The knock-on effects of the global economic crisis have influenced the financing of the commodities trading industry. Changes in the regulatory landscape in Europe and the United States have likewise influenced the manner in which finance is being provided to the sector. One manifestation has been an increase in lending conducted through ownership and intermediation structures that interpose the financier as owner of the commodities. Such structures have the advantage that they may, depending on the accounting practices of the bank, be treated as purchases/sales for regulatory capital purposes, meaning the financing that they provide requires less capital than traditional secured loans.
It is difficult to estimate how big the growth in bank ownership of commodities has been, but indications suggest that it is becoming a must-have option. The metals sector and, in recent years, particularly the Asian copper trade centered in Shanghai (which saw stockpiling on a grand scale), has been a focus for commodity owners wishing to monetise their inventory. Where traditional secured loans, backed by a pledge of a warehouse receipt, were once the financing tool of choice, increasingly wholesalers are looking to enter repurchase transactions or to “repo” the copper to banks willing to participate in these structures.
This article seeks to identify some of the legal issues and risks that arise from this kind of inventory financing.
There is no industry standard form contract for commodity repo, which equates to the GMRA in the context of securities repo. Contracts are often bespoke. Some banks and wholesalers maintain template contract forms for regular trades, based on similar circumstances, but the form of these documents varies considerably. The basic feature of the structure requires at least two sale and purchase transactions, which may or may not be incorporated within one agreement. These transactions may provide for a firm commitment of the bank to buy and then re-sell the commodity or involve some optionality around the second sale leg. Often, one or more further agreements provide for the allocation of risks arising in respect of the commodity during the financier’s ownership. Third-party agreements governing the bank’s rights of possession make up the contractual suite. Analysis of the legal character of these third-party documents is recommended, since commercial practice often does not reflect the legal rights that they confer. Experienced lawyers will help either the wholesaler or the bank – depending on who they are working for – to allocate the risks that they agree to bear during the bank’s period of ownership. In general, banks seek to lay off as much risk as they can negotiate away, as they view their role as one of financing not risk assumption.
Insolvency and recharacterisation risks
At the top of many people’s list of perceived risks is recharacterisation; so it is a convenient place to start.
This risk affects the financier. In short, since transactions are structured as sales to the bank, the bank is unlikely to be willing to enter the transaction unless it is confident that the sale will stand up to the scrutiny of insolvency proceedings, should the seller become insolvent before it repays the bank. Banks will often require legal opinions attesting to the “true sale” nature of the transactions, i.e., that a court will determine that a transaction is a true sale and will not be regarded as a loan, secured by the commodity. Where the latter is the case the commodity may be treated as falling within the estate of the bankrupt party, meaning the bank is not entitled to sell the commodity to recover its money, instead being forced to prove its claim in the insolvency proceedings. The content of such legal opinions varies significantly between the law firms that issue them, either because of a lack of clarity from those instructing them about the matters which the opinion should address, or because of uncertainties in the applicable legal regime.
We make two points regarding recharacterisation risk. First, one should identify which jurisdictions are relevant to the analysis of the risk. To give an example, a Singapore-incorporated entity acting as the “seller” may agree to sell and repurchase commodity located in China, pursuant to contracts governed by English law. From which lawyers should an opinion be sought? Answer: a true sale opinion should be issued regarding English law but Singaporean law advice should be sought as to whether and in what circumstances the Singaporean insolvency courts may apply a law other than English law (the governing law of the sale contracts) to determine whether ownership passed to the bank (for example, Chinese law). Second, the United States is not necessarily the “‘no-go zone” that many perceive it to be, in relation to these structures. Whilst U.S. Bankruptcy Code and state rules undoubtedly make analysis less straightforward, this business can in appropriate circumstances be made to work from a U.S. perspective.
Sale of goods principles
Since the whole premise of the transactions is that the relevant commodities are sold to a bank, one must have regard to principles of sale of goods law in order to analyse the risks, and to properly structure the deals. We therefore stress the importance of seeking advice from lawyers who understand this area of law; pure banking and finance lawyers may often lack the experience and specialism to advise on the particular issues that arise under commodity sales and purchases.
