ConsolFreight Contracts Review

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This document provides an overview of the various agreements that exist between the parties involved in business activity around ConsolFreight’s trade finance offering.

The Parties

Any deal with ConsolFreight involves a number of different parties. The key ones are listed here:

  • Issuer Parent/ Asset Originator (AO) - ConsolFreight
  • Payment Obligors
  • Issuer - Special Purpose Vehicle (SPV)
  • Investors - majority Maker but other parties can buy DROP Tokens
  • Centrifuge Tinlake Protocol
  • Senior Investors (DROP tokens)
  • Junior Investors (TIN tokens)

DROP tokens and TIN tokens are issued by the Issuer using the Centrifuge Tinlake blockchain protocol which is a set of smart contracts capable of minting DROP Tokens and TIN Tokens.

Maker participates as a vault that houses DROP tokens and issues DAI as a loan against that collateral.

ConsolFreight’s Core Agreements

The core agreements that govern ConsolFreight’s interaction with the other parties were made available for the RWA team to review. Due to confidentiality requirements these documents are not attached here. Templates of certain documents are public at Centrifuge docs page.

The core agreements include:

  • Executive Summary - a summary of the pool-specific offer, including scope of the offer, size of the pool, key parties involved and risk factors
  • Limited Liability Company Operating Agreement - dictates the terms of operation of the ConsolFreigth SPV (ConsolFreight Pilot LLC - Series 4)
  • DROP Subscription Agreement - between the Issuer and the Investor. It outlines the terms and conditions of purchase of DROP tokens/ redemption of DROP Tokens by the Investor. It also includes a clear description of key risks that can impact the amounts the Investor will receive in respect of the DROP Tokens
  • TIN Subscription Agreement - between the Issuer and the Investor outlines the terms and conditions of sale of TIN Tokens to Investors/ redemption of TIN Tokens by the Investor. It also includes a clear description of key risks
  • Incorporation documents - documenting the formation of the SPV, referred to as the ConsolFreight Pilot LLC, and the Issuer parent (i.e. asset originator), ConsolFreight LLC

The following picture illustrates the parties and their related agreements:

Additional Agreements & Documentation

In addition to the list above there are a number of other agreements that influence the overall ConsolFreight offering.

  • Contracts between ConsolFreight and Centrifuge - ConsolFreight have engaged Centrifuge to manage payments by Investor to Issuer, redemption of DROP tokens by Investor and payment of interest and principal
    • Tinlake Protocol Service Agreement - between Centrifuge and ConsolFreight. It outlines the terms of use and licensing of the Tinlake Protocol in connection with the Offering of TIN and DROP tokens to investors by the Issuer. It lists out all technical and support services (Annex A) Centrifuge offers the Issuer as the developer of the software.
    • Securitize Sublicense Agreement & Securitize/Centrifuge Licensing Agreement (Exhibit A) - between Centrifuge (Sublicensor) and ConsolFreight (Sublicensee). It outlines the terms and conditions of use of Securitize Licensed products by Centrifuge to onboard investors in its platform. Products include KYC/AML onboarding checks of investors for Offerings, investor accreditation, digital signature of subscription documents, among other solutions.
  • Various financing agreements between Issuer (SPV) and Payment Obligors

Documentation:

  • Payment Instructions by Centrifuge - document providing instructions to Investors (DROP/TIN) on how to use Tinlake, connect wallets, transfer the payable subscription funds

All of the documents above have been collected and reviewed by the Maker RWA Risk Domain team. The team members are not legal professionals and a full legal review by legal professionals is recommended.

Findings

The findings below are not an exhaustive list of all potential risks identified in the contracts, but merely a selection of the key ones, in our non-legal opinion.

TIN/DROP ratio modifications

Likelihood: Low Impact: Medium

Description: Both the DROP Subscription Agreement and the TIN Subscription Agreement give the Issuer the ability to change certain terms and conditions of the Investor’s investment in either DROP or TIN Tokens, including a change to the ratio of DROP Tokens to TIN Tokens outstanding and the ratio of TIN Tokens to DROP Tokens outstanding. (ref. Article 4F in DROP Subscription Agreement and Article 4F in TIN Subscription Agreement). The agreements provide for written notice to be provided prior to any change to ratios taking place. However, the documents don’t state the exact notice period.

Solution: The solution would be for a Maker Representative to subscribe to TIN or DROP. Therefore, there will be a notice as contractually defined and requested by the subscriber. In any case, lowering the TIN ratio would at some point breach a covenant and could lead to liquidation.

Failure of the Issuer/ Asset Originator/ Member

Likelihood: Medium/Low Impact: Medium/ High

Description: The SPV is managed by the Member (i.e. Asset Originator). Article VI.2 of the LLC Operating Agreement deals with the liquidation process, including the priority of distribution of all proceeds from the liquidation of the Company. The process of winding up the business and affairs of the Company or any Series has to be in accordance with the Act. In addition, a reasonable amount of time shall be allowed for the period of winding up in light of prevailing market conditions and so as to avoid undue loss in connection with any sale of the assets of the Company or any Series. This Agreement shall remain in full force and effect during the period of winding up.There is no obligation for the Member to restore negative balances.

In addition, article 4G in the DROP Subscription Agreement clearly states that the Investor will not have a security interest in the assets of the Issuer in connection with their purchase of the DROP Tokens, and that the DROP Tokens are non-recourse to the assets, funds and accounts of Issuer and any affiliates and subsidiaries thereof, except to the extent of payments actually received by Issuer in respect of the Underlying Assets.

