Expert briefing: Insolvency reforms and distressed debt in commodity trade finance
The UK passed the Corporate Insolvency and Governance Act last month in a bid to mitigate the economic fallout for struggling companies in the Covid-19 epoch. The impact of the reforms on the trade and commodities space is significant, especially given many international financings and commercial arrangements in those sectors are governed by English law.
The Corporate Insolvency and Governance Act 2020 (the Act) received royal assent on 25 June 2020 and took effect on the following day. The Act is one of the most significant reforms to the insolvency framework in the UK since the changes to administration in 2003.
The changes made by the Act are seen as necessary to support struggling businesses as they deal with the economic fallout from Covid-19. However, many of them are permanent in nature and will transform the way creditors and others interact with businesses in financial difficulty. In this article, the team at Allen & Overy look at some of the immediate questions arising from the Act through the lens of its likely impact on the trade and commodity finance industry.
For more information on the Act (which contains 248 pages of detailed draft legislation), please click here.
An overview of the Act
Amongst the temporary Covid-related measures, the Act introduces the suspension, until 30 September 2020, of the wrongful trading regime, the suspension of winding-up petitions where financial difficulties are attributable to Covid-19 (and the prohibition of winding up petitions based on a statutory demand), as well as certain other flexibilities in respect to members’ meetings and the extension requirement for companies’ fillings with Companies House.
The permanent reforms involve changes in three key areas: the introduction of a new statutory restructuring plan (the Restructuring Plan); the introduction of a moratorium; and a ban on termination provisions in contracts for the supply of goods and services (or so called ipso facto clauses).
The Restructuring Plan
The Restructuring Plan is similar to a scheme of arrangement and allows any company to propose to its creditors or members a compromise or arrangement - provided certain conditions are met. Regulations may be brought by the Secretary of State that could exclude certain authorised persons from the scope of this legislation but no such regulations have been made to date. Also, the Restructuring Plan is available not only to UK companies, but to companies incorporated elsewhere, as long as they have sufficient connection with the UK.
Importantly, an example of a sufficient connection would be that the debt being compromised is governed by English law. This is relevant given that many international financings and commercial arrangements in the trade and commodities space are governed by English law.
As with schemes of arrangement, classes of creditors and members are formed based on their rights and interests. The ability to cram-down one or more classes of creditors or members is an important feature of this new regime and will likely contribute to the Restructuring Plan becoming the restructuring implementation tool of choice in cross-border restructurings. The court is required to sanction the plan and will consider if (i) the classes have been properly set up, (ii) if there is a dissenting class that is to be “crammed down”, whether that class will receive more than under the plan than they would have received under the “relevant alternative” (most likely some form of insolvency proceedings) and (iii) the plan is fair and equitable.
The new moratorium provisions aim to give struggling companies breathing space in order to effect a rescue as a going concern. For as long as the moratorium applies, a company would be protected from enforcement of security, the commencement of insolvency proceedings or other legal proceedings against it, and would also not have to pay debts falling due prior to the moratorium (note that debts falling due during the moratorium would still be payable). The moratorium is set to last for an initial period of 20 business days with an ability to extend in certain circumstances.
This is subject to certain key exceptions, as follows:
- where the debts and liabilities of the company arise under any “contract or other instrument involving financial services”, they are excluded from the payment holiday provisions (but not the stay on creditor action); or
- where the company is an “excluded entity”, it is not eligible for the moratorium.
We have been considering with our clients to what extent those exceptions would cover trade finance market participants. We will briefly look at each of these exclusions in turn.
The financial services exclusion
The Act set out a list of broadly defined categories of arrangement, each of which constitutes a “contract or other instrument involving financial services”. These categories fall under a series of broad headings, such as “financial contracts”, “securities financing transactions”, “derivatives” and “capital market investments”.
Master agreements in respect of any category of “contract or other instrument involving financial services” are also captured. Consequently, the exclusions to the payment holiday provisions in the moratorium are broad. Of particular relevance for trade and commodity finance are “financial contracts” and “securities financing transactions”.
“Financial contracts” includes:
- contracts providing for (i) lending “including the factoring and financing of commercial transactions”, (ii) financial leasing and (iii) the provision of guarantees or commitments; and
- commodities contracts, including (i) for the sale, purchase or loan of a commodity or group or index of commodities for future delivery, (ii) an option on a commodity or group or index of commodities and (iii) repurchase or reverse repurchase transaction on any such commodity, group or index.
The Act is not clear as to what constitutes the provision of guarantees. The reference to guarantees would include many types of trade instrument, but would it extend to instruments such as commercial letters of credit which are issued as a primary means of payment? We can see no policy reason why it should not. Similarly, there is no clarity on what constitutes “commitment” – we assume that this is not intended to refer to committed financings but may be intended to cover a wider class of bank undertakings.
Note that the Act includes factoring in its description of “contracts providing for lending”. However, we notice that the drafting of the Act specifies that lending includes factoring, whereas factoring is not lending but the sale and purchase of unpaid invoices. Therefore, if the intention is to apply a broad interpretation to the word “including”, it is arguable that “contracts providing for lending” could extend to a broader class of commercial finance. At a glance, lending does not include products such as receivables purchase and issuance of trade instruments.
