Hold on a Second(ary): Rethinking OFAC’s Expanded Sanctions Powers
25 Nov 2019

Although economic sanctions are supposed to be universally adopted, they are only actively promulgated and enforced by a small handful of nations. The United States, in particular, has wielded the power of this tool of economic leverage the most extensively, and enforced its regulations the most aggressively. This is because the U.S.’s status as the world’s largest economy and the issuer of the world’s de facto reserve currency enable it to use sanctions as a tool to achieve its foreign policy goals, above and beyond those dictated by the United Nations. The clearest evidence that the United States takes advantage of its unique global position are the U.S. regulations that impose secondary sanctions.

Secondary sanctions appear to be an effective tool of statecraft, as evidenced by the number of European firms that have cut or rejected financial ties to Iran in order to avoid the wrath of the United States. But are these wise policy tools to implement, and are they being used prudently?

What is a secondary sanction?

Outside of the United States, all economic sanctions imposed by a country are primary sanctions. These prohibitions or restrictions must be adhered to in dealings with specified parties (i.e., individuals or organizations or property, such as cargo vessels) or in specific types of transactions (e.g., exports, imports or investments of certain types). With very few exceptions (the U.S. prohibition, under its Iran sanctions program, against exports of U.S.-origin goods to Iran, is a notable one), primary sanctions are only required for persons and entities subject to the legal jurisdiction of the sanctioning country, which generally includes:

  • Citizens of the sanctioning country worldwide
  • Persons present in the sanctioning country at the time of the relevant violation
  • Organizations formed under the sanctioning country’s laws
  • The offices and agencies of other organizations involved in the violating activity located in the country

In contrast, secondary sanctions impose penalties on persons and organizations not subject to the sanctioning country’s legal jurisdiction and they are applied against entities engaged in the same dealings prohibited under primary sanctions. For example, because the Islamic Revolutionary Guard Corps, or IRGC, is subject to secondary sanctions imposed by OFAC, a person who is not a “U.S. person” who deals in assets linked to the IRGC (e.g., donating to the IRGC’s charitable organization) may be penalized by OFAC. This is true even when there is nothing in the dealings that involves the United States, such as use of its currency or the export or import of its goods.

The effect of the two kinds of sanctions being imposed is likewise different. In the large majority of sanctions programs, the application of primary sanctions results in the prohibited or restricted assets being frozen. In some programs, such as the U.S. and E.U. sectoral sanctions against Russia, or dealings with the Palestinian Legislative Council, affected transactions cannot be executed, but the underlying assets are not frozen. Individuals or entities that violate primary sanctions can face monetary penalties and/or incarceration, though enforcement of sanctions may hinge on whether the country in question has an adequate enforcement regime in place.

Similarly, the party violating the prohibitions or restrictions subject to secondary sanctions is the one subject to the regulatory consequences. However, the penalties are significantly more severe; generally, they consist of restrictions or prohibitions from accessing the imposing country’s financial system and/or broader economy. While there are a range of penalties that can be imposed under various U.S. sanctions regulations, the most severe is the loss of access to the financial system in the United States (and by U.S. financial institutions, wherever located). This measure effectively bars the sanctioned party from doing business with customers and suppliers in the United States, since it prevents access to the currency. It also makes being a significant force in international trade considerably more difficult, as the U.S. dollar is not only involved in over sixty percent of foreign exchange deals (which is how the buyer’s currency is used to purchase the goods and services in the seller’s currency), but is also the primary currency in which important commodities such as oil and precious metals are typically bought and sold.

