NICHOLAS GRANDAGE and NATALIE COVERDALE provide a summary of the top 11 legal developments in trade finance over the last 12 months
A number of the key developments in the legal market during 2011 will continue to impact on the trade finance market in 2012. These include changes to Loan Market Association standard documents and the ongoing debate surrounding the meaning of ‘trade finance’ and the independent nature of trade finance instruments (in the face of ongoing restructurings and non-payments).
1) Basel III: Basel Committee on Banking Supervision changes to regulatory treatment of trade finance instruments
On 25 October 2011, the Basel Committee on Banking Supervision (BCBS) issued a press release confirming two changes to the treatment of certain trade finance instruments under the Basel Accords.
The first change was a waiver of the one-year maturity floor applicable to certain instruments for banks with an advanced internal ratings based approach (AIRB). Basel II requires banks, when risk-weighting their assets, to measure the effective maturity for each facility subject to the provision that it cannot be less than one year.
Evidence presented to the BCBS suggested that trade finance transactions have an average tenor of 115 days. Accordingly, the BCBS agreed that banks with an AIRB may risk-weight short-term self-liquidating transactions (primarily issued and confirmed letters of credit) on the basis of their actual effective maturity without regard to the one-year minimum.
The second change relates to a waiver of the ‘sovereign floor’ under certain provisions of the standardised approach for credit risk. This relates to claims by a confirming bank on the issuing bank in the context of short-term, self-liquidating letter of credit arrangements. The risk-weighting given by the confirming bank to its exposure will depend on the rating of the issuing bank. If the latter bank is unrated, the risk-weighting would be 50%, or even 20% for exposures with an original maturity of three months or less. However, Basel II also states that the risk-weighting cannot be lower than that applicable to the sovereign in which the issuing bank is incorporated – which would be 100% for most low-income countries. The BCBS has agreed a waiver of this floor for the relevant instruments.
The BCBS further considered, and rejected, a request for the modification of the 100% credit conversion factor (CCF) applicable to contingent trade finance products for calculating the additional ‘backstop’ non-risk based leverage ratio being introduced by Basel III.
Finally, the BCBS considered a request for a reduction of the 20% CCF applicable to certain trade finance products under the risk-based leveraged ratios for banks with a standardised or foundation internal ratings-based approach under Basel II. The BCBS concluded that there was insufficient analytical evidence for any modification but supports further work by various relevant organisations to strengthen the data available.
2) Slavenburg register – the undead becomes the actually dead
The Slavenburg register arose because a company with a place of business in the UK was obliged to register security over property in the UK, and the company’s register was not conclusive as to whether it had established such a place of business. The practice developed of trying to register security for overseas companies despite knowing they would more than likely be rejected.
A law passed in 2009 sought to address the point, but technical issues meant that Slavenburg registrations continued. Finally, in October 2011, this lunacy came to an end. There is now no registration requirement in the UK for companies incorporated overseas.
3) European Council adopts new rules on combating late payment in commercial transactions: Late Payment Directive (Directive 2011/7/EU)
Nobody would accuse the European Council of being part of the undead. They are diligent in passing legislation affecting many aspects of daily life.
Early in the year, the European Council adopted a directive regarding late payment in commercial transactions. The directive established specific deadlines for the payment of invoices and the right to compensation in cases of late payment in all commercial transactions, including those involving public authorities.
Under the new rules, a creditor is entitled to interest for late payment without the necessity of a reminder if, having fulfilled his contractual obligations, he has not received the amount due on time (unless the debtor is not responsible for the delay). The creditor will be entitled to interest for late payment from the day following the date of the end of the period for payment in the contract. If the date or period for payment is not fixed in the contract, the creditor will be entitled to interest for late payment after 30 days following the date of receipt of the invoice.
Importantly, in addition, the creditor will be entitled to obtain compensation for expenses incurred due to the debtor’s late payment, such as those incurred in instructing a lawyer or employing a debt collection agency. Furthermore, member states will be able to impose fixed sums for compensation of recovery costs which are more favourable to the creditor, or to increase these amounts, for instance, to account for inflation, and contracts excluding interest for late payment or exclusion of the right to compensation for recovery costs will likely be considered ‘grossly unfair’ under the Unfair Contract Terms Act.
