In contracts for the sale of goods, the transfer of title marks the point at which ownership of the goods passes from the seller to the buyer. Those financing the sector traditionally lend and take security from the borrower. If utilising the borrower’s commodity inventory to provide security (for instance by way of a pledge over inventory), the premise has to be that ownership of or title to the commodity remains with the borrower. But an increasingly common way in which finance can be provided against inventory is for the financier to buy the commodity from its customer, taking title to it and in return providing the customer with funds in the form of the purchase price for the commodity. These arrangements frequently take the form of sales and repurchases (known as ‘repos’) by which the financier purchases commodities from its customer under a purchase contract and sells them back to the customer for delivery at a later date under a separate resale contract. Sometimes the transactions take the form of more bespoke inventory monetisation arrangements.
From the financier’s point of view, acquiring good title to the commodity is a fundamental requirement of these structures because with good title the financier has the best possible interest in the commodity and the best possible protection against a default by or the insolvency of its customer. Faced with such a scenario, the legal owner can sell the commodity to a third party purchaser and retain the price recovered. However, if these title arrangements are not properly due diligenced and documented, a financier may expose itself to legal risk and unintended consequences at exactly the time it needs to move quickly and decisively to liquidate his exposure.
Against this background we consider five key issues below:
1. Transfer of title
Conflict of laws issues
Questions around title to goods raise classic ‘conflict of laws’ issues. The due diligence ahead of any transaction of this kind therefore requires the financier to do some early research of the relevant laws. Typically, that means investigating the law of the place or places where the commodity will be situated throughout the execution of the contracts and the law – or possible laws – of the contracts themselves. Broadly speaking, questions of title to goods will always be determined in accordance with the laws of the country in which the goods are situated when the question needs to be answered. That law will be key to determining from whom/to whom title passed, when and how that title can be evidenced and proven. Many laws will, in that situation, recognise that the parties to a commodity sale and purchase contract ought to be free to agree in their contract (a) how and when title will pass and (b) what law is to govern the contract including, therefore, how and when the parties to the contracts want title to pass.
In that context, if considering a transaction (be it a loan against security or a sale and repurchase, with the transfer of title), it is important at the earliest opportunity to reach out to counsel in the country/countries where the commodity will be situated for input as to how title passes, and how it is evidenced/proven in their country. This includes their legal system and their insolvency rules’ attitude to the recognition of a law chosen by the parties to govern their sale and purchase or borrower/lender relationship.
Having done that and become comfortable, it is then necessary to understand the application of the two laws (of the contract and of where the goods are situated) to ensure that the combination provides the desired solutions.
So, what are the English law rules about passing title under English law? Frequently, that will be the law the parties agree to govern their relationship, and may or may not be the law of the place where the goods are situated.
The English law position
Assuming that title will be transferred to the financier and back to the customer under English law contracts for the sale of goods, the Sale of Goods Act 1979 (SOGA) provisions, concerning when title is transferred, will apply. Section 17 of SOGA provides that, where the contract is for specific or ascertained goods (that is, the goods to be purchased are identified at the time the contract is agreed), title will transfer to the buyer when the parties intend for it to transfer. If, however, the contract is for unascertained goods (that is, the exact goods to be purchased are unknown at the time the contract is agreed), Section 16 of SOGA provides that, subject to Section 20A, title cannot transfer to the buyer until the goods become ascertained.
Contracts for unascertained goods include contracts for commingled goods – namely, goods stored in bulk with goods of the same type owned by other parties. Therefore, if the parties specify in the purchase contract that title to the commodities will transfer to the financier at a time when the commodities are stored in bulk, commingled with commodities belonging to others (for example, as is frequently the case in warehouses, grain silos or oil tanks), then notwithstanding the terms of the contract, subject to section 20A of SOGA, title to the commodities will remain with the customer until the commodities are ascertained.
Section 20A of SOGA provides that if certain conditions are met a buyer can become an ‘owner in common’ of the bulk – meaning that the buyer acquires an undivided share in the bulk in proportion to its share of the total. The financier can transfer such interest to its customer under the resale contract or, if necessary, to a third party buyer. However, as one of the conditions that must be fulfilled is that the buyer has paid the purchase price, the financier can only acquire a share of the bulk in respect of the commodities it has paid for.
A consequence of this is that if a financier pays the price for, say, 100 barrels of crude oil, but the customer in fact delivers 105 barrels of crude oil, the financier will not acquire an ownership interest in the additional five barrels until it has made a true-up payment in respect of the price of the additional five barrels.
These SOGA rules can greatly assist parties to transactions in which the acquisition of title is key. The rules though – if to be relied upon – need to be supported by the documentation and, indeed, by the operational practicalities of the particular trade in order to ensure that title is adequately evidenced and can be enforced. It is important too, of course, that on a default or an insolvency, the benefits of these complex English rules will be applied in the country where the commodities are situated.
It is sometimes thought that the transfer of title and delivery of commodities are concurrent – that is, if title to the goods has been transferred by seller to buyer, then the commodity will also have been delivered to the buyer. As a matter of English law, that is not always the case.
Section 29(4) of SOGA states that “where the goods at the time of sale are in possession of a third person, there is no delivery by seller to buyer unless and until the third person acknowledges to the buyer that he holds the goods on his behalf”. The section states that it does not affect the operation of any document of title, which means that no acknowledgement is required from the carrier in respect of goods on board a vessel delivered by endorsement of a bill of lading. However, as warehouse receipts are not always documents of title (and with some very limited exceptions such as trade custom or usage or by Acts of Parliament, they are not under English law), if the commodity purchased by the financier is inventory in a third party storage facility at the time of sale, the third party storage operator will need to provide the financier with an acknowledgement that it now holds the inventory for the financier before delivery will be regarded as having taken place as a matter of English law.
