COVER STORY: COLLATERAL MANAGEMENT:Security in the middle

Feature

posted 1 Apr 2000 in Volume 3 Issue 7

COVER STORY: COLLATERAL MANAGEMENT
Security in the middle

Nicholas Budd, partner and head of the commodity trade finance practice group at White & Case in Paris gives an introduction and background to the world of field warehousing and the application of collateral management services in commodity financing transactions past and present.

Since the 19th century borrowers in developing countries, including North America and Western Europe, faced many obstacles to capital formation in the form of high taxes, unstable currencies and distorting government policies, lack of local bank liquidity, and inefficient securities markets. Companies operating in the soft commodity sector have the additional burden of high seasonal borrowing requirements, and companies in the mining, metals and petroleum industries have high capital goods borrowing requirements which cannot be amortised in one or two years. The story of gradual capital formation in North and South America and Australasia in particular, where the distances to market are the greatest and personal connections were initially weak, is very much a story of collateral management and third party collateral control.

Virtually every organised society has recognised the possessory pledge as a viable form of security over goods, for several simple reasons. If a company delivers goods to its bank, it is demonstrating clearly an intention to pledge the goods as security. If the bank is holding the goods, it is unlikely that other creditors would be mislead and induced into lending against the same asset, or if they do they are at fault for being reckless in not verifying the collateral. And if the bank is holding the goods, the goods can be sold if necessary without a breach of the peace, which is always an important governmental concern.

From these simple concepts the lawmakers, commercial banks and central banks in a large number of countries fashioned the warehouse receipt as a document of title to goods, and eventually permitted these documents to be issued against goods located in the owner’s plant or warehouse so long as independent control was respected and signs were posted to avoid confusion to other creditors. This simple collateral management tool was tremendously successful in the early 20th century and nothing illustrates this more vividly than the fact that there were over 200 independent field warehouse companies operating in North America alone. These loans were funded by banks though the sale of bankers’ acceptances, which at one time was the prime money market instrument in both North America and England, and was developed in part to encourage short-term secured lending by banks.

An overview of modern collateral management services:

Field warehousing involves the lease of the customer’s plant or storage facilities, the posting of signs giving public notice of the possession by the collateral management company (CMC), the installation of locks and seals, management by bonded staff, and issuance of legally valid warehouse documents.

Warehouse contracting involves the back-to-back issuance of storage documents covering goods in an independent warehouse. The CMC assumes the risk of the local warehouse company.

In non-custodial verification, the CMC merely inspects and confirms the collateral position on a regular basis but assumes no responsibility for the continued availability of the goods.

Document trusteeship means the CMC acts as a depository for fast-moving documents such as bills of lading and warehouse receipts but does not take responsibility for the underlying performance of the issuer of these documents.

Receivables certification and control services are sometimes available through CMCs to ensure that as goods are released from storage they are converted into eligible accounts receivables which have been assigned to the bank.

Role of the collateral manager

To assure physical availability of commodity collateral. Physical availability assures not only that the advances are adequately collateralised but that the proceeds of the advances are being used by the customer to purchase or process the commodities. If the commodities are being stored in a remote location or in many locations, third party control allows a borrower to utilise inventory collateral efficiently as a basis for advances.

Assure legal security of commodity collateral. Legal security in many countries is only possible or practical when the collateral is either delivered to the bank or to the bank’s custodial agent (ie, the possessory pledge). In commodity financing transactions, unless the bank has its own warehouses, this means that the collateral must either be held in an independent terminal warehouse or in the customer’s warehouse which has been leased by the CMC.

Provide practical and cost-effective procedures for monitoring commodity collateral. Collateral monitoring in commodity financing transactions is a complicated business: goods are transformed from raw materials to refined products involving changes in weight, packaging, physical characteristics and values for borrowing purposes. A CMC can report weekly on each stage of this process and provide valuable assistance to the bank and borrower alike to assure that the loan is not only secured but that the borrower is able to utilise the security efficiently for borrowing as well as commercial activities.

