Does a documentary credit secured by an assignment, assignment for security and/or pledge of the underlying sales contracts with payment to be effected to an account pledged in favour of either the lender (i.e. L/C issuing bank) or the security agent (especially in case of a syndicate) satisfy the condition of Annex 1 (3) (a) (i) CRR that “the underlying shipment acts as collateral or that the transaction is otherwise self-liquidating”?
The wording of Annex 1 (3) (a) (i) CRR (“documentary credits in which underlying SHIPMENT acts as collateral and other self-liquidating transactions”) requires the shipment (i.e. the shipped goods) as collateral, while it is not clear if this could also refer to freight papers (i.e. the underlying shipping documents) as collateral.
In certain trade finance transactions - as a consequence of the nature of the shipment and the chosen means of transport (e.g. if the borrower transports and/or trades gas or oil, which is not shipped in self-contained units, but transported in pipelines) or the fact that the borrower purchases and sells on the same delivery terms (i.e. is not involved in transportation or storage) - it is (i) not feasible to obtain the freight papers as collateral (due to the non-existence of such) and also (ii) not advisable to rely on the underlying shipment (i.e. the shipped goods as e.g. gas or oil) as collateral, since there may be (a) legal concerns by whom the gas/oil in a pipeline is owned and consequently whether e.g. a pledge or a retention of title of such gas/oil in pipelines is enforceable at all in the relevant jurisdiction and/or (b) (assuming that it can be established legally valid) factual concerns with regard to the recoverability of such security, as e.g. such gas/oil in some cases is even burnt for the production of thermal or electric energy immediately (meaning that all rights in rem will expire). In such trade finance transactions, therefore, it seems that the requirement of “documentary credits in which underlying SHIPMENT acts as collateral” cannot be fulfilled.
Considering the before mentioned, such financings are typically secured by way of assignment, assignment for security and/or pledge (depending on the governing law) of the borrower’s receivables under the sales contracts (of the goods), whereby payment under the sales contracts is to be effected to an account that is pledged in favour of the lender (i.e. L/C issuing bank) or security agent (especially in the case of a syndicate), because this is considered as the most secure way of taking collateral.
As a consequence, such method of taking collateral (as the only secure way of taking collateral) could qualify as self-liquidating transaction pursuant to Annex 1 (3) (a) (i) CRR (which term is not defined in the CRR).
A clarification of whether such transactions fulfil the condition of Annex 1 (3) (a) (i) CRR that the underlying shipment acts as collateral or that the transaction is otherwise self-liquidating would contribute to consistent application of the CRR.
Where documents are required prior to a payment by the institution confirming that sold goods have been sent (irrespective whether still on the way or already arrived) but which do not provide a security interest (such as through title transfer) on the sent goods to such institution (i.e. the holder), this qualifies as a documentary credit which is a medium risk item in accordance to Annex I point (2)(a) CRR, but not as a medium/low risk item in the form of a documentary credit in which underlying shipment acts as collateral or other self-liquidating transactions, according to Annex I point (3)(a)(i) CRR.
If trade financing constitutes an off-balance sheet exposure where payments by the institution do not require documents confirming that sold goods have been sent, this does not constitute a documentary credit at all.
Update 26.03.2021: This Q&A has been reviewed in the light of the changes introduced to Regulation (EU) No 575/2013 (CRR) and continues to be relevant.