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Rules & Regulations Governing Trade Services

The (Unintended) Impact on Exporters of the Rules & Regulations Governing Banks That Provide Trade Services

Buddy Baker [email protected] (312) 704-6942

mailto:[email protected]

Rules & Regulations - Buddy Baker 4

Speaker Bio: Walter (Buddy) Baker Walter (Buddy) Baker brings more than 30 years of experience in international trade finance to his current position as Vice President and head of Global Trade Solutions Delivery for Fifth Third Bank. Fifth Third is one of the 20 largest banks in the US and provides a full range of risk mitigation and financing products for exporters and importers. His professional experience includes earlier stints with Atradius Trade Credit Insurance, ABN AMRO Bank, Bank of America, Wachovia Bank, and The First National Bank of Chicago.

Buddy is a recognized expert in trade finance and makes frequent presentations for national associations of exporters, importers, bankers, and lawyers. He designed the online training/certification programs used by the Association of International Credit and Trade Finance Professionals (ICTF) and by the Association of Trade and Forfaiting in the Americas (ATFA) and the trade finance sections of the certification program used by the Finance, Credit and International Business Group (FCIB) of the National Association of Credit Management (NACM). Mr. Baker has authored numerous magazine articles and the books Users’ Handbook to Documentary Credits under UCP600, Documentary Payments & Short-Term Trade Finance, and The Regulatory Environment of Letters of Credit and Trade Finance. He serves as a member-at-large of the National Letter of Credit Committee of the Bankers’ Association for Finance and Trade/International Financial Services Association and is actively involved in establishing national and worldwide standard practices for LCs, such as the current version of the Uniform Customs and Practice for Documentary Credits (referred to as “UCP600”), the official ICC guide for examining letter of credit documents, called the International Standard Banking Practices for the Examination of Documents under Documentary Credits (“ISBP”), the eUCP supplement to the UCP dealing with electronic documents, the International Standby Practices (“ISP98”), and Article 5 of the Uniform Commercial Code. Buddy also serves on the Board of Directors of the Association of International Credit and Trade Finance Professionals (ICTF), a multinational association of export credit managers, on the Advisory Council of the Institute for International Banking Law and Practice, and on the Council on International Standby Practices.

Buddy earned his undergraduate degree at Yale University and his MBA at Northwestern. He can be reached at (312) 704-6942 or [email protected].



Rules & Regulations Pertaining to Exporting The Uniform Customs and Practice for Documentary Credits (“UCP”)

International Standard Banking Practice for the Examination of Documents under Documentary Credits (“ISBP”)

The eUCP

The International Standby Practices (“ISP98”)

The Uniform Rules for Demand Guarantees

Letter of credit law (e.g., Uniform Commercial Code, Article 5)

The Uniform Rules for Collections

Negotiable instrument law (e.g., Uniform Commercial Code, Articles 3 and 4)

The International Commercial Terms (“Incoterms”)

The U.N. Convention on Contracts for the International Sale of Goods (“CISG”)

Export licensing (e.g., the Export Administration Regulations (“EAR”) and International Traffic in Arms Regulations (“ITAR”))

FX controls

Sanctions against “enemy” countries (e.g., the Office of Foreign Assets Control and U.N. sanctions)

Antiboycott regulations

Anti-Money Laundering regulations (e.g., the USA PATRIOT Act)

Anti-corruption regulations (e.g., the Foreign Corrupt Practices Act)


What Banks Are Required to Do

Block any assets of parties located in sanctioned countries and of “Specially Designated Nationals” of those countries coming under control of the bank

Block any assets of “Designated Terrorists and Terrorist Organizations” and “Designated Drug Traffickers and Kingpins” coming under control of the bank

Not “implement” any letter of credit containing prohibited boycott language

Report every letter of credit containing reportable boycott language

Conduct due diligence on all “account relationships” of the bank

Report “suspicious activities”

Sanctions


Sanctions - Introduction

Definition: Action by one or more states toward another state calculated to force it to comply with legal obligations.

