Commodities: The brave new world

As the global commodities sector changes faster than ever, with greater opportunities and challenges opening up, international law firm Reed Smith provides some essential insights on the legal and regulatory issues market participants face


Inventory or warehouse financing is a hot topic for the commodities sector these days. As finance from traditional sources becomes more difficult to obtain, because of deleveraging and tighter regulation on banks, corporates have looked at other ways of maintaining their working capital.

One such tool is a sale and repurchase transaction, known as a “repo”. This is, in essence, a commodity sale by the corporate with a requirement or option that the seller repurchases a similar commodity at a later date. Repos are attractive to lenders because lenders should be well protected as the owner of the commodity. For most banks, the regulatory capital treatment of a commodity repo means they are required to hold less capital against the financing than they would for a conventional loan.

However, alongside this and other innovations are an increasing number of potential pitfalls. In particular, commodity inventory fraud has been making headline news. Why? Principally because commodity-backed inventory financing carries a unique set of risks. For example, commodities are fungible; in other words, they’re easily traded. They’re also a portable and, in some cases, perishable asset, which is relatively easy to monetise. This provides lenders with a liquid and flexible form of security, but at the same time makes that security vulnerable to risks such as misappropriation.

Lenders and others can protect themselves, though. How?

  • Proper understanding of the “physicality” of the commodity is essential
  • It’s also important to be clear about the title of the goods, which involves understanding origination and supply chain obligations
  • Being aware of how to obtain and protect whatever form of legal interest is recommended by local legal counsel is important too
  • Knowing the access arrangements and the terms on which the goods are stored
  • Carrying out due diligence on all counterparties and
  • Proper understanding and use of other risk mitigants, such as insurance,

are among the issues that lenders should “stress test” in this rapidly evolving market.

REGULATION

“Regulators slap $4.3-billion fines on six banks in global forex probe.” “European banks wake up to the pain of US-sized fines.” “UK financial regulators to police seven more benchmarks”. Recent headlines such as these dramatically demonstrate the increasingly robust stance taken by regulators, and with new and more demanding regulations coming into force, participants in the commodities market are being kept on their toes more than ever.

This year saw the implementation of further obligations under the European Market Infrastructure Regulation (EMIR), which aims to increase transparency in the market.

The revised Markets in Financial Instruments Directive (MiFID II) was published in June and is due to come into force in January 2017. Many in the commodities sector have already started to prepare for the increased regulation this will impose, particularly on those trading commodity derivatives, given that many of them had previously relied on an exemption in the first version of MiFID, which has now been removed.

The UK is starting to adopt an enforcement style that was previously only seen in the United States with increasing powers for the Financial Conduct Authority

Alongside this, the UK is starting to adopt an enforcement style that was previously only seen in the United States with increasing powers for the Financial Conduct Authority (FCA). For example, the number of dawn raids being undertaken by the FCA has almost doubled in the past year. The UK’s Serious Fraud Office is reported to have a number of cases in the pipeline against companies that are suspected to have breached the Bribery Act, which came into force in 2011.

So, among other things, market participants must ensure they are aware of, and that their contracts and standard forms comply with, all regulations to which they are subject, and that they conduct thorough due diligence on third parties.

SANCTIONS

The use of sanctions as a targeted political weapon is continuing to increase. Recent developments in Russia and Ukraine demonstrate this, and the new approaches being adopted.

Furthermore, fines imposed on banks for breaching sanctions have ranged from millions to almost $9 billion.

While sanctions are not new to the commodities market, “sectoral” measures, dealing with access to the capital markets, imposed as part of sanctions against Russia, are unprecedented, and add to an ever-expanding and more complex body of international rules for commodity market participants to navigate. Unlike other approaches, such as asset freezing, these sectoral sanctions prohibit only certain activities involving certain listed entities.

As well as this, players not previously directly affected by sanctions, such as lenders to the commodities market, are now being drawn in. Furthermore, new names continue to be added to the sanctions lists and, therefore, a contract that is lawful today might be unlawful tomorrow.

Another complication is that the EU and US positions on sanctions differ. Variations include:

  • People subject to asset freezes
  • Controls applicable to imports and investments in infrastructure and
  • How the specific prohibitions are implemented by the respective government agencies.

In an unstable world, with sanctions set to become increasingly commonplace and stringently enforced, regularly updated advice and guidance is more important than ever.

 SANCTIONS TOP TIPS

  • Monitor changes in sanctions
  • Ensure compliance with all applicable regimes and
  • Confirm that contracts contain provisions to protect you if sanctions are imposed.

This article has been written and developed by Reed Smith partners Kyri Evagora and Jonathan Solomon with associates Karen Ellison, Simone Goligorsky, Alex Gordon and Jessica Kenworthy