Article

by Sean Edwards

Readers of DCInsight were last informed of the project between the ICC and the International Forfaiting Association (IFA) to produce a set of rules for the forfaiting market 2011. Now, after nearly four years of intensive drafting with input from national committees, an ICC consultative group and members of the IFA, the project has reached fruition.

The Uniform Rules for Forfaiting (URF) were adopted at the ICC Banking Commission's meeting in Mexico City in November and became effective on 1 January 2013. The URF have received ICC publication number 800, and orders are now being taken for the published booklet.

Modern forfaiting

Readers should be familiar with at least the concept of forfaiting, and the publication of the URF marks an opportune moment to consider what this fast-changing industry has been and what it stands to offer, aided, it is hoped, by the URF.

Modern forfaiting casts a much wider net than the traditional non-recourse discounting of promissory notes and bills of exchange. Letters of credit are widely forfaited and, in some major jurisdictions such as China, constitute the bulk, if not all, of what is an enormous market.

More recent innovative use of letters of credit such as synthetic letters of credit is controversial in some circles, but such structures evidence a need to use these instruments to provide finance and not just payment. The URF are designed to facilitate and boost this trend. And it is precisely in emerging markets that the URF will likely have the greatest impact.

The URF operate, at one level, by sitting on top of the underlying transactions (letters of credit, negotiable instruments, obligations to pay, etc.) being created or traded. Here, the URF will provide the contractual framework often lacking in transforming these instruments into viable bankable investments. The BPO draft, for example, has recognized that this gap needs to be bridged by the market and that appropriate solutions need to be put in place.

Some previously less liquid or esoteric instruments should be enhanced when fitted into the framework of the URF. Sight letter of credit re-financings, for example, which are not dealt with in a commercially satisfactory way by the UCP, can now be slotted into a URF wrapper and benefit accordingly as a result.

New instruments

On another level, the URF can be used, not just to wrap around existing instruments, but to create new ones. This second form of application is perhaps more exciting than the first, but it is also more challenging, and the market will need to seize the opportunity offered. For example, the forfaiting market had developed the use of a combined facility letter and standby letter of credit for use in the Commonwealth of Independent States (CIS). Some doubts had arisen over the legal validity of this structure (a party cannot guarantee itself ), but tradability required that a letter of credit be integrated into the documentation. This also meant that inadequate consideration was given to important issues such as recourse, as it was assumed that the UCP would deal with these adequately. These cumbersome creations can be replaced with a single document governed by the URF.

Confronting Basel III

As banks struggle with the impact of Basel III on trade finance, more focus is shifting to the shorter end of the market favoured by the forfaiting industry and dominated by traditional forfaiting instruments such as letters of credit and negotiable instruments. There are a number of reasons: these instruments, provided they can be easily traded, can be liquidated and taken off balance sheet more quickly with benefits for portfolio management. Second, they are likely to be held in the trading book of banks rather than the banking book, which attracts less capital. The Bank for International Settlements (BIS) is reviewing the use and the manner in which trading books are constituted, which will undoubtedly put emphasis on the true "saleability" of assets placed in the book.

Finally, these instruments are likely to become more attractive to investors such as insurers that will be encouraged by their new capital regime, Solvency II, to invest more in shorter-dated assets. In view of the low default rates evidenced by successive ICC surveys, conservative investors such as insurers can also be confident that they are investing in safe assets. In all of these areas, the URF will help to produce a virtuous circle where legal protection, tradability and financial security can be combined.

Using the rules

What about the nuts and bolts of the rules? The URF are designed for use in both primary and secondary markets. They deal with the needs of the two markets by employing mirror provisions amended only where necessary to take account of structural or commercial differences. A number of common provisions are then introduced. Hopefully, the result will be clarity and transparency for both markets.

The first - and a subject familiar to letter of credit specialists - is the question of what constitutes satisfactory documentation. In this regard, the URF are more general and permissive than those in the UCP rules and for good reason. Because the URF are concerned with marketability, the provisions on satisfactory documentation generally intervene at the point after the instrument has been created. So, for example, a letter of credit that is being forfaited would have had to satisfy the UCP rules in order to be compliant, but would also have to pass through the URF tests to become marketable.

Therefore, the focus in the URF is on authenticity, legality and enforceability of the relevant instruments. In the primary market, these factors are the basic starting point, whereas for the secondary market they are, subject to individually agreed requirements, final and exhaustive. This reflects a basic feature of the forfaiting market, in that originators of transactions, or Primary Forfaiters as they are known, bear increased responsibility for the deals they introduce into the market and must therefore be in a position to ask sellers of paper, whether exporters or importers, to provide whatever documentation the Primary Forfaiter feels necessary to on-sell the transaction into the market. In the secondary market, by contrast, documentation is already available and can and should be assessed by more objective criteria, thereby speeding up dealing time and enhancing liquidity.

Recourse

A central issue has revolved around recourse. Traditionally, forfaiting operates without recourse to the seller, and this principle is expressly spelt out in article 3 of the URF. At the same time, there has also been an expectation that Primary Forfaiters must do all they reasonably can to make sure transactions sold into the market are robust. The URF has tried to steer a middle course through this area by providing:

- for all parties in both primary and secondary markets to be liable if certain basic breaches occur, e.g., a lack of authority of either buyer or seller to sign transaction documentation;

- for recourse to all sellers when the seller was aware of third party rights affecting a transaction, when it fails to transfer all rights and when it does not own the claim being sold;

- for the commercial party that creates the claim, typically the exporter or importer, to be responsible, in addition to the preceding circumstances, when it has breached its obligations under the commercial transaction underpinning the claim and, perhaps more controversally, for fraud;

- for Primary Forfaiters to be liable in circumstances when they have essentially failed to use reasonable efforts to ensure the claim being sold is authentic, legal and enforceable.

True sale

These provisions also focus on a critical technical issue: that of achieving a "true sale". This is an accounting issue, treated somewhat differently under IFRS and US GAAP, and it is clear that an element of recourse to a seller can upset this analysis. Under IFRS, the essence of achieving a true sale relies on the seller transmitting all risks and rewards to the buyer. However, a distinction must be made between guaranteeing payment by the underlying obligor to a buyer and guaranteeing the existence of a claim that may not be paid for commercial reasons, e.g., insolvency of the obligor. The URF have been carefully drafted to pass this analysis whilst still offering protection to financing parties.

Primary and secondary markets

The URF are accompanied by model form agreements for the primary and secondary markets. These, especially for the primary market, will be important in assuring that the benefits of using the URF are understood. Readers of DCInsight will also appreciate that a SWIFT model agreement has been provided reflecting the use of this system, not just as a medium for communication, but one by which contracts can be concluded. The primary market is commercially much more diffuse and fractured than the secondary, essentially inter-bank, market, and it is here that the URF can have the greatest economic impact.

The URF will be launched into a market very different from the one they were initially conceived in; their appearance is more timely than ever, however. The lack of long-term funding in markets generally has put focused attention on short-tenor financing. The clarity, commerciality and cohesiveness which the URF can bring to this sector of trade finance will be a major factor in developing and growing this important contributor to global trade. l

Sean Edwards is Head of Legal, Sumitomo Mitsui Banking Corporation Europe Limited and Deputy Chairman of the International Forfaiting Association. He is a member of the URF Drafting group. His e-mail is sean_edwards@gb.smbcgroup.com