U.S. use of secondary sanctions

The United States currently can impose secondary sanctions broadly under its Iran, Russia and counterterrorism sanctions program. In addition to dealings with every sanctions target subject to asset freezes in these programs being off-limits due to secondary sanctions (and the entities which their ownership interest makes them subject to the OFAC 50-Percent Rule), the following are also subject to secondary sanctions:

  • Dealings with parties on the State Department’s CAATSA (Countering America’s Adversaries Through Sanctions Act) Section 231 List, which contains firms in the Russian defense and intelligence sectors
  • Foreign financial institutions (FFIs) that aid the Iranian government or the Central Bank of Iran in its pursuit of weapons of mass destruction (WMDs) and Iran’s support of designated foreign terrorist organizations, or which aids any party subject to UN sanctions under Security Council Resolutions 1737, 1747, 1803 or 1929 or any other Iran-related Resolution, or launders the funds involved in these activities, or provides “significant” financial services to the IRGC or its agents, or for persons subject to asset freezes for their involvement with Iran’s WMD program or Iran’s development of delivery systems for WMDs
  • FFIs that knowingly conduct or facilitate any “significant financial transaction” for Iranian financial firms subject to asset freezes, or for the Central Bank of Iran
  • FFIs that knowingly conduct or facilitate the purchase of Iranian petroleum, petroleum products or petrochemicals, or for the National Iranian Oil Company (NIOC) or the Naftiran Intertrade Company (NICO), or any entity that NICO or NIOC own or control
  • FFIs that knowingly conduct or facilitate financial transactions related to the purchase of Iranian iron, steel, aluminum and copper (and products made from those metals), the sales, transport or marketing of those products, or the sale of goods or services to Iran in relation to those sectors of the Iranian economy, or for any party designated under the metals sector Executive Order (13871)
  • Parties that have assisted in the evasion of the Iran and Syria sanctions, including the facilitation of deceptive transactions

It is important to note that very few parties have been designated under these authorities. There are 12 listings on the Foreign Sanctions Evaders (FSE) List (which represents 7 distinct parties), and 3 listings on the Correspondent Account or Payable-Through Account (CAPTA) List, all of which represent the same entity. It is impossible to know whether the relatively few designations is a result of compliance or an unwillingness to use the authority in some instances.

A force multiplier to primary sanctions?

Secondary sanctions, when they prove dissuasive, provide imposing countries a force multiplier for the primary sanctions they impose. Most countries possess little leverage, economically or politically, that would make an imposing country think twice about applying secondary sanctions. Companies which might normally conduct significant business with the targeted persons and organizations, therefore, tend to adhere to the prohibitions. This, in turn, increases the pressure of the sanctions imposed , because of the more universal adoption of them.

However, the U.S. Government Accountability Office’s (GAO) October 2019 report Economic Sanctions: Agencies Assess Impacts on Targets, and Studies Suggest Several Factors Contribute to Sanctions’ Effectiveness notes that sanctions seem to be more effective when, among other factors, they are implemented through an international organization, when the targeted country is dependent on the imposing country or where the targeted country has a lower per-capita income. Considering that secondary sanctions are, at the current time, inherently unilateral in application, these factors should also inform the effectiveness of imposing secondary sanctions.

There is a current example that demonstrates all these points: Turkey. Despite Ankara taking possession of Russian S-400 missiles manufactured by a firm on the CAATSA 231 list, secondary sanctions have not been imposed. Why not? For one, the strategic U.S. Air Force base at Incirlik likely blunts the leverage of potential sanctions, and gives the U.S. pause for such a move. Secondly, according to figures from the Observatory of Economic Complexity, Turkey, being the 27th largest exporter and 20th largest importer in the world, is significantly larger economically than any other country subject to sanctions outside of Russia. In fact, Turkey’s per-capita GDP is higher than any other targeted country, including Russia. If the GAO report is to be believed, the threat of imposing secondary sanctions on Turkey are therefore less likely to be successful.

In a similar vein, the secondary sanctions with regard to the U.S. sanctions on Iran and Russia have caused unnecessary friction with the European Union, a bloc that has significant economic and political independence from and/or interdependence with the United States, yet takes a significantly different view on these sanctions programs. The secondary sanctions are as effective with respect to the European Union as they are because, despite the size of the bloc economically, politically, each E.U. member state has significant autonomy in foreign policy. This changes the equation of economic leverage from “U.S. versus the E.U.” to. “U.S. versus France, U.S. versus Germany, etc.” And that likely significantly changes how each E.U. country, and their companies, view the risk/reward of secondary sanctions.

