Tough economic times don’t tend to hit law firms as hard as their banking clients. Cautious lending typically translates into tighter structuring and the threat of litigation looms – both of which can rack up a lawyer’s billable hours.
But is this credit crunch different
As many banks have less liquidity to lend, and others report that deal flow is drying up, are law firms finally feeling the pinch
Not so – at least in terms of trade finance flow – says Mirthe van Kesteren, partner at Linklaters in London. The credit crunch has been generally good news for trade financiers, raising margins and tightening up terms and conditions that by early 2007 some thought had unravelled too far, she says.
She notes: “At the beginning of the year many of the loans, for example to big Russian corporates, were either unsecured or very loosely secured. Now some strong corporates are actually choosing to go secured.”
“Trade finance in emerging markets is not overly affected,” says Michael Foundethakis, partner at Baker & McKenzie in Munich. “There has been no shortage of demand,” although ticket size and the number of participants in any given financing have dramatically reduced.
Lenders still have appetite for trade finance deals but are examining more closely the credit worthiness of off-takers, adds Corinna Mitchell, partner at Dechert in London.
“They’re still very interested, because commodity prices remain very high – it’s a good resource to lend against,” she notes. “But they’ve obviously tightened their terms, their margins have gone up, and financial covenants are tighter.”
In response to tighter credit markets, lenders are seeing increased security and are tightening their security structures, agrees Christopher Czarnocki, partner at Gide Loyrette Nouel in London.
Bankers are insisting on assignments of receivables, being stricter with their requirements for off-take contracts and are increasingly asking that the accounts over which they take security are located offshore, rather than solely in Russia or where they are doing the deal, he says.
These shifts are tending to make trade finance a more popular option for corporates.
Tax advantages enjoyed by trade deals in Brazil mean that more transactions are being “dressed as trade finance,” and hence “becoming more sophisticated,” says Christian de Lima Ramos, partner at Ramos e Zuanon Advogados in Sao Paolo.
“The projects have exports to support the outflow, but the proceeds are not to be applied, directly, to foster the production,” he says. “They are being utilised for capital investment.”
One deal where a trade finance structure was adopted at the last minute was Brazilian steelmaker Gerdau’s US$4.2bn acquisition of US rival Chaparral Steel.
Originally structured as an institutional investor-funded transaction, the deal was scheduled to close at the peak of last summer’s financial crisis, says Amy Dulin, partner at Hughes, Hubbard & Reed in Miami. But with liquidity suddenly gone and only a month to go, “the entire deal was revamped, to effectively turn it into a trade deal,” she says.
“It demonstrated that the market has great faith in the traditional trade structures – even in moments of volatility trade really is the bedrock for a lot of solid financing,” she says.
Deal structures look set to become more complicated, meaning trade financiers will need to get comfortable with financing techniques that are new to the sector, predicts van Kesteren.
One innovation van Kesteren has worked on is Kazakhmys’s US$2.1bn pre-export financing, which she describes as having all the security normally associated with pre-export structures but featuring “some additional bells and whistles.”
Under a funds certainty provision, if Kazakhmys entered into an acquisition agreement and needed to prove to a vendor that it had cash available, it could refer to the loan agreement as evidence, she explains. Other than in very limited circumstances, banks did not have a right to refuse the funds.
This kind of innovation is creating more work for lawyers, as do financiers that allowed structures to become too lax in recent years. “Money is no longer as abundant as it was. And if you structure poorly a transaction you will not be able to sell it in the syndication market,” he notes.
“You have to work more in terms of structuring and you have more contracts to perfect more collateral,” he says. In terms of deal flow, despite problems in the credit markets, “we continue to work at the same pace as we were working late last year.”
“A greater number of pieces of the puzzle being put in obviously requires more input from the legal side,” Czarnocki notes. “From a purely business perspective it’s not a bad thing.”
However, “while the credit crunch has meant increased security requirements, it also has stymied the work flow that the markets would have expected in the absence of the current economic difficulties.”
“We’re not lacking for work, but we would have expected to have been busier and potentially struggling to cope with the various deals in the pipeline going into the summer this year.”
The last 12 months have been quieter for law firms but not significantly so, says Mitchell. “The worst affected area is M&A, but for trade-related deals, particularly when you’re looking at commodities or infrastructure, the assets are still good and there is still appetite to lend.”
An across-the-board surge in commodity prices has created extra work for lawyers in that field over the past year, as credit lines needed to be extended and deals re-documented, says Alexander Moon, partner at Pillsbury Winthrop Shaw Pittman in New York.
All three major categories of commodity finance – energy, hard commodities and soft commodities – saw prices rocket to record highs, he notes. And while banks typically return to any one facility once a year, in this climate some deals needed to be revisited on a much more frequent basis – quarterly or even monthly – “just to keep up with the price-driven demand”.
A commodities price correction would force banks to re-adjust deals on the downside, Moon adds. Banks that suddenly find themselves under-collateralised will need to go back to their customers and figure out how to unload, or gain comfort through extra cash or collateral, he says.
Geographically, trade finance’s current hot markets are Russia, CIS and Brazil, and law firms are rushing to build up bases here.
The resource boom in Russia has created a substantial ‘mini-market’s in trade export finance, and most of the developments have been commercial rather than legislative, says Czarnocki.
Russia and the CIS are not necessarily difficult to navigate from a legal perspective, but Gide typically advises foreign clients to consider subjecting their finance documents to English law, where possible, he says.
“There are many areas where Russian law is fairly ambiguous, where any lawyer, if he’s being realistic, would be uncomfortable giving an unequivocal opinion,” Czarnocki explains.
“The majority of foreign lenders therefore make their finance documents subject to English law and their security, where it pertains to assets located in Russia or the CIS, governed by local laws.”
