Readers of SanctionLaw.com may recall an article that I wrote at the beginning of the year concerning the lawsuit brought by Epsilon Electronics (“Epsilon”) against the United States Department of the Treasury’s Office of Foreign Assets Control (“OFAC”).  If you are unfamiliar with this case, it involves a car and audio equipment company that was recently fined by OFAC for exporting products that were ultimately destined for Iran.  As a result of that conduct OFAC penalized Epsilon $4,073,000 for the violating the Iranian Transactions and Sanctions Regulations (“ITSR”).  The amount of the penalty aside, the main point of interest in this case is Epsilon’s reliance on the “inventory exception”, a purported rule adopted and relied upon by many in the OFAC bar and those dealing with U.S. sanctions.

The inventory exception is thought to be an exception to the prohibition on exporting U.S.-origin products to Iran, when those products are sold to parties in third country who do not predominantly sell to Iran and where there is no other reason to know at the time of the export that products will end up in Iran.  This exception has been derived from interpretations of the language of OFAC’s published July 22, 2002 “Guidance on Transshipment to Iran” (“2002 Guidance”).  Having been relied upon by many OFAC practitioners for years, Epsilon in its current litigation seeks to rely upon the inventory exception as a shield to liability from OFAC’s penalty.  The reason why this case is interesting then, is to see whether or not OFAC will publicly confirm the existence of this rule in the ITSR and define its scope and limitations.

The only time that I recall OFAC explicitly maintaining such an exception in a sanctions program was in the old Libya Sanctions program, 31 C.F.R. Part 550.  Specifically, 31 C.F.R. § 550.409(d)(2) which–in addressing exports to third countries and transshipment–stated that “[e]xports of goods or technology from the United States to third countries are not prohibited where the exporter has reasonable cause to believe that…[t]he goods will come to rest in a third country for purposes other than reexport to Libya, e.g., for purposes of restocking the inventory of a distributor whose sales of the particular goods are not predominantly to Libya…” I was unable to find any similar language in older versions of the ITSR or the Iranian Transactions Regulations (“ITR”), so it appears that the exception in its current form merely derives from the 2002 Guidance, and does not have any other support outside of that guidance.  Epsilon, however, takes the position that this exception exists not only through the 2002 guidance, but also because of established agency practice.

Indeed, in filing a Cross Motion for Summary Judgement, Epsilon has the following to say about the inventory exception and how it applies in their case:

1. “OFAC failed to adequately review and apply its regulations and inventory exception…” p. 6;
2. “OFAC attempts to overlook the ‘inventory exception’ and mislead the Court’s attention from Plaintiff’s legal argument and the law by citing to it in a footnote of its motion for summary judgment. Defs.’ Mot. Summ. J. at 14-15. This is the only mention by Defendants of the inventory exception, yet it is discussed thoroughly in Plaintiff’s claims.” p. 12;
3. “The “inventory exception” provides that the exportation of goods and services to Iran is prohibited when a U.S. person knows or has reason to know that the goods were specifically intended for Iran or if the buyer deals predominantly with Iran. Guidance on Transshipments to Iran at 2, http://www.treasury.gov/resource-center/sanctions/Programs/Documents/iranship.pdf (last visited July 27, 2015); 31 C.F.R. § 560.201. Longstanding industry practice, also well recognized by agency practice, interprets this guidance by OFAC to allow transshipment of goods to Iran when the items are not sold to the third-country party for the specific purpose of being reexported to Iran and the third-country party’s sales are not predominantly to a sanctions target. See Meredith Rathbone et al., Symposium Article: Sanctions, Sanctions Everywhere: Forging a Path Through Complex Transnational Sanctions Laws, 44 Geo. J. Int’l L. 1055, 1098 (2013).” p.11; and
4. “Furthermore, [OFAC] attempt to rebuke Plaintiff’s reference to the inventory exception by using the standard for defining a “reason to know,” which can be established by course of dealing, customer preferences and other circumstantial evidence. Id. at 15. OFAC has provided guidance in the past to a U.S. company whose non-U.S. third-party distributors sold small quantities of the U.S. company’s products to Iran. See Enforcement Information for October 14, 2011, U.S. Department of the Treasury, http://www.treasury.gov/resource-center/sanctions/CivPen/Documents/10142011.pdf (discussed in Symposium Article: Sanctions, Sanctions Everywhere: Forging a Path Through Complex Transnational Sanctions Laws, 44 Geo. J. Int’l L. at 1099).” p. 12.

