Funds
Navigating EU Sanctions: How Investment Funds and Corporates Can Meet the ‘Best Efforts’ Standard
By Renate Prinz on 02. December, 2024
Co-Authors: | |
With the introduction of the 14th sanctions package, entities established in the European Union are required to ‘undertake their best efforts to ensure’ that non-EU subsidiaries they own or control do not undermine EU Regulation 833/2014 imposing EU sanctions against Russia, or EU Regulation 765/2006 imposing EU sanctions against Belarus. This obligation stretches to EU citizens, including those located outside the European Union, who control corporate and fund structures around the world.
The term ‘best efforts’ is not explicitly defined within the EU regulations. On November 22, 2024, the European Commission issued guidance on how to comply with this obligation in its Frequently Asked Questions on Russia sanctions (FAQ). The clarifications, however, largely reiterate obligations set out in the Preamble to the EU Regulation 2024/1745 which introduced the ‘best efforts’ requirement in June 2024.
In this alert, we summarize the key features of this provision, with a focus on how investment funds and other global corporates can meet the ‘best efforts’ standard. In response to the Commission’s overriding emphasis on awareness of one’s operations, existing structures and ongoing activities should be reviewed, and robust sanctions compliance policies should be put into place to efficiently navigate the increasingly turbulent EU sanctions landscape.
Origins of the ‘Best Efforts’ Obligation
The roots of the ‘best efforts’ obligation lie in the lack of consensus among EU Member States on how to address Russia and Belarus sanctions circumvention. Initially, the proposed obligation was designed to hold EU companies fully responsible for any undermining of EU Russia and Belarus sanctions by their non-EU subsidiaries. However, this proposal has been watered down due to pressure from certain Member States arguing that the wording was too extensive and onerous.
The ‘best efforts’ requirement under the EU Russia and Belarus sanctions regimes applies to EU companies and EU nationals in respect of companies they own (i.e., in which hold 50% or more of the proprietary rights or have a majority interest) or control (i.e., they have the right to appoint or remove a majority of the board, the right to use assets of that company, or the right to manage it or exercise a dominant influence over it) outside the European Union.
Implementation Guidance
In its recently issued FAQ, the European Commission emphasizes the need for EU companies and their management to be aware of the activities conducted by the non-EU entities they own or control and the risks related to such activities.
While the determination on whether the business has actually exercised its ‘best efforts’ in ensuring that its non-EU subsidiaries comply with EU sanctions will depend on the nature, size and risk profile of the business, the Commission clarified that ‘best efforts’ may include:
- the implementation of internal compliance programs;
- systematic sharing of corporate compliance standards;
- sending internal newsletters and sanctions advisories;
- setting up mandatory reporting on sanctions breaches; and/or
- organising mandatory sanctions trainings.
According to the FAQ, any of the following may amount to a breach of this obligation:
- knowledge of activities undermining EU sanctions;
- failure to block transactions undermining EU sanctions; and/or
- failure to carry out appropriate due diligence regarding activities of non-EU subsidiaries which resulted in undermining EU sanctions.
In this respect, the German Central Bank also confirmed that this obligation should be seen as satisfied when coherent and consistent mechanisms are implemented by EU entities allowing them to ensure that non-EU subsidiaries adhere to the EU sanctions.
Additionally, as clarified in the FAQ, the only valid defence to failure to comply with the ‘best efforts’ obligation is if the EU company no longer controls the non-EU subsidiary due to external reasons such as, for example, nationalization or compulsory administration. The European Commission expressly stated that liability will not be mitigated in the event that control over the subsidiary is lost due to the EU entity’s own actions, for instance, due to its previous risk-prone decisions to operate in Russia or Belarus. Likewise, EU parent companies or their employees’ decisions to recuse themselves from any Russia and Belarus related business of their subsidiaries would undermine the ‘best efforts’ obligation.
Compliance with the ‘Best Efforts’ Obligation by EU Investment Funds
The European fund industry will be affected by the ‘best efforts’ obligation on multiple levels. All regulated EU investment vehicles such as collective investment undertakings (CIUs) managed by undertakings for collective investment in transferable securities (UCITS), or alternative investment funds (AIFs), managed by alternative investment fund managers (AIFMs) must comply with this requirement in respect of all non-EU entities that they own or control within their structures. Additionally, the obligation may apply to Limited Partners (LPs) who own the entities. The Ultimate Beneficial Owners (UBOs) of both LPs and fund managers, as relevant, who hold EU passports may also be held personally liable in case of breach.