Securities financing transactions
The Act also cross-refers to other financial regulations in order to exclude arrangements from the scope of the moratorium. Certain commodity finance structures may be excluded from the moratorium because they constitute a “securities financing transaction”. The Act takes the definition of securities financing transaction from the EU Securities Financing Transactions Regulation (SFTR) which covers the following types of arrangement relevant for trade and commodity finance:
- repurchase transactions;
- securities or commodities lending and securities or commodities borrowing; and
- buy-sell back transactions or sell-buy back transactions.
The definition of “commodity” for the purposes of the SFTR is taken in turn from another European regulation, and means “goods of a fungible nature that are capable of being delivered, including metals and their ores and alloys, agricultural products, and energy such as electricity.” The Act adds greenhouse gas emission units and allowances and renewables obligation certificates to the list, reflecting the increased focus on sustainability matters across the industry.
It is worth noting that, even if a trade finance agreement does fall within the definition of a “financial contract”, this only excludes amounts due under such a contract from the payment holiday provisions of the moratorium, not the stay on creditor action. However, the monitor is required to bring the moratorium to an end if debts that are not excluded from the payment holiday are not paid and so this should give trade financiers a high level of comfort.
The excluded entities exception
The list of entities to which the moratorium is not available includes banks, insurance companies, investment firms, electronic money institutions and payment institutions. Note that this includes any equivalent entity which is registered or whose head office is located outside the UK.
Overall, the exclusions capture a broad range of structures and entities, but care should be taken in looking at the detail of the drafting when determining whether a particular specific arrangement fits into them.
Termination provisions (the Ipso facto Clauses)
Trade finance market participants have, understandably, been particularly focused on this aspect of the Act.
The terms of a contract for the supply of goods and services may well allow a supplier to terminate its supply if its counterparty becomes insolvent (a so-called ipso facto clause). The clear benefit to suppliers of such provisions is that they may extricate themselves from an obligation to continue to supply in circumstances where their buyers are finding it difficult or impossible to meet their payment obligations. The downside to purchasers which rely on those supplies is that, following termination of the contract, they may find themselves in a situation where their supply chain is cut off and from which it is impossible to recover.
In order to protect struggling companies from suppliers who would seek to use their termination rights to threaten the continuation of an essential supply if, for example, their counterparty has delayed a payment, the new regime seeks to restrict the circumstances in which a contractual right to terminate on insolvency may be exercised.
Broadly speaking, if a company has entered an insolvency procedure (including a moratorium procedure described above), then the exercise of any right its suppliers may have to terminate their supply contracts by reason of the commencement of that insolvency proceeding will be prohibited. This restriction applies to all contracts for the supply of goods and services, but with the same key exceptions regarding financial contracts. Furthermore, the ipso facto ban does not apply if either the insolvent company or the supplier is an excluded entity (as described above for the moratorium).
Given these exceptions, a large volume of trade and commodity financing transactions would fall outside the scope of the prohibition, meaning that ipso facto clauses in these types of contracts would remain enforceable as a matter of contract.
Similarly, if an “excluded entity” is a supplier or a purchaser under a contract for the supply of goods and services, then the ipso facto provisions in such contracts will not be affected by the new regime. A large number of international supply agreements are governed by English law, so many non-UK counterparties will need to consider the effect of this change if they contract under English law.
Should financiers be concerned about the new ipso facto regime?
If a distressed borrower’s supply arrangements are not excluded from the scope of the new regime, then its lenders might draw a measure of comfort from the knowledge that its suppliers may not be able to exercise their ipso facto rights and the borrower may be able to rely on these protections to shore up its supply chain while working through the distressed situation.
On the other hand, there may be implications for financiers where debts owed to them are discharged by the underlying flow of goods and services through the supply chain.
Let’s take an example pre-export finance structure. Under an English law-governed commercial offtake agreement a supplier (S) is contracted to supply goods to a purchaser (P). The commercial agreement is not a “contract or other instrument involving financial services” and neither S nor P are “excluded entities”. A bank (B) provides finance to S under a loan agreement, providing S with the working capital it needs to manufacture the goods it provides to P under the contract. The debt arising under the loan agreement will be discharged through payments made by P upon delivery of the goods flowing into the collection accounts. The commercial agreement contains an ipso facto provision giving S the right to terminate the contract if P is insolvent, and stop the supply. There may be a risk for S and B that the termination provision might not be enforceable under the new UK insolvency regime outlined in the Act. This is because neither the commercial contract nor the parties to it fall within one of the exclusions outlined above. This means that S might be forced to continue supplying to the insolvent P even if it has not been paid in relation to pre-insolvency supplies, and B would be exposed to non-payment risk for such pre-insolvency supplies. If however P fails to pay for the supplies post the commencement of the insolvency proceedings, S can terminate the contract and so B should not be exposed to non-payment risk for that period.
We have seen through various high profile restructurings and insolvencies in the commodities market that England continues to be the centre of choice for resolving complex global distress situations in this sector. On this basis, market participants will be following developments on the new regime closely. The Act seeks to create exceptions so that, broadly speaking, the new protections apply in commercial sale and purchase arrangements but not to financial services arrangements. However, trade finance sits between these two spheres and an interruption in a financed trade may have direct implications for the corresponding financing: trade finance typically relies on the performance of the underlying flow of goods for the bank to be repaid. We will be monitoring developments closely and working with our clients to understand and address the implications for trade and commodities deals under English law and which involve English obligors.
The other A&O authors contributing to this article include: Marianne Webber and Mark Khan, both associates at the law firm in London.