Lawyers look at the bigger picture
Market liquidity and commodity prices – not regulatory tinkerings – are clearly the issues that lawyers need to keep their eyes on in the year ahead. This is the conclusion Helen Castell comes to after talking to leading trade finance lawyers.
Booming commodity prices don”t just affect bankers. For every lender with one eye on his oil price ticker, there’s a lawyer watching it just across the way – wondering if that morning’s spike means it’s time to get his briefcase out, or if it will bring in a slew of structuring jobs.
They also make governments greedy. When an oil company makes record money, what leader wouldn’t want that cash under his own control
- And as slick liquidity pushes bankers in two directions – to riskier regions where the ‘t’s have to be crossed twice, but also towards an assembly-line approach, where the big names get ever-bigger loans – where does that leave the lawyers charged with keeping them out of trouble
With plenty of work, most agree. But as more start to wonder how long the good times will last, are structurers listening to their strict schoolmistresses closely enough, or is trade finance about to be taught a lesson
Pushed towards higher risks
As margins in traditional mainstays like Russian oil become thinner, banks are being forced to take higher risks to achieve their return on equity, says David Lacey, partner, finance group, at Stephenson Harwood in London. One increasingly important sector is agriculture, “which has always been a riskier area because of the nature of the product,” and this translates into more work for lawyers.
“Agricultural financing is a lot more involved, in terms of the security structure and the risk analysis – and part of the legal function is to work out what risks are there and where they should lie – which means greater involvement of legal counsel.”
“If you’re just trading goods on the high seas you tend to take pledges over bills of lading with the insurances and there’s not much more – but once you’re looking at goods stored in warehouses, crops growing in fields, there are a lot more legal issues.”
With soaring commodity prices and high liquidity, structured trade finance has taken a hit in favour of more corporate-style finance and equity deals, says John Tucker, global head of finance and projects at Linklaters in London.
“In previous years, transactions would have been highly structured, secured by offshore repayment flows,” says Mirthe van Kesteren, a partner at Linklaters. “We are seeing more and more unstructured lending to emerging market borrowers, often secured by shares of emerging market companies.”
That “changes the nature of some of our work, but it certainly doesn’t diminish it,” Tucker adds.
“There’s a lot of volatility around – which is good in terms of disputes for lawyers, not good news for traders and their banks,” says Tony George, head of the non-marine insurance practice group at Ince & Co in London. “And we’re all expecting an influx of trade credit insurance claims.”
Basel II should also produce more constructive work for lawyers, says George. “The insurance market is also very keen to tap into Basel II. To do it they have to have much clearer and more user-friendly policies, because they have to come within the definition of guarantee, within the Basel II accord. Lloyd’s has just issued a bulletin specifically to help with this.”
The market has polarised into two extremes, says Geoffrey Wynne, banking partner – head of trade and export finance, at Denton Wilde Sapte in London. Although huge, loosely structured transactions continue to be seen, Basel II requirements and a dearth of good borrowers in the structured trade finance market are causing more banks to tighten up on compliance and structuring issues.
“There are more concerns about making sure that ‘i’s are dotted and ‘t’s are crossed, and a lot more questions being asked.”
Alternative financing techniques are also gaining momentum and this keeps law seminars ticking along, he adds. “There’s more talk about Islamic finance techniques, there’s the perennial talk about securitisation and the general repackaging of risk.”
The kind of risk that concerns lawyers is starting to shift though. “There’s a lot of money swirling around various emerging markets,” says Charles Williams, head of trade at Thomas Cooper in London. “That means there are a lot of deals going on, but not a lot of litigation. Such problems, as there are, tend to be caused by political interference.”
Government pressures in Russia, quotas in Ukraine, Iranian sanctions and nationalisation in Bolivia – these are the kinds of issues keeping traders and their bankers awake at night, he says.
Resource nationalism worries
One worrying trend has been an upsurge in resource nationalism, driven by high commodity prices, says George.
“We thought naked expropriation was a thing of the past,” he says. “There would be some creeping expropriation – a government would suddenly decide it wanted to impose more taxes, or change its mind as to import licences – but suddenly in South America you’ve seen pretty drastic government actions in the form of renationalisations and the FSU is not averse to blatant government intervention.”
