Corporate finance

Why would a publicly listed corporation establish a line of credit that is to be fully collateralized in cash? Here is the relevant language from the 8-K:

" Collateral Account : As collateral for all Obligations, the Borrower shall deposit with Lender funds in an amount not less than the Loans (the “Collateral Account Requirement”), which account shall be account number XXXXXXXXXXXXXX (the “Collateral Account”), and which Collateral Account shall not be otherwise encumbered except as permitted by this Agreement (the “Collateral”). Any amount in the Collateral Account in excess of the Collateral Account Requirement shall be available for withdrawal from the Collateral Account by Borrower at Borrower’s request. "

In other words, “you can borrow money as long as you keep the same amount of money on deposit with us in a non-interest bearing account.” (The “non-interest bearing” bit is set forth elswhere, not in the above text.)

The company in question has around $50 million invested in short-term Treasuries, which currently pay jackshit for interest… The credit line is for a smaller amount, less than $15 million.

So, without the credit line, if that company wants to use some of its funds, let’s say $5 million, it still has $45 million of unencumbered capital, and has no indebtedness so it owes no interest.

With the credit line, the company pays 0.15% on any unused amounts of the credit line, and then when it goes to draw down $5 million on the credit line it has to move $5 million to the collateral account and it now gets the privilege of paying interest on the $5 million it borrowed, while still only having $45 million of unencumbered capital available to it. So you have higher costs than you do without the credit line.

I am sure there is a reason for establishing this credit line, but I am wondering what it is?

It could be a Trade Line of Credit. For example the Company may import products from various suppliers overseas. The overseas supplier doesn’t have a long relationship with the Company. So they are not willing to sell product to them under open credit (i.e. traditional sales terms of 30 days etc.) The supplier will be willing to sell under these normal terms if the Company posts a Trade letter of credit (LC) from an international bank that they do have a relationship with. The bank is willing to issue the trade LC if the Company puts the funds on deposit in the collateral account.

The Company has the bank issue the LC in favor of the supplier. The supplier ships the goods to the company. As long as the Company pays the supplier on time, the LC never gets called. And the company only pays the LC fee (substantially less than the interest rate on borrowed money). If the Company fails to pay the supplier on time, the supplier presents the LC to the bank for payment. The bank pulls the funds out of the collateral account to cover the amount of the LC.

These are common banking transactions done everyday especially by companies that do international business.

Thanks Omar, that is very solid info, but the company in question is not engaged in trade and therefore has no suppliers, distributors, etc. of any consequence. It is a business development company, so it’s need for funds is primarily limited to making investments in smaller companies. Such events are of course very predictable and preplanned, and would not seem to require “quick access” to funds.

The line of credit does not appear to be needed to facilitate the process of making these investments at all, as the company has been operating as a business development company for around 20 years without a similar credit facility in place.

I wonder if “cash” as used in such agreements can actually be construed to include a wide variety of securities?

Many corporations have restricted assets. For example, they may have a sinking fund that has been mandated by other debt agreements (such as a corporate bond issue) or by the Board of Directors. Pension funds might also be present. The company can’t spend that money - it is restricted to certain future uses. When considering the bank to deposit these funds with, why not deposit them with a bank that will then allow a line of credit for the same amount?

You also have to think of corporate ratios. If a company has $50 in assets and $50 in debt, they have a 1.00 ratio. Spend $5 of the assets and now you’re at $45/50 or 0.90. Borrow $5 against the assets and spend that instead and you’re at $50/55 or 0.91. While that’s a small difference, it illustrates how something that appears functionally equivalent can affect how the company’s financial health looks. It might even go back to other debt covenants. If they require that the debt ratio be no lower than 0.91, the second scenario gives you $5 to spend that you didn’t have otherwise.

But all we can really do is guess with the limited information we have here. There are lots of motivations and some of them (especially long-term strategies) may not be apparent until much later.

Yep, sure seems weird to me, too. Here are some WAGs:

  1. Covenants on other debt require the company to have a certain amount of cash on hand, and those covenants are written badly enough to include this cash.

  2. There’s some accounting or regulatory measure that is helped by having more cash on hand and that somehow is not also hurt by the fact that the cash is borrowed and must be held to secure the borrowing.

  3. There’s fine print somewhere that allows the company to use the cash for certain purposes (e.g., if the company BKs). This makes a little sense because maybe the lender could insure against these events (by using CDSs or otherwise).

  4. Maybe the language you quoted saying that the cash much equal the Loans must only be true on certain testing dates (e.g., the end of each quarter), so the company can use the cash as long as they replenish it the day before each testing date.

Another WAG: It somehow minimizes taxes.

For example, the company may have earned money in a foreign country, but will be liable for US taxes if the money is repatriated. Instead, they keep the money in a foreign account as collateral for a loan.

Strange looking financial transactions are frequently driven by the quirks of tax law.

Actually, cash-secured lines of credit are not as uncommon as you might think. They are even a fairly common product for retail customers. Without looking at the specific company, it is difficult to tell why they would need it. If you would provide a link to the 8k, it would be easier to speculate.

Regardless, the L/C suggestion is a good one. I know you discounted that saying that the company was more of a investment type company. Depending upon how their investments are structured, they may be required to post financial surety prior to closing the transaction, which they may prefer posting an L/C rather than putting cash in an escrow account.

This company also may simply be trying to establish a credit relationship with the bank, and they think that this is a good way to do it.

My real guess is that there isn’t a really good reason for the cash secured line of credit, but that their management team is not very sophisticated and they have been basically tricked by the bank.

The “non-interest bearing” part is odd. In my experience, if a company posts cash in order for a financial institution to provide an L/C, that cash still gets invested in some sort of low risk (2a7-type) money market fund. And the company gets to keep that interest income.

Based on the limited info, another possibility is that while the Borrower is a public company, it may have a majority owner (or several large shareholders) that is/are also the Lender being used. The company’s own management may not be able to freely utilize its cash, and have to get approval from the owners (typically in the form of a Board of Directors approval).

In essence, this would mean that the owner(s) apply some sort of charge on any capital used as investment capital.