What are warehouse receipt systems?

Under a WRS, a warehouse receipt (WR) is issued to a named depositor (who may be a farmer, farmer group, processor or trader) as evidence that he or she has deposited a specified commodity, of stated quantity and quality, at a specified location. The holder of the receipt may pledge it to a lender (with the stored commodity being the collateral for a loan) or transfer it to a buyer (by way of a sale). The warehouse operator or collateral manager, who has custody of the stocks, guarantees delivery against the receipt, and should be able to make good any value lost through theft, fire or other catastrophes. The key players in the WRS are depositors, the warehouse operator or collateral manager, and lenders. Their roles, responsibilities and benefits may differ depending on whether the WRS is regulated or not as discussed below.

Unregulated warehouse receipt systems

An unregulated WRS is a legal or formal system of inventory collateralization, in that the provision of services as well as the rights and obligations of parties are based on existing contract law. Aggrieved parties can therefore seek redress through the courts. However, unlike the regulated WRS, neither the collateral managers (who take custody of stored commodities) nor the issuing of receipts are regulated by an independent regulatory agency.

Contractual obligations and rights under the system are usually defined in tripartite collateral management agreements between three key players shown in figure 3.2: borrower, collateral manager and the lender (usually a bank). In the cotton sector, borrowers tend to be medium-scale to large-scale ginning or export companies, handling large enough volumes of seed cotton or lint to justify the cost of this service, and who either own or can lease suitable storage space. Very large traders, especially the vertically integrated multinational companies, often do not use WRS because of relatively easier access to cheaper offshore finance. For reasons of scale, it is often difficult for smaller-scale traders and groups of smallholder farmers to use it.

Figure 3.2: Key players in the unregulated WRS

The collateral managers usually issue non-negotiable, non-transferable warehouse receipts and guarantee of delivery of the stored commodity. Most of them are local subsidiaries of international inspection companies, which obtain international insurance and performance bonds to back their guarantee of delivery. They also tend to have a track record in quality and quantity certification for various commodities. Société Générale de Surveillance (SGS) is the best-known example of such companies. Others include Audit, Control and Expertise (ACE), Cotecna, Baltic International, Bureau Veritas and Socotec/ITS.

Transaction cycle under an unregulated WRS for cotton

The cycle is typically as follows:

• The borrower applies for credit prior to the opening of the harvest season. The loan application is usually assessed on the basis of the borrower's balance sheet and track record as well as on the adequacy of security provided.
• If the loan application is approved in principle, the bank and the borrower will select a collateral manager; but quite often the bank's view is paramount in the choice made. A collateral management agreement (CMA) is then signed between the borrower (ginner), the collateral manager and the financing bank.
• The collateral manager, on the basis of the CMA, takes exclusive access to the warehouse provided by the borrower - it may be leased if the borrower does not own a suitable facility. A nominal fee (about $1) may be paid to the borrower by the collateral manager to cement legal control over the warehouse.
• From that point, the collateral manager has legal custody of the seed cotton and/or lint stored in the warehouse and is authorized to release such stocks only with explicit authorization from the specified lender. The collateral manager is expected to provide regular updates on the quantity, quality and value of stocks, which are expected to be insured by the borrower.
• After ginning and upon receipt of a confirmed order, the bank authorizes release of the lint to an importer. The importer must have either paid for or made satisfactory arrangements to pay for the lint delivered.
• Payments to the ginner are required to be channelled through the lending bank, to ensure full recovery of the loan and related servicing costs. Some banks insist that if the contract is not backed by an L/C then stock release will be permitted only after payment has been received.
• Payments to the ginner are required to be channelled through the lending bank, to ensure full recovery of the loan and related servicing costs. Some banks insist that if the contract is not backed by an L/C then stock release will be permitted only after payment has been received.

Quite often the banks will, in addition to the CMA, require the following as additional security:

• Personal charge over the assets of directors and/or shareholders as well as a fixed and floating charge on the borrower's assets, usually the ginnery.
• A confirmed fixed-price off-take contract or L/C against which the cotton collateral will be valued.

The main drawbacks of the system include lack of access, especially by relatively small ginners for whom the cost of collateral management and insurance may be too high. Financing decisions can be slow and the requirement for fixed-price off-take contracts often denies borrowers the opportunity to benefit from favourable price movements. Since the receipts issued are non-transferable, they can not be used as delivery instruments against contracts, hence limiting their role in facilitating trade.

Collateral managers, like other operators, sometimes experience losses through theft and fraud. Their liabilities, when they occur, are often limited by indemnity and 'limitation of liability' clauses in the CMA. Hence, it is essential for lenders to carry out effective due diligence in the selection of collateral managers and closely monitor their operations.

The regulated warehouse receipt system

The involvement of an independent regulatory agency is what distinguishes the regulated WRS from the unregulated model. The regulatory agency may be government-based, as is the case in the United States (where USDA is the main regulator) and the United Republic of Tanzania, which opted for this model following promulgation of enabling legislation in 2005. A private-sector-based agency, for instance a strong commodity exchange as is the case in South Africa, can also regulate warehouse operators issuing negotiable receipts which are traded. In Zambia and Uganda, another model is being promoted, in which an arm's-length private-sector-controlled agency is authorized by the government to enforce appropriate laws and industry standards regulating the WRS.

