Deep Background
February 8, 2021

Collateral Damage: How Lenders Lose Billions on Fake Commodities and Forged Documents

By: Jingyi Blank and Ian Casewell

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FraudNet recently published an article by Jingyi Blank and Ian Casewell discussing how lenders lose billions on fake commodities and forged documents. The article is included below, and you can view the piece in FraudNet here.

Diamonds aren’t always forever, as a leading European bank discovered when its collateral stash of the world’s most precious stone went missing. In China, a bank was sure all that glittered was gold, but found the billions in “bullion” they lent against was actually gold-plated copper.

Lenders are just as easily scammed over more pedestrian commodities like pig iron and liquor or, quite often, just paper – forged documents representing ownership of stock, real estate, ships, airplanes or automobiles. 

One of history’s most famous frauds involved a product on nearly every kitchen shelf, and landed a crucial investing win for the not-yet famous Warren Buffett. In the 1963 “Salad Oil Scandal,” a consortium led by American Express lost the 2020 equivalent of $1.5 billion by lending against a giant New Jersey tank farm supposedly filled with soybean oil. When the borrower defaulted, lenders discovered their collateral was mostly seawater, with just a little salad oil floating on top, according to “The Great Salad Swindle” by Norman C.  Miller.

According to a November 2015 New York Times article, “American Express was far from blameless in the scandal. An anonymous tipster explained [the] swindle to the company in 1960, including [the] method for filling tanks with seawater except for a narrow chamber of oil positioned under the measuring hatch. The accusations were largely ignored, and the fraud grew tenfold over the following three years, until American Express had guaranteed more soybean oil than actually existed in the entire country.”

Buffett, who famously said “be fearful when others are greedy, and be greedy when others are fearful,” saw a buying opportunity when American Express shares “tanked” in the scandal. He reportedly invested 40 percent of partnership assets into the financial services giant, and in short, more than doubled their money, according to a May 2017 Motley Fool article.

Bankers and debt owners today still face audacious fraudsters and are deploying ever more intensive due diligence measures to thwart collateral scams before they happen. If a fraud does occur, sophisticated investors speedily engage teams of experienced asset tracing detectives to recover the maximum amount possible.

Jingyi Blank leads the Hong Kong office of Mintz Group, providing due diligence and asset tracing services on every continent. While she manages high-stakes global investigations, Jingyi is not your typical private detective. Her first career was in finance, making loans and structuring deals in risky commercial transactions. In other words, Jingyi knows collateral, how it’s managed and what can happen when lenders aren’t conducting appropriate due diligence.

Opportunities for Fraud Fueled by Record Debt

Global debt surged to a record $258 trillion in the first quarter of 2020, and debt levels are continuing to rise, according to the Institute for International Finance (IIF). The IIF reported in July 2020 that the Q1 2020 debt-to-GDP ratio jumped by over 10 percentage points to 331 percent – a record high and the largest quarterly surge on record. As leverage levels rise globally, “secured lending” is usually seen as the safest option because lenders have access to underlying collateral, especially when borrowers have poor or no credit history. However, the due diligence process for verifying this collateral and background checking of borrowers is fraught with challenges.

From Gold to Pig Iron to Liquor

In July 2020, Wuhan Kingold Jewelry Inc. (Kingold), a NASDAQ-listed jewelry maker, was accused of having passed off 83 tons of gilded copper as gold bars to obtain RMB 20 billion (approximately US $2.9 billion) in financing from at least 12 institutional lenders in China, according to a Caixin article from that time. It could be China’s largest loan scandal by value, according to the South China Morning Post. It’s odd no one noticed that the “gold bars” were so light; copper is less than half as dense as gold. Perhaps no one bothered to undertake a physical inspection of the “gold”?

In another form of gold fraud, a company may lease gold from one bank and use the borrowed gold as collateral to borrow from another financial institution. In 2014, the Chinese National Audit Office reported that 25 Chinese companies had obtained more than RMB 94 billion (approximately US $15 billion) in loans over two years in this manner, according to a June 2014 Financial Times article.

In the past, we have worked on fraud involving tens of thousands of tons of Brazilian pig iron – a key steelmaking ingredient – that had been pledged as collateral to a European-headquartered bank. Upon inspection, the bank discovered that bags of sand were substituted for the pig iron, and pursued legal action against the borrower.

