Case Study: Decoding the Cobweb of Letter of Credit

By: R Sumitra, CFE, MBA 

Recently, I worked on a case wherein a loan account of a bank turned bad, otherwise known as a non-performing asset. A preliminary investigation was conducted to know the genuine reason for the degradation of the loan account. The allegations included the diversion of the fund by the borrower, trade-based money laundering (TBML) through letters of credit and improper monitoring of the account by the bank. 

How the Auditor Carried Out the Investigation 

First, the auditor requested data on letter of credit and analyzed the transactions during the past years. While reviewing the letter of credit transactions, the auditor created a master profile that included the purpose of the letter of credit, names of the transporters, the total amount, etc. The auditor conducted public domain searches on the suppliers and noted the names, addresses and related parties of the supplier. The auditor then performed transaction testing from the bank account statement of the borrower. Finally, the auditor checked the "Terms & Conditions of Sanction" to know the purpose and justification for granting a letter of credit facility. 

Based on the above analysis, the auditor noticed the following issues in the suspected borrower’s account: 

• There were inconsistencies in the issuance of the letter of credit with that of the purpose mentioned in the letter of sanction.  
• The beneficiaries of the letter of credit (i.e., the supplier) and the suspected borrowers were related parties.  
• As per the records, the supplier's registered office and the suspected borrower's warehouse were the same. 
• During the preceding year a total of 135 letters of credit amounting to USD 73.33 million had been devolved. 

Upon verification of the trade license number and trade tax number of the supplier in the public domain, it was found that the numbers were cancelled three years prior. The auditor also visited the address mentioned in the supplier's proforma invoice and made a discreet enquiry about the company. It turns out that no such company existed. 

The company befooled the bank using fake documents. 

As the investigation continued, the auditor visited the office of the transporter at the address mentioned in the lorry receipts, which required a serial number identifying the transport company. No such transport operator existed at the address that was listed. 

On perusal of the account statement of the suspected borrower, it was found that there were frequent credits of amounts from the suppliers' accounts to the suspected borrower's account. In addition, such transactions were more frequent after the issuance of a letter of credit. 

The suspected borrower company was dealing in plastic commodities, whereas the suppliers were a dealer of iron and steel rods, revealing even more inconsistencies in the trade activities and additional evidence of money laundering through letters of credit. 

Red Flags to Identify Money Laundering Through Letters of Credit  

When investigating fraudulent activity as it relates to letters of credit, the following red flags are important to explore during the preliminary investigation: 

1. Over-invoicing or under-invoicing of goods. 
2. Goods shipped to the buyers are misrepresented on the official document. 
3. Noticeable change in the scale, volume and frequency of transactions, or a sudden change in the behavior of the customer. 
4. The discrepancy between invoices and descriptions of the goods in the document. 
5. Shipments routed through multiple unconnected subsidiaries without a valid reason. 
6. Payment methods are inconsistent with the value of transactions. 
7. Shipments are made to or from an unusual location. 
8. The types of goods traded under the letter of credit are not in line with the regular business activity of the client. 
9. Goods being shipped under letter of credit are not clear, and hence, difficult to determine the value of.  
10. Complex transaction structuring.  
11. Round-tripping of funds. 
12. A high volume of transactions with the related parties.  
13. Documents submitted with incomplete information. 

Red flags are detection scenarios that call for further investigation and should be escalated as per guidelines, even if the transaction otherwise appears in order. It is essential to understand the red flags for preventing fraud, which can be unlocked through continuous monitoring and creating awareness by investing in the learning and development of employees.