Article

By P.K. Mukundan

Since February 1999 P.K. Mukundan has been Director of the ICC Commercial Crime Services, which is the commercial fraud arm of the International Chamber of Commerce, incorporating the ICC-International Maritime Bureau, the ICC-Counterfeiting Intelligence Bureau, the ICC-Commercial Crime Bureau and the Cybercrime Unit. He has written extensively on matters affecting commercial fraud and has spoken at a number of international conferences.

Controlling the trade finance fraud risk is a challenge. Payment is triggered by documents. There is no document in the typical trade finance bundle which cannot easily be forged by laser printers, colour copiers and scanners. The rules governing trade finance instruments do not require banks to go beyond them. But fraudulent schemes can run into millions of dollars - in some cases hundreds of millions of dollars. In the more serious cases, the banks end up the losers.

This poses special problems for banks. On the one hand, it is impractical to subject every set of documents to verification. On the other, if the bank is inadvertently drawn into financing spurious transactions, it runs the risk, of not only substantial financial losses, but a disproportionately large investment in management time and costs. If these transactions run afoul of anti-money laundering regulations, the bank could find itself subject to criminal investigations, punitive fines and loss of reputation. Arguably, a substantial proportion of the funds recovered by the regulators as a result of anti-money laundering legislation has come not from criminals, but from fines against banks through which the funds passed.

This article highlights some of the risks that banks face, based upon the experience of the ICC International Maritime Bureau (IMB), and suggests steps towards a holistic approach to managing the fraud risk.

The risks

Traditional trade finance fraud involves sellers defrauding buyers. Typically, a seller presents false documents to a bank under a documentary credit and collects its proceeds, leaving the hapless buyer holding worthless documents.

Recently, a European group bid for a tender to supply a large quantity of sugar to Iraq. They were unable to source the sugar from traditional sources. A Portuguese intermediary offered to supply Brazilian sugar as part of a 500,000 tonne contract. Even better, he offered a price of around USD 60 beneath market prices. Similarly, a Middle Eastern Group was offered 50,000 tonnes of Brazilian sugar for supply to Iraq. The documentation in this case was plausible except for the price, about USD 90 less than the prevailing CIF Iraq price.

A reputable trader in South East Asia was offered Ukranian urea by a company in Hong Kong that also provided references of past shipments as evidence of its credibility. On the surface the deal looked workable. But the trader's suspicions were triggered by the price for the urea, which was considerably beneath the market price, and the trader decided to investigate the offer. Checks made by the IMB confirmed that references provided by the trader related to transactions that never took place. The supply of the urea was clearly unrealistic.

There are fraudulent sellers on the Internet with impressive websites complete with references of past transactions, testimonials from satisfied customers and imaginative financial schemes to help the buyer. Nonetheless, information on the Internet should always be treated with caution. It is surprising how, in the heat of closing a potentially profitable deal, many traders ignore the prudence that a transaction of this size demands. Such is the persuasive skill of the professional fraudster. In the cold light of hindsight, many traders agree that they would normally never ignore such obvious warning signs.

Consequences

These deals can have catastrophic consequences for the unsuspecting buyer. He may commit to sell the cargo onwards and then find that the default of the fraudsters means that they cannot perform. He could lose monies put up under performance guarantees, and if the L/C was negotiated he could lose the value of the consignment. The ensuing losses could put smallto medium-sized companies out of business.

There are consequences for banks as well. Agreeing to finance a transaction that does not materialize is a waste of management time and effort. The clients' failure to perform could put at risk sums advanced under lines of credit.

Banks face a greater exposure when buyers and sellers are in collusion. The spurious nature of such transactions can remain hidden for many years. During this time the bank, believing the business transacted to be genuine, can be easily persuaded to provide extensive credit facilities, placing the bank at risk.

A recent case

The IMB was recently asked to verify a bill of lading in respect of a cargo of cars shipped from China to North Africa. There was no vessel having the name stated in the bill of lading. Further checks confirmed that the document was false and that the cargo had never been shipped as stated. It is unusual to find fraudulent documents in such a specialized niche in shipping, where one would expect players on both sides of the ship's rail to know each other well.

Many weeks later, the same NVOCC based in Dubai issued bills of lading for a shipment of over 100 cars, this time in containers from the US to the same North African country. Checks by the IMB confirmed that the shipment was false - many of the container numbers did not relate to existing containers.