“So one is seeing expropriation claims develop under political risk policies,” he says. “And traders, project sponsors and their financiers are dusting off their expropriation and investment policies and checking the definitions.”
“When you’ve got major disputes between an international corporate and a government, there are issues very often of sovereign immunity and other difficulties in progressing claims, which make them challenging to pursue,” says Robert Parson, trade finance partner – international trade and energy group, at Clyde & Co in London. Clyde has been involved in a number of arbitrations led by ICSID as well as the long-running TadAz dispute with Russian aluminium producer Rusal.
The very existence though of trade and investment-related arbitral tribunals, should calm trade financiers’s nerves, says Charles Morrison, partner at DLA Piper in London. “Governments have shown a marked reluctance to go down that road because of the compensation available, because of all the bilateral investment treaties, and because of the effect of such action on future inward investment.”
“You’d need something dramatic to produce the sort of knee-jerk reaction that would go beyond a particular country,” says Wynne. Even after Yukos – a classic case of creeping renationalisation – financing in the oil sector is still going ahead, he notes.
Trade finance has an advantage over project finance in that it is shorter term, he adds. “But with some trade finance transactions going out to five, even seven years, it is a risk you need to look at.”
Expropriation affects big ticket structured deals more dramatically than short-term commodity transactions, says Williams. However quotas, sanctions and more general political interference can have a significant effect on even the simplest transaction.
One country with direct experience of renationalisation is Ukraine, where President Yushchenko annulled the 2004 privatisation of steel major Kryvorizhstal, then auctioned it off again a year later to Mittal Steel.
Grain export quotas, which left traders dumping rotting crops into the Black Sea earlier this year, have had a much more damaging effect on trade finance though, says Oleg Alyoshin, a partner at Vasil Kisil & Partners in Kiev in Ukraine.
Another key obstacle is the fact that not all trade finance instruments are incorporated into Ukrainian legislation. Forward certificate of receipts (FCRs), for example, are not always recognised by the courts, many of which are headed by Soviet-era judges who lack experience in international finance, he says.
A couple of years ago, Vasil Kisil worked on one case for a bank which had been financing grain exports in Ukraine against an FCR. “The cargo just disappeared and it took a lot of effort to prove in court that the FCR was not just a piece of paper, but was something that places obligations on the party who issued it.”
Only after taking the case all the way to Ukraine’s supreme court did the firm receive a favourable decision. “The problem was that Ukrainian law does not regulate this kind of instrument, says nothing about it, and the decision was finally made on the basis of generally accepted rules of foreign trade.”
Similarly, “we have quite a good law about the storage of commodities, which is regulated, and have established a number of different types of warehouse receipts – but in practice it sometimes doesn’t work,” he says.
Some progress is being made in these areas, though with more pressing political concerns in the country, trade finance law is unlikely to be prioritised, he notes.
Busy in the ‘west’
Elsewhere in Europe, it is the ‘west’s that has been generating more of the trade finance action, says Andrew Gamble, partner, banking, structured commodity and export finance, at Lovells in London. “There have been far fewer transactions in relation to places like Russia, for the simple reason that the commodity suppliers have been making so much money they haven’t needed the finance.”
In line with this shift, banks have found themselves grappling with security structures in countries like Germany, Italy, Spain and France, which all have their own complications, he says.
“Some of those jurisdictions are seeking to provide more flexible security instruments to enable businesses with large inventory stock to provide security to banks for the purpose of raising finance.”
In France, legislation allowing banks to take charge over inventory even when it is not in their possession took effect in March. Privilegio specialie, which seeks to achieve the same thing, was also introduced in Italy.
Middle East and Africa rush
“The Middle East continues to be of major interest,” says Parson. Clyde & Co has accordingly ramped up its presence in the region, opening offices in Abu Dhabi and Doha, and increasing head count at its Dubai office by around 50% over the past 12 months.
