The Keys to Factoring Fraud Prevention

Kevin Day, CEO, HPD LendScape Kevin Day of HPD LendScape explains why technology, staff and training need to be aligned to prevent factoring fraud during the current COVID-19 crisis.

BY KEVIN DAY, CEO

Canadian-American economist JK Galbraith once said, “undiscovered fraud shrinks when money is watched with a narrow eye.” In the current economic downturn, lenders’ eyes might indeed be getting narrower, but increasing pressure on U.S. businesses also is making the likelihood of fraudulent activity even higher. Lenders need to continue to be vigilant by using the latest fraud prevention technology but should also remember the human aspect and implement the correct processes and staff training. Scandals are not only bad for the affected company; they may deter banks from lending at a time when businesses need funding the most. It is worthwhile analyzing the various types of fraud and assessing what measure factors can take to prevent them.

Different Forms of Fraud

If a debtor cannot pay back an invoice, there are three scenarios: won’t pay, can’t pay and nothing to pay. The first is usually a dispute between the client and the customer that can be resolved relatively easily. The second starts with overdue invoices and eventually leads to bad debts. The third is where we enter the realm of fraud, and in the factoring industry there are two categories of fraud: circumstantial or premeditated.

Circumstantial fraud occurs when struggling businesses need cash urgently, but there is insufficient availability on their factoring facility. Yet optimistic business owners may, for example, see a sales order that is being processed with delivery due in two weeks. Producing the invoice a little bit earlier and submitting it to the factoring company for an advance might seem like an easy solution. So might pushing back the due date so that it matches the date that it would have been paid had the invoice been produced at the proper time. This ‘pre-invoicing’ may go through the factoring company’s systems without any problems, but can quickly evolve into optimistic invoicing, leading to the creation of fake or “fresh air” invoices to keep the factoring company happy. Before long, there may be a vicious circle of invoices, credit notes, disputes and excuses, only for the factoring company to find it difficult to recover the funds in use.

While circumstantial fraud usually involves an under pressure business owner trying to resolve short-term situations, premeditated fraud involves organized criminals deliberately targeting a factoring company. Fake businesses are established to represent the supplier and its customer, often with legitimate trading carried out to create a business track record prior to obtaining the factoring facility. Fraudsters then use advances to settle the invoices, creating an illusion of legitimate cash flows and recycling the factoring company’s cash.

Collusion between the client and its customers, or even an employee of the factoring company, also can occur, which makes detecting fraud more difficult. Earlier this year, for example, a $13.2 million instance of factoring fraud was discovered by the Bank of San Antonio involving a former employee. Making sure all parties involved are properly scrutinized is therefore vital, and KYC, due diligence and employee background checks are becoming increasingly stringent.

With all types of fraud, factoring companies should bear in mind Donald Cressey’s “Fraud Triangle,” which identifies three things that create an environment for fraud: pressure, opportunity and rationalization. Given that financial pressure is likely to be ramped up for many businesses due to the current economic environment, factors need to be especially alert.

The good news is that all types of fraud have tell-tale signs that factoring companies can use to defend themselves. Sophisticated technology, thorough processes and well-trained employees are the pillars of this defense. And with fraud prosecutions or court processes sometimes taking years, prevention is almost always better than cure.

Defending Against Factoring Fraud

There is no magic bullet for combating fraud. Various measures and strategies must be deployed. Like with cyber crime, the weakest link is often the human element: gullibility, lack of process or not following rules or best practices.

Picking the right client is the first step. Vetting processes should be robust and KYC and AML guidelines must be followed. Looking into the relationship between the client and its customers is next. Are there connections between them? For example, do two debtors trade from the same address? There are many red flags.

Once a client is on-boarded, it is important to repeat the client due diligence process regularly. Field audits are an important defense mechanism and can be augmented by desk-audits that rely upon the analysis of data obtained from the clients.

Trust, but Verify

Verifying invoices is a core part of fraud prevention once a business relationship is established. Verification itself could involve a physical review of the documentation, but with e-invoicing being the direction of travel, this level of scrutiny may not be possible or may be too onerous for the factor, especially for small values.

Verification also could simply mean a telephone call to the debtor to double check that the invoice is in line with the debtor’s expectations. It is also wise to check at this stage that the debtor has the correct payee details of the factoring company — intercepting invoices to override these details is increasingly common, especially with PDF invoices sent via email.

For lenders, it is simply not economical to have a huge team of people verifying each invoice, so strategies must be employed to sample a proportion. The two common approaches are to select invoices for verification by value and by payment terms. Looking at the second approach, if a client is normally selling on 30-day terms and suddenly there is an invoice on 90-day terms, it may signal pre-invoicing or fresh-air invoicing. Applying Benford’s Law and random sampling are two other methods often used to verify invoices.

Identifying and Analyzing Trends

There are a number of signs, red flags and indicators that could mean a fraud is in progress. A “too good to be true” test with, for example, no overdues, a perfect DSO, no disputes and no credit notes, deductions or adjustments could signal the lead up to fraud. If the client’s sales are disproportionately skewed toward newly created debtors, it may be a sign that the client is loading up invoices against fake debtors, hoping that this will not be noticed until it is too late. A sharp increase in sales volumes could also signal the client has completed the beginning phase of the fraud and is now going “in for the kill.” Whatever trend might be identified or being monitored, it is important to analyze these in depth, although the precise time range in which to compare metrics and the final interpretation will be unique for each business.

Trend analysis is important, but factors cannot expect staff to have the time, focus and discipline to study the charts every day across a portfolio of clients. A good way of transforming this data to a more digestible form is to convert it into a risk score, awarding points for each of the metrics. Each increase in sales volume by 5% would count as one point, for example, and one can then compare the last 30-days total with the 30-day total three months ago. Comparing the risk score for the same client over time creates a pattern that can then be used to identify potentially fraudulent activity.

Exception Handling and Collusion

With factoring companies becoming ever leaner operations, collateral controllers and relationship managers have to manage larger client portfolios, so it is essential to use computer systems to track each client and alert users when there is a potential problem. Managing these exceptions is always a balancing act, however, as the factor needs to ensure thresholds are neither too tight nor not sensitive enough.

Finally, as in the example of the Bank of San Antonio, collusion is a situation that needs to be carefully monitored. The ‘four-eye’ principle is useful in this situation, where at least two people are required to enact a significant action, and the key areas to monitor are transactions that affect the availability and the actual paying out of money, such as increasing the advance rate. On top of four-eyes control, a healthy amount of audit tracking is also important, which provides evidence and acts as a deterrent, limiting ‘opportunity’ in the Fraud Triangle.

With all elements of fraud prevention, factoring company employees are the first line of defense, but they also can be the weakest link. Receivables finance technology has been adapted and fine-tuned through each economic crisis to create a framework to support people in highlighting areas of potential concern, and to provide a framework to ensure people do the right things. Good technology, people and training create a fraud-aware environment to ensure that criminals are kept at bay for the benefit of businesses and the wider economy.