Can PNB Blame Foreign Bank Branches for Nirav Modi Scam?

The PNB are trying to say that foreign bank branches were also at fault for the NIrav Modi scam, but this won’t fly.

Who exactly is responsible for the whole PNB-Nirav Modi fiasco? Is it Nirav Modi himself, whose diamond trading firms used irregular LoUs to get money from foreign branches of Indian banks, without paying the required collateral? Is it the diamond trading firms but not Modi? The PNB officials who issued the LoUs and operated them outside the bank’s proper framework? PNB itself?

The CBI will no doubt investigate the role played by each of these parties, among whom the fault for the scam will lie in varying degrees. The headlines will of course belong to the allegations of fraud and the anger that Modi has been able to leave the country and get away. However, this kind of thing will keep happening unless we understand the institutional failures that made it possible.

PNB’s failure to detect the fraud is obviously one, and the bank is having to agree to pay astronomical sums of money to the foreign branches of Indian banks who aren’t getting their money back from Modi’s firms.

But what about those foreign banks themselves? Should they have been able to detect that these LoUs were wrongly issued? Can the PNB claim that they don’t have to pay back the full amounts requested by these foreign branches?

PNB Attempts to Put Blame on Foreign Branches

PNB has attempted to lay at least some of the blame on the foreign branches in both their complaint to the CBI as well as their ‘caution notice’ to other banks. Citing RBI guidelines which say that credit for import of precious stones like diamonds should not be for more than 90 days, they point out that the LoUs were often for longer periods, including some which extended to 360 days.

According to their complaint (dated 13 February 2018):

This should have evoked suspicion in the minds of overseas branches of Indian banks extending buyers credit. These banks never raised any alarm on violation of RBI guidelines and continued to provide funding against fraudulent LoUs… There is no documentary evidence available to prove that these import transactions are bonafide trade transactions. There are several discrepancies in LoUs which could have been easily detected by ordinary due diligence.

Basically, the embattled bank has tried to claim that the documents used to obtain funds from the foreign branches were so obviously wrong, the foreign branches should have raised red flags about them, rather than give money for Modi’s firms to pay their overseas suppliers. As a result, they claim that there must have been “criminal connivance” of the officials of the overseas branches of Indian banks, as they put it in the caution notice.

According to the Economic Times, the investigating agencies are exploring this angle, and officials of the overseas branches are likely to be questioned about their role and why the RBI guidelines were overlooked in the transactions. If such a link is in fact found, no doubt the PNB will look to use this to reduce their liability.

Did the Foreign Branches Contribute to the Fraud?

There are two ways in which the foreign branches could be responsible:

1. By actively conspiring to help make the scam happen – this would open them up to criminal charges of fraud, which could mean the LoUs become void and so PNB won’t have to pay them;
2. By failing to have conducted sufficient due diligence on the LoUs – which would amount to violations of RBI guidelines.

PNB has tried to allege both of these, but the CBI would have to find some solid proof for the first to show that there was collusion, and this is likely to come up after much more investigation.

The second, however, would be relatively easy to prove, if:

• The foreign branches had a duty to scrutinise the terms of the LoUs including checking the duration of credit;
• The LoUs violated RBI rules; and
• The foreign branches failed to do what they needed to.

Unfortunately for the PNB, establishing any of these things seems unlikely.

Foreign Branches Didn’t Have Extensive Due Diligence Duties

First, it doesn’t look like the foreign branches had to scrutinise those LoUs in detail. According to Jayesh H, founder partner at Juris Corp:

The foreign branches of these banks would not be required to conduct extensive due diligence on the LoUs which they were asked to extend credit on… Given that all this was done through SWIFT, that itself is enough to satisfy due diligence requirements under global banking standards.

The foreign branches would not have been expected to actually go into the terms of the LoUs, and so didn’t need to examine whether or not the term of credit went beyond 90 days. They may have had to do this if these transactions were out of the ordinary, or the LoUs were presented separately to the bank, but this wasn’t the case for Modi’s firms. The LoUs from PNB were all notified to the foreign branches through SWIFT, the international electronic payment messaging system that is used to send secure, standardised messages.

A bank’s SWIFT system cannot be accessed by just anybody – only authorised representatives can use the system, which requires specific keys and codes to be used. As a result, if something like an LoU is notified to a bank through SWIFT, banks around the world will consider this to signal that everything is fine with it, and won’t have to examine all the thousands of transactions they have to deal with on a daily basis.

Abizer Diwanji, partner and head of financial services at EY, confirmed the same thing to BloombergQuint, saying:

If there is a SWIFT-tested coded message that is received then it means the counterparty bank has done its diligence... A SWIFT message is kind of taken as an effective contract.

Violation of RBI Rules?

Now it’s not as though just because SWIFT was used, the foreign branches didn’t have to care about anything. Apart from the rules to be followed in the countries they were based in (Hong Kong, Belgium, Bahrain, Mauritius and Germany), by virtue of being foreign branches/subsidiaries of Indian banks, they also had to ensure their operations complied with any relevant RBI rules.

It is true that the RBI does have some rules on how long credit can be allowed for import of precious stones like diamonds. Paragraph C.12.1 of the RBI Master Direction on Import of Goods and Services says that this “should not exceed 90 days from the date of shipment.”

However, ensuring that the LoUs complied with this was not the responsibility of the foreign branches. Jayesh H told The Quint that “The obligations under the RBI's Master Direction are upon the issuer of the LoU, not the recipient bank, or even the beneficiary.”

This means that it was the PNB which had to ensure compliance with those RBI requirements. A senior associate from the banking practice of a leading law firm clarified to The Quint that these deviations from the RBI guidelines didn’t mean that the LoUs were invalid. Just because the duration of credit was longer than 90 days doesn’t mean that the PNB won’t have to honour them – unless SWIFT messages from the PNB clearly mentioned this.

Where Does This Leave the PNB and Their Obligation to Pay the Foreign Branches?

As a result of this, if the CBI can’t prove that the foreign branches knew about the fraud and actively participated in it, the PNB is the only institution which failed to fulfil its duties – there are no mitigating factors which can change that. This means that even though there was fraud involved in the issue of the LoUs, the PNB will still have to pay all the dues out to the foreign branches, because they failed to have sufficient security in place.

For the foreign branches and the RBI, however, this could be a useful moment to reflect on improving the regulatory system which allows something like this to happen. They must obviously take care not to over-regulate, but it would be worth setting in place some more detailed due diligence obligations on foreign branches/recipient banks in such situations, to add another reasonable layer of protection.

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