Risks and issues include the importance of defining the subject matter of the transaction appropriately. For example, when and in what circumstances can a bank – or any buyer for that matter – acquire title to commingled goods? Other principles include the relevance of the law of the place where the commodity is located; in the event of a competing claim over the commodity which law will be applied? What does experience tell us about the practical steps that should be taken to protect an owner’s interest in particular jurisdictions? These are amongst the relevant questions that should be asked and answered before transactions are entered into.
The consequences of ownership
Those whose business includes the trading of physical commodities will be familiar with the legal and other consequences that accompany ownership in the locations in which they habitually trade. Many banks, however, are not quite as familiar. A few consequences of ownership are:
Environmental liability – many jurisdictions provide for the strict liability of an owner of goods for environmental damage caused by those goods. Appropriate legal due diligence should be carried out in the jurisdictions where the commodities will be located and, if appropriate, contracts might include indemnities in favour of the banks regarding such liabilities. Where goods will be transported by sea during the transaction, the various international conventions and local rules relating to marine pollution should be assessed. Closely linked to this is the issue of franchise risk, which will be a key factor in obtaining approval from the senior management of new market entrants.
Regulatory restrictions – consideration should be given to whether an organisation requires a licence to buy/sell/own/supply the particular commodity in the relevant place. In addition there may be regulatory restrictions in the jurisdictions in which the bank operates. The direction of the current regulatory drive in the United States makes bank ownership of commodities less straightforward, but we feel it is possible for some U.S.-regulated financial entities to enter into some inventory financings of this nature.
Tax – sale and purchase of commodities may give rise to both direct and indirect (i.e., VAT/GST) tax consequences, particularly where the commodities are due to be stored in non-bonded storage facilities during the period of the transaction. In addition to appropriate jurisdiction-specific tax due diligence, contractual documentation can and should provide for the tax consequences.
Accounting treatment is a key driver for some businesses seeking to monetise their inventory through ownership structures. In particular for those businesses that are publicly traded – and thereby subject to public reporting of accounts – it will often be important that transactions are treated as “off balance sheet,” i.e., that they are treated as outright sales to a bank, rather than as loans, which will appear as a liability in the wholesaler’s accounts. There are some structures that will permit this. Accounting practices do not follow legal classification of a transaction, meaning extra measures may be necessary in structuring the transaction to satisfy the requirements of a company’s auditors, even where “‘true sale” legal opinions exist. Care and precision in the drafting of the documents is required if one wishes to give effect to both the wholesaler’s accounting aims and the bank’s aims to acquire unimpeachable ownership at minimum risk.
Finally, a few words about some of the issues that affect the execution of sale and purchase transactions, when entered into for financing purposes. The sorts of problems that arise where commodity sales are not properly documented are well known, and those issues are no less relevant in this context. Suffice it to say that rigour around contractual and documentary procedures should be maintained. Other concerns associated with the storage of commodities may also come into play including the risk of theft, damage, contamination and so on. There is no substitute here for understanding the physical risks and insuring against them. Insurance, meanwhile, is not the assurance of indemnification that it is often assumed to be, particularly in cases of large loss. Care to ensure compliance with insurance policy conditions and warranties is necessary. Appropriate due diligence on the relevant facilities, plus at least some level of ongoing supervision is also highly recommended.
Given the flexibility of this form of finance and its favourable regulatory capital treatment, we expect to see commodity ownership structures continue to gain a larger share of the structured commodity trade finance market. Legal and risk management around these structures currently lags behind their commercial growth. We hope that this briefing has identified some of the more important issues that arise. When structured and executed well commodity inventory finance provides a financing solution that meets the needs of the market and allocates the risks in accordance with a party’s ability to manage them effectively, thereby facilitating the flow of commercial trade at a time when it is much needed.