What are the risks ?
Once the goods are to be stored for a period of time in a specific storage location, which can either be at the place of export or at destination, the borrower applies for inventory financing from the lenders.
The stored goods are the lender's collateral and the primary source of repayment.
Lenders may face certain risks especially during bad economic times.
Indeed, this leaves room for hijacking, fraud and lack of transparency in communication due to physical distance.
Unfortunately, we have seen cases in recent years related to inventory financing by ill-intentioned companies creating fictitious inventory, manipulating inventories and financing the same goods from several banks.
How to mitigate these risks ?
The risks associated with inventory financing can be mitigated by appointing an inspection company to monitor and/or keep custody of the goods being financed.
A Stock Monitoring Agreement or Collateral Management Agreement is then agreed between the Lender, the Borrower and the Inspection company.
These agreements provide additional security to the lender and give them transparency over their collateral.
Collateral Management Agreements
“Collateral Management Agreements (CMAs)” regulate how goods that are pledged to a financial institution as security against a loan, or remain owned by the original seller, are stored, checked and released against specific instructions.
The Borrower, as original bailor of the goods, bails the goods to the Collateral Manager, and the Collateral Manager, as bailee, acknowledges the transfer of possession of the goods to the Lender and agrees to hold the goods on the Lender's behalf in accordance with the terms of the CMA.
Acknowledgement of transfer of possession of the goods to the Lender is crucial in order to ensure that the Lender has good security.
The Collateral Manager is responsible for the physical possession and control of the goods being financed and is legally responsible for their storage, securing and monitoring.
Upon receipt of the goods financed, a warehouse certificate will be issued to the order of the Lender and the goods will only be released on the instructions of the Lender.
Once the goods have been sold, the Lender will then authorize the Collateral Manager to release the goods to the new owner, under the financing structure agreed between the Lender and the Borrower.
However, in the event of default under the agreed financing structure, the Lender may consider all available actions to enforce its rights against the Borrower and the Collateral.
Stock Monitoring Agreements
A SMA is an agreement between a Borrower, Lender and Inspection company, whereby the Inspector provides monitoring services in respect of goods subject to the SMA.
There is no physical possession or control of the goods from the Inspector and no responsibility toward receipt, storage, security and release of the goods.
The Inspector will provide the Lender with a monitoring report for receipt, release and dispatches of stock, compare the physical stocks against the storage documents.
Compared to CMA, SMA provide less protection but is less expensive.
Key points to consider for Lenders:
The decision to choose a CMA or a SMA should be guided by the lender's requirements for the underlying transaction.
A CMA or SMA will only be a useful means of risk mitigation if it is properly drafted.
Using the terms and conditions of an existing agreement is unlikely to achieve the desired results.
When drafting these agreements, lenders should consider the following:
1. Governing law and jurisdiction:
It is extremely crucial to be cautious on the Governing law and jurisdiction clause that should be clear and unambiguous.
Standard terms and conditions of the Inspector shall be under the same Governing Law than the one of the CMA or SMA.
2. Counterparties and sub-contractors:
Lenders should consider with whom they contracting and whether this entity is a local subsidiary or holding company of the Inspection group.
3. Insurance:
The inspector appointed should be reputable and maintain adequate professional indemnity insurance (including for the contractual counterparty and all affiliates responsible "on the ground"). This should include, where possible, cover in the event of fraud or collusion involving the inspection company's own personnel.
4. Scope of services:
The terms and conditions must be well defined and clear to ensure that they correspond to the needs.
SMA must be clear on the checks to be carried out and the frequency of reports… while under CMA, the obligations of the Collateral Manager such as receipt, storage security, release of goods… must be properly stipulated without any ambiguity.
5. Inspection company and terms of appointment:
The instructions to be followed by the Inspector will be those of the Lender and not of the Borrower.
If the borrower does not pay the inspector's fees, the lender will be authorized to do so and to maintain the inspector's obligations.
6. Storage of financed goods:
It is preferable that the goods be segregated and marked to the order of the Lender. If segregation is not possible, appropriate measures must be put in place to ensure that the goods financed are not financed by several lenders.
Original storage documentation and storage facility records should be checked against physical inventory to ensure they are authentic and match in terms of quantity and location of storage.
In addition, the Borrower must insure the goods and name the Lender as the loss payee under the policy.
7. Access:
The Borrower shall provide the Inspector with access to storage facilities in order to process the agreed services.
For CMAs, the Collateral Manager must be able to demonstrate that it has legally enforceable rights of access to the Storage Facility at all times and that it has exclusivity over the goods.
The lender should also have the right to access the storage facility to view the assets it has financed.
Conclusion:
Although CMA and SMA can help mitigate risk, they cannot eliminate all risk.
They should be tailored to the underlying transaction.
Lenders should properly monitor transactions and take the necessary steps to stay close to their customers and have a good understanding of the underlying transaction.
‘’Each door has a key’’
Mourad Nait-Atmane
Founder of Tilelli Consulting Ltd
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