Provide a basis for other types of insurance. There are a variety of risk management products available to assist in a structured commodity trade finance transaction: political risk insurance to cover the inability to export or to repay loans due to government interference; cargo insurance to cover the risk of fire, flood, and theft; options and futures to cover the risk of a decline in the value of the commodities. All of these coverages are useful but none is effective if the goods do not exist or if the bank’s legal claims are defective. Collateral management can assure that these other risk management services have a sound foundation.

Modern collateral management service providers

International terminal warehouse companies. Some international terminal warehouse operators to actively solicit banks as clients and are providing collateral management as a stand-alone business. Cornelder, for example, is active in Central and Eastern Europe, the Far East, and Latin America.

International inspection companies. SGS initially entered the collateral management business in the early 1970s in partnership with a large North American insurance and financial services conglomerate, INA Corporation. Eventually the INA interest was acquired by Citibank, and the joint company at its most active had offices or representatives in over 26 countries. Unfortunately Citibank withdrew from this company in 1985, and SGS has carried on independently, but on a reduced scale. In the meantime other inspection companies, notably Bureau Veritas, have established collateral management capability in certain geographical areas.

Local bank-owned field warehouse companies. In Latin America in particular banks have organised field warehousing subsidiaries to service their customers. Bank-owned field warehousing companies are particularly prominent in Mexico, Colombia, Brazil and Paraguay.

Dedicated collateral management companies. Full-time collateral management companies do not exist in large numbers today. Audit Control & Expertise (ACE) has appeared in the market within the last several years and has enhanced greatly the awareness of the potential for collateral management among international bankers in Europe. Auxiga and Le Warrant have been quietly and successfully doing collateral management work in France and Belgium for many years, and there are several specialist collateral management companies operating in the US.

A closer look at field warehousing

Field warehousing is a security device which enables the borrower to deliver to the lender legally valid documents of title and to grant a possessory pledge of goods stored in the borrower’s own plant, mill, refinery or warehouse. The issuer of the field warehouse receipts creates a legally independent warehouse within the borrower’s premises by leasing the storage area, controlling movements in and out, and posting prominent signs giving public notice that the controlled area is operated by the field warehousing company. Access to the warehouse is controlled either by members of the borrower’s staff who are temporarily employed by the warehouse company for this purpose, or by members of the field warehouse company’s staff. The warehouse records and inventory levels are periodically audited. The integrity of the staff (whether permanent or temporary) and contractual liability of the field warehouse company are insured under a fidelity and errors and omissions policy.

In a few words, the objective of field warehousing is to enable the lender and borrower to enjoy the benefits of warehouse receipt financing, but instead of moving the goods to the warehouse, the warehouse is moved to the goods. In doing so, the possessory pledge is converted to a relatively convenient and cost-effective form of security with a much higher degree of legal protection and practical control than is afforded by a registered charge or security interest. This technique addresses directly the most critical commercial finance issues in developing countries where perceived risk is high and both the legal structure and local bank sophistication in collateral management techniques are, for the time being, in need of substantial development. This development process may be inevitable, but will take time, and in the meanwhile field warehousing, where legally recognised, can provide a useful halfway house to enable lenders to lend safely and for borrowers to borrow efficiently.
The possessory pledge and financing of goods stored in independent warehouses has been a financing technique employed by lenders since at least the 5th century BC. Even today in countries such as the US and UK, which have adopted registration by filing, creditors holding documents of title such as warehouse receipts enjoy a super-preferred status vis-a-vis other secured creditors and expedited treatment in insolvency proceedings.

The reasons for the preferred status of warehouse receipts as security are several:

In many countries a document of title held by a good faith purchaser or lender cuts off claims of unpaid sellers and other encumbrancers, and need not be registered. This is an extremely important advantage in countries in Central and Eastern Europe and the CIS where the chain of title to goods and the existence of competing creditors and unpaid sellers is often difficult to verify with certainty.

