Sharing risk

Feature | 26 June 2017
Mountain_Parachute

Hannah Fearn looks at the different instruments financial institutions use to share the burden of risk and what steps can be taken to avoid a dispute

Banks and other institutions share risk for different reasons, such as permitting the bank to lend without breaching its single obligor or country limits, or to obtain capital relief on exposures. Institutions can be both providers and recipients of credit protection through risk sharing arrangements.

Common examples of risk sharing techniques in trade finance transactions include corporate guarantees, demand guarantees, standby letters of credit, funded and unfunded risk participations, and credit insurance. With the exception of funded risk participations, where the participant provides funds at the time of utilisation by the underlying obligor, these are all examples of unfunded risk sharing techniques. This means the recipient of the credit protection takes the risk that the protection provider will pay out following a demand or claim, which is usually triggered by a default in the underlying transaction.

The boundaries between different unfunded risk sharing arrangements are not clear. Parties could enter into an agreement identified as one thing, but find that the court or a regulator interprets it to be something different.

This matters for a number of reasons. For example, different instruments are subject to different bodies of law. This can impact the availability of defences to the protection provider that might allow it to refuse to pay out. It is also important to understand that different instruments are subject to different regulatory regimes. For example, a bank cannot offer contracts of insurance and an insurer can only conduct non-insurance business in limited circumstances.

Is it a guarantee?

A typical corporate guarantee might be given to a bank by a parent company in support of a loan to its subsidiary. For example, in a pre-export financing to an emerging market commodity producer, lenders may seek the comfort of a guarantee from an onshore parent company with an established borrowing record. Under English law, a guarantee is a secondary obligation to fulfil the obligations of a third party, and is contingent on the validity and scope of the underlying guaranteed obligations.

A demand guarantee is an independent payment obligation, payable on demand by the beneficiary. The issuer is usually unrelated to the underlying obligor and demand guarantees are often issued in the context of a cross-border contract between two commercial parties, in order to protect against the risk of non-performance of the obligations owed by one party to the other. The issuer receives a fee for issuing the instrument and obtains an indemnity or other collateral from the applicant in respect of amounts it may be required to pay. A demand guarantee is much more similar to a standby letter of credit than a corporate guarantee (and in this respect its name is rather misleading).

There are a number of consequences of an instrument being categorised as either a guarantee or a demand guarantee. For example, the issuer of a corporate guarantee is far more likely to be able to assert defences to having to make payment to the beneficiary following a default. An independent demand guarantee will provide recourse to the issuer even if there is a dispute in relation to the obligations of the underlying obligor.

There are themes that arise from the cases where the courts have been tasked with distinguishing between a guarantee and a demand guarantee:

  • The nature of the guarantor is relevant - independent demand guarantees are typically given by banks as part of a commercial relationship between the guarantor bank and its applicant customer, rather than as financial support for an affiliate company (as would often be the case for a secondary guarantee).

  • Consistency in drafting is crucial - there could be room for dispute even when an instrument contains wording such as 'principal obligation' or 'primary debtor', if there are terms in the agreement as a whole that are contradictory to the independent nature of the guarantor's payment undertaking.

  • The courts will give weight to the commercial context of the arrangement - demand guarantees have an important role in the support of trade finance and other cross-border transactions, and preserving their independent nature is vital to their efficacy.

When entering into a guarantee, it is critical to ensure that its terms are consistent with its intended nature. Understanding the commercial intention of the parties and focusing on reflecting this in the drafting at the outset will reduce the scope for dispute later on.

Is it insurance?

The boundary between guarantees and insurance is particularly interesting. The business of underwriting and broking contracts of insurance is a regulated activity under the Financial Services and Markets Act 2000, and is subject to prior authorisation and regulation by the Prudential Regulation Authority (PRA). This means that only an authorised insurer can legally provide contracts of insurance.

Contracts of insurance are also subject to a specific body of law, including the provisions of the Insurance Act 2015, which came into force in 2016. If an instrument is classified as an insurance policy, the duties of the insured with regard to fair presentation of the risk and the consequences of the insured breaching its obligations under the policy would be interpreted using insurance law principles. In a nutshell, an insurer may have more scope to assert defences to making payment under an insurance policy, than a guarantor or risk participant might have to making payment under a demand guarantee or risk participation agreement.

It is not unusual to come across instruments that appear to straddle the boundary between a contract of guarantee (which, in this particular context, would include demand guarantees and risk participation agreements) and a contract of insurance. It is accepted as a matter of English law that different types of instrument exist that have a similar commercial effect. However, the courts and the regulators have generally declined to provide any definitive definitions and thus the boundaries are not clear. Instead, principles have emerged from an extensive body of case law, providing some guidance that can be applied to try to distinguish a contract of insurance from other risk sharing arrangements.

Contracts of insurance vs guarantees and risk participation agreements

Under a typical risk participation agreement, a lender would loan an amount to a borrower and sell a share of its exposure to a third party risk participant. The risk participant undertakes to pay its share of any defaulted amount in the underlying transaction to the lender. In return, it receives a share of the profit element of the underlying transaction. This allows the beneficiary of the risk participation to remain lender of record for the financing, while sharing the non-payment risk with other lenders.

In the same transaction, the lender might also take out an insurance policy in respect of a portion of its remaining exposure. The insurer would promise to indemnify the insured for the insured amount of the loss it may suffer, as a result of a default in the underlying transaction. The insured pays a premium to the insurer as consideration for its indemnity obligation.

