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Post Credit Crunch – how resilient are trade finance structures and what to do if transactions start to go wrong?

Talk to be given by Geoffrey Wynne,

Partner, Denton Wilde Sapte LLP

on 22 October 2008

at 2nd Annual GTFP Bank Partners Meeting

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Introduction – areas to be covered

• Where we were pre-credit crunch and interbank crisis and where we are now

• What history teaches for the future of trade finance transactions

• Risk analysis and its place in trade finance• Use of trade finance structuring within and outside

conventional trade transactions• How to read warning signs early on and what to do• Conclusions

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Pre credit crunch and now

• Pre-credit crunch• an end to trade finance predicted – why?

• too low margins

• too loose structures

• commodity prices very high

• traditional borrowers access to other markets

• running out of tried and tested borrowers

• reluctance of many to choose new borrowers

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Where we are now

• analysis of what went wrong to cause sub prime crisis• BUT problems with interbank market• more solid structures• look at the old ideas of trade flows• lack of liquidity meant smaller transactions• will lack of liquidity mean no transactions?• commodity prices falling• cautious go ahead to structured transactions• not all will be financed

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Lessons of history

• Historically few losses in trade transactions• Apart from fraud, even fewer losses• Successful repayments turned on sound structures

• due diligence

• good monitoring

• ability to withstand minor problems

• All of the above together with the tougher analysis could mean:• reward for good structuring (including taking security)

• more reasonable (higher) returns to make it worthwhile

• BUT will/can lenders join with each other?

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The basic structure

• Key elements• Finance to exporter to buy/produce/export

commodity

• Structured because conventional balance sheet may not support lending

• Options• Security over commodity

• Security over export receivables

• Security over collection account

• But sufficient commodity/resources may not be there at the start

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Risk analysis and its place in trade finance

• There always has been risk analysis in trade finance• Almost by definition an understanding of the

underlying business and trade flows• “Cash is King” theory meant

• follow the commodity

• follow the cash

• self-liquidating transactions

• Hedging and other derivatives, risk mitigants were “add-ons” not replacement

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So what about risk? - 1

• Performance risk• producer

• commodity

• logistics

• Country risk• likelihood of government intervention analysed

• importance of commodity

• analyse borrower

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So what about risk? - 2

• Payment risk on commodity• buyer

• timing of payment

• price

• Structural risk• does it work?

• is it resilient?

• involvement of other parties

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Involvement of other parties

• Who are the parties involved?• do they help or hinder transaction?

• what do they do?

• Review of commercial documents• are they prejudicial to lender’s interests?

• are there any “gaps” that need to be addressed?

• do the terms enable the financing to be repaid on time and/or reflect term sheet requirements?

• How critical to the structure?

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Structural issues with some third parties

• Government• can the product be exported/exploited?

• can receipts be held offshore in foreign currency?

• Transporters/storers• do they have a lien for their fees?

• can rights to the commodity be identified for sale/security purposes?

• other areas of issue

• Interference by other creditors

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The imponderable risks

• Reputational risk• the Lender’s position

• external factors to the transaction

• Know your customer• track record works

• how to deal with new obligors?

• The tighter credit approach• encourages risk analysis

• can reward dealing with risk (Basel II for example)

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The risks considered• Transfer them

• other parties who accept risk:• insurers, hedge providers

• the risk participation market BUT

• credit default swaps etc. BUT

• Mitigate them• structure

• security

• monitoring

• Co-lending with multilaterals• Accept them

• BUT care to be taken

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Financing structures

• What are the options?• pre-export

• prepayment

• tolling

• pre and post shipment

• warehouse

• others

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Pre-export

Purchase/Sale Contract

EXPORTER BUYER

Undertaking to perform P/S contract and assignment of payment rights and possibly security over supplies

Loan agreement

Payment of balances

Assignment of P/S contract and undertaking to perform

Payments for cargoes

BANK

Physical Supplies

OffshoreOnshore

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Pre-export

• Funds directly to the producer• Taking the producer risk• Who will be involved in production/transportation?• Mitigants

• to cover production, country, payment risks

• Quality of sales contracts• Quality of buyers• Security questions

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Advance payment

EXPORTER BUYER

Physical supply

Advance payment

Purchase/Sale Contract

Balance payment (less interest)

Loan Agreement for all or part of advance payment

Assignment of Advance Payment

OffshoreOnshore

BANK

sells commodity (or uses it)

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Prepayment

• Funds to buyer• Likely limited recourse to buyer• Similar risks to mitigate

• production, country BUT payment less so

• Involvement of buyer mitigates• More control over contracts• Evidence of prepayment to producer• Quality of buyer and when full recourse arises• Security?

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Tolling financingraw material finished product

rail

railship

railwaybillB/L

rail ship

B/Lrailwaybill

transportation production

Supplier/Exporter

loadport Arrival port

Borrower/Exporter

Tolling Facility e.g.Mill

port BuyerEuropean

port

Onshore Offshore

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Tolling

• Performance risk of more parties• Possibly more than one country risk• Take out financing possible at each stage• Multiple financing options e.g. letters of credit,

guarantee, loans• Ultimate buyer risk BUT what is finished

product?• Security problems

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Pre and post shipment financing

• Product onshore• Product in bonded warehouse• Product onboard ship• Warehouse in OECD• Storage issues• Warehouse warrants

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Stock financing

• Product clearly exists• How to protect product?• Taking security• Price risk• Performance risk

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Others, e.g. countertrade

• Use of structure to allow for expansion of plant• Borrowing base structures possible• Use existing receivables to support expansion• Use of product to support acquisition etc.

