- Nola Beirne, partner, Reed Smith Richards Butler
- Celia Gardiner, partner, Watson, Farley & Williams
- David Lacey, partner, Stephenson Harwood (chair)
- Andrew O’Keeffe, counsel, White & Case
- Ursula Owczarkowski, DLA Piper
- Robert Parson, partner, Clyde & Co
- Mike Sullivan, partner, Sullivan and Worcester
- Charles Williams, partner, Thomas Cooper
- Geoffrey Wynne, partner, Denton Wilde Sapte
DL: To what extent has the threat of expropriation and resource nationalism affected the structuring of trade deals?
CW: The situation in Latin America is the most obvious example. What has gone on in Venezuela, Bolivia, and also Ecuador, demonstrates that governments can have an active influence on banks’ desire to lend.
DL: Do you think it will stop people investing in those countries?
CW: As with anything it would need to be done with a considerable amount of care, and would largely be dependent on the availability of insurance products and insurers’ ability to support such lending.
AO: I think that you have to look at the history of where there have been examples of that kind of resource nationalism, such as Iran. There has been limited investment in the country, except in the recent few years with the buy-back deals. Before then, there was no investment in Iranian production for years, and the country wasn’t able to access the technology to develop its resources.
Insurers are just not going to wear the risk of nationalism, they take a calculated assessment on things. The banks can’t always pass on the risk to the insurers, because the insurers aren’t stupid.
If there is a degree of risk in a deal with a 10 to 20-year payout that might come away in three years, and you don’t get the return you are expecting, you just aren’t going to spend the time and the money doing it.
MS: Is that because of sanctions?
AO: In terms of the US and Iran, sanctions have had a huge effect.
Regarding US legislation, I have found myself in a situation where you have banks in syndicates, and you then really have to look at the documentation to see what you are allowed to do.
US legislation is so wide-ranging. Even if you are only advising on a meaning of a clause, you could be viewed as though you are facilitating the deal. You end up treading a very fine line.
CG: There is also a certain amount of bilateral pressure going on in the European banking system that is not based on law at all. That’s an issue that endlessly comes up, that geopolitics underlines everything we do. That is obviously a risk in this very international business.
AO: Exactly. Returning to the example of the US, because its legislation is so wide-ranging it can affect a number of different international businesses. There have been big issues for tobacco companies with their involvement in the cigar business. With the recent takeovers in the tobacco industry, people are looking at such deals and thinking what about Cuba? What can we, as a US party, do here?
In a European context, you don’t even think about these kinds of problems on a day-to-day basis.
GW: But do you think the banks are actually so worried about any of this?
I don’t exactly know why people are worried about expropriation or resource nationalism as many of the world’s resources are owned by the government anyway.
One relatively recent expropriation example is Yukos in Russia, a private firm that was taken back into the hands of the Russian government. Has that stopped the banks getting involved?
AO: I think the thing is that people make an assumption about the period of time they will be involved in something. If that period changes, they will take a more cautious approach.
GW: I was happy to do loans into Iran, and to a certain point I still am so long as there are no legal prohibitions. That is part of our job to help in relation to interpretation. The great thing about this market is that the players are very grown up.
Insurers are actually also growing up. They will still cover Russia even if they have actually seen over the past three years what is a blatant expropriation process. The interplay is very interesting.
NB: But lenders must consider not only commercial risks, but also legal risks, and in the case of Iran, the risk of breaching OFAC sanctions. Clients with operations in the United States are extremely concerned not to cross the line, although in my experience OFAC are helpful in giving a view when the position is not crystal clear from a legal perspective.
MS: In my experience, the multinationals are getting more concerned with OFAC sanctions, they have become far less cavalier.
CG: What we are seeing as an English firm is that we are getting enquiries from clients saying that they want to do business in Iran and get it to work. Of course, while taking a prudent position, business has certainly not stopped completely.
DL: Do you think that reflects the fact that it is perceived as a high-risk business anyway, so only the more experienced banks would provide facilities in Iran?
GW: But trade finance is a low risk business, not a high risk business.
DL: But I suspect that credit committees would view lending money into Iran as a high risk business?
