Trade

FinanceFunds-AvoidingFraud

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February2017

TradeFinanceFunds–AvoidingFraud

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TradeFinanceFunds–AvoidingFraud

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TABLEOFCONTENTS

INTRODUCTION......................................................................................................................................4

1. Whatdowemeanby‘fraud’?........................................................................................................5

2. HowtoAVOIDfraud.......................................................................................................................6

§ APPRAISEthecustomerthoroughly.......................................................................................7

§ VERIFYtheinformationobtained...........................................................................................7

§ OPTIMISEthefinancingstructuretomitigatecustomerreliance..........................................8

§ INSPECTallsecuritydocumentsandthirdpartyconfirmations.............................................8

§ DOUBLECHECKatregularintervals........................................................................................9

3. FRAUDPracticalCaseStudies.......................................................................................................10

Financingagainstinsuredreceivables.........................................................................................10

FinancingagainstBillsofLading/WarehouseWarrants&Receipts..........................................12

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INTRODUCTION

Trade Finance is increasing in popularity as an asset class for investment, opening the door to new funds to meet investor demand. With it comes a responsibility to ensure that funds deploy their resources productively into genuine trade flows, to protect the integrity of the asset class and to close the door firmly on those who would abuse trade for nefarious purposes. For Trade Finance has been viewed by banking regulators as carrying a high risk for money laundering and financial crime, culminating in a shake-up and awakening in the industry with a renewed clampdown on compliance and due diligence processes. As one door closes, another opens and the substitution of banks by Trade Finance Funds should not be seen as an opportunity for the unscrupulous to circumvent the system. The same caution and techniques now being applied by the banks needs to be replicated in the funds space.

Does it matter? These extracts from Money Laundering Bulletin (Business Intelligence/Informa) give some idea of the concerns:

Fraud remains the main cause of loss but it is avoidable with proven techniques. This paper therefore serves to explain the impact of fraud and how to prevent it.

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1. What do we mean by ‘fraud’?

‘Fraud’ in context refers to the deliberate and contrived abuse of Trade Finance for illegal, immoral or criminal purposes.

The intended outcome is a deception. This may be through the creation of an artificial trade to launder money or to gain funds illegally, or the use of a genuine trade for the same purpose.

The real problem lies in how trade has been exploited to foster drug cartels, terrorism and other criminal activities, for which this article below is just an illustration:

Extract from The Economist, May 3rd 2014, Trade is the weakest link in the fight against dirty money

CUDDLY toys don’t have to be stuffed with cocaine or cash to be useful to traffickers. A few years ago American customs investigators uncovered a scheme in which a Colombian cartel used proceeds from drug sales to buy stuffed animals in Los Angeles. By exporting them to Colombia, it was able to bring its ill-gotten gains home, convert them to pesos and get them into the banking system.

This is an example of “trade-based money laundering”, the misuse of commerce to get money across borders. Sometimes the aim is to evade taxes, duties or capital controls; often it is to get dirty money into the banking system. International efforts to stamp out money laundering have targeted banks and money-transmitters, and the smuggling of bulk cash. But as the front door closes, the back door has been left open

More recently, concerns have been raised that the terrorists behind the Paris attacks have been funded through trade, especially through the sale of oil from the oilfields under IS’s control.

Typical scams involve the mis-invoicing of goods to launder funds through the banking system:

- over-invoicing of exports or under-invoicing of imports brings funds into a country

- under-invoicing of exports or over-invoicing of imports gets funds out of a country

Where banking practice means that banks deal in the documents of trade rather than in the goods, the onus has historically been on the banks only to check the consistency of the trade documents with what the commercial contract and financial arrangements call for. There was no obligation to check if the price was right in absolute terms, only that it was right inter-alia the paperwork. This unfortunately perpetuated trades such as one where plastic buckets were reportedly exported from the Czech Republic to the US at $970 each to facilitate laundering funds out of the US. The scale of abuse is hard to quantify. Global trade volumes amount to some $18 trillion according to the International Chamber of Commerce, whilst The Economist feature on May 3rd 2014 suggested that around 5% was associated with some form of corruption. It may not seem much in relative terms, but given where it ends up and

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what it helps perpetuate, it’s little wonder that eradicating it has become a major focus.

