Case of the empty crates

Fraudulent use of letters of credit has run rampant in Libya amid a chaotic civil war. We look at cases in this opaque corner of the trade finance market to better understand how fraudsters are exploiting a financial instrument that helps drive global trade but also opens doors for wrongdoing.

In the early to mid-2000s, Libyan authorities started to notice a strange phenomenon at the country’s ports all along its Mediterranean coast. Ships were delivering containers that were either empty or filled with rotten goods or heavy substances like sand. This was certainly odd and concerning for a nation that desperately needed to import a whole range of basic goods from medicine to food during an ongoing and bloody civil war. But the country’s financial regulator — the Libyan Audit Bureau (LAB) — had few doubts about who the culprits were and why this was happening.

In its 2015 annual report, LAB accused a string of companies and banks of fraudulently using financial instruments called documentary credits, better known as letters of credit, to effectively rob the central bank of vital hard currency reserves and deprive Libyans of essential goods. The scam allowed fraudsters to transfer millions of dollars overseas and profit from arbitraging the disparities in local exchange rates. (See “Libyan Audit Bureau General Annual Report 2015.”)

The then-widening gap between the official and black-market exchange rates for the Libyan currency — the dinar — had opened an opportunity for bad actors and armed groups. Whoever could obtain U.S. dollars from the central bank at the stronger official rate, usually around 1.4 dinars against the U.S. dollar, and sell them at a parallel rate — as weak as 10 to the dollar — could enjoy a windfall in local currency. (See “Libya’s Monetary Crisis,” by Jalel Harchaoui, Lawfare, Jan. 10, 2018, and “Conflict Economies in the Middle East and North Africa,” by Tim Eaton, Christine Cheng, Renad Mansour, Peter Salisbury, Jihad Yazigi and Lina Khatib, Chatham House, June 2019.)

Understanding the market

In this crime, fraudsters use letters of credit to get their hands on that hard currency. The scam then takes on many forms. But before we go any further, let’s consider a definition of letters of credit and how they can be used for fraud.

A letter of credit is a widely used financial instrument, which helps drive a multitrillion-dollar market in global trade, designed to help facilitate the buying and selling of goods between importers and exporters. It’s a guarantee from a bank that becomes responsible for the timely payment to the seller of goods on condition that the seller meets certain documentary requirements. By having trusted financial institutions involved in the process, a seller feels more comfortable transacting with a buyer whom it doesn’t necessarily know and is based in a different country and legal jurisdiction. (See “Letter of Credit Example: How Money and Documents Move,” by Justin Pritchard, The Balance, July 16, 2021.)

Regardless, letters of credit are still potentially vulnerable to fraud because of the way they’re structured. Payment to the seller is solely dependent upon the bank’s receipt of the relevant shipping documents. Violation of the terms of the underlying commercial contract between the exporter and importer won’t impact the transfer of those funds. So, for example, the bank will honor the payment to the seller even if poor quality goods are delivered to the importer, as long as the shipping documents are in order. While there are legal exceptions to those terms — including cases of fraud — a clever fraudster could potentially poke holes in the system to their benefit with good forgeries or simply by bribing officials. (See “Restraining payment under letters of credits and similar payment instruments: the position under English, Singapore, U.S. and Chinese law,” Reed Smith, July 13, 2020.)

Tim Harvey, CFE, a former detective superintendent with both the City of London and the Metropolitan Police’s economic crimes departments in the U.K., has in the past worked on fraud cases involving letters of credit. He’s now the ACFE global chapter liaison. Harvey says letter-of-credit terms and conditions have made it an easy swindle.

If you can produce a bill of lading, a certificate of insurance, a shipping certificate etc., it’s money for old rope [money earned for little effort] if you know what you are doing. The fraudster is being given loads of money by the banks just for a few good forgeries.

“The letter of credit is just an agreement between the banks releasing the funds on production of the documents,” he says. “If you can produce a bill of lading, a certificate of insurance, a shipping certificate etc., it’s money for old rope [money earned for little effort] if you know what you are doing. The fraudster is being given loads of money by the banks just for a few good forgeries.”