GW: That is a different point, whether you would lend money into Iran with growing sanctions. But would you lend into an emerging market country where there is a theoretical and actual expropriation risk?
I think most players are pretty grown up about this, and in fact the risk is actually relatively low. The insurers don’t see the risk as you can insure most countries in relation to expropriation risk.
RP: I don’t think Iran is a country where resource nationalism is a major issue, as the government already owns the resources.
Where I have seen interesting expropriation incidents come up is in some of the former Russian satellite countries where there have been a few malaises with a few briefly privatised industries that have been pulled back into government control.
It has not always involved direct state intervention, but often state-sponsored private manoeuvrings used to take assets back under local political ownership.
This has been an issue in Africa as well, where you see some savvy use of incorporation vehicles by investors to make future use of some of the bilateral investment treaties to ensure that they and their banks won’t be squeezed out in the event of an expropriation. It has been more of an interesting litigation area overall though than a transactional issue.
GW: Angola is a good example. Year in and year out banks are taking the view that whatever is going to happen, the financing will continue to be needed.
Most of the time, most countries will require financing to support the development of their natural resources. With the exception of Zimbabwe, for the majority of these countries ruining the country’s natural resources is a fairly foolish thing to do most of the time.
DL: It doesn’t matter who’s in charge, the government or private firms, they are still going to need to produce oil.
DL: Moving on to the implications of Basel II, has it actually changed anything for the banks?
CG: I think banks are very interested in this. But my feeling on this is that it should not affect structures. Regulation should not be driving deal structures. The idea of Basel II is to make regulation better fit risk patterns.
However, what Basel II does do is perhaps create a little more consciousness among banks when looking at legal documentation and other regulatory issues.
But ultimately deal structures are driven by far more important things than regulation, and I think the credit crunch is going to have much bigger impact on deal structures that Basel II.
When you talk to bankers about it, they find all rather boring as the legislation asks for them to ensure they are getting their security right. One hopes they are always getting the security right.
GW: But they will be taking security. Whereas before it didn’t matter whether you take security or not, what Basel II is saying is that it will positively reward you if you do.
CG: But it did matter before whether you took security or not. Your credit committee would be looking at a risk profile and looking at the risk mitigants.
Basel II has linked deal structures more closely to regulatory capital, but that is not the only reason banks would take security.
CW: I agree that it helps banks concentrate what they are doing.
NB: It depends on what kind of institution the bank is. Banks with an internal ratings-based (IRB) approach will be able to tailor more sophisticated deal structure to more efficiently take advantage of capital weighting.
However a lot of banks in this area are adopting the standardised approach and don’t have those sophisticated internal risk models.
RP: Basel II has given a strong lead on who banks would want to lend to, and what they want to lend on. Of course, ironically, it gave the lead that property was a good thing to lend on. It did point the way to some special categories, including property, where banks could be comfortable if they follow the rules, and if they got the structures right. In this market, regulation is following the market.
GW: If you put the question round the other way: would there have been a credit crunch in trade finance assets?
The answer would be no as the trade finance community deals with real transactions, but the problem with the sub-prime issue is that they stopped looking at the real transaction but rather looked at the fee they got for putting it together, not the real asset, and kept building on that. Then the music stopped.
MS: To what extent has trade finance stayed with ‘real transactions’ as described in the 80s and 90s? I think the technique has evolved, for example, bundled transactions are now more common. There is some debate whether these are ‘real trade’ transactions or not.
GW: There is a lot of talk about securitisation but the reality is there are very few. However, most of these securitisations are based on short-term receivables so your test of the strength of the transaction comes very fast.
If you look at the big losses that were made, a prime example of this is the Solo industries case. Banks took their eye off the ball and stopped asking so many questions.
MS: But that was a cashflow deal?
GW: But that is what a trade finance deal is.
MS: But the cashflow was independent of the trade – the object of the finance.
GW: In all the major trade finance deals, you’ll find they are all straight receivables in some form. You take security over the commodity, and ultimately your exit is the trader or ultimate buyer and they finish up being receivables.
You should see your repayment coming out of production, export or receivable payment.