“It’s a springboard to such a rich, fertile area throughout the Middle East and North Africa, and the authorities have done very well to create what is the major trading financial hub,” he says. “We’ve been involved in a lot of work bringing banks and other new entrants into the Dubai International Financial Centre, which is attracting all the major players.”
Africa’s legal landscape is meanwhile coming up to speed very quickly, says Morrison. “If you look at Tanzania with its new land law, new companies law and new insolvency law, it’s modern, very easy to work with, and very familiar to English lawyers. You’re seeing that right across the continent.”
“The World Bank’s efforts to have the legal landscape modernised there really has now begun to show, and that’s being felt in the way that banks have been able to structure their deals in these jurisdictions,” he adds. “Buttressed by the more modern legal framework, it’s making deals more straightforward in terms of taking security, and enforcing it if things ever go wrong.”
Not all news out of Africa has been good though. Lessons are being learned the hard way from the demise of Indian Ocean oil company Gapco. And in Zambia, where DLA Piper has been defending the government, vulture funds have become a big issue, he says.
Bullish in Brazil
Over in Latin America, trade has been as active as ever. “Emerging market banks are moving from their traditional stomping grounds in Africa into other continents,” he notes.
In Brazil the mood is bullish, says Christian de Lima Ramos, a founding partner at Ramos e Zuanon Advogados in Sao Paolo. “An incredible amount of money is being invested into Brazilian sugar mills, soy is back on track and a lot of resources are going into biodiesel projects,” he says. And that means busy times for trade financiers, and lawyers.
Changes in foreign exchange rules had less impact on deal structures than expected, says Ramos. Brazilian entities exporting goods had been authorised to maintain part of their revenues in foreign currency. “But because the real is appreciating against the dollar, no one wants to hold foreign currency.”
Instruments are certainly becoming more sophisticated though, he says. Although excess liquidity is causing a softening of some traditional structures in terms of the local guarantee or the collateral being provided, there is also more appetite for mezzanine finance, project finance and equity investments, he notes.
“China, and to a lesser extent India, are driving everything,” says Denys Hickey, partner at Ince & Co in London. “I am involved in a big aluminium arbitration between a Chinese client and a western metals company,” he notes. The contracts the Chinese client entered into were incredibly one-sided and when aluminium prices jumped the western trader terminated the deal and sold the alumina elsewhere for a massive profit. “For some of the PRC clients it’s a steep learning curve. I’m sure they won’t enter into that sort of contract again.”
Lawyers are “jealously watching” legal developments in India and China, adds Tucker. Regulatory constraints continue to exist in India, for example, over the way in which banks can finance transactions, especially in the acquisition arena. “But opportunities in both countries have opened quite dramatically” and “we expect regulatory constraints to liberalise over time.”
So what’s new
The issues lawyers discuss over lunch change every year. Basel II and UCP600 have been keeping tongues wagging for a number of years now, so what’s new on the horizon
A revival of origin finance has been one big trend, says Morrison. Banks’s recent favouring of the ownership structure as opposed to the traditional loan and security approach, is a cyclical phenomenon but no less interesting for that, he says.
Connected with this, the issues of collateral management agreements and their position in a deal structure have gained more attention.
“Banks are being far more careful about their whole approach to collateral managers. They are appreciating that there’s a lot more to it than simply putting the collateral manager in place,” he says. “It’s a question of have we got the right collateral manager for this commodity, in this country, at this port, and are we really going to live with the standard form collateral management agreements proffered to us. Or are we going to dig our heels in and say that we want them to accept more liability for what goes wrong
The law surrounding warrants for warehouse receipts is constantly evolving, notes Lacey. “A legal system that says ‘this piece of paper represents the grain in that silo’s helps the farmer to raise money,” and he doesn’t have to sell it at harvest time, when prices are lowest. That helps keep prices up and is good for emerging economies that are dependent on agriculture, he notes.
“But it all revolves around the bank being comfortable that if it doesn’t get its money back it can go to the warehouse and get that grain. And that’s an interesting example of how the legal system can actually promote economic development by providing this kind of mechanism – rather than the law following it.”