The banks have invested heavily in this space since 2012. It is partly why they don’t fund certain counterparts any more. The challenge for the emerging trade finance funds who look to fill the gap is to ensure they plug the due diligence gaps too.

2. How to AVOID fraud

Fraud in the STCF business continues to be a nuisance, and whilst we may not be able to

avoid it altogether there is still much we can do to prevent the opportunity for fraud and to mitigate the extent of any fraud that may be perpetrated.

The following steps therefore provide a guide to AVOID fraud:-

Appraise Verify Optimise Inspect Doublecheck

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§ APPRAISE the customer thoroughly: is there transparency; does the underlying business make commercial sense; is the customer experienced in trading / is he adding value in the product chain or a simple middle-man (in which case, beware!); does his company results mirror the market or does he make abnormal profit or loss; is it a one-man/family show or are there interested third parties to provide consensus; is it a public company accountable to shareholders and giving regular information, or a private company where information is scant and relies on honesty from the owner(s); who do they deal with... do we know them, are they reliable/trustworthy / have we had positive bank checkings; what tangible support do we have and is it independent of the fortunes of the company itself (eg. a personal guarantee has little worth if the assets behind it are only those in the company itself). Is the customer's integrity 'undoubted' or is it questionable (what is the market perception)?

§ VERIFY the information obtained: many frauds succeed because lenders place too much trust on the customer and find it awkward/embarrassing to check-up on what has been told, believing that the customer will be angered and go elsewhere! Any customer who seeks to prevent the verification of information given is to be exited... "the customer with nothing to hide will not hide it!" We should see from trade flows who the true counterparties are, and if funds are required to pay suppliers, we should pay them directly (but beware to verify the relationship of the supplier to the borrower... they may be related and that would facilitate a fraud). Where we rely upon third party receivables for repayment, we have to verify the standing of those third parties, their relationship to the borrower, and that a true contract exists to trigger the receivable... receivables are always conditional, and until the condition is met they don't exist (eg. an LC receivable is not a receivable until a conforming presentation of documents has been made and the confirming/paying bank confirms its acceptance/payment). Similarly, a contract may exist and goods have been delivered, but is the payment definitely coming to you, or has it been offset or paid elsewhere - if in doubt, get the debtor's authenticated acknowledgement. Lenders should develop and use their networks to verify information received.

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§ OPTIMISE the financing structure to mitigate customer reliance;

a transactionally secured structure in which the borrower controls some or all of the secured elements is not secured! A credit request must clearly delineate the type of exposure and the risks involved, and where the lender relies upon the borrower to supply documents or perform a task to perfect its security this should be explained and preferably mitigated by an alternative structure: perhaps we need to involve acceptable third parties, to certify or confirm or submit documents. Consider too the timing of vessel arrival to the document flow... maybe the vessel will already be discharged by a Shipping Indemnity because it arrives before the documents will! Note too, that it is imperative to seek Credit approval for any deviation in the financing structure from that originally approved, and to ensure that any security documents (including insurance cover) are not jeopardised by any deviation.

§ INSPECT all security documents and third party confirmations:

amazingly, in hindsight one can spot glaring errors or anomalies in documents/confirmations that get missed in the ordinary course of events! Read the small print, and match up signatures/details on previous documents with what you have now... maybe they're the same thing with a few alterations (is the typing/print consistent; is the signature uniform (same size/angle/place) in all documents (if so, be suspicious... can you write your signature exactly the same uniformly each time?!). Scanners and copiers facilitate falsifying documents, so vigilance is required to inspect that documents we rely upon are genuine, original and duly authenticated. Legal due diligence on the validity of pledges/assignments/guarantees etc. has to be undertaken BEFORE engaging. As for any insurance, the terms have to be inspected to determine the extent of cover, who can claim/when/how, and to ensure the lender’s interest is noted... noting that fraud will seldom be covered!

