Fraudulently-issued Letters of Indemnity – Risks, Mitigation, and Prevention

Introduction – the contraction of Singapore’s Trade Finance industry

The recent spate of allegations of fraud or foul-play that have rocked Singapore’s beleaguered commodities market, and in particular the oil trading industry have brought to light the significant effect of various pervasive practices that are seemingly innocuous, but have potentially left the trade-finance banking industry reeling from billions of losses.

To name a few examples, the immediate short-term impact of the Hin Leong Trading (Pte) Ltd. (“Hin Leong”), Zenrock Commodities Trading Pte Ltd (“Zenrock”) and Hontop Energy (Singapore) Pte Ltd (“Hontop Energy”) sagas has seen various banks either ceasing their regional trade commodity finance operations, or exiting the trade and commodity financing industry altogether.

One only needs to look at ABN Amro Bank, who is ending all of their engagements in trade and commodity financing and shedding 800 jobs in the process, a decision that is at least in part linked to its overall exposure of around US$300 million to Hin Leong[1].

Likewise, Societe Generale SA (“SocGen”) was reportedly closing its trade commodity finance unit in Singapore and has halted fresh funding to trade finance firms in the region[2]. Large Asian commodities trading clients with operations in Singapore would henceforth be handled by SocGen’s Hong Kong office, with SocGen ceasing ties with Singapore-based small and medium commodities trading firms.[3]

Australia and New Zealand Banking Group (“ANZ”) has also reportedly decided to only service their existing commodity trading clients and will not take on any new business in commodity finance, following its exposure to Hin Leong Trading.[4]

In this article, we will examine the role of letters of indemnity in international trade transactions, and the risks associated with its use in the commodities industry. We will conclude by looking at what steps can be taken by the industry as a whole to mitigate and prevent these risks.

The role of a letter of indemnity in Trade Finance

What has spooked the trade finance industry in such an arguably unprecedented manner?

One major contributing factor to this state of anxiety is the rampant and systemic misuse of letters of indemnity (“LOIs”) in the context of letters of credit. This is a common theme underpinning many of the allegedly fraudulent trades associated with Hin Leong, Zenrock and Hontop Energy.

Letters of credit are an indispensable tool in commodities trading.

Often heralded as the lifeblood of commerce, letters of credit are a boon to the supplier who is seeking to have the payment for the cargo that he ships secured by a credit-worthy bank but also to the buyer who seemingly only after he is armed with the knowledge that the cargo has been shipped. Towards that end, letters of credit ordinarily call for various documents that evidence the shipping of the cargo, to be presented, including but not limited of course, to Bills of Lading (“BLs”).

Over the years, it has become an industry accepted practice, especially in the oil and gas industry, for parties to include contractual provisions in the sale and purchase contracts which stipulate that where the BLs are not available at the time of presentation, payment may be made against the presentation of a LOI and a commercial invoice.[5] This arrangement also finds its way in the provisions of the letters of credit that are issued to finance the underlying trade with the effect that a beneficiary under a letter of credit may therefore simply present a LOI and a commercial invoice in lieu of key shipping documents such as the BL.

One can view this as a practical solution to deal with the increase in the speed of carriage of goods, as a result of which ships are more likely to arrive at a discharge port before the necessary paperwork. While documents can be couriered around the world, there are frequently delays before BLs are finally produced, or released, at the load port and delivered to the beneficiary under the letters of credit for presentation.

The LOIs however, do not, in and of themselves assure the buyer or the bank that the cargo bought has been shipped. For this reason, the LOIs are drafted in such a manner that contain various representations and/or warranties from the seller that include the following:

  • That the seller has good title to the cargo in question and the right to transfer title and give delivery of the cargo to the buyer;
  • That the relevant shipping documents, which are required to be presented, including the BL do exist and are valid and that the seller will surrender them to the buyer when they become available; and
  • That the seller will indemnify the buyer in respect of the consequences of the shipping documents being outstanding, or any breach of the foregoing representations and/or warranties.