There are many similarities between the arrangements described above. In fact, the three key features established by the leading English law case on what constitutes a contract of insurance (Prudential v Commissioners of Inland Revenue [1904] 2 KB 658), could be said to apply equally to both contracts of insurance and to many types of contracts of guarantee (such as demand guarantees or risk participations). Those features are:

  • The provider's undertaking is given in consideration of payment.

  • The provider undertakes to make payment to a recipient.

  • Such payment is in response to a defined event the occurrence of which is uncertain (either as to when it will occur or as to whether it will occur at all) and adverse to the interests of the recipient.

The case law demonstrates that certain types of contract are capable of being interpreted as either a contract of insurance or a contract of guarantee. Although the form of an agreement is relevant, it is not decisive. The courts will look at the substance of a contract and at the nature of the provider's obligation as a whole. Some factors emerge from the cases that help distinguish a contract of insurance from a contract of guarantee. These are set out below. It is very important to note that no single factor listed below would, on its own, be a definitive indication of an arrangement being one type of agreement or another.  

Features of a contract of insurance:

  • It contains terms consistent with insurance principles, including the duty of utmost good faith.

  • It is given by an authorised insurer acting in the course of its insurance business.

  • The premium payable by the insured is calculated by reference to the probability of occurrence of loss and/or likely severity of such loss.

  • The insured has extensive disclosure obligations and the insurer is entitled to rely on the fair presentation of the risk by the insured, to make its decision whether to undertake the risk. Breach of this duty by the insured may permit the insurer to avoid the contract or reduce or decline the claim.

  • The insurer assumes a risk of loss only.

Features of a contract of guarantee, such as a demand guarantee or a risk participation agreement:

  • It contains terms inconsistent with insurance principles, or expressly excludes applicable principles of insurance law.

  • It is given by a bank or entity other than an authorised insurer.

  • The remuneration of the provider is typically calculated by reference to the profit element of the underlying transaction (although it is not unusual for credit insurance to be priced in this way).  

  • The recipient may exclude any responsibility for information provided in respect of the underlying transaction, and the provider may even expressly agree that it makes an assessment of the risk based solely on its own investigations.

  • The provider may in some circumstances assume a risk of both profit and loss. For example, if its remuneration is contingent on the underlying obligor making the corresponding payment to the beneficiary of the protection arrangement.

From a regulatory perspective, the PRA's guidance indicates that it will have regard to the relevant common law principles to determine whether a particular instrument falls within insurance business. From a beneficiary's perspective, it is critical to understand the nature of the credit protection it receives and the scope of its duties, including the extent to which its actions or omissions might prejudice its rights to receive payment.

As the distinction is subject to common law principles as applied by the courts to the specific facts, it is difficult to extract a set of rules for institutions to follow. For contracts that could fall into either category, it may be possible to consider the terms of the contract and give a reasoned opinion by weighing up the relevant factors. Institutions should carefully consider the relevant features of an arrangement at the time of structuring and drafting, taking advice where necessary as to how a particular agreement might be interpreted.

Risk substitution and capital relief

One of the driving factors for obtaining credit protection is for an institution to obtain capital relief on its exposure. Under the Capital Requirements Regulation (Regulation (EU) No 575/2013 - the CRR), eligible credit risk mitigation techniques are used by institutions to reduce risk weighted exposure amounts for the purpose of calculating capital requirements.

Unfunded credit protection is defined as a technique of credit risk mitigation where the reduction of the credit risk on the exposure of an institution, derives from the obligation of a third party to pay an amount in the event of the default of the borrower, or the occurrence of other specified credit events. This is divided into two categories - guarantees and credit derivatives. However, 'guarantee' is not defined. There is support in the market for the view that this should include a range of risk substitutes including guarantees, risk participations and insurance, so long as the relevant instrument satisfies all of the applicable CRR requirements. This is of interest as, despite the distinguishing features between them and the legal and regulatory consequences thereof, different risk sharing arrangements are treated as one type of instrument under the CRR for the purposes of obtaining capital relief.

Funded risk participations, a common risk substitution technique, are not specifically included as an eligible credit protection arrangement under the CRR. An institution might in fact treat a funded participation as reducing its exposure to the underlying obligor, rather than as credit protection. If an institution does want to treat a funded participation arrangement as credit protection, it is necessary to consider the arrangement as being analogous to one of the specified types of eligible asset in the CRR, such as cash on deposit, as the lender receives payment from the participant up front, instead of following a default.

For comfort, banks can seek the benefit of legal opinions on whether a particular risk sharing arrangement meets the relevant legal criteria to be eligible as credit risk mitigation under the CRR. Legal opinions may be transaction-specific or given on a generic basis in relation to a particular type of arrangement.

Be wary

There are a number of commonly used risk sharing arrangements that all achieve a similar commercial effect. As outlined, there are some important reasons why parties might seek to distinguish between different types of credit protection arrangements, but it is not always easy.

In many circumstances, the parties to an agreement may feel that it is clear how it ought to be categorised. But parties should bear in mind that despite their best intention, there may still be scope for dispute and the courts and regulators will look at the substance of an obligation against a variety of factors in determining its nature. From a legal perspective, the most practical tips for institutions are to consider these points at the outset and take legal advice where appropriate. Where an agreement contains features indicative of more than one type of arrangement, drafting with care is essential.

Hannah Fearn is a senior associate at Sullivan & Worcester

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