AlAhli Bank v AlSanea – Did ABK Miss the “Red Flags” on the LC Approval?

This is a follow-up to my earlier post on this topic. There I looked at the case AlAhli Bank Kuwait brought against Mr. AlSanea and his company Saad Trading Contracting and Financial Services ("STCFS) in the Supreme Court of New York. While ABK has made allegations, there has not been a court ruling. Mr. AlSanea continues to deny any wrongdoing.

Today I'd like to take a closer look at some "red flags" that ABK should have noticed when asked to  issue the letters of credit.  Here I am presuming that if AlAhli believes these are fraudulent transactions, then they should have noticed some things at the inception of the transaction.  Of course, as far as I know, Mr. AlSanea vigorously defends these transactions as proper.

Even after acknowledging that hindsight is usually 20/20, I think there are some really obvious points that ABK should have noticed at the time.  And which should have given them pause about these transactions and their client.  And thus sparked a review.  Perhaps, they did. Perhaps, they resolved them to their satisfaction. The Court documents (which are all that I have to go on) do not discuss this as it is not particularly relevant to ABK's case.

Some background.

Prior to the issuance of the LCs, ABK had already made a decision that STCFS was creditworthy. Based on its analysis the bank set an overall limit of US$100 million and established the type of facilities it would was prepared to extend: (a) US$80 million of that amount for letters of credit for the import of building materials for STCFS and (b) US$20 million for a "clean" working capital loan. A "clean" loan is a term bankers use to describe a loan that is not tied to a specific project or type of transaction. Under this facility, STCFS could borrow for whatever purpose it wanted. It's unclear to me from the filings if STCFS had already drawn down under the "clean" loan facility. If it had, that would be an important fact supporting ABK's allegation of fraud. That is, they had to resort to the LCs to get money.  Otherwise they could have simply drawn down on the loan facility.

But that's not the end to the credit process. In addition to reviewing subsequent financial information (financial statements and other such data), a bank should monitor usage of a client's line to determine if there is anything in the pattern of usage that indicates distress or other behavior that should be cause for concern.  With all such concerns to be examined and resolved.

Let's look at STCFS's request for the four letters of credit.  There were several "red flags" that should have raised questions about the transactions and about their client.

Before we get to that analysis, a few words about letters of credit ("LCs").

A LC is a financial instrument issued by a bank on behalf of its client (the applicant or buyer) to a beneficiary (the seller) in which the bank promises that it will pay the beneficiary a certain amount of money if the beneficiary presents certain prescribed documents within a certain time period. Most LCs are now irrevocable which means that the beneficiary has the bank's absolute commitment to pay if the right documents are presented in time. In effect the LC substitutes the credit of the bank for that of the applicant. 

LCs are used when the seller is not certain that the buyer will pay for the goods if shipped. This generally occurs when the buyer and seller are located in two different countries. If the seller is comfortable with the buyer's creditworthiness, it would not ask for the LC because the LC costs money and imposes documentary requirements – the documents have to be right and the group of documents have to be internally consistent.  Precise wording is very important.

It's also important to note that the bank does not check the actual goods shipped. It checks the documents. There have been many a case where the documents were in order but the actual goods shipped were not.

Other alternatives are to ship the goods and send the documents, including title documents for collection. Documents are released against payment. Or if the parties have some level of trust, documents are released against the buyer's acceptance of a draft.  In effect that creates a promissory note.  The seller then has a legally enforceable document it can sue on if needed. Where there is complete trust, the seller ships on open account with payment at some mutually specified time.

Now to the analysis.

Red Flag 1: The Transaction Itself

The first red flag - and the major one - was the transaction itself.   This should have perked up the credit officer's antennae and made him or her extremely sensitive to another further "red flags' in the transaction.

ABK should have asked itself why on earth apparently very small companies were asking for a payment guarantee for a company of the stature of STCFS. Both buyer and seller are in AlKhobar.   In AlKhobar/Dammam, Mr. AlSanea is سمك كبير (big fish).  He and his companies are very well known. At that time he was on the Forbes list of richest people in the world.

A second relevant question would be why a company of STCFS' stature would entertain such a request. It would seem a likely bet that companies would be falling all over themselves to deal with STCFS. So, it could just simply say "no" and there would be another potential seller knocking at its door.

Perhaps, STCFS was doing a bit of charitable work to help develop local small and medium enterprises in the Kingdom? And so it would be willing to entertain a request that many large companies would find insulting.  Maybe it was helping out these companies.  A lot of small companies don't have access to credit  - especially for amounts in the millions of US$.  So when they don't already have the goods, then they ask their buyers to open an LC in their favor (the Original LC) and then use this LC with a bank to issue another LC (the Back to Back LC). The Back to Back LC is then used to acquire the goods from a third party to be sold to the buyer on the Original LC.  

However, the goods for these LCs are not being imported. According to the LC applications completed by STCFS, they are being shipped from the beneficiary's warehouse to STCFS's warehouse. It seems highly likely that the beneficiary already has the goods. So the LC appears to be serving as a simple payment guarantee for the obligations of a very major Saudi company.

We seem to be left with two main explanations.

