The risks of forfaiting

What risks do the various parties run when forfaiting? Senior consultant Michael Kenny, senior associate Ian Clements and trainee solicitor Meryl Rowlands, all representing Watson, Farley & Williams, guide us through the different aspects of forfaiting.

What is the traditional structure of forfaiting arrangements?

A well-established form of trade finance, forfaiting refers to an arrangement whereby a forfaiter (usually a bank or other financial institution) purchases, at a discount, a debt owed to a creditor, the exporter, on deferred payment terms from its debtor, the buyer. A negotiable instrument, such as a draft drawn under a letter of credit, a bill of exchange or a promissory note, is given in respect of a sale of goods from the creditor to the debtor. This is the ‘primary’ forfaiting market transaction.

As a result of the process, the creditor obtains immediate access to a reduced amount of cash from the face value of the negotiable instrument—cash that would be unavailable until the negotiable instrument matures. The forfaiter will either hold the negotiable instrument until its maturity, when it will receive the payment due from the debtor, or it may sell the negotiable instrument to another bank or financial institution active in a ‘secondary’ forfaiting market transaction.

The sale of the negotiable instrument to the forfaiter is on a ‘without recourse’ basis, meaning that should the debtor not make payment under the negotiable instrument, the forfaiter is prevented from making any form of recovery against the creditor.

How are guarantees structured in forfaiting transactions?

If a debtor’s obligations under a negotiable instrument are to be guaranteed, the customary practice in the forfaiting market is for the debtor’s bank to issue its guarantee by means of an ‘aval’.

An aval is an unconditional, irrevocable, freely assignable and freely transferable promise to pay on the maturity date of a bill of exchange or promissory note, created by the addition on the bill or note of the words ‘for aval’ or ‘per aval’, or similar, together with the signature of the avaliser.

Avals are a creation of civil law. Many legal systems have adopted the Geneva Uniform Law on Bills of Exchange and Promissory Notes, under which the concept of an aval is recognised. The UK has not adopted this law, and at present English law does not provide for the creation of guarantees via an aval. However, English courts recognise avals in forfaiting transactions involving non-English law negotiable instruments.

How does forfaiting fit into the broader export trade financing landscape?

Forfaiting is an extremely popular form of short to medium-term and medium value trade financing. Transactions are usually completed on standard form documentation that allows transactions to be completed in-house by forfaiters without the need for engaging external legal advisers, thus cutting down significantly on time and expense.

Forfaiting should be distinguished from the similar process of factoring—the latter generally refers to smaller transactions over shorter terms where the receivable sold to the factor is not evidenced by a negotiable instrument and is not normally guaranteed. As mentioned, negotiable instruments in forfaiting transactions are usually guaranteed.

To aid participants in both the primary and secondary forfaiting markets, the International Chamber of Commerce (ICC) published, with effect from 1 January 2013, its Uniform Rules for Forfaiting (URF). The URF seek to provide for the forfaiting market a general set of rules that will assist in relation to the harmonisation of forfaiting practice and the interpretation of forfaiting documentation, in the same way that the ICC’s Uniform Customs and Practice currently works in respect of documentary credits. The URF also contain model agreements that participants in the forfaiting market may use if they wish.

What are the risks associated with forfaiting arrangements?

There are few risks facing the creditor. Once the creditor has sold its debt to the forfaiter, it has no further financial exposure. Indeed, forfaiting is a mechanism enabling the creditor to remove the future payment risk that it would take on its debtor, at the cost of the discount from the face value of the debt. The ‘without recourse’ principle that underpins forfaiting means that the creditor has no continuing liability to the forfaiter if the debtor or the avaliser does not pay. The only exception to this principle would be that the creditor will be liable to the forfaiter in respect of any representations it makes in relation to the debt or the debtor.

The forfaiting of a debt does not alter the risks assumed by the debtor. The effect of forfaiting is that the obligations owed by the debtor to its creditor are transferred to the forfaiter. However, the nature and amount of those obligations are not changed or increased.