In Libya, the turmoil caused by the civil war, the presence of armed groups and the involvement of the central bank, which signed off on letters of credit, brought a new twist to the scam. The process went like this: An importer asked its bank to issue a letter of credit to facilitate importing goods, exchanged its dinars into hard currency at the official exchange rate, and the central bank then transferred the funds to an overseas correspondent bank, which released the funds to the seller’s bank once it met the required documentary conditions.

While those are standard steps in many letter-of-credit transactions, Libyan fraudsters were quick to exploit the system in several different ways. Armed groups used their close connections with local importers to apply for what were forged letters of credit, whose value were often inflated compared to the real worth of the goods. Sometimes, they created fake shell companies to act as bogus importers and/or exporters and simply sent sand or rotten food to fool customs officials — hence the mysterious appearance of the empty containers.

Either way, the emphasis was on obtaining the letters of credit and forging the required documents to release the funds, mostly through bribery and extortion. The fraudsters could then pocket those dollars, euros or other major currencies and use them for other illicit purposes, often exchanging them for dinars at a much better black-market rate. (See “Predatory Economies in Eastern Libya,” Global Initiative Against Transnational Organized Crime, Noria Research, June 2019, and “Libya’s War Economy: Predation, Profiteering and State Weakness,” by Tim Eaton, Chatham House, April 2018.)

Allure of complex markets for fraudsters

The use of letters of credit in Libya to commit fraud may be an extreme example, but it’s not unique given its position as a major financing vehicle in the global trade system. Not only is the importing and exporting of goods big business, but it’s also complex, involving different languages, financial instruments and legal jurisdictions — all fodder for fraudsters and criminals looking to carry out a scam.

“If you are looking for fraud, money laundering and kleptocratic theft, there is no better place to look than the global trade system,” says Michael Schidlow, CFE, a financial crimes compliance expert and professor. “As the amount of global trade increases, so letter-of-credit fraud increases in parallel."

Indeed, trade volumes are bouncing back after the COVID-induced economic downturn last year. The United Nations Conference on Trade and Development (UNCTAD) forecasted earlier this year that the value of global trade in goods and services would hit $6.6 trillion in the second quarter, marking a 31% increase year-on-year. And according to the International Chamber of Commerce (ICC), more than $1 trillion in trade transactions using documentary credits are carried out each year with its rules for the issuance and use of letters of credit. (See “Global Trade Update,” UNCTAD, May 2021, and “Global rules,” ICC.)

Scandals galore

One of the latest scandals involving letters of credit fraud broke in April 2020 when Singaporean oil trading firm Hin Leong filed for bankruptcy after years of hiding derivative trading losses. Among the frauds Hin Leong allegedly carried out to obtain billions of dollars in financing from financial institutions was the use of several letters of credit. It allegedly used 60 letters of credit worth $1.5 billion to finance cargo that didn’t exist or was already pledged to multiple buyers. (See “Trade Finance Under Scrutiny in Singapore,” by Chanyaporn Chanjaroen, Alfred Cang and Lulu Yilun Chen, Treasury & Risk, July 9, 2020, and “Analysis: Hin Leong’s ‘vicious cycle’ of trade finance fraud,” by John Basquill, Global Trade Review, Aug. 19, 2020.)

Some banks have withdrawn from financing trade altogether following a string of financial scandals among Singapore-based commodity trading companies that resulted in billions of dollars in losses for banks and other creditors.

In another case last year, banks issued letters of credit for Sugih Energy International Pte. Ltd to purchase oil from another trading firm Hontop Energy to sell it to BP. The banks did this based on what they thought were binding contracts with BP only to discover that the oil company never agreed to the purchases. (See “Burnt Banks Claim Fraud, Fabrications in Asian Oil-Trading Web,” Serene Cheong and Alfred Cang, BNN Bloomberg, July 16, 2020, and “Factbox: Commodities and energy trading firm scandals,” by Reuters staff, Oct. 7, 2020.)

Commodities trading, like other corners of the trade finance world, remains opaque and often very profitable for the institutions involved — hence an ideal playground for anyone wanting to commit fraud.

