What’s in store?

Field warehouse receipts are increasingly being utilised as credit instruments in developing countries. This form of financing has many advantages, but only if used correctly, as Andre Soumah explains.

Many commercial banks and major commodity traders adopted warehouse receipt financing in the mid-1980s following the take up of market liberalisation policies in a number of developing countries. Most of these financiers suffered massive credit defaults, which led to a virtual abandonment of this mode of financing. The losses suffered could be attributed to a poor enabling environment and lack of prudence on the part of financiers. In recent times, a number of banks have shown interest in warehouse receipt financing, particularly in areas of export and import commodity trade.

In light of this growing interest, and conscious of past negative experiences, this article intends to examine measures and conditions for successful use of warehouse receipts as a lending instrument. The focus is on field warehouse receipts as a financing tool in developing countries.

Definition and conditions

A field warehouse is a special warehouse established by a registered or licensed warehousing company on the premises of a business concern for the purpose of taking custody of commodities, which the business concern intends to pledge as collateral for a loan. A field warehouse is different from a terminal warehouse or other forms of public warehouses in two ways: First, the warehouse is located on the premises of the depositor, who also either owns or is the legitimate lessee of the warehouse. Second, the warehouse is specifically set up to receive and store only commodities belonging to the business concern owning the warehouse.

The usual purpose of a field warehouse managed by an independent warehousing company is to enable the warehousing company to issue warehouse receipts, which could be used by the commodity depositor as collateral security for a loan. In this way, field warehousing makes inventories of a business concern bankable. It is therefore a credit-facilitating device. In order for the field warehouse to meet this basic objective, the following conditions must be assured:

The warehouse and its management must be under the complete control of an independent warehousing company. This requires that the warehousing company leases or sub-leases the warehouse at a fee (often a token fee) and that the landlord signs a landlord’s waiver and consent, which will not permit confiscation of stored goods by the creditors of the landlord.
Integrity and competence of the warehouse company and its staff must be assured.
The custodian of the warehouse must be a staff member of the warehousing company.
The depositor must carry appropriate property and casualty insurance to cover the pledged merchandise. In many developing countries, such insurance policies do not cover acts of God or acts of public enemies, such as riots, public disorder, war (including civil war), fires caused by lightning, explosions, etc. In such cases, a supplemental policy will be required to cover losses from these perils. The lender will be named the loss payee of the insurance.
The warehousing company must carry staff fidelity, errors and omission insurance indemnifying holders of its warehouse receipt against losses arising from staff negligence or fraud.
The warehouse must bear external signs or appropriate markings showing that it is under control of the warehouse company and independent from the business concern owning the premises.
The goods referenced must be under full control of the warehouse company and marked as belonging to the lender.
Access to goods, even by employees of the borrower, must be limited at all times.
Since the legal framework in many developing countries is weak in supporting warehouse receipt financing, a detailed collateral management agreement must be put in place and should specify, inter alia, legal ownership of the commodity and legal responsibilities of the parties – the depositor (borrower), the financier and the warehousing company.

The meeting of these conditions will establish an effective bailment where the warehouseman has “continuous, exclusive and notorious possession” of the stored produce.

Advantages

The operation of field warehousing has several advantages, especially for small and medium-sized enterprises and those in agriculture and agro-industries, where banks and other financiers may have limited opportunities for extending credit. Small and medium-sized industries in developing countries have weak capital bases and are often constrained in expanding their operations by inadequate working capita. Such enterprises with marginal creditworthiness can take advantage of asset-based lending. The key advantages of warehouse receipt financing are that it:

Provides a good opportunity for working-capital borrowing by making inventories and accounts receivable bankable through asset-based lending. Asset-based lending involves lending to a borrower on the basis of assets made available by the borrower to serve as collateral. Such assets could include inventories, accounts receivable, LCs, machinery, equipment and other tangible and intangible assets. Asset-based lending, using inventories and receivables as collateral, is self-liquidating if cash received from sales are applied to the repayment of the loan. This form of lending therefore provides opportunities for banks to lend to small and medium-sized enterprises with minimum and managed exposure to default risks.
Provides a good credit device for enterprises whose business is seasonal or cyclical, such as agricultural and agro-processing industries and import-export trading concerns, which need to carry inventories or receivables due to the seasonal or cyclical nature of their operations and for economic reasons. For example, an agri-business may need to hold large inventory to take advantage of better off-season prices; an agro-processor may need to buy agricultural commodities at harvest to assure supply of raw material for processing at off-season. Borrowing may be required to meet immediate needs while holding inventory. Such borrowings are usually tied to asset account balances, of which inventory and account receivables constitute the greater part.
Creates an investor-friendly climate by improving opportunities for profitable operation for borrowers as well as lenders, while improving protection against loss of investment.
Reduces commodity losses as it provides the opportunity for well-managed commercial storage by a warehousing company with a high level of technical and managerial competence. It also minimises price instability through inter-temporal and inter-regional market integration. Costs of storage are kept low since goods are held in the warehouse of the producer, thus eliminating the transport and handling costs of moving commodities to the terminal or any other forms of warehouse.
Enjoys certain advantages as a security document, even under the laws of many developing countries. For example, a warehouse receipt held by a lender cuts off claims of other encumbrancers and does not need to be either registered or attorned in the case of non-negotiable warehouse receipts. Furthermore, a lender holding a warehouse receipt has a claim against the issuer and borrower in the case of non-existence of the commodity or unauthorised release of goods serving as collateral.
In the case of a loan default, goods covered in the warehouse receipt can be sold promptly and at minimal cost either by negotiation of the warehouse receipt or auctioning of the goods. In the case of bankruptcy of the borrower or the warehouse company, goods covered by warehouse receipt have fewer disputes as to ownership, thereby avoiding competing claims.
Gives comfort and confidence to owners of the business, who might not be available full time to monitor the day-to-day running of the business, as the goods are under control of the third party – the credit support company and/or collateral manager. Prompt accountability for stocks is assured through verification of the collateral manager’s warehouse reports.

Credit appraisal

The development of field warehouse receipt lending in several developing countries has generally relied on the promotional effort of credit-support companies with experience in credit structuring and management, as well as technical competence in field warehouse establishment and operation, including management of inventories and accounts receivable as credit collateral. ACE – Audit Control and Expertise and similar companies have mounted training and educational programmes for bankers, producers, agro-processors and government functionaries in the use of field warehouse receipt as a financing instrument.

Most of the field warehouses issuing warehouse receipts for credit, in general, have been established by warehouse companies at the insistence of banks. Growth of the use of field warehouse receipts as a lending instrument will require banks to develop a suitable credit-appraisal system that will lead to the evolution of a special credit standard and procedures to minimise default risk. In the early period of building their internal capacity, it will be advantageous for banks to maintain a close working relationship with an experienced credit-support company.

Indeed, asset-based lending requires assessment of two important elements – namely, the creditworthiness of the borrower and the quality of the collateral provided.

As already mentioned, asset-based lending is used by banks for clients with marginal creditworthiness; therefore, the credit rating of asset-based lending is dependent more upon the quality of the collateral. In field warehouse financing, using inventory and accounts receivable as collateral, banks will depend, to a large extent, on the services of a credit-support company/warehousing company for evaluating the quality of the collateral, and for assuring maintenance of collateral quality during the credit period, since most banks in developing countries have limited technical competence to evaluate the quality of the collateral, and to control the inventory serving as collateral. Extension of field warehouse receipt credit therefore requires financier’s confidence, not only in the borrower, but also in the independent credit-support company or warehousing company.

