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Feature | 27 April 2016
Page 75 TFR April 2016__WEB

Forfaiting has huge potential as a set of principles and techniques that can be applied to a wide range of receivables. Sean Edwards explains how

The widespread use of forfaiting has not always been apparent in recent years. This is in large part due to perception rather than substance as the employment of forfaiting techniques has continued without abatement and found fresh applications. The following definition of forfaiting from the recently published ICC supply chain finance definitions contributed by the International Trade & Forfaiting Association (ITFA) shows why these techniques offer solutions and opportunities for practitioners of trade finance.

Forfaiting is a form of receivables purchase, consisting of the without recourse purchase of future payment obligations represented by financial instruments or payment obligations (normally in negotiable or transferable form), at a discount or at face value in return for a financing charge.1

Tenors are flexible and the range of forfaitable instruments is wide and always capable of being added to.

Raison d'être of forfaiting

There are other good indicators of the vitality of forfaiting:

  • the size of the forfaiting market has increased considerably over the last decade in the largest export markets and is especially popular in Asia, where Bank of China estimates the value of forfaited receivables in China alone at well over US$30bn in 2012;

  • new payment instruments have been forfaited, for example the bank payment obligation (BPO) introduced by SWIFT and the range of forfaitable receivables is extremely wide;2

  • rules in the form of the Uniform Rules for Forfaiting (URF800), published by the ICC in partnership with the ITFA have for the first time provided standardised global rules in the same way as documentary credits. The recognition accorded by the ICC to forfaiting is evidenced in its 'Standard Definitions for Techniques of Supply Chain Finance'.3

Many institutions offer forfaiting as a product without necessarily using that label or, in some cases, being aware that they are in fact acting as forfaiters. This can, over time, lead to a dilution of expertise and a lack of awareness of solutions to issues which have been developed and tested. Furthermore, possible new users or potential entrants to the industry may simply be unaware of how forfaiting can be used to their and their customers' benefit. By focusing on concepts and concrete problems faced by exporters, importers, and financers alike, rather than labels, this article tries to show the value of employing forfaiting techniques.

For exporters the advantages of forfaiting their receivables are as follows:

  • eliminates a number of risks;

  • provides financing for 100% of contract value;

  • protects against risks of interest rate increase and exchange rate fluctuation;

  • enhances competitive advantage;

  • enables sellers to offer credit to their customers, making their products more attractive;

  • helps sellers to do business in countries where the risk of non-payment would otherwise be too high;

  • improves cash flow;

  • enables sellers to receive cash payment while offering credit terms to their customers;

  • removes accounts receivable, bank loans, or contingent liabilities from the balance sheet;

  • increases speed and simplicity of transactions;

  • fast, tailor-made financing solutions;

  • financing commitments can be issued quickly;

  • documentation is typically concise and straightforward; and

  • relieves seller of the administration and collection burden.

What makes a payment instrument forfaitable?

Payment instruments, or payment claims, are the hook on which forfaiting transactions are hung. This does not imply, however, a narrow range of options. There is no longer any slavish adherence to any particular type of instrument and it is best to think of a payment instrument as serving a means to an end rather than being an end in itself.

While not all forfaiters will agree that the following list is exhaustive, most practitioners would agree that a payment instrument should attempt to satisfy at least some if not all of the following criteria:

  • be independent from the transactions they finance, i.e. be 'autonomous and abstract';

  • benefit from legal certainty;

  • be as legally straightforward as possible, but capable of some flexibility;

  • be tradable;

  • enjoy best possible capital treatment; and

  • enjoy favourable trade status in sovereign and private debt restructurings.

Instruments traditionally associated with forfaiting, such as bills of exchange and promissory notes, display a number but not all of these characteristics as some features have little to do with the legal nature of the instrument itself.

For example, negotiable instruments are not, per se, trade debt for the purposes of sovereign restructurings; their status will be derived from the underlying purpose for which they have been issued which could, of course, be for raising working capital. Such instruments can also, in some circumstances, give inadequate rights to their holders, e.g. the lack of an ability to accelerate payment, as in a loan, although this can sometimes be overcome by the use of side-letters or other collateral agreements. Legal certainty and tradability are, however, close to the ideal.

The BPO benefits from a set of specific rules published by the ICC (the URBPO),4 which give certainty and provide for instrument autonomy in the same way as letters of credit. Similar issues with trade status would, however, arise as above. The assignability of BPOs is currently limited to the banks within the closed BPO system which precludes them from being traded unless additional contractual rights are granted.