Insurance law changes concerning non-disclosure and misrepresentation, and aimed at making insurance more consumer friendly, are much in discussion. “At the moment it can be a pretty technical area, which means that when insured you can get caught out by the underwriter saying you’ve failed to disclose something, which as an innocent assured you may have had no idea was in the least bit relevant,” says Hickey.
“There is a running [UK] Law Commission enquiry into the insurance market generally, looking at revision of duty of disclosure and duty of good faith. Those are potentially hugely interesting areas,” says Parson. However, with a change of prime minister now announced, and more politically pressing concerns for the UK government, this could get pushed down the agenda even if the Law Commission finally recommends change.”
Anti-climax for UCP
UCP600 meanwhile hasn’t excited as much as expected, he says. It was hailed as the saviour of classic documentary credit business, but nothing seems to be stopping that business’s slow decline.
“People who have been tempted to go to a two-day conference on UCP600 had better take a good book,” he adds. “It’s exciting on a micro level on certain issues, but it’s not earth-shattering in terms of what it’s going to do for trade finance, and what it’s going to do for the longevity of the traditional documentary credit business.”
“If you’re looking for the next exciting thing there, it’s got to come through automation of payment and processing of goods in the supply chain – and that’s not grabbed the public imagination yet to any great degree, though its success in improving the management of credit risk and payment time in open account business in international trade is a significant factor in the decline of the traditional doc credit market.”
“I’m surprised there’s been so much made of UCP600 given the modest nature of the changes,” adds Morrison.
English law is meanwhile being used in more deals, even those that seemingly have no connection with the country, says Richard Gwynne, partner, finance litigation, at Stephenson Harwood in London.
English commercial courts recently quashed attempts by a Chinese state-owned bunkering company to raise speculative defences against claims under an independent payment undertaking brought by RZB’s Singapore branch.
In the deal, the RZB branch had financed a sale of a consignment of oil to the Chinese firm and had obtained a payment undertaking in RZB’s name that was subject to English law and jurisdiction. RZB had duly passed on the letter of its indemnity and invoice but when payment time came the Chinese firm said that they were acting as an agent for another firm in China that had got into financial difficulties.
When RZB made a claim under the independent payment undertaking, the bunkering firm produced a supplemental contract arguing they did not have to pay the seller unless they had been paid by the Chinese buyer. The English court upheld RZB’s claim for summary judgement.
Increasing use of English law “is good news for the legal profession in England, and it’s good for the reputation of English courts,” Gwynne notes.
Another dispute concerned a letter of credit between trade finance house Trafigura and South Korea’s Kookmin Bank, he says. Trafigura had been the beneficiary of a letter of credit (LC) issued by Kookmin Bank, which was payable in London and which was delivered to a buyer against a letter of indemnity. The buyer went into liquidation before paying for the LC and Kookmin had brought proceedings in Korea claiming that Trafigura had acted in breach of the LC and making claims in tort under Korean law.
The English courts upheld last year that English law governed all Kookmin’s claims against Trafigura and that Trafigura was entitled to an injunction against Kookmin to prevent it bringing the claim in Korea.
Firms are increasingly including an English law jurisdiction clause in banking documents, but the ‘popularity’s of English law is otherwise nothing new, argues Parson. “If you want to achieve certainty in your contractual dealings then there are only a limited number of jurisdictions around the world which offer the kind of certainty of law built on commercial and legal precedent – rather than the one-off judgements of sometimes inexperienced judges covering trade law in some countries – that we enjoy in the UK.”
“[English law] has long been the choice of law of the financial, insurance and trading community, because of the proximity of the great institutions,” he adds. “There’s a trend, but I think it’s a continuing trend.”
The ‘plain English’s favoured by British law firms in documents is meanwhile helping them maintain an advantage over their US counterparts, which tend to use more jargon, Lacey adds. “Particularly in trade finance, the customers of the bank will often be working with English as a second or even third language, and so one of our goals is to produce documents that the customer might not agree with, but which he understands.”
Fraud is another issue that always interests trade financiers. “Based on my experience I believe we are likely to see an increasing amount of fraud around in connection with all kinds of trade finance,” says Hickey. “We’ve seen an increase in fraud over the last three or four years and I don’t suppose that’s going to go away.”
