Risk Sharing Techniques – Similarities, Differences and Consequences

Presentation by Hannah Fearn, Senior Associate Sullivan & Worcester UK LLP on 23 March 2017 At Pinners Hall, 105-108 Old Broad Street, London, EC2N 1EX

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Overview Unfunded risk sharing techniques

Different types of instruments › Guarantees › Demand guarantees › Risk participations › Non-payment insurance

Key features, similarities and differences

Consequences of characterisation › Regulatory regimes › Credit risk mitigation under the CRR

Conclusions › Some pointers on what to do

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Language and effect Guarantee

› A commitment of the guarantor to repay a debt if the original debtor fails to pay. › The Guarantor [irrevocably and unconditionally] guarantees to the Lender that

whenever the Obligor does not pay any amount when due under or in connection with the Facility Agreement, to pay on demand that amount as if it was the principal obligor.

Demand guarantee › A primary obligation on the guarantor to pay the beneficiary on demand where

the primary obligor fails to perform the contract. › The guarantor hereby [irrevocably and unconditionally] undertakes to pay the

beneficiary any amount up to the “Guarantee Amount” upon presentation of the beneficiary’s complying demand.

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Language and effect Risk participation

› Agreement of the participant to reimburse the grantor amounts unpaid by the borrower following a payment default under the underlying agreement.

› Following a “Default”, the Participant [irrevocably and unconditionally] undertakes to pay to the Grantor within four business days of the Grantor's first written demand, an amount equal to the relevant “Participation Portion”.

Non-payment insurance › Insurance protection against non-payment by the obligor under a specified loan

agreement. › The Insurer hereby agrees to indemnify the Insured in the Policy Currency for the

Insured Percentage of the Loss caused by Non Payment.

Drafting and terminology

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Key features: guarantees Example transaction: A parent company provides a guarantee in support

of a financing granted to its subsidiary › Guarantor typically connected to guaranteed party

Nature of obligation: Promise to ensure third party fulfils obligation and/or to perform in their place › Secondary obligation, contingent / co-extensive

Creation requirements › Requirements for a contract – consideration › Formalities - section 4 of the Statute of Frauds 1677

Key provisions › Indemnity › Waiver of defences and other lender protections

Disclosure: No disclosure requirement

Recourse: Indemnity from underlying obligor and recourse to other guarantors and security

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Key features: demand guarantees Example transaction: The applicant enters into a supply contract with a

third party. To protect against the risk of non-payment by the applicant, the third party requires the applicant to arrange for the issuance of a guarantee by a bank. › Commercial relationship between the applicant and the bank. The applicant pays

fee for issuance of the guarantee

Nature of obligation: Undertaking by one party to pay another party on receipt of a demand that complies with the requirements of the guarantee. › Independent, primary obligation not contingent on the underlying transaction

Key provisions › Short form, incorporates standard rules e.g. URDG 758 › No waiver of defences language

Disclosure: No disclosure requirement

Recourse: To the applicant through a counter-indemnity

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Which type of guarantee is it? Why does it matter?

› Independent or not? › When does the obligation to pay arise? › Formalities

Distinguishing a surety guarantee and a demand guarantee › Labels and language: courts will consider agreement as a whole › Nature of the guarantor › Context › Wuhan Guoyu Logistics Group Co Ltd v Emporiki Bank of Greece SA [2013] –

identified key factors indicating a demand guarantee

Drafting considerations › Consistency › Waiver of defence language may not always help › Uniform rules

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Key features: risk participations Example transaction: A lender grants a loan to a borrower and sells a risk

participation in 50% of that loan › Grantor pays fee to and/or shares profit element of underlying transaction with

participant › Underlying borrower may not be aware of arrangement

Nature of obligation: Promise to pay the lender an amount equal to the defaulted amount in an underlying transaction › Independent debtor / creditor relationship between grantor and participant › Alternatively, grantor may grant an interest in the underlying transaction

Disclosure: No disclosure requirement

Recourse: Recourse via the grantor sharing recoveries, or assignment of rights against the borrower

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Is it a swap? Why does it matter?

› Regulatory requirements applicable to derivatives › UK and US

Why might a risk participation be seen as a swap? › Credit default swaps used as a method of transferring credit risk › Protection seller agrees to pay par value of underlying bond on occurrence of a

specified credit event › Protection buyer pays a return › If credit event occurs, protection seller pays and the protection buyer delivers

the underlying instrument or its cash market value › Similar commercial effect

Comparing key characteristics

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Comparing key characteristics

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Risk participation Credit default swap Relationship to underlying exposure

Closely connected: Grantor owns underlying exposure. Total amount of participations cannot exceed total exposure

Potentially remote: No requirement to own reference asset

Trigger for payment / risk assessment

Default / non-payment by underlying obligor

Credit event – may include other events

Settlement and recoveries

Participant pays its share of each default. Grantor pays participant its share of any recoveries

