Article

by Jee Meng Chen

Back-to-back shipment sales financing1 is one of the simplest forms of structured trade and commodity finance (Figure 1). The financing decision (i.e., issuance of an import L/C, trust receipt financing and/or freight financing) is predicated on the identification and ringfencing of a secured means of repayment on the export leg, e.g., timely lodgment of the export L/C.

Back-to-back L/C issuance is fraught with multi-dimensional credit and operational risk-control issues. A seasoned practitioner can be caught off-guard and fall prey to the perils of back-to-back L/Cs. Any seasoned trade finance practitioner would probably agree that the middleman's competence in execution, including his proficiency in trade documentation, is of the utmost importance. This article recounts how a supposedly straightforward oil shipment went awry when the sine qua non principle of risk management, Know Your Customer ("KYC"), as well as fundamental credit risk management principles, was not carefully observed.

The proposed oil deal

Jeremy Yang was happy to receive a referral - an FOB oil shipment deal. Although the prospective customer, Newbie Company Incorporated (Newbie Co.), was very new to oil trading, the proposed deal appeared to be tenable. First, the transactional flow did not involve a long chain of buyers and sellers (Figure 2). Second, both the ultimate supplier and the buyer were well-established companies, known to the bank. Third, the master L/C was going to be issued by a known financial institution. Last, Newbie Co. would self-finance the freight costs.

One of the senior business managers, Dominic, was concerned that the trading intermediary, Trust Me Limited (TML), was not a known player in the market. In addition, Dominic also questioned the authenticity of the deal, as the contracted purchase price was below market prices (Table 1). The transparency of the market would have eroded any significant price differential instantaneously.

To allay the Bank's concerns, TML explained that, as an authorized agent of the ultimate supplier, it had privileged access to domestic supplies at lower prices, unlike non-authorized agents.

Red flags

It does not make economic sense for any trading company to sell at below market prices. In addition, why would TML sell the cargo to Newbie Co., which was a new and unfamiliar name in the market? Wouldn't it be a safer option to sell it to reputable parties? It pays to be extra cautious if supplies are offered at non-market prices, as the said commodities may be non-existent.

To affirm the genuineness of the commodity, the seller committed to submit a "Proof of Product" (Table 2) [Red flag: An unusual document in relation to the underlying commodity] as a requisite document for negotiation. While Jeremy should have questioned the purpose of having this document, he did not probe further, as he argued that the bank's position was protected, since the issued L/C would remain inoperative until the seller submitted the documents called for.

The master L/C did not include the provision that negotiation could be effected against a letter of indemnity (LOI)2 [Red flag: It was obvious that Newbie Co. was not familiar with oil trading. The LOI provision was not negotiated as a requisite term in the sales contract]. To facilitate the transaction, the bank agreed to issue the import L/C while the amendment to the master L/C incorporating the LOI provision was pending.

Dominic was highly critical and was not convinced that the proposed oil deal would work out. However, Jeremy was optimistic that the transaction would proceed without a hitch. Only time would tell.

Continuing changes

Around two weeks after the issuance of the import L/C, TML informed Newbie Co. that the purchase contract had to be cancelled, as it was unable to load the cargo within the stipulated time. Newbie Co., being anxious to protect its reputation, was determined to keep the deal alive. Somehow, Newbie Co. managed to find another source of "cheap" (i.e., unrealistically priced) supply from a trading intermediary and requested Jeremy to re-issue a new L/C upon receiving TML's agreement to cancel the L/C. Jeremy was reluctant, because the proposed supplier was not familiar with oil trading.

Some one-and-a-half weeks later, Newbie Co. secured a purchase contract with yet another trader, an authorized agent, Confirmed Supplies Company (CS Co.). But the deal with CS Co. was doomed to fail, because:

- The contracted supply price of US$65 per bbl was too low; the market price was US$79 per bbl.

- The mismatched quantity (Table 3) between the import and export leg could jeopardize the deal. To protect the bank's position, the shipment quantity in the import L/C was stipulated to be 7300MT, prohibiting the insertion of +/- 10%. No shipper would be able to supply the exact and absolute tonnage of oil! Consequently documents submitted by CS Co. would be clearly discrepant.

The outcome was not surprising - CS Co. could not deliver the cargo, and Newbie Co. was forced to look again for alternative suppliers. With the latest shipment date and master L/C expiry drawing near, Jeremy faced an unpleasant dilemma: to exit the relationship or continue to facilitate the deal until its completion. Ultimately, he decided to link up Newbie Co. with a reputable trading company. While the purchase price was potentially to Newbie Co.'s disadvantage, the company was committed to reimburse the bank for shortfalls, if any.

Post-mortem analysis

What appeared to be a simple transaction had turned into a virtual nightmare for Jeremy. After a more than two-month ordeal, the transaction was successfully concluded. Notwithstanding this, Jeremy, an experienced banker, had re-learned some hard lessons from the transaction, namely:

- Never ignore the fundamental of credit risk management - proper due diligence.

- Know the industry and the market. Having a good grasp of the market and its practices is imperative in determining whether a prospective transaction makes economic sense in the prevailing circumstances.

- Once a financial institution is involved in a transaction, it is difficult for it to subsequently withdraw from the deal. More often than not, the financier finds itself sucked into a downward spiral and morally obligated to complete the transaction. A banker should be doubly cautious before engaging in transactions where anomalies cannot be duly explained and/or risk-control issues cannot be resolved outright.

- L/Cs should be issued to genuine beneficiaries, as they can be subject to misuse should they fall into the wrong hands.

Jee Meng Chen (Singapore) is a freelance writer on general banking topics. His e-mail is guanming_ insight@hotmail.com

1. The back-to-back terminology does not necessarily connote a strictly matching back-to-back L/C. In practice, it refers to the issuance of an import L/C against the lodging of an export L/C.

2. The required documents are stipulated under Field 46A: Documents Required. Under Field 47A: Additional Conditions, the LOI provision could be worded as follows: "In the event that original B/L and/or shipping documents are not available ... the beneficiary may claim payment against presentation of commercial invoice (original) and Letter of Indemnity ("LOI") under seller's format (telex invoice and LOI acceptable)."