Basel III, FATCA and compliance with global sanctions are some of the salient trends highlighted by lawyers active in the trade finance market today, writes Kevin Godier.
The flow of work for the trade finance industry’s legal advisors has undergone a noticeable change in focus. “The flow is still there but transactions are more short term and focus more on the receivables. This means that supply chain financing looking at the major buyers is more common,” says Mike Sullivan, New York-based partner and co-director in Sullivan & Worcester’s (S&W) litigation department.
There is also less pre-export finance (PXF) at the moment, he emphasises. “That is a pity given the Loan Market Association’s (LMA’s) new PXF protocol but perhaps as confidence grows we will see more borrowers in emerging markets being offered these facilities again. Traders are involved in pre-payment facilities, which helps a bit,” he says.
DLA Piper’s James Willcock is in broad agreement, pointing out that, “in particular, funding pre-payments to domestic exporters via limited recourse structures to international traders can assist bankers in obtaining credit sanction for transactions for which appetite might otherwise currently be limited”.
Similar observations are made by Edwin Borrini, partner at Jones Day. “By most general indicators, the market in 2012 was at best sluggish, with volume of deals using PXF structures for example, down on previous years. Lower commodity prices, combined with limited overall liquidity in the banking market meant that both demand for, and supply of, bank loans was lower.”
However, “despite such overall figures, we were busier than ever last year due to a number of factors”, he notes, pointing to good volumes of instructions from top-tier clients, banks from Japan and elsewhere which are plugging gaps left by some of the traditional banks in the trade space and an upturn in business at the firm’s African practice.
At Norton Rose, “our workflow is within its normal oscillation, with lots of commodity activity”, says Nick Grandage, structured trade and commodity finance partner. “Africa is a major focus and a significant market for us. We’ve also been doing more in Russia, where we were involved in several recent significant transactions, and our offices in Asia are also busy,” he adds.
Grandage highlights a series of inventory-based deals occupying Norton Rose in Africa. “A few PXF, trade and commodity lenders feel very relaxed about these in a way that balance sheet lenders don’t. There is a continuous squeeze on liquidity, so borrowing bases are used more to increase funding, not just for raw commodities but also for semi and finished goods. Interestingly, we have been working on a capital markets-style inventory finance.”
Borrini at Jones Day stresses that constraints on banks have also led to some larger commodity producers bypassing the loan markets altogether and turning to bond markets. “The challenge for lawyers is to come up with funding structures which allow traditional banks to combine efforts with alternative credit suppliers in order to meet the financing needs of the growing trade and commodity industries. As such, some capital users have been able to obtain financing through alternative structures such as trade receivable securitisation.”
At Stephenson Harwood, David Lacey, a partner in the finance group, cites the potential for alternative financiers to fill the gaps left by banks. “One new source of business for lawyers could be alternative financiers coming into the market, with experience in areas such as M&A but not necessarily in trade finance,” he posits. “That is an opportunity for us to provide value, particularly in relation to deal structures and regulatory compliance.”
In those trade transactions where non-bank lenders participate, “they want a clear exit strategy, and this is where lawyers can provide education based on an understanding of the market”, says Grandage. In respect of a recent trader-arranged syndicated PXF transaction on which DLA Piper advised, Willcock comments: “Even if certain elements of the LMA documentation are not necessarily applicable to a trader arranging and financing 100% of a transaction as of day one, the documentation must nonetheless contemplate loan market expectation if it is to be ultimately syndicated.”
Overall, says Lacey, there is less work around across the whole sector compared to 2005/06 levels. “Big trade finance deals are getting done, such as Cocobod and Sonangol, which always generate interest, but there is a lot less liquidity combined with the desire of banks to allocate their limited liquidity to their own customers. Credit committees are risk-averse, tending to favour the flight to quality.”
However, Grant Eldred, partner and head of trade finance at Thomas Cooper reports that the first few months of 2013 have proved to be just as busy as ever for his practice. “Receivables financing, sanctions, some trade insolvency and specific trade finance disputes – more out of court than in – have kept us busy so far this year. On the regulatory side, advising and designing risk mitigation programmes to address aspects of capital, large exposure and liquidity arising from trade transactions has also significantly increased,” he says.
Basel III views
In terms of other key focus points, Basel III is never far away from lawyers’ desktops. With Basel III legislative measures still to be voted on by the European parliament and adopted by the commission, and two versions of the draft regulation currently in circulation, there remains some degree of uncertainty as to whether further adjustments could be required to documentation. “Given the uncertainty of the regulatory environment and, in particular, how susceptible it is to political whims and sentiment, it would be a brave lawyer who felt comfortable telling their client that no further adjustments are required,” says Borrini at Jones Day.
“Documentation certainly never stands still,” suggests S&W’s Sullivan. “Basel III means that there is a greater focus on getting the documentation right, which means lawyers keeping on their toes to produce the careful structuring required to gain clients as much advantage as possible from the regulations.” Willcock at DLA Piper notes that with regard to LMA documentation, “we see continuing negotiation around the extent to which the risk of increased costs resulting from Basel III should be allocated to the borrower or lender side”.
