Spotlight on Commodities Disputes – Civil Fraud
In this article we take a look at six recent commodities cases involving fraud to identify key areas of risk and ways to mitigate it. The article is structured as follows:
A. Analysis of recent fraud trends and developments in the commodities space, key issues from the cases, expectations for the future, and practical steps which can be taken to help reduce the fraud risk.
B. Key takeaways from the six cases. For more detailed summaries of the six cases click here.
Part A – Analysis
Commodities fraud: trends and developments
Fraud has been a real theme of recent cases. Several high profile and high value international warehouse receipt frauds were uncovered between 2017 and 2019, which have generated three of the cases we feature. The remaining three cases give a sense of the wider landscape for potential fraudulent activity in the market. They concern a mis-performance ‘carousel’ in relation to an oil transaction, a bill of lading fraud and a cyber-hack that led to the fraudulent notification of payment details.
Commodities frauds tend to follow established patterns, with most of our cases examples of at least one of the following:
- Type 1: bad document fraud – the fraudster provides a fraudulent document (e.g. an invoice, a receipt or a document of title) in a commodities transaction for assets, which may or may not actually exist. The document is often a forgery. The document does not give the rights over or title to the assets the defrauded party contracted and paid for.
- Type 2: double dealing fraud – the fraudster provides an apparently authentic document for assets that exist, but commits the same assets to multiple different counterparties. When the fraud unravels, there are multiple competing claims to an inadequate pool of assets.
- Type 3: spinning plates fraud – the fraudster lacks funds or assets to meet its immediate transaction obligations. It meets them by sourcing (often on false pretences) new funds or alternative assets. When the plates stop spinning, someone (usually the last person brought in) finds they have lost out, for example their funds or assets are gone with no replacements or payments forthcoming, or the assets due to them have already been used.
- Type 4: sham transaction fraud – the fraudster obtains finance from a lender on the basis of a misrepresented or fictitious transaction or tries to explain away its defaults with specious commercial rationale. The lender’s funds are used, the financed parties become insolvent or otherwise disappear and the lender finds itself out of pocket.
Commodities fraud: key issues from the cases
Knowledge gaps and due diligence
The cases demonstrate how knowledge gaps, and a lack of general transaction transparency in the market, create the opportunity for fraud. Natixis v Marex and EDF Man involved parties in repo chains not identifying warehouse receipts as forgeries; in Engelhart a bills of lading fraud was only discovered when an unexpected cargo was actually delivered. Knowledge gaps productive of fraud are potentially an even greater risk where parties trade with the fraudster in parallel with each other - as in Quadra (a double dealing type fraud, where the same goods in a warehouse were sold up to six times over).
The cases also emphasise the need for effective upfront and ongoing due diligence – especially on documents tendered in transactions. The industry remains heavily paper based and there is widespread use of more informal documentation. Informal papering, systemic knowledge gaps and ineffective general diligence practice create opportunities for a fraudster to capitalise.
Not all frauds can be caught early or easily. But the better the diligence systems in place to spot suspicious patterns or document irregularities aggregating, or to identify and challenge suspicious commercial explanations, the greater the chances of catching it (see practical steps below). Due diligence and risk mitigations need to be broad ranging and tailored to the circumstances. In Quadra, the buyer had inspected assets held for it in a warehouse (in bulk unascertained) but this was insufficient to expose the fraud, which was in the re-selling of those goods multiple times over. A key protection to consider against double dealing is having assets ascertained and segregated. If that is not acceptable or practical, the increased risk needs to be adequately priced in to the transaction.
Be careful what you sign
Euro-Asian Oil SA highlights the importance of a financing party exercising caution in counter-signing ‘trading’ documents - and being sure of the client and the client’s performance of the transaction when it does. On the facts, the Court held that a bank had assumed liability to its client’s trading counterparty for the client’s breach of warranties, which the bank did not know had been broken. The liability arose from the bank having counter-signed a letter of indemnity, supplied in lieu of title documents. The bank’s liability was as a secondary obligor, which meant that if the bank had to indemnify the counterparty it could recover those sums from its client. However, this situation is a risk for the bank since a ‘mis-performance’ by a client resulting in breach of warranty is likely to arise out of financial difficulty – and it did so on the facts.
Is there any hope if ‘they got me’?
The cases illustrate the suite of legal options potentially available to a defrauded party to recover its losses – claims in contract, claims in tort, claims in equity or claims on own account insurance policies. Appropriate insurance cover is a must, as frauds are often exposed when the fraudster gets into serious financial difficulty or has disappeared. However, insurance is not a substitute for effective due diligence and steps aimed at prevention. Some common acts of frauds may be outside the scope of standard policies, or those available at economic costs, or otherwise render certain policies unenforceable.
The mid-chain back to back repo problem
In EDF Man a defendant fraudster attempted an interesting argument that EDF Man, a mid-chain party in a series of back to back repos, had suffered no, or reduced, loss. The argument ran that the loss fell finally on EDF Man’s counterparty in an onward back to back – so EDF Man either suffered no loss, or only the amount it had taken EDF Man to settle that loss with the counterparty pre-trial. The Court rejected this argument, holding that back to back repos are legally separate transactions, that cannot be taken into account in calculating damages due in a different repo set. Being mid-chain in the repos can be a difficult place.
In Natixis v Marex, Marex, an ‘innocent’ mid-chain party, found itself held liable to its ‘innocent’ counterparty, Natixis, for having unwittingly delivered to Natixis forged warehouse receipts, which it had accepted in another set of repos. Marex could not rely on the legal rule of common mistake to avoid the Natixis repos; the Court held that Marex had assumed an obligation to deliver genuine receipts to Natixis under their repos, which impliedly allocated the risk of fraud to Marex. (Courts are likely to find an implied risk allocation in the terms of many commercial contracts that do not address the issue expressly). Marex could also only recover limited losses against the warehouse which had negligently mis-authenticated some receipts, as the Court upheld the warehouse’s exclusions of liability. Marex may have had other options for loss recovery not considered in the case – such as a claim direct against the fraudsters or on any insurance policy – but in reality, these may not have been available or viable (see section above).
