1 Executive summary
For some years, so called "diverted" or "borrowed" trade finance structures have been popular in the Agri business where major commodity corporates leverage against a physical shipment of goods to allow finance to be enjoyed by emerging market banks and other institutions. In a typical transaction the goods are sold through a chain enabling an emerging market selling entity to receive sight payment from the end buyer (a division of a major corporate) while their purchase of the same goods, often from an affiliate of the end buyer is through a deferred payment credit. In this way the intermediate buyer/seller and its bank enjoy the deferred credit period. For the major agri corporates, the schemes are attractive. They make use of an otherwise time and money consuming (and unproductive) trade flow and at the same time the profit generated in the deal is achieved while maintaining a non-recourse relationship with the financing bank which is content to take on the foreign bank LC reimbursement risk. Variants of these schemes, some involving accepted drafts and other payments methods have evolved over the last 20 years. Recently, however, the viability of these transactions has been questioned following the 2008 decision of a US court in the case of AWB (USA) Ltd v Standard Chartered Bank (the AWB case) where AWB were ordered to reimburse the bank for a shortfall which occurred when the underlying emerging market debtor defaulted.
The court's decision has raised the prospect that borrowers selling these transactions to their banks might find that the non-recourse structure they assumed to be in place might be dismantled if the financing bank alleges that the borrower has been economical with its disclosure of the detail of the transaction. While the facts of the AWB case probably takes it out of the ordinary type of transaction seen in this sector, the aftershock has sent many borrowers running to check that their paperwork doesn't leave them exposed to a similar fate.
There are concerns in some quarters, that the AWB case marks a further step along the way in the willingness of courts to offer protection to banks which have simply underestimated risks in a market where informed risk sharing and participation is the norm. Could the "McDonald's coffee case" approach of requiring every risk – however vanilla - to be spelled out and documented, be the death knell for these types of deal. Almost certainly not: but it remains to be seen how trade finance banks will react to the introduction of disclosure provisions, and whether or not courts in other jurisdictions will readily distinguish the bespoke AWB deal from the structure adopted in some of the more typical diverted trade financings.
2 Summary of the AWB (USA) v SCB case
The structures of the transactions in question here vary from deal to deal, but in general the terms "borrowed", "diverted" or "merchanted" trades describe a scheme in which a bank in an emerging, developing or simply undercapitalized market issues a deferred payment letter of credit in favour of a corporate commodity trader whose financing bank takes the country and credit risk of the issuing bank. This bank discounts or negotiates the deferred payment credit to cash which is then paid through the "borrowed" trade chain to provide the same issuing bank with immediate credit for the deferred payment period of anything up to 360 days.
The AWB – SCB deal followed in some respects a similar outline structure, beginning with an intra-group sale and repurchase of soybeans from AWB USA to AWB Geneva, allowing AWB USA along the way to take advantage of an American government agriculture guarantee ("CCC Guarantee") covering 65% of the value of the cargo when the product was nominally brought back into the US. The cargo was then sold to an Indonesian importer, with payment provided for by 180 promissory notes (the "Notes"). The Notes and the CCC guarantee were assigned to Standard Chartered under a Note Purchase and Assignment Agreement ("NPAA") at a discount, and so AWB USA gained immediate full payment for the soybeans. A letter of credit was opened by AWB Geneva, issued by ANZ Banking Group Ltd ("ANZ"), for the benefit of Standard Chartered. Separately, AWB Geneva protected itself by taking collateral and an indemnity from the Indonesian importer. The structure appeared on first examination to give the bank comfort that it would be repaid through the various payment instruments and risk mitigants established.
Following a squeeze in the price of soybeans the Indonesian importer defaulted and so a chain reaction was set off; Standard Chartered claiming under the LC; ANZ claiming against AWB Geneva and AWB Geneva claiming against the collateral of the importer.
AWB had structured the transaction in order to ensure that both AWB USA and AWB Geneva would be left 'whole' i.e. with a 100% recovery. Unfortunately, this fell foul of US law, as any monies recovered needed to first be applied to pay back the 65% guarantee provided by the CCC so Standard Chartered found themselves short-changed on the insurance proceeds. Standard Chartered sued AWB for the shortfall and argued on two fronts; firstly that AWB Geneva should not have been interposed in the transaction in such a way as to circumvent its rights (and, therefore, should not have taken the 'extra' security in the form of the collateral); and secondly that AWB had misled Standard Chartered, breaching the terms of the NPAA. Specifically, the alleged breach related to the legality of the transaction. Standard Chartered Bank succeeded on the first point and AWB were ordered to compensate their bank for the losses caused by that action.
