All for one and one for all

Feature | 8 September 2016
Musketeers

When it comes to restructuring corporate debt,
care needs to be taken that trade is prioritised and the "each lender for itself" approach is suppressed
for a better collective outcome, says Geoff Wynne

In a market of low commodity prices and global trade growing at marginally less than world GDP, it is no surprise that some trade finance facilities are looking distinctly fragile. This article takes a closer look at restructurings involving trade finance obligations and, importantly, sets out the advantages of giving "true" trade debt priority.

Historic context

The argument started way back in the 1980s, particularly with the Latin American debt crises, where short term debts were paid - country restructurings paid short term debts because they matured quickly and should be outside long term restructurings. There was an assumption that because it was short term, it was trade debt, but this was not always the case.

There is certainly no evidence that any legal system actually grants trade debt priority. But as many know, the argument resurfaced in 2008-09 after the financial crisis, particularly when looking at the bank restructurings in Kazakhstan.1

Definitions were crafted for trade debt and its priority in a number of cases. Each was different and in some cases trade debt (as defined) was paid off in full. These restructurings went through a court process.

Since the financial crisis pre-export finance (PXF) facilities have been getting caught in restructurings. It happened in Russia and it is happening in Ukraine.2 So the discussion then was, what security would you give priority to? What would you recognise?

Recognising security

And certain people, of whom this author was one,3 said that structurally, you should recognise security given in the trade financings. So where these were PXF or prepayment financing and they created security, that security should be recognised.

The counterargument is that you might have security, but you do not have full security. In other words, at the time of the financial difficulty, you, the secured (providers of the PXF) cannot liquidate your security at that time to be repaid in full. And if you do not have full security, the restructurers will not believe you have any meaningful security and as a result, it defaults to what is called the 'liquidation model', which assumes that the business stops at that point.

That ignores, in reality, any security going forward because the commodity is in the ground, but if the company is in liquidation, it is not going to produce anything anymore, and therefore there is no security.

Even though the whole purpose of the restructuring is for the company to survive, organisers of restructurings sometimes do not recognise that future security.

In many ways, that had an adverse effect on the structure of trade finance because people ask if structured trade finance is worth doing if they are going to be caught out by the obligor's default.

Receivables in a restructuring

As the volume of PXFs and true prepayments to producers has diminished, interest in receivables finance has grown - either loans against receivables or indeed purchase of receivables.

And many believed that structurally, what they were going to do was to purchase trade receivables - in other words, these were payments made by a party receiving goods or services, and thus key to trading relationships. If the receivable could not be paid at the time, there was a suggestion that whatever happened to the paying party, that money would be paid because it was required for business continuity.

Here is another clue that there could be better treatment for these trade receivables. A payer will argue that they will pay their trade receivables in an ongoing business because they want to guarantee the source of supply. But as has been seen in a number of restructurings which are continuing, where the paying party starts looking at the receivables that it has, and says, "Ah ha! But within my receivables, there are those which I regard as short term supply of assets or goods to me, and those are the ones that I will pay. But unfortunately, creditors, many of you were generous to give me longer payment terms, and that's really like working capital for me, so it's more like finance, and I'm not going to pay as a trade receivable, I'm going to treat that as a finance payment and unfortunately I'm going to put you in the finance restructuring club".

Some people have taken it further to say that "When I'm looking at the receivables, I will pay trade receivables that are owed to suppliers, but I don't want to pay trade receivables that are held by a financial institution. And I am going to treat receivables that are owed to financial institutions as financial debt, even though it is in reality trade debt. If it was held by a supplier, I would have paid it." In other words, the argument that a receivable held by a financial institution is a financial debt and not a trade debt affects its repayment priority.

That seems to be defective reasoning, but once again it affects the ability to be involved in this financing if there is a danger of being treated differently and unfairly.

Types of financing

What is also interesting, if you look particularly at some of the larger borrowers, some of whom are in difficulties and some of whom are not and might be in the future, is that they are raising different forms of debt. So they are using structured trade products (PXF and prepayment financing), they are also involved in borrowing base and in reserve base lending. And in all of those structures, remember, there is security, but it is security that assumes that business will continue in the future, in order to realise all of that security.

There is an argument that revolving credit facilities (RCFs) are not trade finance. While the facility might just about be trade-related, it is in effect more like working capital. Perhaps the expectation, if something happens to the obligor who has an RCF, is that the claims under that part of the financings would not be treated as trade. But does it matter?

In other financings, a bank issues letters of credit (LCs), yet how do you treat the reimbursement obligation from the issuing bank if the bank is a confirming bank. If the bank is an issuing bank, what about its claims against the applicant. Are they trade? Are they trade financings?

The regulators started introducing a phrase called "self-liquidating" which meant that they began to think about whether LCs were in some way something special.

The problem was the self-liquidating determination assumed that the bank that had the obligation to pay out on the LC, held onto the goods, represented by the documents of title presented under the LC and therefore held security. As many know, that is unlikely to be the case. In reality, the LC is used for payment of goods and the goods will be on sold into other parties. The bank does not hold the documents of title for very long.

