Compliance requirements continue to burgeon within the regulatory matrix, writes Kevin Godier.


From a regulatory perspective, the impact of Basel III on trade finance remains high on the agenda of many banks.

The trade finance market and its legal advisers “have worked very effectively following the financial crash in areas such as Basel III and CRD IV, establishing that trade finance is a great product, with low losses, that should be well treated by regulators”, says Geoffrey Wynne, partner at Sullivan & Worcester, and head of its trade and export finance practice. “What is pre-occupying everybody now is compliance, in its widest sense,” he adds.

Wynne underlines that the London market has been significantly impacted by the summer 2013 thematic review of financial flows undertaken by the Financial Conduct Authority (FCA). “This was somewhat critical of the efforts of trade finance banks in policing money laundering and financial crime generally, including terrorism,” he notes.

The post-review remit for banks, says James Willcock, senior associate in DLA Piper’s structured trade and receivables finance practice, includes “structuring and documenting their transactions to ensure that anti-money laundering (AML) and know-your-customer (KYC) requirements are satisfied prior to financing and that sanctions risk is effectively allocated between the parties under the finance documentation”.

Wynne points out that one area of the FCA review cited failures to properly monitor transactions involving dual-use products, and other laxity in relation to dual-use goods. “This means that if you are financing a commodity like sugar, which is also a major component of explosives, the regulators say you should be looking at parties and counterparties, to ascertain if the consignment may be getting into the wrong hands. For trade finance practitioners, KYC has effectively been replaced by know-your-customer’s-customer (KYCC).”

In turn, stresses Wynne, this requires due diligence processes whose cost and time elements can weigh down dynamic or low-value transactions. “Taken to its illogical conclusion, it creates more risk for banks in trade finance, not least the fear of the huge regulatory fines for AML and other misdemeanours that can affect reputational risk.”

Widening attention span

The gamut of areas which require keener attention spans AML, terrorism, KYC and increased regulation in general, including FATCA and the implementation of Basel III, says Grant Eldred head of finance group at Thomas Cooper. “At the same time as the trade finance industry is being pushed more and more towards the underlying contract by AML and KYC requirements, the sanctions and embargos regimes are also expanding. The banks are being asked to police all these areas which, particularly with regard to dual-use goods, requires them to devote resources to acquiring new specialist knowledge,” he explains.

Eldred highlights that pressure on capital resources has not been relaxed either. “Credit risk mitigation policies and large exposure limit issues are becoming increasingly important. The CRD IV framework, placing greater emphasis on formal legal opinions, needs to be clarified particularly with regard to internal and external opinions and the acceptability of generic opinions. Resources are finite, and there is a danger that the costs of separate formal compliance opinions will ‘eat into’ the resources available for the more important task of ensuring the transaction as a whole is properly documented and secured.”

John Sayers, partner at Simmons and Simmons, suggests that “discrete advisory projects are more frequent” for legal advisers than any continual focus on compliance, given the size of many in-house compliance teams at banks and their integration into the wider business. “Many banking organisations profess the view that good KYC, updated regularly, and strong client relationships are the front-line in compliance. External advice is still sought, but there is a considerable source of expertise available in-house, and there are cost and time savings flowing from this. On the contentious side, advising in relation to compliance failures has increased significantly and is an integral part of a trade finance legal offering.” Clients will usually seek external advice in such situations, which are occurring more frequently, he adds.

Sayers emphasises that one focus of advice covers developing markets that have revisited their domestic anti-corruption initiatives and enforcement priorities. “The message to our clients is that compliance with ‘extra-territorial’ anti-corruption legislation will not necessarily guarantee compliance with local laws,” he explains.

For Edwin Borrini, partner at Jones Day, the areas of greatest concern for lawyers tend to depend upon the identity of the counterparty, the relevant geography and nature of the underlying transaction. “For example, dual-use regulation is much less likely to be relevant to certain agri trades. Otherwise, each of the areas is important given the often draconian consequences of getting the issue wrong both from a reputational and also a financial perspective,” he says.

Sanctions arena
Sanctions continue to be a major trade finance preoccupation, say lawyers. Willcock reports that DLA Piper has received a number of queries from clients concerning how to address sanctions risk within trade finance instruments themselves as well as general market practice in this regard. “A further challenge for some global clients is how to remain competitive in certain jurisdictions in which they operate where their global compliance policy requirements can be higher than required by local regulation, sometimes handing local players a competitive advantage.”

The experience at Jones Day, says Borrini, “is that there is a much greater appreciation of sanctions risk arising out of trade finance than, say five to eight years ago. In particular, clients are increasingly aware of the risk of sanctioned entities seeking to take advantage of the comparatively complex and fragmented nature of trade finance activity where multiple parties – in many cases with limited knowledge of one another – become involved in the handling of trade finance, as a way to breach or circumvent sanctions”.
Given that only 2,800 or so individuals are on sanctions lists, in themselves, sanctions are not too difficult to check says Wynne. “Iran and Cuba were the main sanctioned countries a few years back. Iran was very simple – it was about financing oil. But Libya, for less than a year, and now Russia, have seen sanctions wielded more as a political than an economic tool.”