This is important in the context of a repo-type transaction, because on the sale contract side, the financier will, on a default, want to be able to establish that the commodity was delivered to him and that his title is unimpeached. On the resale contract side, because, if no acknowledgement is provided by the storage operator that it no longer holds the commodities for the financier and instead holds them for the customer so that delivery is not effected, the financier could be in repudiatory breach for failure to deliver the commodities, so making it hard to claim payment of the price. The parties may, under the terms of the resale contract, deem delivery to have taken place without the need for an acknowledgement, however, they should proceed with caution. For example, in the widely publicised High Court case of Mercuria v. Citibank1, a provision stating that delivery could be made by means of in-warehouse transfer “without the need for any confirmation from the owner/operator of the storage facility” was rejected on the basis it was inconsistent with preceding wording, the meaning and effect of the contracts and the overall commercial transaction.
3. Implied terms under SOGA
Under SOGA, terms are implied into contracts for the sale of goods relating to the seller’s title (Section 12), the description of the goods (Section 13) and the satisfactory quality and fitness for purpose of the goods (Section 14). These terms will be implied into the resale contract (as well as the purchase contract) notwithstanding that the financier may be selling to the customer the same commodities as were purchased from the customer under the purchase contract, or that the customer has more information regarding the commodities than the financier.
As an example of the exposure a financier could face, it is an implied term under Section 12(1) that the seller will have a right to sell the goods at the time when title is to transfer. Section 21(1) of SOGA provides that a buyer cannot acquire better title to goods than the seller had. If, therefore, the customer did not have the right to sell the commodities to the financier under the purchase contract (for example, because title had not passed to the customer at the time of sale), it follows that the financier would also not have a right to sell the commodities back to the customer, and would be in breach of the implied term under Section 12(1).
Section 55 of SOGA provides that the terms implied by the Act can be excluded by express agreement, so a robust exclusion clause should be included in the resale contract. As the exclusion clause would likely be construed against the financier (that is, contra proferentem), care should be taken to ensure that the exclusion clause captures all relevant types and classes of terms.
4. Storage arrangements
In case the customer does fail to repurchase the commodities, the financier will need the ability to recover its money by selling the commodities to a third party.
To this end, the financier should ideally ensure that the party with control over the commodities (namely, the storage operator or shipowner if the commodities are transported by sea) is independent of the customer so as to get additional comfort that such a party will cooperate. The storage operator should also have a contractual obligation to follow the financier’s orders in respect of the commodities to which the financier has title. It may, therefore, be necessary for the financier to enter into an agreement with the storage operator directly.
The commodities owned by the financier should be distinguishable from commodities owned by third parties. For example, commodities stored in warehouses should be segregated from commodities owned by third parties, and clearly labelled such that they can be identified as belonging to the financier. In respect of oil stored in oil terminals, the storage operator should keep up-to-date records of the precise quantities of oil held by each party and the tanks in which the financier’s oil is stored.
The financier should have a right to inspect the commodities in the storage facility to conduct stock checks and ensure that the storage operator is storing the commodities in accordance with its obligations.
5. Recharacterisation risk
Recharacterisation in the context of these transactions refers to a situation where the transaction is considered by the courts to be a loan of money, rather than two separate and distinct contracts for the sale and purchase of commodities. If the transaction is viewed as a loan, the financier would have a right to repayment of its loan (that is, the payment of the purchase price, with interest and costs) but would not receive title to the commodities under the purchase contract.
Recharacterisation is particularly relevant in the event that the customer becomes insolvent. If the financier has title to the commodities, it can sell the commodities and retain the entirety of the proceeds. If, however, the financier instead has a right to repayment of a loan, it would become an unsecured creditor of the customer and unlikely to receive repayment of the loan in full, as it will not have taken any steps to register and/or perfect any security interest it may have in the commodities.
The English courts have generally been reluctant to recharacterise sale and repurchase transactions as loans where it is clear that the parties intended for there to be a sale and purchase of the commodities. If, however, the customer is incorporated in a foreign jurisdiction it will be subject to the insolvency laws of that jurisdiction, and the local courts may apply different principles in determining how to characterise the transaction.
In determining the parties’ intentions, the English courts will consider the transaction as a whole. They will likely take into account a wide range of factors, including the wording of the contracts, the extent to which the financier is entitled to sell the commodities to a third party and any obligations on the financier to account to the customer for any profits or for the customer to account to the financier for any losses on such a sale, the price payable for the commodities and whether the commodities remain in the control of the customer. It is therefore important that the financier monitors the recharacterisation risk throughout the course of negotiations, as the transaction structure develops.
In this article we have considered five key issues that are likely to be relevant to financiers in these types of transactions. There may, however, be other considerations when taking title to commodities, such as environmental liability, insurance, tax, and duties and sanctions which may be specific to the commodities purchased and sold, the start and end points of the trade, and the counterparties involved.
Financiers entering physical commodity repos and other inventory monetisation arrangements should take care to ensure they are aware of all the potential legal risks that may arise from taking title to commodities prior to entering the transaction. In doing so, they will need to consider the legal risks that may arise under the purchase, the resale and under the transaction when considered as a whole, as well as any conflict of laws issues.
- Mercuria Energy Trading Pte Ltd v. Citibank NA  EWHC 1481.
Client Alert 2019-194