The rationale behind the inclusion of such representations and/or warranties is to provide assurance that not only does the cargo exist but it has been shipped in return for which the seller should be entitled to be paid. The recent sagas however have shown that such a system for releasing payment against the veracity of these representations is undoubtedly open to abuse as described below, leaving the bank that has already paid out cold and dry.

The contamination of the lifeblood of commerce through fraudulently issued LOIs

What is the contractual effect of a LOI?

While the LOI often makes certain representations (such as the date of shipment, the name of the performing vessel, and reference to a BL that is said to be consigned in favour of the financing bank as evidence of the shipment), there is no real way of actually verifying that the BL has been so issued and so consigned without the original BLs being presented.

The problem is exacerbated by the task that the financing bank is required to undertake in reviewing whether the documents are compliant – all that the financing bank needs to do is to examine if the documents presented, including the LOI, is compliant with the terms of the letter of credit. Sophisticated fraudsters, (sometimes under the guise of trading houses), know the very limited extent of financing bank’s scope of obligation in reviewing the documents and can easily exploit this limited scope of examination by simply inserting details in the LOI, which are, on its face, compliant with the letter of credit. The financing bank is therefore obliged to pay out, even though it has no way of ascertaining if the statements made in the LOIs are true.

The fact that the financing bank may resort to the LOI subsequently, as evidence of fraud or false representations come to light, is usually cold comfort, particularly if the beneficiary is financially crippled and therefore cannot make good its losses. In that event, the financing bank may be forced to bear the brunt, if not the entirety of its losses. Even if the financing bank subsequently takes steps to try to obtain possession of the BLs that are referred to in the LOIs, it may be too late to perfect their security (assuming that the BLs and underlying shipment exist in the first place). It is entirely possible for example for the title to the cargo to have already been conveyed to a bona fide buyer, prior to the BL coming into the lawful possession of the financing bank.

The risk of abuse is particularly acute in the context of a letter of credit that is issued on terms that it is available for negotiation, often with any bank. The fraudster-beneficiary will be quick to present the LOI and the commercial invoice, on the pretext that the original BL is not available, to obtain payment (even if that sum may be a discount of the purchase price of the cargo), knowing that the negotiating bank will, in all likelihood, pay out if the documents are, on their face, compliant with the letter of credit. In most cases we have seen, the buyer would not be aware that the documents have been negotiated under the letter of credit. By the time the buyer receives notice that the documents have been presented (albeit via its issuing bank), it would be too late for the buyer or indeed the issuing bank to resist payment even if compelling evidence of fraud may come to light because the fraudster has been paid by the negotiating bank at the time when the latter has no notice of the fraud and therefore has an arguably a good claim against the issuing bank for reimbursement.

How can we mitigate these risks?

While there is no quick fix to eliminate each and every risk of fraud and/or false statements, the issuing bank would, at least in some respects, be significantly better off if the letter of credit had strictly called for the presentation of the original BLs instead. The issuing bank would not, for example, face the problem of becoming lawful holders of the BLs too late in the day and would be able to perfect their security earlier. The presentation of the original BLs would also provide a greater degree of assurance that the BLs were issued and that the description of underlying shipment (with the details set out in the BLs) is consistent the terms of the letter of credit. Although not strictly necessary, it also enables a issuing bank to better verify the authenticity of the shipment details as evidenced by the original BL with the carrier.

It does not eliminate the problem of course if the BLs were themselves fraudulently issued or contain false representations. It does not assist the any of financing banks if the BLs that have been surrendered do not relate to any underlying shipment for example. The likelihood of that occurring however is probably lower if the original BLs were asked to be presented. That is because the bank has a further means of verifying whether the original BLs presented are genuine by cross-checking it with the third-party carrier that is identified on the BLs, if it so wishes. Unless the carrier is complicit in the fraud (which is ordinarily unlikely because it would otherwise leave the carrier and its ship exposed to a claim), the financing bank would derive greater certainty from the validity of the original BLs and the underlying shipment if the original BLs are required to be presented. One key red flag however is if the carrier is not in fact a third-party to the beneficiary under the letter of credit, but a related entity. It will be prudent for further steps to be taken to ensure the integrity of the original BLs issued by such a carrier and the existence of the underlying shipment.

