There has been an upturn in the frequency of trade finance workouts, restructurings and formal insolvencies. Susan Moore and Luci Mitchell-Fry look at some key issues that banks face when trade finance lending passes to "bad bank".
The bank's decisions at every stage of a trade finance transaction are critical: at origination; when following a workout/restructuring; and once a formal insolvency process becomes a reality.
Trade finance is self-liquidating: the producer or trader ("offtaker") uses the finance provided by the bank to buy goods, the sale of which will provide the funds to repay the loan. This allows the bank to focus on the transaction rather than the wider financial health of the borrower. The borrower's creditworthiness is important; but the trade flow is king.
This shapes the nature of the bank's security. The security will vary depending on the locations and jurisdictions involved. However, the suite of security documents might typically comprise security over goods and documents of title (perhaps by pledge); contract rights (by assignment); and cash balances (by fixed charge security). Buttressed by credit support (credit insurance, parent guarantees, export credit agencies etc.), the lawyer's pen tracks the trade flow at every step.
The bank is naturally most concerned with the ability of the producer to produce and deliver goods to its end buyer. It is vital to consider what happens when there is a break in the chain. It is easy to overlook the jurisdictions in which any insolvency issues might play out. Local counsel can advise not only on whether security is valid, but also on how to enforce it.
The bank's internal processes once drawdowns begin (its "collateral monitoring") are key. They must be rigorous. While facility agreements typically provide the bank with strong powers to demand information from the borrower, the bank must exercise these with diligence and consistency. The quality of the information at the bank's disposal will determine how successful the outcome to any workout may be. Typically, alarm bells will ring when payments are not made into collection accounts. However, this may already be too late.
Whatever the trigger for involving the bank's restructuring team (and the dreaded move to "bad bank") in a transaction, the bank has a natural opportunity to pause for breath. New faces now look at the deal in isolation from the front office relationship. The bank should plug any omissions or gaps in the bank's internal procedures immediately.
Even from this early stage insolvency filings should be monitored in each jurisdiction. Whether the bank forms part of a syndicated facility or stands among competing bilateral lenders, it will want to ensure it is driving, not reacting, to events.
At an early stage the bank must assemble a team of advisers, including overseas counsel, to ask the right questions (and interpret the answers) before a formal process becomes a reality. Independent business reviews are common; but they, too, are limited by the quality of the information at the accountants' disposal. The bank should consider all options. Clearly a successful workout is going to offer a much better outcome than the certain value destruction of a formal insolvency process and this must be the aim of the bank. At the least, the bank's lawyers should prepare a position paper addressing all issues and the effects of all actions.
A formal insolvency process
The multi-jurisdictional nature of trade finance structures can make formal processes uncertain. The EC Council Regulation on Insolvency Proceedings requires that a company's centre of main interests (COMI) will initially determine where main proceedings are opened and which jurisdiction's insolvency processes apply. However, in certain circumstances it may be possible to migrate a company's COMI, or recognise insolvency office holders appointed in other jurisdictions. There will be reliance on judicial assistance and co-operation across jurisdictional borders. Lawyers specialising in cross-border work have developed a body of knowledge on how to react to these challenges, so they must have input at the earliest stage.
Once a borrower enters a formal insolvency process, the bank faces huge challenges. The breakdown of the trade cycle inevitably threatens the value of the bank's collateral.
A moratorium neuters the bank's ability to act unilaterally. Banks may be asked to release funds from collection accounts to finance, for example, ransom payments by an administrator to (unpaid) warehouse operators who are refusing to release goods. Similarly, if misfeasance or fraud is involved, the bank may be asked to provide a fighting fund to pursue directors. In a real sense, creditors' meetings provide banks with a painful opportunity to follow closely the destruction in the value of their own collateral.
The realisations made and the rank of the bank's security against other lenders will decide the bank's recovery. However, the die may already have been cast by then. Polished security documents only get the bank so far. The practical challenges of enforcing security are far greater. It is only by reacting quickly when the trade cycle is first threatened that formal insolvency can be avoided or, if inevitable, controlled.