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Screening Letters of Credit for Sanctioned Parties

Letters of credit are a common payment method used in international trade transactions. They provide security and assurance of payment for both the buyer and seller. However, screening letters of credit for compliance with sanctions regulations has become an increasingly important issue.

Sanction clauses included in letters of credit aim to ensure payments aren’t made to any sanctioned parties. But determining the validity and enforceability of these clauses can be tricky. Let’s take a look at some key considerations around screening letters of credit for sanctioned parties.

Understanding Sanctions Clauses

Sanctions clauses are provisions included in letters of credit and related documents that prohibit transactions with sanctioned parties. They’re intended to ensure compliance with sanctions regulations like those from the Office of Foreign Assets Control (OFAC).

For example, a sanctions clause may state that the bank will not process any transactions that violate applicable sanctions laws. The clauses act as a safeguard to prevent unlawful payments.

However, the enforceability and interpretation of sanctions clauses is not always straightforward. Questions arise such as:

• Are sanctions clauses enforceable when they conflict with the terms of the letter of credit?
• Can confirming banks unilaterally insert sanctions clauses when advising letters of credit?
• What is the interplay between sanctions clauses and the principle of autonomy in letters of credit?

Recent court cases have tried to provide some clarification on these issues. But screening letters of credit for compliance remains a complex process.

Autonomy of Letters of Credit

One of the key principles governing letters of credit is autonomy. This means the letter of credit is an independent contract between the issuing bank and beneficiary. It is separate from the underlying sales contract between the buyer and seller.

The principle of autonomy aims to provide certainty of payment. The issuing bank must pay the beneficiary if the terms and conditions of the letter of credit are met. This payment must be made irrespective of any disputes related to the underlying sales contract.

However, the inclusion of sanctions clauses can undermine the autonomy of letters of credit. The clauses introduce external factors outside the terms of the credit itself. This has led to legal disputes regarding the validity of sanctions clauses.

Court Cases on Sanctions Clauses

There have been several notable court cases addressing the enforceability of sanctions clauses in letters of credit:

Kuvera v JP Morgan (2022)

In this case, Kuvera as the beneficiary had a letter of credit issued by ICICI Bank, with JP Morgan acting as the confirming bank. JP Morgan’s confirmation of the credit included a sanctions clause prohibiting payments to sanctioned parties.

When JP Morgan rejected Kuvera’s demand for payment due to sanctions concerns, Kuvera sued JP Morgan. Kuvera argued the sanctions clause was unenforceable as it undermined the autonomy of the original letter of credit from ICICI.

The court ruled in favor of JP Morgan. It held that while the letter of credit from ICICI was an independent contract, JP Morgan’s confirmation created a separate contractual relationship. Therefore, JP Morgan was entitled to include additional terms like a sanctions clause in its confirmation.[3]

Transfield v Bank of China (2021)

Here, Bank of China refused payment on a letter of credit to Australian company Transfield. It cited concerns that Transfield would use the funds to pay taxes in sanctioned countries.

The court upheld Bank of China’s rejection, finding the sanctions clause valid and enforceable. It stated the clause was part of the bank’s risk management and did not undermine the autonomy principle.[1]

Key Implications

These cases demonstrate:

• Sanctions clauses included in a bank’s confirmation of a letter of credit are likely enforceable
• Such clauses may be upheld even if they seemingly contradict the autonomy principle
• Banks can cite sanctions concerns as a justification for non-payment under a credit

However, there are still grey areas around interpreting sanctions clauses. Parties should exercise caution when including or relying on these clauses.

OFAC Compliance Requirements

Banks must comply with OFAC regulations when screening letters of credit. OFAC prohibits transactions with sanctioned individuals, entities, and countries.

OFAC takes an expansive view of compliance obligations. Both the issuing bank and advising/confirming banks are responsible for verifying parties to a letter of credit are not subject to sanctions.[4]

Specific OFAC requirements applicable to screening letters of credit include:

• Checking all parties against the Specially Designated Nationals (SDN) list
• Screening transactions against sanctioned countries
• Freezing payments and assets when a match is found
• Reporting matches to OFAC within 10 days

OFAC expects banks to have sanctions screening policies, procedures, and technology in place. Fines for non-compliance can be severe.

