At the start of 2020, few could have foreseen the disruption ahead for banks and traders involved in commodity finance. As allegations emerged of fraud at several energy trading companies, many of which were in Singapore, international banks were quick to review their appetite for risk – all of which was happening against a backdrop of economic turmoil caused by the Covid-19 pandemic.
Towards the end of the year, GTR gathered six prominent lawyers specialising in trade and trade finance for a virtual roundtable discussion, looking back at whether there are lessons to be learned from that disruption. The discussion touched on how banks can reduce the risk of those fraud cases happening again, the role regulators can play, and the potential – and the limitations – of emerging technology.
Omar Al-Ali, partner, Reed Smith
Catherine Lang-Anderson, partner, Allen & Overy
Robert Parson, partner, Clyde & Co
Philip Prowse, partner, HFW
Richard Usher, partner, DLA Piper
Geoff Wynne, partner and head of trade and export finance, Sullivan (chair)
When fraud strikes
“I have seen this all before,” said Geoff Wynne, partner at Sullivan and head of the law firm’s trade and export finance practice. “From the 1980s onwards, whether by accident or by design, these cases all ultimately involve double funding invoices. For banks to say that because it was fraud, there was nothing they could do about it seems pretty lame to me, speaking as a lawyer. It is a question of how much due diligence you do.”
Accusations of double funding – where two or more banks are duped into providing finance based on a single invoice, cargo or trade receivable – were rife in the notorious Agritrade and Hin Leong fraud cases. The collapse of those two Singapore-based traders left banks with a combined total exposure of over US$5bn.
That has given rise to questions across the industry as to whether those scandals should be seen as a trade finance problem, a Singapore problem, or as isolated incidents.
Philip Prowse, partner at HFW in London, acknowledged that there can be inherent risks around the provision of finance, for example in repurchase agreements. “That would not be a secured loan, and there has not been a registry where you can check if something has already been financed,” he said.
Though there are measures lenders can take – Prowse gave the example of carrying out a site visit when providing inventory finance, to ensure the goods being sold have not already been sold elsewhere – the lawyer said those are “largely easily overcome if there’s fraud”.
However, as DLA Piper partner Richard Usher suggested, trade finance structures themselves “are not the reason why we’ve seen these collapses and frauds. Such things happen from time to time, but the underlying trade finance structures that have developed over many years are actually quite safe. The problem is some of those structures are not being implemented and/or monitored correctly.”
Singapore-based Omar Al-Ali, partner at Reed Smith, said it is “unfortunate that there have been some high-profile fraud cases involving Singapore-based trading companies”, but said the underlying issues are by no means unique to the city state.
“There’s no doubt that the cases we’ve seen are very serious indeed, but I agree they should be seen as isolated incidents,” added Catherine Lang-Anderson, partner at Allen & Overy in London. “There’s a lot to learn, but it’s important to look at that carefully in the context of the amount of trade finance that goes on globally.”
One of the most visible side-effects of those commodity finance fraud scandals has been the reaction across much of the banking sector.
ABN Amro announced in August it would withdraw entirely from the trade and commodity finance markets, having sustained heavy losses in the Agritrade case, while others, including Société Générale and BNP Paribas, have scaled back or consolidated commodity finance offerings.
Robert Parson, partner at Clyde & Co, said that response is “to some extent an emotional, immediate knee-jerk reaction” that could make it harder for commodities traders to access finance. “We’re all concerned when we see banks stepping back, because it could widen that trade finance gap,” the London-based lawyer said.
“Fraud has made banks skittish generally, in and around this sector, and that is a global problem that we’re seeing arise from this.”
Reed Smith’s Al-Ali said it is possible some banks were already thinking about their exposure in the trade finance market before fraud scandals hit. ING, for instance, has announced it plans to scale back its wholesale banking operations but denies fraud has played any part in that decision.
“There has always been a trade finance gap,” he said.
“The concern is that as more banks step away, will there be anyone to step into their place? Are we going to see some companies not being able to find financing because banks with reduced risk appetite are cherry-picking borrowers with only the best credit quality to lend to?”
A flight to quality?
There have been reports of difficulties among smaller and medium-sized commodities traders in obtaining finance – even in cases where those companies have no link to Hin Leong, Agritrade or other scandal-hit trading houses.
However, executives at larger traders, including Vitol, Trafigura and Glencore, all reported in the final months of last year that their access to finance has remained resilient, characterising the trend as a “flight to quality” among lenders.