Generally, five credit elements are considered when evaluating field warehouse receipt financing. The first three relate to determining the quality of the collateral:

In developing countries where banks are less conversant with field warehouse receipt financing, a credit-support company that combines credit design, appraisal and management with technical competence in field warehouse establishment and management will be preferred to a pure warehouse company with competence only in the latter. The bank should evaluate the company as to technical competence in programme design, appraisal and credit management; quality and quantity certification and control as will be reflected in past performances; experience; range of services; financial status and responsibility; integrity and reliability of its warehouse receipt; cost of operation relative to quality and range of services provided; and the amount, coverage, reliability and worth of its bond.
The field warehouse should be assessed with respect to the adequacy of the physical conditions, including suitability for storage of the commodity concerned; accessibility; security arrangements; facilities for quality and quantity certification; natural-disaster proneness; the validity of the lease/sub-lease agreement; existence of landlord waiver and consent; the extent, value coverage and reliability of casualty insurance carried by the depositor; competence and integrity of the custodian; and independent and exclusive warehouse management by the warehouse company.
The merchandise constituting the collateral will be assessed as to susceptibility to deterioration, breadth of market, value, price fluctuation, ease of liquidating the inventory, inventory obsoleteness and legal impediments to liquidating collateral. In cases where accounts receivable constitute part of the collateral, the trade-credit policy of the borrowing firm and collectability of receivables are major factors for assessment.
The borrowing business enterprise will be assessed as to its financial strength and capital base; management capability and technical ability to complete the transaction cycle; character; moral and financial responsibility of its principles; financial policies including trade-credit practice, working-capital management; and cost-control measures.
Legal and regulatory aspects should be considered, such as recognition within the country’s legal framework of field warehouse receipt as an instrument for secured lending, and assurance that the laws on secured transactions give practical protection and remedies (e.g. interim relief), including unimpeded recourse to assets pledged as collateral to the lender in the case of default by a debtor. In addition, the integrity and functionality of the judicial system itself requires examination by local and international lenders. The history of the application of legal self-help mechanisms, such as rights of seizure and the civil procedure for execution of judgement debts. Regulations and policies that interfere with free-market operations should be recognised as risks, which may influence market accessibility and price fluctuations.

Credit standard

Banks, before entering into any field warehouse financing deal, should also set credit standards. Credit standards may vary from bank to bank, but the following are fundamental:

Credit extended must be used for actual business operations and not for speculation. Funds will be available to allow the borrower, inter alia, to accumulate inventory; to better plan production schedules; to take advantage of low off-season prices or transportation costs; to permit extension of the trade-credit period for sales expansion; and to enable the borrower to take advantage of quantity discounts.
Financing is limited to raw materials, semi-processed or finished goods not easily susceptible to deterioration, and for which a ready market exists.
Where loans are made against commodities tradable in the commodity-exchange market (such as cocoa, coffee, cotton and sugar) some banks may require the borrower to hedge its purchases or products made from them where there is a future market for them.
The lender will also consider rights of subrogation on all insurance policies and where the perceived risk is high, as well as on contracts for services to add value to the collateral through processing, transport, etc.
The bank has to make decisions in three important areas, namely the maximum credit line, the percentage of funds advanced to the value of the field warehouse receipt outstanding and the total credit cost.

In fixing a maximum line of credit, three factors should provide the guidelines: the financial statements of the borrower, the performance capability, the trade-credit policy of the borrower, and the transaction cycle and related projected cashflow. A carefully prepared due diligence and business appraisal carried out by an experienced independent credit-support company and evaluated by the bank will provide a sound basis for a decision in this respect.

The percentage of loan advance to the value of outstanding field warehouse receipts is an important risk-controlling factor as it determines the bank’s margin of safety or excess of collateral value over the outstanding loan balance. Usually – other factors being held constant – the percentage of advance will be higher, the less the expected rate of deterioration in value during storage, the lower the degree of its price fluctuation, the broader the market for the stored commodity, the lower the probability of default (the warehouse company outstanding payment has a priority lien on the stock of commodity if the borrower defaults) and the smaller the maximum credit line in relation to the borrowing concern financial strength. The bank’s control of this risk is aided by regular reports, including the submission of a borrowing-base certificate by an experienced credit-support company or warehousing company.

The total cost of credit secured by a field warehouse receipt should include the lender’s charge for funds and the warehouse-company charge for installing and operating the field warehouse.