CW: I think there is a real feeling that the structures now being designed are moving far away from the idea of the goods as security and more towards cash and receivables. In the RBG Resources case you saw a situation where the receivables just didn’t exist as the pledged goods didn’t exist.
AO: This leads into the challenges of Islamic finance, where you are dealing with commodities and cash flow. These are the concepts everyone is grappling with at the moment.
The way the practise is expanding into other areas indicates a level of flexibility. However, when they were first developed it was not imagined they’d be applied in the way they are being used now.
DL: I think it is a good example of commodities dealings done to generate cash rather than because of a need for the commodity.
A number of the Islamic deals move commodities around that nobody either wants or needs, so as to generate cash.
DL: Let’s move on to discuss post-fault dynamics between trade financiers and trade credit insurers.
MS: What I noticed was insurers and trade credit specialists using the same words and applying completely different meanings. That is the first issue.
The second issue is that, on an anecdotal basis, insurers really don’t understand the risk they are insuring until that risk is realised.
There is a difficult period of time following a default when they examine the asset class and compare it to the cover they issued and that’s when they confront the semantic issues.
I have noticed that in the first six months until you file that claim, you are not given guidance from the underwriters because they don’t understand the risk. They are spending that time to figure out their exposure.
GW: Is this a US phenomenon? Are you saying that the UK market and Lloyd’s market don’t understand what they are insuring?
MS: Yes, absolutely.
GW: I think that even anecdotally you’ll still find yourself hugely challenged.
Most of us see the insurance policies alongside the deals we are doing and the quality of policy wording is getting much better. The insurance market understands that if it’s seen not to pay out on claims, it can’t sell its product.
That was the problem 15-20 years ago, there was a feeling of why bother with insurance if they never pay out? The market reacted to that and said we need to be seen to pay out. Those in the insurance market say that there is a good track record of claims being paid out.
In its rightful place having insurance policies works and certainly gives great comfort to those institutions that see risk transfer into the insurance market as a means of doing more deals.
CW: You can make a comparison to the marine insurance market, although admittedly it might not be a totally fair one. If you have a problem, you tend to have a proactive response from the marine market, but you only seem to get a reactive response from the credit risk insurance market. It is a completely different attitude.
MS: If you look at the evolution of the credit risk insurance market you’ll see that it was originally used to provide cover to a manufacturer for open account sales. That’s fairly far removed from exotic cross-border trade finance activity of today’s market. I don’t know whether policy wording has caught up yet.
RP: I think it has changed over the last few years. There is also a big appetite for instruments that genuinely transfer risk rather than just mitigate it.
That has required people to address policy wording issues and it brought up that old adage that bankers do their due diligence at credit committee stage while insurers do their due diligence when the claim comes up.
However, I think there is a lot more plain speak in policy wording recently.
DL: Do insurers pay as it is their best interests rather than because the policy requires it?
CW: No, not at all. As we’ve said, banks are obliged to act as a prudent uninsured.
RP: I think if you are selling a product on the basis that it is an umbrella that promises to keep you dry when it rains, you have to have that umbrella unfold sometimes or the market might take the view that it is not a particularly good product.
AO: But it is important to note that insurers are not charities. If it is not covered then it is not covered. On the grey points, that’s where the litigators come in.
CG: What I’m interested in hearing from the litigators is whether we are seeing more defaults?
MS: In the US, I am seeing preliminary signs of a slide towards default, some technical defaults and some lawsuits did begin on some of the larger firms, but these have been resolved before the preliminary hearing and little has developed beyond that.
CW: We are looking at a possible recession and that is when documentation and insurance gets tested. We haven’t had, as far as I remember, a real sequence of trading company defaults since 1992. Since then trade finance has moved on, so much so that if we get a sequence of defaults, we are looking at something entirely new.
DL: In the absence of fraud, trade finance deals have a strong track record.
CG: That is the pattern. Trade finance bankers will always say that the deals are theoretically high risk because of difficult jurisdictions involved, but actually the market has a good trading history.
GW: Why did you pick 1992? Why not Russian crisis in 1998 or the Argentina crisis two years later?
