Letters of indemnity…lack of information?

12 April 2018

The recent case involving a documentary fraud at the Punjab National Bank (PNB) highlights the enhanced risk of accepting letters of indemnity (LOI) or letters of undertaking (LOU) for firms offering trade finance services.
Money laundering and terrorist financing

Two employees issued fake LOUs for fraudulent transactions, enabling a now disgraced national jeweller to receive cash advances in the name of PNB. Whilst entering the transactions into SWIFT, the employees deliberately omitted the transactions from the Bank’s core banking system, allowing the transactions to go undetected for years and mount up to US$1.77bn; the largest ever fraud to hit India’s financial system.

It has long been common practice within commodity related trade finance and financial institutions to release payment upon presentation of an LOI or LOU in place of shipping documents. LOI/LOUs are solely an agreement between parties under which the seller or shipper undertakes to submit shipping documents at a later date and/or indemnify the buyer in the event that they fail to perform under the contract. There is often no requirement to prove that shipping documents actually exist. LOI/LOUs contain minimal information relating to the transaction such as quality, quantity, shipping route etc., and therefore provide limited information on which a financial institution may perform due diligence.

It is this lack of detail from the underlying transaction that presents a material risk of misrepresentation and potential sanctions, money laundering and fraud risk.

Regulators globally have advised on the risks of trade based money laundering and specifically LOI/LOUs for some time. The FCA’s 2013 thematic review: Banks’ control of financial crime risks in trade finance, warns that presence of a LOI should not be considered a control against money laundering, instead suggesting that additional scrutiny should be applied. They call upon institutions to apply sufficient scrutiny to information available, including SWIFT messages, when processing transactions on the basis of invoice and LOI alone. HKAB/HKMA and MAS trade finance guidance calls out transactions without transport documents to evidence the movement of goods, or customer requests for the same, as a trade based money laundering red flag.

Despite these warnings, institutions continue to process payments pending presentation of shipping documents without additional controls to mitigate the risk or verify the information within the LOI/LOU. It is also not uncommon for institutions to neglect to obtain and analyse shipping documents at a later date. The fact that the PNB fraud had been running for a number of years highlights the value of look back exercises for these types of higher risk transactions. These shortcomings are due, in part, to firms’ unfamiliarity with the specific financial crime risks associated with transactions involving LOIs and LOUs.

If you would like to discuss managing the risk of LOI/LOUs, or any other aspect of your trade finance operations, please get in contact. We have extensive experience advising financial institutions and trading firms globally on financial crime risks involved in international trade. In particular, we have:

  • Supported the development of firms operating models in support of efficient, yet effective management of risk
  • Developed and executed comprehensive risk assessments to provide insight into gaps or areas of heightened risk
  • Created and delivered training to operations, compliance and senior management
  • Conducted independent reviews either in support of proactive requests for insight or as part of regulatory activity.
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