Securing Creditors’ Interests under International Commodities Trade/ Finance Transaction in Ukraine

By Oleg Alyoshin
Vasil Kisil & Partners

Structured commo dity finance in Ukraine is an important area of growth for the banking and corporate sectors. The increased demand results, in part, from industrial and trade development and the need to finance such development. Ukraine has been witnessing economic growth recently despite permanent political instability in the country. With all these political risks and within the limitations of applicable laws, the most widespread means of obtaining financing on affordable terms and conditions is structured commodity finance. The popularity of structured commodity finance has been growing recently among foreign financial institutions.

In general terms, structured commodity finance may be defined as a commodity-based financing technique, specifically designed for commodity producers and trading companies doing business in developing markets. The structure of the deal itself contains two essential parts: (1) the first one is that there should be arrangements which ensure that if a transaction proceeds normally, the financier is automatically reimbursed; the loan is therefore self-liquidated; (2) the other part is the arrangements which have to ensure that if anything goes wrong the financier has recourse to some assets as collateral. By their very nature these types of transactions give rise to a number of risks the financier has to bear in mind. For example, the insolvency of a producer or distributor, problems in realizing the security or even discovering that the commodity which had been financed is no longer in existence. These risks need to be secured. One of the key features that characterize commodity finance transactions of the secured variety is that they normally involve security over commodity stocks as part of the security package granted to a financier in respect of the borrower’s indebtedness. Another consequence of this is that the very security being offered to the financier acts also as the means by which the debtor’s indebtedness will be repaid. In other words, repayment of the loan will depend greatly on the debtor’s ability to sell the very goods, which create the subject of the security. These specific features usually make it harder for the financier to control or monitor the security.

Taking Security over the Goods

Ideally, a security package should provide the creditor with (a) an opportunity to react promptly and effectively against the borrower defaulting, which, in fact means to enable the creditor to enforce a claim against secured goods in the most effective manner and, if possible, without resorting to court procee dings, and (b) if for some reasons this is not possible, to enforce its claim against secured goods – to have in addition such a security instrument, which would allow the creditor to bring a claim against a company which has assets; normally it is a company – guarantor for the debtors obligations.

Where the financier wishes to take security over the goods themselves there are a number of legal issues which arise in this regard. The first one to be taken into account is the importance of legal regulations of the place where the goods are physically located. Whatever law and jurisdiction may be selected for financing agreements, the effect of security over the goods will be governed by the law of the place where the goods are located (lex situs).

Security of goods can take a variety of different forms. Generally, there are two different groups: pledges and ownership.

Ownership or title to a commodity as a means of security is hypothetically the best option to the financier. However, lenders often prefer that their customers hold ownership title to the goods taking into account the formalities that ownership in a foreign jurisdiction can sometimes involve. For instance, financial institutions as foreign entities may be unable to export or sell the commodities due to the necessity to comply with certain formalities; another reason is that such ownership of goods may be subject to taxation or licensing problems. For these reasons, financiers will often prefer not to take title as a means of security.

(A) Pledges

As a result of the issues relating to ownership outlined above, many financiers prefer to take pledge over the goods as security. In many cases a pledge involves the delivery of possession of goods as security until payment. Creation of a pledge involves transfer of possession over the goods, whether actual or “documentary” possession (or so-called “constructive” possession).

In addition, the borrower retains the title in the goods. Before effecting a pledge over goods, a financier will need to be satisfied that that the borrower is the existing owner of the goods as a matter of Ukrainian law. Normally, this should be done through some due diligence process. The financier rarely takes actual physical possession of the goods but instead will take “documentary” possession by taking control of the goods. For example, by taking delivery of a warehouse receipt, or by taking delivery or endorsement of a document of title, such as a bill of lading. Under Ukrainian law the pledger (that is the borrower) may not sell or dispose of in any manner the pledged goods without the prior written consent of the pledge (that is the financier), unless otherwise provided by law or respective pledge agreement. Properly formalized contractual documentation and verification of the rights of third parties to the commodities, which are subject to pledge, enables financier to recover their claims quite effectively.

(B) Warehouse Certificates/Warehouse Receipts

Warehouse certificates or warehouse receipts, as mentioned above, are one of the ways in which the rights of “documentary” possession may be given to a pledgee (that is the creditor). Warehouse receipts are often assumed to be a document of title similar to a bill of lading. Under Ukrainian law the warehouse certificate/ receipt is not a document of title; transfer of the warehouse certificate/receipts does not mean transfer of the title to goods. The bank will need to take a pledge over the goods themselves and will hold the warehouse certificate/receipt as evidence of its rights of possession or right as a pledgee.

Under Ukrainian law the following types of warehouse documents exist: (a) twofold warehouse certificate; (b) simple warehouse certificate and (c) warehouse receipt. The twofold warehouse certificate consist of two parts, which are a warehouse certificate itself and warrant certificate, which can be separated from each other. The pledge of the goods, accepted for storage under the twofold warehouse certificate, arises from the moment of conclusion of the pledge agreement and when the warrant certificate is separated for the purpose of the pledge and transferred to the creditor. The holder of the simple warehouse certificate may pledge the certificate itself and in this case the simple warehouse certificate must be transferred to the creditor (pledgee). If the holder of the simple warehouse certificate decides to pledge the goods instead of the certificate itself, the simple warehouse certificate needs to be changed into the twofold warehouse certificate.

(C) Forwarders Certificate of Receipt (FCR)

There are a number of cases when financing for commodity trade was provided against a FCR, which means that the FCR was used as a primary security instruments. You probably know that the forwarder’s certificate of receipt (FCR) is a tool which was originally developed by the International Federation of Freight Forwarders Associations (FIATA). In short, in FIATA terms the FCR means that a forwarder issuing FCR (a) acknowledged receipt of certain goods, (b) assumed control over the goods with an irrevocable instruction to forward them to a foreign purchaser named as consignee in the document; meaning that the goods are beyond the control of the exporter, and (c) the forwarder must follow the instruction of the holder of the original FCR.

The question is: how reliable is a FCR as a security instrument for commodity finance in Ukraine? The answer based on our previous experience is that financiers accepting FCRs as a means of security still need to be quite careful since, in our opinion, FCR does not provide the holder with the appropriate level of security. Undoubtedly, an FCR is a quite flexible and convenient instrument for the purposes of short-term financing, but in Ukrainian practice it is associated with a number of risks. The regulation of professional activity of freight forwarders in Ukraine is of very poor quality. No regulation similar to FIATA regulations still exist in Ukraine. In fact, formal Ukrainian regulations do not support the intended purpose for which FCRs were originally developed and introduced.

Conclusion

As a general rule the financier tends to apply a combination of various techniques to receive the best security. Unlike many other methods of secured financing, commodity financing transactions undoubtedly carry some specific risks. Financiers can, however, take steps to mitigate these risks by fully understanding the legal issues that the security arrangement give rise to. Issues such as those relating to risk management and mitigation are set to become even more important with the European Union, giving effect to the new Basel II Banking Accord. Changes to capital adequacy requirements for banks will inevitably have an impact on the structure of loans for commodity finance and the cost of borrowing funds.