The independent regulator is responsible for licensing or certifying warehouse operators as custodians of collateralized stocks (ensuring that they comply with criteria set in relevant laws and regulations); regulating the issue of standardized warehouse receipts to minimise the risk of fraud; and overseeing the operations of warehouse operators (including carrying out unannounced stock and quality verifications).

Licensed operators offer 'public' warehousing services, implying that they can store commodities on behalf of multiple depositors (of all sizes) in a single warehouse or site. The receipts issued may be transferable and negotiable, depending on the enabling legislation. Licensed warehouse operators may include international as well as local inspection companies, and processing companies such as ginneries.

Transaction cycle under the regulated WRS

Depositors requiring financing for initial procurement of seed cotton apply for credit prior to the opening of the marketing season. The application is usually appraised on the basis of traditional criteria and procedures, including:

• The borrower's balance sheet and credit history or track record.
• Satisfactory demonstration of the feasibility of the proposed activity.
• Personal charge over the assets of directors and/or shareholders, and/or fixed and floating charge on the company/group's assets.
• Price risk mitigation, in the form of off-take contracts, where market-based price risk instruments are absent.

As in the case of lending under the unregulated WRS, decision-making is slow and bureaucratic, involving recommendations by credit officers, credit committees and management.

Once seed cotton is procured or assembled by farmer groups, it is delivered to designated ginneries for storage and processing. The independent regulatory agency is responsible for licensing or certification of the designated ginneries. Deposits can be made by any party but must meet the following criteria:

• Minimum volumes as determined by individual designated ginneries (e.g. 3 to 7 tons of seed cotton in the United Republic of Tanzania and Uganda) - in order to reduce administrative, transport and transaction costs.
• Minimum quality standards set by the independent regulator in consultation with the trade. The seed cotton must be storable, and the lint readily marketable.

The designated ginners issue WRs to depositors, after weighing and grading the seed cotton deposited. The WR states the quantity and quality of the seed cotton deposited; the name of the depositor; and the obligation of the ginner to deliver the seed cotton described or its lint equivalent to the depositor or a bona fide party to whom the receipt has been transferred. The WR also contains the terms and conditions under which the stocks are being stored.

Where the depositor intends to borrow against the collateralized stocks, the process involved includes the following steps:

• The borrower approaches a bank providing inventory financing with the relevant application backed by the WR and, where required, an off-take contract.
• The bank confirms the status of the WR from the designated ginner before advancing any credit - this is critical in minimizing the risk of fraud.
• The credit advanced depends on the market valuation of the lint out-turn from the deposited seed cotton, with appropriate adjustments reflecting anticipated future price movements.

Prior to sale, a system of monitoring the collateralized stocks is enforced to safeguard the interests of depositors and lenders, including:

• Submission by warehouse operators of daily stock position reports to lenders and the regulators.
• Unannounced inspections by regulators to verify the volume and quality of stocks and confirm compliance with storage standards and regulations.
• Complementary inspections by insurance companies and banks.
• Monitoring of market developments that affect the value of the collateral by credit officers, who can advise clients liquidate stocks if necessary to minimize exposure to potential adverse price movements.

When the crop is sold, payment is required to be made through to the financing bank. This is often included in the off-take contracts.

The financing bank will, after being satisfied that the loan obligations have been satisfied, release the WR to the bona fide buyer, who can take delivery of the lint or seed cotton, after presentation of the WR to the designated ginner. When the WR and instructions from the bank are presented, the ginner will allow delivery of the lint or seed cotton to the buyer and cancel the WR to complete the transaction.

The regulated WRS has the added benefit of being accessible by small-scale operators, such as farmer groups, as illustrated in the cases from the United Republic of Tanzania and Uganda. However, establishing such a system requires painstaking work on creating and maintaining a supportive regulatory and policy environment.

WRS pilots for cotton in the United Republic of Tanzania and Uganda

The regulated WRS has been successfully piloted in the United Republic of Tanzania and in Uganda. One farmer group, the Oridoyi Rural Cooperative Society in the United Republic of Tanzania, which has used the system, was able to raise seed cotton output by its members almost 10-fold over a period of four years. Financing was provided by a local bank, CRDB Bank Ltd, which also lends about $10 million per year against collateralized coffee. The cooperative was also able to market its lint direct to a United Kingdom-based cotton merchant in the 2005/06 season. The rise in output was primarily financed by the cooperative society from retained profits accumulated through marketing cotton on behalf of its members, through the WRS.

In Uganda, the Nyakatonzi Cooperative Union offered storage and toll-ginning services to its member primary cooperative societies, making it possible for them to use the WRS. The primary societies did not obtain inventory finance, as members were prepared to wait for payment until after the lint was sold. Participating farmers earned incremental income of over 40% because they sold lint and cottonseed, instead of seed cotton. The cooperative union also benefited from increased throughput without having to raise additional financing for procuring seed cotton.

Source: Natural Resources Institute reports.