There is still a debate as to whether there is a thing called "self-liquidating LC", and this might be a clue as to how one can get better treatment.

If a guarantee was issued for trade purposes, can the reimbursement obligation under the guarantee that was issued, result in some sort of better treatment?

Are any of these financings trade? Are they trade related? Does it matter? In whose eyes does it matter? Well, that will be important, because the result of what happens if something goes wrong may very well be determined by the view that is then taken in relation to the debt that is held.

Where financing goes wrong

The first question is, where does the creditor rank if its loan or receivable is not paid?

The obligor of that instrument at that particular point is unable to pay. Is its position just an unsecured creditor? Or can it do better? Should it do better than being just plain unsecured?

The first point to look at is: can the creditor deal with its secured position? Does it have security? Can it keep security over the goods that it has financed, sell them, and keep the cash?

How long can it continue that position against the pressure building up, about joining with the parties trying to restructure. What arguments can a creditor make? Can it get better ranking in the insolvency or the reconstruction of a producer or a buyer of goods? What sort of arguments are there left to use? What position would one take as a creditor that felt it was involved in the narrow financing of the trade business of the party that is now in difficulty and what can be done?

Stance in restructurings

Does one just try to exert pressure by holding on to security and security rights and saying "try and restructure around me"?

When this author was involved in a restructure for a bank which had secured its structure, it held onto its position for a good few months against growing anger from a number of other banks. But the result was, since the company continued to perform and since the bank held security over the sale contract, it was getting cash which it said it was allowed to keep and not put back into the restructure. In the end, there was a great deal of pressure on the bank, and there were also suggestions along the lines of: "if you think you've got an assignment, we're just going to stop that contract and we'll find a series of other contracts to sell the commodity, and one way or the other, you will be dispossessed of your security rights." That ultimately got the bank around the table to discuss what to do.

If there is a restructuring, who runs the negotiation? Because that is quite an interesting and challenging question. Who runs it will depend on what view is taken on ongoing business or liquidation model. Most of the time, the larger lenders and debt providers are doing this on an unsecured basis. If they are banks, they are doing it on an RCF or equivalent or they may well be bondholders - the combination of the lenders and bondholders may well mean that they control the creditors' committee - they drive the structure forward -and they want to achieve the best deal for themselves. That is really at the price of anybody else.

They will look at how the company can survive, they will look at whether new money is needed, and of course the general proposal is, "let's put new money in, but actually, we - the creditors committee (set up to run the restructuring) - will put the new money in. And of course, it's new money so we're going to take super security in relation to this because that way, we'll put in that money, we'll charge a lot of interest for it and we'll get it out first".

When you have these negotiations, there are other parties involved. First of all, many of the loan arrangements are not bilateral; they are syndicated loans. And as somebody said only the other day, "I find myself quite often a minority lender in a syndicated transaction. Who my fellow lenders are is becoming more and more important to me".

This concept of, not KYC (know your customer) but KYL (know your lender), know your fellow lenders (KYFL) is becoming increasingly important to a lender. If one is going to be involved in the restructure, one would like to know that the agent is going to handle this professionally, is going to come to the participant and talk to them, and that the syndicate are not going to be held to ransom by a recalcitrant small lender, who will not vote in favour of any situation that requires 100%.

This is an interesting point - whether in fact one goes back into document arrangements to make sure that it does not get held to ransom in trying to achieve some form of restructuring by an individual who says, "I just don't want to know. I'll sit where I am and you can come and buy me out."

The last group to discuss are those who provide the credit support - such as insurers. The problem is that they quite often express the view to their insured as being, "Just act as if uninsured." Which does not help when one needs to make decision A or decision B.

Generally speaking, one would expect that the insurer, the guarantor or anyone sitting behind, would accept its interests were best served by joining some form of restructuring if that looked like keeping the company going and achieving repayment.

The problem then is what to do with trade debt? Analyse it first. Is there anything that one would regard as trade debt? Is there anything that, when looking at the restructuring, ought to be dealt with? Quite often, a restructuring is driven as much by the debtor as it is by the creditors because depending on how the restructuring proceeds, there is an issue of whether the trade gets paid, gets better treatment, or whether it is subject effectively to the same haircut, if that is what is required to proceed.

It is often the case that time is against any complex form of restructuring because at various stages, there are parties who can pull the trigger. An interesting dynamic is if a creditor has a debt owing to it, if it is a lender and its loan hit repayment date and repayment is not paid, it has a right to be paid. It may well be able to accelerate at that point. If it is a participant in a syndicated loan and the repayment is not due for some time, it may not be able to do anything.

Who can pull the trigger?

So the question is, is there anyone who can pull the trigger and should they be dealt with first? Should short-term receivables be paid because they are clearly going to be due and payable and somebody may take action in relation to it?

The liquidation model is not a useful idea when there is layered debt with different forms of security but it does equalise the parties. In liquidation, everyone is unsecured, so the restructuring is based on this and the restructurer having control of payment flows, having control of all the security.