DL: But in the case of Russia in 1998 many of the trade finance deals generally continued to perform?
GW: Initially the Russians said they weren’t paying anyone. In the end, they actually only paid out 180-day deals. There were a lot of people left with promissory notes losses, it wiped out a number of banks and the whole forfaiting market.
Some people have lost money in Zimbabwe in recent years, but most will be keeping quiet about that.
Yukos would have been a huge loss in the insurance market I would have guessed, and the pressures on the Russian government to honour the loans were huge.
Insurers pulled out of Russia over the last couple of years and only recently felt comfortable going back in to cover for example the oil or aluminium industry.
We are seeing delays in payment delays in production and if the structure isn’t resilient you may have a default. When something goes wrong you have to prepare to act immediately, but also be aware that the first decision may not be the best decision and it could be advisable to wait and see what is going.
CG: Trade finance is notorious for delay, but this is not necessarily a fatal flaw.
GW: Yes, you need to see why there is a default.
DL: And if you are not making a few losses then you are not lending aggressively enough and are missing opportunities.
DL: Shall we further explore issues with nomenclature and semantic problems?
MS: In 1988-89, I litigated a case which essentially asked what the difference is between trade finance and trade-related activity.
I litigated the same issue in a case for the last three years.
There are core terms that the market will not precisely define. There is a capacity to do it, but there is an unwillingness to do so for various reasons and this can create problems.
GW: But in what context?
MS: I see problems over whether something was properly described or not. Whether something required extra disclosure because it was revealed to be what some people think is trade-related, and not classic trade?
In the most recent example, this debate over meanings was advanced on behalf of the insurers.
I still think today if you got a roomful of trade financers and asked them to give a definition of what trade-related finance is, you’d get as many different answers as people in the room.
NB: I completely agree with that. If you look at some banks involved in the sector, their whole focus is on supply chain finance and letters of credit. That is not what we are talking about here where the underlying commodity, its nature and origin, dictates the structure of the financing, and a knowledge of that particular market is what enables the funder to participate.
GW: Government re-scheduling has been the classic example of the debate surrounding whether a transaction is trade or trade-related, in that the use of the term decides whether or not a transaction is going to be paid.
MS: Then you’ve got Argentina where they redefined what trade is. I don’t know how much comfort people take from that.
DL: Isn’t that down to the fact the government will pay whatever it wants to pay?
MS: That’s the myth that trade is going to be favoured. But then you dig below the myth a little and you often find it is not valid.
GW: What was decided to be trade last time, for example in Argentina, won’t necessarily be what is used to define trade the next time a country reschedules it debt.
We have this discussion with clients where the banks who lost money in 1998 thought they were doing trade activities when they were actually doing trade-related activities. The whole forfaiting market was actually deemed trade-related, if that, and they didn’t get paid.
However, I don’t think there is much call to define the terms. I don’t think it would serve the market to create a definition. And we’d kill the litigation market!
I think we’d do ourselves and the marketplace a disservice. A lot of my clients in trade departments of banks would love to redefine all the time, they would like trade finance to include project finance or whatever they want and some of them succeed.
CG: We are lawyers and love precise definitions, it is the way we work.
But if you get a massive default, it will be politics that decides the way it is going to be paid.
DL: Let’s move on to the issue of whether or not there should be a master participation agreement (MPA) schematic for UK-centric deals?
MS: Last Fall a collection of bankers came up with an outline for a master participation agreement (MPA). I haven’t seen it used and wondered whether anyone had any experience of it?
DL: Is the market really interested in it?
GW: The market is very interested in it. Whether it gets to be the market standard is whether the market decides to adopt it or adapt it.
What will happen with the MPA is interesting regarding what individual banks do with it. But it is streets better than trying to do trade deals based on an LMA (loan market association) master participation agreement and I defy anyone here to dispute that.
How many of you do your loan agreements based on a pure LMA? I suspect nobody.
Do I think there is a need for standardised MPA? Not really, as those that know what they are doing will continue to use their own forms, with some modification. However, I might be proved wrong if 20 major banks all adopt the document in the coming years. Ask this question in six months time.