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§ DOUBLE CHECK at regular intervals: times change, and customers' fortunes change with them, so a regular "audit" of the above is required on an on-going basis to spot changing trends/new counterparties/ payment delays etc. The deal that was done 3 months ago but is not due for payment for another 3 months may be impacted by a dispute between the parties, or may even have been offset by an arrangement between themselves; the borrower may have run into problems on other investments, and seek to fabricate or double-finance trades to raise funds. Each lender should establish an "audit" routine with buyers/suppliers/shippers/third parties to verify details on which the lender relies for repayment - the more routine it becomes, the less conspicuous it will appear.

Examples of actual fraud cases are given below, from which can be seen the shortcomings of the lenders which facilitate a fraud being carried out. In the majority of cases, we can all spot a fraud that is a fraud from the moment it walks in the door... but can we spot a fraud from a customer that we have known and worked well with for a number of years?! That's the real test, and is the type of fraud which is more prevalent in difficult times, and the only way to guard against it and other frauds is not to let familiarity breed contempt for normal credit due diligence.

Hindsight should now provide the foresight to AVOID such cases in the future.

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3. FRAUD Practical Case Studies Financing against insured receivables

Borrower is joint venture (5O/50) between a respected China corporate and a Hong Kong Chinese businesswoman. Activity is sourcing commodities from Australia for import into HK/China. Facility available for financing against D/A receivables (Docs against Acceptance), insured 90% with EFIC (then Australia’s Export Credit Agency).

Evolution

Very satisfactory relationship over 3 years: the customer becomes the largest earner for the local STCF unit of a major global bank. Against this history, the customer requests an increase and to relax the terms to Open account, still against EFIC insurance. The bank insists on paying suppliers directly to protect use of funds, but copy invoices/bills of lading from the customer are all that are now required to trigger drawdown. New buyers emerge, whilst some disappear then later reappear. An unpaid receivable occurs at the end of May, but the insurance allows the customer a discretion to claim or not within 60 days. No claim is made, and no payment received by 31st July. The bank continues to allow drawings during August.

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Consequence

In October the bank learns by chance that another lender has met with unpaid receivables, and EFIC discovers that although certain buyers still existed, they hadn't concluded the purchase contracts with the borrower. The copy bills of lading are inspected and seen to be issued by always the same company (no address given), where signatures are uniform in all respects, right down to the line dot they begin and end on, and the type/print face is not consistent within the document but always varies for the same entries. Subsequent checkings on the suppliers and buyers reveal that some are owned/controlled by the same Hong Kong Chinese businesswoman. Further enquiry reveals that 2 directors of the respected China partner resigned in September, and that the other lenders and EFIC were encouraged to relax their terms only based on what they were told by the customer that each other had agreed to do.

Lesson - "Trust, but Verify!"

§ each lender was told that the other had agreed to be more flexible, and each wanted not to lose out to the others, but nobody sought to verify this important persuasion with each other: confidentiality laws restrict a cross-exchange between competing lenders, but the customer's consent should have been obtained to do so, or a joint meeting arranged, and if rejected should have given cause for concern.

§ a random check to authenticate some of the copy Bills of Lading would have been an early indicator of a fraud (there was no contact address of the shipper / no container numbers referenced). Checks with the International Maritime Bureau would confirm the vessel's registration, its suitability for the cargo, and where it was at the time of loading.

§ a random check with the known buyers that they did indeed enter into a purchase contract and confirm that a receivable is due and payable would have brought an earlier conclusion to the drawings being made

§ a random check on the new buyers/suppliers would have revealed the connection with the fraudster

§ the provision of [ copy] shipping documents by a third party (eg. the freight forwarder) would have restricted the company's ability to provide fraudulent papers

§ a receivable due in May was already an unpaid overdue (and outside the support of the insurance policy) when further advances were made in August. This should have triggered closer enquiry and prompted a random check as above

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Financing against Bills of Lading / Warehouse Warrants & Receipts

Borrower is a large multinational trader of metals, particularly between Latin America and Europe. It obtains finance against the security of full set Bills of Lading pledged to the lenders and replaced by Warehouse Warrants or Receipts.

Evolution

Business expanded rapidly and more lenders were brought into a financing pool. The company began to take big market positions, believing itself to be a market mover. When the markets moved against it, the company struggled to meet its commitments and talked of organising a creditor's meeting with all its lenders.

