Feature

posted 30 Nov 2001 in Volume 5 Issue 3

Voulez-vous forfaiter avec moi?

For those in the trade finance market unfamiliar with forfaiting, who want to know the similarities with factoring, and are curious to know why the financial technique is less popular in North America than in Europe, Saturnino Lucio, President at Lucio Bronstein Garbett Stiphany & Allen, in Miami, gives his impression from a US perspective.

Voulez-vous forfaiter avec moi? The question has to be asked, since only a smattering of banks are willing to engage in this type of trade financing activity, at least in the US. In Europe, forfaiting has been an accepted form of financing trade receivables, and there is great experience in this respect particularly among financiers in the UK and in France, where the term originated (ie, to surrender or release one’s rights). It is also an operation used, albeit even more sparingly, in other parts of the world. It is mostly an international, cross-border type of financing, but there is no logical reason why it should not applicable to domestic sales as well.

Forfaiting involves the purchase of trade receivables without recourse, meaning that the purchasing bank or finance company cannot claim against the original trade creditor in the event that the trade debtor refuses or is unable to pay its obligations when due. A frequent exception is when non-payment is due to a trade dispute between the seller and buyer, who claims the seller did not ship the right goods or otherwise committed fraud in the transaction. This risk is often mitigated by requiring the seller to complete its performance (eg, shipment) before conducting the forfait transaction, while at the same time having the buyer acknowledge the goods are conforming (through preshipment inspection or otherwise), before the forfaiter disburses any money to the seller.

By contrast, ‘factoring’ (much more common in the US) involves the purchase of trade receivables with recourse to the selling creditor (as well as against the debtor under a subrogation-type theory). The documentation requirements for engaging in a factoring transaction are also generally more complex than those involved in a forfaiting operation, and it is not uncommon to see multi-page agreements. These could contain provisions allowing the factoring company to obtain a security interest over the trade goods the subject of the receivable (which can be very difficult when dealing with moveable goods under the UCC and under the secured transaction laws of some countries). There could be very detailed representations and warranties by the receivables debtor and by the selling creditor. The factoring company may have to assume the administration of the collection of the receivables, and may be worried about ongoing operations between the buyer and seller. The factoring agreement could contain provisions for creating a growing ‘reserve’ base of funds to function as collateral, and so on.

On the other hand, a forfaiting transaction usually involves the buyer’s acceptance of a bank draft or other written acknowledgment of debt by the debtor, and perhaps a bank guaranty or ‘aval’ by a bank selected by the debtor. Of course, the foreign bank granting the ‘aval’ must satisfy itself of the creditworthiness of the debtor, may request a position over assets of the debtor, and will exact fees for acting as the guarantor of the transaction, in much the same way that a bank would if asked to issue a standby letter of credit to guarantee the performance of an importer. In fact, a forfait-with-bank-aval and a trade transaction supported by a standby letter of credit are very similar. Whether the ‘discount’ charged by a forfaiter is competitive with the fees charged by a factoring company (which could include a flat or time-based discount fee, an option or commitment fee as well as a flat service fee) compared to the cost of other forms of risk mitigation (eg, the issuance of a bank standby letter of credit or the insurance premia charged by a credit insurer), is an issue that can only be answered on a case-by-case basis.

There is an active and established world secondary market for forfait obligations. Most of these transactions are denominated in some form of hard currency, ie, the US dollar, principally because soft currencies may be subject to sudden devaluations and/or access to such currency may be restricted by the central bank where the soft currency is issued.

Bankers’ favourite

There is a certain simplicity in engaging in forfaiting operations. Not only is the transaction less complicated in nature, requiring minimum documentation (which makes it a favourite of banks though perhaps not of lawyers), but for the seller in the transaction there is an elimination of all credit risk, the freedom from credit administration, and the possible acceleration of payments agreed to be made by the debtor under a deferred payment plan. Sellers can offer extended financing terms to their buyers, ranging from six months to 10 years (usually three-five years), which may facilitate sales, particularly to buyers in developing countries. Factoring tends to be shorter-term in nature.

