In 2008-09 with the credit markets nearly frozen, firms that had been healthy are facing unprecedented challenges to secure sufficient operating funds. And falling commodity prices left some end users holding “above market” purchase contracts, further adding to their basket of risk. Elevators and farmers wonder how to quantify these risks and how to know who are safe trading partners in this environment.
No single approach to managing counterparty credit/contract risk is foolproof, but there are steps that collectively can help.
• Work with competent knowledgeable legal counsel — a firm that understands grain contracting and our industry. Have them review all your contract language and forms.
• Send written trade confirmations to buyers as well as producer/sellers.
• Always send a written sales cofirmation/contract even if the buyers send their confirm to you. National Grain & Feed members can specify that dispute will be subject to NGFA Trade Rules, and also subject to resolution by NGFA arbitration.
• You can include language that says your contracts will be subject to reciprocal performance margins. This means if prices decline (on sales) you may be able to ask your buyer to send you the cash equivalent to at least part of the equity of the contract as a performance assurance. (The same as asking farmers to send money to you when prices rise against their contract.) Coordinate with legal counsel on correct legal steps, however.
• Consider using Master Contract Agreements — documents which outline standard trading terms that apply to all future transactions with the counterparty.
• Know your trading partners! Assess all potential buyers and rate each one and each potential transaction on a scale. (see chart below right) This is subjective, of course, but it forces you to recognize risks.
• Owners and boards should quantify acceptable maximum accounts-receivable exposure with any single buyer (or farm seller) and limit bushel volume per counterparty where justified.
• Decide what basis premium you want to deal with a given firm. You might sell only limited quantities to a firm that’s low on your scale, and demand a higher basis value. But even a nice basis premium on a sale to a low-rated buyer can turn into a costly loss if the buyer fails to perform. Sometimes a cheaper basis is the more prudent sale!
• Keep forward sales unpriced where possible to reduce price exposure until shipment. This is negotiable on a contract, but if not agreed otherwise, a cash buyer has the right to determine time of pricing. While reducing counterparty risk it does raise your potential financing requirements (margin call risk).
• Don’t be afraid to insist on daily payment by buyers, or in some cases prepayment. Consider selling in-store with warehouse receipts to the buyer upon payment. These acts don’t mean you distrust someone; it’s about protecting your business.
• In some cases owning a small percentage of exchange-traded put options against priced sales can lessen the financial cost of a counterparty failure. But this protection has a cost; use it with restraint.
One of Warren Buffet’s favorite sayings is “You don’t know who’s swimming naked ‘til the tide goes out.”
There are various factors that can help you set your subjecting rating of a counterparty.
1. Business structure: You might rate a farmer-owned ethanol plant higher-risk than an integrated publicly traded processor/exporter, for example. LLCs are an effective shield; identify the real assets behind the LLC as members are not individually liable!
2. Consider buyers’ payment history. Has anything changed? Is payment history more important for certain business structures?
3. Review public information on firms where possible; stock trend, earnings, SEC reports (available on firms’ websites), analysts’ reports. Check Secretary of State records on LLCs, LLPs.
4. Public companies: Check their Credit Default Swap price (insurance against default). This signals the broader market’s assessment of the cost to guarantee credit default risk on a given quantity for a fixed time period. You don’t have to buy a CDS but check the cost. Bloomberg Service subscribers can access most CDS values.