Sanctions Screening Challenges

While banks must screen for sanctioned parties, doing so effectively poses some key challenges:

Weak Aliases

OFAC listings don’t always include extensive alias information for sanctioned entities and individuals. Many OFAC listings only provide a few high-level aliases, known as “strong” aliases. They may exclude other “weak” aliases not deemed useful for screening purposes.[1]

The lack of comprehensive alias data creates potential gaps in name screening. A sanctioned party could be missed if operating under a weak alias not listed by OFAC.

Name Matching Difficulties

Matching names during screening is inherently challenging. Even minor differences in spelling, punctuation, word order, etc. can prevent matches.[2]

In addition, parties on OFAC lists may intentionally use name variations specifically to avoid detection. Sophisticated screening technology is essential to overcome these obstacles.

Corporate Ownership Complexities

Sanctioned companies often use complex corporate structures across jurisdictions to hide their ownership. This includes layers of shell companies and intermediaries.[3]

Unraveling these structures to identify sanctioned beneficial owners represents a major screening challenge. It requires extensive analysis and information gathering across disparate sources.

Data Management Difficulties

Effective screening depends on robust data management. However, banks often struggle to maintain accurate, comprehensive databases needed for screening.[4]

Data issues like fragmented systems, incomplete customer information, and lack of automation create significant obstacles. Resolving these data problems is essential for reliable screening.

Improving Sanctions Screening

Banks can take several steps to enhance their sanctions screening programs:

• Implement automated screening technology with advanced matching capabilities
• Centralize customer data into a single platform
• Enrich data by integrating external information sources
• Use AI and machine learning to uncover hidden relationships
• Conduct lookbacks when new OFAC listings are released
• Perform interdiction testing to identify program gaps
• Continuously tune screening rules to reduce false positives

With the right focus on data, technology, and testing, banks can significantly strengthen sanctions screening. This helps reduce compliance risk and avoid potentially massive penalties. Here are some additional steps banks can take:

• Implement centralized data management systems to eliminate silos and inconsistencies across sanction screening processes. Consolidating data into a unified platform improves accuracy and automation capabilities.
• Leverage AI and machine learning to continuously improve name matching, uncover hidden relationships, and reduce false positives. Advanced algorithms can account for spelling variations, word order differences, and intentional name changes.
• Conduct ongoing testing and auditing of screening programs to identify gaps. Regular assessments by internal audit teams or external experts provide assurance that controls are working effectively.
• Closely track regulatory changes and updates to sanctions lists. New OFAC listings need to be incorporated into screening platforms right away to avoid misses.
• Improve coordination between AML, KYC, and sanctions screening teams. Collaboration ensures holistic compliance coverage and consistent risk management.
• Invest in training and awareness for frontline staff involved in screening. Well-trained employees help catch potential issues before transactions are processed.
• Consider outsourcing screening processes to specialized vendors. Third-party solutions can provide efficiencies, expertise, and scale.

Sanctions regulations continue to grow in complexity. But with robust governance, data, and technology foundations, banks can effectively navigate the challenges involved in screening letters of credit and other transactions. Here are some additional steps banks should take to strengthen their sanctions compliance programs:

• Establish clear policies, procedures, and controls for sanctions screening that are approved by the board and senior management. Ongoing governance and oversight are essential.
• Invest in training across the organization to ensure all relevant staff understand sanctions requirements and how to effectively screen transactions.
• Conduct periodic audits and testing to validate the effectiveness of sanctions screening systems and identify potential gaps.
• Monitor technology and data management capabilities to ensure screening platforms can adapt to changing regulations and new OFAC listings.
• Collaborate closely with regulators and industry peers to share best practices around sanctions compliance.
• Consider leveraging specialized software, tools, and services from vendors to enhance screening accuracy and efficiency.
• Develop detailed escalation protocols for handling potential sanctions matches detected during screening.
• Maintain comprehensive documentation of screening policies, procedures, and transaction monitoring to demonstrate compliance.

Adhering to principles of sound governance, vigilance, and continuous improvement will enable banks to manage sanctions risks effectively. Close coordination with regulators can also help interpret complex sanctions rules and expectations.

While screening letters of credit and other transactions adds time and costs, robust compliance protects banks’ reputations, avoids penalties, and upholds the integrity of the global financial system.