In the current period of flux, lenders should review their finance documents regarding protections and/or vulnerabilities; and where exposed to industries particularly affected by the COVID-19 outbreak may consider (i) invoking provisions to demand early repayment and/or to preclude further lending; and (ii) whether there is material benefit in doing so. They should also consider pre-emptive steps with a view to staving off critical defaults.
Such a review will involve looking at receivables purchase and factoring arrangements, both in terms of the viability of existing arrangements and whether such arrangements can be helpfully introduced if absent, and the impact on other trade finance arrangements. Such positions can be easily affected by the credit positions of third parties, rather than direct counterparties, so vigilance in the current environment is encouraged.
This note provides some high-level reminders of some key considerations.
True Sale - Outright Disposal or a Security Interest
Factoring and invoice discounting are examples of financing techniques that involve the sale of receivables by a seller to a financier, rather than the provision of a loan secured against the receivables.
If the financing is structured as a sale, the monies advanced by the financier should be characterised as a purchase price and the assignment of the receivables by the seller as a sale.
The risk from a purported sale of receivables failing the "true sale" test is that on the insolvency of the seller a court may recharacterise the transaction components: payment of the purchase price as a loan and the purported sale as a security assignment.
If the seller's jurisdiction of incorporation requires security assignments to be registered, that recharacterisation could lead to the security being void against the seller's liquidator as security for want of registration, leaving the financier as an unsecured creditor of the seller.
English case law has reached the position that there is no one characteristic or test which conclusively determines whether a transaction amounts to an outright disposal of receivables, rather than a secured loan.
In Re George Inglefield Ltd  Ch 1, the English Court of Appeal identified certain essential differences between a sale and a secured loan:
- In a sale, the seller is not entitled to get back the sold assets by returning the purchase price to the buyer, whereas a loan secured by a mortgage or charge of the asset would include such a right.
- If a mortgagee sells the secured asset for an amount in excess of the outstanding balance of the loan, it would have to account to the mortgagor for any surplus, whereas in a sale transaction, if the buyer subsequently sells the asset for a profit, it does not have to account to the original seller for the profit.
- If a mortgagee sells the secured asset for an amount that is insufficient to discharge the outstanding loan balance, the mortgagee is entitled to recover the balance from the mortgagor, whereas in a sale transaction the buyer of the asset will have no right to recover any shortfall from the seller where the buyer has on-sold to a third party for a loss.
Broadly speaking, the courts will look to see that the risks and rewards of ownership of the receivables have transferred from the seller to the financier, by reference to the economic substance of the transaction.
In a receivables purchase arrangement, the main risk of ownership is non-payment of the receivables by the underlying debtor.
Where the financier has a right to sell back the receivable (recourse) to the seller in the event of non-payment by the underlying debtor, the courts may take the view that the seller has retained the risks of ownership, and therefore that the economic substance of the transaction is that of a secured loan, rather than an outright disposal.
So, while on the one hand multiple opportunities to sell back the receivables (that is, greater recourse) to the seller under the receivables purchase agreement may appear attractive to the financier at first blush, it could increase the risk of recharacterisation of the arrangement as a secured loan.
Intention of the Parties
On the basis of the principles set out in Re George Inglefield Ltd, as considered and applied by the English Court of Appeal in Welsh Development Agency v. Export Finance Co., Ltd  BCLC 148, the threshold for recharacterisation is generally a high one and will not be made unless the transaction is in substance a mortgage or charge of receivables and not a sale, or is a sham.
The courts may find an arrangement to be a sham where the terms of the receivables purchase agreement do not represent the true intentions of the seller and the financier, which may be determined from provisions in it said to be materially inconsistent with a sale.
In Orion Finance Ltd v Crown Financial Management Ltd  2 BCLC 78, Millett LJ pointed out that it may be that no single one of the three criteria set out by Romer LJ in Re Inglefield is determinative.
"The difficulty is that no single one of these features may be determinative. The absence of any right in the transferor to recover the property transferred is inconsistent with the transaction being by way of security; but its existence may be inferred, and its presence is not conclusive. The transaction may take the form of a sale with an option to repurchase, and this is not to be equated with a right of redemption merely because the repurchase price is calculated by reference to the original sale price together with interest to the date of sale."
