Pre-export financing in Russia: market practice and common legal structures Ragnar Johannesen Alexander Zalivako In this article Ragnar Johannesen, a senior associate, and Alexander Zalivako, an associate, both based in Herbert Smith s Moscow office, explain the key benefits of pre-export financing and examine some of the legal issues and common structurings for with such arrangements, focusing on the position under Russian law. What is pre-export financing? The key characteristic of a pre-export finance (PXF) structure is that the exposure of the lenders to the general commercial risks associated with the borrower is mitigated by the lenders taking security over cashflows due to the borrower under confirmed orders from pre-agreed offtakers under export contracts. Accordingly, in a PXF transaction, the key objectives are: to ensure that the cashflows under the export contracts are sufficient to repay the loan provided under the facility agreement; and to put in place a mechanism which, in the event of a default scenario, allows the lenders to use those cashflows to repay the loan. Why PXF? Historically PXF structures have been very popular with Russian borrowers seeking offshore financing for a number of reasons: as far as many banks are concerned, PXF structures (and the associated capture of cashflows under export contracts) are a type of secured financing and, by implementing such structures, Russian borrowers may access long-term funding at a lower rate of interest than would be achievable on an unsecured basis; many banks have specific capital allocations for different types of financing. Accordingly, if a bank s capital allocation for unsecured financing has been exceeded (or is not available for the relevant borrower), PXF may be the only structure which allows the borrower to access funds from that particular bank; given that some banks do not lend on an unsecured basis to non-investment grade borrowers, borrowing on an unsecured basis may not be an option; although the PXF structure imposes restrictions, a borrower may potentially be able to negotiate lighter general commercial covenants in connection with a PXF transaction than in connection with an ordinary unsecured transaction. This distinction may be important for a borrower that is reluctant or unable to restrict its commercial activity; and from a lender s perspective, by capturing cashflows offshore, the PXF structure is helpful as it is neither dependent on local law account security nor (if implemented properly) subject to currency control. However, there are practical difficulties and legal risks associated with PXF structures: the implementation of an acceptable PXF structure requires the co-operation of the relevant off-takers because the export contracts over which security is created have to be acceptable to the lenders and contain specific features (such as no termination without lender consent, no set-off and so on). Offtakers are, in many cases, independent third parties that do not benefit directly from the financing raised by the borrower and obtaining the relevant concessions may therefore require lengthy discussions. In practice, a mutually acceptable compromise is usually realistic and achievable ultimately, the prospect of entering into a new export contract provides the borrower with good leverage in negotiations with off-takers; another difficulty inherent in PXF structures stems from the fact that production and delivery are key to the export and therefore PXF arrangements. Given that the lenders are lending against the cashflow generated by delivering a commodity under export contracts, if production and delivery levels fall, the ability of the borrower to repay the loan will be compromised. Production and delivery risk therefore affects the borrower, the off-taker (who, in the absence of deliveries, is unlikely to honour his payment obligations under the export contract) and the usefulness of the PXF structure itself. Other associated business risks such as commodity price and currency fluctuations are also relevant but can more easily be mitigated (for example, by way of hedging arrangements); and finally, although lenders sometimes agree to spot sales if there is a back-up off-taker, the implementation of a PXF structure usually requires the borrower to commit (on a long-term basis and in respect of committed volumes) to supply particular off-takers with a commodity during the term of the facility. Such a lock-in arrangement creates certainty for the lenders but can restrict the borrower s ability to sell its commodity on the most favourable terms to the most reliable and creditworthy off-takers at a given time. On balance, and as market practice indicates, the advantages associated with the PXF structure outweigh the disadvantages, and this financing method has retained its place in the Russian finance market. 13
Typical PXF structure A typical PXF structure is straight-forward: a syndicate of banks enters into a loan facility agreement with a borrower. If the loan is granted to: a financing vehicle (which does not carry out any business operations apart from raising financing); or a group company (which does not have the highest credit rating in the group), then the lenders will often also ask for guarantees from the operating companies, the holding company, or both of these entities. The borrower enters into export contracts with one or more off-takers. Given that the off-takers are critical to the performance of the export contracts (and, accordingly, the value of the cashflows underpinning the PXF arrangements), the borrower and the lenders usually preagree the identity of the relevant off-takers. Payments under the export contracts are credited to specific bank accounts opened in the borrower s name (usually with the bank that is acting as security agent under the facility agreement). The lenders take security over the rights of the borrower under the export contracts and the proceeds credited to the bank accounts. If local laws or regulation do not permit the taking of proper security over the bank accounts, the lenders may seek to introduce