Forfaiters, unlike certain governmental insurers, are not concerned with the nationality of the vessel on which the goods are transported or the national content of the goods, for example, and do not require the selling creditor to retain some portion of the risk ? and the discount charged by the forfaiter is often included in the original selling price of the goods, so that the seller is essentially made ‘whole’, even after engaging in the forfaiting operation. Banks which engage in forfaiting operations therefore rely more on the creditworthiness of the buyers (eg, US Fortune 50 companies that buy from small foreign suppliers) than the creditworthiness of the seller(s).

The difficult part of forfaiting transactions occurs when a foreign bank aval is not available, either for reasons of cost or of the lack of creditworthiness of the buyer. In that event, many forfaiting transactions just do not take place, although there are some forfaiting companies which then obtain a collateral security interest over the goods (which may be hard to do, particularly after the goods have been received by the buyer).

Nonetheless, some banks in the US and elsewhere will still engage in forfaiting under the following limited circumstances: (1) the buyer executes an unconditional (irrespective of any trade disputes with the seller) and absolute promissory note in favor of its holder; and (2) there is a bank or finance company, usually with an office in the debtor’s local jurisdiction, which previously commits to buy the promissory note from the forfaiter. Note that obtaining a foreign bank aval is conceptually similar to having a foreign bank ‘commit’ to buy the paper from the forfaiter – the major difference seems to be that, in the former case (aval), the foreign bank is usually found by the buyer and, in the latter case (commitment to buy), the foreign bank is usually a correspondent bank of the forfaiter with whom it has lots of experience and perhaps even holds correspondent bank balances. There is always the counterparty risk that the local bank does not perform on its stated intention to buy the promissory note from the forfaiter, but that appears to be rare.

All of which requires the forfaiter to have good correspondent banking relations and good communication with all of the parties to the transaction. Then it becomes just an issue of how “rich” the discount becomes, and who shares and how much in such discount.

One important possibility is to draft the promissory note in a form that, under local law, would qualify as an ‘executory’ instrument (eg, a ‘pagaré notarial’ in the Dominican Republic), meaning that the holder can proceed very quickly against the maker (rather than waiting for a long and slow local judicial process) and even begin place an embargo on his goods under certain local laws. Having an executory instrument usually requires the signature of the promissory note in the local language, signed within the country in the presence of a registered notary public (whose fees then have to be added) and the promissory note must be specific as to interest rate, amount due and maturity date without reference to an external source.

Local laws

Obviously, the forfaiter does not want to become involved in local enforcement proceedings, but the local bank considering buying the instrument may regard these features as a plus. Nonetheless, promissory notes used in forfaiting transactions tend to be very simple and are usually drafted in English. Accepted drafts sometimes qualify as executory instruments under some local laws, but having a promissory note is better and the laws do vary in how they treat accepted drafts (eg, the obligor of a draft may have more defences than the maker of a promissory note). It has been my experience that forfaiters prefer promissory notes rather than other types of ‘accepted’ paper. Some are even known to extend the date for repayment if the buyer agrees to sign a promissory note.

A problem that sometimes arises is that the seller may have previously pledged all receivables to a financing institution, in which case the consent of that bank may need to be obtained for the forfaiter to feel more secure. Since the effect of a forfaiting operation is to immediately put dollars in the seller’s pocket, however, most banks with a global security interest on the assets of the seller would not likely object to subordinating their interest in the proceeds of specific sale transactions.

The big question, of course, is can the two conditions noted above be met in a particular case? In particular, will the buyer be willing to sign a promissory note (particularly an executory promissory note) and does there exist a local bank willing to buy the promissory note offered by the forfaiter? That may depend on a number of circumstances, including the risk appetite of the forfaiter.