Letters of credit (L/Cs) have many honourable uses but some recently reported applications - where L/Cs have been used to overstate profits or to guarantee loans to top executives - seem to fall outside the boundaries of corporate governance.

An executive from Hannover Reinsurance has strengthened claims that the HIH insurance group had overstated its profits in the two years before it collapsed in Australia last year. Henning Ludolph told the royal commission investigating the HIH collapse that he had in 1999 negotiated two contracts between subsidiaries of Hannover and the Australian insurer.

Apparent profits

These contracts apparently covered a sharp deterioration in undiscounted reserves and were used by HIH to book profits of more than A$92 million and A$108 million in 1999 and 2000 respectively. These amounts were sufficient to make it look like HIH had recorded an overall profit for each year.

But according to Ludolph, the contracts were not as they appeared to be legitimate reinsurance deals in which the reinsurer would take a significant risk, hence enabling the insured to use the amounts reinsured to bolster its profit and loss account. Rather, because the deals were structured with a L/C for the reinsurer to fall back on if things went wrong, Hannover had only taken a small risk in the deal.

As well as the two deals with Hannover, the royal commission is investigating two more alleged sham reinsurance deals between HIH and FAI insurances.

Personal loans

Meanwhile it transpires that Bernie Ebbers, one of the biggest deal-makers in the telecoms boom of the late 1990s used a L/C raised by a company of which he was chief executive officer to guarantee a personal loan that part-funded a US$60 billion spending spree.

Ebbers admitted borrowing US$141 million from WorldCom and that the company had supplied a US$35 million L/C to support other personal obligations.

Analysts have expressed surprise at these arrangements the like of which they say risk shareholders funds and create a conflict of interest because the company's top employee is also a big creditor.

Some of the Ebbers borrowings were secured by his WorldCom shares, which soared to more than US$60 at the end of the 1990s but have fallen sharply since the telecoms bubble burst leaving the entrepreneur with debts estimated at US$375 million.

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