Structured trade and commodity finance (STCF) is central to international trade and is progressively becoming an important source of finance for Chinese companies, given that China is now the most significant player in the commodities market. Since the introduction of the free trade zones (FTZs) in China, there has been increasing discussion amongst Chinese leaders on how to implement a robust legal framework and infrastructure to attract more global companies into the market. Whilst, in our view, this is unlikely to have any significant effect on the STCF market, it is a step in the right direction provided that financiers do not lose sight of the risks inherent in STCF.
STCF structures have a long history in the Russian and Latin American markets and some of the risks arising from these structures offer valuable lessons to any player in the market. Typically, the structures themselves are robust, but as these transactions depend largely on verifiable and secure tracking of physical goods, the primary risk in these structures has always been, and remains, that of fraud. This article examines some of the common things that can go wrong in STCF and what financiers can do to protect their position, particularly in China.
Common STCF structures
Structures commonly seen are:
Pre-export finance, where finance is provided (and often secured by way of security assignment) against the value of receivables payable in respect of the export of goods.
Prepayment finance, where finance is provided to a buyer to make payment for goods (usually to an affiliated company) in advance of their delivery.
Post-export finance, where finance is provided to a seller by discounting bills of exchange or letters of credit, or by prepaying a deferred payment letter of credit.
Warehouse finance, where the finance is provided (and often secured by way of pledge) against inventory (e.g. metals, agri-commodities) held in warehouse.
Where the financier wishes to finance, and take security over, the whole trade cycle, a combination of the above structures can be devised. As financing for onshore China commodity producers becomes ever tighter given the controls over Chinese banks' liquidity, there will be a greater demand for larger and syndicated prepayment facilities. The structures will likely be a hybrid of traditional commodity financing together with typical borrowing gap lending (adding the extra layer of enhanced credit support). In addition to the typical STCF risks, risks specific to the Chinese market and the Chinese regulatory and foreign exchange framework must therefore be considered.
Tough lessons from Brazil to China
Pre-export finance and prepayment facilities are commonly provided to companies in Brazil and other Latin American markets to prepay future exports of agricultural commodities. There is usually a security package covering the entire trade cycle, all the way from the field, to the warehouse, through to the end buyer. In the late 1990s, Société Générale learned some tough lessons after offering prepayment facilities to a Brazilian soya processing group commonly known as Olvepar. As with most sophisticated financiers, Société Générale had a good security package of pledges, guarantees, warehouse warrants and assignments. However, for a variety of commercial reasons, it increasingly relied on the offtaker, an Olvepar affiliate, rather than the specialist collateral manager, to monitor the stock and performance of Olvepar. The problem was that the soya was not in fact being produced by Olvepar and that Olvepar was in fact purchasing the soya from farmers and on-selling it. That soya was therefore subject to proprietary claims by those farmers, which of course prejudiced Société Générale's collateral. Effectively Olvepar was buying "performance" from the farmers to meet its obligations under the prepayment documentation, and this only came to light when the soya market crashed. Similar cases of competing security interests over the same assets have also been reported in the Chinese market.
Post-export finance can unfortunately create similar opportunities for widespread and systematic fraud through the production of false documents and phantom shipments. Typically, an importer would open a letter of credit with a bank who would pay the exporter on sight of the (false) documents. Usually the fraud in such cases is at the expense of the importers rather than the banks, however, a risk to be particularly alert to is the risk of collusion between importer and exporter. In such cases, the exporter might discount the letters of credit so that it obtains upfront payment from a financier (on the presentation of false documents). That financier will then likely end up in a dispute with the issuing bank over who bears the risk of fraud in a case of who holds the liability when the music stops.
In China, there have been all sorts of fraudulent transactions in recent years. International attention was drawn in particular to the International Maritime Bureau (IMB) of the International Chamber of Commerce's Commercial Crime Services' warning in August 2012 on a post-export financing scam involving exporters in China and importers in West Africa. The IMB noted that false documents indicating that cargoes had been shipped were presented under documentary credits to generate trade finance for the Chinese exporters before the shipment was made. The IMB identified the biggest risk for banks as being that more than one set of documents relating to the same shipment could be in circulation, with different banks financing the same cargo on the basis of duplicate documentation.
Importer/exporter collusion and phantom shipments have been a major problem in recent years in the trade of copper in China, as a result of which China's State Administration of Foreign Exchange (SAFE) intervened by issuing two circulars on 5 May 2013 and 6 December 2013 respectively imposing regulations against, among other things, fraudulent trade finance transactions and also imposing obligations on financiers in China to verify the authenticity of trade finance deals and to strengthen their relevant due diligence and compliance measures. While this means more onerous obligations on financiers in China judging from SAFE's emphasis on the potential criminal consequences for failure to comply, the impact of these measures on offshore financiers remains to be seen.
As a result, financiers should be incentivized to look not only at the commodity structure, but to also look behind the commodities and examine the business model, trading background and financial conditions of the company whose assets they are looking to finance, as they might in a balance-sheet financing.
Whilst it is essential to have the right structures in place as a roadmap to dealing with problem situations, financiers have to identify the risks that cannot be properly addressed in a structure and determine how to mitigate those risks. Especially with commodities, controls must be strictly enforced by independent parties to monitor the quality (or even, in extreme cases, the existence) of the collateral and minimize the potential for collusion between importer and exporter, and financiers should appreciate that it is usually a seismic event such as a market fluctuation that reveals problems in a financier's structure that would otherwise have lain dormant, by which time it is of course usually too late to act.
The recently published FTZ plan discusses the possibility of introducing legislative regime for the licensing of warehouses and setting minimum licensing conditions on storage conditions, maintenance of records, capital adequacy, liquidity, managerial qualities, insurance and bonding cover in order to protect against mismanagement and fraud. Such a regime can potentially reduce the risk of fraud and increase the effectiveness of collateral management. However, as the year progresses and the real details of the FTZ fail to emerge, it may become increasingly apparent that the FTZ offers little more to the commodity trader or trade financier in China than already available. Whilst the FTZ is a step in the right direction, it will not however, suddenly solve all the issues and difficulties foreign traders face in doing business in China.
Finally, trade financiers must appreciate that Chinese borrowers will increasingly require more sophisticated hybrid STCF structures, and trade financiers should therefore familiarize themselves with the SAFE approval process in China, and other regulatory and foreign exchange restrictions as Chinese companies are heavily restricted in their ability to seek finance for capital account transactions.