Trade finance is often structured as self-liquidating financial transactions, with trust receipts and sale and repurchase agreements being the common staples of the industry. Such structures confer title to the goods on the Bank, while simultaneously transferring the risks attendant on these goods to the Bank. Banks are therefore vulnerable to the risk of fraud that may be perpetuated by its direct or indirect counterparties, or other third parties. The heavy reliance on paper documentation in the trade and financing of such goods makes it open to abuse by fraudsters. To ameliorate the risk of fraud, a Bank should seek legal advice to ensure that its financing structure, due diligence and legal documentation are sufficiently robust to reduce its risk exposure, and that prompt remedial steps are taken to contain any losses.
Risks of Fraud in Warehouse Financing
Trade finance, a form of asset financing, is often conducted through self-liquidating financial structures. Trust receipts are an example of such a structure, with the Borrower executing a trust receipt that provides that it holds the financed goods and its proceeds on trust for the Bank as the beneficial owner. Another example is where the Bank enters into sale and repurchase agreement, or repo, with the Bank purchasing the goods and the Borrower agreeing to repurchase them at the end of a stipulated period.
In both structures, the Bank's title to the goods insulates it from the insolvency risk of the Borrower and it can repossess the goods and dispose of it in the event of the Borrower's default. However, the transfer of title to the Bank also means that risks attendant on the underlying goods are transferred to the Bank. Losses arising from damage to or disappearance of the goods are prima facie shouldered by the Bank.
Such losses may arise from fraud that is perpetuated internally by the Bank's counterparties. A notable example of internal fraud is the Qingdao fraud in 2014, where a Chinese trader colluded with port companies in Qingdao to issue fraudulent warehouse receipts to obtain multiple loans for a single cargo of goods. Similarly, in 2008, RBG Resources, a London-based trading company, singlehandedly created a bogus paper trail of non-existent transactions to obtain financing from multiple banks.
Losses may also arise from fraud perpetuated by external parties whom the Bank has no direct or indirect relationship with. In the recent trade finance scandal involving Access World, the Australia & New Zealand Banking Group Ltd ("ANZ") suffered losses when it discovered that the warehouse receipts in its possession, issued in the name of Access World, were not authentic. ANZ had obtained these warehouse receipts pursuant to a chain of repo transactions and it is suspected that an external party along the repo chain had duplicated the warehouse receipts.
The prevalence of fraud on the metals finance industry is largely attributable to the industry's heavy reliance on paper documentation. Commodities traders and financiers commonly purport to effect possession of goods by way of endorsements on warehouse receipts and the chain of endorsement can grow for months before the warehouse receipts are presented to the warehouse operator. For example, in the Access World fraud, ANZ's warehouse receipts were purportedly never presented to Access World or any other warehouse operator for inspection until ANZ wanted to sell the goods, and this resulted in the fraud being detected at a very late stage. Similarly, in the Qingdao fraud, if the financiers had imposed more stringent monitoring requirements over the goods or presented their warehouse receipts for inspection of their goods, the fraud may have been uncovered earlier. These incidents underscore how easy it is for fraudsters to take advantage of this paper trail and the risk of fraud in warehouse financing.
Steps to Mitigate Fraud
The easiest way to prevent fraud is to maintain a keen eye for details. Fraudsters often lack the patience nor meticulousness to conceal their tracks. For instance, in the RBG Resources fraud, the fraud was unraveled when counterparty confirmation letters were mistakenly faxed from Hong Kong along with some routine paperwork to the auditors of the RBG Resources. These counterparties were supposed to be competitors operating in separate parts of the world but the signed paperwork came from the same Hong Kong fax number. This raised the suspicions of the auditors, and led to the discovery of the fraud. Vigilance in preventing fraud may help detect fraud at an early stage and keep losses at bay. Another example would be the Qingdao fraud whereby one bank alone was supposed to have 73,000 tons of aluminum, however the warehouses only contained 60,000 to 70,000 tons of aluminum. It is relatively easy to pick up such mismatches and conducting such checks at the very least reduces the possible number of duplicate receipts.
Properly drafted service agreements, whether with warehouse operators or third-party collateral management or inspection agents, can also be designed to reverse the effects of a repo's transfer of a risk to the Bank. These may give the Bank an independent claim against the counterparty for damages stemming from a breach of undertakings in respect of the storage and safekeeping of the goods. The Bank should also make sure that the collateral manager is insured against employee fraud.
(c) Due Diligence
Notwithstanding the robustness of legal documentation, it remains the case that there is often no substitute to proper due diligence on the counterparties, local legal system and underlying trade transaction. This needs to be supported by trustworthy monitoring and access to the inventory during the life of the credit. A second inspector could be appointed to monitor the collateral manager. SWIFT launched a regional initiative in Asia to create a compliance repository where banks can submit and share know-your-customer and anti-money laundering information.
Commodities financiers should also bear in mind that warehouse receipts (unlike LME Warrants) are not documents of title and they should not solely rely on repeated endorsements on warehouse receipts to effect transfer of possession of these goods. It is crucial to present these warehouse receipts to the warehouse operator to ensure that the latter acknowledges the Bank's interests in the goods. The importance of the warehouse operator's acknowledgement was underscored in the English High Court decision of Mercuria Energy Trading Pte Ltd and another v Citibank NA and another  EWHC 1481, which arose out of the Qingdao fraud.
(d) Warehouse Visits
Regular warehouse visits to inspect the goods are critical. It is important during these visits to ensure that the goods are properly segregated and identified. The lot numbers in warehouse receipts must be matched against the physical lot numbers in the warehouse. In addition, the warehouse receipts must also correspond to the warehouse accounting system. This is because there may be duplicate receipts that appear to be authentic.
When Fraud Occurs
When fraud has occurred, swift action is essential. It is important to be properly advised in commencing court proceedings and/or arbitration proceedings. The choice of judicial redress or arbitration would depend on a multitude of factors, including the location of the assets and the parties, the jurisdiction clauses (if any) in the legal documentation and other tactical considerations. Parties may choose arbitration for its advantage of greater privacy and enhanced flexibility. Emergency arbitrators of the Singapore International Arbitration Centre can issue freezing injunctions orders for the preservation and inspection of evidence as well as anti-suit injunctions. However, it is not possible for emergency arbitrators to grant ex parte relief. This may necessitate an application to court for a freezing injunction, especially in cases when an element of surprise is needed to avoid tipping off the respondent. Emergency arbitrators cannot grant relief against third parties, and this is what is usually needed when fraud is committed by third parties in trade finance transactions.
Therefore, banks can mitigate the risks of fraud involved in warehouse financing by remaining vigilant and obtaining legal advice on proper documentation, monitoring processes, and necessary recovery measures.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.