First, that local companies didn't want to take STCFS's credit. And that STCFS has no other option (no other suppliers) so it must grant the request for the LC. If true, that should be an extremely troubling sign to ABK. Something is really wrong at their client. I remember reaming one of my subordinates who approved (interesting coincidence) four domestic LCs for a client. Prior to that all of the client's LCs had been for foreign imports. The domestic LCs were therefore a change in pattern. A couple of them were for trivial amounts (US$100,000) which was a sign that the domestic trade would not take the client even for such a small amount. Yes, the client later hit the wall. Recovery was, if I remember correctly, five cents on the dollar.

Second, that the transactions themselves are not what they appear to be. That they are disguised financing. Several banks got "stuck" with such transactions between (Mainland) Chinese Red Chip Companies in Hong Kong and their affiliated companies on the Mainland.

Red Flag 2: No Title Documents

Generally, among the documents required under an LC are title documents. These are various forms of these, bills of lading etc, that represent ownership in the underlying goods shipped. The shipping company is only supposed to release the goods upon presentation of the B/L. 

At every financial institution I worked at the absence of title documents under an LC transaction was an exception and required special approval.

There were two reasons for this. 

First, the title documents gave reasonable evidence that there was an underlying trade transaction. The carrier was certifying that it took a certain number of crates or boxes on board its vessel or truck. And thus there was a third party – besides the applicant and the beneficiary – testifying to there actually being a trade transaction. 

Second, as long as the documents were in the bank's possession the bank could seize the goods. This provides the bank some collateral though usually for only a short time.

Without title documents, ABK essentially is issuing a standby letter of credit or guarantee. These transactions (if properly recorded in a bank's books) call for a higher risk weight for capital adequacy purposes and should therefore be priced higher than a commercial LC. Also given the credit implications, such transactions should be reviewed in detail to determine if their occurrence is an adverse sign.

Red Flag 3: Outside the Terms of the Facility

ABK's facility letter to STCFS states that the purpose of LC's is "to import building materials for SAAD Construction business". You'll find a copy as NYSC Document #18 which is Exhibit 7 to the Serio Affirmation of 22 December 2009 (NYSC Document #17). Mr. Serio is Mr. AlSanea's counsel in this case and others.

A domestic shipment is not an import.

This should have triggered a review by a credit officer. Again, the principle being that if a transaction does not meet the facility conditions, it is not under the facility.  Therefore, it requires special approval. There might have been good reasons to allow this transaction, though based on all the "red flags" present it seems to me that an approval should have had quite a steep hill to climb. Or perhaps  a mountain.

Red Flag 4: Troubling "Coincidences"

All the beneficiaries on these four LCs just happen to be clients of The International Banking Corporation, a company with a connection to Mr. AlSanea. What are the probabilities of this happening? 

A credit officer might also wonder why these rather small Saudi companies are banking with a foreign bank (TIBC) and not with a Saudi bank with an office the Kingdom. That would certainly seem to make more sense in terms of making their daily operations easier.  Nip around the block to do banking.  Rather than deal by phone, fax and courier with a bank in Bahrain. Or shlep across the Causeway to Manama.

Two of the beneficiaries had account numbers one digit apart. So our probabilities are getting even smaller. Not only are the beneficiaries customers of one foreign bank, but they appear to have opened their accounts one after the other. Of course, TIBC may have a very small number of customers. And, thus, the probability is not as small as it appears. 

To digress on a similar topic I remember the look of amazement when I pointed out to one distraught investor troubled by thought of losses on a "wise" investment in APP Holding Company bonds (Just how does one value air?) that the Singapore companies whose receivables Asia Pulp and Paper had just written off (a rather small sum of a couple of billion US dollars) were all from the Virgin Islands. And just by coincidence their Commercial Registration numbers were all in sequence. And all established by the same  local law firm.  And a check with the local Singapore "D&B" revealed these companies had no assets -- unless you count the equivalent of a folding table, two chairs and a phone line as assets. And that they apparently had received some administrative support from APP in the form of seconded personnel, etc. One explanation is, of course, that APP was helping aspiring small businessmen to get ahead. That it had extended them credit in the form of shipping paper products against deferred payments well in excess of what their financial condition warranted. And what better way to give them a leg up than to ship two or so billion dollars of paper products to them. That would give these small businessmen the clout to undertake major transactions. To literally transform their businesses. Unfortunately, this experiment which began with no doubt the best of intentions the year that APP hit the proverbial credit wall – but before it actually did - did not succeed. After selling the paper products, these companies for some reason didn't have the cash to settle their payables with APP. Perhaps some overhead that wasn't immediately apparent in their modest financials. So APP had to write off these receivables. No doubt reluctantly. But I suppose at least we should commend APP for its effort to give small businessmen a hand.

Two of the beneficiaries' (AlGamea and AlDelijan) description of the goods were identical down to the date of their pro-forma advices. Perhaps, 14 December was a particularly auspicious Feng Shui day for selling A/C goods. Or perhaps just another remarkable coincidence in a transaction with many. On the other hand, if STCFS were acquiring A/C equipment for a project, it would use one description for the goods. Sellers would necessarily parrot back this in their quotes to show they were supplying what the buyer wanted.

A strange saga.