“Trade finance transactions tend to be good performers,” notes Lacey. “When they do go bad, they go bad spectacularly – and usually as a result of fraud.”
“Most of the deals we do are of the size and magnitude that the opportunity for fraud is remote,” says Gamble. “It normally happens when you’re doing small deals, normally in relation to soft commodities.” Banks are also being more careful in terms of structures, largely with an eye on the implementation of Basel II, he adds.
The high profile RGB/Allied Deals fraud that burned many a banker’s finger a few years ago has improved many banks’s lending, says Williams. Fraud is impossible to eliminate, particularly when the fraudster is plausible, but banks were reminded that frameworks and documentation are not enough and that they have to ask themselves more searching questions about their borrower.
“The only way to protect yourself from fraud is by going out and looking, or by having somebody you trust go and look. Are the products really there
- Is the factory really there
- ” Lacey says. “That’s expensive – you have to weigh up the costs of constant due diligence against the risk of fraud.”
Bon Pour Aval in Malaysia
Fraud can however take many forms and factory inspections aren’t always enough, as Paul Mills, chairman of Bon Pour Aval in London, says he found out.
In 2003 his brokerage and arranging firm was introduced to a US$12mn promissory note deal by an agent in Malaysia. The note’s obligor was Malaysian firm Safire Pharmaceuticals (M), the investor behind the deal was Siemens Financial Services and the primary forfaiting bank was Bumiputra Commerce Bank’s Batu Gajah branch. Ministry of Health Malaysia provided a letter of guarantee in addition to the aval provided by Pharmanagia Logistics.
Mills flew out for an onsite visit and met the factory’s owner, who showed him around. “Having walked around this factory, worn all the garb, visited the various pill pulpers and blister machines? we came out the other end thinking ‘what an efficiently run operation.’”
However, “the players involved existed, the rationale of the deal seemed logical, but what nobody knew – and what the legal opinion Siemens obtained from a Malaysian law firm failed to uncover – was that Safire was in administration and had no right to issue promissory notes.”
Siemens settled with Bumiputra mid-way through the case but Bon Pour Aval was pulled into court as a Part 20 defendant under claims that it had vicarious liability for the actions of its representative, who had been implicated in the case for his role in repatriating funds to Malaysia after they had been paid out.
However, the representative had done so under the name of his own companies and Bon Pour Aval maintained that the relationship had never been anything but client-representative; a letter presented by Bumiputra in court – alleged to be from Bon Pour Aval Malaysia – was upheld by a graphologist to be a forgery; and expert witnesses agreed that validating information was the responsibility of principals, not a broker. Bon Pour Aval was cleared of any charges.
Other flaws in the deal though emerged in court. The chain of endorsements on the back of the promissory notes were broken. Also, it was discovered that the Bumiputra officials signing the documents – who Bon Pour Aval argues should also have known that their client was not allowed to issue notes – were not authorised to sign the transaction.
When Bumiputra’s personnel files were produced in court, it showed the officials involved “had been disciplined or reprimanded several times for authenticating signatures from signatories that were suspended due to the company being in administration – it wasn’t that this situation was a one-off,” says Greg Warburton. “The fraudulent transaction would never have come to fruition if it hadn’t been for the intentional collusion of Bumiputra Commerce Bank’s and Safire’s officers.”
“It was a very elaborate fraud if you go into it,” he adds. And the main losers were Siemens, which lost its money and had to pay part of Bon Pour Aval’s court costs, and Bon Pour Aval, which as a small firm, lost time and money preparing the court case. It suffered a damaged reputation and as such is no longer trading, he says.
“We have learned that you have to engage a very proficient bank to close for you. We choose our banks very carefully now,” says Mills. “It has made us much sharper in describing our relationships with people too – our agreements have been bolstered to specify that a correspondent is just a correspondent, not to be misinterpreted as an employee, although this was already clearly stated in our agreements.”
Another recent case, with practical repercussions for fraud, involved Banque Saudi Fransi and Lear Siegler Services, says Gwynne. Banque Saudi Fransi had issued a performance bond in respect of a contract entered into by Lear Siegler. When a claim arose against the bond, Banque Saudi paid and claimed under the counter-indemnity clause. Lear sought to allege that the claim was baseless, and therefore fraudulent.
