Counterparty risk is the risk to each person in a deal that the other party will not live up to its contractual obligations.
There are two types of counterparty risk.
- The risk of default where there is a question of whether payment will be received or the delivery will be made (default risk).
- The contract will have zero value (exposure risk).
While this might be new terminology for many farmers, these scenarios are not. Farmers should start assessing their counterparty risk.
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Historically, farmers have entered into agreements to hold or deliver product without performing due diligence on the party with whom they contract.
Trust was the basis for the confidence that the contract would be honoured. It can, however, be difficult to extract money from that trust if there is a default.
Counterparty risk can also take the form of uncertainty, when there is a question about the willingness to pay, which is different than the ability to pay. An example is a grain buyer using more stringent grading practices to take a product out of scope.
Risk increases with the number of parties involved in a contract. Lapses in time between a transaction and settlement also increases counterparty risk. A relatively extreme example occurred this summer when farmers were encouraged to pay for fertilizer to guarantee supply for next year, with the promise of future delivery. This meant paying for and deferring delivery of a 2009 input before the 2008 crop was even a certainty.
Before entering a contract, apply a structured process to perform due diligence. All assessments should attempt to quantify all potential risks and include an examination of how it will affect the farm’s financial situation.
This process requires discipline and constant vigilance because situations and a company’s financial position can change quickly. A farmer’s due diligence on a company can follow the five Cs that lenders have used for years: capital, capacity, collateral, character and condition.
A risk checklist
Here are suggestions for handling the counterparty risk management process:
- Analyze the farm’s balance sheet, focusing on indicators such as liquidity (short term) and solvency (long term).
- Set limits on exposure.
- Set limits on concentration (value of contracts with one business).
- List the main contracts that are in place.
- Read and review existing contracts and agreements, considering the predetermined limits on exposure.
- Establish a due diligence process and apply it to new contracts based on the predetermined limits on exposure.
- Attempt to make a determination about the management ability of the counterparty.
- Try to learn as much about the financial picture of the counterparty as possible, including the ownership structure.
- Try to avoid hasty decisions.
- Be cautious of the too-good-to-be-true opportunities.
- Ask questions and collect as much information on the company as possible.
- Be aware of industry developments.
- Consider having a lawyer review potentially significant contracts.
Do your homework
The counterparty will have a reputation in the industry. Check with a peer group or other industry contacts to get insight into the company.
The internet can also be a source of information regarding a counterparty but there are limitations to its usefulness.
Other documents that can help include accounting and regulatory disclosures for publicly traded companies, letters of credit, bonding, escrow accounts, insured receivables, guarantees and insurance.
As the 2008 production cycle winds down, farmers are delivering and contracting to deliver grain, oilseeds and special crops. Some will defer income to 2009 as a tax management strategy. Perhaps you have already been presented with production contracts for 2009.
While counterparty risk can’t be eliminated, it can be managed.
Terry Betker is a partner with Meyers Norris Penny LLP, working out of the Winnipeg office. He is director of practice development in agriculture, government and industry. He can be reached at 204-782-8200.