With the increasing use and sophistication of technology, the potential for fraud to impact trade finance has increased significantly in recent years. Indeed, technology has allowed fraudsters to globalise their practices and both corporates and banks are under an ever increasing compliance burden just to keep pace. In this article we look at how the certainty of letters of credit may be impacted by wider fraudulent/illegal conduct and what can be done to mitigate the risks.

Introduction

International trade finance relies heavily on letters of credit (LCs). They secure quick, clean payment and are generally unaffected by the circumstances of the underlying commercial transaction. For this reason, they are ripe for abuse by criminal organisations as a means of laundering money or obtaining payment for corrupt or illegal purposes.

In such circumstances, whilst a bank may be justified in refusing to honour an LC where evidence of fraud is present it is not clear whether lesser levels of wrongdoing and/or underlying illegal conduct would allow the bank the same discretion.

At a time when the international community is increasing its cooperative implementation of robust anti-bribery and corruption (ABC) and anti-money laundering (AML) measures in international trade, it is at least possible that underlying ABC and AML will (in the future) affect the certainty of LCs.

The autonomous nature of LCs

The utility of LCs is in providing a guaranteed method of payment for exporters from a familiar and creditworthy financial institution. The key feature of an LC that achieves this function is the autonomy principle. By this principle, an issuing bank’s obligation to honour a draft on an LC is independent of the underlying contract to which the credit relates. Instead, the bank’s sole consideration is whether a request to honour is accompanied by documents which appear, on their face, to comply with the terms of the credit. In this way, LCs have been described as being as good as cash.

The fraud exception

Despite the importance of certainty, unscrupulous sellers are not protected by the autonomy principle. The fraud exception enables buyers to restrain sellers from drawing on an LC, or issuing banks from honouring a credit, if the documents presented to the bank are tainted by fraud. Whilst the exception has been adopted around the globe, its precise scope is unclear and varies from country to country.

A key area of contention is whether the exception extends to fraud in the underlying transaction or is confined to fraud in the documents presented under the LC. An example illustrating this distinction would be an American distributor purchasing 500kg of full-blood Wagyu beef with a marble score of 9 from an Australian exporter, secured by an LC for the purchase price. The Australian exporter ships 500kg of Wagyu beef, but fraudulently ships substantially inferior beef with a marble score of 4. If the invoice presented to the issuing bank described the product as ‘500kg of Wagyu beef with a marble score of 9’, this would amount to fraud in the documents. However, if the invoice merely described ‘500kg of Wagyu beef’, the fraud would be limited to the underlying transaction.

This question of the location of fraud is an important one because if the exception extends widely to fraud in the underlying transaction, this may open the door for courts to consider other disentitling conduct affecting the commercial deal.

Courts in the United Kingdom have largely taken the narrow view. The general consensus there is that the exception is limited to circumstances where the seller fraudulently presents documents that contain, whether expressly or by implication, material representations of fact that are known to be untrue. However, there has not yet been a definitive judicial statement that the exception cannot extend to fraud that only resonates in the underlying contract and the position remains open. By comparison, in Canada the exception extends to fraud in the underlying transaction if it is of such a character as to make the demand of payment a fraudulent one. In the USA, the same result is achieved by Article 5-109 of the Revised Uniform Commercial Code, which extends the fraud exception to circumstances where honour of the presentation would ‘facilitate a material fraud’ on the issuer or applicant by the beneficiary. Similarly, in China, LC fraud will fall under the general principles of civil fraud laid down in Chinese law and the aggrieved party may apply to the court for payment to be suspended. The courts will treat such claims in accordance with the property preservation provisions of the civil procedure law of the PRC. However, if the bank has already made the payment, the court has no power to interfere or suspend the transaction.

The illegality exception

While fraud allows a bank to refuse to honour an LC, it is not so clear whether illegality in the underlying transaction provides the same justification. In North America, the prevailing view is that no illegality exception exists. There is nothing in the Revised Uniform Commercial Code to excuse an issuing bank from paying because of supervening illegality. In Canada, courts have emphasised that LCs are not tainted by illegality in the underlying transaction. However, the possibility has been entertained in the UK. Courts there have contemplated cases where illegality would affect the enforceability of an LC. The cases include judicial comment that, for example, that the courts could not rationally enforce an LC that secured payment for the purchase of heroin or to facilitate the illegal sale of arms to Iraq. While the UK courts have contemplated the existence of an illegality exception in LC law, its nature and scope remains a vexed question. Amongst other things, it is unclear how far removed the illegality would have to be from the LC transaction to justify disturbing the autonomy principle. The bounds of the exception may need to be determined on a case by case basis. The potential for an illegality exception to justify refusing payment is an issue of increasing relevance given worldwide moves to counter bribery in international business and trade based money laundering.

LCs ripe for abuse

The autonomous nature of LCs mean they are ripe for abuse whether through the provision of false documents evidencing shipping, insurance fraud or as a means of laundering money.

In addition, it is easy to see how bribery might arise in the LC process.  For example, an exporter might promise to pay a bribe to the buyer’s agent in order to secure a lucrative sales contract. The exporter might then request an LC to cover an inflated sales price that incorporates the bribe.