Second, payment under a letter of credit against representations in a LOI continue to pose a significant risk even if the issuer of the LOI (which the financing bank is relying on) is not engaged in any of fraudulent practices per se.

As is often the case, commodities are not ordinarily sold by the ultimate supplier to the ultimate receiver on a simple, bilateral basis. By the time the commodity reaches its ultimate receiver, it would have typically passed hands through multiple trading entities, each increasingly distant from the act of shipment. In those circumstances, it is not unusual for the issuer of the LOI, who is say a party in the middle of the chain, to rely on representations of shipment given by its immediate supplier up the chain which in turn relied on its own immediate supplier, contained in LOIs that are issued on a back-to-back basis, without independently verifying whether the shipment is genuine or otherwise. It may even be the case that the issuer of the LOI may not even in a position to independently verify whether the shipment took place in the first place.

This back-to-back reliance is therefore at best dubious. It assumes, often mistakenly, that the parties that have provided the representations on which the issuer of the LOI rely on, are (i) making a statement that they know to be true and (ii) are financially sound such that any losses arising from a statement that turns out to be false can be made good.

These difficulties are again arguably circumvented if the original BLs are required to be presented. Barring the scenario of fraudulently issued BLs or BLs containing false representations already discussed above, such a requirement will lay to rest, at least some of the doubts, about the existence of the shipment.

Conclusion – looking ahead

As foreshadowed above, there is no immediate or even long-term panacea to fraud.

For banks financing the opaque world of commodities trading in Singapore, these malpractices are not isolated cases. The trading hub has seen a clutch of failures in recent times with lenders struggling to reclaim loans, alleging they were tricked by forged documents and by traders pledging cargoes to multiple banks[6].

Apart from the overt actions by banks at de-risking or dis-engaging altogether, it is likely that what is required moving forward, at least for the banks that still intend to engage in trade and commodity financing, is an in-depth and comprehensive review of the trading and shipping ecosystem which the financing banks play a crucial role in. The industry practice of utilising LOIs in lieu of actual shipping documents would in all likelihood be an area of necessary reform, notwithstanding its undisputed utility.

One promising solution, to mitigate at least some of the concerns raised, based on blockchain technology aims to do just that. A working group, led by Standard Chartered Bank and DBS Bank, has pioneered an industry-wide solution using blockchain technology, which has been named the Trade Finance Registry. The initiative involves ABN Amro Bank, Lloyds Bank, ANZ Bank, ICICI Bank, OCBC Bank, Natixis Bank, UOB Bank, Deutsche Bank, CIMB, and Rabobank, with other banks likely to follow suit in the near future.

At the heart of this collaboration is the ability for each bank to validate whether or not another financial institution has already submitted a particular title instrument for financing purposes. Underpinned by blockchain, it is possible to share this data such that it does not violate client confidentiality and compliance rules, while still reducing the risk to the finance provider.[7] It remains to be seen if this acts as a sufficient deterrence to fraud or at least mitigate some of the risks of fraud occurring, in the context of payments under a letter of credit, or more needs to be done.

Footnotes

[1] https://www.businesstimes.com.sg/banking-finance/abn-amro-quits-trade-and-commodity-financing-in-corporate-bank-overhaul

[2] https://www.bloomberg.com/news/articles/2020-07-31/socgen-shuts-singapore-trade-commodity-desk-after-hin-leong-hit

[3] https://www.bloomberg.com/news/articles/2020-07-31/socgen-shuts-singapore-trade-commodity-desk-after-hin-leong-hit

[4] https://www.reuters.com/article/us-singapore-oil-trade-financing-idUSKCN2231N9

[5] However, this is to be distinguished from a LOI which is used to secure the discharge/release of cargo, without presentation of the BLs.

[6] https://www.treasuryandrisk.com/2020/07/09/trade-finance-under-scrutiny-in-singapore/?slreturn=20201023064519

[7] https://www.tradefinanceglobal.com/posts/singapore-launches-the-worlds-first-blockchain-based-solution-aimed-at-preventing-double-financing-fraud/