By Ramsey B. Jurdi

A critical look at the US record of enforcement of sanctions against Iran reveals that prosecutions and penalties are not keeping pace with legislation and diplomatic developments.

The Office of Foreign Assets Control or "OFAC" appears hampered by a lack of resources to investigate and prosecute sanctions violators, and the State Department remains reluctant to step on diplomatic toes, particularly those of China and India, through use of extraterritorial laws. New sanctions have been enacted on average every three to four months over the last three years, but much of this legislation has been either symbolic or used sparsely.

Notwithstanding this, sanctions are severely affecting Iran. However, this can be significantly attributed to the imposition of a fairly broad sanctions regime by the European Union in January 2012. The Iranian economy is reeling from severe inflation and reports of profiteering are increasing. US diplomacy no doubt played a key role in convincing the EU to shut its energy markets to Iran, but similar efforts with China and India, now Iran's key markets, have thus far been ineffective. Similarly, US threats of sanctions against foreign entities conducting business in Iran's energy sector have often gone unheeded in the absence of credible and aggressive enforcement efforts.

Legislation and enforcement activities over the past three years fall into three broad categories.

The first and most active category of sanctions enforcement is restrictions on US companies and their foreign subsidiaries, with a focus of enforcement on banks such as HSBC and Standard Chartered. Imposition of penalties on non-US companies, under the Iran Sanctions Act, is the second and largely symbolic front for US efforts to isolate the Iranian economy. Third, denial of US correspondent accounts for non-US financial institutions conducting significant transactions with Iran is an additional area of focus.

This article examines each of these three categories and attempts to draw conclusions about the future of enforcement efforts.

Enforcement Against US Companies

US banks and foreign subsidiaries of US companies have been the primary focus of enforcement and legislation, respectively, over the past year. Enormous fines were imposed on US branches or subsidiaries of HSBC and Standard Chartered, encouraging a significant adjustment in behavior worldwide. Further, in August 2012, the US Congress closed a loophole that allowed foreign subsidiaries of US companies to conduct transactions with Iran if the US parent company and US citizens were not involved. As a result of these developments, the focus should shift over the next year to trade-related enforcement actions.

OFAC receives several hundred "leads" per year and opens more than 100 investigations in response. On average, approximately 20 enforcement actions a year result from these investigations. These numbers are surprisingly low given the broad reach of sanctions and the political importance of the Iran issue.

A review of recent OFAC enforcement actions reveals a focus on financial institutions, small trade-related violations, and voluntary disclosures. This pattern of targets and the relatively low number of enforcement cases indicate a reliance on voluntary disclosures, a focus on high-profile actions that will have a deterrent effect and limited resources to investigate violations.

Change should be coming within the next year as a result of recent legislation, namely the Iran Threat Reduction Act of 2012 or "TRA," but any change will be tempered by sequestration in the US budget. US agencies have been ordered to make across-the-board reductions in spending in each of the next nine years. OFAC has been ordered to cut its spending by 8.2% for the remainder of this year. The cuts may lead to furloughs of government employees.

The TRA tightens sanctions in several areas. One such area is a prohibition on foreign subsidiaries of US companies conducting any transaction that would be prohibited for a US company to conduct directly, regardless of the nature and extent of connections between the subsidiary and the US parent.

As a result of the TRA, the activities of foreign subsidiaries of US companies are now within the focus of OFAC and provide a new front for enforcement. Although the actual number of enforcement actions will probably not increase, particularly in light of US budget cuts, a renewed focus on trade-related violations is likely. In a sign that the legal industry is moving in anticipation of this pivot, there has been a noticeable uptick in internal investigations, voluntary disclosures and compliance audits in the six months since the TRA was enacted.

Enforcement of the Iran Sanctions Act

The US government has had authority under the Iran Sanctions Act since 1996 to impose penalties on non-US entities for certain trade with Iran. However, this authority was not exercised by the executive branch. Congress has been putting pressure on the Obama administration to use the authority by passing a series of amendments, beginning in July 2010 with the Comprehensive Iran Sanctions, Accountability and Divestment Act. The amendments expand the activities subject to penalty, add to the available penalties and remove much of the discretion previously afforded to the executive branch to impose penalties.

Since reinvigoration of the Iran Sanctions Act, the US State Department, which has primary jurisdiction for enforcement but works closely with OFAC, has penalized approximately 18 companies for energy-related transactions with Iran. This equates to an average of approximately one company being penalized every two months. When looking beyond the statistic, to the size and relevance of the companies that have been penalized, a record of sparse enforcement is evident.

