New obligations around credit risk mitigation

What do banks need to know about the requirement to obtain a legal opinion when establishing credit protection arrangements? Hannah Fearn, an associate in the trade and export finance team in the London office of Sullivan & Worcester, explains the requirement and the recently-launched industry standard legal opinion.

Original news

BAFT and ITFA legal opinion to help banks’ regulatory compliance

A joint industry standard legal opinion for banks to use in satisfying new regulatory requirements in the EU has been announced by the Bankers Association for Finance and Trade (BAFT) and the International Trade and Forfaiting Association (ITFA). The joint legal opinion aims to allow BAFT and ITFA’s member institutions to reduce the cost and complexity for banks subject to EU rules, and to make it easier to do business under the English law version of the BAFT Master Participation Agreement (MPA).

What has fuelled the creation of this industry standard legal opinion?

When calculating capital requirements, institutions can take into account eligible forms of credit risk mitigation to reduce the amount of capital they are required to hold for a particular exposure. To be an eligible form of credit risk mitigation, a credit protection arrangement must meet the applicable criteria set out in the Capital Requirements Regulation (EU) 575/2013 (CRR).

Under CRR, art 194.1, an institution must be able to provide, upon request of the competent authority, the most recent version of the independent, written and reasoned legal opinion(s) that it used to establish whether its credit protection arrangements are legally effective and enforceable in all relevant jurisdictions.

ITFA, working together with BAFT, instructed Sullivan & Worcester to provide an industry standard legal opinion on the enforceability of the BAFT English law MPA for the purposes of CRR, art 194.1 to help facilitate this process for banks.

How will the new regulatory requirements in the EU affect credit risk mitigants?

The requirement that a credit risk mitigation technique must satisfy certain criteria before it can be taken into account in the calculation of risk-weighted exposure is not new for Basel III. In fact, the applicable requirements are broadly similar to the requirements under the equivalent legislation under the Basel II regime.

However, the requirement to obtain a legal opinion under CRR, art 194.1 is new and this requirement came as somewhat of a surprise to the industry. It potentially adds an extra layer of complexity and cost for banks entering into credit protection arrangements.

What is the scope of the legal opinion? Can it be used for all forms of master risk participation agreements?

The legal opinion covers the enforceability under English law of participations entered into using the template BAFT MPA. The opinion also addresses how the BAFT MPA can be used to document credit protection arrangements meeting the CRR credit risk mitigation requirements under both the standardised approach and internal ratings-based approach.

As a generic opinion, it has limitations. The opinion contains a list of assumptions relating to specific requirements of the CRR that would need to be confirmed for each participation agreement. For example, in relation to risk participation, an institution would need to confirm that its participant meets the criteria for eligible credit protection providers under the CRR. The institution would also need to address the capacity and authority of, and due execution by, the parties to the participation agreement.

The opinion is given in respect of participation agreements documented using the BAFT template MPA. However, institutions will invariably make changes to the template document when entering into participations. In such circumstances, it may still be possible to use the opinion by referring to the guidance in the opinion on the provisions of the BAFT MPA that are central to satisfying the requirements for credit risk mitigation under the CRR.

Institutions should be aware that CRR, art 194.1 requires that legal opinions are obtained to establish that the relevant credit protection arrangement is legally effective and enforceable in all relevant jurisdictions. In the context of a participation agreement, we would expect this to include England (as the governing law jurisdiction) and the jurisdiction of the parties to the agreement. The opinion is limited to English law, but includes some guidance on reciprocal enforceability of English court judgments and arbitral awards in other jurisdictions.

An institution intending to benefit from the credit risk mitigation would also need to satisfy more general requirements of the CRR—for example, in respect of its internal systems and policies applying to all credit protection arrangements.

How will the opinion impact the trade finance industry on risk transfers?

We understand that the intention of ITFA and BAFT in publishing this opinion is to facilitate the use of the BAFT MPA in distribution of trade risk by assisting institutions with regulatory compliance, while minimising the cost and time impact for those institutions.

We hope that the opinion will indeed achieve this, as this type of risk transfer represents a large volume of transactions between institutions and is a key element in the functioning of the trade finance market.

What does this mean for trade finance lawyers?

Trade finance lawyers drafting participation agreements and other forms of credit protection need to be more aware than ever of making sure the terms of those agreements can meet the requirements of CRR, where the institution intends to use those agreements as credit risk mitigation.

Lawyers, both in-house and external, need to familiarise themselves with the CRR, art 194.1 legal opinion requirement. No doubt satisfaction of this requirement (either using generic or individual opinions, as appropriate) will gradually become a standard part of banks’ internal procedures.

How does this fit into the broader regulatory framework?

Sullivan & Worcester is pleased to have had the opportunity to work with ITFA and BAFT to help in providing a solution for institutions using the BAFT MPA under the Basel III framework. We hope to see other industry bodies and institutions working together to find effective ways to deal with ever changing and increasing regulatory requirements so that regulation does not become an obstacle to doing trade finance.

As well as finding ways to address the EU regulatory framework in respect of Basel III, institutions are reacting to new regulatory requirements on a global level. One particularly relevant example in this context is the uncertainty over the treatment of trade finance risk participations under Dodd-Frank. We, with the rest of the industry, are eagerly awaiting the outcome of the dialogue between BAFT and the US authorities.

Hannah Fearn is an associate in the trade and export finance team in the London office of Sullivan & Worcester. She has advised on a wide range of cross-border trade finance transactions in a variety of jurisdictions, with an emphasis on emerging markets. She has acted for leading banks in the market and her experience includes advising on syndicated and bilateral pre-export commodity financings, letter of credit facilities, trade instruments and receivables financings.

Hannah worked with Geoffrey Wynne, head of Sullivan & Worcester’s London office and trade and export finance group, on preparing the Article 194 legal opinion on the BAFT Master Participation Agreement.

Interviewed by Barbara Bergin.

The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.

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