RBI bars banks from issuing LoUs over PNB, Nirav Modi fraud case fallout

In the backdrop of Punjab National Bank (PNB) scam that is being blamed on two jewellers Nirav Modi and Mehul Choksi, the Reserve Bank of India (RBI) on Tuesday, decided to discontinue the Letter of Undertaking (LOU)/ Letter of Credit (LOCs) for trade credits for imports with immediate effect. RBI said in a notification, "On a review of the extant guidelines, it has been decided to discontinue the practice of issuance of LoUs/ LoCs for Trade Credits for imports into India by AD Category –I banks with immediate effect." It added, " Letters of Credit and Bank Guarantees for Trade Credits for imports into India may continue to be issued subject to compliance with the provisions contained in Department of Banking Regulation on “Guarantees and Co-acceptances”, as amended from time to time."

Also, AD Category-I banks may bring the contents of this circular to the notice of their constituents and customers.

 It all started on February 14, when Punjab National Bank (PNB) revealed that it was cheated by two big diamond jewelers namely Nirav Modi and Gitanjali Gem’s Mehul Choksi with the connivance of some officials. The alleged fraud at state-owned Punjab National Bank (PNB), involving diamond traders Nirav Modi and Mehul Choksi, has taken a new twist as the amount rose to Rs 12,700 crore from previous Rs 11,400 crore, putting the health of gems and jewellery sector's growth at stake.

The CBI since then registered seven cases that also include other banks like State Bank of India, OBC, Bank of Maharashtra and Telangana Grameena Bank.

Letter of Undertaking (LoU)
LoU is sanctioned by one party, such as an independent contractor, describing the scope of work that’s going to be provided.
 
In Nirav Modi’s case, LoU is a bank guarantee and was issued for overseas payment. By giving LoU, PNB agrees to repay the principal amount and interest on the clients (Nirav Modi) loan unconditionally.
 
During issuance of LoU, there are four parties involved - issuing bank, receiving bank, importer and beneficiary entity overseas.
 
What happened in this case is that PNB officials allegedly used their access to SWIFT messaging system, which is used for overseas transaction. This led into verification guarantees on LoUs without taking necessary sanctions.

Thus, many Indian banks' overseas branches sanctioned forex credit.

RBI in 2015 only observed that  banks are extending non-fund based credit facilities like guarantees / stand-by letter of credits / letter of comforts etc. on behalf of JV / WOS / WoSDS for purposes which are not connected with their business, rather, in certain cases, these facilities are used to avail foreign currency loans for repayment of Rupee loans.

Thus, the earlier master circulation of RBI said, "Banks should not extend any non-fund based facilities or additional/ad-hoc credit facilities to parties who are not their regular constituents, nor should they discount bills drawn under LCs, or otherwise, for beneficiaries who are not their regular clients. In the case of LCs for import of goods, banks should be very vigilant while making payment to the overseas suppliers on the basis of shipping documents."

Coming back to discontinuance, the central bank's decision is expected to impact businesses who are depended on imports, and needed LoUs for opting bank guarantees. 

The Finance Minister Arun Jaitley, on Tuesday, in a written reply to the Rajya Sabha revealed that Nirav Modi obtained his first fraudulent guarantee from PNB's Brady House branch in Mumbai on March 10, 2011 and managed to get 1,212 more such guarantees over the next 74 months, reported in PTI.