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Look to other Commodities and Non Commodities

• oil v softs v metals• alternative fuels• term loans for softs• alternative suppliers• what non commodities?

• telecom receivables

• remittances

• other payments to government

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Securing the commodity

• Pledge security – principles• physical/constructive possession

• Warehoused commodity• warehouse receipts – not always regarded as

documents of title

• Perfecting the pledge over warehoused goods• Securing the commodity being transported

• bills of lading – what are they?

• other transport documents

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Securing the receivables

• Assignment of sales contracts• can a first ranking security interest be created?

• notices of assignment sent to buyers

• acknowledgement – will it be given?

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Taking the security

• Financing document governed by English law (or equivalent developed law)

• Temptation to use same law for all security documents, but local law on security/pledges and warehousing will apply

• What is local law and can it be relied on?

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The security

• The considerations• the ideal v. the practical

• the commodity and/or the proceeds

• is sufficient security available?

• why do you want it?

• is there enough cash?

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Obstacles to effective security

• Inadequate laws on security• Costly to create• Enforcement of security

• can be costly, lengthy and unpredictable

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One recurring idea is use of special purpose vehicles

• What is an SPV?• Set up only for the transaction (single purpose)

• Limited recourse

• Increased use in commodity financings• Ownership of commodity

• Standby purchaser

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Why use an SPV?

• SPV as Borrower/Obligor• Isolate the transaction

• Ring fencing of assets

• Protection from insolvency of Borrower

• Owning is better for realisation purposes• But recourse limited to transaction assets

• Guarantees

• Other security/support

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Structuring to reduce financing costs

• benefit from strong party• supply chain financing• financing segments of supply chain• export and transportation• split out risks to different parties• better quality receivables possible• will it work?

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Other uses for trade finance structuring

• Start with a trade flow• Use it to service financing in whole or• Use it to finance increase in production etc.• Where flow is available (or will be):

• financing acquisitions of companies, businesses

• finance acquisition of assets which will produce more cash flow

• assets can be within production cycle or even outside it

• even give flexibility for use of funds within constraints

• borrowing base facilities

• new holders of debt

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The warning signs• Lessons on structuring may be learned• Taking of security has its place

• BUT who wants to enforce?

• Monitoring is the way forward• done by lender

• done by third parties

• the empty Collection Account is no surprise• if no production

• if no control of receivables

• React early to the warnings• so not always the time to enforce

• may be necessary to restructure

• recent examples show this

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Some conclusions

• The crisis may ultimately have had some positive effects on trade finance

• Keep in mind where and what transactions went wrong and compare trade finance transactions

• Things can still go wrong• BUT many can be concluded profitably

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Changes in the market

• More variety of structures• The strong get weaker structures?• That does not mean everyone will have this• The weaker may still get no money• Need for new borrowers may mean more

structuring• Commodity prices an issue• Risk analysis points to more care needed

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Is STCF resilient?

• Sovereign interference• Importance of commodity

• Country restructurings generally ignore trade finance

• Important to keep third parties involved and committed

• Taking security avoids actions by other creditors

• Good structures keep transactions running

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ContactGeoffrey Wynne is a partner in the Banking and Financial Markets Group of Denton Wilde Sapte LLP. He is head of a group specialising in Trade and Emerging Finance and Project Finance. He has extensive experience in banking and finance, specifically corporate and international finance, bank mergers, acquisitions, conversions and restructurings, trade and structured trade and commodity finance, structured finance, asset and project finance, syndicated lending, equipment leasing, workouts and financing restructuring, leveraged and management buy-outs and general commercial matters. He has advised extensively many of the major trade finance banks, trading companies and other market participants around the world on trade and commodity transactions in virtually every emerging market including CIS, Far East, India, Africa and Latin America. He has worked on many structured trade transactions covering such diverse commodities as oil, nickel, steel, tobacco, cocoa and coffee. Tel: +44 (0)20 7246 7050Fax: +44 (0)20 7246 7777Email: geoffrey.wynne@dentonwildesapte.com

Denton Wilde Sapte LLP is a major London-based international law firm with 180 partners, more than 500 or so other lawyers and nearly 1,400 staff in total in their offices around the world. It has other offices in Abu Dhabi, Almaty, Cairo, Dubai, Doha, Istanbul, Moscow, Muscat, Paris, Riyadh and Tashkent and alliances with several law firms in continental Europe. Denton Wilde Sapte has associations in Algeria, Botswana, Ghana, Kenya, Mauritius, Nigeria, Rwanda, Tanzania, Uganda and Zambia and close working relationships with other African firms.

Its leading trade and export finance practice was named in 2008 as Best Law Firm for Trade Finance by three leading polls. For the ninth year running, by Trade Finance magazine, fifth year running by Global Trade Review and the fourth year by Trade & Forfaiting Review.

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Any questions?

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Post Credit Crunch – how resilient are trade finance structures and what to do if transactions start to go wrong?

Talk to be given by Geoffrey Wynne,

Partner, Denton Wilde Sapte LLP

on 22 October 2008

at 2nd Annual GTFP Bank Partners Meeting