Then one should ask: "who can call default?" Can the number of loans repaid at one time be increased? Can there be some sort of standstill? And what is interesting, logically, is that a standstill is a good idea because it at least gives time to reflect but in many ways, a standstill can be the slippery slope to being obliged to restructure.

The liquidation model, if put into practice, has the most uncertainty in most jurisdictions, and that probably includes the UK too. One loses the contractual right to discuss things and the law takes control.

If one thinks about its own position if one is a senior creditor, i.e. unsecured, its position against a subordinated creditor is to say, "I'm not going to let you have any control at all of what's going on because I want to be able to work out the best thing, and ultimately, if there's a liquidation I get paid first and you are subordinated."

Perhaps there should be a reverse subordination, in other words, to say at the outset that the true trade creditors should get the benefit of a continuing business, and that consequently the unsecureds should agree that they will not liquidate for the purpose of depriving those who have security of their security.

Essentials of restructuring in a trade context

The essential in a restructuring trade context is to keep the company going. There is no doubt that when documenting transactions, one should be looking at producing something that is designed much more to keep the company going, particularly when there is a structured transaction, than creating a transaction that has trip wires that can in fact force a company into liquidation.

  • Keep the company going. Documents that have 26 events of default, when in reality the lender actually wants to keep the company going, should not be creating that number of defaults.

  • Respect the financings structure and avoid liquidation. If one does this, then structured secured trade has a better chance of getting paid ahead of the unsecured. There should be flexibility in the structure and in the documents to avoid defaults to start with, and then flexibility in the restructuring to avoid throwing it into default.

  • Flexibility from all lenders. In practice, that does not happen and that is the problem. There is always somebody who has a better idea, somebody who is trigger happy and as a result of that, it is difficult to keep voluntary restructurings going if the business continues to take a down turn or if everybody is not involved.

Some examples

Metinvest faced the issue of how to treat its PXF lenders when its 2015 eurobonds needed restructuring (see note 2). One gets the feeling with Metinvest as one did with RUSAL that it was too big to fail and too complex, but what is good news and will take structured trade forward is that they did not dismantle the PXF type facilities. They kept them going and they kept the security going forward.

Abengoa, the Spanish renewables corporate kept insolvency at bay because its creditors agreed not to proceed with insolvency. It has recently landed a €1.17bn debt for equity rescue package.4

How to move forward

Can one put trade debt in a better position to improve the number of financings going forward? Is there any likelihood of legislation to achieve this?

Legislation is unlikely because ultimately, it needs to cover the jurisdiction of the obligor and that takes one into all sorts of emerging markets where that may not be possible. In any event, when all financial creditors agree that trade should get a better position, that control point depends on who becomes the lender because if a company is in financial difficulty, the debt may well be transferred to what one might call vulture funds and the like, whose interests are very different.

If they are buying the debt at 20, they make the profit at 30, they put that money in a bank and consequently, there is a question as to whether there would be a better way of controlling who might become a lender so that all the interests are aligned.

Anyway, if the interests are aligned, would it agree to priority for true trade? What can true trade be? The examples of the narrowest forms of true trade debt are those arising from goods and services for import or export, where there are independent third parties involved, and perhaps they are short-term. So bear that in mind as a conceptually working definition for true trade, if one wants to deal with true trade.

Respecting structures

Now here is the revolutionary bit. Can there be general agreement that preference is for a workout solution and that that workout solution, should itself contain principles that grant trade, true trade or however it is defined, as a priority?

If this cannot be legislated, what about some guiding principles being produced by the industries where the trade finance business is working? Would BAFT, the ICC Banking Commission or the WTO support this, so that a growing number of bodies take the line, "Look, in order
to encourage trade, we need
to make sure that there is
priority given to trade debt."

If the market can go down that route, will the regulators accept that where this arrangement is in place or is bought into, that trade should be treated as having priority in a regulatory sense, and consequently, regulatory capital relief can be given to the trade debts that have been structured within this agreed preference.

Now this is a big step from where regulators currently stand - they appear not to understand trade and trade finance.

The point here is that, if this can be done, this could well make trade finance more attractive in a way that it is not currently as attractive as it could be.

Is it worth doing? Is this idea worth proceeding with and how can the market go proceed with it? The guidance then becomes important because it can be, in some ways, built into a voluntary code, but a code that will be followed.

Restructuring of debt still remains problematic if one is a trade finance provider. While one can certainly get oneself into a better position by structure, what is more important is how to put pressure among the market players and among those who restructure and with the regulators to obtain better results for trade finance.

This article is based on a Sullivan & Worcester breakfast briefing held in June 2016 in London. Geoff Wynne is a partner at Sullivan & Worcester UK LLP

References: 
  1. See www.tfreview.com/node/7493

  2. See coverage of Metinvest at www.tfreview.com/node/12046

  3. The author was acting for Alliance Bank in Kazakhstan during the restructurings. See www.tfreview.com/node/5402

  4. See the WSJ report at http://on.wsj.com/2bCzc6L

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