Tightening regulation has highlighted the benefits of using collateral management agreements to secure commodity deals in Sub-Saharan Africa. But bankers still need to do their own groundwork to minimise the risk of fraud and corruption, writes Rebecca Spong.
While structured commodity bankers active in Sub-Saharan Africa have used collateral management agreements (CMAs) in their deals for many years, the requirements of Basel III regulation coming into force this year are heightening their importance as useful risk mitigants.
A CMA entrusts a collateral manager to take care, custody and control of stock until the commodity is exported and borrower has repaid its debt.
Its usage could not only help banks obtain much-needed capital relief on their structured commodity deals, but could also encourage some lenders to become more comfortable with the risk of lending in Africa, helping plug the current financing gap across the continent.
“Commodity lenders are sophisticated and are certainly aware of the usefulness of CMAs, but as banks look to use the value of commodities secured in their favour when calculating the effect of credit risk mitigation under the EU capital requirements regulations (CRR), there are more reasons to use them now,” says Omar Al-Ali, a trade and commodities finance partner at law firm Simmons & Simmons. “In certain circumstances, in order to achieve this, banks may push harder to put them in place.”
While a CMA has many benefits, industry experts also warn the agreements will not make bad deals ‘good’, and lenders still need to do their homework before signing off on a transaction in order to minimise the risks of fraud, stolen stock or default on payments.
“CMAs can perhaps be misunderstood,” says JJ Gagiano, a commercial manager at UK-based Vallis Commodities, which has operations across Africa and the Middle East, where it offers collateral management services to banks, corporates and funds. “The CMA is a risk mitigant, it does not eliminate risk and should be used in conjunction with other mechanisms at the parties’ disposal,” he says.
Typically, lending money in Sub-Saharan Africa is perceived as high risk and, since the global financial crisis, regulators are keen to ensure banks don’t take too many risks without having adequate capital in place to act as a buffer. Tightening regulation, such as Basel III or the CRR, can make trade deals in Africa an expensive business.
The use of a CMA in a commodity finance deal provides lenders with a level of security.
From the borrower’s perspective, a CMA allows them to use their stock as collateral and secure funding or working capital to help run their operations before they receive payment for their goods.
In the event of a non-payment by the borrower, the CMA enables the lenders to access the commodities – be they cocoa beans, coffee, or fertiliser – in the warehouse, in order to sell the goods and recover their lost funds.
Under Basel III and the CRR regulations, the use of a security such as a CMA could help banks obtain capital relief – meaning that they don’t have to put aside as much high-quality expensive capital in order to off-set the risk of the transaction.
According to Al-Ali, a CMA can demonstrate to regulators that the bank has possession of the commodity stored in the warehouse, a requirement needed to obtain favourable regulatory treatment for the deal.
“For the commodities to be eligible collateral for the purposes of CRR, the security arrangement must satisfy a number of conditions, including that it must be legally effective and enforceable in all relevant jurisdictions and the financing bank must have priority over all other lenders to the realised proceeds of the commodities,” he explains.
In many jurisdictions, the only way to get legally effective and enforceable security is to take actual or “constructive” possession of the commodities.
“Financing banks can normally get that ‘constructive’ possession if they have a collateral manager who is essentially in control of those commodities in storage, and that manager answers only to the financing bank,” he says.
There are also other benefits that a CMA brings. CRR requires the bank to have the right to physically inspect the collateral, which can be achieved through the agreement. Institutions also need to be able to “realise the value of the collateral in a reasonable timeframe” in case of default.
“It is a lot easier for a bank to evidence that it can do that if it has agreed upfront with the collateral manager, the storage operator and the owner of commodities that upon enforcement, the collateral manager can immediately access the commodities on the bank’s instructions and arrange delivery of the commodities to a purchaser without any opposition or logistical challenges,” he says.
“In my experience, the alternative is a potentially time-consuming negotiation with the storage operator on enforcement, who will often have a lien over the commodities and will want full indemnities and payment of any unpaid fees before releasing them.”