From the bank's perspective, it was disturbing that a client, who until then had a fairly good track record, should have become involved in such spurious but high-value transactions.

There are two possibilities. First, the bank's client may claim it was not aware that the documents were false but was itself a victim of others further up the trading chain. If so, its judgement in choosing its trade partners was questionable. Blind reliance on the good judgement of the client could have embroiled the bank in capital flight or other breaches of Central Bank regulations. The client should be grateful that the bank's due diligence measures led to the fraud being uncovered before funds were paid out on his behalf.

Second, it is possible that the client, having gained the trust of the bank, had presented documents it knew to be false and was part of a deliberate scam against the bank. In the circumstances of this case, this is a more probable explanation. Again, it was the checking of the bill of lading that identified the fraudulent document and alerted the bank to the problem. There are echoes here of the Solo Industries fraud in 1999, which shook the trade finance world in Dubai and beyond.

Collusion

What is the economic rationale for traders to collude in this way? One possibility is that the trade finance transaction provides the trader with funds at low interest rates which are lent out at much higher rates in the underground economies of countries where the local currency is under pressure. For example, in Russia the underground dollar rate of interest was around 30 per cent in the months leading up to the banking crisis of August 1998. In recent years, the currency in Iran has been under pressure. Such arbitrage between currencies can bring phenomenal returns to traders, but since it takes place in an unregulated market, there are great risks. The banks would certainly never have agreed to lend had they known where their funds would end up.

Why should banks care so long as the funds they advance are repaid with interest? The answer is that trade finance can be used as a cover for many illegal transactions, including money laundering, and if banks allow themselves to be used for money laundering without having measures in place to prevent it, they can face civil and criminal liability.

Basel II

With Basel II in force, all trade finance banks may need to carefully revisit their due diligence procedures. The Basel II Capital Adequacy Rules came into force in the European Union on 1 January 2007. Lending to most companies in the commodity and trade sectors represents a higher risk than lending to corporates rated by Standard & Poor's or Moody's. The regulatory capital cost to the bank of doing trade finance is higher.

Furthermore, the "loss given default" in the case of a fraudulent transaction is extremely high - in many cases close to 100 per cent. Reducing this category of risk can go a long way toward increasing the turnover permitted under Basel II. What may be required are systemic procedures so that the fraud risk can be better evaluated and the risk of default/fraud minimized. In the post- Basel II environment, no bank with a significant trade finance portfolio can afford to ignore these solutions.

The holistic approach

Since banks cannot verify every single transaction, the alternative is a holistic, risk-based approach. This involves the bank's having a strong system in place that discourages fraudsters from introducing dubious transactions. If, despite this, a bank nevertheless becomes a victim, the existence of such a system can provide some defence to the charge of negligence or recklessness.

In this connection, many banks use software to map a client's transactions based upon set criteria. Any departure from these patterns can cause enquiries to be made by the bank's audit teams. While a departure may be for perfectly legitimate reasons, locating it can still identify activities of the client the bank may not wish to participate in.

These kinds of pro-active loss prevention measures are not new. Credit card companies have been successfully using them for years to alert them to changes in a client's spending patterns.

As fraudsters become more sophisticated, it is important to devise strategic responses to deal effectively with new types of risk. One response may be to pick out a representative sample of transactions for verification. These are checks designed, not to prevent a single fraud, but to identify long-term patterns of client fraud. The parameters of the transactions to verify should be carefully drawn up and should be varied from time to time without notice. When the parameters remain unchanged over time, fraudsters tailor their transactions to bypass them. A fluid, uncertain sampling of transactions makes fraudsters anxious, especially those running long-term frauds, and they will move to attack a more predictable system.

Some member banks of the IMB take a robust approach to deterring the fraudster. They state openly at the outset of the client relationship that it is the policy of the bank to verify with the IMB documents presented for payment. Banks advise us that this has a magical effect on dubious customers, who quietly take their business to a more accommodating bank. The system acts an efficient filter, leaving the bank to service the remaining clients having legitimate business.

Like other market activities, combatting fraud largely depends on perception. Fraudsters and money launderers quickly learn which banks are vulnerable and which are difficult to penetrate. Those that are seen to be vulnerable may find undesirable clients and transactions flocking to their doors. The welcome initial surge of business looks good on the books, but soon after the bank will have to face the consequences.

P.K. Mukundan's email is PMukundan@icc-ccs.org.uk