When the White House recently announced that it was extending sanctions against Russia for another year, it cited a continued “unusual and extraordinary threat” from Russia’s activities in Ukraine. President Obama also signed the Ukraine Freedom Support Act of 2014 at the end of last year, which authorized the White House to enact further sanctions on Russia. This act was a supplement to previous U.S. sanctions in 2014 against individuals and businesses linked to Russia’s government and to key sectors of its economy.
However, there has been a large wave of Russian investment in U.S. technology companies in recent years, particularly after then-President Dmitri Medvedev’s visit to Silicon Valley in 2010. Russian investors, such as billionaire Yuri Milner, RUSNANO, Sberbank and VTB Capital, invested approximately $2 billion into various U.S. technology companies from 2011 through 2014. They deployed funds in a variety of industries, including e-commerce, life sciences, fiber optics, healthcare, nano components and real-time messaging—and placed stakes in such high-profile companies as Facebook, Twitter, Zynga, Groupon, Pinterest and 23andMe.
The exchange between the U.S. and Russia was reciprocal. A group of U.S. venture capitalists visited Russia in the fall of 2010 looking for investment opportunities in Russian technology. Likewise, over 100 Russian technology companies opened offices in Northern California, and former CEOs of large public tech companies in Silicon Valley joined boards of various Russian technology companies.
A Change in U.S. and Russian Reciprocal Investments
However, much of this investment and exchange stalled in the spring of 2014 over concerns about political tensions between the U.S. and Russia.
Investors and companies became wary of the sanctions that had already been issued by the White House and implemented by the U.S. Treasury Department’s Office of Foreign Assets Control (OFAC), and were unsure of the future relationship between the two countries. Some venture firms, such as Corebridge sponsored by Sofinnova Ventures, sought to raise funds from Russian limited partners, but abandoned their efforts in light of the complex requirements and the change of political environment.
To be clear, some efforts to receive Russian investment in U.S. companies have carried on. For instance, Domain Associates, a healthcare-focused, venture capital firm in Silicon Valley, has continued its $760 million co-investment partnership with RUSNANO. Similarly, U.S.-based Siguler Guff has continued to sponsor Russia Partners Management, a Russian private equity firm, to make investments in Russian companies—placing funds into a Russian education company as recently as February 2015. Domain Associates may benefit from its focused investment in healthcare. Also, the investment by Siguler Guff in education may point to receptivity to lenience in sectors that are outside the financial, oil and energy sectors, which appear to be the target of the sanctions.
Portfolio Company Concerns About Russian Investors
However, many Russian investors presently hold shares in U.S. companies that may be acquired or go public, and there are concerns about violating the sanctions when distributing such assets to Russian investors. These portfolio companies now face questions as to what risks they may face in the event of liquidity.
As it stands, the sanctions imposed by the U.S. on Russia apply to limited transactions with specific parties, and would not prohibit Russian banks or finance companies from recovering assets from U.S. companies in which they have invested—unless the Russian entity is specifically placed on OFAC’s Specially Designated Nationals and Blocked Persons List (SDN List).
The Russia sanctions were first put in place by the White House as a response to Russia’s annexation of Crimea. These sanctions came in the form of three executive orders initially issued in March of 2014, which sought to prevent U.S. entities from dealing with certain Russian businesses and individuals.
The first executive order (EO 13660) was tailored to prohibit transactions with Russian entities or persons that specifically contributed to the Ukraine crisis, e.g., by undermining “democratic processes” in Ukraine. The second executive order (EO 13661) expanded the scope of the sanctions to cover entities or persons that were connected to the government of the Russian Federation or its arms sector. These two executive orders prohibit transactions with over 130 Russian entities and individuals, including the Kalashnikov Concern, United Shipbuilding Corporation and the Kalinin Machine Plant JSC.