As a result, EU funds and corporates, irrespective of geographic markets or the sectors they operate in, should carefully assess their roles and determine who exactly has the responsibility to ensure the compliance of non-EU entities with EU Russia and Belarus sanctions, and decide on how compliance can practically be assured within the specific corporate structure. As a follow-up, if any exposure to Russia or Belarus is identified, stand-alone group sanctions policies should be put in place in line with the ‘best efforts’ requirement. It is no longer sufficient for the fund to impose a general ban on activities or investments touching upon Russia or Belarus. The fund and the involved parties, including any EU holding companies and concerned UBOs who are EU nationals, are now required to actively ensure that all umbrella entities (owned or controlled by them) are not involved in any activities that would be prohibited under EU Russia and Belarus sanctions.
Identifying prohibited activities may not be an easy task. In addition to prohibitions on the export of numerous types of goods or services to Russia or Belarus from non-EU entities, certain imports from Russia or Belarus, including non-EU intragroup trade, may also be restricted. In relation to fund managers, prohibited activities could include, for instance, the purchase, sale, provision of investment services, or dealing with transferable securities and money-market instruments issued by Russian or Belarussian companies subject to EU sanctions. In practice, trading in securities issued by these companies may be restricted, regardless of whether the trading is made through a non-EU entity or occurs on non-EU primary or secondary markets. The same may apply to trading in units or shares of CIUs, regardless of their denomination, particularly if they provide exposure to securities issued by Russian or Belarussian entities.
In the FAQ, the Commission has followed teleological interpretation of the prohibitions and insists on primarily taking into account the goal of particular sanctions (e.g., to weaken Russia’s economic base and curtail its ability to wage war), instead of the literal wording of the underlying prohibition. It remains to be seen if this approach will be shared by EU national authorities and courts. As clarified by the European Commission, the mere fact that an EU company (or an EU citizen who controls it) is aware that a non-EU subsidiary is involved in activities undermining EU Russia or Belarus sanctions is sufficient to conclude that the EU company did not comply with its ‘best efforts’ obligation. Therefore, EU funds who fail understand Russia / Belarus sanctions related risks and put in place comprehensive sanctions policies extending to their non-EU subsidiaries could find themselves exposed to potential liability.
The penalties for sanctions violations are set out in EU Directive 2024/1226 on sanctions criminalization and include prison sentence of at least 5 years (in the case of natural persons) and a maximum fine of at least 5% of worldwide turnover (in the case of companies), although EU Member States may impose even higher penalties at their discretion. Alongside increasing enforcement risk from EU Member States which have begun focusing on non-EU activities, funds and corporates will be also faced with meticulous scrutiny by EU banks and financial institutions. In fact, it is market practice for EU lenders to require extensive warranties on absolute compliance with EU sanctions (including compliance with the ‘best efforts’ obligation) and for lenders to periodically request EU funds and corporates to explain how such compliance has been put in place.
US Exposure and Risk
EU investment funds should also monitor the activities of their US subsidiaries to the extent that there is any Russia or Belarus exposure. EU and US sanctions are not entirely aligned when it comes to restricted products or activities directed to Russia or Belarus, and this gap may widen if new trade policies are adopted by the US in the near future.
Currently, the United States does not have any blocking regulations that prevent its companies from complying with EU-imposed sanctions (such as EU Regulation 2271/96 which has countered certain US sanctions since its implementation in 1996), and we can only speculate on how the new US administration will respond to this situation. However, it is clear that any prudent EU fund operating globally would start preparing their sanctions policies now to enable quick and efficient navigation of potentially conflicting US and EU sanctions.
Distribution of closed-end funds – On the necessity of revocation instructions under the German Civil Code (BGB)
By Frank Müller on 13. September, 2023
Posted In Funds
When distributing investment funds and designing the fund documentation, information on revocation rights must be observed. This applies not only to mutual funds, but also to special funds if they are sold to “consumers” as defined by the German Civil Code. In addition to small investors, this may also include semi-professional investors. While the KAGB contains a special regulation in the area of open-end funds, the general regulations of the BGB apply to closed-end funds – which, however, do not apply to investments in closed-end funds.
