What is a Forward Flow Agreement?
Forward Flow Agreements are contractual arrangements between buyers (i.e., the financial institutions) and sellers (the originators) of future payments or receivables. Their basic purpose is to establish a framework in which the seller can sell, on a regular basis, a defined stream of payments. For example, the seller may commit to selling all of the payments related to a pool of loans (or a mortgage servicing portfolio) that are at or below a specific interest rate, and the buyer will commit to purchase those payments over the defined period. Forward Flow Agreements can only be properly structured by parties with a strong understanding of the risks involved with the underlying payment streams . Since forward flow transactions reoccur over several months or even years, a proper risk assessment must take into account not only the quality of the individual loans that are pledged to meet the forward flow obligations but also the expected results on the entire pool of loans over the term of the transaction.
As with all financial transactions, both parties to a Forward Flow Agreement are exposed to inherent risks which must be carefully considered prior to the transaction’s close. In addition to these standard risks, Forward Flow Agreements may also expose the parties to several other transaction-specific risks. For example, cat and youth loan Forward Flow Agreements have specific risks inherent to their underlying asset class which could be different from other senior-sub debt transactions which are based on other types of loans.
Benefits of Forward Flow Agreements
A forward flow agreement (FFA) presents numerous advantages for both buyers and sellers. For instance, an FFA allows for effective long-term financial planning for sellers, enabling them to allocate their resources accordingly. The consistent sales of receivables provide a predictable cash flow and minimize the impact of market volatility on their business operations.
For buyers, FFAs offer the convenience of predictable and regular access to a steady pool of assets at a set price, allowing them to estimate their financing needs for a given period. In the future, buyers can forecast how many debtors will be acquired for a specified price during the next quarter. They can also create a schedule for the number of debtors they want to buy over a long-term period.
In addition, the forward (or fixed amount) aspect of the forward flow agreement helps buyers better manage their cash reserves, by ensuring that the amount which will need to be paid out and the anticipated inflow are, presumably, relatively constant.
Finally, there are additional benefits to FFAs and asset purchases including immediate delivery; identified pools of assets rather than unidentified assets; cheaper cost of capital compared to discounting; etc.
Common Use Cases in Industry
Forward flow agreements see applications in the insurance, banking and asset management sectors. For example, a typical usage for a forward flow agreement (FFA) in the insurance industry would be where a broker has secured binding general cancellation rights on a portfolio of life and disability insurance policies with a life insurer, and seeks to sell such binding cancellation right to a reinsurer via a FFA so as to spread the risk across reinsurers who are willing to accept the cancellation rights and pay for such cancellation rights, rather than just one reinsurer. Under the FFA, the cedent (i.e. the broker) would be obliged to offer the FFA reinsurer rights under the insurance policies as and when they arise and subject to the FFA reinsurer paying the premium. The premium paid by the FFA reinsurer would bear some correlation to the value of the cancellation rights transferred, so as to reflect the underlying mortality, in cases of life insurance or claims rates, in cases of disability insurance, rather than being a flat percentage of the amount of the policies. Banks may use FFAs in connection with loan syndication transactions, where the company next in line in the syndicate is an affiliate of the arranging bank and the syndication would not proceed unless the arranging bank has acquired the syndicate rights. In this way, the FFA operates to ensure that, as a consequence of the syndicate failing, the last syndicate right-holder is a company controlled by the arranging bank. Investment funds, may use FFAs in a similar manner, in connection with the acquisition of target companies. In this case, the FFA would operate to ensure that the target company is ultimately controlled by the fund. In all cases, there may be a commercial rationale for the parties to the FFA to structure the transaction in a particular way. However, those reasons may not impact materially the legal and regulatory treatment of the transaction and, depending on the structure adopted, the parties may be subject to risk-based capital charges and/or reporting obligations in Australia, Europe and the United States.
Associated Risks
Forward flow agreements, like any complex financial tool, carry a number of potential risks. The parties involved may find that there is an imbalance between the costs and benefits of the arrangement or that external market influences outweigh the benefits. Each of these considerations should be analyzed prior to contracting.
When analyzing the cost benefit of a forward flow agreement or deal, the most important concern is whether the deal is beneficial for both parties. In other words, whether the analysis shows a positive NPV. If so, the parties can go forward and agree terms in the forward flow agreement. However, if the deal is negative, then the parties may want to discontinue their negotiations.
The creditworthiness of the buyer may be of concern to a seller. In that regard, the seller may wish to put specific qualifications into the contract, perhaps requiring that if the buyer falls below a specific credit rating, the terms of the contract must change or the contract terminated. The seller may also wish to consider whether the deal should be secured.
If the deal is secured, there should also be a discussion about who is responsible for the securing of the deal. While many times banks will be able to secure a deal themselves, it is not unheard of for the collateralization process to involve outside entities. The parties will want to ensure that there is no ambiguity regarding this issue. The same goes for whether there is recourse as to the selling party if the counterpartily defaults.
Not surprisingly, deals that are considered forward flow transactions often involve extreme price volatility. The parties may them be wary of entering into an agreement that locks them in to transacting at a set rate. This problem becomes exacerbated where third parties can continue to purchase and resell the same financial product from the seller. This may be particularly problematic for a seller who is worried about competitors undercutting their prices. The buyer may be unwilling to enter into an agreement where the seller can always set their prices lower. Here, the parties may want to consider opening the door to renegotiating the price in the agreement if the market price fluctuates a certain amount.
The parties may also want to consider other effects on long-term pricing. For instance, how will inflation affect the contract terms? Are there any terms in the contract that could lead to litigation? Do the parties have a plan in place to address disputes?