Sanctions are supposed to persuade rulers to change their military, economic, or human rights policies, so as to end wars, civil conflicts, or other crises that threaten international peace and security.

Sanctions are meant to bring about a change of behavior; they are not supposed to be punishment or retribution.

The U.N. Security Council imposes sanctions to enforce international law, but depends on member nations to actually enforce them.

The U.S. often takes independent action, usually before the U.N.


Sanctions - An Analysis

Typically, sanctions cut off trade and investments, preventing a target country from buying or selling goods in the global marketplace.

Sanctions aim at particular items like arms or oil.

They may cut off air traffic, suspend or drastically curtail diplomatic relations, block movement of persons, bar investments, or freeze international bank deposits and other property.

U.S. Office of Foreign Assets Control (OFAC)


Office of Foreign Assets Control

OFAC is a division of the U.S. Department of Treasury. It administers and enforces economic and trade sanctions against hostile targets to further U.S. foreign policy and security objectives.

“Enemy” countries

Individual sponsors of terrorism and any agency sponsoring terrorism

International narcotics traffickers


Office of Foreign Assets Control

Many of OFAC sanctions are based on United Nations or other international agreements. As such, they are multilateral in scope and involve close co-operation with concerned governments.

OFAC acts under Presidential wartime and national emergency powers and under the authority granted by specific legislation to authorize imposing of controls on trade transactions and foreign investments and even freeze foreign assets that may come under U.S. jurisdiction.


OFAC Sanctions Apply to…

U.S. residents or nationals

This includes-

Individuals

Any partnership, corporation, company, association, or other entity organised under U.S. law

U.S. companies’ foreign subsidiaries, partnership affiliates, branches, offices, or other permanent foreign establishments that are controlled in fact by such U.S. company

The government of the U.S. or any department, agency or commission thereof; the government of any state of the U.S., the District of Columbia, the Commonwealth of Puerto Rico, any territory of the U.S. or any subdivision, department, agency, or commission of any such government


Role of Banks…

U.S. banks & U.S. branches of foreign banks must comply in all respects with the laws, policies, and regulations of the United States Department of Treasury.

They are like a ‘front-line’ defense against foreign threats to U.S. interests.


Role of Banks… Enforce sanctions against imports and exports of any goods and services

from/to: – Sanctioned countries

– Specially Designated Nationals (SDNs)

– Specially Designated Terrorists (SDTs)

– Specially Designated Narcotics Traffickers (SDNTs)

– Foreign Terrorist Organisation (FTOs)

– Blocked Persons (companies and individuals)

Block or freeze property and payment of any funds transfers or transactions intended for these entities.

Report all blocked property to OFAC within 10 days of occurrence.

This does not mean the bank returns the funds or property they’ve received. They must hold the funds/property on behalf

of the U.S. Treasury Department.


Property…

Property includes

Money, checks, drafts, bullion, bank deposits, savings accounts, debts, indebtedness, obligations, notes, debentures, stocks, bonds, coupons, financial securities, BANKERS’ ACCEPTANCES, mortgages, pledges, liens or other rights in the nature of security, property, warehouse receipts, B/Ls, TRUST RECEIPTS, bills of sale, any other evidences of title, ownership, LETTERS OF CREDIT, powers of attorney, goods, wares, chattels*, stock on hand, ships, goods on ships, vendors sales agreements, land contracts, real estate interests, lease holds, rents options, NEGOTIABLE INSTRUMENTS, TRADE ACCEPTANCES, royalties, account payable, patents, trademarks, copyrights, insurance policies, safe deposit boxes, pooling agreements, contracts of any nature.

* Moveable possessions


General & Specific Licenses

A license is a permit issued by OFAC allowing an activity that would otherwise be prohibited by sanctions.

A General License allows certain types of transactions described in the regulations. (A General License is not a document.)

In the other cases, the shipper or importer can apply for a Specific License. (A Specific License is a document. It is signed and on U.S. Treasury Department stationery.)


