
In early March this year, Celestial issued a demand for payment in respect of all seven LCs, amounting to nearly US$46mn, but UniCredit has refused to make payment. The German lender, a wholly owned subsidiary of Italian bank UniCredit, argues that UK, EU and US sanctions each prohibit it from doing business with Sberbank, prompting Celestial to turn to the courts.
The case is now being heard alongside another similar lawsuit, brought by two Constitution Aircraft Leasing entities, both of which are incorporated in Ireland. Their claim also relates to leasing agreements with AirBridgeCargo, with irrevocable standby LCs issued by Sberbank and confirmed by UniCredit.
When the duo issued demands for payment totalling a little over US$23mn, also in March, UniCredit again refused to make payment.
As of press time, legal proceedings remain in their early stages, with an initial hearing taking place in the last week of September, but skeleton arguments produced by the parties involved and seen by GTR show a disagreement over the fundamental workings of an LC.
Celestial argues that its aircraft “passed into Russian hands under leases entered into several years ago – and the leasing of the aircraft has not terminated”.
“The sanctions are designed to shut the stable door – but the horse bolted several years ago,” it argues. “Payment under the letters of credit would have no effect at all on the supply of aircraft to Russia. The payment obligations are instead wholly autonomous and independent of the underlying leases.”
It adds that as the issuing bank, Sberbank would be required to reimburse UniCredit once payment to Celestial is made. The Russian bank is not enriched and receives no benefit, it argues.
Similarly, Constitution suggests that the obligation to pay under the LCs is independent of the sanctions regime, and that payment by UniCredit does not constitute dealing with funds owned or controlled by Sberbank.
UniCredit, however, argues that the case “is not a question of contract law. It is a question of criminal law”, adding: “The issue is not whether the terms of the LCs require payment but whether the terms of the applicable sanctions legislation prevent it. UniCredit submits that they do.”
It points out that UK sanctions legislation prevents a bank from providing “funds… in connection with… making restricted goods or restricted technology available… to a person connected with Russia, or for use in Russia”.
Funds, the bank says, is a broad term that encompasses LCs, and any payment would by definition be “in connection with” making restricted goods – aircraft – available for use in Russia.
UniCredit adds that International Chamber of Commerce rules state that the confirming bank’s obligation cannot be amended without the consent of the issuing bank. That means Sberbank “has a direct interest in the terms of the arrangement” between UniCredit and the airline leasing companies, even if it is not enriched.
Since March, when the demands for payment were submitted, authorities have stepped in to prevent similar clashes occurring in future, Hogan Lovells’ Doussin points out. “In aviation, the EU responded to that and amended those regulations, because in effect they were negatively affecting EU companies rather than Russian companies,” she says.
“But the debate is still happening, and the key question is whether sanctions frustrate a letter of credit-based transaction from a contractual law perspective. At this stage, the courts have not given us a clear response.”
Overlapping jurisdictions
The multi-jurisdictional, overlapping nature of sanctions programmes creates another potential problem for international banks. In some cases, a European bank may be involved in a transaction that is clearly outside the sanctions regime in the UK or EU, for example, but be captured by controls introduced in the US.
“These waves of sanctions against Russia were coordinated at G7 level,
and are pretty similar across the board, but there are a number of differences if you look at the UK, EU and US laws,” says Doussin.
“That means a key issue in the UK is deciding whether a trade finance transaction has an EU nexus, so the risk comes from the applicability of EU sanctions, or whether it is governed by English law, which might not have the exact same prohibitions.”
One influential factor is the currency used. Doussin points out that if a company is carrying out a euro-denominated transaction in an EU member state, but buys an insurance or financial services product from a UK provider in sterling, guidance published by the UK’s Office of Financial Sanctions Implementation (OFSI) suggests the whole transaction would be within scope of UK laws.
“As a result, it might be subject to restrictions that are not necessarily replicated in the EU,” she says.
UniCredit makes a related argument in its defence against Celestial and Constitution. It points to enforcement action taken by US authorities against Union de Banques Arabes et Françaises (UBAF) in 2021, which agreed to pay US$8.5mn to settle allegations of sanctions breaches.
Paris-headquartered UBAF was found to have processed 127 transactions – including 13 LCs – on behalf of Syrian financial institutions between August 2011 and April 2013, with a total value of over US$2bn.
Some of the transactions did not involve dollar clearing, but utilised an intermediary whose LCs were dollar-denominated. In other cases, UBAF would carry out dollar payments on its own books, or only use dollars in the leg of the transaction involving a non-Syrian entity, the US Treasury Department said at the time.
UBAF had “incorrectly believed” that as a French institution that was avoiding direct dollar clearing on behalf of sanctioned entities, it was operating outside the US sanctions regime, the Treasury said. UniCredit says that action suggests US enforcement authorities would take issue with any dollar-denominated transaction involving Sberbank.
The licensing option
In the US, EU and UK, businesses can apply for a licence – in effect, a case-by-case exemption from sanctions controls – to carry out transactions that would otherwise be blocked.
In the UniCredit case, the bank has already applied for licences from several sanctions authorities that would allow it to fulfil its obligations under the disputed LCs. Its skeleton argument says that if all relevant licences are granted, the proceedings will “fall away”.
It was granted a licence by Germany’s Bundesbank in May. It has also received permission to proceed from a unit within the UK Department of International Trade, but only if OFSI also issues a licence. UniCredit says correspondence received from the UK authority in September “may suggest a licence is imminent”.
It says no licence has yet been issued by the US Office of Foreign Assets Control, adding: “This is despite extensive ongoing steps which UniCredit has been taking to advance the remaining applications.”
But licensing is far from a perfect solution for banks. Sullivan’s Fowler-Holmes points out that – as in UniCredit’s case – separate licences must be sought from each relevant authority. Permission from one is no guarantee that another will follow suit. It is also usually a time-consuming and potentially costly process.
“With the licensing regime, guidance from OFSI suggests that OFSI will engage with applicants within four weeks – but that doesn’t mean you would actually have the licence issued within that time,” the lawyer says. “It may well take significantly longer if it’s a complex transaction, and though OFSI can expedite certain applications, there has to be a real sense of urgency, usually for some clear humanitarian or economically important reason.”
The regulator has drawn criticism for its slow handling of licence applications. Bloomberg reported in September that nearly US$30bn of Russian-issued foreign-denominated debt had fallen into default, in part due to delays at OFSI.
OFSI responded by saying it would continue to reprioritise resources to implement the Russian sanctions effectively. Its director, Giles Thomson, said during a webinar the same month that the scale of the restrictions brought in since March has proven a “challenge for us”.
Representatives for UniCredit, Celestial Aviation Services and Constitution Aircraft Leasing did not comment further when contacted.