Many of the issues that have been raised are handled through insurance. For instance, both parties may consider insuring the collateral in the loan. However, they may also structure regular premiums into the contract using the buyer’s cash flow as a guarantee for the seller.
It is important to read the forward flow agreement carefully before signing. Failure to do so can lead to lost money, time and resources, as well as long-term legal repercussions.
Legal and Regulatory Considerations
In the context of forward flow agreements (FFAs), parties must also consider a host of legal aspects and regulatory compliance issues. The particular regulations surrounding FFAs largely depend on the jurisdiction within which the transactions take place.
In the United States, forward flow transactions could raise a number of securities law issues. Some market participants have determined that the forward sale of loans is the offer and sale of a security resulting in the offer and sale being a "securitization transaction" under the Securities Act. As a result, companies selling these loans to loan purchasers in a forward flow arrangement typically must either register the transaction with the Securities and Exchange Commission (SEC) or must elect an available exemption from registration. Some sellers have been able to structure transactions such that they do not constitute a security under various approaches to the "sale" of a forward-flow right. Other sellers in the same space find it difficult to satisfy the SEC’s interpretation and have chosen to register the transactions.
The Dodd-Frank Wall Street Reform and Consumer Protection Act established a new integrated regulatory framework for derivatives. As a result, the Commodity Futures Trading Commission (CFTC) will regulate certain derivatives transactions , while the SEC will regulate others. Of relevance to forward flow transactions, certain derivatives transactions, including swaps, are required to be reported to a trade repository, known as a swap data repository (SDR). However, although FFAs may well have swap-like characteristics, the CFTC, in effect, exempted FFAs from the SDR reporting requirement because considered forward and call loan sale transactions to be fundamentally different than swaps. As such, FFAs are not subject to the SDR reporting regime.
In the UK, there are no specific regulations governing FFAs. However, both the Financial Services & Markets Act 2000 and the FSA’s Principles for Businesses apply. The key principles will often be met by a FFA as both buyer and seller should treat their agreements consistently with the nature of the commercial relationship between the parties. In addition, both parties should establish proper governance and risk management processes.
Similar to the United States, some derivatives regulators in Canada (including the Canadian province of British Columbia) have taken the view that certain FFAs constitute derivatives transactions and should be regulated as such and are subject to mandatory reporting under Canadian Securities Administrators’ National Instrument 91-102 Derivatives: Product Determination.
How to Draft a Satisfactory Forward Flow Agreement
When drafting a forward flow agreement, there are several critical elements to consider. The terms of the agreement should clearly detail the scope of the transaction, the process for identifying and delivering the assets, how the assets will be priced and how the price will be communicated, how the transactions will be scheduled and how they will be settled, how changes in law and new regulatory requirements will be handled, how regulatory capital treatment will be determined, a mechanism for termination or substitution, the treatment of legal, tax and other fees and expenses, restrictions on sales to related parties, a protocol for notice and amendment, and chosen law and forum provisions. In many cases a well drafted forward flow agreement serves as a companion document to a first currency option transaction in order to restate the framework to satisfy the collateral base requirements.
A critical clause often neglected is the so-called "trade cooperation" clause. Such clauses may look something like the following:
If a Transaction Grouping includes a Transaction that is not consistent with the representations and warranties set forth in the Transaction Confirmation issued pursuant to the On-Market Terms in respect of Transactions, Buyer and Seller shall cooperate so that that Transaction may be restructured so that said Transaction is consistent with such representations and warranties (the "Trade Cooperation"). Seller, in its reasonable discretion, shall determine whether such Transaction may be "restructured" in accordance with this sentence, and such trade cooperation shall include the right for Seller to amend the terms of such Transaction including, but not limited to, the strike price, duration or sizing of such Transaction. To the extent that a Transaction subject to a Trade Cooperation cannot be restructured in accordance with the preceding sentence, the Terms and Conditions of the Transaction Confirmation shall be voided with respect to that Transaction, and at that point, the terms and conditions shall be restructured so that the Transactions are consistent with the representations and warranties noted above, and the Transaction Confirmation will be deemed amended. In no event will Buyer, in its capacity as Buyer under the On-Market Terms, incur any costs or liabilities resulting from the Trade Cooperation.
While the terms of the transaction will likely be negotiated repeatedly and in great detail, it is critical that the key concepts be restated in the full transactional document. Such concepts include: trade pricing, scheduling, and settlement; encumbrance provisions; description of the assets; collateral valuation; regulatory capital treatment; loan servicing; margin calls; tracking and reporting capabilities; collateral monitoring procedures; and tax treatment.
The most effective practice for expediting the negotiation process is to draft a master template document that can be used to address the key terms of the transaction, and that is then amended to address other transient elements specific to the deal.
It is common for financial institutions to require that both Issuer and Counterparty be represented by counsel. This is a red flag that they are using a "box transaction" or "fund through" structure, whereby the institution acts as an intermediary for many investors. Such representations, almost universal in Europe, are not usually needed for U.S. documentation. This is a major difference between European and U.S. style forward flow documentation.
Future Trends
Looking forward, the use of forward flow agreements will likely continue to evolve along with the broader financial markets. We anticipate that forward flow agreements will remain an important tool in securitization markets, where they will be used as a risk-reduction mechanism for market participants. As these agreements become more common, however, new methods and technologies may emerge to optimize such transactions. Digitalization of markets may also affect the way that contracts are executed and enforceable, as well as the types of information that can be captured in the forward flow process . These changes will benefit from continued engagement with the various constituencies involved and may lead to increased transparency and better data standards for such products. The development of standards to facilitate analytics on forward flows, both from an origination and trading perspective, will also be particularly important to ensuring that forward flows can be better compared to other securitized products across markets and sectors.