A collective failure

Globally banks recognise letters of credit “LCs”, which are governed by Uniform Customs and Practice for Documentary Credits “UCP 600” or by Guarantees. Letter of undertaking “LU” in the context of NM fraud is being used in India.

Can a single employee of the bank or few of them repeatedly abuse the system and play a fraud like the case in hand is a difficult proposition to digest. Let’s analyse.

Customer is given fund based and non-fund based facilities by the bank

Non fund facilities include guarantees, letters of credit, letter of undertaking, etc

LU is provided in India to customer for imports as per RBI guidelines. The import is for raw material or for capital goods. It has a valid time lines for payment of obligation and is not a general facility. It is related to import obligations

Customer is expected to accept the letter of sanction, execute security documents and comply with formalities entitling the customer to use the facility in the nature of LU

Most important part if that this LU is to be issued by means of SWIFT. To issue a coded message by way of SWIFT to make the LU valid the authorised bank officers have to punch in codes, exercise SWIFT log in password and then issue SWIFT which is globally called MT 799 — this is worldwide accepted guarantee format

Upon issuance of the LU as per above the NASTRO account of the bank maintained overseas is credited which established and authorises the other banks to take position based on this credit

There is a process laid down to issue SWIFT which is recognised globally

Based on the IU under the SWIFT which tantamount to unconditional guarantee on the part of the issuing bank, the other banks participate for the banking requirements of the client. What other banks, including the subsidiaries of the Indian bank overseas, recognise is the IU which becomes the basis of their advancing loans or any other credit facility to the customer

There are bound to be internal control mechanisms to ensure that the SWIFT is rightfully exercised, someone in the bank must be analysing how much IUs have been issued, whether compliance made or not, whether payment is coming on time or not, if IUs are being rolled over who is granting permission and why, is the customer ensuring timely payment of obligations under IUs, is each time customer is abusing the system by availing similar facility from some other bank and after paying again availing the similar facility by the same bank. There must be internal controls as well as Auditors responsible for internal audits.

All large facilities are in the knowledge of senior management as well as discussed in the board of directors. If for years together senior management or the board has not raised any questions on such large exposures and how the IUs have been issued, there are holes at macro levels which should be plugged in.

There can be one isolated case of fraud but if the same facility is being given again and again and for many years it is not a fraud but a system failure where all are collectively responsible.

There is no point in identifying a single person and holding him solely responsible as if justice is shown to have been done by arresting some junior officers of the bank or of the NM. Why there is hurry to arrest anyone. Let the passports of such persons be impounded and investigations carry on. If these junior officers are found to be innocent tomorrow after languishing in jails for years would the arrest be justified? Catch the bigger fish who has perpetrated the fraud and who has permitted the fraud to happen. Catching small fishes who perhaps may not be aware what is happening around or who are subjected to system failure which is a collective failure will not do justice to anyone.

By alleging fraud would PNB can escape its liablity is a million dollar question.

It won’t be easy. For the issuing bank, PNB, in this case to hold fraud it may be important to establish that NM companies and the banks who have relied upon the IUs were in hands and glove and that they had together in a conspiracy hatched this fraud.

The other banks, perhaps, are being victimised and the entire banking industry which has been impacted by this has been hood winked by the fraudster. It may be difficult for PNB to escape liability by merely coining out the fraud theory especially when the IUs were being issued under SWIFT for years together and that the entire accounts and facilities were being monitored and approved by the hierarchy of management responsible to run the bank.

Judicial pronouncement on such issues have always supported the idea of honouring a bank guarantee or obligations under the LCs. To drive analogy to the LUs the courts have held time and again that LCs are the life blood of international trade and commerce and must not be interfered with. If PNB’s plea is adopted the international banks will lose faith in the Indian banks and Indian banks will be subjected to high risks by the counter parties. It will not be an easy sail at all.

In the matter of M/s Millennium Wires Vs State Trading Corporation the Supreme Court has made observations while reiterating the position of law as explained and held in various other judgments. The relevant part reads as under:

“In view of that, the following observation of the Court in R.D. Harbottle (Mercantile) Ltd. v. National Westminster Bank, (1977) 3 WLR 752, should suffice: Banks must be allowed to honour their guarantees without interference except in clear cases of notice of fraud to the bank. The merchants take risk which are not to be imposed on the banks. Such interference will deter trust in international commerce. We would uphold and restate the law on injunction against honouring Letter of Credit by a Bank as summed up by the learned Single Judge as follows: (1) The Court must be slow in granting an order of injunction restraining the realisation of a bank guarantee or Letter of Credit. (2) There are two exceptions to the above rule. The first is that it must be clearly shown that a fraud of a grievous nature has been committed and to the notice of the Bank. The second is that injustice of the kind which would make it impossible for the guarantor to reimburse himself, or would result in irretrievable harm or injustice to one of the parties concerned, should have resulted. (3) It is not enough to allege fraud but there must be clear evidence both as to the fact of fraud as well as to the bank's knowledge of such fraud. It would suffice to say here that injunctions against the negotiating banks for making payments to the beneficiary must be given cautiously as constant judicial interference in the normal practices of market can have disastrous consequences as it affects the trustworthiness of the Indian banks and markets.”

In this case in so far as PNB is concerned, there are approvals on credit facilities, participation from time to time on grant and roll over of facilities, facilities have been carved out, LUs have been issued time and again, SWIFT mechanism has been used, internal and external audits must have happened so it will not be an easy fight for PNB to allege fraud. Collective responsibility, collective failure and contributory negligence on part of the bank is there which enabled NM to perpetrate fraud. There must be some strong and cogent reasons enabling PNB to take up the defence under Fraud, which may not be clear to us at this stage. Whether PNB will get respite on the plea of fraud only time will tell.
(The writer is managing partner, SNG & Partners)