As noted above, OFAC only made one mention of Epsilon’s reliance on the inventory exception, stating in a footnote:

“…Epsilon references the “inventory exception,” and relies on OFAC’s July 22, 2002 “Guidance on Transshipments to Iran” for such exception…..Epsilon’s reliance is misplaced. The Guidance cited by plaintiff does not establish an exception from the export prohibitions for Epsilon’s exports to Asra. On the contrary, the Guidance states: ‘It is important to note that the prohibited sales to Iran through a non-U.S. person in a third country are not limited to those situations where the seller has explicit knowledge that the goods were specifically intended for Iran, but includes those situations where the seller had reason to know that the goods were specifically intended for Iran, including when the third party deals exclusively or predominately with Iran or the Government of Iran. “Reason to know” that the seller’s goods are intended for Iran can be established through a variety of circumstantial evidence, such as: course of dealing, general knowledge of the industry or customer preferences, working relationships between the parties, or other criteria far too numerous to enumerate…..’ As detailed above, Epsilon, through its knowledge of and working relationship with Asra, knew or had reason to know that the goods it exported to Asra were intended for reexport to Iran.”

This response from OFAC left an open question as to whether or not the the Guidance did not establish an inventory exception, or whether any such exception’s scope merely did not extend to the conduct at issue in Epsilon’s matter.  I wrote about this ambiguity in an article from March of this year, and thought at the time that OFAC would eventually have to take a position on whether the rule existed through construction of the language of the 2002 Guidance.

However, Epsilon’s Cross Motion for Summary Judgement adds a new wrinkle to their article: whether the rule is also created through agency practice and industry standards. So will Epsilon’s reliance upon agency practice be enough to establish a violation of the Administrative Procedure Act (“APA”) by OFAC?  One place the court may look to make such a determination is the seminal U.S. Supreme Court case of I.N.S. v. Yeuh-Shaio Yang, where the Court held that:

“Though the agency’s discretion is unfettered at the outset, if it announces and follows–by rule or by settled course of adjudication—a general policy by which its exercise of discretion will be governed, an irrational departure from that policy (as opposed to an avowed alteration of it) could constitute action that must be overturned as “arbitrary, capricious, or an abuse of discretion” within the meaning of the Administrative Procedure Act, 5 U.S.C. §706(2)(A).”

The Supreme Court has also previously noted that in cases involving alleged changes in an agency’s interpretation of a statute that, “[although] the mere fact that an agency interpretation contradicts a prior agency position is not fatal…[s]udden and unexplained change…or change that does not take account of legitimate reliance on prior interpretation…may be arbitrary, capricious or an abuse of discretion.” Smiley v. Citibank (South Dakota), N.A., 517 U.S. 735, 742 (1996).  Finally, “[while] an agency has a well-settled right to modify or even overrule established precedent, it is equally settled that an agency must provide a reasoned explanation for any failure to adhere to its own precedents.” Grace Petroleum Corp. v. F.E.R.C., 812 F.2d 589, 591 (10th Cir. 1987) (citing Hatch v. F.E.R.C., 654 F.2d 825, 834 (D.C. Cir. 1981)).

Despite this legal precedent, the administrative record in the Epsilon matter is devoid of any evidence to establish that an inventory exception has been established by prior agency positions or policies. Indeed, it wasn’t until Epsilon filed suit that it ever raised the inventory exception.  Moreover, the only authority Epsilon really offers to support the inventory exception’s existence is the discussion of the exception in Ms. Rathbone’s 2013 article.  A closer look at that article actually discusses the fact that exporters may not receive much comfort from the so-called exception given the ambiguity around it.

I don’t think this is going to end well for Epsilon.  That is certainly not meant in anyway to disparage their lawyers’ arguments or efforts–we don’t do that on this blog–but rather, is based on a belief that Judge Walton is going to have a hard time finding an established agency practice based on the information contained in the administrative record.  Furthermore, I am not aware of any additional information to suggest that OFAC has ever announced the existence of the inventory exception in the context of the Iranian trade embargo, even if they had been applying such an exception behind closed doors.

Thus, while it is perhaps true that OFAC has been letting certain parties slide in situations which may fall under circumstances similar to the one in the 2002 Guidance, or in which attorneys have been advising that the inventory exception would apply, that does not necessarily make it a rule.  Moreover, OFAC is always careful to note that their actions in certain scenarios are non-precedential, and that every matter is treated on a case-by-case basis.  As such, although we’ll have a more concrete sense on what to make of the inventory exception after the Court’s ruling, I will be continuing to do advise clients as I always have: don’t rely on the inventory exception to engage in transactions which you fear may otherwise be prohibited by the ITSR.

The author of this blog is Erich Ferrari, an attorney specializing in OFAC matters. If you have any questions please contact him at 202-280-6370 or ferrari@ferrariassociatespc.com.