Implementation of the directive must be complete by the end of the first quarter 2013.
4) Creation of the African Loan Market Association and LMA developments in London
The African Loan Market Association (ALMA) was established in September 2011 to provide standardised documents for syndicated financing in Africa. To date, single currency syndicated unsecured loan facilities have been formulated by the ALMA Documentation Committee for South Africa, with Kenyan and Nigerian loan agreements, and English law loan documents for the pan-African market facilities, under consultation. Term sheets, mandate letters and confidentiality letters are also presently under consultation or will be available for consultation in the near future.
ALMA is dedicated to supporting and growing the African syndicated loan market. The body will work closely with the Loan Market Association (LMA) in London and the Asia Pacific Loan Market Association (APLMA) in Hong Kong to align with international best practice in doing so.
Key South African banks, including ABSA, Investec, Nedbank and Standard Bank, are leading the charge. The sector will watch with interest in 2012 as ALMA advocates policy change for liquidity, efficiency and transparency of loan syndication in the Sub-Saharan region. Meanwhile in London, the LMA is working on a standard form document for pre-export financing transactions.
5) Modernisation of OHADA uniform security interests law
In May 2011, a new uniform law simplifying the creation, perfection and enforcement of security interests came into force. Among other things, the OHADA uniform security interests law permits security to be granted directly in favour of a security agent, allows security over both existing and future debt (as long as the future debt is determinable) and existing and future assets and authorises cash collateral and security assignments over trade receivables.
The Council of Ministers of the OHADA member states, the pan-African organisation for harmonisation of business law in Africa, formally adopted the law in late 2010. Much of the OHADA uniform security interests law was initially inspired by French law, organising security interests according to the nature of the category of assets over which the security is sought to be created, applying different rules for the creation and perfection of security over each such asset class. However, significant streamlining of OHADA procedures was needed. The new OHADA uniform law on security interests brings the OHADA legal framework on security interests in line with the more recent developments under French law, and in some cases goes beyond it, addressing issues unresolved by French legislation.
The new law is a welcome addition to the OHADA legislative body, providing increased certainty to debtors and creditors alike and greater flexibility in both the options of security interests on offer and in the manner in which they are created, perfected and enforced.
6) International Chamber of Commerce Global Risks – Trade Finance 2011 report
In October, the International Chamber of Commerce (ICC) released their Global Risks – Trade Finance 2011 report, telling us what we already know, that trade transactions enjoy a very low incidence of default.
Based on analysis of the ICC Trade Finance Register, the most comprehensive dataset available on the market, the report involved an estimated 60-65% of global trade finance activity. Fewer than 3,000 defaults were observed in data which comprised 11,414,240 transactions from 14 leading international banks, with operations covering a broad range of jurisdictions. The ICC maintains that new Basel regulations should not constrain trade finance supply and that, by focusing on the critical connections between default levels in trade finance and the shaping of new regulatory recommendations, the report can assist in improving the global financial system’s resilience.
7) Expanding scope of financial services
Staying outside the scope of the European financial services regime is becoming ever more difficult for commodities traders. By the end of this year, persons trading commodity derivatives (a) on a regulated trading platform, or that are (b) cash settled or (c) deemed to have financial characteristics, outside a regulated trading platform, could find themselves subject to an obligation to clear through a central counterparty, whether they are licensed or not. This is part of the worldwide effort to reduce counterparty risk in the derivatives market, which also involves collateralising non-cleared contracts bilaterally and higher capital requirements for regulated entities.
Several other proposals to widen the scope of the financial services regime were also published last year. These are on a slightly longer trajectory and not likely to become effective until 2015. While the lobbying has already started, effecting amendments is likely to be an uphill struggle given widely held concerns about the volatility of the commodities markets. The proposals are to:
8) MF Global and the London Metal Exchange
Just over three years after the Lehman Brothers default, we were rudely reminded of the lessons learned when MF Global UK Limited was put into administration on 31 October 2011.
