What’s in your Borrowing Base?
Borrowing base credit facilities are a well known and popular basis on which banks and their corporate clients raise secured commodity finance. Lenders may be able to offer more leverage against specific identifiable assets compared with wider balance sheet lending. Borrowers gain from the potentially wider asset classes they can offer as collateral to improve their access to credit without encumbering other assets or restricting additional credit lines and the revolving nature of the facilities is beneficial to assist with fluctuating funding requirements.
The central premiss on which the facility operates is that the lender commits to lend an amount up to a certain percentage limit (often referred to as the ‘advance rate’) of the value of the borrowing base comprising eligible assets from time to time. The advance rate may actually be an aggregate rate made up of different sub limits applied against different assets or the same assets viewed in different ways from a risk perspective. As the value of the collateral fluctuates up or down, whether due to changes across supply chain and/or production cycles or movements in market prices, the availability limit of the credit facility moves accordingly. Although there will be a fixed upper maximum facility limit, within that limit the available facility is not a fixed amount.
From a lender’s perspective, a key feature of a borrowing base credit is that the assets constituting the collateral are properly secured in the lenders’ favour without significant or unknown competing preferential claims and for there to be an enforceable exit route, especially in time of distress. Although there is a clear commercial benefit from including in the borrowing base a variety of asset classes which fluctuate over time and in their location, without proper legal analysis, this element carries the risk of making such structures more challenging to enforce and for actual recoveries to be undermined.
In the trade and commodity finance market, borrowing bases are typically made up of a combination of all or some of raw materials, inventory, receivables and potentially cash. For a lender to be confident in the level of security it has over these assets, a number of factors need to be taken into account. Questions of the appropriate form of security (pledge, charge, assignment, other), governing law and perfection requirements can vary significantly depending on the asset and its location. What role needs to be played by third parties and what are the priority and preferential creditor issues? All of these factors will have a bearing on the enforceability of the security and the amount recoverable.
Lenders should make themselves aware of these issues from the outset of a transaction. If the real value of the security the lender believes it has is actually undermined because of a legal issue which had not been investigated when the deal documentation was completed, the lender risks being exposed through making available a higher loan amount because the security value attributed to the collateral has been inflated by a false assumption.
Proper legal due diligence and documentation is therefore strongly advisable. Once signed, however, for the continued effectiveness of the lender’s security, ongoing monitoring of the borrowing base is essential. Regular reporting by the company or a third party on the value of the assets is required. The basis of the valuations (eg. self-certification by the borrower, third party valuer, desk-top valuation, physical inspection) and their frequency have an important bearing on the value of the collateral from a credit perspective. The asset descriptions, terminology and classifications should match those the lender is expecting which would usually correspond to those used in its performance modelling. Agreeing on the requisite form of, and level of detail in, the borrowing base certificate from the outset (usually scheduled to the credit agreement) is strongly advisable.
Borrowing base assets typically change in form and location over time and the security and loan documentation needs to factor this in. Crude oil being imported on a vessel may be covered by a pledge over bills of lading. How are letters of indemnity issued in place of bills of lading to be treated? Once discharged into storage at a port or tank farm, a pledge or charge over the inventory in that jurisdiction may be required. Are there new products being refined and stored and what is the relevant security interest to capture these until title passes to a buyer? Are there co-mingling issues which apply? How is the receivable payable by the buyer to be secured? In the case of oil and certain other natural resources, are there questions over prior claims regarding national reserve allocations to be considered? Similar or equivalent chains will apply to other commodities and goods. Each circumstance will have different consequences for the enforceability and value of the security for a particular stage at a given time.
It will be a credit decision for the lender how advance rates for particular assets are determined and one of the factors should be the attributable security value (in terms of its legal strength) from time to time. For example, take an export contract receivable the subject of a well documented security assignment under the same governing law as the export contract which has been perfected by notice to the buyer.
This is likely to have a greater security value than the same receivable only secured by an unperfected master security assignment granted under a different governing law from the receivable. Inventory in a third party warehouse the subject of a properly managed pledge and collateral management agreement should have a higher security value than the same inventory for which the lender cannot demonstrate it has control for the purposes of maintaining its pledge. There may be justifiable commercial reasons for not always fulfilling all legal requirements for achieving enforceable security, but in such circumstances lenders would do well to be informed and to consider a reduced advance rate.
Advance rates can be used to mitigate against numerous factors which a lender may consider relevant for it to manage the eligible borrowing base. If it is too expensive or cumbersome to try to properly secure a complete book of fluctuating customer receivables, acceptable limits can be applied to an unsecured portion, to customers designated by name, jurisdiction or credit rating. Receivables covered by credit insurance can be distinguished from the uninsured. Commodity stock subject to an acceptable (and possibly secured) hedging contract may have different treatment from an unhedged stockpile.
The flexibility associated with the borrowing base facility is one of its major attractions for both lender and borrower. The varied means of analysing the borrowing base which are available give the lender the tools to keep within its credit criteria whilst allowing its borrower to maximise the leverage it can from the eligible asset base. Understanding and implementing the legal details combined with vigilant monitoring will assist in avoiding unexpected misunderstandings from being exposed at a critical time. A strong security interest cannot protect the lender against a sharp fall in market prices for oil or steel, but it should avoid the lender in any market from simply finding it does not have the rights it assumed in relation to the stock. A locally perfected security assignment of receivables cannot protect against the deterioration of a purchaser’s credit rating, but it should avoid the lender finding it has no enforceable recourse against a defaulting purchaser because of a false assumption as to its security position in the purchaser’s jurisdiction.
Once established, knowing what is really in your borrowing base from a legal and documentation perspective should continue to be central to the lender’s credit decisions and relationship management. Is the lender receiving timely, trustworthy and accurate borrowing base information? Is the reporting comprehensive and in sufficient detail for the lender’s monitoring? Are the borrower, lender and any third parties fulfilling their obligations under the facility and security documentation? Does the lender understand how the reported borrowing base value corresponds to the enforceable security value attributed to the borrowing base? Only if the answer is yes can the lender be confident about the legal basis on which the facility is made available and that the advance rate reflects the real security risk on the assets.