Inventory Finance and a View on Qingdao
by Mark Sachs
The investigation into falsified warehouse receipts, the warehouse lock-down and fraud investigation against Decheng Mining (and others) in the Chinese port of Qingdao has raised many questions over the robustness and confidence of warehouse finance in China, both among international banks and traders directly exposed in the affair and also with those outside of the region but concerned that lessons can be learnt for their own regions’ markets. Estimates place exposures of international banks at in excess of $1 billion and more than $2.5 billion is thought to be at risk for domestic Chinese banks. There will no doubt be lessons learnt by way of reminder of the importance of staying close to your inventory and having trusted local counterparts but there are a number of peculiarly Chinese factors at play as well.
Chinese macro circumstances
Although public details of this specific case are few and opaque, what is apparent about commodity finance in China is that in the past couple of years a particular market has developed which uses warehoused commodities, primarily metals, as collateral for disguised commercial lending and arbitraging of Chinese interest rates. This has been an unintended consequence of the Chinese government’s attempts to control speculative lending and overheating, particularly in the property market. At the macro level China instructed its state banks to restrict lending. Builders and others in the construction market sought other sources of liquidity. A very sizeable market built up using rolling L/Cs supposedly issued in respect of warehoused commodities to provide USD finance to builders’ subsidiaries in Hong Kong which could then sell the goods back to the parent company (or related company) in the Chinese mainland in CNY. These transactions were “rolled” multiple times. This is an aspect of what has been called the shadow banking industry in China.
These distortions (large inventories, higher than expected level of L/C issuance) were noticed by the Chinese authorities and in due course regulations were introduced this spring to curb this practice by controlling L/C issuances and other measures. It may well be that the Qingdao case is an incident of pure warehouse receipt fraud (there have been other similar recent cases in China) but the Qingdao case may have more or as much to do with the air deflating out of the speculative disguised lending that has been going on. During the good times, parties involved may well have been more concerned about what could be earned from the financing transactions and not paid enough attention to the collateral. It may have been too easy to issue multiple warehouse receipts during this period when in fact the commodities involved were not actually being consumed and normal commodity finance conditions did not really apply.
In any case, and whatever the reason, it seems unlikely the foreign banks involved will see any significant recovery. The Chinese authorities may well take the position that if what was going on was disguised lending then the banks should not recover because they were engaging in or facilitating prohibited speculative lending. There may be limited sympathy in such cases and the Chinese courts are likely to attempt to favour Chinese banks over foreign ones.
Implications for orthodox trade finance structures outside of China?
It is probably unlikely that the bare fact that, for regulatory reasons applicable to offshore financings, the offshore banks will have structured their financings along sale and purchase “repo” lines whereas the onshore secured creditors will have been more likely to use pledges over warehouse receipts and inventory, will have any specific bearing on the outcomes in contested recoveries between creditors with competing claims over the same pot of assets. If the receipts and quantity of the inventory are fraudulent, issues of possession and title are unlikely to be pertinent to the cases. The likely distinction in recoveries between Chinese banks and offshore banks in terms of treatment by the Chinese courts is probably more to do with different treatment for domestic as against offshore banks than the legal structures employed for the provision of finance.
Outside of the Chinese courts, there may be some judicial development concerning the effect of repo structures as to when title passes and where responsibility lies for dealing with inventory whilst the goods are under lockdown by the authorities and inaccessible to all parties concerned. In the London High Court, there are widely reported cases ongoing involving Trafigura, Citibank and Mercuria (among others).
Despite the particular Chinese backdrop, it is clear that the Qingdao experience serves as a further reminder that notwithstanding the strength of the legal documentation, it remains the case that there is no alternative than to undertake proper due diligence on the counterparties, local legal system and underlying trade transaction and that this needs to be supported by trustworthy monitoring and access to the inventory during the life of the credit.