| Frauds Against Financial Factors |
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Fraud Against Factors Interview of EITS Manager of Investigations Paul E. Clapper, FCLS, CFE By: Dawn Taylor, MBA, CFE What should be a mutualistic relationship all too often turns parasitic when merchants bleed dry the very factors upon which they depend for their working capital and investment needs. With the desperation resulting from the current economic downturn, factoring frauds like the one perpetrated by Kasmerski and Kaz Paving Company can be expected to accelerate. “There are probably a lot of folks out there who never would have thought about committing any type of fraud, but are way in over their heads financially,” explains Paul E. Clapper, CFE, FCLS, NYSPI, and Manager of Investigations for Executive Investigation & Testing Services, Inc. (EITS), where he specializes in corporate support and due diligence. In other cases, Clapper finds that “the people who commit these frauds are nothing more than street-level criminals who have received guidance and direction from others on the methods and operation of factoring companies. … The process is simple, Clapper has extensive experience investigating multimillion-dollar factoring frauds, including a recent case in which culprits took over the Web site of a major New Jersey city and enhanced the site for use in a fraud they were perpetrating against a factoring company. Clapper and the EITS team of investigators pursued and identified the conspirators, turned over the evidence to the client and are currently cooperating with the Federal Bureau of Investigations in bringing the conspirators to justice. In a factoring transaction, a merchant sells its trade receivables from debtors to a third party, known as a factor, at a discount in exchange for immediate cash with which to finance its continuing operations and investments. In a typical factoring arrangement, the factor pays the merchant a percentage (usually 80 to 90 percent) of the face value of an invoice upon submission, holding the remainder of the value as a reserve until payment from the debtor is received. Upon settlement of the account by the debtor, the factor forwards the reserve amount, less a factor fee and any interest or service charges, to the merchant. Whether to avoid appearing financially distressed or to placate debtors who do not want to deal with third-party collectors, some merchants prefer that their debtors remain unaware of the factoring arrangement. In these hidden” factoring models, the debtors continue to be invoiced by the merchant, and the merchant turns over the collections to the factor. Some factors also prefer this hidden arrangement due to the high costs involved in collecting receivables. However, when the factor has little or no direct knowledge of collections and the factor cannot verify invoices submitted by the merchant, this system is especially vulnerable to fraud. Alternatively, in an open factoring model, not only are debtors made aware of the arrangement, but the factor takes over responsibility for collection of payments from the debtor. Although less vulnerable to fraud on account of their greater involvement in collections, factors who participate in open arrangements remain at risk of being defrauded through collusion between merchants and debtors. When honest exchange takes place between merchants and factors, both parties can benefit. For the merchant, although bank lending is generally more affordable, factoring doesn’t require the same restrictive covenants or stellar credit as bank loans might; therefore, financing through factoring is more readily obtainable. When a merchant can earn a rate of return on the proceeds from factoring that exceeds the costs of factoring, factoring makes good business sense. In addition, factoring can be a viable option for companies that want to accelerate cash flow, outsource collections activity, mitigate collections risk, avoid adding debt to their balance sheet, obtain incremental working capital or offset any potential cash crunch. When a factor is able to collect more money from debtors than it pays to its merchants or loses due to non-payment, purchasing receivables can be lucrative. Depending on the particulars of the arrangement, factors can generate earnings through factor fees, service and interest charges and fees for credit checks and collections, among others. But since not everyone is honest, and because factors don’t always do their homework, factors often find themselves the victim of fraud. “Many companies are lax in conducting their proper due diligence, and the criminal element finds these companies and spreads the word,” says Clapper. “[S]ome companies spend less time doing research on a factoring client’s application than a car dealer does on a new car sale. These companies MUST do extensive due diligence/background work on all of their new clients. … Spending a little money upfront to verify and validate your new clients is certainly cost effective when compared to some of the losses these factoring companies have sustained.” For anyone interested in committing factoring fraud, there exist myriad ways to carry it out, limited only by imagination. (Note: There are also a number of federal statutes under which one can be charged if caught, including mail and wire fraud.) One of the most common frauds is the false invoice scheme concealed by a lapping scheme. This scheme can be successful in both hidden and open factoring models, although in an open model it generally requires collusion by the merchant with a debtor or the involvement of a shell company. Below is an illustration of the process by which a fraudulent merchant carries out a false invoice scheme, in conjunction with a lapping scheme, to defraud its factor. The assumptions used in the illustration are as follows: (1) the factoring agreement is hidden; (2) the factor pays the merchant 85 percent of the face value of the invoice within three days of receipt; (3) payment from the debtor is due to the factor (via the merchant) within 30 days of the initial payment to the merchant; and (4) the factor fee is five percent of the face value of the invoice. Day 1: The merchant creates and submits to the factor false invoice (FI) 1 against a debtor for $100,000. Day 3: The factor advances the merchant 85 percent of the value of FI 1 ($85,000), holding back a 15 percent ($15,000) reserve until payment is received from the debtor. Day 26: The merchant must forward to the factor payment for FI 1 by Day 33 or risk being found out. However, the merchant does not have the funds available, so it creates FI 2 for $123,529.41, knowing that the 85-percent advance it receives from the factor will be just enough to offset the $100,000 payment due for FI 1 plus the five-percent factor fee. Day 29: The factor nets the $105,000 (85 percent of $123,529.41) due to the merchant for FI 2 against the $100,000 due from the merchant for FI 1. The $5,000 difference is added to the $15,000 reserve on FI 1, less the $5,000 factor fee, resulting in a $15,000 balance due to the merchant. A $15,000 payment is made to the merchant, and FI 1 is closed out. Day 54: Payment on FI 2 is coming due from the merchant. Once again, the merchant does not have the funds available. Also, because the scheme seems to be working, the merchant decides to increase the amount of the fraudulent invoice to cover the factoring fee and pocket some additional cash. So the merchant creates FI 3 for $185,750.42 and submits it to the factor. Day 57: The factor nets the $157,887.86 due to the merchant for FI 3 against the $123,529.41 due from the merchant for FI 2. The $34,358.45 difference is added to the $18,529.41 reserve on FI 2, less the $6,176.47 factor fee, resulting in a $46,711.39 balance due to the merchant. A $46,711.39 payment is made to the merchant, and FI 2 is closed out. The scheme continues on indefinitely, with the merchant constantly increasing invoice amounts (to cover rising factor fees if nothing else), until either the fraudster repays the misappropriated funds or gets caught. Ironically, the more successful the merchant is at pulling off the scheme, the more successful he appears in the eyes of the factor, and the more likely the factor is to offer the merchant better rates and to relax controls. Thus, the fraud becomes even easier to carry out. The fraudulent merchant employs a number of techniques to keep the false invoice scheme concealed as long as possible, including the use of multiple fictitious and existing debtors, previously paid actual invoices, shell companies and collusion. And with minimal, if any, direct verification from the debtor of invoices or payments, success is not too difficult to achieve. Other popular, albeit less sophisticated, factoring fraud schemes exist too. One scheme common in hidden factoring arrangements involves the failure of the merchant to assign to the factor select receivables when under contractual obligation to do so. Another ploy under a hidden arrangement occurs when a merchant factors invoices prematurely, such as after goods have been ordered, but prior to their shipment. In these pre-invoicing situations, there exists the possibility that the debtor will cancel his order prior to shipment. The factor that advanced the funds against the invoice, unaware of the fraud, may have to write off the loss. Finally, a common fraud in an open factoring arrangement is the misdirected payments scheme, in which the merchant fails to turn over to the factor payments erroneously received and instead misappropriates the funds. To insulate themselves from the risk of fraud, factoring companies should employ the following measures:
ü Conduct background checks on the merchant, its key corporate officers, past owners, related companies and debtors. Be sure to look for negative character traits. ü Be especially leery of “spin-offs.” ü Review financial statements and records, including aging reports; dilution rates; charge-off history; and payroll, income, and property tax records (to spot liens).
ü Perform a weekly review of aging reports, dilution rates and charge-offs for anomalies and deterioration. ü Conduct continuous random audits of merchants and debtors, including sample verification of invoices and payments. ü Ascertain that ample reserves are on hand, especially for dubious merchants. ü Examine anomalies in short pays, charge-offs or invoice age to determine the cause. If justified, discontinue funding, reduce the advance rate and/or increase verifications and audits. ü Review charged-back receivables, ensuring they were not later collected or processed as non-factored. ü When merchant sales increase at a rapid pace, review the merchant’s inventory and payable records to see if they correspond. If they do not, investigate the possibility of a false invoice scheme in conjunction with a lapping scheme. ü Look into consistently increasing invoice values to a particular debtor, or the sudden introduction of a significant number of new debtors. Either of these scenarios may also indicate a false invoice scheme in conjunction with a lapping scheme. ü Investigate billing “errors.” ü Run a monthly lien search on all merchants.
To fraud examiners who battle factoring fraud, Clapper recommends mixing together several methods of investigation, including surveillance, covert secure photos of the culprit, interviews and “cold stops” to the culprit’s business location. According to Clapper, this strategy will assist examiners in finding fraudsters who are quite mobile and those who don’t have an actual business address (other than a post office box). Also, fraud examiners “will need to do their computer database research and paper chase to develop as much information as possible on the culprits.” Clapper and his firm “have found success in evaluating all of the suspects and trying to identify the most knowledgeable and lowest level suspect (weakest link), then approaching him at the end stages of the investigation and giving him the option of being a witness or a suspect. … This method has worked for us, but only after we have all the facts,” cautions Clapper. “We would never approach anyone and try to bluff our way through an interview.” Published in the Association of Certified Fraud Examiners ACFE / National e-newsletter / Sept. 2009.
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but relatively few people know anything about factoring. … Once taught the ‘tricks of the trade,’ the suspects normally hit on several factoring companies at one time and spread their fraud like a cancer.” For these criminals, “factoring fraud is neater, cleaner and easier than bank robbery, and can be done from the comfort of their home.”