Some E.U. companies, such as Maersk, have therefore complied with U.S. wishes on Iran sanctions out of economic self-interest. This is despite the expansion of the E.U. Blocking Statute to include penalties imposed due to violations of OFAC’s Iran sanctions program. On the other hand, the U.S. has not imposed any secondary sanctions on any European company. How much that is a function of U.S. reticence to impact E.U. diplomatic relations and economic ties, it is impossible to say, but it is likely to be at least somewhat a factor. It is likely similar to how OFAC has recently placed a number of subsidiaries of China COSCO Shipping on the Specially Designated Nationals (SDN) List due to their business dealings in Iran, yet chose to not sanction the whole firm.

Taking the long view, coercive measures, while expedient and effective in the short term in achieving desired outcomes, are not as effective as negotiating a common multilateral path forward. Pushing other nations, whether currently friend or foe, is destructive to longer-term relationships and cooperation. Twenty years from now, will a country whose company was penalized because of secondary sanctions violations be ready to forget the interference with its economy and sovereign foreign policy goals?

While cooperation is more likely when there are common interests, one need only look to the military coalitions assembled by the U.S. in the wake of the September 11, 2001 terror attacks to imagine what that coalition might look like if some of those countries’ significant business enterprises had been penalized with secondary sanctions.

An alternative model

All this being said, secondary sanctions can be a powerful tool. Could they be replaced with an alternative that achieves the scale of economic leverage while minimizing needlessly antagonizing current allies?

As a unilateral tool, the downside of secondary sanctions might be blunted somewhat by offering a system of waivers or licenses in return for a limit on activities that are undesirable by the imposing country. A system similar to the oil waiver system that existed in the Iran sanctions program might mollify impacted nations by providing a more prolonged glide path to replacing the lost business. The downside of such an approach is that the leverage on the sanctions targets would be lessened. The U.S. would therefore require a longer time to achieve the desired pressure to incentivize a change in sanctioned parties’ behavior.

There is another possible use for secondary-style sanctions. If the United Nations sanctions programs were modified so that parties which have proscribed dealings with those designated by the U.N. Sanctions Committees could be designated themselves, effectively cutting them off from all member-states that enforce U.N. sanctions, that would increase their effectiveness. Such a system would require mechanisms to propose parties for designation and an evaluation process that provided the targeted parties due process, as well as mechanisms for appealing and delisting designees. While such an enhanced set of U.N. sanctions would not address the general lack of enforcement, they would inhibit some of the additional parties from continuing to ignore primary sanctions, because of the devastating impact of being designated themselves.

Lesson learned?

Secondary sanctions contain the germ of a good idea: create a dissuasive disincentive for parties that diminish the effectiveness of sanctions prohibitions through continued business dealings, so that sanctions are, in the long run, adhered to more broadly. However, as currently implemented, they are overly coercive and insufficiently cooperative in nature for maintaining good international relations long-term.

Secondary sanctions are often desired to deter parties that can make a substantial difference in the fortunes of the primary sanctions targets. These tend to be from larger countries, which also tend to be less dependent on the country applying secondary sanctions. This combination of factors can result in secondary sanctions being less effective than desired. When one also considers the long-term negative effect on diplomatic and economic cooperation with countries whose firms feel the brunt of severe sanctions penalties imposed from afar,  it would seem to behoove all nations to find a better model that maximizes international cooperation and, when that is not possible, aims to preserve alliances and relationships necessary for the successful marshaling of resources and willpower when the times demand them.

Eric A. Sohn, CAMS, global market strategist and product director, Dow Jones Risk & Compliance, New York, NY, USA, eric.sohn@dowjones.com

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