Eldred stresses that sanctions – in the form of asset freezes and travel bans – may only so far have been imposed on individuals (and one bank) in relation to the Ukrainian crises. “However, as was demonstrated by the Libyan and Syrian sanctions regimes in particular, the consequences of naming individuals, thereby catching assets ‘owned or controlled’ by them, often has a much wider impact. This will be a crucial aspect of the current sanctions regimes being imposed following events in Crimea.”

Sayers depicts a backdrop in which regulators have made their position on sanctions non-compliance perfectly clear, and in which bank investors and senior management will thus expect to benefit from recent investment in their personnel and procedures. “In that environment, who would prioritise customer relationships where there is any hint or suspicion of a possible sanctions issue? No-one will want to take a flyer on a new deal which isn’t crystal clear in terms of the sanctions position.”

Sayers indicates that trade finance users would be recommended to consider the issues both on their underlying business and in connection with their trade finance borrowings. “The advice is to be prepared, plan ahead for possible future sanctions, argue for suitable protections to be included in new contracts, and understand the impact of such sanctions on existing agreements. You might also examine the potential consequence for your business if US and EU approaches to sanctions were to diverge.”

On the contentious side, “advice around compliance fails throws up a number of issues”, he adds. “These include: Who do you have to disclose to? Do you have sufficient information to trigger a disclosure, or is there more work to be done first? Are you allowed to terminate your existing transactions? Can you consent to someone else exercising theirs?”

Russia questions
Lawyers note that difficult jurisdictions inevitably bring greater complexities.

Any sanctions against Russian banks active in trade finance are likely to be a step-change from those applied against Syria, Libya or Iran, simply because Russia’s trade and financial system are much larger and more integrated into the world economy. Russia, says Eldred, “is hugely embedded within the European trade system”. He cites 2012 bilateral trade flows which topped €267bn. In the wake of the invasion of Crimea, he argues, “the immediate problem for banks in this uncertain environment will be to assess whether to sit tight and hope the dust settles or to incur the costs extracting themselves now”.

Sayers predicts that non-Russian banks may struggle to source sufficient accurate information on which to base accurate compliance decisions, erring on the side of caution as a consequence. “Furthermore, regional supply chains reliant on finance may find the handbrake applied abruptly, and also that available financing could fall to levels seen immediately post-global financial crisis, while urgent decisions materialise on existing financings.”

Borrini underscores that the US has already imposed sanctions on one Russian owned bank: Bank Rossiya. “We saw immediate consequences from that, when international payment service providers such as Visa blocked card services to the bank’s account holders. In addition, Bank Rossiya has reportedly had to cease all foreign currency operations and is transacting only with the Russian rouble in response to US sanctions.”

Future vistas
Are due diligence and compliance requirements across a trade chain now so daunting that banks are thinking twice about their trade finance operations? Not according to Sayers. “We don’t see many banks pulling back from trade, commodity and supply chain finance. The view of trade finance as a permanent, stable source of business predominates once more over fears about profitability, and banks have been entering or re-engaging en masse,” he says.

Borrini agrees: “While we have certainly seen individual deals not proceed due to a bank experiencing problems getting sufficient comfort on due diligence matters, there are plenty of banks who are very experienced in the sector and we have not seen a more general pulling back solely due to these issues.”

However different banks can still reach different conclusions. “We advised a banking client on an export financing which foundered on sanctions issues, only for the same deal to appear in the press some months later, linked to another bank which must have got comfortable,” Sayers adds. Eldred is a little more cautious. He believes that the extent to which the returns in trade finance are sufficient to absorb the new compliance costs – and the consequences if they cannot – is not yet clear and does not seem to be of much concern to regulators. “However laudable the aims of increased compliance may be, the world is not a ‘level playing field’ and a balance must be found that enables the trade finance industry to continue to operate in the London market before it moves elsewhere.”

Willcock shares this wariness, noting that it remains to be seen whether the good news in respect of the leverage ratio will be sufficient to persuade banks whose core business is not trade finance not to divest short-term, self-liquidating trade finance assets as a relatively easy way to downsize their balance sheets. “Further, will other parts of Basel III impact trade finance disproportionately if regulatory capital requirements for trade finance products are equal to other products but returns are comparatively lower?” he asks.
Wynne envisages that smaller banks and non-banks which specialise in particular markets may be less affected by compliance burdens. “The risks are likely to be less when a bank or a non-bank operates in a market that it understands intimately. Big banks with huge flows may miss things.” He also believes that the traditional trade finance position that bank finance work pivots upon documents is outdated. “That is no longer a position to adopt in the real world. Banks have to tell customers to ensure the correct systems are in place to facilitate transparency and the required level of information for the bank to assess its position and comply with its own procedures,” he concludes.