Prepayments
We offer a unique perspective on prepayments. We are able to, and will, cater for every detail as related to the physical trade, logistics and storage, and effectively wrap the same in robust and bankable financing terms
In this note, by “prepayment” we will refer to a sale purchase contract where the price of the goods (yet to be delivered) is paid in advance.
Prepayments are common in the commodities industry and are an important tool for the producers and trading houses. For the producer, a prepayment allows access to longer-term funding; for the trading house, a prepayment ensure access to the flow of commodities. Since trading houses typically seek long(er) term sources of commodities, the prepayment market is highly competitive.
For a trading house, a prepayment combines the risk inherent in a long term off-take agreement with credit risk. Not only the producer may be unable to deliver the goods (jeopardising performance of resales), the producer might also (thereby) default on repayment.
In many prepayment transactions, and certainly, in larger ones, the trading house will (re)finance the prepayment amount in the banking market. Typically, the banking facility will be with limited recourse to the trading house: the trading house’s direct liability to the banks will be limited to a portion of the prepayment, with the remaining part payable only upon recovery from the producer. Of course, the trading house will undertake to the syndicate to seek recovery from the producer.
An important exception for the limited liability is the case of a commercial dispute. The scope of matters considered to be “commercial disputes” is paramount both to the trading house and the banks. Many facilities fail to specify what commercial disputes actually are, but it must be noted that hardly any non-performance by the producer will be disconnected from a “commercial dispute” whether real or manufactured.
From the banking community perspective, the trading house takes the burden of negotiating with the producer and also carries the risk of the first loss. It is also assumed that producers are less likely inclined to default on delivery obligations. Thus, prepayments can be seen as an improvement on the banks’ risk. Where the benefit of the reduced risk is passed on, this also results in a cheaper interest cost for the producer.
Prepayments can be interesting documents to work with: on the one hand, they include off-take terms; and, on the other hand, they include financing terms. A chimera of sort.
There is the temptation to focus on just on part of the prepayment, either the off-take or the finance part, but this must be resisted. It is quite easy for the document as a whole to become unworkable if it forgotten that the primary source of repayment of financing is the deliveries of goods and not payments in cash. Compared to a straight off-take agreement and a straight loan facility, a prepayment must include arrangements to ensure that both parts work well together. This will require counsel’s daily involvement in both the commodities market and the finance industry.