The Court of Appeal however decided that the burden of proof lay with Lear, but that it hadn’t raised a sufficiently arguable defence of fraud.
“There have been a number of cases in recent years where the fraud defence has been raised, and it appeared that the ability to get through a claim for summary judgements had been getting easier,” he adds. “To some extent that case will at least place a check on that.”
Beware the risks
Fraud is not the only threat trade financiers face though. “Companies that two years ago wouldn’t receive debt from banks are now being flooded with facilities,” says Ramos. Some of them have poor records – of spurious business practice as well as weak balance sheets – but as top-tier companies need less finance, banks are forced to take bigger risks.
“Not only the structures but also the credit analysis is getting softer,” he says. “So this raises some eyebrows and concerns me that by next year we will see some [deals] go bad.”
With prices historically high and lots of liquidity in the market, obligors might be tempted to spend their money on riskier projects, Wynne says. The worry is what happens to these projects if commodity prices suddenly slump.
A ‘cookie-cutter approach’s to documentation, which an increasing number of banks think they can get away with in deals, is another danger, he says. “We’ve got a desire in banks to commoditise transactions, and a problem that not all these transactions are capable of being commoditised.”
Some banks are also agreeing to uncommitted facilities too lightly, underestimating the time needed to get proper documentation and back office sign-off in place once they are finally ready to make the advance, he adds.
High trade volumes have meanwhile meant “a lot of insurance being written at silly rates,” says George. “Underwriters are having to write them cheaply because they have to provide banks now with a rate which still gives the banks a margin on their own reduced returns. Something will go wrong and claims will arise.”
Otherwise, trade finance is still a market that more lawyers want to be part of.
“There are probably more firms looking at entering the market or just being in the market, partly because it’s a growing area of law, and there are plenty of lawyers about,” Lacey says. “So there will always be competition – it’s a matter of providing a good quality product at a value-for-money price.”
Not everyone succeeds though. “A number of firms at any given time continue to aspire to do this work. Some, to their cost, think it’s easier than it actually is,” says Wynne. “And consequently you get low-balls coming to the market saying ‘I’ll do it cheaply’. And they come and go.”
Smaller and more specialist law firms continue to make their mark in trade finance however – especially those with strong industry experience, says Williams.
Tucker agrees. Although international firms often dominate major deals, “for smaller structured transactions, the commodity maritime firms still have a very active practice.”
Specialist law firms are buffered to an extent from the stiff competition seen in other areas of trade finance law, for example among firms involved in structured derivatives trade finance, notes Hickey.
And there are still some areas of the world where lawyers can enter guns blazing. International law firms remain under-represented in Ukraine, according to Alyoshin, while in Dubai “more people are looking to nibble the cake, but it’s a huge cake,” says Parson.
With generally hot competition though, fees are always an issue.
A difference of perception between banks, which may believe a transaction suits a commoditised approach, and law firms, which believe it warrants closer attention, can prove a pricing problem, says Wynne.
However, “as long as you do a good job for them, banks are probably one of the best paying clients, as are insurers, as long as you’re acting for them,” says George.
“Banks are well accustomed to the price that they have to pay seasoned professionals for their advice, and that’s what’s being paid in the market,” says Morrison.
Ultimately though, the fortunes of a law firm depend on the health of the sector it serves. And while bad times for bankers can create a litigation fest for lawyers, over the long term they both want the same things.
It’s economic shifts rather than regulatory change that can make or break opportunities for a law firm, Tucker says. “The law is the law – and must be addressed,” but “in those places that are going through dramatic change, most of our attention is directed to the economic and business risks associated with the work that’s going on.”
Expropriation, political tensions and regulatory change all affect trade finance and the lawyers who serve it, but in terms of drama, nothing beats a basic price shift. “A dramatic drop in commodity prices – that to me is a bigger problem,” says Wynne.
Market liquidity and commodity prices – not regulatory tinkerings – are clearly the issues that lawyers need to keep their eyes on in the year ahead.