Understanding collateral quality
Domicio dos Santos Neto and Fernanda Marques Bayeux, partners at law firm Santos Neto Advogados in Sao Paulo, look at, from a legal perspective, the risks that financial institutions and other financiers are most commonly exposed to when lending to commodity traders or producers who operate in Brazil.
Our experience in structuring trade-related transactions shows that in the case of litigation, the recovery of amounts due by a debtor basically depends on two things: the effectiveness of the Brazilian legal documents that created a lien over the financed assets; and the quick action by the creditor to obtain possession of such assets.
That is why an asset-backed lending must involve from the very beginning a strict control of the collateral.
Having said that, in general pre-export and other trade financings extended by foreign entities to Brazilian producers and/or traders are generally guaranteed by a combination of (i) collateral or real guarantees (garantias reais) over the inventory of the goods being financed, real estates or plants (such as pledges, mortgages, endorsement of warrants, etc.) and (ii) personal or fiduciary guarantees (garantias fiducirias) generally given by the controlling shareholder and/or other companies belonging to the same group of the borrower.
In addition, in the last few years, certain transactions have been guaranteed by insurance bonds containing specific provisions that allow their use as a guarantee (so-called performance bonds).
In this context, it is also worth mentioning CPRs (cédulas de produto rural or rural notes), which are titles that represent a promise to deliver agricultural products. The obligations arising out of a CPR may be secured by any kind of acceptable guarantee in Brazil, especially agricultural pledges (ie, pledges over crops) and mortgages over real estates or plants, which make CPRs widely used as security instruments in the green financing of soybeans, cotton and other soft commodities.
Main risks arising out of collateral
It is generally accepted that there are four types of risks borne by creditors in general: the debtor risk, the collateral risk, the risk related to lack of liquidity of the collateral and legal risks.
Our assessment of the legal risks associated with deals carried out in Brazil by commodity traders and other financiers will be based on this approach, as outlined by the Bank of International Settlements in its paper ‘The Standardized Approach to Credit Risk’ (www.bis.org).
Debtor’s risk. This may be defined as the potential that a borrower or other counterparty will fail to meet its obligations towards the creditor. The credit risk department of each financier has (or is expected to have) a sound credit-granting process in order to weight the track record, payment habits, financial statements and other information related to its client. It is further to maintain an appropriate credit/collateral administration, measurement and monitoring, mostly when dealing with commodity financing, since the goods being financed are easily movable, sometimes perishable, and can suffer huge market price fluctuations, which requires from the creditor an intensive collateral management policy.
Collateral risk. The collateral risk is related to the quality of the guarantees rendered by the debtor to the creditor and the constitution of valid and binding collateral. As mentioned above, asset-backed lending, such as trade-related ones, must be accompanied by the strict control of the inventory collateral that secures the loan.
Such a control process has two aspects: legal and physical. The legal aspect entails making absolutely certain that under the law governing the lending transaction, including the location of the collateral, the lender has absolute control over the collateral, vis-íÂ -vis the debtor or any other third party, and has the right to dispose of the collateral if the loan is not repaid timely.
Given the movable and perishable nature of the commodities, the physical aspect involves making certain, from time to time, according to the nature of the products being financed, that the collateral is where it is supposed to be when it is supposed to be there.
Lack of liquidity risk. The third type of risk is the lack of liquidity of the collateral. This is measured by the time spent by the creditor trying to enforce and/or sell to third parties the collateral for the settlement of the debt.
Under Brazilian law, apart from the institute of ‘banking guarantee’s (fiana bancria), unfeasible today in our market due to Basel’s requirements, there are no guarantees that could be classified as being a ‘first demand guarantee’.
Thus, if the creditor has no choice but enforce the guarantees rendered by the debtor, it will be exposed to the usual problems arising from our judicial system, including delays in court decisions, costs of collection procedure, risks arising from bankruptcy or insolvency of debtor.
Legal risk. The legal risk deals with the effectiveness of the collateral given in guarantee and all steps that must be taken by the creditors to fulfil local contractual requirements and perfect the security interest. In this sense, collateral is effective only if the legal mechanism by which it was given ensures that the lender has clear rights over the collateral and may liquidate or even retain it in the case of default, bankruptcy or any other similar event.
Such risks will have a considerable impact on the transaction costs and have to be fully understood by creditors. A summary of extensive research we made last year may help creditors to understand what kind of situations they are exposed to in Brazil, offering also some alternatives for the mitigation of legal risks arising out of commodity financing.
