Update: UK sanctions ‘scrutiny’ raised in Hellard case

Asset freeze measures imposed by the UK against Designated Persons (DPs) can, in certain circumstances, cover entities “owned or controlled” by the DP. To date, there have been few – and sometimes partly conflicting – English court cases on the “ownership and control” criteria under the UK sanctions regime. The latest judgment in Hellard v. OJSC Rossiysky Kredit Bank tried to reconcile the earlier guidelines issued by the courts in Mints AND Litasko Affairs.

The case also examined the nature of creditors’ voting rights in the event of insolvency and whether those rights constituted “funds” or “economic resources” for the purposes of UK sanctions.

BACKGROUND

IN Hellard(1) the court considered whether the UK bankruptcy trustees could breach sanctions by allowing Russian creditors to participate in the UK bankruptcy proceedings.

The case concerned Anatoly Motylev, a Russian citizen resident in London, who faced bankruptcy in both Russia and the U.K. The U.K. bankruptcy trustees received debt claims totaling £741 million, including from four Russian creditors — OJSC Rossiysky Kredit Bank (in liquidation), CJSC Mosstroyeconombank (in liquidation), AMB Bank (in liquidation) and JSC KB Retail Lending Company (in liquidation) (collectively, Russian Bank Creditors) — accounting for 52.88% of the claims.

Russian Bank Creditors were banks previously managed by Mr. Motylev that collapsed due to alleged mismanagement and fraud shortly before he left Russia. The banks are now administered by the Russian Deposit Insurance Agency.

The central issue was whether the involvement of creditors of a Russian bank in the UK insolvency proceedings was covered by the Russia (Sanctions) (EU Exit) Regulations 2019 (the 2019 Regulations). Specifically, the trustees sought guidance under section 303(2) of the Insolvency Act 1986 (IA 1986) and/or statements on the following matters:

Should the trustees treat the creditors of the Russian bank as subject to asset freeze measures under the 2019 Regulations (i.e. whether they are owned or controlled by the lenders)?
If the creditors of the Bank of Russia are subject to sanctions, do the trustees have the right to accept the votes of these creditors for the purposes of the creditors’ decision-making procedure and/or allow them to participate and vote at meetings of the creditors’ committee?

These questions were central to the continuation of the bankruptcy proceedings. If the trustees had wrongly found that the creditors of the Russian bank were not subject to sanctions when in fact they were, they could have faced significant criminal and civil liability under the UK sanctions regime. On the other hand, if the trustees had wrongly found that the creditors of the Russian bank were subject to sanctions and as a result excluded them from participation in the bankruptcy proceedings, they could have faced civil liability to the creditors of the Russian bank.

Section 44 of the Sanctions and Anti-Money Laundering Act 2018 provides statutory protection by stating that if an act is done under a “reasonable belief” that it complies with the 2019 Regulations, the person doing the act is protected from civil liability. However, if the trustees cannot show that they have formed the necessary “reasonable belief”, section 44 will not provide them with protection.

LEGISLATIVE FRAMEWORK AND PREVIOUS RULINGS

Regulations 11-15 of 2019 provide that all funds or economic resources owned, held or controlled by the DP must be frozen and that funds or economic resources may not be made available to or for the benefit of the DP, including through an entity “owned or controlled” by the DP. Regulation 7(4) of 2019 provides that a person who is not a natural person (“C”) is taken to be “owned or controlled” by another person (“P”) if, among other criteria, “it would be reasonable to expect that P (if P chooses) would be able to . . . achieve a result in which C’s affairs are conducted in accordance with P’s wishes”.

Before HellardThere were two key bodies dealing with the definition of “control” in the 2019 Regulations.

IN JSC National Bank Trust v. Mints,(2) The Court of Appeal adopted a broad interpretation of Regulation 7(4). The Court held, although obiter dicta, that P controls C if he “decides or may decide” in relation to C. The Court held that Regulation 7(4) does not place any limit on the means or mechanisms by which P may exercise control over C, and may include control exercised through a political office.

This Mints The ruling raised concerns among practitioners, as the court’s interpretation suggested that all companies in Russia could be deemed to be “owned or controlled” by a DP, based on the sanctions designation of the most senior Russian government officials. In response to these concerns, the Office for Financial Sanctions Implementation (OFSI) and the Foreign, Commonwealth and Development Office issued a joint statement assuring the market that the UK government does not assume that all private entities registered in Russia are “owned or controlled” by designated officials.

Soon after MintsIN Litasco SA v Der Mond Oil & Gas Africa SA(3) Judge Foxton dealt with the “control” element Mints decision. Noting that the issue of control had as its central concern the ability of DP to control the use of funds made available to C, he adopted a much narrower interpretation of Regulation 7(4), concluding that it concerned the existing influence of DP on C, rather than a state of affairs which DP was likely to bring about.

