GPs are including sanctions requirements in fund docs

Managers are increasingly looking to include in fund documents specific actions they must take regarding sanctioned investors, experts told Private Funds CFO.

Darshak Dholakia, a partner at Dechert, said he is increasingly seeing sanctions and AML laws spelled out in fund documents so managers have something specific to point to should they need to act.

Fund documents are usually silent on sanctions issues, except for asking for representations from investors that they have not been sanctioned, but managers are considering including explicit actions they may take against sanctioned investors, as required by the Office of Foreign Assets Control (OFAC) and anti-money laundering laws.

“We’re considering whether to include language in our fund docs to let investors know that we reserve the right to remove investors or freeze assets of sanctioned individuals, as required by regulatory authorities,” the CCO of a large asset management firm noted.

She added that sanctions are not typically addressed in representations and warranties, and that adding relevant language might give the firm extra protection from angry investors. Regulators, ever focusing on firms’ policies and procedures, may also appreciate fund managers spelling them out in fund docs.

“We’re still navigating the complications of removing sanctioned investors from funds, but we want investors to be very clear on our obligations and to understand what could happen if the situation arises,” the CCO added.

Keep it broad

Typically, fund documents are broadly drafted when it comes to sanctions, says Richard Marshall, a partner at Katten Muchin Rosenman. And while he’s seeing some clients who are nervous about potential risks add sanctions language to docs, that is with good reason: adding language that is overly prescriptive can lead to managers’ handcuffing themselves when it comes time to act.

Vague language gives managers some flexibility to deal with each situation, Dholakia said. And the CCO said, “You don’t want your fund documents to be too specific because you don’t want to limit yourself in how you can deal with certain situations.”

“Every situation will be different,” she added. “So you will want to be able to act accordingly, which is why our docs don’t say much beyond that we will take necessary actions under applicable laws. But we’re considering whether and how we can be a little more specific.”

Investor reps and warranties usually require investors to attest that they are not sanctioned themselves, while covenants might include language allowing managers to act if a given investor becomes sanctioned. Reps and warranties usually allow managers to act in whatever way they deem necessary to comply with AML regulations and sanctions laws, though some managers include specific actions, such as the ability to freeze assets and block future investments, without expressly limiting themselves to them.

Some LPAs allow sponsors to recoup fund expenses from a sanctioned investor, although these provisions are not common since it is unlikely that money will be returned anyway.

How to deal with a sanctioned investor

GPs typically must freeze the stakes of sanctioned investors or those connected to sanctioned people or companies, as well as notify OFAC. After ensuring further distributions to the investor are blocked and that no further capital calls will be taken from them, they must transfer the investor’s stake to a blocked account. That investor will still own the stake, but the assets will be frozen, and cannot be sold or transferred unless and until OFAC gives permission to do so.

Dholakia said that sanctioned investors cannot be compulsorily redeemed, as this would be considered a prohibited dealing.

“While managers want to cleanse themselves of a sanctioned investor, they simply can’t. Managers also can’t replace the sanctioned investor because you can’t give up or sell their shares,” he noted.

However, managers can bring on another investor to supplement allocations.

Katten’s Marshall added that fund managers can set up a segregated account to hold the sanctioned investor’s money, but that can be difficult since most banks won’t want to deal with that sanctioned individual.

A costly violation

Under federal law, any American or anyone “subject to US jurisdiction” can be fined or imprisoned for doing business with anyone on the sanctions list.

GPs do not have to have knowledge of a sanctions violation to be held liable, Dholakia said, and he advises ongoing screening of customers and beneficial owners to see if new sanctions affect holdings.

In the criminal context, for instance, where a fund sponsor knew of a sanction and ignored it, offenders face a $1 million fine per violation and up to 20 years imprisonment for natural persons involved.

“It’s pretty rare to have criminal violations in the investment context but the prospect is out there,” Dholakia cautioned.

Think globally

Because of sanctions’ strict liability nature and the fact that they vary from country to country, Marshall advised GPs to “look globally” when screening potential investors or conducting ongoing diligence.

Dholakia agreed and noted that the EU and UK have been much more aggressive in sanctioning individuals and companies to date than the US.

“There could be gaps in your compliance screening if you rely on the US sanctions only, so it might be prudent to comply with the EU and UK, as they are more restrictive,” Dholakia noted. “Canada has also been very aggressive with their sanctions, so if you have any Canadian nexus to your activities then it would be prudent to include this country in your screenings.”