Similarly, LCs provide an efficient mechanism for laundering money. Certain behaviours associated with international trade have been identified as indicative of money laundering. These include:

  • deal structures beyond the capability of a customer or involving improbable goods, origins, quantities or descriptions;
  • significant discrepancies between the description or value of goods on the documents stipulated under an LC; 
  • significant or repeated amendments to or extensions of an LC that are not reasonably justified; and
  • transfers of funds to international jurisdictions associated with dangerous drugs or with weak anti-money laundering regimes.

With advances in technology the scope for fraud and the sophistication of those frauds has increased.

ABC and AML laws

In 1997, the Organisation for Economic Cooperation and Development (OECD) finalised theConvention on Combating Bribery of Foreign Public Officials in International Business Transactions. The convention has since been ratified by 34 countries around the world. The United Nations Convention Against Corruption has been even more widely adopted. In line with their treaty obligations, Australia, the UK and the US have all criminalised bribery of foreign public officials in international trade. In the US, for example, the Foreign Corrupt Practices Act 1977 criminalises the corrupt payments of anything of value to a foreign government official in order to secure an improper business advantage. Similar conduct is criminalised in Australia by the Criminal Code (Cth) and in the UK by the Bribery Act 2010.

On the AML front, Australian laws were beefed up in 2006 to align with international best practice to deter money laundering and terrorism financing. The Anti-Money Laundering and Counter-Terrorism Financing Act 2006 (Cth) is Australia’s cornerstone legislation. It adopts the practices of the Financial Action Task Force, an international intergovernmental organisation tasked with combatting money laundering. The Act imposes various AML obligations on financial institutions, including establishing robust AML programs, conducting customer due diligence and reporting suspicious activities to Australian authorities. The US and UK impose similar obligations on financial institutions operating in those countries.

Protection mechanisms for banks

The potential recognition of an illegality exception to LCs begs the question: what does a bank need to do to detect illegality in the underlying transaction? Generally, a bank providing an LC will not have any visibility of the underlying transaction. However, this does not mean that banks cannot undertake robust due diligence at the LC application stage.

ABC due diligence

In 2006, an OECD working party developed recommendations designed to prevent bribery in export transactions. While the recommendations apply to official export credit providers that provide export credit insurance (ECI), the measures are transferable to the approval phase of an LC. Adopting those recommendations, issuers of LCs should consider:

  • requiring exporters to provide a declaration that neither they, nor anyone acting on their behalf, such as agents, have engaged in bribery in the transaction or have been charged with bribery offences in any country in the last five years;
  • verifying whether exporters are listed on publicly available debarment lists of the World Bank and other regional international banks; 
  • requiring exporters to disclose any commissions or fees agreed to be paid to persons acting on an exporter’s behalf; and
  • if suspicions of bribery arise before an LC is approved, suspending the application, engaging in enhanced due diligence and refusing the application if bribery is substantiated. 

AML due diligence

Prior to issuing an LC, AML laws require due diligence by an issuing bank to identify and verify the applicant. This can involve standard procedures at the account opening stage. The Wolfsberg Group recommends that this stage of due diligence consider the applicant’s countries of trades, the goods traded, the parties with whom the applicant deals and the location of any agents or third parties. If information indicates that high risk countries are involved or that relevant parties and goods are on sanctions or terrorist lists, the issuing bank should conduct further enquiries. Due diligence by the confirming, negotiating or advising bank (as the case may be) should mirror this process in respect of the beneficiary. The banks should also conduct due diligence on one another. It is highly recommended that counterparties utilise electronic screening tools to facilitate this process.

Once an LC is on foot, a bank’s means of reviewing the transaction are more limited. However, banks should continually review LC transactions using the latest technology and be alert to new parties or countries mentioned in documents presented under a credit.

Declarations

Although an illegality exception to LCs has been suggested, it is not yet clear whether these suggestions will crystallise into hard law. Instead, banks could require that a declaration in line with ABC and AML laws be presented as a condition of an LC. A declaration of this nature would require an exporter to assert that neither it, nor anyone acting on its behalf, has engaged in illegal conduct, bribery or used the transaction to launder money.

In practical terms, an issuing bank will generally become aware of illegality upon notice from the applicant, who may not wish to complete a sale that is affected by illegal conduct, bribery or money laundering. Even if the applicant can provide the bank with strong evidence of illegality, it is not clear whether the bank could refuse to honour the LC on that basis. However, if the bank was then presented with the beneficiary’s fraudulent declaration that neither bribery nor money laundering objectives had affected the transaction, the issuing bank would be firmly within the established fraud exception in refusing the pay.

How can banks minimise exposure?

For reputational reasons and as part of good corporate governance, banks have an interest in ensuring that the LCs they issue, confirm or negotiate are not used to further illegality, bribery or money laundering. In practice, there are some key steps that can be taken by a bank to mitigate the ever increasing risks

  1. The most fundamental strategy is a robust and fulsome due diligence process at the LC application stage. Banks need to verify the identity of an LC applicant and be aware of the countries, goods and counterparties involved in a transaction – advances in technology and screening have made this process more exhaustive but not necessarily simpler from an operational perspective.  
  2. If due diligence procedures identify issues of high risk, banks should carefully monitor the transaction. While an issuing bank’s insight may be limited, continuous review of new parties, locations and goods specified in documents presented under an LC provides a means of ongoing due diligence.
  3. Finally, banks might consider requiring an ABC/AML declaration to be presented as a condition of an LC. This would create a mechanism to refuse payment based on the fraud exception.