All eyes are fixed on the English High Court, which is due to make a ruling on a dispute between Citi and Mercuria which could send shockwaves through the trading world.

Last year at the giant port at Qingdao and a smaller facility at nearby Penglai, the Chinese trading company Decheng allegedly used fake warehouse receipts to borrow multiple times against a single instance of metals.

The case has led to a far-reaching fraud investigation in China, but the can of worms that it opened on the wider commodities sector could have significant consequences.

It was reported last year that China’s banks have around Rmb20bn (around US$3.2bn) exposed to the fraud probe at Qingdao, while the losses incurred by international banks is thought to top the US$1bn mark.

Furthermore, it has led to a re-evaluation of the market by some of the key players: according to sources closely involved, banks have tightened up their lending criteria, meaning that fewer deals are deemed creditworthy and that those deals that are done are taking longer to complete.

Trader Mercuria and megabank Citi have had a longstanding relationship, with the latter providing finance for the former to buy and trade commodities around the world for years. But as the pair attempt to argue that the other is responsible for the estimated US$270m in potential losses stemming from the fraud in China, the relationship has soured.

The case is centred on repurchasing agreements – or repos. In Qingdao, Citi purchased metal from Mercuria and sold it back, with the interest rate on what are effectively loans built in to drive up the price. After the fraud was uncovered, Citi demanded early repayment, which Mercuria refused to comply with.

Experts are predicting that whichever way the case is determined, it will be a landmark ruling and could shape the repo market for years to come.

As the world awaits a verdict (which is expected any day), GTR speaks with Linos Choo, a litigation at law firm DLA Piper with vast experience in shipping, commodities and trade finance, to discuss the potential fallout.

GTR: You’ve said that Citi vs Mercuria is a precedent case in the trade world – please explain why it is so significant.

Choo: The case is, of course, fact specific but the legal issues which the English High Court is being asked to consider have not to the best of our knowledge arisen in the past. In particular the contents and conditions under which a party can serve a Bring Forward Event (‘BFE’) Notice under a Repo Master Agreement in order to advance the resell dates will be considered carefully in the Court’s judgment. The practice of redelivering the physical commodity by way of blank endorsed warehouse receipts and how physical delivery is properly effected under the forward sale (and whether such provisions are consistent with the Sale of Goods Act 1979) is also expected to be carefully considered by the English High Court.

GTR: Please explain why the case is being heard in London.

Choo: The case is being heard in London because the Repo Master Agreements which form the contractual basis for the dispute where all governed by English law and contained London jurisdiction clauses.

GTR: Why are banks and traders so concerned? What sort of questions are your clients coming to you with?

Choo: Banks are concerned because hitherto they had understood sale and buy-back/repo transactions to be risk-free since they would involve a sale of a physical commodity on a specific date together with a simultaneous forward sale. The bank’s position is that all risk under these types of transactions is contractually allocated to the trader throughout the transaction since the trader usually (under a separate services agreement) undertakes various obligations in relation to the commodity including its proper storage and warehousing. The transactions are known as ‘obligated repos’.

Mercuria in this case have argued that although they accept the commercial purpose of repo transactions is to achieve loan finance, when the transactions are properly analysed, they involve genuine sales of physical commodities in which title and risk is intended to pass from the trader to the bank leaving the bank with full ownership and risk of the commodity until such time the metal is repurchased by the trader under the forward sale.

GTR: What would be the possible repercussions of the verdict (either way) on the repos market?

Choo: It will not be known until judgment is published. However, what is clear is that the case had led to a surge of metal leaving Qingdao and other Chinese ports to “safe haven” destinations. The most affected markets are said to be nickel and zinc and the two countries which have most benefited from the movement are Malaysia and South Korea, both which host London Metal Exchange (LME) warehouses. Also I would add that the banks are now reviewing carefully the extent of future exposure to metals and other commodity trade financing in China.

GTR: Has there been a major crackdown on this kind of fraud in the aftermath of the scandals?

Choo: It’s not possible to crack-down on this type of fraud. The fraud in Qingdao allegedly involves collusion between the Chinese company which was the supplier of the metal (Dacheng) and possibly one or two more employees of the port authority at Qingdao and/or its agents. As you know the port authority in Qingdao has imposed a “lockdown” on parts of the port preventing any third party (including Citi, Mercuria and the warehouse operators) from having any access to the locations where the metal is supposed to be stored.

GTR: How have banks and traders been attempting to tighten up their own controls to ensure it doesn’t happen again?

Choo: It is very difficult to detect fraud of this nature but is it expected that, depending on which way the judgment goes, banks may be forced to take a more active role or at least review with greater care the extent of the obligations placed upon the traders under the obligated repo transaction particularly in relation to storage and warehousing.