Solution: As the asset value of the SPV approaches $5M (and most likely below), we plan to mandate the assignment of an Independent Manager that will take over the management of the assets if needed. Actual requested DC’s for the first Centrifuge-related projects are at or below this threshold. This would imply an updated operating agreement of the SPV and appointing an Independent Manager as already prepared in the operating agreement template. This should also include provisions for transferability of the SPV and its assets in case of dissolution of the Member (i.e. Asset Originator).

Failure of Centrifuge

Likelihood: Low Impact: High

Description: The tokenization of the SPV “tranches” rely on the Tinlake system developed by Centrifuge. The system is decentralized and autonomous, but Centrifuge is providing technical support. Interruption of this support might lead to adverse events. This issue is already somewhat mitigated by annual due diligence on Centrifuge’s financial situation and the Tinlake Protocol Service Agreement forcing Centrifuge to provide these services. Centrifuge’s protocol services have limitations of liabilities, so long as their failure is not derived from wilful misconduct or negligence.

Solution: One way of mitigating this issue even more would be to incorporate some of the operational knowledge to a third party (e.g. MakerDAO or the Centrifuge Community).

Failure of the Payment Obligor

Likelihood: Medium/Low Impact: Medium/ High

Description: The DROP Tokens and TIN Tokens are unsecured. Various events can impact on the underlying trade activities of the Payment Obligor. The Issuer may not receive full payment from the Payment Obligor and as a result the amounts Investors will receive in respect of DROP Tokens and TIN Tokens may reduce. The Investor cannot pursue collection against the Payment Obligor directly (Annex B in both DROP Subscription Agreement and TIN Subscription Agreement) and does not have a security interest in the assets of the Issuer.

Solution: The AO will purchase an amount of TIN Tokens. TIN Tokens are subordinate to the DROP Tokens and the DROP Tokens have a fixed interest rate that gets paid first. TIN Tokens receive the pool residual cash flows and are subjected to first losses. Eventually, as the reserve pool grows in size, Maker can conditionally request the Issuer that any single borrower exposure not to exceed the TIN tranche value to reduce credit risk.

Incorporation of other legislation by reference

Likelihood: Medium Impact: Medium/ High

Description: There are a number of documents that outline the contractual obligations of each party. The different documents utilise different terminology. Whilst it appears that different terms in different documents may designate the same concept a proper legal review of the documents and the defined terms is required to ensure the contract terms and implications are fully understood.

In addition, other pieces of legislation are incorporated by reference into some of the agreements. One example is the Delaware Limited Liability Company Act which is referenced in the LLC Operating Agreement. The DROP and TIN Subscription Agreements also include a number of warranties that the Investor (Maker) is making to the Issuer (ConsolFreight). These include warranties around AML and the definition of the Investor under Regulations (Articles 5, 6, 7, 8, 9 in the DROP Subscription Agreement and the TIN Subscription Agreement). The impact of these incorporations by reference has not been analysed and it is recommended to seek legal feedback to get a clear view of the legal implications of referencing the Act in the agreement.

Solution: A review of the whole documentation by a professional legal team should be launched as soon as possible and at least before increasing significantly the Debt Ceilings.

Termination of DROP subscription agreement and Offering

Likelihood: Low Impact: Low

Description: Article 18 of the DROP subscription agreement gives the Issuer the right to terminate the agreement in its sole discretion, with or without cause, by giving the Investor written notice. The notice period is not specified. In the same agreement, article 2.b confirms the Issuer’s right in its sole discretion to terminate the Offering at any time without notice. Maker needs to be aware of different termination provisions and different notice periods.

Solution: Complete a legal review of the agreement to ensure the implication of termination provisions are understood and aligned with Maker’s risk appetite. One option is to agree with the Issuer the addition of a notice period suitable to Maker if it is outside of its risk appetite. Additionally, it is recommended that the right to terminate should be mutual.

In addition to the key findings listed above, the review of the documents provided revealed a number unilateral rights and obligations of either the Issuer or the Investor. For this reason, it is strongly recommended that Maker, as the Investor, conduct a full legal review to ensure the implications are fully understood.

Discrepancies around security interests

Likelihood: N/A Impact: High

Description: There seems to be a discrepancy between the securitization process discussed for NFTed assets and the terms relating to security interests in the underlying assets in both the DROP Subscription Agreement and the Operating Agreement. As an example article 4G of the DROP subscription states that “The Investor understands the Investor will not have a security interest in the assets of the Issuer in connection with their purchase of the DROP Tokens, and that the DROP Tokens are non-recourse to the assets”. In the Operating agreement, article X.1.13 states that “[neither] the Company [nor any Series thereof] shall grant a security interest or otherwise pledge its assets for the benefit of any Person.”

Solution: As per the finding on “failure of the Member’’ discussed above, we recommend the assignment of an Independent Manager to take over the management of the SPV if needed. This Independent Manager should prevent any “Material Actions” to the SPV assets, as defined in the Operating Agreement, from taking place without oversight and approval. This might imply an updated Operating Agreement document.

Storage, custody and insurance of SPV ERC20 funds

Likelihood: N/A Impact: High

Description: According to the tinlake protocol services agreement (3.1.c), all amounts received by the SPV in respect to the underlying assets need to be promptly converted from fiat into DAI and transferred to an Ethereum address controlled by the SPV. Annex B of the DROP Subscription Agreement covers Issuer and Asset Originator cyber security risks in its disclosure to investors. However, there is no explicit provision relating to best practices for storage, custody or insurance of funds hosted in SPV Ethereum address.

Solution: The solution would be to include a provision under which the SPV is required to use best security practices for storage of funds (ideally in “cold storage”) and cover cyber risks by subscripting to insurance of amounts in Ethereum address used as intermediary between on-ramp (fiat to DAI) and Tinlake contracts. In case of use of a custodial service, a provision that the service is properly insured and follows best security practices for storage and management.

Thanks @SebVentures, @Philinje and @cass for peer-review contributions.

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