The third executive order (EO 13662) broadened the sanctions to also cover persons and businesses in Russia’s financial services and energy sectors, including large Russian banks that have invested in U.S. companies, such as Sberbank and VTB Bank. To implement this third executive order, the White House authorized OFAC, which also implements sanctions against Iran and North Korea, among others, to issue directives and assess penalties against entities that violate such directives.
OFAC Directives on Forbidden Transactions
OFAC then issued the specific directives, forbidding certain transactions with listed Russian entities. Directive 1 prohibits the “provision of financing for and other dealings in… new debt of longer than 30 days maturity or new equity… of persons determined to be subject to this Directive.” Directive 2 and Directive 3 have similar language but they only apply to issuances of new debt by Russian sanctioned entities. Each of these directives applies to different Russian entities that are listed on a Sectoral Sanctions Identification List, and they are specific to new debt or equity “issued by, or on behalf of, or for the benefit of” Russian entities or individuals on that list. OFAC also issued a fourth directive, which restricted activities with certain Russian entities involved with deepwater, Arctic offshore or shale projects that could produce oil in Russia.
Under these directives, “new debt” and “new equity” are each defined very broadly, to collectively cover any new bonds, loans, commercial paper and letters of credit as well as any stocks, share issuances or depositary receipts. However, the restrictions on new debt and new equity only apply on a going-forward basis, which means they only prohibit transactions by Russian-sanctioned entities that take place after the directives were issued. In particular, Directives 1 and 2 cover issuances on or after July 16, 2014, and Directive 3 covers issuances on or after September 12, 2014.
There are major Russian banks that were specifically listed under these directives. For instance, Sberbank is included on the Directive 1 list and is the current owner of Troika Dialog. Troika, in turn, was the first institutional investor in several startup companies, including the high-profile company Evernote, a Sequoia Capital-backed portfolio company providing digital note-taking and archiving software. However, Directive 1 only considers debt or equity issued by Sberbank, and does not restrict debt or equity held by Sberbank from a portfolio company, nor does it completely prohibit dealings with Sberbank. Thus, this directive would not impose any limitations on payouts to Sberbank that would result from a sale or some other liquidity event of one of Sberbank’s U.S.-based portfolio companies, such as Evernote.
The recent Ukraine Freedom Support Act is also unlikely to affect many U.S. companies or individuals; it specifically authorizes the president to provide defense goods to Ukraine and to impose sanctions on Russian energy company Gazprom and arms exporter Rosoboronexport. President Obama has also stated that he does not intend to use these sanctions at present, and may be reluctant to impose such sanctions, as he originally resisted the bill while awaiting a similar set of sanctions from the European Union.
To be clear, OFAC does publish the aforementioned SDN List, which includes Specially Designated Nationals that are prohibited from doing any business with or owning assets of U.S. companies. There are Russian individuals and entities listed from the first and second executive orders because they have connection to Russia’s government or arms industry. U.S. persons and businesses are prohibited from engaging in any transactions with these SDNs, and must block any property that SDNs have an interest in. As such, any entity that may be undergoing a liquidity event could not distribute liquidation proceeds to such Russian entities or individuals. The current Ukraine-related SDNs are listed here.
Risks of Further Investing by Russians
Even though down-round financings have not been en vogue recently given the frothing public and private markets, Russian investors may be concerned about the U.S. sanctions because as investors they will need to invest further funds into their U.S. portfolio companies in these rounds to preserve their percentage ownership. If they fail to do so, these financings will be highly dilutive to such portfolio companies. In these instances, unless the Russian investor is on the SDN List, it would generally not be prohibited from investing additional funds into U.S. companies under the current sanctions in order to protect against heavy dilution. Russian investors should be aware, however, that a controlling interest or potentially controlling interest in a U.S. business may be reviewed by CFIUS, the Committee on Foreign Investment in the United States.
Overall, most U.S. companies with Russian investors are unlikely to be prohibited from distributing liquidation proceeds to such investors. Likewise, Russian entities are unlikely to have problems repatriating their funds unless they have been placed on the SDN List. U.S. companies should make sure that their Russian investors are not on that list, available here, before making such distributions.