Many have been disappointed to realise that, despite extensive work to create a system that better protects clients of firms that trade on exchanges and clear through central counterparties, little action has been taken to amend insolvency law or remedy the perceived shortcomings in the FSA’s client money rules that underpin the arrangements. As a result, most European clearing houses exercised their extensive powers by transferring client positions to other, solvent, clearing members but required clients to double margin positions as they lacked the data to transfer what collateral they held.
It remains to be seen whether traders will have to wait for their cash as long for the return of their assets as with Lehman.
MF Global’s membership of the London Metal Exchange also raised issues around the holding of large positions in metal with the LME having to suspend steel billet warrants and not being able to enforce its lending guidance in order to ensure an orderly unwind.
It will be interesting to see how the sale of MF Global’s shareholding to JP Morgan, making it the largest stakeholder, affects the sale of the LME and what changes its new owners might make to the way it operates.
9) New York law court hears case related to ‘synthetic’ letters of credit?
In Fortis Bank v Abu Dhabi Islamic Bank, reported at the end of 2010, the court considered whether a structured LC transaction could constitute fraud on the confirming bank. The confirming bank argued (in outline) that a deferred LC transaction did not involve the financing of trade, but was merely being used as a financing method for the issuing bank, and that the presentation of documents was unlawful.
The LC in question had a number of provisions that would be unusual in a traditional vanilla letter of credit for the payment of goods, such as calling for copy documents only and allowing for discrepancies.
The proceedings were preliminary. The judge ruled that the documents presented were in accordance with the strict terms of the credit, and, while the provisions were unusual, that was not of itself the basis of any objection. He found that the parties understood the transaction structure and as such there was no question of fraud.
Some commentators have made the point that the structure would work irrespective of that knowledge: a bank chooses whether to issue or confirm an LC, and should not object to a presentation that is complying even if it turns out that other factors mean that the underlying transaction is different to that bank’s understanding. The whole point, they maintain, of LCs is that the bank is not concerned with the underlying transaction.
There is some force in this argument. However, parties to such schemes will want to consider carefully the terms of the credit and whether a complying presentation can be made and, following the decision in the case, will want to ensure that all parties are fully aware of the structure of the transaction. It is important that there is a real trade underlying the transaction. (see 'Transaction independence' in TFR, volume 15, issue 3, which covers synthetic LCs and Fortis in more detail).
10) Changes to Russian security law
Changes to Russian security law were officially published on 7 December 2011 and came into force 90 days later on 7 March 2012.
Changes were also introduced to many Russian laws such as the Civil Code, the law on pledge, the law on mortgage, the LLC Law, etc. The changes are extensive and some are ambiguous. In the absence of any clarifications and court practice, the main changes appear to include:
2011 saw a significant increase in the imposition of trade sanctions by the UN, US and EU. Sanctions against Libya were short-lived and were overshadowed by the military action but they had a significant effect on parties in the Mediterranean with close trade ties to Libya. They also caused considerable concern over a wider field as financial sanctions became effective and transactions with entities controlled by Gaddafi, which transpired to be the large majority of Libyan entities, were restricted. Although relaxed now, sanctions remain in place to target Gaddafi family interests. In contrast, US and EU sanctions against Iran and Syria have increased in scope and intensity; the aim being to stop the flow of funds into those countries earned from oil and petrochemicals.
The deteriorating situation in both states as seen by the West suggests that sanctions will become tougher during the course of the year and both the EU and US has shown real resolve in making the sanctions effective and taking action against those who try to evade them. A significant degree of caution must be exercised by those trading with these states. The extent of sanctions wording in letters of credit remains a subject frequently debated. See also 'Not in national interest' in TFR, volume 15, issue 4 for more information on sanctions.
Nicholas Grandage is a partner and Natalie Coverdale is a paralegal in the Banking Group of Norto Rose LLP.
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