various quasi-security arrangements. A diagram of a typical PXF structure appears below. Deal specific issues may result in variations to this basic structure. For example, tax considerations may require that a direct lending structure is replaced with an alternative lending structure, and security considerations may require the borrower to interpose a special purpose vehicle (SPV) between itself and the ultimate off-taker, such that the security is granted by the SPV (and the borrower and the security provider are different entities). However, regardless of the precise contractual arrangements used, there are three key structural considerations in respect of each Russia-related PXF structure: the financing structure; the cashflow structure; and the security structure. The financing structure The financing structure is usually the most straightforward part of a PFX transaction, and is ultimately determined by tax and capital adequacy issues. If all banks in the syndicate are incorporated in jurisdictions with a double taxation treaty with Russia, the facility agreement will usually be governed by English law and based on standard Loan Market Association documentation (and will therefore be very similar to an ordinary syndicated loan transaction). Capital adequacy considerations may also weigh in favour of straightforward secured syndicated lending. However, if interest payments from the Russian borrower are not fully exempt from withholding tax the classic syndicated loan structure may be sub-optimal. Alternatives, which seek to avoid such tax leakage, include fronting bank structures, prepayment structures and structures pursuant to which risk is transferred by issuing debt securities. A fronting bank structure involves the use of a fronting bank (located in a jurisdiction with a favourable double taxation treaty with Russia) which, by entering into funded sub-participation agreements with the relevant banks, assumes the exposure of those members of the syndicate to whom interest payments from the borrower are subject to withholding tax. In a prepayment structure, the borrower (often an SPV) uses the loan proceeds to prepay for commodities (withholding tax does not apply to the purchase price) which are delivered under a primary delivery contract before being on-sold by the borrower to off-takers under secondary export contracts. Finally, in debt issuance structures, the lenders issue debt securities to capital markets participants and apply the proceeds to fund the loan under the facility. Given that their tax treatment remains a grey area, the implementation of any of these alternative structures requires careful consideration from a Russian law perspective. Outside Russia Russia Lenders assignment loan Borrower / Exporter Debt Service Account excess export contract Offtaker 14
The cashflow structure In the Russian market, the cashflow structure is often the most difficult part of a PXF transaction to implement. Although Russian currency control laws have been liberalised over the past few years, particularly between 2003 and 2006, there remain certain restrictions with which Russian borrowers have to comply and which therefore affect the cashflow mechanics. The traditional expectation of the lenders is that export contract proceeds will be credited to offshore bank accounts and will either be applied towards the repayment of the loan or remain credited to those accounts until the borrower makes the relevant payment under the loan agreement. However, Russian currency control regulations affect how the export proceeds of a Russian borrower are credited to (and subsequently retained in) offshore accounts. The most important restriction is the mandatory repatriation requirement. As a general rule, Russian law requires Russian exporters to receive (into their Russian bank accounts) all export proceeds within the time frames set out in the relevant export contract. A failure to comply with this mandatory repatriation requirement results in severe sanctions: the exporter may be fined an amount equal to between 75% and 100% of the export proceeds and, in addition, the management of the borrower may be subject to criminal sanctions. Another important currency control restriction is the regime relating to the opening of offshore bank accounts by Russian borrowers. This regime only allows the borrower to receive funds into its offshore account in a limited number of circumstances. Given that Russian law does not permit effective security to be granted over bank accounts, from a lender s perspective agreeing a structure whereby the borrower is able to repatriate funds to its Russian accounts can be problematic. To mitigate this risk, effective security over the export proceeds must be implemented offshore. Fortunately, Russian currency control laws contain a relevant exemption: if the export receivables are used to repay a loan granted by a bank based in an OECD country with a term of over two years, no repatriation is necessary and the borrower may credit the export proceeds to its offshore account and apply such monies towards the repayment of the loan. Although the exemption itself is straight-forward, its scope and practical application is not entirely clear. Read restrictively, the exemption may be interpreted as requiring the borrower either to use the export proceeds for the purposes of repaying the loan (or an installment) or, failing that, to repatriate the proceeds to Russia as soon as they are received from the off-taker. However, as mentioned above, the account security usually requires the borrower to retain the proceeds in its offshore account until the next payment date under the facility. The lenders also usually request that their claims are over-secured (so that the amount held in the account is greater than the next repayment). In our view, provided that the export contract and the facility agreement contain appropriate contractual provisions, such a restrictive reading of the Russian currency control laws is not justified. However, in the absence of clear guidance or commentary, it is not possible to entirely exclude the risk that