Of the 18 companies examined, six appear to be Iranian-controlled, eight appear to be small to medium-sized companies, and four are major players. The deterrent value of penalizing Iranian-controlled or affiliated entities can be disregarded. Similarly, penalizing small to medium companies, which likely have few US links, is of limited value. That leaves arguably only four notable actions under the Iran Sanctions Act over the course of 33 months. The actions were against Belarusneft, Petróleos de Venezuela, Sytrol and Zhuhai Zhenrong Company.

Moreover, the State Department exercised restraint when selecting the penalties to impose on the 18 targets. The Iran Sanctions Act requires that the executive branch impose a minimum of five penalties (recently increased from three) from a list of 12. The penalties range from the comparatively minor, such as no export assistance from the US Export-Import Bank, to the severe, such as a blocking of all transactions with the United States. The State Department has consistently imposed the minimum of five penalties and, with limited exception, chosen penalties from the lighter side of the spectrum.

Despite this sparse record of enforcement, the State Department has used the Iran Sanctions Act effectively and diplomatically, and we do not foresee a marked increase in enforcement actions. The Iran Sanctions Act is a cogent threat to non-US companies conducting transactions with Iran, but its extraterritorial application creates sensitivities among foreign governments. Accordingly, the State Department typically reaches out to targeted entities prior to imposing penalties and seeks a commitment from the targeted company to wind down or cease Iran transactions. Given this practice, and in light of potential diplomatic repercussions, enforcement levels are likely to remain steady.

Denial of US Correspondent Accounts

Over the past year, the US has effectively isolated the Iranian financial sector, in part by threatening non-US banks with a denial or closure of US correspondent bank accounts if the non-US bank conducts significant financial transactions with Iranian financial institutions. Section 1245 of the National Defense Authorization Act, which was enacted in December 2011, has forced many banks to stop transactions with Iranian financial institutions, including the Central Bank of Iran, under threat of losing their ability to conduct dollar-denominated transactions. The threat of penalty has thus far been effective, and the US has not yet actually penalized a bank under section 1245.

However, the effect of section 1245 has been diluted through the executive branch's broad use of its waiver authority. The US president is permitted by section 1245 to issue six-month waivers for any jurisdiction that significantly reduces its volume of crude oil purchases from Iran in the preceding period. Waivers have been issued for much of Europe and the Far East (including China), and financial institutions established within those jurisdictions can continue doing business with Iranian banks without threat of penalty under section 1245.

Without question, section 1245 has been effective, and Iranian companies are facing difficulty when conducting cross-border transfers. However, the gaping hole in the US enforcement campaign is China and India, which are taking advantage of Iran's loss of other markets to buy Iranian crude at discounted rates. If the political conflict with Iran continues to escalate apace, and the US and the EU seek to weaken the Iranian regime further through economic means, then the US will need either to begin sanctioning Chinese and Indian financial institutions or to convince both countries to stop buying Iranian crude. Both of these choices are unappealing for the US administration, particularly given the sensitivity of trade relations between the US and China.

Looking forward, a large batch of waivers was renewed in March 2013 and will not come due for renewal again until August 2013. Accordingly, we do not foresee material activity with respect to section 1245 within the coming six to 10 months. However, the US could choose to make an example out of a bank in a non-allied and non-exempt jurisdiction, as it has done with the Iran Sanctions Act, in order to spur further conformity and set the stage for discussions when waivers come due for renewal.

Other Areas to Watch in 2013

In addition to the enforcement efforts discussed earlier, over the next year, the US will also be looking to close off avenues for circumvention of the restrictions on financial transactions, namely transfers of precious, raw and semi-finished metals. These items, as well as the Iranian shipbuilding industry, were the target of additional sanctions in January 2013 that will come into full effect in July 2013.

Further, the US has recently opened a new front for enforcement through use of Securities & Exchange Commission disclosure requirements. Effective February 2013, issuers required to file a 10-K or 20-F annual report or a Form 10-Q quarterly report with the SEC must disclose certain transactions with Iran, notwithstanding that the transactions are legal. Such disclosures must be accompanied by a stand-alone statement highlighting the presence of an Iran disclosure in the broader filing. In the case of non-US companies, the executive branch is then required to initiate an investigation into whether to impose penalties under the Iran Sanctions Act. This specific area is expected to be active throughout 2013.

Lastly, the US Congress is expected to keep up the pace of additional sanctions legislation every three to four months, which in the past year has focused on expanding the Iran Sanctions Act and limiting the president's discretion with respect to the imposition of sanctions under both the Iran Sanctions Act and section 1245. The Nuclear Iran Prevention Act currently pending before Congress contains no novel sanctions, but further targets non-US companies and financial institutions.

New legislation is only achieving incremental changes in behavior and trade. The US executive branch already has a wealth of tools that it can employ to change behavior, yet it understandably continues to tread softly. It is only a matter of time before the US will have no choice but to use its sanctions stick more actively and aggressively.