Lúcio Feijó Lopes is the Managing Partner and Head of the trade finance team of law firm Feijó Lopes Advogados, one of Brazil’s premier trade finance law firms. Here he writes about strategies to mitigate the risk of trade finance transactions in the country.
Trade finance programmes have been decisive for the growth of Latin American exports, particularly in Brazil, over the past 20 years. From commodity finance (CF) to supply chain finance (SCF), Brazilian medium to large-sized companies have been able to access sources of foreign funds to finance their exports from soft and hard commodities to capital goods.
Despite the growth of export financing programmes, crafted in a variety of legal structures and complexity, the legal environment of business in Brazil and the understanding of such an environment by foreign financers have not followed the same pace of growth, and still present certain relevant challenges yet to be addressed and improved and taken into account by foreign lenders at the time of assessing, structuring, and closing trade finance programmes in the country.
The challenges range from (i) Brazilian authorities’ constant change to laws and regulations affecting CF and SCF, (ii) borrowers’ and guarantors’ unsophisticated corporate governance and corporate transparency that jeopardise risk assessment, (iii) foreign lenders’ failure in post-closing surveillance on covenants compliance and negative facts harming the borrowers’ and guarantors’ businesses, and (iv) foreign lenders’ relative understanding of the negotiated collateral package, including rights and limitations that come from it.
Based on Feijó Lopes Advogados’ unique expertise and experience as Brazilian legal counsel to foreign lenders doing trade finance transactions in Brazil, both in blue sky and distressed scenarios, we identified four key strategies that in our perspective will help foreign banks, funds, insurers, and investors to mitigate some of the most relevant risks associated with CF and SCF deals with Brazilian companies.
Strategy 1: Keep track of changes in Brazilian laws and regulations affecting CF and SCF
Brazilian authorities change, amend and/or supplement banking and tax laws and regulations with certain frequency. Being updated on such legal developments is crucial for foreign lenders at least at two moments. One, at the time of planning, structuring and closing the deal, as they may impose additional costs or limitations to the overall transaction structure. Two, after closing, at the time all transaction documents are signed and the funds, as a whole or partially, have been disbursed to the borrower. Lenders should make sure that the loan documentation, from time sheet to loan agreement to security instruments, includes a clear language indicating, in the occurrence of any change of Brazilian laws and regulations imposing (i) additional costs, or (ii) limitations to the transaction, which of the parties should bear such extra costs, or how the parties involved should proceed to adjust the structure or the transaction documents to the newly-imposed limitation.
Strategy 2: Make detailed risk assessment and due diligence prior to closing
Although detailed assessment of risks involved in a specific trade finance transaction and careful due diligence on the borrower’s business are two basic must-do procedures by foreign lenders, the reality shows otherwise. A mix of reasons as (i) pressure to close the transaction, either internally at lenders’ level, and by borrowers, (ii) borrowers’ and guarantors’ weak transparency on average on relevant business information, including operation, commercial, financial, and corporate, (iii) difficulty by foreign financiers to access public information about the borrowers and guarantors, such as updated credit history, tax, labor and environmental liabilities, relevant pending litigation, induce lenders to close the deal without the appropriate risk assessment and due diligence. The result, in many cases, is that lenders are caught by surprise by material-adverse facts on the borrowers business (for example, a tax liability that drains the existing working capital available for payment of the due quarterly interest). Foreign lenders in particular should made all efforts to conduct a detailed assessment and due diligence prior to closing, in order to mitigate the changes of unnoticed material-adverse facts during facility term. For that, they must count, not only on their back office, and also on local lawyers, accountants, and other advisers to have access to all available public information about the borrowers and guarantors.
Strategy 3: Surveil periodically during facility term
There are generally two types of foreign lenders doing trade finance business in Brazil. One group is composed of lenders that surveil the borrowers’ and guarantors’ information periodically and follow up on relevant changes in the course of their business and covenants compliance with frequency. The other group is defined as lenders that opt to not practise surveillance and tend to knock the borrowers’ door at time of interest payment and principal repayment. Our experience shows that the first group, the “vigilant”, is able to anticipate potential material-adverse facts or non-compliance of relevant loan covenants by borrowers, and so is capable of making strategic movements ahead of the other creditors, such as demanding collateral enhancement, enforcing specific collateral, or imposing specific restrictions or oversight obligations to borrowers. The second group, the “relaxed”, not infrequently is caught by surprise of material-adverse facts relating to the borrowers’ business and tends to suffer bigger losses for being the last in line given the relaxed profile. For foreign lenders doing trade finance business in Brazil, we firmly recommend to be part of the first group and surveil periodically the borrowers and the guarantors during facility term. This approach will dramatically reduce the risk of unhappy surprises and increase the odds of a successful deal.
Strategy 4: Understand the collateral package, its rights and limitations
Trade finance programmes, including CF and SCF, between foreign lenders and Brazilian borrowers are generally structured with part of the transaction documents governed by the laws of a developed jurisdiction (for example, the laws of the State of New York, US, England, Germany, etc), and part-governed by the laws of Brazil. What if, in a one-year CF facility secured by mercantile pledge (or warrants) over soybeans, the borrower defaults on the interest payment, and the foreign lender decides to enforce the transaction documents? What transaction document is going to be immediately enforced in courts to secure the loan repayment? Is it the loan agreement governed by New York law and subject to New York City courts? Is it the assignment and security agreement governed by New York law and subject to New York City courts? Or is the mercantile pledge agreement (or warrants), jointly with the promissory note, both governed by Brazilian law and subject to a particular court in Brazil (such as São Paulo)? Which of the above will provide the foreign lender immediate possibility of relief, seizure of the financed goods, and execution of the outstanding loans at the borrower’s jurisdiction, where his assets are located? The response is the local law-governed transaction documents. In a plain vanilla CF financing, such as export prepayment of soybeans/sugar/tobacco/corn/etc, out of the total facility cycle (from plantation to storage to port, and finally to export) lenders are exposed 75% to Brazilian law, and 25% to foreign law. The message to foreign financiers under strategy 4 is that they should fully understand the collateral package in place for the specific trade finance programme, particularly which documentation can be immediately used to remedy any potential default by borrowers, with purpose of securing the financed goods and to reduce the lenders’ exposure.
We believe that, upon observation of the four key strategies above, foreign lenders will be able to mitigate some of the most relevant risks associated with trade finance transactions in Brazil, and will increase their chances of a successful and profitable track record over the years in the region.