In addition to the above, special precautions will need to be taken in the following areas:

Insurance – Apart from the standard all-risks insurance by the borrower, and the fidelity, errors and omissions from the warehouse company, there might be a need to require “supplemental contract” or extended-coverage endorsement to cover losses that might arise from an act of a public enemy or an act of God. If the insurance policy covers all goods stored in the warehouse, including those financed by other financiers, allowance should be made in the insurance for these other financiers. It is usual to include a clause that may specify that “loss, if any, to be payable to bank (name) and/or others as their interests may be reflected in field warehouse receipts or other documents evidencing ownership”. In addition to all risk insurance carried by the borrower, it might be important to require the warehouse company to insure the warehouse receipt. In this case, each warehouse receipt is an insurance certificate that states the value assured and the protection afforded. Insurance of warehouse receipt assures that goods are insured when in the custody of the warehousing company. Requesting warehouse-receipt insurance will increase the costs of a warehouse company, but the additional security provided to the borrower might make it worthwhile. Some banks, in response to political factors, have also taken out political risk insurance.

Basis of evaluating collateral value – In order to avoid any misunderstanding with the borrower in future, the bank should inform the borrower that advances will be based on the current value of goods as will be determined by the bank from time to time based on quantity and the quality of goods pledged and the current price. Perishable goods should be avoided, as it is more difficult to guarantee the quality of such goods over a considerable storage period. If goods held unpledged are later offered as pledge, it is advisable that goods are examined closely as to quantity and quality by an independent warehouse company and to ascertain the reasons for lack of sale or demand for the goods.

It is better to make a loan on somewhat rigid terms and, if necessary, make concessions later rather than making loans on loose terms and then making conditions more rigid during disbursement.

Credit management

A number of measures need to be taken by the bank to assure proper management of credit extended under field warehouse receipts, among which the following are important:

The bank should obtain and maintain in its records the names and signatories of staff of the warehouse company who can sign warehouse receipts. The bank, for its part, should provide to the warehouse company the names and signatories of its staff who can authorise release of goods pledged as collateral for the credit.
The value of the collateral should be regularly checked and adjusted in line with price changes. The bank-determined value should be checked with the value declared on the warehouse receipt, which is based on the price declared by the borrower, before any advance is made. If the bank-determined value shows that further advancement will make the amount lent exceed the bank’s commitment, the supervising officer should stop further advancement and bring the discrepancy to the attention of the appropriate officer.
Goods-release requests indicating item(s), quantity, price and total amount to be paid to the bank or covered by trust receipt before release should be submitted to the bank by the borrower. The bank must ascertain that the validity of the information is in line with its own record and that due amount has been paid into the appropriate collecting account before authorising release. If goods are released against trust receipt, the bank must assure that the borrower is not going to use the goods as collateral for further borrowing from other financiers. If a trust receipt is issued, the bank must specify the period of validity, and if payments are not received within the period and goods are not returned, reasons for the delay must be ascertained and appropriate action taken. Payments for goods released against trust receipt should be computed based on the value of the goods as of the date the goods are released. Other checks made by the bank for goods released against cash must also be carried out for goods released against trust receipt. The high risks faced under release against trust receipt suggest inadvisability of this practice unless unavoidably required. Release of goods against trust receipt may be required in pre-export financing when payments by buyers are to be made against shipping documentation. In this type of special circumstance, it will be important to request that the warehouse company supervise shipment operations, including the collection and dispatch of shipping documentations appropriately.
The bank should assure appropriate supervision of the operations of the warehouse company to ascertain that the warehouse company has, at all times, “continuous, notorious and exclusive possession” of the goods stored and pledged as collateral; that the insurance policies carried by the warehouse company and the borrower are valid; that the losses assured are appropriate; that the physical conditions of storage are satisfactory; that proper records are kept; and that required reports are submitted as appropriate. The bank should also assure that the borrower meets its obligations to the warehouse company to avoid any claims by the company in case of default by borrower.

It is also important to take the following precautions: If the warehouse receipt refers to another agreement between the depositor and the warehousing company, the bank should insist on seeing the agreement; a non-negotiable warehouse receipt issued to anyone else should not be accepted to avoid unauthorised release of goods or attachment by other creditors; and insurance coverage of pledged commodities must be assured at all times.

Andre Soumah is executive chairman of ACE – Audit Control & Expertise in Geneva.