Parties to warehouse financing structures using LMEshield warehouses will need to revisit their familiarity and assumptions regarding the methods for taking and perfecting security over metal stored in warehouses and over warehouse receipts. This article explores some of the key questions a financer should ask when taking security over metal stored in LMEshield warehouses.
Introduction Warehouse financing is a flexible financing option enabling borrowers to receive advances against inventory stored in warehouses. The structures followed enable borrowers to monetise their inventory during the storage phase to enable them to receive funds to invest in further supplies of goods, either for processing and/or onward sale to end buyers. In addition, financers are able to provide finance to borrowers with the benefit of being fully collateralised.
In a warehouse financing of metal, where the metal is not held in an LME warehouse1, typically a financer would seek to take security over the metal stored in the warehouse and/or the warehouse receipts representing the metal. The key priority for a financer is to ensure that it can create first ranking security, with a power of sale upon enforcement, so that the financer can quickly and easily enforce and sell the metal upon a default by the metal owner/borrower. This means that it is preferable to provide finance where both the borrower and the metal are located in jurisdictions with out-of-court enforcement regimes to avoid lengthy court proceedings and public auctions of the metal.
The pledge security structure In many jurisdictions, security over metal and warehouse receipts must conform to local law requirements and, therefore, a financer must seek local law advice on creation of the security to ensure that the security interest is enforceable against the metal owner/ borrower. We have found that, in most jurisdictions, security over most goods is created by way of a possessory form of security which is, invariably, similar to an English law pledge or its equivalent under local law. Typically, in order to perfect the pledge, a financer needs possession of the goods secured by the pledge. Given that, absent an enforcement situation, a financer is unlikely to want physical possession of the goods, they will prefer to instead take ‘constructive possession’2 of the goods. The financer may satisfy the requirement for constructive possession by the possession of warehouse receipts in jurisdictions where a warehouse receipt is, under the laws of that regime, treated as a document of title3. However, where the warehouse receipts are not documents of title, which is the case in most jurisdictions, having control over the goods may be a way of demonstrating possession. Whether this is sufficient to perfect the pledge will depend on the laws of the jurisdiction where the goods (and, therefore, the warehouse) are located.
Perfection requirements for pledged security Perfection of security over a warehouse receipt that is recognised by the law of the jurisdiction of the location of the warehouse as a document of title, can occur by it being reissued in the name of the financer. However, perfecting security is less simple when it comes to goods represented by a warehouse receipt that is not so treated as a document of title. One method, which can be fairly burdensome on the parties, is to carry out an ‘attornment’ process. Under this process, the financer requests the borrower to instruct the warehouse to (i) hold the goods in the warehouse to the order of the financer and (ii) issue a new warehouse receipt to the financer reflecting that arrangement. In response, the warehouse will issue an attornment to the financer, promising to follow the borrower’s instructions to hold the goods to the order of the financer and to issue a new warehouse receipt. The original warehouse receipt is returned to the warehouse and a new warehouse receipt is issued to the financer.
If the attornment process proves too cumbersome, another way of perfecting a pledge is by the borrower assigning the warehouse agreement to the financer or entering into a tripartite warehouse agreement between the borrower, the financer and the warehouse so that the warehouse owes direct obligations to the financier to hold the goods to his order as well as certain other important obligations relating to storage conditions, access rights and the release mechanism. Finally, constructive possession can also be achieved through use of a collateral manager, whose obligations include inspecting, monitoring and controlling access to the goods on behalf of the financer.
How will this work in the context of an LMEshield warehouse? The LME has recently introduced an electronic environment in which warehouse receipts are issued and immobilised. This involves a depository4 as well as an electronic register (the ‘LMEshield system‘). The depository is currently located in England and the terms under which the LMEshield system operates are governed by English law.
Where the metal to be financed is located in an LMEshield warehouse, parties to warehouse financing structures will need to revisit their familiarity and assumptions regarding the above methods for taking and perfecting security over metal stored in warehouses and over warehouse receipts.
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The diagram above demonstrates how arrangements to create security over warehouse receipts issued by the depository are supported by the LMEshield system. The rules envisage that the borrower and the financer still enter into a pledge agreement outside of the LMEshield system in respect of the warehouse receipts and the goods represented by the warehouse receipts and stored in the warehouse. In broad terms, the system operates as follows: (1) a warehouse receipt is issued by the depository at the request of the warehouse; (2) the warehouse receipt (which is intended to be the tangible warehouse receipt issued and immobilised by the depository) is credited to the account of the metal owner/borrower; (3) the borrower will issue a ‘Pledge Instruction‘ to the depository; (4) the financer shall either reject or confirm the Pledge Instruction, and upon confirmation by the financer of the Pledge Instruction; and (5) as a consequence, a number of important actions occur simultaneously:
- the warehouse receipt is debited from the borrower’s account;
- the warehouse receipt is credited to the financer’s account;
- the electronic record of the financer’s account is marked as “pledged”;
- the warehouse is notified of the pledge by the LMEshield system; and
- the depository makes an attornment, on behalf of the warehouse as its agent, that the goods held in the warehouse and specified in the warehouse receipt and credited to the financer’s account are held to the order of the financer.
The ‘pledged‘ flag will remain on the financer’s account until the pledge is either enforced or released by the financer.
As the warehouse receipts issued under the system are not, as a matter of the laws of England and Wales, documents of title, the key to creating the requisite possession to perfect the pledge is the attornment from the depository on behalf of the warehouse. The financer has control of the warehouse receipt and the goods represented by it through the crediting of the warehouse receipt to its account on the LMEshield system. This control is achieved as no person other than the financer can release the warehouse receipt from out of the depository (or the financer’s account) and, therefore, the goods represented by the warehouse receipt from out of the warehouse.
Conclusion The LME states that it shall only add jurisdictions to its list of ‘Eligible Jurisdictions‘ where legal opinions have been issued in respect of the operation of the system and the LME user terms in such jurisdictions. However, it is important to note that these opinions are not public and may not be relied upon by anyone other than the LME and, furthermore, the LME and the depository both exclude any liability for the lack of effectiveness of a security interest created using the LMEshield system.
Therefore, it is important that a financer seeks its own advice from counsel in the jurisdiction of the location of the assets and where the borrower is incorporated to ensure that the warehouse receipts issued by the depository, and the goods represented by the warehouse receipts, are capable of being effectively secured, and that the constructive possession purported by the LMEshield system validly perfects the security.