U.S.-Sanctioned Countries (and Their Agents) Include:

Broad Cuba Iran North Korea* Sudan Syria

Limited to Specific Individuals The Balkans Belarus Burma (Myanmar) Congo, Democratic Republic of Iraq Ivory Coast Liberia Libya Russia (Sectoral Sanctions) Somalia Zimbabwe

* Imports are prohibited; exports are permitted.

http://www.treasury.gov/resource-center/sanctions/Programs/Pages/Programs.aspx

In addition, importation into the U.S. of rough diamonds from any country is prohibited without certain documentation proving the country of origin.


Penalties

Fines: USD50,000.00 to USD1,075,000.00 per count

Criminal Penalties – Up to 20 years in jail

Certain violations, e.g., money laundering, can carry more adverse consequences

Loss of reputation due to adverse publicity

If a bank participates in a transaction that violates OFAC regulations and a correspondent bank, freight forwarder, airline, etc., detects the omission, they are obligated to report that bank

to OFAC.


What Banks Actually Do

Check the names and addresses of all parties and the routing instructions in all letters of credit (import, export, standby) against the OFAC lists and various lists of “bad people,” like the list of Denial Orders, and Politically Exposed Persons; refuse to issue or advise L/Cs that involve any such people

Check the names and addresses of all parties and actual routing of goods in letter of credit documents against the OFAC lists and the lists of “bad people”

Block both funds and documents if any people or countries from the OFAC lists show up in the documents



Include language of the following sort in transferable letters of credit:

– “This letter of credit may be transferred, however, the name of any proposed transferee must be provided to us for approval prior to any transfer being effected.”

– “This letter of credit is transferable. Transfer to any parties under this letter of credit is subject to the United States Office of Foreign Assets Control regulations in force from time to time.”

This has, however, become problematic…


Sanctions Clauses Used in Letters of Credit

Were originally used by foreign branches of U.S. banks to remind parties that they will follow U.S. law and regulations

Are not standardized

Are generally not objectionable when they simply inform the parties

Are objectionable when they give the issuer discretion as to whether or not to honor

Are objectionable when they are unnecessarily complex

There is no requirement for banks to include sanctions clauses in L/Cs

The best sanctions clause merely reminds the parties to the L/C that the bank follows U.N., U.S., etc., sanctions



An example of a simple, informative sanctions clause is:

Presentation of document(s) that are not in compliance with the applicable anti-boycott, anti-money laundering, anti-terrorism, anti-drug trafficking, and economic sanctions laws and regulations is not acceptable. Applicable laws vary depending on the transaction and may include United Nations, United States, and/or local laws.



An example of a more complex sanctions clause that brings into question the bank’s obligation is:

[Bank] complies with the international sanctions laws and regulations issued by the United States of America, the European Union, and the United Nations (as well as local laws and regulations applicable to the issuing branch) and in furtherance of those laws and regulations, [Bank] has adopted policies that in some cases go beyond the requirements of applicable laws and regulations. Therefore [Bank] undertakes no obligation to make any payment under, or otherwise to implement, this letter of credit (including but not limited to processing documents or advising the letter of credit), if there is involvement by any person (natural, corporate or governmental) listed in the USA, EU, UN, or local sanctions lists, or any involvement by or nexus with Cuba, North Korea, Sudan, Iran, or Myanmar, or any of their governmental agencies.

U.S. Anti-Boycott Regulations


What Are We Talking About?

Boycotting of countries, individuals, companies, and products

Regulations prohibiting U.S. Persons from participating in another country’s boycott by:

– Refusing to do business (with blacklisted firms & friendly countries)

– Discriminating (based on race, religion, sex, or national origin)

– Furnishing individual information (about race, etc.)

– Furnishing business information

Public disclosure of participation in a boycott

The point of the anti-boycott regulations is to prevent U.S. entities from being used as pawns in someone else’s game


Structure of Boycotts

1. Primary Boycott

Syria refuses to trade with the country of Israel.

Countries are free to boycott one another. U.S. Persons may comply with a Primary Boycott, by contracting not to ship goods from a boycotted country, but must report receipt of requests to comply.