A lender holding a warehouse receipt has a claim against the issuer as well as the borrower in the event of the non-existence or unauthorised release of the collateral. This is why banker’s acceptances secured by warehouse receipts or bills of lading are sometimes referred to as ‘three party paper’ (the borrower, the accepting bank and the custodian of the collateral). In the event of loan default, collateral covered by documents of title can be auctioned or sold promptly and at minimal cost ‘as is where is’ by the lender by negotiation of the document or written notification to the warehouse operator.

Even in OECD countries, the bankruptcy laws and tribunals can deal far more easily with security given in the form of a possessory pledge, because the identity of the collateral is incontestable and the intent of the borrower to pledge the collateral is clear. When a pledge is coupled with delivery of a title document, disputes as to ownership and competing claims are also avoided. One reason for the slow processing of claims and pro-borrower and pro-unsecured creditor bias of courts in security registration jurisdictions is the potential for over-collateralisation and disputes over title and the formal aspects of perfection. These problems are substantially reduced in cases where the borrower has delivered possession of specific, identified collateral to a third party bailee expressly for the purpose of securing the loan and the bailee has issued a negotiable title document, and the courts and bankruptcy laws in a number of countries accept this important distinction.

Certain types of highly efficient money market instruments, such as eligible bankers’ acceptances in the US and UK, require the lender to hold title documents as a condition to the use of central bank rediscount facilities, and in many OECD countries these facilities are not subject to mandatory reserve and provisioning requirements as are other loans of similar tenor and form where security is taken merely by registration. US banks are expressly authorised under Federal Reserve regulations to create banker’s acceptances against goods in foreign storage and to use field warehouse receipts as title documents.

The law or practice of most countries already recognises the concept of the possessory pledge and the legal standing of independent warehouses to act as pledgeholders. Field warehousing in those countries which practice it has developed largely as a matter of case law over the past 100 years, in which the courts have considered whether particular field warehouses are operated in a sufficiently independent, continuous and notorious manner so that possession can be said to have passed to the warehouse company and constructively to the lender. In developing countries and new market economies, these standards could be codified to speed up the process and remove any doubt.

The laws relating to documents of title to goods held by recognised bailees and the rights of good faith purchasers and encumbrancers holding such documents are not well developed in the new market economies and in many developing countries. And this is an unnecessary and easily corrected impediment to both trade and commercial finance. Any number of North American, European and Latin American jurisdictions could provide workable models.

As a related matter, the laws concerning the qualification, supervision, and insurance of independent warehouse companies, while probably not essential to accommodate field warehousing, should nevertheless be brought into line with international standards. Many Latin American countries have quite advanced laws relating to warehouse operator qualifications.

One issue which is key to the efficient and convenient operation of field warehouse finance is the clarification of the right to rotate and substitute collateral without affecting the validity of the pledge, in order to facilitate normal commercial operations. Another issue is the clarification of laws relating to the comingling of fungible goods which may be pledged to several lenders or which may constitute both pledged and unpledged goods. The law regarding title to bulk goods was resolved favourably in the US under the Uniform Warehouse Receipts Act and latterly under Article 7 of the UCC, but until recently was a problem under English law. The UK has now adopted the US practice.

Field warehousing can and does exist side-by-side with security by registration, however apart from (and because of) its control features, holders of title documents and possessory pledges have procedural advantages and priorities. The control elements and procedural and priority advantages of field warehousing are precisely suited to the needs of commercial lenders, both local and international, operating in the new market economies and developing countries, and should be available as an alternative means of taking security in goods in these countries. With the passage of time, as local banks develop effective collateral management capabilities and the laws relating to registered security and insolvency develop, this technique will doubtless be used only in exceptional cases, as it is in the US today. In the meantime, however, and probably for the next 10 years at least, field warehousing where recognised will provide a powerful tool for lenders to lend and for borrowers to maximise the collateral value of their inventories.