Transaction Type: Recurring examination for an asset-based lender. The lender provided a $10MM revolving credit facility supported by the company’s accounts receivable and inventory assets. The company was in the business of processing potatoes for soup mixes, mashed potato mixes, and mixes for the production of potato chips and other snack foods.

Significant Finding: This company had always done relatively well in its collateral and financial performance. Potatoes are a single-harvest commodity, harvested in the late summer months. The company would typically purchase large quantities of potatoes and store them in air-cooled buildings until needed for production. Purchased lots would be based on past production levels. Potato prices had typically been stable, but during the past several years, foreign sources had been supplying potatoes into the United States at lower prices than they could be harvested for domestically. And potato harvests were producing larger and larger quantities because of favorable environmental conditions and increasing planted acreage. The company had typically been relatively conservative in its purchase forecasts. Upon purchasing another local potato processor, however, the company began to speculate more aggressively. During the crop year leading up to our examination, the company purchased more potatoes than it had in any other year, speculating that it would be able to sell through the additional potatoes at attractive margins. Following potato purchase, however, the company found that sales were actually lower than in previous years, leaving a large quantity of potatoes to either sell in bulk or let spoil. Earlier examinations had completed a typical cost test comparing the vendor/grower invoices to the inventory cost. Because potatoes are a single-harvest commodity, the costs matched identically and were tested on three occasions (once at harvest and twice after) without variance. Based on information from a company insider, the lender became nervous about the costing of the potatoes and requested another examination. We tested the cost not only to the invoice (which matched again), but also to bulk sales, which demonstrated a much lower sales cost. This was the only way to determine the actual price for the prior crop year; there is no publication that reflects current potato prices. This revealed that the current value of the prior year’s crop was approximately 40% lower than that stated on the inventory report and borrowing base. The adjustment to the potatoes’ cost immediately put the revolving line of credit into an over-advance position. We then went further and determined that the value of the potatoes was declining daily because of the approaching harvest for the current crop year. By the completion of the examination, the cost of the potatoes had declined to less than a third of their initial cost.

Impact on Transaction: The revaluation of inventory provided for the aforementioned shortfall in collateral. This put the line of credit into a default position. Management moved the company quickly into a chapter 11 bankruptcy and arranged to have another lender finance the new inventory and receivables of the post-petition company. The lender ended up writing off a large portion of the transaction because of the hidden shortfall in the collateral value.