United States: Sovereign Trade Finance Transactions: A Legal Perspective

Last Updated: January 28 2005
Article by Scott W. Wright

In today’s low-yield climate, institutional investors, hedge funds and others are seeking to maximize yield. One investment product gaining in popularity is sovereign trade paper. This article will provide a short background into the nature of sovereign trade paper and address two of the main legal concerns of investors.


The rationale for generating sovereign trade paper can be illustrated very simply. Take a machine tool manufacturer, for example. The company wins a contract to export equipment to a buyer in another country, but the buyer requires deferred payment terms. The machine tool company has no interest in taking credit risk on the buyer, so the buyer arranges for trade paper to be created. Third party financing is sought in the trade paper market in order to fund the machine tool manufacturer in full, while allowing the buyer to repay the third party financier at a specified time in the future.

Typically, sovereign trade paper is traded by sophisticated investment boutiques and large financial institutions, traditionally in Europe. However, U.S. investors increasingly are attracted to this asset class, because of relatively high yields. The pricing of such paper can be straightforward. From an investor’s perspective, sovereign trade paper usually is priced on a discount to yield basis, and the maturity profile looks like a "zero coupon bond," i.e., it does not pay periodic interest. To determine the purchase price of a trade paper transaction, the "discount to yield" rate is obtained by adding an agreed risk margin to the appropriate average life USD LIBOR rate, usually set three to five days prior to the settlement date ("rate setting date"). For example, assume that an investor is buying a one-year foreign Ministry of Finance guaranteed obligation with a face value (i.e., maturity value) of USD 1 million, a risk margin over LIBOR has been agreed at 6 percent, and on the rate setting date USD 1 year LIBOR was 2.80 percent. Therefore, the net proceeds would be discounted at a rate of 8.80 percent per anum. The settlement bank would use a standard formula to calculate the net proceeds that the investor would be required to fund. In this example, the investor would pay approximately USD 916,500 on the settlement date. At the end of 12 months, the investor would receive back the full face value of USD 1 million.

Legal Perspective

From a U.S. lawyer’s perspective, sovereign trade finance transactions are un-remarkable. Typically, a finance company purchases promissory notes from an exporter or is issued promissory notes directly from the importer in an emerging market economy. As part of the transaction, an emerging market sovereign or an emerging market sovereign entity will issue the promissory notes directly or guaranty payment. Either way, an international financial institution acts as settlement agent for the purchase of the notes to avoid fraud and to lend its expertise to the settlement process.

One question investors sometimes have is what is meant by "sovereign" and "sovereign entity." The International Monetary Fund ("IMF") de- fines a "sovereign" as the "the central government [and] all administrative divisions and agencies that form part of the central government’s budgetary process." International Monetary Fund, "The Design of the Sovereign Debt Restructuring Mechanism—Further Considerations," at 14, www.imf. org (Nov. 27, 2002). The IMF defines a "sovereign entity" to be "[a] public entit[y] that [is] established as separate legal entit[y] rather than as administrative departments of the central government and which do not form part of the central government’s budgetary process." Id. Such entities may be established by statute or may be corporations that are owned or otherwise controlled by the government. Id.

The Fraud Concern

Investors in trade paper often are concerned about fraud. Under the law established by the Uniform Commercial Code in the United States, the investor in a typical sovereign trade finance transaction purchases the promissory notes free of any fraud defense, so long as the investor is a "holder in due course." A "holder in due course" is a person who purchases the promissory notes for value, in good faith and without knowledge of any underlying defenses to payment, such as fraud. See generally UCC Section 3-302. This principle has been upheld in trade finance transactions in the United States. See, e.g., A. I. Trade Finance, Inc. v. Laminaciones de Lesaca, S. A., 41 F.3d 830 (2d Cir. 1994). In that case, the United States Court of Appeals for the Second Circuit ruled that a holder of promissory notes in a trade finance transaction was a "holder in due course," unless it had actual knowledge of fraud.

In general, there are two aspects of fraud that are of concern. The first is that the underlying transaction was fraudulent or that the sovereign entity did not have the authority to issue its guaranty. This concern can be addressed by the investor being given a legal opinion from a reputable local law firm. Such a legal opinion helps to establish the factual basis for the investor being a "holder in due course." At Reed Smith, we routinely coordinate for our clients the delivery of legal opinions in emerging market countries.

The second concern is with fraud in the settlement process itself. This concern is readily addressed by using an international financial institution as settlement agent. The typical settlement agreement, which is used to govern the obligations of the financial institution as settlement agent, obliges the financial institution to undertake to ensure the validity of the settlement process and that no fraud is apparent on the face of the settlement documentation.

Sovereign Immunity

A second concern for investors in sovereign trade finance transactions is ensuring that the sovereign performs its payment obligations. This raises the issue of sovereign immunity. In the United States, courts asked to enforce contractual obligations of foreign sovereign governments tend to find in favor of the investor. In Republic of Argentina v. Weltover Inc., 504 U.S. 607 (1992), for example, the United States Supreme Court found that the issuance of bonds by Argentina was not subject to traditional rules of sovereign immunity from law suit, because this amounted to commercial activity. Trade finance activities of emerging market sovereigns would likely be afforded the same treatment.

In addition to this rule of law, it sometimes is possible to obtain an explicit waiver of sovereign immunity from the emerging market governmental department involved in the particular transaction. In those cases in which such an express waiver is obtained, the courts in the United States uphold them under their express terms. It is important, though, that any waiver not only apply to jurisdiction and legal service of process in any suit or action to enforce contractual rights, but also in connection with execution, or attachment in aid of execution, prior to or subsequent to judgment. This will help in collecting on any judgment entered against the sovereign.

In sum, sovereign trade paper can be an attractive asset class for sophisticated investors interested in increasing yields. Settlement and legal risks can be mitigated through the use of an international financial institution as settlement agent and experienced legal counsel. Also, sovereign immunity concerns have been resolved in U.S. courts.

This article is presented for informational purposes only and is not intended to constitute legal advice.

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