Consequence

Lenders were bringing pressure on the company, but stopped short of realising their collateral until the creditor's meeting took place. This meeting due in October was postponed until November by the company, and still the lenders held on to their collateral. When finally it became clear, after the November meeting was again postponed, that the company had no intention of getting together with its creditors, the lenders sought to realise their collateral, only to find that the customer had already taken and disposed of it.

Lesson - "Know thy collateral!" § the company was able to take and dispose of the collateral, despite the lenders holding full set Bills of Lading or Warehouse Warrants / Receipts, because in many cases the company owned the vessels and the warehouses itself (nobody had checked!) § in other cases, the company had given its own Indemnity to the independent shipper/warehousekeeper to release the goods, made possible because the independent shipper/warehousekeeper had no knowledege of the lenders' collateral interest. § when taking collateral, it is imperative to know something about the relationship of the borrower to the shipper/warehousekeeper, and preferably to give notice to them respectively of the lender’s collateral interest, which should be acknowledged in return (note that in some jurisdictions, a holder for value is obliged to give notice in order to enforce a claim). The local laws and the text of the security instrument itself therefore have to be read and understood in order to properly protect the lender’s recourse [a Warehouse Warrant is deemed a document of title in some countries but not recognised as such in others, whilst a Warehouse Receipt is not a title document at all]. Be aware too that shippers and warehousekeepers usually have a prior lien over the goods for any unpaid freight or storage fees due to them, and that the

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lender will often have to pay these itself in order to realise the collateral. Useful contact:

Contact Details for the International Chamber of Commerce, Commercial Crime Services:

- ICC International Maritime Bureau for due diligence on shipping documents or shippers

- ICC Commercial Crime Bureau for company/transaction vetting/authentication

ICC Commercial Crime Services

Cinnabar Wharf

26 Wapping High Street

London E1W 1NG

United Kingdom

Email: ccs@icc-ccs.org Phone: +44 (0)20 7423 6960 Fax: +44 (0)20 7423 6961 Website: http://www.icc-ccs.org

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AboutBankingwiseLimited

Bankingwiseisanichebusinessandmanagementconsultancydeliveringtailoredadvice,supportandtrainingtotheFinancialServicesandCorporatesectors.

AboutKimuraCapitalLLP

KimuraCapital,LLPisanassetmanagementfirmheadquarteredinLondonwithanadditionalrepresentativeofficeinNewYork.KimuraprovidesanalternativetobankfundingincommoditytradefinanceforSmall-MediumSizedEnterprises(SMEs).Kimura’ssectorfocusisEnergy,BaseMetals,SoftsandAgriculturewithsubsectorexposuretopetrochemicals,alloys,concentrates,polymersandfertilizersandwillconsidertransactionsglobally.Kimuraadoptsastringentclienton-boardingprocess.Duediligenceisatthecentreofthecompany’soperationalmandate;athoroughreviewprocessisconductedoneachnewcounterpartyandeverytransaction.

Disclaimer

ThispaperisintendedasgeneralinformationforanyoneconsideringTradeFinancefundsasaninvestment.ItdoesnotconstituteanofferorrecommendationtoapplyforanyparticularfundorfundsandneitherBankingwiseLimitednorKimuraCapitalLLPholdthemselvesoutassolicitingforanyspecificinvestments.TheinformationhereinistohelpinformopinionandtosuggesttopotentialinvestorswhattheyshouldbetakingintoaccountwhenconsideringanyTradeFinanceinvestment.CounterpartiestoTradeFinancetransactionsmaynotthemselvesbeofinvestmentgradeandthereisariskoflossofpartoralloftheinvestmentsthroughdefaultonrepaymentdespitebesteffortsinselectingcreditworthytransactions.Potentialinvestorsshouldnotethattheirfundsmaybeinvestedinunregulatedandmorevolatilemarketswherethereislikelytobelessinformationpubliclyavailable.PotentialinvestorsareencouragedtoreadthetermsandconditionscontainedinarelevantOfferingMemorandumbeforeanyinvestmentismadeandtoseekguidancefromaregulatedadviserwhenrequired.

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