Essentially, the lack of a CMA could heighten the risk of a transaction by making it harder for banks to get hold of the commodities in the event of a default.
Plugging the gap
The use of a CMA also has the potential to increase the availability of funding for trade in Sub-Saharan Africa.
“Many banks do not have the approvals to take developing market country risk, misappropriation risk and fraud risk. So collateral management could help to get them comfortable when structuring Africa-based trade financings, together with, for example, development finance institutions, providing some of the debt alongside commercial banks,” says Richard Wilkes, senior associate, structured trade and commodity finance, at Norton Rose Fulbright.
Trade funds, who have more appetite than commercial banks for “risky” clients, are also driving demand for collateral management services, as they use collateral management as part of the deals they offer.
“They understand it much better because it’s all they do – they do the transactions the banks don’t. Funds spend money on understanding and sending someone to look in detail at transactions. Banks don’t necessarily understand it and they are inclined to do coal the same way they do ground nuts,” says Andreas Rusch, managing consultant at Bongani Consulting in South Africa.
When things go wrong
While collateral management agreements bring a number of benefits to a transaction, they do not illuminate the potential for bad behaviour: a well-drafted CMA is simply not enough.
Missing or stolen stock, bribery, fraud, default on payments or foodstuffs left rotting in silos are some of the risks that lenders and collateral managers need to manage.
“A lot of collateral managers operate at client premises so propensity for collusion or fraud by employees exists. There have been few cases over the past few years. That’s always a risk managing millions of dollars of stock by a person earning a meagre salary in comparison. There are a lot of checks and balances that need to maintained,” says Dheerie Govender, CEO of Global Collateral Control (GCC).
Many of the problems boil down to either human error or malicious behaviour at the warehouses themselves, and risks can be minimised if lenders have an awareness of what is happening in ‘real life’ and not just through legal documents.
“On-the-ground diligence needs to be done in terms of both the storage provider and the storage facility in order to be comfortable that, for example, the storage facility is actually secure and that the goods are kept segregated,” says Wilkes. “It is this second layer of mitigation which lawyers in this space can overlook in favour of taking a ‘red pen’ to the CMA.”
Rusch at Bongani Consulting explains that banks often lack sufficient awareness of the physical processes at the warehouses, factories or processing plants.
“Where is the commodity harvested? How is it carted to the silo or warehouse? All these stages could pose a risk if you don’t know about it.” If wet grain is harvested and put in a silo, for example, it could contaminate everything and rot, he explains.
Collateral management companies must do a regular stock audit, comparing physical to theoretical stock. The greater the quantity of the stock and number of releases or receipts per week, the more frequently these audits – both planned and unannounced – needs to be undertaken.
Selecting the collateral management company with the best procedures in place to combat the risk of fraud or bribery is crucial
“It is a function of management. Consider the in-country warehouse manager who is paid US$1,000 a month for looking after literally millions of dollars-worth of fertiliser. I can see why it’s not difficult to offer that guy his month’s salary to turn a blind eye to open gates and let a truck or two in,” says Zhann Meyer, head of agricultural commodities at Nedbank CIB.
To combat this, collateral managers often employ expat country managers in their key locations: someone who hasn’t grown up in the location and hasn’t had the chance to build relationships with people who would be looking to collude. Staff rotations are also recommended.
The role of technology
Technological advancements are also helping improve the way collateral managers look after commodities in warehouses.
“We’ve trialled cameras in warehouses as well as digital locks, which send a text message every time they are moved,” says Gagiano.
Drones are being used by some collateral managers to remotely monitor stock and report discrepancies immediately.
For many, however, technology will not solve the problem of a company or person that really wants to commit fraud, steal stock or in some other way dupe the lending banks.
“Technology can never replace your own compliance and due diligence procedures in terms of knowing your client. If a client has an intention to take you for a ride and not repay your facility they’ll find a way – regardless of the calibre of the collateral management team on the ground,” says Meyer.
Technology cannot completely eradicate the foibles of human nature. Rather it must be used in conjunction with lenders really getting to know who they are dealing with on-the-ground and at the warehouse or factory door.