Trade in a Cold Climate – How can you protect yourself?
This year is proving to be an unpredictable and turbulent one for international state relations, with the imposition of tariffs by the US and China and the sanctions imposed by the US against various Russian individuals and companies being prominent recent examples.
The effects are being felt amongst commodity traders worldwide; this is a dynamic situation and this article considers how they can minimise the impact of high level decisions on their businesses, in particular when negotiating contracts.
What has happened?
In April 2018, the US implemented sanctions on various Russian individuals and connected companies for alleged "malign activity" conducted by the Russian state. These included Oleg Deripaska, his EN+ group and UC Rusal, the world's second largest aluminium company, which is controlled by EN+; for an update on EN+ Group see HFW's newsflash. Since then, the commodity trading headlines have been dominated by the fallout.
Aside from the impact on alumina prices and the gap in the global supply chain, other challenges have ensued for commodity traders: payments have been blocked by banks and new deliveries from Rusal have been blocked by the two largest metal exchanges; LME and CME Group. The impact has been so severe that the US has subsequently allowed more time for Rusal's customers to comply with the sanctions and even indicated that it would consider lifting them if Deripaska gave up his control of the company, moves which have been positively received by world markets.
What are sanctions?
Sanctions are a political and economic tool used by governments to exert pressure on another country or its government to encourage a change in behaviour or other policy objective. In recent years, the UN, EU, US and others have made extensive use of sanctions against the likes of Iran, North Korea and Russia.
More information on sanctions generally can be found in our Client Guide.
What can businesses do?
There are some "safe harbours" available to businesses in turbulent times, if they plan accordingly. It is important to take some basic steps before entering into contracts:
- Undertake due diligence about your counterparty
- Ensure contracts properly allocate the risk of an unanticipated event
- Consider the benefits of an enhanced insurance policy
Complying with international sanctions is a constant challenge for businesses operating globally. No single authority governs the global sanctions regime, with multiple governments and organisations imposing, amending and enforcing sanctions across jurisdictions.
The consequences of getting it wrong are high. Companies are at risk of fines running into millions of US Dollars; directors can face imprisonment; there is potential to damage both reputation and brand. Conducting thorough and well documented due diligence before entering into a contract, and throughout its life, in relation to the whole contractual chain, can both minimise the risk of exposure and operate as a defence, or reduce the level of penalty in the event of a breach. It can also help to reduce exposure to credit risk.
Contractual risk allocation
It is possible to provide in the terms of the contract for the risk that sanctions which affect performance will be imposed and to allocate that risk between the parties. Termination and/or suspension rights can provide helpful "breathing space" when dealing with a sudden change in sanctions, whether that is new sanctions being imposed, previously permitted entities suddenly becoming prohibited, or suspended sanctions snapping back into place.
While such terms will not prevent the application of sanctions (or excuse a breach of sanctions), they can manage the impact of sanctions on the performance of the contract. Having mutual agreement on these issues in advance permits the parties to be measured and proactive rather than reactive in their response.
Force Majeure (FM)
Following the recent US sanctions against Rusal, Rio Tinto announced that it would trigger the FM clauses in several of its contracts, including one to supply bauxite to Rusal’s Aughinish plant in Limerick, Ireland.
FM contracts are relatively common but this can mean that parties do not always consider or scrutinise them before finalising their contracts.
A FM provision has the effect of suspending or terminating a contract upon the occurrence of one of a range of specified events. FM will only be available to the extent that the contract expressly provides for it and the event prevents performance by a party. Any ambiguity will be resolved against the affected party and if the circumstances preventing performance change, the FM provision may cease to apply. Parties must therefore have in mind the particular risks and circumstances they are seeking to cover when drafting their FM clause and make sure that it is carefully worded so as to operate as they intend. They should also be cautious when triggering a FM clause.
Hardship clauses are used less frequently than FM clauses. They are an attempt to allocate risk in circumstances where performance of the contract is still possible but has become excessively onerous for one or both parties due to unforeseen events outside their reasonable control. They are therefore likely to have limited application. Depending on the terms of the clause, they offer a mechanism to allow parties an opportunity to renegotiate the contract and/or, if agreement cannot be reached, to terminate.
The major challenge when drafting a hardship clause is to ensure that its terms are sufficiently certain as to be enforceable under English law, in particular, what level of onerous performance will trigger it. From a practical perspective, parties considering a hardship clause should also weigh up the risk that a counterparty will invoke it against them.
Credit risk is an inevitable part of the commodities business. Political risk also exists since commodities are often produced and sometimes consumed in countries with political and legal systems characterised by a weak rule of law. Trade credit and political risk insurance is available to mitigate against these risks.
The trade credit product insures against the risk that a buyer does not pay, because of bankruptcy, insolvency or similar legal status. Some policies cover the situation when a buyer pays late (i.e. protracted default cover), the trigger being the expiry of a 'waiting period' which is usually ninety days from the due date. It can be purchased on a 'key' or 'whole turnover' account basis, the difference being the extension of cover to include 'specific' or 'all' counterparties of the policyholder.
There are a number of pre-qualifying requirements which, if not complied with, may allow the insurer not to indemnify the loss or to negotiate down any indemnity. These usually include counterparty credit limits, retention of title clauses, prescribed timeframes for the rendering of invoices and geographical limitations. In the context of protracted default cover, the policy will not respond if there is an on-going dispute about payment between the policyholder and the creditor.
The political risk product insures against the following loss or damage causing events:– Confiscation, Expropriation, Nationalisation, Deprivation (CEND); Political Violence (PV); Currency Inconvertibility / Exchange Transfer (CI/ET); Forced abandonment and Forced Divestiture (FA/FD). The policies are usually bespoke because the risks to which a company is exposed will depend upon a number of variables, such as the identity of the insured, the nature of its business and its trade network, as well as the political and economic situation in the regions in which it operates.
Trade credit and political risk insurance merit close consideration not least because the effect of 'de-risking' transactions can lower the cost of monetary lending which in turn releases money for investment projects.
If cover is purchased, insureds should check whether their policies contain clauses that exclude or limit cover (including by reference to the position under reinsurance contracts) or terminate the policy in a sanctions situation, so that they can assess the value and effectiveness of the insurance to mitigate the sanctions risks.
International trade sanctions are undoubtedly here to stay, and their effects will continue to be felt by commodity traders. International relations remain sensitive and challenging in many parts of the world and sanctions are attractive to politicians and diplomats as an instrument to encourage or coerce change. Parties should be proactive in taking steps to manage the effects on their businesses as far as possible.
At HFW, we are specialists in providing advice to those who work in 'uncomfortable' jurisdictions with a global team of experts available to help. We always recommend seeking business specific legal advice to ensure that you remain fully protected.
On 27 April 2018 RUSAL’s parent company EN+ Group (which was also sanctioned by the US on 6 April 2018 for being linked to Oleg Deripaska) announced that:
- Mr Deripaska has agreed in principle to reduce his shareholding in EN+ to below 50%
- in addition he has agreed to resign from the Board of EN+ and consent to the appointment of certain new Directors such that the Board of EN+ will comprise a majority of new independent directors.
Until these changes occur the situation remains unchanged, but it needs to be kept under careful review.
For further information, please contact the authors of this briefing:
T +44 (0)20 7264 8184
T +44 (0)20 7264 8189
Partner, São Paulo
T +55 (11) 3179 2902