By Amanda Montano, associate, and Talal Khan, trainee
In the latest edition of Sullivan's webinar series, Geoffrey Wynne, Head of the Trade & Export Finance Group at Sullivan's London office, discussed key aspects of structuring trade finance transactions, including best practice approaches and risk mitigation. Geoff was joined by Jacqueline Cook, Of Counsel and Senior Knowledge Development Lawyer, who gave an informative overview of the key aspects of security used in trade finance structures. Here are some of the key areas discussed.
A risk based approach?
The recent Wolfsberg Group report on "Demonstrating Effectiveness"[1] took the view that a "risk-based" approach might be best when it comes to trade finance. This would require parties to focus initially on the risks inherent in a transaction and evaluate them to establish whether a risk should be eliminated, reduced, mitigated or allocated. Such considerations drive home the importance for financiers and their counterparties to discuss how to balance their expectations versus their needs.
What are the risks?
The Financial Conduct Authority (FCA) has named four key areas for trade finance practitioners to concentrate on with a particular focus on risk assessment:
The FCA emphasised the need for (i) credit analysis of all trade finance counterparties, including all parties with an interest in the transaction; and (ii) due diligence on other parties with an interest in the transaction, where appropriate, with a view to identifying fraudulent activity. When it comes to approving transactions, financiers should focus on both the financial and non-financial risks posed by end-buyers, as well as transaction payments (specifically, the need for more effective risk management in relation to end-buyers, credit insurance arrangements and security).
Security in a trade finance transaction
Security plays a key role in trade finance transactions and relates to the commodity itself, sale proceeds and cash flows. As an asset's nature can change over the lifecycle of a transaction, the question of how to protect that asset, its value and cashflow is a crucial part of structuring the security package.
A typical security package would include an assignment of receivables, a charge over a bank account and a pledge over goods and documents of title, depending on the commodity at the heart of the transaction. Key features, such as when to give notice of an assignment can be a decision based on legal and commercial considerations. While it is a legal perfection requirement to create a statutory assignment, there is also the commercial question on when and if to give notice and until then rely on an equitable assignment.
A key feature of a pledge of goods, delivery, actual or constructive delivery, is required so possession is transferred to the secured creditor. Of course, English law is in the process of reform to remove the blocker which currently means that English law does not recognise possession of intangible assets.[2] With respect to fixed and floating charges, financiers looking to take security should be aware of two key points in particular: (i) the actions of parties may affect a fixed charge, effectively rendering it a floating charge; and (ii) that a floating charge ranks behind a fixed charge and so, under English law, at the point of insolvency, is subject to claims by preferential creditors and the prescribed part of the floating charge assets available to unsecured creditors, the latter up to a maximum threshold.
The international nature of trade means parties looking to take security should consider legal advice on any local law requirements to perfect the security e.g. any requirements for additional perfection or registration requirements, such as notarisation, legalisation or translations.
What can go wrong and how to avoid it
A financier's primary focus may not be on taking security and enforcement but rather ensuring the return of cash advanced in relation to a transaction. One solution is to ensure that there are sufficient checks throughout the lifecycle of a trade transaction e.g. on the goods themselves. Has the receivable been properly created and paid? Are there safeguards in place to ensure that it is not sold or charged to someone else? Taking security is not intended as an alternative to these checks, particularly as the enforcement of security takes time and often brings its own issues. Furthermore, it is worth bearing in mind that trade finance is not immune to the risk of fraud. Financiers carrying out adequate due diligence should be more likely to avoid fraud.
Potential solutions and the future of trade finance
Some fintechs are working to solve duplication of documents using platforms. The World Blockchain Trade Consortium has focused its efforts on creating a multijurisdictional decentralised registry for invoices. This would allow financiers to cross-reference an invoice on the registry before financing it. Open banking may be useful with the possibility of financiers incorporating third party solutions into their in-house systems. The success or failure of these projects will depend in part on the regulatory environment in which they operate. Data protection legislation, confidentiality duties and the approach regulators take to protecting financiers are also important.
Ultimately, the extent to which trade finance practitioners can protect the asset, cashflow and value of the asset and avoid the pitfalls discussed will rely on them carrying out robust due diligence checks and the effective structuring of trade finance transactions.
Please click here for a link to a video of the webinar.
For further information on the importance of security in trade finance transactions, please contact Geoff Wynne, Jacqueline Cook or your usual contact at the firm.
[1] https://www.wolfsberg-principles.com/sites/default/files/wb/Wolfsberg%20Group_Demonstrating_%20Effectiveness_JUN21.pdf
[2] See the Law Commission website and consultation and draft Electronic Trade Documents Bill https://www.lawcom.gov.uk/project/electronic-trade-documents/