Court decisions in commodity financing
In the beginning of 2006 we carried out an extensive analysis of case law related to security instruments, and more than 1,000 court decisions were reviewed. The case law comprises decisions by the Superior Tribunal of Justice of Brazil (the highest court in Brazil to deal with federal legislation) and the Tribunal of Justice of the States of Rio Grande do Sul, Santa Catarina, Paran, So Paulo, Gois, Mato Grosso do Sul, Mato Grosso and Minas Gerais (State Courts of Appeal).
Most of the case law analysed refers to pledges created over stocks and pledges created over crops. In relation to the former, case law unanimously dictates that whenever there is a failure to prove the existence of the pledged asset by the creditor, or the debtor had created a lien over merchandise already sold (but not delivered) to third parties, the pledge shall be deemed null and void.
Case law is also unanimous in ruling that, in cases where the debtor was able to dispose the pledged goods, which resulted in no goods being available for legal seizure, the creditor had its status changed from preferred creditor to an unsecured creditor. One of the best options for creditors to mitigate such risks is to maintain effective monitoring of the financed goods, while such monitoring should start before the perfection of the pledge agreement and should remain in place until repayment in full of the obligations.
Another option is to hire a third party (such as an inspection company) as faithful depositary of the goods, which would then be liable for the existence, safekeeping and maintenance of the pledged goods for the duration of the underlying financing transaction.
As to pledges over crops, Brazilian law guarantees the automatic pledge of the subsequent crop, if for any reason the original pledged one is not sufficient to satisfy the credit. This creditor’s prerogative has been repeatedly confirmed by Brazilian court decisions.
Notwithstanding, in cases in where the subsequent crop has already been financed by a third party, the third party will have the preference over such a crop. The best way to mitigate such risks is also to create a pledge over the subsequent crop, which can be released by the creditor as soon as the debtor repays all its obligations. .
In our experience, an issue which is commonly raised by our clients is the effectiveness of Brazilian law to provide for the imprisonment of the depositary in case he or she fails to deliver the goods according to the agreed terms.
In these cases, our courts have been reluctant to apply the ‘imprisonment provision’s in approximately 70% of the cases, wherever the depositary is the borrower, one of its shareholders or officers.
Surprisingly, the courts have not had any reluctance in applying the imprisonment provision in relation to warrants issued according to Brazilian Decree No1,102/1903, which shows effectiveness of the original regime for warrants in Brazil, revoked, in relation to agricultural and cattle products, by Law No11.076/04.
It should be noted that this new regime for warrants and certificates of deposit, or WAs and CDAs, as defined by the new law, to the best of our knowledge, have not yet been submitted to higher court decisions.
Concerning CPRs, the effectiveness of such instruments must rely on a true purchase and sale transaction of the products which are the object of such a guarantee. Thus, CPRs are accepted as a guarantee mostly in the financing of trade companies that buy merchandise from several producers for export purposes, being first issued on behalf of the financed trade company and further endorsed to the order of the lender.
In these cases, before accepting such an instrument as a guarantee the creditor must ask for proper evidence that the payment of the products (or advance of other products, such as fertilisers) have already been made on behalf of the issuers of the CPRs.
For most parts of the case law analysed for this article, the payment in advance for products, either in cash or in other kinds of products, is a condition precedent for the effectiveness of the CPR and therefore to the collection against its issuer.
The only way to mitigate risks described above is to have a careful first lien checked by specialiszed lawyers, who will, among other things, make sure that all necessary certificates are present, that all parties sign the guarantee instruments and analyse all partnerships and leasing of land agreements in connection with those lands where the pledged crops have been or will be planted.
On top of that, the importance of securing effective monitoring of crops and/or goods or even the participation of an inspection company as collateral manager and holder of the goods must be emphasised.
The creditor must always remember that, in trade finance transactions, the key aspect for a successful enforcement of its rights arising from security instruments is to ensure that goods being financed do exist and to keep a continuous monitoring of their exact location.
Developments in legislation
An important recent development in Brazilian legislation is the enactment of the Complementary Law No126/07, dated January 15, 2007, which opens the Brazilian reinsurance market to foreign players. This brings to an end the 70-year monopoly held by IRB (Brasil Resseguro), a private and state-owned company with major participation from the federal government.
The regulatory framework for the reinsurance market is still to be developed by the National Council of Private Insurance (CNSP) and its analysis is outside the scope of this article.
However, it is worth noting that according to the Brazilian ministry of agriculture (MAPA), the opening up of the Brazilian market will allow the expansion of rural insurance in Brazil, a sector which, due to its significant costs, cannot be supported by national players alone.
The new regulation can also have a significant impact on the use of performance bonds or other kinds of insurance polices as an adjunct or even as a main piece of the security package within the context of a commodity finance transaction. In the case of the latter, creditors must always be aware of the limitations and risks involved in the use of performance bonds as the main guarantee in an asset-backed transaction.