Those producers who survive the current economic uncertainty will be the ones that have managed the risk of their businesses. We all recognize the risk of price both in terms of buying commodities and selling products.

But as volatile and dangerous as price risk is, the one risk that is far more serious is counterparty risk. Simply stated, counterparty risk is the risk that the person on the other side of any contract you have does not perform as agreed. The losses from this risk come without warning, come at the wrong time (for example, when markets are at their highest) and come big. Often, so big that even seemingly strong companies fail.

Examples of counterparty default are many. For example, you prepay for fertilizer for the year and the supplier goes out of business without delivering; you ship young heifers to be raised and the landowner evicts the raiser and sells your calves to pay for the rent; or you contract for silage from a local farm and the farmer fails to harvest in time, rendering it unusable as silage. Each of you no doubt have similar experiences, maybe nightmares, of your own.

Today’s rapidly rising and volatile marketplace with shortages has magnified the risk of the other party defaulting. Over the recent past, relatively stable pricing and availability of feed and fuel has reduced the risk, lulling us sometimes to think it has gone away. It has not. It is here. It is bigger, and it is real.

Recognizing and controlling this risk is essential in today’s marketplace. Those dairymen who survive this current market condition will be those who are able to not only manage the risk of commodity prices but the risk of counterparty default. It is not just a question of morality or ethics; it is a case of economic reality that ultimately decides the winners and losers. Drought, diabolical market price swings, disease, dishonesty and disaster all compound the risk to an enterprise’s viability to volatile market prices and product availability.

So what can you do to control this counterparty risk? Here are some thoughts to consider.

First, think about the risk when it is a risk and not a reality. In most cases, the risks that undo businesses were predictable enough that they could have been protected against. As part of any deal, considering the risks of what could go wrong and what that means is no less important than the price and quantity.

Second, always put the transaction in writing. Handshakes are great, but when it comes to enforcement, there is nothing in that shake that tells others, such as judges, what the agreement is. You can write it down yourself, though a lawyer knowledgeable in agriculture is highly recommended. In any event it is fundamental that all of the agreed terms be written down by someone so that future understanding and enforcement of the agreement is possible.

Do it when the deal is made. It is amazing how without written agreements, and even sometimes with them, changes in market conditions change the parties’ perception of what the terms were. Also, when third parties are involved, something that they can see in writing better explains the deal. Though having signatures by all the parties is preferable, a memo from you to the other parties with all of the terms may be binding on the other side if they do not respond in disagreement.

Please note that whether you, a lawyer or someone else writes it down, you must understand every term. If you do not understand what each clause means and why it is there, ask questions until you do. There are no “special words” that make a well-drafted agreement, just common English words that are fully understood by all parties.

Third, have as few middle persons as possible in the deal. As the number of included parties grows, the risk of default compounds. So it is important to get as close to the source as possible. One way, for example, to have it both ways is to have an agreement with the supplier with an agreement to pay the broker the fees. In this way, there is no risk of the broker defaulting.

Fourth, identify the other persons who are in a position to interfere with performance. These include such persons as landlords, banks, secured suppliers and business partners of the supplier, among others. Make sure that their interests are covered in the agreement. They may not necessarily need to be a party to the agreement but, depending on individual facts, may need to be notified or at least recognized in the agreement.

Proof from the supplier of silage, for example, that he has a good lease on the land and is not in default is one way to recognize and remove the risk of a third party land owner undoing your deal. Do not be afraid to ask the third party to sign off on the agreement.

Fifth, performance by both parties should be as close in time as possible to avoid risk. There is no counterparty risk when you fill your gas tank at the local station and pay for it at that time. The risk is when the timing of your performance comes before the timing of the other party’s performance, like prepaying for 5,000 gallons of diesel at the beginning of the year for delivery through the season.

Often it is the prepayment that gets the good price. The problem is that you are, in essence, providing a loan to the company without any security. The bank that is also lending money and the big supplier all have priority over you when it comes to that diesel. An alternative to consider is to place money in an escrow account that pays out immediately upon delivery.

Sixth, recognize that there can be a default and prepare as if one is going to happen. Besides having the agreement in writing, obtain security agreements or other guarantees of performance. When it comes to contracting for a supply of silage from a farm for a year, it is not at all unreasonable to expect a security agreement for the crop that places your interest ahead of everyone else. Take out insurance on the crop or get a security interest in the proceeds of any crop insurance that the grower has.

Seventh, make provisions that show that you have title to the property held by the third person and the right to enter the property to remove your property. For example, in the case of a contract for growing crops, the right to enter the ground to harvest the crops is critical. In other agreements, a clause that allows for a specific performance is also a way to provide for default and get what you have paid for, particularly in times of a shortage. Another way is to obtain a third party guarantee of the performance of the supplier either through guarantee or letter of credit.

The types of risk and the ways to reduce them are all individual. Not all of the risks have been identified above. But what is important is to realize those risks exist and then contract around them so that at the end of the day, you get what you pay for. The assistance of a lawyer experienced in agriculture is invaluable in reducing the risks and insuring your survival.

Survival in the end is not given to those who endure no hardships, but those who expected them, prepared for them and had a plan to work out of them before they occurred. So it is with counterparty risk. PD

Ben Yale for Progressive Dairyman