NB: When I was involved in a recent trader-to-trader deal the MPA was presented to me as the market standard, so it is getting out there.
RP: You are seeing a lot more flexibility; there has been quite a big turnaround in the last ten years in terms of what people accept as market forms. This whole MPA exercise will be interesting to test the appetite of the market.
However, when it comes to banks producing standard forms in trade finance generally, the big corporate multi-banking players now like to think they have their own standard forms which the banks will sign up to, not the other way round.
GW: There were some major banks in the group behind the development of the MPA and I had an interesting experience with a bank that said that for its participations it didn’t want to sign an MPA, but it wanted to sign up credit default swaps. I don’t know if anyone else seen that?
DL: It just puts the commission in another part of the bank?
GW: But you’ve got to negotiate a master agreement, you can’t just pull it off the peg and say it is a credit default swap. But it was quite interesting in that it demonstrated there is a drive for something more standardised.
DL: But having greater standardisation is that just code for not having to involve lawyers?
MS: That was part of the motivation I imagine, to cut down on transactional costs.
DL: Will the implications of the credit crunch encourage people to go back to trade finance as, asides from fraud; it is seen as a less risky transaction based on real assets?
DL: We saw in the last half of 2007 more trade finance deals in the market, which marks a return to an interest in financing tangible assets.
I think one of the interesting outcomes of the credit crunch is that banks do not trust each other to repay as they once did. It is the first time in the years I’ve been involved in this business I have seen this effect. Some institutions will no doubt find they cannot get funds at margins that enable them to participate in the market.
I’m not sure I’d like to be trying to syndicate a large facility in the current climate.
NB: I think it also depends on what region you are looking at. For instance, in the Middle East the situation is not as bad and there are no severe liquidity issues, at least not on the scale of those we are facing in the US and the UK. When we talk to our clients in this region they say credit crunch – what credit crunch?
DL: Do we think that high commodity prices are making poor deals good?
GW: Looking at all commodities, prices are all very high. This means the the basis on which people are lending on rests on high commodity prices. People are going to make mistakes and lending might tend to be more careless if they base their deals on the assumption that prices will never go down.
CW: If you have a rising market, a poor deal will be hidden, but as soon as the market turns it will all be exposed.
GW: Someone once remarked to me recently that with China’s insatiable appetite for commodities the prices won’t fall.
AO: But that’s not following it through, because China has such high demand for commodities in part due to US demand for Chinese exports, but the US is going into a recession so this may have an effect.
People always argue that countries have huge demand. However, I remember listening to speeches at conferences 10 years ago where project financers would be saying there was trillions of dollars-worth of demand for power in the emerging markets. However, this confuses demand (which is practically unlimited) and the financeability, ie how the consumer pays for it.
The situation is the same now, there is unlimited demand for everything but ultimately it has to be paid for.
I think that the poor deals will be shown to be poor in time and some deals have been done in a hurry.
DL: Is the correction in the market going to be dramatic? Or will oil prices slowly drift downwards. Also will the fact that deals tend to be more short-term limit the impact?
AO: Let’s hope everyone has been smart in structuring their deals.
GW: But we know that they haven’t. Tenors are going out for longer. Again if you compare deals made in 1998, they were being done on a 180-day basis. Oil deals are now going out to five or seven years.
AO: I suspect that you’ll find that they probably have some internal hedge on the oil price, that there is some stuff that you aren’t seeing.
DL: What happens if the offtakers you are dealing with go bust? Some of these firms who are mitigating the price risk won’t be around in a few years time.
AO: When prices are very low, all people see are prices going down, the financing dries up.
Gold is a classic example of this. One of the reasons gold prices are so high is that financing declined and there was no mine development. The only way around this was by selling forward future production but now they probably wish they didn’t hedge as much as they would have made far more money selling at spot now.
That is the other thing is that for someone who has bought an insurance policy or credit default protection they need to have a default to be able to claim. The last thing an unprotected party would want would be a default.
AO: There will be a different type of litigation this time round, we will see the credit default counter-parties against the banks, as opposed to the banks against the borrower.