The future
We expect to see more fraudulent activity - and fraud cases - in the times ahead. The pressures of the current economic climate are likely to cause defaults, which tend to expose as yet undisturbed frauds. Economic pressures may also lead to an increase in certain types of ‘new’ fraudulent behaviours, as some stressed market participants struggle to meet their obligations. More litigation may still filter through from other high profile, high value international frauds already exposed in the past few years, and from instances of fraud facilitated by less effective due diligence being possible during the pandemic. The prevalence of fraud in commodities cases is consistent with a wider trend for an increase of fraud claims in English banking litigation, which we track through our proprietary Court Intelligence Database (see our post here).
Digitalisation in the commodities markets has the potential to reduce frauds by making it easier to track transactions and scrutinise documents effectively; blockchain technology has the capacity to significantly improve transparency for commodities trading and financing, by providing a single consolidated source of truth in the market, updating in real time. These innovations should reduce those frauds which have relied on information and communication gaps between parties, allowing assets to be double pledged or documents to be doctored more easily. We will discuss innovation in trade finance further in part 2 of our Spotlight on Commodities Disputes.
Practical steps to reduce fraud risk
Fraud is, and is likely to remain, an industry risk but the steps that can be taken to reduce its occurrence and/or impact include:
- Transacting parties having robust risk and due diligence systems and processes, which are regularly reviewed and updated.
- Thorough and specific due diligence on the other parties, the transaction and the assets involved, both at the outset and throughout the transaction lifecycle.
- Following up suspicions or red flags and suspending further steps, if possible, until they are resolved. Questioning unusual transaction patterns and commercial rationales.
- Using reputable warehouses for commodities storage and checking their terms and conditions for unacceptable terms, particularly exclusions of liability.
- Checking underlying assets at warehouses (which ideally should be segregated) and ensuring comprehensive inspection reports.
- Careful scrutiny of documents and other communications for evidence of forgery or other fraud (e.g. unusual inconsistencies or consistencies).
- Building monitoring and information reporting requirements into transaction structures/documents, particularly of money and asset flows, and acting on issues these raise. Financing parties can use their industry knowledge to properly scrutinise this information (e.g. seasonal variations, comparing client vs market trends).
- If a financing party, exercising particular caution in counter-signing ‘trading’ documents – this can create unexpected liabilities (e.g. for warranties that may not be true).
- Seeking additional written confirmations of certain expectations in the transaction arrangements e.g. acknowledgement of payment owed to the financing party, specific endorsement on a credit insurance policy.
- Considering taking guarantees from parent or other group companies. Having appropriate own account insurance.
- Having a plan ready for if things go wrong – covering legal options and reputational mitigations.
- Seeking early legal and other professional advice.
Part B: Key takeaways from the six cases
1. EDF Man Capital Markets v Come Harvest Holdings Ltd [2022] EWHC 229
Key takeaway: in a high value warehouse receipt fraud, the claimant’s non-contractual claims, including in deceit and unlawful means conspiracy, succeeded. The Court rejected a defendant argument that there was no, or reduced, loss to the claimant because it had entered into back to back repos with another party. These back to backs were legally separate transactions, so could not be taken into account in calculating damages due to the claimant – which amounted to over USD280m. [Appeal outstanding].
A detailed case summary can be found here
2. Quadra Commodities SA v XL Insurance Company SE & Ors [2023] EWCA Civ 432
Key takeaway: an insurance policy against physical losses to property covered a trader’s losses in not having received commodities due to a substantial warehouse receipt fraud. The Court of Appeal upheld the High Court’s decision that the trader had a sufficient “insurable interest” in the commodities, which were stored in bulk, unascertained, in a warehouse, and that they had been “lost” by misappropriation, a covered loss.
A detailed case summary can be found here
3. Natixis -v- Marex and Access World Logistics (Singapore) Pte Ltd [2019] EWHC 2549
Key takeaway: the Court held that: (1) repos affected by forged warehouse receipts were not void for common mistake; (2) mis-authenticated warehouse receipts did not create contractual relations between the warehouse and a buyer before “attornment” (the warehouse’s acknowledgment that it held goods on behalf of the buyer) which had not occurred; and (3) the warehouse was liable for mis-representing the authenticity of some receipts, but its liability was limited under its standard T&Cs.
A detailed case summary can be found here
4. Euro-Asian Oil SA v Credit Suisse AG, Abilo (UK) Ltd, Mr Dan Igniska [2019] 1 All E.R. (Comm) 706
Key takeaway: In a transaction for the sale of oil, the Court of Appeal held that a bank was liable for its customer’s breach of the title warranties in a letter of indemnity the bank had counter-signed. However, the bank could recover any payments it was required to make under the indemnity in full from its customer.
A detailed case summary can be found here
5. Engelhart CTP (US) LLC v Lloyd's Syndicate 1221 for the 2014 Year of Account [2019] 1 All E.R. (Comm) 583
Key takeaway: The High Court held that an “all risks marine cargo and storage” insurance policy did not cover an insured’s loss for commodities fraudulently not shipped to it.
A detailed case summary can be found here
6. K v A [2019] EWHC 1118 (Comm)
Key takeaway: The High Court confirmed that a clause requiring payment to the seller’s bank meant the seller’s bank account at that bank, in the context of an email hack and fraudulently notified bank account details.