Article

by P. Mukundan

Under sub-article 14 (a) and article 34 of UCP 600, banks are not obliged to go beyond the documents as they appear on their face nor can they be held responsible for the falsification of the documents presented. If that is the case, does it matter to banks if the documents presented relate to a non-existent cargo?

There are two aspects to this issue. On the one hand are the obligations that banks enter into between each other under the UCP. UCP 600 correctly reflects the position with the articles above. Notwithstanding this, there are very real risks that banks assume vis-à-vis their counterparties and regulators if inadvertently they finance customers who regularly present spurious shipments to them.

Compliance with the UCP is only one side of the risk coin. It is easy for bankers, through blind adherence to the UCP and the exclusion of all else, to ignore the flip side risks of fraud and money laundering. A few current cases highlight this.

Middle East banks

The secondary market in L/Cs in the Middle East is a well-established business through which banks seek to fully exploit their correspondent banking relationships or increase the volume of their trade finance transactions. This sometimes helps those banks that do not have direct access to a wide range of trade finance customers.

A Middle East bank active in this trade was approached by a bank in North Africa to "buy" a set of documents, valued at tens of millions of US dollars, on a 90-day deferred payment basis, which appeared to involve a government buyer in that country. It was only when the bank investigated the transaction through the International Maritime Bureau (IMB) that it discovered the shipment had not taken place as described on the documents and rejected the offer.

This information was passed on to the originating bank in North Africa. Within weeks, a number of other banks were offered the same set of documents. Secondary banks offered these transactions are inherently remote from the customer with little knowledge of the customer's business and the true context under which the transaction was offered to the banks. They are vulnerable.

The easy approach is to take the view that the secondary bank is not concerned with whether the goods exist or not, but simply takes a credit risk on the North African bank. However, there is the practical risk in the event of a fraud that local courts in the North African country may take a different view concerning the contractual obligations under the UCP. This may not be what the UCP intends, but hard-pressed nations have tried to resist paying out tens of millions of dollars if they have not received value in return. It is this reality which may impose upon the prudent Middle East bank a need to make checks to ensure that the shipment was performed. Buyer beware!

An Asian case

A bank in Asia received a substantial L/C (Master L/C) for the shipment of finished garments. In turn, as permitted under the L/C, it split the L/C into many different "back-to-back" sub-L/Cs favouring various subcontractors who were to complete different processes leading to the finished product. In the local market, everyone referred to these L/Cs as "backto- back" with the implied assurance that the risk on the sub-L/Cs was covered under the Master L/C.

Using the sub-L/Cs as collateral, the subcontractors drew funds from various banks in advance of negotiation. What the banks failed to appreciate was that the L/Cs were not back-to-back, and performance under the Master L/C was significantly different from the performance under the sub-L/Cs. The Master L/C and, in many cases, the sub- L/Cs, were not performed.

Furthermore, it turned out that the beneficiaries of the sub-L/Cs, the subcontractors, were all part of the same group as the beneficiary under the Master L/C. Around USD 300 million was lost as a result of this fraud on a large number of these transactions. The fraud was also facilitated by political pressure on the bank managers to ignore the warning signs as the amounts at stake accelerated to unacceptable levels. Checks to verify the shipments would have gone a long way to make a strong case for stopping the financing before the fraud got to a stage where the losses became so severe that it became a major issue for the many local banks embroiled in this relationship and required the intervention of the Central Bank.

Structured trade L/Cs

Another transaction doing the rounds in recent years, and which reportedly has had takers in trade finance markets around the world, is the "structured trade L/C". This is a misnomer. There is nothing "structured" or "trade-related" about the transactions described below.

The other names by which it is known, "financial engineering" or "synthetic L/C" perhaps describe it better, particularly if its intent is similar to the now infamous "synthetic CDOs" which, at least partly, set off the financial crisis in 2007/2008. A "synthetic L/C" is said to occur when trading companies with strong balance sheets lend money to smaller banks and business groups. Instead of being described as a loan, the documentation dresses it up as a deferred payment (typically 365 days) trade finance transaction relating to a shipment of goods.

All parties, including at times the confirming banks, know that there are no underlying goods. In fact, the L/C often calls for presentation of copy documents. Setting up the loan as a trade finance transaction circumvents oversight by regulators into the "loan". Fees earned by the confirming banks are high, encouraging them to ignore the obvious warning signs. Confirming banks are led to believe their sole risk is the credit risk on the opening bank.

The often overlooked fundamental flaw in these schemes is that they are building substantial debt obligations on transactions that have no intrinsic value and that are based on documents that misrepresent the true nature of the transaction. Do you hear familiar echoes of the recent past?

Purists may rightly say that this was not the purpose for which the UCP was designed. There have been cases when on the due date the confirming bank has not been able to collect on its debt. When that happens, it will find itself on its own, with little support from the trader who invited it into the transaction, who will say, correctly, that the banks knew from the outset exactly the kind of transaction they had financed.

Risks

Often, banks enter into this type of transaction because it is seen as an easy way to meet hard-to-achieve targets in a tough economic climate - particularly when other banks set the trend. Management in banks need to focus on the true nature of these transactions and provide clear direction to their teams as to the type of transactions acceptable to the bank. Many banks have taken the position that they will not participate in these schemes.

Financing spurious transactions may comply with the terms of the UCP, but for many good reasons it may not be in the bank's interest to become involved. These include vulnerability to fraud, involvement in money laundering schemes, illegal capital flight and reputational risk. What starts off being perceived as a short-term manageable risk can soon escalate in value and risk as the message that this is acceptable business quickly filters through to lower levels in the bank. The bank itself eventually becomes the victim; hence, the need for it to have measures in place to identify and avoid these schemes.

Trade finance in its traditional form is a reliable, solid business, based on goods traded or services provided. The financing of these spurious shipments in the knowledge that the goods do not exist distorts this model and weakens the case, strongly made to regulators and governments, that trade finance is a nonspeculative and inherently safe financial activity. n

P. Mukundan is Director of ICC Commercial Crime Services, of which the International Maritime Bureau is a specialized division.
His e-mail is pmukundan@icc-ccs.org