April 2022

Circular Trades or Financing Going in Circles? – What Happens When the Music Stops?

Circular trading: the practice of buying back a cargo at a higher price previously sold by the same trader can raise eyebrows. While the lack of a commercial benefit hints at the trade being fictitious, such circular trades in a pre-structured arrangement can serve a legitimate purpose of taking advantage of credit and financing positions. In close trusted loops, traders would sell and buy back their goods, trading off their credit positions rather than the physical delivery of cargo. As traders sought to leverage on their financing capabilities, the practice of credit sleeving emerged where an intermediary trader with better credit worthiness is inserted into a chain to sleeve its credit to a buyer of lesser financial muscle. But in recent times, circular trades have also been deployed to hide fictitious trades designed for the purposes of generating revenue on the books or for dressing up loans – where fake trade documents belie any genuine sale or even existence of cargo. For a margin, intermediary traders can be manipulated into inserting themselves into a chain to create opaqueness in fictitious or double financing schemes – with the risk that when the music stops, an assessment of its knowledge becomes key if it wants to enforce its claim.

This was the issue raised in Goodwood Associates Pte Ltd v Southernpec (Singapore) Shipping Pte Ltd [2020] SGHC 242 (“Goodwood case”). In that case, Southernpec (“SPPL”) as a buyer of oil alleged that it was not liable to pay its seller Goodwood on two broad grounds: (i) because Goodwood did not treat the sale contract as binding; and (ii) that Goodwood knew the transactions were a sham, i.e, designed for a purpose other than for the sale of fuel oil.

Knowledge not circularity is key to determining sham transactions

Goodwood was asked to facilitate the purchase of fuel oil from BMS to SPPL because the latter did not have a trading credit limit with BMS. As an intermediary of this purported trade, Goodwood received from BMS, ITT certificates curiously issued by SPPL confirming that the fuel oil transacted had been physically transferred on the vessel. Goodwood also received cargo release notices on SPPL’s letterhead which represented that the fuel oil traded was held in SPPL’s lawful possession.

This meant that at the time Goodwood was purporting to sell the goods to SPPL it would have known that the trade was circular with SPPL being involved somewhere earlier in the chain.

It transpired that not only were the Goodwood-SPPL contracts part of a circular chain of transactions starting with BMS but more importantly that the fuel oil was actually owned by Glencore and not by any of the six parties in the chain.  

In other words, the transaction appears designed to facilitate the movement of money to various parties in a chain with no actual corresponding delivery of goods. More akin to a loan, BMS would kickstart the loan by “lending” UA on Day 1 for the purported trade at a price of $445/ MT and on Day 30, BMS would receive repayment of its “loan” at US$460/ MT. When Taigu could not pay SPPL, the circular financing scheme unravelled with SPPL contesting its liability to pay Goodwood as the transactions were a sham. The Court held that the transaction was not a sham because a sham transaction required a common intention to mislead. Goodwood could not be said to have known that the structure was indeed a financing arrangement or that it was not receiving and passing good title (i.e., the cargo was owned by a third party).

In seeking to justify its non-payment, SPPL raised various peculiarities of the structure including the lack of negotiations, unsigned contracts, price anomalies and the absence of specific details of the fuel oil being sold. In addition, SPPL alleged that Goodwood knew that the supporting documents it issued, i.e., the ITT Certificates and the cargo release notices, were falsified. The Court rejected all these arguments on account of the credit sleeving nature of the transaction whereby Goodwood’s role was only to act as a pass through “sleeve” rather than to take delivery of the cargo. Critically, the Court found that Goodwood had no reason to doubt SPPL’s representations in their certificates and in any case had no ability to verify this information. As such, SPPL was held liable to Goodwood.

This could be a key distinguishing factor when looking at other cases of credit sleeving. 

Letting the loss fall on the wrongdoer

In arriving at its decision, the Court distinguished another case involving circular transactions (BWG v BWF [2020] 1 SLR 1296), which found on rather similar facts that BWG as orchestrator of the sham transaction could not rely on its own wrong to enforce payment against an intermediary trader. The reason why the Court took a different position in BWG than in Goodwood was because of the knowledge attributed to the party seeking to enforce the sham contract. Unlike BWG, Goodwood was not in the position of performing the role of the “lender” (which was BMS).  More importantly, it was BWG who played a primary role in orchestrating the arrangement, introducing false shipping documentation, and at the same time seeking court redress to get repayment from BWF. It is therefore unsurprising that the Court found that BWG must have known that the trading arrangement was not a bona fide sale but a disguised loan. In contrast, here it was SPPL and not Goodwood that falsified the shipping documentation.

Without visibility of the full trade chain or the goods, intermediary sleeve traders run the risk of their trades being challenged as sham transactions, designed not for the sale of goods but to disguise financing. The allegation of circularity carries with it different consequences depending on the context – circular trades between traders might be uncontroversial but different standards might be expected when presenting a claim to a bank under a letter of credit or a claim to an insurer insuring credit defaults from the physical delivery of goods.   

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