Permissible but Reportable

Example: Goods of Israeli origin prohibited



2. Secondary Boycott

Syria refuses to trade with anyone who does business with Israel. Syria develops a “black list” of those trading with Israel.

U.S. Persons may not comply with a request to participate in another country’s boycotts and must report receipt of requests to comply.

Prohibited and Reportable

Example: Certificate that goods are not of Israeli origin



3. Tertiary Boycott

Syria refuses to trade with anyone who does business with those on Syria’s “black list.”

U.S. Persons may not comply with a request to refuse to do business with people on a “black list” and must report receipt of such requests.

Prohibited and Reportable

Example: Certificate that the exporter does not do business with companies on the Saudi Arabian “black list”


Other Concerns

“White List” A list of companies, etc. that a country is willing to do business with. Opposite of a “black list” but is considered Reportable and Prohibited.


Role of Banks…

No bank may issue, pay, honor, confirm, or otherwise “implement” a letter of credit that contains a condition or requirement, compliance with which would violate a prohibition of the Export Administration Act.

A bank may, however, advise a beneficiary that there exists a letter of credit in his favor.

It is not clear whether the bank may deliver a copy of the letter of credit to the beneficiary before Prohibited language is

deleted.


Role of Banks…

Review letters of credit and documents

Identify boycott-related language

– Reportable but not Prohibited

– Reportable and Prohibited

– Neither Reportable nor Prohibited

Report findings


Penalties

Fines are imposed by the Department of Commerce.

Fines can be for “implementing” an L/C with Prohibited language, for failing to report an LC with Reportable language, or for late reporting.

Fines may be for up to USD50,000.00 per violation -- more for repeat offenders and serious violations.

Criminal penalties maybe sought against individual for up to USD50,000.00 and or up to 5 years in prison.

Companies can also have their export privileges denied.



Read every export L/C before advising it to catch boycott language; obtain amendments when necessary before advising and file reports when required

Examine documents presented under export L/Cs for prohibited and reportable language; refuse documents with prohibited language (get the language removed); file reports when necessary

USA PATRIOT Act


What Is Money Laundering?

Money laundering is the process of integrating the proceeds of crime into the legitimate stream of financial commerce by masking their origin

A process to make illegitimate funds appear legitimate

Seeks to conceal or disguise the existence or source of funds

Facilitates crime by allowing criminals to maintain control over such funds after they’ve been laundered

Involves more than handling deposits of large amounts of cash – may involve elaborate systems of loans, wires, purchase and sale of goods, front companies, and shell banks


Example 1

Trade price manipulation - sell something for nothing:

Move USD1,000,000 from U.S. drug dealer to foreign drug supplier through U.S. export at low price

1. U.S. drug dealer has USD1 million cash from street sales to pay to foreign drug supplier

2. Dealer buys 200 Rolex watches at USD5,000/ea (pays USD1,000,000 cash)

3. Dealer exports watches to foreign supplier at USD5.00 each (receives USD1,000)

4. Foreign supplier sells 200 Rolex watches at USD5,000 each = USD1,000,000


Example 2

Trade price manipulation - buy nothing for something:

Move USD1,000,000 from U.S. drug dealer to foreign drug supplier through U.S. import at high price

1. U.S. drug dealer has USD1 million in bank deposits to pay to foreign drug supplier

2. Foreign drug supplier buys 10,000 pencils at equivalent of 10 cents (USD1,000) locally

3. Foreign drug supplier sells 10,000 pencils to U.S. drug dealer at USD100 each

4. U.S. drug dealer pays USD1,000,000 to foreign drug dealer


Activities That Need Money Laundering

Criminal activities – Primary objective is financial gain

Terrorism – Primary objective is to intimidate

a population or to compel a government to do or abstain from doing an act

Both terrorism and other criminal activities must develop: – Sources of funding

– Means of laundering those funds


Sources of Terrorist Financing

Some governments sponsor terrorists

Illegal revenue-generating activities – Kidnapping

– Extortion

– Large-scale smuggling

– Fraud

– Thefts and robberies

– Narcotics trafficking

Income derived from various “legal” activities – Community solicitation

– Fundraising by charitable or relief organizations

– Donations


The USA PATRIOT Act, Section 326

Requires banks to establish and maintain Customer Identification Programs (“CIPs”) for ALL persons seeking to open “accounts”