The forfaiter does take one risk. In return for the discount charged by it, the forfaiter essentially assumes the risks previously borne by the creditor. The most important of these is the credit risk on the debtor—that they will make the payment due under the relevant negotiable instrument on the maturity date. In addition to this, there are certain ancillary risks, such as:

  • political risk affecting payment—for example, the imposition of sanctions on the relevant country
  • transfer risk in relation to the relevant currency—caused by currency unavailability, introduction of exchange controls and so on
  • legal risk arising from the documentation and the jurisdictions involved

However, the negotiable instrument will normally represent a crystallised debt, and therefore the forfaiter is not taking performance risk on the creditor as regards the underlying commercial contract. The one exception to this general principle is that if there is fraud affecting the underlying contract, this may entitle the debtor or avaliser of the negotiable instrument not to perform its payment obligations, to the detriment of the forfaiter.

What are the benefits of the discount without recourse feature of forfaiting?

The creditor benefits by selling his deferred payment claim on the debtor to the forfaiter, and thus receiving immediate cash. Their cash flow therefore benefits, at the cost of the discount, and they can remove their payment risk on the debtor—together with the other ancillary risks mentioned above. This may have the wider commercial benefits of enabling the creditor to access more risky markets, where other forms of finance may not be available, and to offer credit terms to his customers. As his sale to the forfaiter is ‘without recourse’, he has no continuing liability to the forfaiter, whether or not the debtor pays on maturity.

The benefits to the debtor are essentially the counterpart to some of those enjoyed by the creditor—the availability of credit on more advantageous terms than would be otherwise available. The transaction costs can be lower, and the documentation much simpler, than for other more structured forms of financing, such as buyer credits offered by export credit agencies.

The essential benefit to the forfaiter is the financial return from the forfaiting transaction—this arises from the discounted purchase of the debt and, in addition, any fees or commissions it charges for providing the financing.

Have there been any notable disputes around forfaiting? What lessons should lawyers take from these?

The key point to note is that the forfaiter’s legal rights depend on the assignment in its favour granted by the creditor (the assignment of the creditor’s own right to receive payment from the debtor) and not the underlying transaction between the debtor and the creditor.

The main issue for forfaiting arising from recent cases is the possible impact which fraud risk in the underlying commercial transaction may have on the discounting of a deferred payment before its maturity. This, of course, is the essence of a forfaiting transaction.

The general principle is that as letter of credit transactions are separate from the underlying commercial transaction, they should be viewed as autonomous transactions involving the relevant documents only—a creditor, and equally a forfaiter as assignee of the creditor’s rights, has the right to receive payment irrespective of any dispute which may arise under the underlying commercial transaction.

The main exception to this general principle is the ‘fraud exception’—where a seller presents documentation to a bank that contains misrepresentations of fact. In these circumstances, the principle of the letter of credit transaction being autonomous is set aside, provided the evidence of the fraud is clear.

In the context of discounting deferred payments, fraud could become an issue for a paying bank—a paying bank may prepay under a letter of credit, with the risk that only at the later date, fraud on the documents is discovered and the issuing bank then refuses to pay. This was essentially the situation in Banco Santander SA v Banque Paribas [2000] All ER (D) 246. There it was held that the confirming bank would have to bear the loss. In response to this decision, the Uniform Customs and Practice for Documentary Credits (UCP) rules were amended—art 7 of UCP 600 now expressly recognises that the risk of a seller’s fraud rests not with the paying bank but with the buyer during the deferred payment period. The further effect of art 7(c) is to create a new definite undertaking by an issuing bank to reimburse the confirming bank or nominated bank on maturity, whether or not that bank prepaid or purchased its own deferred payment undertaking before maturity.

However, what is relevant for the forfaiting market is that the protection given to confirming and nominated banks by art 7 does not extend to third party forfaiting banks. There are two possible ways of addressing this issue:

  • an amendment to be issued making the letter of credit available with the forfaiting bank—in effect making it the nominated bank and therefore covered by the protection now provided by art 7
  • require the issuing bank expressly to undertake that it will pay under the letter of credit at maturity notwithstanding any subsequent discovery of fraudulent documentation

As noted in the answer to question three above, URF has introduced model forms for forfaiting agreements. Use of these by market participants is likely to reduce documentation and legal risk, as use of standard market documentation should make disputes between parties less likely and also help to achieve consistency in judicial interpretation.

Interviewed by Sarah Parry.

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

First published on LexisPSL Banking & Finance. Click here for a free trial.

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