Protection seller pays par value on credit event. Protection buyer delivers underlying instrument or cash

Market usage and secondary trading

Not subject to market pricing. Limited secondary trading

Market pricing and valuation. Traded on secondary markets

Documentation Risk participation agreement ISDA documentation

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Key features: non-payment insurance Example transaction: A bank lends an amount to a borrower, and takes

out an insurance policy against the risk of non-payment by the borrower › Insurance provider must be authorised to undertake insurance business › Commercial relationship – insurer receives a premium › Underlying borrower may not be aware of insurance policy

Nature of obligation: Promise to indemnify the insured for losses suffered as a result of non-payment

Key provisions › Subject to body of insurance law and Insurance Act 2015 › Requirement to mitigate the loss during a waiting period – typically 180 days

Disclosure: Insurer relies on disclosure of information by insured for its assessment of the risk › Disclosure subject to statutory or common law requirements – duty of fair

presentation under the Insurance Act 2015

Recourse: Subrogation to rights of insured against borrower › No direct indemnity claim against borrower

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Could any risk sharing instrument be an insurance policy? Why does it matter?

› Regulated activity subject to authorisation › Laws applicable specifically to insurance policies

How can we determine if an instrument is a contract of insurance? › Accepted that alternative instruments exist that have a similar commercial effect › Boundaries not always clear

CDS and insurance › Potts opinion › Dependence on existence of insurable interest

Definition of “contract of insurance” › No definitive definition › Common law definition – interpretation by the courts › Extended definition in context of regulation › Regulator’s guidance on common law principles that apply

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Could any risk sharing instrument be an insurance policy? Common law principles

› Extensive case law › Decisions fact specific

Prudential v. Commissioners of Inland Revenue [1904]: any enforceable contract under which a 'provider' undertakes: › (1) in consideration of one or more payments; › (2) to pay money or provide a corresponding benefit (including in some cases

services to be paid for by the provider) to a 'recipient'; › (3) 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.

Other principles drawn from case law › Form of contract › Protection provider › Pricing › Disclosure › Payment vs performance

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Credit risk mitigation Capital Requirements Regulation (Regulation (EU) No 575/2013)

› Eligible credit risk mitigation is used to reduce risk weighted exposure amounts for the purpose of calculating capital requirements

› “Unfunded credit protection” – 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 (Article 4(59) CRR).

An institution may use a “guarantee” or “credit default swap” as eligible unfunded credit protection (Articles 194(6), 203 and 204(1)(a) › Other types of eligible credit derivatives listed in Article 204

› No guidance on meaning of “guarantee”

› Is this intended to be construed in a broad way to refer to a range of direct unfunded credit risk substitutes including guarantees, demand guarantees, risk participations and insurance policies?

› There is some support for this approach in the guidance and in the approach taken by the regulators

› In this context, despite distinguishing features, different types of risk substitution treated as a single category

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Conclusions Variety of risk sharing techniques, which achieve a similar commercial

effect

Boundaries between different instruments are not always clear

Consequences of characterisation

Courts (and in some circumstances, the regulators) will consider substance of an instrument against variety of factors

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Any questions?

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Hannah Fearn Senior Associate

Hannah Fearn is a senior associate in the Trade & Export Finance team in the London office. Hannah’s practice area covers trade and export finance. Hannah has advised on a wide range of cross-border trade finance transaction in a variety of jurisdictions, with an emphasis on emerging markets.

She has acted for leading banks in the market and her experience includes advising on syndicated and bilateral pre-export commodity financings, commodity repo structures, letter of credit facilities, trade instruments, receivables financings and insurance policies. Hannah has advised clients on related regulatory issues, including sanctions arising out of cross-border finance transactions.

Hannah has advised a number of banks on the use of credit risk mitigation techniques under the EU’s Capital Requirements Regulation (implementing Basel III), including guarantees, sub-participations, insurance, cash on deposit and payment instruments such as standbys and demand guarantees.

Hannah is a contributor to A Guide to Receivables Finance, a special report from TFR published by Ark, and has contributed practice notes on a variety of trade finance topics to Lexis PSL.

Sullivan & Worcester UK LLP

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Awards & Recognition TFR “Best Law Firm in Trade Finance”

Trade & Forfaiting Review (TFR) named Sullivan & Worcester "Best Law Firm in Trade Finance" in its 2014, 2015 and 2016 TFR Excellence Awards GTR “Best Law Firm 2015 Poll”

Sullivan & Worcester UK LLP was top ranked firm in the Global Trade Review (GTR) Best Law Firm 2015 poll The Legal 500 UK 2016

Sullivan & Worcester UK LLP was ranked in the following category in The Legal 500 UK:

› Trade Finance (Tier 1)

Chambers UK 2016

Chambers UK ranked Sullivan & Worcester UK LLP, along with Geoffrey Wynne and Simon Cook in the following area:

› Commodities: Trade Finance (UK-wide)

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