Frank Müller and Tobias Koch outline which special features have to be observed in the context of revocation rights for closed-end funds and which risks are threatening in case of missing or incorrect information. Read the full article here (in German).
The year is drawing to a close – what’s new for 2023?
By Renate Prinz on 19. December, 2022
Posted In Banking Law, Financial Services, Funds
As the year draws to a close, it is worth taking a look at new regulations at the start of the year: As of January 1, the new Regulatory Technical Standards (RTS) on the EU Disclosure Regulation will apply to financial market participants and financial advisors. With the Disclosure Regulation, which already came into force in March 2021, respective companies must prove how sustainable their products are, the extent to which ESG criteria, i.e. ecological and social standards and good corporate governance, are observed and pursued and which strategies are applied here.
The Disclosure and Taxonomy Regulation applies to financial market participants, especially in the fund sector, but also to insurance companies offering insurance investment products, credit institutions and investment services companies providing portfolio management, as well as providers of pension products and financial advisors in these areas.
Important points of the disclosure regulation remained unclear and left questions unanswered. This is now to be remedied by the technical standards, which were already adopted in August 2022. These will once again specify with more detail what information is to be disclosed about individual financial products, how it is to be disclosed and, in particular, how information is to be disclosed about how significant environmental impacts are avoided.
From January 1, 2023, the Regulatory Technical Standards on the Disclosure Regulation must be taken into account. However, this will not be the end of the story – the EU Commission has already initiated a review to revise the RTS, with a particular focus on financial products that invest in nuclear energy and gas.
More information can be found here with further links to more detailed information.
New requirements for investment funds: PRIIPs key information document replaces key investor information – FAQs:
By Frank Müller | Hannah Henseling on 28. August, 2022
Posted In Funds
As of 1 January 2023, capital management companies (Kapitalverwaltungsgesellschaften) have to prepare a PRIIPs key information document for an investment fund that is distributed to private and semi-professional investors. The following is a summary of five frequently asked questions and answers on this topic:
What is the purpose of the key information document?
- The key information document shall enable retail investors in the EU to better understand the basic features and risks of PRIIPs (Packaged Retail and Insurance-Based Investment Products).
- In addition, the requirements for PRIIPs key information documents should lead to a better comparability of such products across Europe.
For which funds does a PRIIPs-KID have to be prepared?
- All open-ended and closed-ended public investment funds with an existing sales notification (Vertriebsanzeige).
- In principle, for all open-ended and closed-ended special investment funds that issue units to semi-professional investors. This does not apply to special funds that will no longer be actively distributed after 1 January 2023, i.e. no new units will be issued to investors and this does not have to be expected.
When does the PRIIPs-KID have to be made available?
- Until 31 December 2022, capital management companies (Kapitalverwaltungsgesellschaften) are excluded from the obligation to prepare a PRIIPs-key information document if they prepare key investor information according to the KAGB (Kapitalanlagegesetzbuch).
- As of 1 January 2023, capital management companies (Kapitalverwaltungsgesellschaften) must prepare the PRIIPs key investor information sheet for an investment fund that is distributed to private and semi-professional investors. At this time, the obligation to prepare key investor information will no longer apply. Reason: The key information document, which meets the requirements of the PRIIPs Regulation, is considered equivalent to the key investor information.
In which form does the PRIIPs-KID have to be provided?
- The PRIIPs-KID must be made available free of charge.
- In general, it has to be made available on paper. Under certain conditions, it may be made available via other media (permanent data carrier or website).
What is the scope and format of the PRIIPs-KID?
- The PRIIPs Regulation and the Delegated Regulation specify numerous (in some cases complex) details regarding the form and content of the key information document.
- To illustrate this, the following points should be mentioned here as examples:
- The information contained must be precise, fair and clear and must not be misleading.
- The order and headings of the sections for the key information document are compulsorily stipulated.
- Certain passages or headings must be highlighted.
- The key information document shall be drawn up with a maximum of three sides of A4-sized paper when printed.
