May 14, 2018

Blocked out: why the EU will struggle to counter US sanctions with blocking legislation

There has been much discussion in recent days about the EU using so called “blocking legislation” to counter the reintroduction of US secondary sanctions against Iran, as it did in 1996 with US sanctions against Cuba. The potential trans-Atlantic battle of legislation did not materialise then because of a political resolution of the differences. But a precedent was set. Can it work again now?

The reality today is that many EU (and non-EU) firms refrain from business with Iran not because of any legal prohibitions, but because of the contractual restrictions imposed on them.

The model is Regulation 2271/96 which was passed in 1996 to “counteract the effects of the extra-territorial application” of US sanctions under the Helms Burton Act (Cuba) and Iran and Libya Sanctions Act. 

The old US Cuba sanctions imposed requirements on non-US persons to cease trafficking (i.e. dealing) in Cuban property formerly owned by US persons or potentially face judgments from US courts to pay compensation. The Iran and Libya sanctions prevented investments in Iran or Libya that could significantly contribute their development of petroleum resources. 

The 1996 Blocking Regulation

The EU blocking legislation did a number of things: it required EU persons whose economic interests were affected by the sanctions to report this to the Commission; it prohibited the recognition or enforcement of foreign judgments for compensation within the EU; it enabled EU persons to recover damages from US claimants who had caused them loss by the application of the US sanctions; and it prohibited EU persons from complying actively, or by deliberate omission, with any prohibition resulting from the legislation. 

The 2018 iteration of US secondary sanctions are notably different to the 1996 Cuba sanctions.  Firstly, the potential penalties for engaging in any of the activities targeted by the US secondary sanctions are what are referred to as “denial of access” penalties. The choice the US gives non-US persons is to avoid carrying out the activities targeted by the US secondary sanctions (i.e. providing significant support to Iran’s energy sector) or risk being denied access to crucial elements of the US economy. That means, potentially, losing the ability to obtain finance from US banks, bid for US government contracts, travel to the US or, in extremis, asset freezes and the loss of the ability use US dollars. The legal mechanism by which the US would enforce these penalties would be to actually impose primary sanctions prohibitions on US persons preventing them from, say, providing finance to the non-US person in question or designating the non-US person as a SDN, thus obliging US persons to freeze their assets and prevent dollar clearing.

These are quite different to the penalties under the old Helms-Burton Act, which were positive obligations to pay money judgments for trafficking in Cuban property. It was relatively easy for the EU to offer protection from those penalties by preventing the enforcement of judgments within the EU and providing for causes of action in the EU against US claimants. The old blocking legislation may have worked to protect EU firms from Helms-Burton penalties, but it is difficult to see how, for example, the EU, through blocking legislation, can prevent a US bank from complying with US law requirements to freeze the assets of designated person. 

But the old US sanctions against Iran and Libya were much closer in nature to the modern US secondary sanctions against Iran, both in the actions they proscribed and the penalties they imposed: in 1996 these included import and export restrictions, the loss of primary dealer status and denial of access to loans from US financial institutions. The inability of the EU to effectively counteract these prohibitions did not dissuade it from passing the blocking legislation in 1996, so why should it now? 

It's the financial institutions, stupid

The answer may lie in the fact that in 1996 there were few other restrictions on EU firms investing in Iran or Libya. It would, therefore, have been relatively easy to enforce blocking legislation that required EU firms to report incidents where their interests were affected by US sanctions and prohibit them from complying with those restrictions. After all, the US had already provided the example of how blocking legislation could work effectively with its own anti-boycott legislation, which requires US firms not to comply with the Arab boycott of Israel, and report incidences where they had so complied (and face penalties for doing so). 

But the position is somewhat different today, largely due to the role that international financial institutions (and their dramatically beefed up compliance functions) play in the enforcement of sanctions. 

Most major financial institutions outside the US are much more intimately connected to or reliant upon the US financial system and the ability to clear US dollars than they were 20 years ago.  And in the face of considerable overlapping and conflicting compliance obligations they comply with the most stringent forms of legislation in order to ensure cost effective compliance. When it comes to dealing with sanctioned jurisdictions generally, and Iran in particular, that has effectively meant that they comply with the often more stringent US sanctions position.  Even after Implementation Day, the US maintained stringent primary sanctions prohibiting US persons from dealing with Iran, and this is often the base line compliance standard adopted by even non-US financial institutions.  Indeed, they often deliberately over-comply with even that position: more than six months after the removal of US financial sanctions against Sudan, it is still all but impossible to find a major financial institution that will process payments in any currency for transactions connected to Sudan. 

The effect of this compliance outlook is the imposition of sometimes onerous terms and conditions on banks’ customers. These will usually prevent customers from using accounts to engage in business with sanctioned jurisdictions - irrespective of the currency used or whether or not the funds are being transferred to or from that jurisdiction. They will also commonly restrict the ability to use the proceeds of any lending for the purpose of business with sanctioned jurisdictions. It is not just banks that have imposed such restrictions: insurers too have made extensive use of sanctions clauses to limit cover where they might be exposed to sanctions risk. And even outside the financial institution community, sanctions clauses and warranties are used in commercial contracts to prevent counterparts reselling goods to Iran, for example. 

That has largely been the position even throughout the interregnum of US sanctions relief following Implementation Day in January 2016. In fact, Secretary of State John Kerry earned something of a rebuke from HSBC in 2016 when he urged non-US financial institutions to increase engagement with Iran, being reminded tartly that most financial institutions’ links to the US will constrain their ability to do so.

The reality today is that many EU (and non-EU) firms refrain from business with Iran not because of any legal prohibitions, but because of the contractual restrictions imposed on them. That was simply not the case in 1996. To actually be effective, therefore, any new blocking legislation will need to differentiate between a refusal to do business with Iran due to US secondary sanctions and a refusal that is imposed by contractual restrictions from financial institutions or otherwise. The alternative is to compel financial institutions to remove those restrictions from terms and conditions.  Both would be incredibly difficult to either legislate for or enforce.  

Moving the goalposts

It also sits rather uneasily with the changed compliance landscape after President Trump’s 8 May announcement. After all, these same financial institutions have been unwilling to support trade with Iran for more than 2 years now, even in the absence of US secondary sanctions. There has been no legislative compulsion on them to support EU firms looking to do business during that time. It would be rather odd to change the rules of the game and impose such a restriction now - once their regulatory exposure has actually been increased by the re-introduction of US secondary sanctions. 

Moreover, legislators and regulators cannot have their cake and eat it: the general anti-money laundering and counter terrorist financing compliance obligations of financial institutions are vastly more complex and onerous to comply with now than they were 20 years ago. It would sit uneasily with these obligations to force EU financial institutions to support business with Iran. It should not be forgotten that the EU still maintains its own - admittedly more limited - sanctions program against Iran, designating a number of entities still for asset freezes. 

All in all, it will be difficult therefore for the EU to effectively counter US extra-territorial sanctions by means of blocking legislation alone. The other tactic pursued by the EU in 1996 was to refer the matter to the WTO, alleging that the US sanctions breached obligations to other WTO members under the GATT and GATS. The US response at the time was to threaten the use of the rarely used tool of the national security exception. It would not be a leap of the imagination to see President Trump making similar threats in this case. Ultimately, the resolution of any dispute between the US and EU lies in the old art of power politics.