My Collateral Includes a Commodity Account. Now What?
Prices for agricultural commodities fluctuate. A producer attempts to mitigate this price risk through hedging. A lender attempts to mitigate the risks of loaning money to the producer by taking a security interest in producer’s commodity hedging accounts. The commodity broker provides the lender with a control agreement, and says that it is the “standard form” signed by all lenders. No changes needed.
It all sounds so simple, right? Not necessarily.
A commodity account control agreement is a crucial document for an agricultural lender whose collateral includes a commodity account and the securities, cash and other investment property held in the account (hereinafter referred to as, “Account Property”). Utilizing a “standard form” prepared by the commodity broker, without analyzing the provisions of the control agreement, can create unnecessary risks on a lender. This article provides a brief overview of the purpose of a control agreement, and “standard” provisions that should be avoided.
Pursuant to Article 9 of the UCC, a commodity account and the assets held in that account are investment property. To perfect its security interest, a lender should take “control” of the commodity account and the Account Property. Control of a commodity account and the Account Property exists if the commodity broker has agreed in writing that it will comply with the lender’s instructions regarding the transfer or redemption of the Account Property without the consent of the owner of the account. Therefore, for purposes of perfecting a security interest in the commodity account and the Account Property, the control agreement must (1) be executed by the commodity broker, account holder, and lender, (2) accurately describe the account and the Account Property, and (3) include a provision similar to the following:
“Lender is authorized, without further authority from debtor, to request broker to remit to lender any funds that may be due to debtor or to direct the transfer, liquidation, or redemption of any of the Account Property. Broker is authorized to pay to lender such sums, and to comply with lender’s request to transfer, liquidate or redeem any of the Account Property, all without the consent of or notice to debtor.”
The typical control agreement, however, includes more than just the broker’s agreement to honor lender’s instructions described above. It often establishes additional rights and obligations of the account holder, broker and lender with respect to the account and the Account Property. There are two provisions in the typical broker-prepared control agreement that are particularly problematic and create undue risks to lender—the broker’s right-to-payment provision and the margin call provision.
It is standard industry practice to pay a broker’s commissions and fees from the cash in a commodity account and for a broker to have a lien on the account and the Account Property to secure such payment. The typical broker-prepared control agreement, however, goes well beyond this with a provision similar to the following:
- “The security interest of lender in and to the commodity account and the Account Property is subject to the prior payment of all indebtedness of debtor to the broker as such may exist from time to time, including fees and commissions, which may have been incurred in connection with debtor’s transactions with Broker, and to the broker’s lien, and the right of foreclosure thereof in connection with any indebtedness of debtor to broker…”
The problem with the underlined language is that the term “indebtedness” includes all obligations owing from debtor to broker, not just fees and commissions. By agreeing to this type of language, the lender puts itself in second position behind the broker who, upon liquidation of the Account Property, will be entitled to be paid in full for all “indebtedness” owing from debtor to broker. To avoid this result, the lender should require the broker to revise the control agreement to limit the “indebtedness” of debtor to broker that has priority over the lender. We recommend the following:
- “Notwithstanding any provision contained herein to the contrary, (a) the term “indebtedness” as used in this paragraph shall not include any loans, advances or other extensions of credit from broker to debtor and (b) broker shall have no right of set-off in connection with any such loans, advances or other extensions of credit from broker to debtor.”
It is also possible for a broker to make margin calls on the debtor. The typical broker-prepared control agreement takes this one step further with the following provision:
- “If the commodity broker requires additional margin for an open position, lender shall advance to the commodity broker on behalf of the debtor such amounts as may be required by the commodity broker to margin such position.”
The use of the word “shall” creates a mandatory obligation on the lender to advance funds to cover a margin call by the commodity broker. There may be instances—particularly if the borrower is in default—under which the lender does not want to make such advances. If the lender enters into a control agreement with the “shall advance” provision and then refuses to make an advance, the lender risks the broker making a claim against it for breaching the contract. To avoid this risk, the lender’s obligation to make margin calls should be optional, rather than mandatory. We suggest language similar to the following:
- “If the commodity broker requires additional margin for an open position, lender may, but shall not be obligated to, advance to commodity broker on behalf of debtor such amounts as may be required by commodity broker to margin such position provided, however, that debtor in all respects shall remain liable to the lender for any amount so advanced.”
In summary, a commodity account control agreement is more than just “words on paper”. It perfects the lender’s security interest in the account and the Account Property, and just as importantly it establishes the lender’s rights and obligations with respect to the account and Account Property vis-à-vis the broker. Given the importance of the control agreement, don’t rely on assurances that it is a “standard form” that is not negotiated. Instead, take the time to tweak the two provisions discussed in this article. Those small revisions could make all the difference in protecting you as the lender.