Doing deals in Russia and the CIS is more straightforward now than four or five years ago, says Mitchell. In Russia, for example, deals with a foreign currency element still require involvement of a passport bank, but the fact that there are now more passported Western banks in Moscow has made that easier, she says.
In spite of continued political instability, Ukraine’s steady economic growth has made it more attractive to foreign investors, traders and lenders involved in international trade, says Oleg Alyoshin, partner at Vasil Kisil & Partners in Kiev.
Legislation has not however kept pace with the market’s growth and “the laws of Ukraine still have essential gaps or shortcomings,” he notes.
Trade finance mechanisms such as escrow accounts and the use of security agents are absent in Ukraine, as is a solid legislative framework for securing creditors’s interests under trade finance transactions such as pledges, warehouse certificates and forwarders’s certificates of receipt.
Ukrainian law also stipulates many obstacles to cross-border trade finance, he adds. Loan agreements concluded with foreign creditors are still largely subject to mandatory registration by the National Bank for Ukraine, for example.
Positive developments though include a rule introduced in January that provides 180 days – instead of the previous 90 – from the date of an export to credit proceeds from the exported product to a borrower’s account.
New legislation abolishing the previous procedure for procurement of goods, works and services for public funds has also been adopted, he adds. Processes are now expected to be “more transparent, open and attractive for the tender participants, including foreign companies.”
Business in Latin America meanwhile is “busier than it’s ever been – there’s a tremendous amount of trade,” says Dulin “Bankers say they have very healthy pipelines.”
Brazil’s anticipated investment grade rating has provided impetus to that market, she says. “Creditors are more interested in being well positioned and there is such a strong expectation that [the upgrade] will occur that’s keeping people very interested.”
Brazil should see more soft commodity deals in the coming year, she adds. “The producers and the cooperatives are becoming more sophisticated, more educated about international financing options. They are taking advantage of that.”
Chinese demand for natural resources is also bringing Africa to centre stage, Foundethakis says. While trade deals are typically supported by short-term finance, Chinese banks and companies are luring African governments with offers of long-term development and infrastructure investment.
“One of the biggest problems in Sub-Saharan Africa is performance risk – the risk of getting your commodity from A to B,” he says. “What infrastructure there is tends to be a mess.”
So instead of offering one or two-year financings as Western banks traditionally have, “Chinese companies are saying: ‘if you agree to export this commodity to us, we’ll finance you for a longer term ? and to make sure we get the deal, we’ll help construct the relevant road/railway that links your mine to the port,’” he says.
“If you’re an African government, that’s a considerably more enticing offer,” he adds. “European banks cannot compete with that – though they can certainly ride on its coat tails.”
With business in these regions booming, law firms are also finding themselves facing some stiff new competition.
More big law firms are opening shop in the CIS, especially Romania and Kiev, lawyers note. But in New York it’s a different story.
The rush towards securitisation and CDOs in recent years has left New York law firms with a dearth of trade finance expertise, and this puts those firms with experienced trade finance professionals at an advantage, says Moon.
While American banks tend to retain trade finance legal expertise in-house, the US-based operations of many European and Asian banks rely to a much greater degree on outside counsel, and sometimes struggle to find a law firm with the right skill set, he says.
Cost pressures from lenders and borrowers mean that more international law firms are meanwhile staffing deals from cheaper locations, and this trend looks set to continue, says Mitchell.
For example, on one Ukrainian deal that she worked on while at Baker & McKenzie, the borrower’s legal representative did its English law capability out of Hong Kong. “It wasn’t terrifically convenient from a time perspective,” she says. “But I dare say it suited the borrower from a cost perspective.”
Most of the year’s big developments have been commercial rather than legislative but there have been some key technical changes.
Basel II remains a talked-about topic, says van Kesteren. Previously, a clause in Loan Market Association (LMA) documentation allowed banks to pass on increased costs in relation to laws and regulations that came into effect after a loan agreement was signed.
For any deals inked after January 1 however, when Basel II was finally introduced, banks are required to absorb these costs themselves, and are currently seeking ways to address this, she says.
Basel II has made banks more conscious of the need to double-check on the documentation of old deals, particularly those that have quickly ballooned in size, adds Moon.
Other technical areas generating discussion include the general adoption of UCP600 and how well it applies to stand-by letters of credit, says Foundethakis.
UCP600, which replaced UCP500 as the ICC rules applicable to commercial LC documentation, “hasn’t covered all the things it should, be it in relation to commercial letters of credit or, where applicable, stand-by letters of credit,” he argues.
In relation to the latter, although many bankers and lawyers are instead applying ISP98 – a set of ICC rules specific to stand-by letters of credit – some bankers remain resistant to using them and still incorporate the UCP, he adds.
With all the above on their plate, lawyers are by and large upbeat, despite the slowdown in deal flow. Yes, the future still looks uncertain but so far they have more than enough to keep them busy.
At the end of last year, as commodity prices shot up and the credit crunch hit the overall marketplace, deal flow was “hot and cold,” says Moon. “But as the credit crunch is now something that everyone has factored in, the banks still need to go out and address the needs of customers in what has been a raging commodity market.”
“Most of our bank clients are saying that they know this is going to be a rough year, but they’re more optimistic in terms of being able to see the mandates they were expecting,” he says.
The coming year could see more defaults and company collapses in Brazil, as volatile commodity prices compound the credit crunch, says Ramos. “It will take its toll here in Brazil.”
But for law firms, the wake-up call can be good news. “It’s much easier for a bank and a lawyer to structure a soft deal. But when you need your structure to be stronger, you need to rely on the legal advice of an expert,” he says. “I think it will be a very good year for law firms that are already well established.”
“The credit crunch doesn’t harm this market,” he concludes. “It’s bringing back the discipline that was lacking.”
