Collateral management has become a big topic for banks – many of which have been burned by recent events. GTR solicited a selection of pertinent questions from African bankers, and put them to the ACE Global Depository team. These are their answers.
Q: Professional indemnity (PI): Banks require collateral managers (CMs) to have PI to cover professional negligence in their course of work, with the bank’s interest noted. This is a cost that CMs take up reluctantly, arguing that stocks may be stored in different locations, and probability of loss is less than 50%. Thus PI cover is undervalued. What is the optimal value of PI cover – is it equivalent to the value of goods?
A: The value of a warehouse receipt or other document of title, held by a bank is only as good as the CM that issues it. For this reason, banks must require CMs to provide adequate insurance in the event of a negligent act on the part of the CM.
What is appropriate depends on the value of inventories taken under custody by any given CM at any given location. Typically, refined petroleum products will commend the necessity of a higher coverage than certain agricultural products.
CMs should optimally carry limits that would respond to the full value of any loss for which they could be found responsible. Banks should verify whether the limit of coverage being provided is aggregate or per occurrence, with the latter being preferred.
The strength of a policy is given by the amount of its monetary cover, its geographical cover, and the extent to which third-party agents/contractors are covered. The policy must also be provided by a global insurer of strong financial rating that has a history
of meeting valid claims. Banks should also check whether fraud by employee is covered by the policy, as experience shows that when a claim occurs it is not as a result of negligence of the CM but by convoluted fraud by its employees.
Any prudent lender considering hiring a CM to secure the commodity serving as loan collateral should only consider firms with a strong insurance programme, and the ability to meet higher limits should the transaction call for it.
Q: Priority of cover: If the bank goes into loss, which insurance cover does it go to for compensation? The PI cover or the “all risks” cover by the general underwriter? It is usually the all risks cover. But then, what’s the purpose of the PI?
A: CMs should generally not be regarded as insurers of the inventory. Banks must have well-structured documentation that requires adequate coverage by the borrower for events not related to the acts of negligence by the CM.
Cargo Marine Insurance provides a very large coverage extending the “all risks” cover to all other risks such as insolvency of the owners of the vessel, rejection of the goods by local authorities, infestation, removal and destruction fees, heating/sweating/spontaneous combustion, material damage resulting from delays, etc. This coverage starts from farm gate to entry of destination warehouses – including stay/storage. This is more suitable for the insured than to have a simple FLEXA (fire, lightning, explosion and aircraft fall on warehouse) policy for the storage.
Here we extend the marine cover to warehousing. So, those coverages are different. Cargo all risks looks after the damages to the goods resulting from fire, water, theft, etc – principally from natural perils, but ideally, must also cover misappropriation of those goods. Not all cargo policies cover fraud by employee as this is not a cargo insurance risk but a PI-related risk, while the PI covers gross errors, omissions or fraud generated by the CM in the course of their services.
Without a CM, banks rely on the borrower to accurately report the collateral balance physically on hand. CMs substantiate the borrowing base by providing documentation of the existence of the bank’s balance sheet item. Should the CM provide inaccurate inventory reporting that is relied on by the bank to satisfy the outstanding loan balance, the PI coverage would be called upon. Without a CM, there would be no recovery for misreported balance.
Q: Obligation for collateral management agreement (CMA) charges/responsibilities: Who is the CM’s client? The bank or the depositor (the bank’s client)? It’s usually the depositor that CMs maintain in their books as clients. Statements are addressed to depositors, giving room for escalation of unpaid charges at the exclusion of the bank. The CM holds lien of the goods for unpaid charges.
A: CMAs’ defining obligations and liabilities are typically tripartite (three-way) agreements between the CM, the lending bank and the owner/depositor of the goods. However, those agreements dictate that regardless of who is paying the fees, the CM will only release goods under their control upon receipt of formal instructions from the bank. All parties agree to the transaction and specifically the delivery or release instructions provided by the holder of its warehouse receipt.
Notwithstanding which are the lines of communication between the parties involved in a collateral management agreement, the CM’s principal is the bank, in the name and on behalf of which the CM is custodian of the goods. Several variations around the same theme are possible.
There are contracts whereby no bank is involved – in which the vendor is extending finance to the buyer/depositor. The CM’s principal will be the seller, who wants to keep control over the goods for the tenor of the loan he is granting to the buyer. Sometimes the importer/depositor is associated. Although it has a solid working relationship with the depositor, the CM is ultimately responsible to the holder of its warehouse receipt.
Some CMs might take lien on goods for unpaid charges, but in most cases it is not necessary as the bank is guarantor of the unpaid fees. In any event, the bank can be notified, through their instruction letter to the CM, to provide notification of unpaid charges at an agreed upon frequency.
Q: Clarity of responsibilities: Aren’t CMs responsible for maintenance of quality and weight, save for force majeure?
A: CMs certify to quantity, not quality. Reputable borrowers/depositors will record inventories with appropriate shrink factor, when applicable. As for quality, holders may require assay of inventory at their discretion. Weight and quality are subject to natural variation because of loss or increase of moisture as well as natural quality deterioration in a given time frame. This is why warehouse receipts are issued with a given validity and subject to reconfirmation when expired. The experienced CM will be familiar with the natural characteristics of the particular commodity under their control. The CM will become aware if storage conditions deteriorate to the point that the stored goods are at risk.
The CM will alert the depositor and the bank when problems with quality and weight are foreseen – or as soon as they become known. It should also take protective actions if necessary – ideally with the bank’s approval (sometimes the CM has to act in an emergency – but always to the benefit of the protection of the goods).