Sometimes lenders continue to take risks on unusual collateral previously proven to be troublesome. In April 2020, a department store in China’s Guizhou province pledged more than 1 60,000 bottles of Moutai liquor for a RMB 230 million (approximately US $34 million) loan from the Bank of Guiyang, according to a Sina article from that time. So far, the 2020 loan is not known to be problematic, but in a well-known 2013 case, four Hangzhou province fraudsters were apprehended for taking about RMB 200 million (approximately US$ 33 million) in loans against more than 8,000 bottles of fake vintage Moutai, according to a December 2013 Sohu article.

Alcoholic beverages provide attractive opportunities for counterfeiting. Moutai is China’s “national liquor” and its producer, Kweichow Moutai, is currently the world’s most valuable spirits company, according to a June 2020 BBC article. In 2010, a genuine bottle of vintage Moutai could retail for up to $4,400, while a fake could be produced for a fraction of this amount. There are also well-known cases of fraud with other alcoholic beverages such as wine.

Fake Collateral, Forged Documents

The use of fake commodities often goes hand-in-hand with forged documents to create the appearance of authenticity. In a well-known case in 2014, a Chinese metals company, Dezheng Resources, was caught using fake certificates and receipts for copper and aluminum at a warehouse in Qingdao. In fact, Dezheng duplicated those documents to pledge the same fake collateral to at least 13 banks, creating losses of over $3 billion, according to a December 2018 Reuters article.

Companies facing financial trouble may also sell pledged collateral without the knowledge of their lenders, as with the recent case involving Hin Leong Trading. In early 2020, battered by Covid-19 and the sharp fall in global oil prices, the Singapore firm – formerly one of Asia’s largest oil traders – was found to have covered up about $800 million in trading losses, and had sold oil inventory that it had pledged to banks as collateral, according to a June 2020 Business Times Singapore article.

As of April 2020, Hin Leong owed approximately $4 billion to at least 23 banks, and had less than $200 million in oil inventory and cash, according to media reports. In August 2020, Hin Leong’s founder, Lim Oon Kuin, was also charged for instigating an employee to forge a document stating that the company had transferred one million barrels of oil to another company; this document was used to secure a further $56 million in financing, according to an August 2020 Straits Times article.

Lenders Impacted, Opportunities Available

While the full extent of the fallout from the collapse of Hin Leong, and a number of other Singapore-based commodity traders like Hontop, Zenrock and Agritrade remains to be seen, lenders have curbed their exposure to commodity traders after a string of collapses and scandals globally, according to various press articles. In a contrarian move in September 2020, Deutsche Bank announced plans to increase lending to commodity-trading firms in the Middle East, “even as other banks back away after a spate of defaults in the industry, to help double the size of its business in the region.” Clearly, when some investors retreat after a painful loss, others are ready to make significant new investments to seize a perceived opportunity.

Due Diligence as Competitive Advantage

Savvy lenders, investors, and insurers conduct background checks before they part with money. They conduct due diligence of the other party’s business practices and reputation, verify authenticity of the commodities and documents provided in the transaction through inquiries with people relevant to the transaction, and conduct site visits. Most fraud takes place at local levels so it is important to get on-the-ground intelligence. For example, in the Qingdao case, global lenders thought they were dealing with international storage facilitators, but these companies were in turn using local warehouse operators to store the metals. Thus, the corruption that resulted in the forged documents and missing metals likely occurred at the lowest levels, according to media coverage of the lawsuits filed after the fraud was uncovered.

We began with diamonds and will end this article with a story that is still unfolding. A major European bank became frustrated with non-payment on a more than $300 million line of credit issued to a major diamond producer with global operations including in India, Belgium, Israel, Dubai and Angola.

The borrower repeatedly failed to make payment and their most recent exchanges with the bank were caustic – “a complete breakdown of [the] relationship” to quote one of the parties involved.

Suspecting fraud, the bank held a board meeting, and engaged lawyers and investigators. They served the diamond producer’s principal owner at his residence, then went to the firm’s nearby headquarters to serve more papers and inspect the bank’s primary collateral: numerous bags of diamonds worth hundreds of millions of dollars.

Once the firm’s vault was open, the bankers expressed relief that the bags they expected to see were there. But their hopes were dashed when they opened the bags and found diamond dust – an industrial product of much, much lower value than the diamonds they were expecting.

The asset search is on. To be continued …

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