The Hong Kong Court of Final Appeal has cited the English cases of Welsh Development Agency and Orion Finance with approval in Secretary for Justice v Global Merchant Funding Ltd (2016) 19 HKCFAR 192. In Global Merchant Funding, Ribeiro PJ articulated the following approach:
"Assuming that the transaction is not merely a sham, the Court can only decide whether a transaction is or is not a loan by construing the relevant documents and analysing the legal effect of what the parties have actually agreed. The language used by the parties is relevant but if it is inconsistent with what, as a matter of law, they have mutually agreed, the Court disregards the parties' terminology in categorising the transaction".
Accordingly, the receivables purchase agreement will generally be structured on a sale transaction basis rather than a secured loan basis and the terminology used consistent to support a sale transaction basis.
Off-balance Sheet Accounting
One rationale for entering into these arrangements is for the seller to be able to remove the receivables it has sold from its balance sheet and then show the payment it receives from the financier as cash, providing an improvement in its liquidity while avoiding a need to report additional liabilities on its balance sheet (subject to applicable accounting rules).
Considerations for Receivables Financing
Receivables financing frequently involves trade transactions where the seller (i.e., the supplier in the underlying transaction with the third-party debtor) has performed its obligations in full, leaving only the payment obligation of the underlying debtor. The financier will generally pay for the underlying debt only upon the final invoice being issued, at which time the seller will represent that it has fully performed its obligations and that the receivable is due in full with no deduction. If those representations are breached, it would generally give the financier recourse to the seller for the loss sustained as a consequence of the purchase of the relevant receivable.
In a limited recourse receivables financing the risk of late or non-payment by the underlying debtor will generally rest with the financier, rather than the seller. The financier's recourse to the seller will typically arise where the non-payment is linked to a breach by the seller of its obligations under the underlying trade transaction, or where a dispute has arisen between the relevant seller and debtor.
In arrangements where the financier has paid for future receivables and the seller/supplier still has outstanding obligations to perform, delays in shipment of goods or provision of relevant services might allow an underlying debtor to argue that it is entitled to delay/withhold payment, which may in turn trigger the financier's recourse to the seller.
Considerations for Trade Receivables Financed Off-balance Sheet
The current slowdown in trade transactions may well affect typical structures where receivables are being acquired by a special purpose vehicle (SPV) which is financed by the issue of notes secured on a wider portfolio of receivables.
Such structures can involve the SPV's reliance on a continued flow of receivables through the portfolio, so as to generate returns to pay interest on the notes issued by the SPV. An inability to source sufficient new trade receivables can mean that a structure has to be terminated early.
It will often be intended that the SPV is treated as insolvency remote. It is therefore often a separate corporate entity with no trading history and accordingly no initial liabilities. Contractual provisions are then also included with a view to insulating the SPV from creditor claims, such as:
- Limited recourse provisions, whereby liability is limited to the net proceeds of disposal or enforcement of the relevant assets;
- Non-petition clauses, which purport to prohibit a creditor from initiating insolvency and/or other proceedings against the SPV; and
- Covenants not to incur liabilities or undertake actions outside those contemplated for the transaction the subject of the agreement.
While under English and Hong Kong law, courts are unlikely to treat the assets of the SPV as those of the originator, as separate corporate identity is generally upheld, insolvency set-off is applied automatically on liquidation (and cannot be contracted out of) so that debts owed between the SPV and the originator could be automatically set off against each other.
Considerations for Providers of Trade Instruments
Financial institutions may decline a demand against a documentary letter of credit if the necessary supporting trade documents, such as the bill of lading, are unavailable to the claimant. However, that would be on the basis of failure to meet the specified list of documents required for a valid demand, as stipulated in the instrument.
Standby letters of credit and bank guarantees generally operate independently from the underlying trade transaction for which they have been issued, so that problems in the underlying transaction generally cannot be raised as a defence to payment.
However, it is anticipated that regulators may ask bank financial institutions to have COVID-19 action plans in place; and request that existing payment operations are maintained under those plans. Where relevant payment instruments involve a chain of financial institutions through operations, requisite operational workarounds would probably need to be agreed at each level.
A whole host of issues will surface for lending counterparties as liquidity continues to tighten as a consequence of the COVID-19 pandemic.
Trade finance arrangements are particularly affected by the credit positions of third parties, rather than just direct counterparties, and so market participants need to consider the implications for their cash flow projections and liabilities, especially where underlying debtors/consumers are within sectors materially exposed to the pandemic .
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