For Wynne, that makes commercial sense for those companies, but does little to resolve worries over a growing trade finance gap. He said: “If you’re sitting as one of the big oil traders, you will absolutely be saying that: ‘Come to us because we’re the quality traders. If you’d come to us, this wouldn’t have happened’. But it’s not the big players you need to get financing to; it’s the SMEs.”
When reports first emerged that smaller traders were struggling to access trade finance facilities, Singapore’s regulator was quick to issue a public statement urging banks to remain active in the sector.
But according to Parson, the gradual increase of regulatory pressure on the financial services sector has potentially “widened the trade finance gap by pushing banks towards this so-called flight to quality”, to the detriment of SMEs.
“As a result, they have created and encouraged – not by design, but in effect – the entirety of the shadow banking sector, which of course is what fills that gap,” he said. “Large commodity traders effectively now class themselves as financial institutions, recirculating and regurgitating money that comes in at the top of this food chain.”
Lang-Anderson said it would be “a real shame if the pool of trade finance lenders was reduced because of regulatory barriers making it more difficult for those willing to provide trade finance”.
“This is a lesson for the legal sector too. We need to continue to engage with the regulators to help them understand how trade finance works and why it’s important.”
Thankfully for the commodities industry, not all banks are cutting ties with trading houses. According to Parson, some “are taking a more proactive or positive approach to dealing with this”.
“We do need to tie back the commodities, the physicals, to these deals, and projects like the digital registry in Singapore – which has a lot of banks behind it – are the kind of thing that could have been helpful in the past.”
That registry, a project coordinated by DBS Bank and Standard Chartered, will use dltledgers’ blockchain-based platform to cross-check invoices and alert banks if a company appears to be seeking financing from multiple banks for the same cargo.
For Usher, other initiatives could centre on documents themselves. “There is the possibility to look at more efficient ways of producing warehouse receipts or bills of lading, so there aren’t fraudulent documents floating around in the system,” he said.
“We don’t need to change fundamentally how commodities are financed; we need to be more diligent in the operational aspects, and tie these structures back to where the physical goods being financed are. That’s where you can see things might potentially go wrong before they actually do.”
Al-Ali added that ensuring transactions have been structured so that they are self-liquidating is another safety net banks can deploy.
“If there are competing claims over the same commodities in an insolvency or enforcement situation, that suggests that creditors may not have done sufficient due diligence or taken all of the necessary steps to ensure that they definitely had the requisite security or ownership interest in those commodities,” he said.
Minimising a lender’s exposure to risk while ensuring it remains open for business remains a difficult balancing act, however. Prowse pointed out that as much as banks want to avoid straying beyond regulatory boundaries, sustaining reputational damage and even grappling with fines, it is “not just a case of spending more on due diligence, or having more eyes on the ground”.
“The banks’ concerns go deeper than cost: they’re going to be bogged down by having an army of regulatory and compliance people. Sometimes that can leave them feeling a bit straightjacketed,” he said.
Covid-19 containment measures, including office closures and travel restrictions, have opened companies’ eyes to the urgency of digitisation in the world of trade, Lang-Anderson said.
Though that helped resolve situations where physical documents could not be moved or signed, it is now important that lawyers, legislators and regulators can “make sure the legal structures are keeping pace with that change”.
“There are some specific questions, for instance around the cross-border element of these transactions,” she said. “While you might have a legal framework that supports something like the electronic signing of documents in one jurisdiction, does it necessarily work for the different legs of that transaction?”
If those issues can be resolved, it is possible the funding gap could also be narrowed without the need for banks to increase due diligence spending for relatively little financial reward. Some smaller traders, Al-Ali suggested, may decide to pay a premium themselves as an incentive for banks to take them on as customers.
“Maybe they would be willing to pay that extra cost to have people who are financing them do that enhanced due diligence – if it means that, as a result, they can actually be financed,” he suggested. “Maybe there is room for enhanced due diligence in certain cases, and that can open up funding for trading companies that wouldn’t otherwise receive it.”
However, Usher warned that digitisation should not be seen as a silver bullet for countering fraud and boosting access to finance.
“A lot of platforms have been trying to make parts of trade finance more efficient – digital documents, e-signing, electronic bills of lading for instance – but ultimately you can’t get away from the fact this is a physical business. You can’t digitise the actual oil or grain,” he said.
“That, I think, is where the limit of digitisation kicks in. We can make processes more efficient, digitisation has a lot to offer, but we have to be aware of what the limitations are in the commodities sphere.”