How To Identify Fraudulent Activity

The single greatest threat to any asset-based lender or factor company as they grow their business is fraudulent activity. Aaron Hughes of RiskFactor Solutions discusses what fraud is and why lenders need to be more vigilant in order to protect their businesses. He also talks about how technology can support and make it easier for lenders to interpret the data they already have available, and how businesses can benefit from detecting fraud before it happens rather than after they've had a loss.

The single greatest threat to any assetbased lender is fraudulent activity that results in a bad debt or a near miss. There is a high degree of trust in assetbased lending where the client manages the security on behalf of the lender. The client has first-mover advantage and could potentially expose the lender to significant losses through manipulation of the underlying collateral.

Fraud is most often recognised as the client obtaining cash against collateral that is fabricated, or by manipulating the "good" collateral to extend the cash cycle. This can include:

* Raising "fresh air" or false invoices, i.e.; invoices for goods or services that have never been provided.

* Pre-invoicing, i.e., raising invoices for a genuine order in advance of goods or services being provided. Clients can intercept payments from debtors for genuine transactions and divert the funds into their own bank account.

Clients can also manipulate their reporting of the collateral. Examples of this include:

* Withholding issuing credit notes for faulty or returned goods. This allows the client access to inflated facilities that will expose the lender if, or when, they have to collect what they believe are genuine invoices.

* It can also happen when clients reage invoices. This involves moving invoice dates back, i.e., they become youngerand remains in the funding cycle for longer.

* Collusion with debtors, where both parties (client and debtor) agree that a debt is genuine and collectable, also occurs.

Why Does Fraud Happen?

Fraud is an ever-present danger, but there are certain events or cycles that encourage clients to commit fraud against lenders. Examples of these typically include:

l) The loss of a major customer. This can have a catastrophic impact on a business and clients seek to salvage the business by fabricating sales in the hope of salvaging the business.

2) As businesses emerge from a period of sustained downturn, they struggle to match cash flow with their growth. This can result in clients manipulating facilities to maintain consistent cash flow.

3) Clients can have distinct trading seasons that cause cashflow spikes. In situations where the cash flow of the business is out of sync with the trading cycle, clients may manipulate facilities to maintain consistent cashflow.

4) Family-owned businesses can have a greater tendency towards the manipulation of facilities in times of cash pressure. They frequently have significant cash and emotional investment in the business and often more than one generation of the family rely on the business for their income.

There is a human element to fraudulent activities. Many people wish to maintain an inflated lifestyle, or the size of the business exceeds their capabilities and they panic when the cash flow of the business becomes stressed. The majority of fraudsters live with a misguided belief that they will not get caught or that the fraud will unwind before the lender discovers what has happened.

Protecting Against Fraud

Before taking on new business, the lender will undertake pre-lend reviews or surveys. These are on-site assessments of the prospect that confirms the quality of the security, and the adequacy of the prospect's systems and processes (accounting information, order processing, etc.). The pre-lend review or survey analyses the prospect's financial health and identifies anything that would prevent the lender recovering money from debtors in the event of client failure. The assessment covers the quality of debtors and lenders often ask themselves if it passes the "tin of beans test" - it's just a tin of beans, what could possibly go wrong with a tin of beans?

Once a prospect becomes a client, the lender has a number of ways of prevent- ing and identifying fraud on an ongoing basis:

The client is obligated to provide certain information as part of the facility. When used correctly, these can be vital risk triggers, and they include:

* Month-end reconciliation.

* Receipt of bank statements.

* Receipt of debtors and creditors listings.

* Financial and collateral covenants to which the client must comply.

Other risk-based activity:

* Verification: contacting the debtors to confirm that they have received goods and will make payment on the due date.

* Field audits: a similar exercise to a pre-lend review or survey. These have a slightly different approach, but seek to validate client health and adequacy and collectability of security.

Early Signs of Fraud

In order to catch fraudulent activities as early as possible, lenders need to look closely at changes in client behaviour.

All clients typically display regular, consistent behaviour. Lenders need to be alert to any changes in that behaviour, and examples could include:

* Clients whose business appears to be growing when other clients in the same industry are not experiencing the same growth.

* Clients who are overly compliant, i.e., they provide all the information on time in the format required, who perhaps want to be "perfect" in order to avoid suspicions.

* Clients who cancel field audits or who fail to provide information on time as they know they will be caught out.

* Requests for increase in facilities. The vast majority of frauds require the client facility to grow.

Top Five Most Obvious Signs of Fraud

Some of the most observable warning signs that should alert lenders include:

1) Debt-turn extending, where the debt is false and cannot be collected, or the client has diverted cash from genuine sales into their own bank account.

2) A significant improvement in debt turn, where the client is recycling cash advanced from the lender to repay false invoices.

3) Dilution through high credit notes, where clients reverse false invoices to avoid identification or through low or nonexisting credit notes. A change in behaviour of credit notes often indicates security manipulation.

4) Increased sales. The illusion that the business is growing rapidly where clients raise false invoices to maintain cash flow.

5) Increased number of new debtors that act as vehicles for false invoices.

Occasionally, lenders can miss fraud because they just don't have sufficient time or resources to successfully manage relationships and risk. They may not have the technology available to help them work smarter, or they run core systems with no supporting sophisticated risk management tools.

Technology as a Defence Shield

Using technology to spot early warning signs of fraud removes any emotion or subjectivity from the relationship. Risk analysis tools look objectively at data, trends and behaviour and allow for constant monitoring, removing the potential for human error. Technology can be used to identify fraud and minimise lenders losses earlier.

There are many benefits that lenders can take advantage of by using technology to combat fraud rather than relying on spreadsheets and paper reports, where the problems are not always possible to identify easily or quickly.

Any risk management tool that is working 24/7/365, provides lenders with a consistent shield against small or large deceptions. It means that more facilities can be managed by individual managers, improving efficiency across the organisation. It also means that staff can spend more time with their clients to build loyalty and long-lasting relationships. More often than not, if a lender has built a strong rapport with a client, they will think twice before defrauding a lender and will share their challenges and seek a conventional solution to resolve their cash-flow dilemmas.

While technology shouldn't be seen as the only preventive tool, it can help to reduce the losses that lenders suffer as a result of fraud as lenders identify and intervene in frauds earlier, helping to mitigate losses.

Improving a lender's ability to spot fraud signs early allows the lender to focus on the positive aspects of providing high levels of client service that ensure market-leading client retention, maximised income and minimised exposure to fraud.

Aaron Hughes is account director, RiskFactor Solutions Ltd. He has over 25 years' invoice finance and ABL experience, with the majority of his career in senior risk and operational roles with GE Capital and Barclays Sales Finance. Hughes joined RiskFactor in September 2012 from National Australia Bank where he was National Operations Director for Invoice Finance.

Hughes has been a RiskFactor user in a number of previous roles and has an outstanding track record for using the software to manage risk, deliver productivity efficiencies and to support and enhance governance frameworks. His role at RiskFactor is to assist customers in maximising their use of the application and support the development of the software.