When Hong Kong-style “underground banking” meets identity fraud

Here is a story about a quintessentially Hong Kong form of "underground banking".  The mechanism typically starts with someone in Mainland China giving Renminbi to a third party in Mainland China for currency exchange.  In return, a sum of non-Renminbi currency that is roughly referable to the original Renminbi sum at the prevailing exchange rate is then deposited into a designated Hong Kong bank account. 

Variations on this basic mechanism have long existed.  They are contrary to Mainland Chinese law relating to foreign exchange controls.  There are also question marks over their Hong Kong legality and regulatory compliance.  Yet, they serve as means for Mainland Chinese money to be "converted" into another currency in Hong Kong.  But what happens when an "underground bank" itself stole money from others to give to its "customers"?  Who owns the money that are now in the hands of the "customer" – is it the victim of fraud or the "customer"?  This question was considered in the case of DBS Bank (Hong Kong) Ltd v Pan Jing [2020] HKCFI 268.

Background: an "underground bank" funded by identity fraud

The case started out as a typical example of identity fraud. An impostor fraudulently identified himself as a DBS Bank (Hong Kong) Ltd (the "Bank") customer. He successfully procured the Bank to transfer US$12.6m from the customer’s account to the account of a Hong Kong company called H2H Trading Co Ltd ("H2H").  H2H was a shell company which conducted unlicensed underground money exchange.

H2H then transferred the funds that was sent to it fraudulently to various "customers".  The "customers" did not know that the money they received was fraudulently obtained.  One such "customer" was the Hangzhou-based Defendant. He received US$150,000 (the "Sum") in his Hong Kong account after he deposited RMB1,025,000 in Mainland China with a friend in Mainland China in a typical "underground banking" transaction.

Decision: illegality is key

(a) Whether "underground banking" arrangements can be considered an act of "illegality" in unjust enrichment cases: the Court held that based on the expert evidence provided by the parties, "underground banking" arrangements are unlawful as a matter of Mainland Chinese law. This was considered to be sufficient to constitute illegality on the part of an enriched party (eg the Defendant in this case), even though (i) this illegality is only punishable by an administrative fine; and (ii) no such fine was in fact imposed by Mainland Chinese authorities in this case. 

(b) Whether the Defendant can raise a "bona fide purchaser for value" (ie he bought the Sum with RMB1,025,000 in good faith) defence against returning the Sum to the Bank: The Court held that given that the US$150,000 was bought as part of an illegal "underground banking" transaction, the Defendant cannot claim to have provided value to obtain the Sum.

(c) Whether the Defendant can raise a "change of position" (ie he had already irretrievably transferred out RMB1,025,000 in Mainland China to his friend) defence against returning the Sum to the Bank: The Court accepted that the Defendant did not know that the Sum was sourced from an identity fraud. However, as the Defendant was an experienced businessman, it would be incredible to suggest that he somehow did not know that the currency exchange transaction would be illegal.  And given the illegality, the Defendant could not rely on a "change of position" defence to keep the Sum.

As a result of the above conclusions, the Court ordered the restitution of the Sum by the Defendant to the Bank.

Commentary: Hong Kong-style currency exchange risks

Practically speaking, the Defendant had effectively lost his RMB1,025,000 because, unluckily for him, the US dollars he received were the proceeds of an identity fraud, which then led to the Bank's claim in restitution.  In practice, whatever the question marks over their legality or regulatory compliance, not all "underground banking" rackets are quite so brazen as to defraud third parties in order to pay their "customers".

Having said that, the idea of a dim view being taken in Hong Kong of using "underground banks" to get around Mainland Chinese foreign exchange controls is not new.  On the financial regulatory front, the Securities and Futures Commission had sanctioned licensed financial professionals for taking part in similar mechanisms as far back as 7 years ago. The Court’s ruling against the Defendant in the current case is merely an extension of the basic position of being against condoning the use of Hong Kong as a base to undermine Mainland Chinese foreign exchange controls. 

Foreign currency transactions always involve exchange rate risks.  But when it comes to persons or entities seeking to convert foreign currency using Hong Kong "underground banks" as a means of illegally getting around Mainland Chinese foreign exchange controls, this case shows that they face the additional Hong Kong style currency exchange risk of losing everything.