October 9, 2014

Emerging Trends: Escalation of International Tensions Creating Significant Supply Chain Risks for Prospective Purchasers of Russian Products

Since the Russian invasion of the Ukraine and annexation of Crimea, the United States and the European Union have implemented a series of measures to punish Russian aggression against a friendly democratic country which had been increasingly pro-Western in recent years.  Since first introduced, these measures have been periodically broadened and deepened to increase pressure on the Russian government.  For its part, the Russian government has retaliated against these trade restrictions by imposing measures against the United States and Europe.  In this Emerging Trends feature, Kaye Scholer Partner Ronald K. Henry discusses how this escalating tit-for-tat cycle creates an inherently unpredictable situation with significant supply chain risks for prospective purchasers of Russian products.
The political risks of Russian purchases are growing and Russian suppliers find that even the mere disclosure of Russian sourcing can change the risk profile of a transaction.  For example, the special issue of Police Aviation News published for the 2014 Farnborough Air Show noted that a company called Transas Group had put out a statement through a Russian news agency supporting and repeating the Russian government’s opposition to sanctions.  The Police Aviation News article then explained, “…the Transas statement may have been a misjudgment…[F]or the first time it highlighted a little heeded truth that the Transas Group … was Russian.”  The article continued, “…now everyone knows that is a Russian product…when they seek to consider whether Ukrainian sanctions matter.”
Restrictions imposed by the United States government will apply even if the Russian item is only passing through the United States.  For example, a Russian item that is to be integrated into a larger U.S. export item may cause the whole end product to become subject to restrictions.  In the United States, these restrictions generally are of two types.  The first is economic sanctions maintained by the Department of the Treasury against specific named people and entities. A growing list of Russian companies and individuals with close links to the Russian government, or which are engaged in business related to defense and security, are now subject to specific sanctions.  Although the “bite” of the sanctions has been limited to date, we note that the list has been continuously expanding.  The list of specific entities subject to U.S. sanctions is now almost 30 pages long and growing.
The second type of restrictions involves heightened scrutiny or denial of export licenses required for trade in high technology and security related goods and services.  In the United States, most military technology is controlled by the International Traffic in Arms Regulations under the jurisdiction of the Department of State and most fire, police, rescue and related items are controlled by the Export Administration Regulations under the jurisdiction of the U.S. Department of Commerce.  Effective April 28, the Department of Commerce announced that it will deny pending applications for licenses to export or re-export to Russia or occupied Crimea any high-technology item subject to the Export Administration Regulations that contributes to Russia’s military capabilities.  TheDepartment of State has also announced a policy of presumptive denial of license requests involving Russia.  It is worth noting that the United States has been paying particularly close attention to not just military technology but items used by police as well.  In a recent concrete example of the heightened enforcement environment, on September 30, a U.S. company was slapped with a Temporary Denial Order by the Department of Commerce because of its unlicensed trade in crime control items with Russia.  The punishment included suspending its export privileges completely for 180 days. 
While exports to Russia have received most of the media attention, U.S. export controls can also have a substantial impact on items imported from Russia.  Anything passing through the United States becomes subject to United States regulations even if it is just being integrated into another item that will be exported from the United States. Exporting a Russian item from the United States, returning items for repair or exchanging information with a foreign supplier about the design, maintenance and repair of items commonly will require export licenses. If a U.S. manufacturer or integrator needs a license to share information with a Russian supplier, that license will be hard to get in the face to the current policy of presumptive denial.  Even if a product has been successfully delivered, the still unfolding sanctions call into question whether such licenses will be available going forward, potentially leaving customers stranded without after sales support for training, warranty repairs, spare parts, etc.  Even where licenses for high technology or security related items are being granted, however, they are subject to heightened scrutiny by government authorities.  This substantially increases both the compliance burden and overall risk with both financial costs and time delay costs.  
At the same time, Russian retaliatory sanctions on the West could result in the Russian government prohibiting the export of items to U.S. and European customers.  A recent example includes threats to bar the export of certain rocket motors used by the United States to launch satellites.  Purchasers of Russian goods can easily find themselves in deeply complex situations. When items require a significant lead time between order and delivery, the buyer may commit to a Russian supplier only to later be informed that the Russian government will not permit delivery.  If delivery has been made, warranty, repair, spare parts and post sales service risks still exist.
When considering Russian sources of supply for security related items, we urge our clients to plan carefully and fully assess the risks both in terms of supply chain disruption and in terms of compliance burden in a highly scrutinized environment.  This international standoff, which seems likely to worsen before it improves, creates a high risk business environment.  Significant numbers of U.S. companies have had their business relationships with Russian firms disrupted by these restrictive measures, and we anticipate that their numbers will grow as more sanctions are added.   
Accordingly, we recommend that clients with existing exposure to Russia in high technology and security related trade should mitigate the risk of new restrictions on trade by increasing the diversity of their suppliers outside of Russia. Where new lines of business are being pursued, particular care is required in evaluating bids by Russian suppliers.  U.S. and European customers must be sensitive to the fact that new restrictions could interrupt deliveries, prevent the supply of spare parts, prevent returns for warranty repair, or impede other after sales service support.
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