Applies to federally-regulated financial institutions, including US offices of foreign banks

Minimum requirement is to obtain and verify

– Name (and birth date for individuals)

– Address

– Tax ID

– …then keep a record


Penalties

Reputational damage

Supervisory penalties – Possible loss of banking charter

– Other enforcement actions

Civil monetary penalties

In some cases, criminal penalties – Fines

– Jail

Disciplinary action/termination of employment


Elements of an AML Compliance Program

A Customer Identification (Know Your Customer)/Enhanced Due Diligence Program that provides for identification of clients at account opening or inception of a business relationship and collection/verification of additional information commensurate with the risk assessment

A process to identify high-risk customers for on-going transaction monitoring and enhanced due diligence

Procedures to identify and report suspicious transactions to government authorities


When Is Customer Identification Required?

Before a “relationship” is established with any new client, anywhere in the bank, a due-diligence process known as a Customer Identification must be undertaken

“Relationship” is not defined in the regulations, but can be taken to involve some formality

– New credit facilities always require approval

– New depositary accounts always require approval

– Repetitive or large transactions may justify approval

“Increased risk” clients require Enhanced Due Diligence (“EDD”)


Applicability to Global Trade Services Departments at Banks

Trade transactions, by definition, involve 2 parties – A bank will not usually deal directly with both parties, but with one party

and the other party’s bank – For the purposes of KYC, there are 2 potential customers in a trade

transaction, the domestic corporation and the foreign bank Who is considered the customer depends on the type of transaction Although the bank must know their own customer, it is not necessary to know

the customer’s customers (or suppliers)



Make sure a KYC due diligence review has been conducted on the parties with whom an “account relationship” seems to exist (most banks use the IFSA guidelines as to what constitutes an account relationship under a letter of credit)

Decline transactions where no appropriate party can be properly identified and classified as a desirable relationship

Return and/or report all “suspicious transactions,” e.g., where the value of the goods seems out of line or the type of goods seems out of character for the business the buyer and/or seller appear to be in.

Suspicious Activities


Red Flags for Suspicious Activities

Politically Exposed Persons (“PEPs”)

Individuals who have or have had senior positions of public trust such as government officials, senior executives of government corporations, politicians, important political party officials, etc. and their families/close associates

Examples of PEPs: heads of state, government/cabinet ministers, senior judges, senior political party functionaries, members of royal families, etc.

Denied Parties

Companies that have had their export privileges revoked or suspended, making it illegal for them to sell U.S. products to foreign buyers

PEPs and Denied Parties are added by many services to the list of

Specially Designated Nationals so a subscriber can search on all at once.


Suspicious Trade Transactions

The customer engages in transactions that are inconsistent with the customer’s business strategy or profile (e.g., a steel company that starts dealing in paper products) or make no economic sense

A customer deviates significantly from its historical pattern of trade activity (in terms of markets, monetary value, frequency of transactions, volume or merchandise type)

Transacting parties appear to be affiliated, conduct business out of a residential address, or provide only a registered agent’s address

Customer that conducts business in jurisdictions that are at higher risk for money laundering, terrorist financing, or other financial crimes

Customer shipping items to, through, or from higher-money-laundering-risk jurisdictions including countries identified by the Financial Action Task Force as “non-cooperative jurisdictions” as regards anti-money laundering regulations



Customers transacting in activities/goods that potentially involve a higher risk of money laundering and other financial crimes including activities/goods that may be subject to export/ import restrictions

Obvious over- or underpricing of goods

Obvious misrepresentation of quantity of goods shipped

The payment terms or tenor are inconsistent with the type of goods

Transaction structure and/or shipment terms appear unnecessarily complex or unusual and designed to obscure the true nature of the transaction