FOUR TYPES OF CONTROL

IN HellardDeputy Judge Nicholas Thompsell sought to reconcile the narrow interpretation of “control” adopted by Judge Foxton in Litasko with a broader interpretation by the Court of Appeal in MintsThe Deputy Judge’s analysis focused on the phrase “(if P elected)” in Regulation 7(4). He concluded that the concept of “control” fell into four distinct types:

Actual de jure control. This type of control exists where there is an absolute legal right for P to exercise control, usually established by an express provision in C’s constitutional documents. The presence of this control is demonstrated by a review of C’s constitutional documents and other legal instruments binding C. The absence of such provisions equally indicates that this type of control does not exist. There is reasonable cause to suspect this type of control where there is reason to believe that such documents or instruments may exist.
The actual current de facto control. This type of control exists where P clearly “decides” without having the legal authority to do so. This can be shown by showing circumstances in which P exercised decisive influence over C so as to control his affairs. There is reasonable cause to suspect that this type of control exists where there is reasonable cause to suspect that such events may have occurred.
Potential future de jure control. This type of control exists when, although no existing provision confers de jure control over P, P has the legal means to obtain control over C, for example through an option agreement or a forward contract. The existence of this type of control is demonstrated by a review of such agreements. Its absence is demonstrated when no relevant documents or instruments exist. There is reasonable cause to suspect this control if there is reason to believe that such documents or instruments may exist.
Potential future de facto control. This type of control exists where there is no current evidence that P exercises actual control, but there is good reason to believe that P could exercise such control if he wished. This type of control requires some special feature that leads to the belief that P could, if he wished, exercise control in some way other than through the exercise of a legal right or authority.

Importantly, potential de facto control is unlikely to arise if (1) P could obtain control only if other entities cooperated with P and/or (2) P would face significant penalties or adverse consequences that make it unlikely that P would choose to exercise such control.

VOTING RIGHTS OF BANKRUPTCY CREDITORS

Another issue considered by the Associate Judge was whether a creditor’s voting rights in insolvency proceedings constituted “funds” or “economic resources” under the 2019 Regulations, which would require freezing if held by a DP. This question arose because under the EU sanctions (on which the 2019 Regulations were modelled) voting rights were treated as “economic resources” as explained by the European Commission.

The Associate Judge distinguished between voting rights attaching to shares and rights attaching to insolvency proceedings. He found that the rights of creditors to attend and vote at meetings of a creditors’ committee, under Section 301 IA 1986 and Part 17 of the Insolvency Rules 2016, were not “funds” or “economic resources” for the purposes of the 2019 Regulations. Accordingly, the exercise of such rights or the acceptance of creditors’ votes did not amount to dealing with “funds” or “economic resources” for the purposes of the 2019 Regulations.

APPLICATION

Financial institutions and other market participants are often faced with the question of whether a customer is “owned or controlled” by a DP. Whether they can form a “reasonable belief” that their customers are “owned or controlled” by a DP determines whether they will be liable in potential civil proceedings, such as claims to recover frozen funds.

The Associate Judge’s guidance on the four types of control and what constitutes a “reasonable belief” regarding each type is welcome as it provides much-needed clarity to financial institutions and other market participants dealing with potentially sanctioned clients, as well as to those clients seeking to rebut claims of “ownership or control” of an entity acquiring control.

Although the court did not ultimately rule that the creditors of the Russian bank were not “owned or controlled” by DP, it did order the trustees under section 303 of the IA 1986 to act as if the creditors of the Russian bank were not “owned or controlled” unless new evidence indicates otherwise. The court’s willingness to deal with these matters may be beneficial to many companies that find themselves “between a rock and a hard place” (to adopt the phrase of Hellard) trying to clearly understand their (or their counterparties’) sanctions status. Given OFSI’s reluctance to make definitive determinations on ownership and control, as demonstrated in this case, recourse to the courts may become an increasingly viable option for many companies currently stuck in sanctions compliance limbo.

Finally, while the court’s ruling that voting rights in bankruptcy are neither “funds” nor “economic resources” offers valuable guidance to bankruptcy administrators, it does not address the nature of shareholders’ voting rights or lenders’ voting rights in a syndicate. The court’s distinction between voting rights under the articles of association and voting rights attached to shares may prompt further discussion of the nature of such rights for both lenders and shareholders, leaving the issue still open to interpretation.

Morgan Lewis attorneys are monitoring updates in this area Hellard and we are ready to provide assistance to those who interpret these new judgments.

(1) Hellard & Ors v. OJSC Rossiysky Kredit Bank & Ors (2024) EWHC 1783 (chap.).

(2) (2023) EWCA Civ 1132.

(3) (2023) EWHC 2866 (Communications).