Book receivables are forfaitable. Here the principal issues tend to be dependence on, and vulnerability to, the underlying transaction and legal certainty. Contractual wording can, to some extent, overcome this.

In short, 'traditional' forfaiting has always accepted some commercial and legal limitations to the instruments it deals in and there is, consequently, no reason in principle why more recent instruments cannot be forfaited.

URF800

The Uniform Rules for Forfaiting (ICC Publication No 8005) are published by the ICC and are the fruit of a four-year collaboration with the ITFA. The drafting group consisted of experienced professionals from the forfaiting, documentary credit, and wider trade finance community, as well as leading trade finance lawyers.

The URF was implemented on 1 January 2013, but must be incorporated into relevant contracts to have effect and govern the transaction in question. Its vocation is to serve the same purpose in the forfaiting industry as the Uniform Customs and Practice for Documentary Credits serves in the documentary credit industry.

The URF contains 14 clauses or articles and deals with important issues such as the determination of what is satisfactory documentation and the degree of recourse to sellers.

The meaning of 'without recourse'

It is considered to be a fundamental characteristic of forfaiting that the buyer will not have any recourse to the seller. Indeed, this is the origin of the word 'forfaiting'. Given the liability of endorsers of negotiable instruments, this principle resulted in the practice of qualifying endorsement with the words 'without recourse' or 'sans recours'.

It is not, however, literally true that there is never any recourse to a seller. There would always be recourse for fraud, for example, and it has long been believed in the market that forfaiters originating a transaction (so-called 'primary forfaiters') have a duty to ensure that the paper they introduce is legally valid, binding, and enforceable. The precise limits and constituents of this duty have never been legally tested, which is a testament to the integrity of the market, but lack of clarity on this fundamental point is not desirable.

The URF has therefore introduced a 'liability cascade' in its Article 13, which sets out the grounds for recourse to different parties. Some grounds, e.g. that the party has authority to enter into the transaction, are common to all parties, but thereafter Article 13 sets out specific grounds of recourse against each party. The party selling the transaction to the primary forfaiter (called the 'initial seller' in the URF) has the greatest liability since it is typically the closest to the obligor, e.g. the exporter. The URF makes the initial seller liable in the following circumstances:

  • it has not passed on information which it knew or ought to have known would affect the existence of the payment claim or any credit support documents;

  • it is not the sole legal and beneficial owner of the claim being sold free of any third party rights;

  • it has not irrevocably and unconditionally transferred the claim;

  • it has breached any of the terms of the payment claim or the underlying transaction; and

  • fraud in the underlying transaction, for example.

Primary forfaiters have a duty generally to take appropriate steps 'in accordance with market practice' to ensure a transaction is valid. Thereafter, subsequent sellers only have a duty to pass on such information as they have available to them.

Recourse is not, of course, simply a legal issue, but will have important implications for determining whether or not a 'true sale' has been achieved under applicable accounting standards. In the US, these standards are set out in FAS 125 while the applicable standards for IFRS are set out in IAS 39.

The US standard is stricter and requires legal transfer to have been achieved, while IFRS looks to the transfer of risks and rewards in the underlying instrument. Generally speaking, recourse is possible for matters which are within the control of the relevant seller, and Article 13 has been drafted in order to achieve this. Figure 1 shows the essential steps in any primary market forfaiting transaction:

  • the agreement between the forfaiter and the seller of the payment claim;

  • the delivery of documents relating to the payment claim and the underlying trade transaction, and the forfaiter's examination of those documents;

  • calculation of the purchase price and payment 'without recourse' to the seller; and

  • collection by the forfaiter from the underlying obligor who may be the avalising bank as above or the importer directly.

Set of principles

It is best to think of forfaiting not as a single product, but instead as a set of principles and techniques that can be applied to sell a wide variety of financial receivables. While this also means that it can be difficult to precisely define forfaiting, it draws attention not just to the accumulated wisdom that the industry possesses, but to an ability to grasp, integrate, and render tradable receivables that could not otherwise be monetised safely and securely.

Sean Edwards is chairman of the International Trade & Forfaiting Association and head of legal, Sumitomo Mitsui Banking Corporation Europe Limited, and. This article is an amended extract from Chapter 7, A guide to Receivables Finance, 2nd edition, published by ARK Group

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Figure 1: Structure of a typical forfaiting transaction - Primary market

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