Eldred believes that the trade finance industry is still “trying to hit a moving target” as far as the worldwide adoption, implementation and enforcement of capital and liquidity requirements are concerned. “If the understanding and appreciation of the enhanced security provided by tangible trade could be improved, that would not only help the trade finance bankers but should help unlock the appetite for liquidity sourced from outside the banking industry,” he contends.
Lacey argues that Basel III has been “a thorn in the side for lenders, since it reared its ugly head”. But, despite what he terms as “an unfair penalisation of trade finance deals”, he professes himself “sceptical on the likelihood of any changes”.
“In terms of regulatory change, FATCA [the Foreign Account Tax Compliance Act] is the bigger talking point,” says Grandage, “but that has also been delayed, and could be a storm in a teacup again.” He comments: “A whole lot of regulatory events are imminent or on the cards, but nothing is causing any major regulatory problems for people at present.”
Sullivan concurs that no particular statute stands out in terms of the diligence required. “However the combination of FATCA and Dodd Frank in the US and the tightening of supervision generally elsewhere mean that transactions take longer to put together and KYC [Know Your Customer] becomes a major component of this,” he advises.
“There is a much greater compliance burden now and we have to carry out client due diligence driven by legislative concerns over the need to fight fraud, money laundering and terrorism,” Lacey adds. “There is undoubtedly a greater requirement now among professionals to know with whom you are dealing and clients must provide much more information than 10 to 15 years ago.”
He elaborates that the trade finance market’s most experienced bankers rarely require much advice in well-established scenarios where the documents generally follow a well-structured path. “However no document in the world can save you from fraud, which can readily scupper a trade finance deal, however much recourse is provided by the perceived comfort of trade finance, and its excellent performance history.”
He continues: “FATCA is primarily a US tax compliance issue but demonstrates the burden of complying with legislation with extra territorial effects, which has in turn triggered a series of inter-governmental agreements. The transaction documents can allocate the risk of the costs associated with this legislation but the increasing burdens and the penalties for non-compliance raises the regulatory cost of running a banking business,” he affirms.
According to Borrini, banks are “adopting a pretty rigid approach to compliance with laws relating to corruption and there is often little wriggle room on the drafting of the covenants which cover this area”. But, “given the nature of the jurisdictions in which many producers of commodities are based, this is an issue which always needs to be considered”, he underlines.
Another of the key prevailing regulatory trends over the last five to 10 years has been the increasing emphasis on strict compliance with global financial sanctions, as well as more wide-ranging and draconian sanctions measures targeting not just designated individuals or entities, but entire sectors and classes of transaction.
“Checking for sanctions issues is the main issue for all of us, and care must be taken to check all elements of the transaction. As many others have noted, sanctions represent traps for the unwary,” cautions Sullivan.
“Sanctions are an ever-changing environment, and a major compliance issue which will not go away,” chimes Lacey. “At present US sanctions are hitting the shipping industry, so that a vessel flagged in Iran cannot then sail to US ports. There is also both interplay and inconsistency between sanctions from different jurisdictions, such as the UN, US, UK and the EU, all of which we have to pick through carefully from London, and all of which is now part of the regulatory overhead of running a business.”
Grandage reports that transactions involving sanctioned countries such as Iran are not seen in the trade finance market, and the personal sanctions in relation to places such as Zimbabwe tend to be a matter of due diligence. “Banks and borrowers are pretty clued up on the rules now.”
Adds Eldred: “However broad the various sanctions regimes become, the fundamental issue for lawyers remains the same – how to try to give definitive advice in relation to sanctions which often retain uncertainty to secure the broadest compliance.”
Borrini says that “most international financial institutions now have sophisticated internal counsel teams who are very familiar with the international regimes, and tend to take a zero risk approach to transactions with any sanctions implications in the countries where the US particularly applies its so-called universal sanctions: in Iran, North Korea, Sudan and Cuba”.
He explains: “The practical impact of this is that many international banks are now unwilling to provide corporate finance across the world without a clear understanding of and assurances around use of ultimate funding. Most day-to-day work focuses on countries where more limited sanctions are in place, for example Belarus and Zimbabwe.”
What other trends issues are on lawyers’ scanners? “There are still banks getting involved in trade for the first time or gearing up their teams. There is more interbank activity on risk sharing – this includes between OECD banks and also with banks in emerging markets. Each presents its own challenges,” says Sullivan.
Willcock notes that DLA Piper has seen the strategy of certain banks to focus on growing revenue from traditional sources result in the merging of their trade and supply chain finance teams. DLA Piper has responded by consolidating its offering in these areas within its structured trade and receivables finance team, he says.
Asked about the extent to which cost is a factor in lawyers being retained, Lacey answers in the affirmative but underscores that it is not an overriding factor. “Banks tend to look to people they know and in whom they have confidence. Firms have responded to cost pressures in the market with greater efficiencies while clients also have a role to play. In contrast to the late 1980s with teams of lawyers working through the night, clients are more cost-conscious and recognise that effective management of the transaction plays an important role in controlling legal costs,” he concludes.