Fraud: Losses, Losers, and LOIs

If fraud, like the poor, is always with us how can the parties involved in trade flows protect themselves against this ever- present risk? Within the recent past, trade finance banks have suffered billions in losses due to fraud. This has obliged many banks to reconsider their role in financing trade flows whilst others have simply abandoned the business.

A brief recap of recent frauds includes Agritrade International (USD 983 million owed to secured lenders and circa USD 600 million inter alia to ING, UOB, MUFG, Commerzbank, Maybank, Natixis) and Hin Leong Trading together accounting for some USD 5 billion in losses, ZenRock Commodities Trading (USD 600m owing), Phoenix Commodities (USD 400m), Hontop Energy (Singapore) Ltd. (USD 470m owing), Coastal Oil (USD 340m), Inter-Pacific Petroleum Pte (USD 168 owing), all of which are Singapore based, and of course Dezheng Resources, Qingdao, China (multiple pledging of warehouse receipts) that went down owing some USD3b to sundry financing banks. It is little wonder that such substantial and dramatic losses have driven banks like ABN Amro and BNP Paribas, which was at one time the biggest financier of oil trading, to exit this
market.¹

Whilst there might not be 40 shades of fraud, there are enough facets to give the most avid proponent of commodity trade finance pause for thought. It is widely considered that more than 80% of global trade is executed on open account basis, ergo no supplementary security is sought or given. This still leaves a significant proportion that requires some form of payment risk mitigation.

Bearing in mind that about 90% of world trade is seaborne,² the importance of Bills of Lading (BLs) can be imagined. And where you have BLs, you invariably have LOIs (Letters of Indemnity). Whence derives this questionable relationship? Absent a generally acceptable, universally applied means of electronic title transfer of goods from seller to buyer or, in the cases discussed below, seller to financing bank to buyer, trade partners must rely on paper BLs for their transactions. The speed with which goods are carried these days often means that they arrive at destination ports before the shipping documents are available for the timely discharge of the underlying goods. This is desirable to avoid demurrage that would otherwise be incurred.

According to a previously referenced source, some 91% of international traders questioned said that they want/need inventory finance. This is a niche that has traditionally been filled by CTF (Commodity Trade Finance) banks, albeit other parties are engaging in this activity now. Seaborne goods have been referred to as representing a floating warehouse and the BL as the key thereto. So it makes perfect sense for a bank to take such goods, deem them to be acceptable collateral, and to advance finance against them. This is, however, predicated upon the assumption that title to the goods remains with the bank until such time as they are sold and the debt is discharged. This is the point at which LOIs enter the picture and threaten to disrupt the orderly flow of title transfer in the goods representing the bank’s collateral security.

Having opined on this subject previously in DCW,³ I would like to discuss in this article some of the problems that can arise when LOIs are used, even when as in these cases allowed for, and the consequences for the participants in the trading environment.

Perhaps we can first consider just some of the means available to traders for obtaining finance and the respective pitfalls: inventory finance is in demand as it bridges the gap between purchase and the sale of goods. Security can exist in the form of e.g. LME warrants. This is a classic and well- regarded means; warehouses are vetted by the LME (London Metal Exchange) and deemed reliable and secure. However, if as in the Quingdao scam, the same stock is pledged or sold to different banks/buyers, the fraudster can illegally generate sales (and offer invoices for discounting purposes for advance payment) or leverage the pledges to obtain additional finance. The same is true of warehouse certificates where goods are held in the custody of the particular warehouse who will/ should only release goods to buyer(s) with the financing bank’s written consent. But fraudulent copies of the warehouse certificate can be made and pledged elsewhere or sales invoices raised against them and be discounted as noted above. Fraudulent copies of allegedly original BLs can be used to support multiple sales of the same goods whilst the goods are in transit or indeed if the goods are subsequently discharged against an LOI without the prior assent of the true receiver/ order party.