And while the International Chamber of Commerce has long established global rules for letters of credits, it’s still a complex market that lacks transparency and isn’t necessarily standardized. The combination of these factors creates an ideal playing ground for fraudsters, says Michael Pocalyko, CFE, CEO of SI, a Washington-based professional services firm and government contractor in the investigations, intelligence and cyber sectors. He’s also former chairman of the investment banking firm Monticello Capital and has worked in Saudi Arabia, Lebanon, the United Arab Emirates and Bahrain.

“Every issuing bank is different, every central bank is different, every country is different and every contract is different,” says Pocalyko. “That is always where you will have the opportunity for fraud, in complex systems that vary from nation to nation. The big frauds, like the Libya letter-of-credit frauds, can be hard to catch because they are private transactions that the letter-of-credit issuing banks are not necessarily required to disclose, even if they are public companies."

And because the letter-of-credit process is still largely paper-based, it’s also easy to miss red flags, says Schidlow. “The documentary collection process oftentimes relies on manual review,” he says. “There will be subtle variations, and if you are not paying attention, which often happens as you try to process these transactions quickly, you will miss [the red flags].”

If you are looking for fraud, money laundering and kleptocratic theft, there is no better place to look than the global trade system ...

In plain sight

Even so, in the Libyan case, signs of fraud were in plain sight for those who were paying attention. In its 2015 report, LAB cited how the weight of some containers bore no resemblance to the amount of goods being imported. There were also big discrepancies in the dates on letters of credit and the dates that the goods actually arrived at port, and the size of the cargo listed was sometimes far too big for the crates that were supposed to contain them. The regulator called for more banking oversight, better controls and inspection procedures at ports, and froze the accounts of individuals and companies involved, forbidding them from taking part in letter-of-credit transactions. (See “Libya: Empty Containers for Foreign Currency Scams & Fraud – Warning!” Libyan Lines, Aug. 10, 2015.)

According to a U.N. report released in 2016, armed groups had extorted some $20 million in letters of credit through bribery and threats, and a World Bank report said that central bank fraud involving these financial instruments cost the Libyan state hundreds of millions of dollars since as far back as 2011. [See “Letter from the Panel of Experts on Libya established pursuant to resolution 1973 (2011) addressed to the U.N. President of the Security Council,” United Nations Security Council, March 9, 2016, and “Supporting Peace and Stability in Libya,” World Bank Group.]

Despite LAB’s call for change in 2015, incidences such as this continued throughout that decade, with several reports in 2017 of containers found stuffed with sandbags, bricks, bottled water and other useless goods. (See “40 containers in US$8 million LC fraud discovered at Benghazi port,” CSO Alliance Maritime, Nov. 28, 2017, and “Libyan customs confiscates fraudulent cargo containers in Misrata,” by Abdullah Ben Ibrahim, The Libya Observer, April 11, 2017.)

Digging deeper

NGO Global Witness, which released a report earlier this year on the subject, found continued evidence of fraud despite reforms intended to prevent bad actors from arbitraging Libya’s official and black-market exchange rates.

Global Witness scraped open-source data on letter-of-credit and trade activity between April 9 and July 20, 2020, that showed the amount of money leaving the country was more than the reported imports on certain goods. From that data, Global Witness created a new database on close to $2.5 billion of letter-of-credit transactions over that period, showing glaring discrepancies in the numbers. In one case, the value of letters of credit for fresh and frozen meats during the three-month period exceeded the average annual imports of the same product between 2016 and 2018. The most likely explanation was “ongoing fraud, on a large scale.” (See “Discredited,” Global Witness, Feb. 19 2021, and “Global Witness - CBL Letters of Credit,” April 14-July 30, 2020, Global Witness.)

Global Witness also found that a key financial intermediary for many of the letter-of-credit transactions was the London-based Bank ABC, which is indirectly owned by Libya’s central bank, raising red flags about conflicts of interest for the regulator. While Global Witness said it wasn’t suggesting that either entity had engaged in the illegal use of letters of credit, it pointed out that loopholes in the U.K. rules about bank ownership left London’s correspondent banks open to money laundering. Both the central bank and Bank ABC questioned and contested the findings. (See “Discredited,” Global Witness, Feb. 19, 2021.)