the Russian courts will take a different view. The security structure The final element of any PXF structure is structuring the security over the export contracts and the associated receivables. Security is taken over the borrower s rights to: payments under the export contracts; and monies held in its bank accounts. The second element of the security is straight-forward. The exact nature of the arrangement is determined by the laws of the jurisdiction in which the relevant account is located. Lenders therefore usually request that the borrower open an account in a jurisdiction which permits effective enforcement of their security. Russia is not such a jurisdiction, so usually the relevant collection account will be opened in France, the Netherlands or the UK (with the security being structured under the applicable local law). As a rule of thumb, when taking security over the rights of the borrower under export contracts, the export contract and the associated security agreement should be governed by the same law. If possible, lenders usually prefer that both documents are governed by English law. The reason for this approach is primarily that, compared with other legal systems, English law provides the contracting parties with more flexibility to agree a bespoke enforcement regime. However, this standard approach does not eliminate all of the issues that can arise in connection with structuring security over rights under contracts. For example, in Russian insolvency proceedings English law security may not be recognised. In practice, lenders are usually willing to accept this risk in exchange for the superior enforcement available under English law. Bankability of export contracts A key benefit of the PXF structure is that it provides the lenders with an alternative debt repayment source: the proceeds of export contracts over which security is granted. It is this security that reduces the risk profile of the financing and, potentially, allows the lenders to offer better terms to the borrower. Accordingly, ensuring the bankability of the export contracts is crucial in any PXF structure. The borrower will usually: discuss and agree the lender s specific requirements as to the form and substance of the export contracts; and approach the off-takers with a view to negotiating and implementing these requirements. A bankable export contract meets a number of commercial and legal requirements. The following commercial provisions are usually important: payments by the off-takers under the export contracts should match the borrower s payment obligations 15
under the facility agreement. Accordingly, the lenders will usually insist that the borrower and the off-taker undertake to supply or purchase committed volumes and that the term of the export contract exceeds that of the facility agreement. From a commercial perspective, the borrower may prefer the ability to enter into spot or short-term contracts. From a lender s perspective, such contracts are likely to be acceptable only if they are supported by long-term standby contracts which become effective upon a default of the borrower under the facility agreement. The export contracts should also provide for equal supplies in each quarter, so that payments by the off-takers can be matched to the borrower s periodic payment obligations under the facility agreement; the lenders will want to include an obligation on the off-taker to increase the volumes it has committed to take if this is necessary for the borrower to comply with its obligations under the facility agreement. Lenders will also require the export contracts to include clear price calculation mechanics (and an associated obligation not to change this method); and the last (but by no means the least) issue concerns the identity of the off-takers to the export contract. From a lender s perspective the creditworthiness of the offtaker is a key requirement, and letters of credit can be used as a means of credit enhancement if necessary. Being restricted to selling to a limited number of offtakers under long-term export contracts may mean that the borrower cannot obtain the best price available in the market from time to time. Accordingly, the banks and the borrower need to reach agreement and be comfortable with the off-take arrangements and the identity of the off-takers. The legal issues relating to the bankability of the export contracts are more straight-forward. Essentially, the aim is to ensure that the lenders can take effective security over the contracts. Accordingly, lenders will want the export contracts to contain the following features: an unrestricted right to assign the borrower s rights under the export contracts; a confirmation from the off-taker that it has received no prior notice of assignment or charge in respect of the borrower s rights under the export contracts; provision that all payments under the export contracts are to be made without set off or counterclaim in respect of any payment due from the off-taker; provision that all receivables due under the export contracts are to be credited to the secured account; 16
an obligation on the off-taker not to terminate or amend the export contracts without the consent of the lenders (save for technical amendments, which do not prejudice the interest of the lenders under the facility agreement); and the alignment, between the export contracts and the finance documents, of governing law and dispute resolution provisions. Conclusion In the Russian market there is no one-size-fits-all PXF structure. The specific structure used will depend on the business model of the borrower, its relationship with the off-takers and the nature of the exported commodity. Nevertheless, and notwithstanding the many issues that have to be addressed before a PXF transaction can be implemented: in 2011 a number of the largest finance transactions in the Russian market were PXFs; and new participants are constantly entering the market. Accordingly, given that the Russian economy is commodity driven, it is likely that PXF will remain an important instrument for Russian borrowers in the years to come. 17