Navigating criminal risks in supply chain finance

Non-licensed entities are increasingly marketing “supply chain finance” or “bill financing” products that amount to covert lending. They construct circular transaction structures that involve order flows and bill endorsements, but no physical movement of goods.

In the event of overdue repayment, the funders tend to escalate the matter through criminal complaints, reframing a civil dispute as a criminal one. The borrowing company, once a seeker of liquidity, finds itself a criminal defendant, with its business ground to a halt.

One case handled by the author illustrates the risks. To obtain funding, company B adopted a “chain sales plus bill settlement” structure devised by funder company Z. This arrangement formed a closed loop transaction in which funds moved from company Z through an intermediary buyer (company A) to company B, while bills were endorsed from company B to company Z.

Crucially, no physical goods were ever exchanged between the parties throughout the financing process, and the acceptances issued by company B were merely deferred payment undertakings due at maturity.

Initially, company B repaid on schedule, but when its funding chain broke, bills totalling more than RMB3 million (USD442,700) went unpaid.

Rather than initiating civil proceedings based on the financing arrangement, company Z lodged a direct criminal complaint against company B’s principal for bill fraud. The principal was convicted at both first instance and on appeal, until a high court ordered a retrial.

The case raises two central questions: How can businesses detect the criminal exposure in such financing arrangements, and what compliance safeguards should be established?

Risk identification

Criminal exposure in corporate funding deals has three hallmarks:

1. 1. Complex structures with several parties and contracts that mask their real purpose;
   2. Funders without a financial licence evading oversight through nominal trading, agency or service arrangements; and
   3. Contract terms containing hidden default penalties and sole interpretation rights weighted against the borrower.

If a borrower falls into arrears, the funder may leverage criminal allegations. These warning signs should be carefully checked when financing packages are assessed.

Compliance strategies

Financing enterprises should build three defence lines addressing the pre-financing, interim and post-financing periods, respectively.

First line of defence: pre-financing risk controls. When weighing funding options, companies should place legal and regulatory checks ahead of cost analysis by:

1. 1. Vetting the counterparty’s credentials through the National Enterprise Credit Information Publicity System, financial regulators’ official websites and court judgment databases to verify its financial licensing and litigation track record;
   2. Conducting a look-through structural analysis, requesting full transaction flowcharts and contract chains to spot anomalous patterns including paper-only order/bill circulation, circular trading and round-tripping. If no actual goods are delivered, funds flow back in a loop, or price differentials are effectively interest, the proposal must be rejected; and
   3. Operating a negative list that places unlicensed lenders and structurally evasive counterparties on an internal blacklist, ruling out co-operation.

Second line of defence: full documentation during transaction execution. For active financing arrangements, enterprises should continually preserve compliance evidence to avoid being caught unprepared in later disputes. Measures include:

1. 1. Ensuring that any bill-based settlement is backed by real goods or services, and keeping purchase contracts, delivery and logistics documents, acceptance records and VAT invoices so that both stock and paperwork reconcile;
   2. Executing a clear loan contract that sets out principal, interest, maturity and default terms, rather than hiding interest in price spreads or “service” and “advisory” fees, thus making funding costs transparent and the true legal relationship clear in court; and
   3. For major financings, engaging legal advisers experienced in both financial and criminal compliance to vet the documentation and provide a written opinion, which can support internal approvals and later demonstrate the absence of criminal intent.

Third line of defence: emergency response and legal recourse. Once a borrowing company falls into arrears and the funder threatens or initiates a criminal report, the company should quickly fast to implement an emergency plan by:

1. 1. Gathering all materials showing the transaction structure was designed by the counterparty – including emails, chat logs and contract drafts – to prove the counterparty knew there was no underlying trade and did not act under a “misapprehension”; and
   2. Organising records of past performance (amounts repaid and communication logs); details of the company’s and management’s assets; and evidence of how the funds were actually used to demonstrate there was no intent to misappropriate and that late payment was driven by business stress rather than fraud.

Takeaways

Companies should embed criminal law compliance into everyday risk management. This means: regular risk reviews of financing channels and counterparties by legal teams or external counsel; training business staff to spot criminal red flags; and introducing layered approval for financing contracts.

Against the considerably heavy price of cleaning up after the event, early compliance is the most cost-effective form of risk insurance.

Criminal law is meant to serve as the final safeguard in social order, not a go-to weapon in business disputes. By putting compliance defences in place upfront, businesses can convert legal risk into a protective barrier and secure more predictable growth in an uncertain environment.

Shen Xinyu is a partner at Starrise Law Firm