Although Standard Chartered failed on the misrepresentation point (as it was deemed they were sophisticated enough to be expected to ascertain the legality of any given transaction on their own) it raises interesting points on the level of disclosure to be expected in these structures and how the test would be applied as against a bank that was, for the sake of argument, inexperienced in such transactions. In the current market there are banks with the liquidity to make an entry into this market but without much experience. The court accepted that absent knowledge or experience on the part of the bank, a borrower could in principle be liable for non-disclosure towards its bankers if the transaction was considered out of the ordinary. Corporates in AWB's place might therefore now consider that in order to protect themselves going forward, they should be transparent about the nature of the structure being suggested to the bank; and the bank, equally, might want stronger representations and greater due diligence carried out to ensure that the structure being put forward is watertight.
3 The implications of the AWB decision: the future for "diverted" trade financings
The AWB decision has a number of implications for these type of "diverted" trade finance deals and, perhaps more fundamentally, for the relationship between the banks and their customers in the trade finance market. These implications flow from the finding that AWB was in general terms under a duty to disclose to Standard Chartered the full details of the structure of the underlying transaction to which the NPAA related.
This decision was greeted with some surprise and concern in trade finance circles. Coming after the controversial decision of the English courts in the Mahonia case where the courts were prepared to consider downgrading the obligation of an issuing bank under a letter of credit where there was "illegality" in the underlying transaction, there is concern that that courts might indeed be veering towards a "McDonald's Coffee" approach on disclosure (after the celebrated 1994 US case where Stella Liebeck successfully argued that MacDonalds should have warned her that she might be burnt if she spilled hot coffee on her lap). Is it realistic to expect borrower and banker to go through a ritual of disclosure of matters they ought to know if they are lending in that market at all? It is generally accepted by most commercial players in this market that banks entering into these kinds of transactions, and assuming the role of either ANZ or Standard Chartered Bank in the AWB decision, are usually aware of the structure of the wider transaction, including the contracts to which it is not a party. Indeed, this was implicitly recognised by the New York District Court in the AWB decision by refusing to grant Standard Chartered's application for legal costs on the basis that Standard Chartered's failure to inform itself of all elements of the transaction amounted to the "equivalent of negligence". Nevertheless, Standard Chartered had succeeded on their main claim covering the overall losses they had suffered on the transaction.
Accordingly, the AWB decision, were its underlying principles to be followed in future cases, might yet expose a borrower to significant risks that it will face recourse from its financing bank. It follows from the rationale of the AWB decision that the only way that a borrower can protect itself with certainty is by ensuring that the discounting bank (or, depending how the transaction is structured, the issuing bank) does in fact inform itself (or receives information) of the wider structure of the transaction.
Technically, this should be relatively easy to achieve: By inserting an appropriately drafted clause in the discounting, assignment or other relevant agreement pursuant to which the Bank acknowledges and accepts the wider structure of the transaction. This is easier said than done, however. In the current economic climate, where banks are pushing for borrowers to accept more structured, security-laden deals with covenant-heavy facility agreements, it is unlikely that borrowers will meet with a lot of success in trying to get banks to agree to such terms, especially as these deals tend to be standard form low margin deals with little room for legal costs.
Without some degree of comfort, the borrower is at risk of being treated like an insured under an insurance policy with the sufficiency of his disclosure being evaluated at the time of the claim – or in front of a judge rather than at the time of the transaction.
So, is this the end of the road for "diverted" trade financings? There are some grounds for hope. Borrowers may succeed in negotiating their way around the AWB decision. Also, we may find that other jurisdictions come to different decisions, given the general market acceptance that banks in the market tend to be aware of the normal and variant structures of these deals, and have been aware for some time (as hinted at by the costs order in the AWB decision). There are also grounds to distinguish the AWB decision. In particular, the AWB decision involved (1) a US government-sponsored export credit agency being put out of pocket and passing on that loss to the bank, and (2) the goods being traded in a synthetic sale and repurchase at the start of the transaction where an "artificial" profit was created.
It could be, therefore, that courts in New York and elsewhere will find ways of distinguishing the AWB decision, and the problem for borrowers will thereby be alleviated.