Here are some of Global Witness’ recommendations following the report.

1. Full transparency around Libya’s letters of credit. By disclosing the names of overseas companies that are selling goods through letters of credit and the correspondent banks involved, authorities can identify suspicious patterns of behavior and potentially fraudulent transactions. Beneficial ownership disclosure should also be a condition for receiving a letter of credit.
2. Reform of the central bank’s overseas network of subsidiaries. End the practice of senior central bank officials holding directorships in commercial banks overseas. Establish accountability mechanisms for investments in those banks and create conflict-of-interest provisions for state representatives on those banks’ boards. Examine central banks’ role and the accountability and oversight attached to their stewardship of public funds. Central banks should disclose the terms of all funds distributed to public and private entities.
3. Develop stronger regulation of U.K. correspondent banking activity and ownership. Ensure that parent or controlling entities aren’t solely responsible for due diligence. Incorporate “conflict finance” into due diligence, requiring correspondent banks to identify entities or individuals connected to combatants in armed conflicts. Treat transactions between a U.K. correspondent bank and another group bank as high risk. It would ensure adherence to AML/CTF regulations and proper due diligence checks to minimize any potential risks. Correspondent banking has emerged as a significant money laundering vulnerability for the global financial system and should have greater oversight.

Preventing fraud by going paperless

Improving transparency not only in Libya but in other parts of the world may go a long way toward preventing fraud with letters of credit and in other parts of the trade finance world. Using new technologies to better assess documentation may be one solution. Banks have already been digitalizing trade finance services and adopting blockchain and AI in the wake of the Hin Leong scandal. (See “Trade Finance Under Scrutiny in Singapore,” Treasury & Risk, July 9, 2020.)

The big frauds, like the Libya letter-of-credit fraud, can be hard to catch because they are private transactions that the letter-of-credit issuing banks are not necessarily required to disclose, even if they are public companies.

And new technologies are starting to seep into the staid and antiquated trade finance market that has traditionally been heavily paper-based. The industry is seen as ripe for digitalization and has been increasingly looking to blockchain and distributed ledger technology as a replacement for the Society for Worldwide Interbank Financial Telecommunication (SWIFT) system, the messaging system often used in letter-of-credit transactions. [See “New ICC survey shows pace of trade finance digitalisation,” ICC, May 23, 2018, and “Blockchain for Trade Finance: Payment Method Automation (Part 2),” Cognizant, October 2017.]

“There is talk about replacing the SWIFT system with blockchain or other forms of technology,” says Harvey. “The SWIFT system, if you think about it, is pretty antiquated, and it is really nothing more than a unified coded telegraph system, which in today’s age is pretty stale.”

In 2018, HSBC and ING executed what was touted as the first-ever live letter of credit conducted through blockchain. And more and more banks and other financial institutions are signing up to a system that they see as more transparent, faster and less exposed to fraud risks. (See “The Network of Networks Digitalizing Trade Finance,” R3., June 2020.)

Global Witness data scraping is another example of how investigators can better prevent and detect fraud in letter-of-credit transactions. Indeed, the case of letter-of-credit fraud in Libya especially highlights the need for greater transparency and oversight of public funds.

For Libya, a country marred by civil unrest, letter-of-credit fraud has had an outsized impact in the form of huge capital outflows and the diminished imports of critical goods for Libyans. But a fragile ceasefire between the warring factions last year with plans to hold elections for a unified government in December have raised hopes. The members from two warring central banks also met for the first time in five years in December 2020 and agreed to devalue the dinar under a single exchange rate, helping to eliminate distortions in the value of the dinar and reduce the temptations to carry out fraud in the letter-of-credit market. (See “Libya’s divided central bank agrees exchange rate after first meeting in years,” by Reuters staff, Dec. 16, 2020.)

Milind Tiwari, CFE, is a doctoral candidate at Bond University in Australia and vice president of the ACFE Brisbane Chapter. Contact him at milind.tiwari@student.bond.edu.au. Kuldeep Kumar, Ph.D. and Adrian Gepp, Ph.D., who are respectively professor and associate professor at the Centre for Data Analytics at Bond University, Australia, also contributed to this article.