The L/C contains non-standard clauses or phrases or has unusual characteristics

The L/C is frequently significantly amended for extensions, changes to the beneficiary and/or changes to payment location



The transaction appears to involve the use of front or shell companies for the purpose of hiding the true parties involved

The bank is approached by a previously unknown party whose identity is not clear, who seems evasive about their identity or connections, or whose references are not convincing, or payment instructions are changed at the last minute

Trade-related documentation under an L/C or documentary collection appears illogical, altered, fraudulent, or certain documentation is absent that would be expected given the nature of the transaction

Transaction involves obvious dual-use goods

Questions?

Basel Accords Requirement Basel I Basel II

2013 Basel III

2015

2019

Common Equity 2.0% of RWA 3.5% of RWA 4.5% of RWA 4.5% of RWA

Tier 1 Capital 4.0% of RWA 4.0% of RWA 4.5% of RWA 6.0% of RWA 6.0% of RWA

Total Capital 8.0% of RWA 8.0% of RWA 8.0% of RWA 8.0% of RWA 8.0% of RWA

Capital Conversion Buffer -0- -0- +2.5% of RWA

Counter Cyclical Buffer +Up to 2.5% of RWA

Additional Loss Absorbency +1% to 2.5% of RWA

Leverage (based on Tier 1 Capital) (based on Total Capital)

Observation Observation 3% of direct and contingent assets

(4% of direct assets)

Liquidity Coverage Observation 21 days (30 days)

21 days (30 days)

Net Stable Funding Observation Observation 1 year

The amount of Risk-Weighted Assets (“RWA”) is computed by multiplying the amount of each asset and contingent asset by a risk weighting and a Credit Conversion Factor (“CCF”) Under Basel I, risk weightings are set: 0% for sovereigns, 20% for banks where tenors ≤ one year, 50% for municipalities and residential mortgages, 100% for all

corporate obligors Under Basel II, risk weightings are based on internal or external (rating agency) risk ratings with no special distinction for banks; capital requirements for

exposures to banks are increased by as much as 650% (from 20% to as much as 150%) The Credit Conversion Factor for Letters of Credit varies under Basel I vs. Basel II and Basel III

Under Basel I, this is 20% for commercial L/Cs, 50% for performance standbys and 100% for financial standbys; confirmation of a commercial letter of credit has a capital requirement of 0.32% (8% x 20% x 20%)

Under Basel II and III, “Sophisticated Banks” are required to do a statistical analysis of losses based on structure (and, due to limited losses, there are insufficient loss data for any bank in the world to do this for letters of credit, resulting in using the default CCF of 100%; under Basel II, the capital requirement to confirm a letter of credit can jump from 0.32% to 12%, viz., 8% x 150% x 100%; under Basel III, it can be as high as 23.25%, viz., 15.5% x 150% x 100%)

In the US, Basel II only applies to “Large, Internationally-Active Banks”--the 9 largest commercial banks fit the definition; as of January 1, 2013, Basel III applicability has not been finalized, but is proposed to remain the same

The Leverage ratio does NOT apply risk weightings or credit conversion factors; the ratio is 100% for all direct and contingent assets except performance-based standbys (50%) and commercial L/Cs (20%)

The Additional Loss Absorbency requirement applies only to “Globally Systemically Important Banks” Depending on the bank and the point in the economic cycle, under Basel III, the total capital requirement for a bank in 2019 may be as much as 15.5% of Risk-Weighted

Assets (“RWA”), compared with 8% under Basel I and Basel II

Under Basel I, confirmation of a commercial letter of credit has a capital requirement of 0.32% Under Basel III, it can be as high as 23.25% Banks will need to charge 4.2% per annum to get a Return on Capital of 18% and 72 times as much to get the same Return on Capital as before!

The Impact on Exporters of the Rules & Regulations Governing Banks That Provide Trade Services

Buddy Baker [email protected] (312) 704-6942


Rules & Regulations Governing Trade Services