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FRAUDS RISKS AND FRAUD FACTORING

Monday 11 May 2020/Contribution: Bachir El NakibCAMS, CCO, ACFE, CRP, CFAP

An effective fraud risk management framework will enable organisations to have controls that first prevent the fraud from occurring, detect as soon as a fraud happens and respond effectively to fraud incidents when they occur

As part of the annual fraud awareness week, we wanted to bring you a quick summary of the principles of fraud risk management. These points are based on an extensive review titled Managing the Business Risk of Fraud: A Practical Guide.

As the Practical Guide emphasizes, “An organization should strive for a structured as opposed to a haphazard approach.” The Guide is a good place to start developing a fraud prevention and detection program as part of your overall risk management efforts (or structuring a review of an existing program). But as always, diving into the details of organizing and implementing a program like this requires significant effort. Skipping steps or making assumptions about risks and mitigation practices without systematic assessment will often lead to gaps or weaknesses in the plan.

Let’s look at the five principles:

1. Fraud Risk Governance

Fraud risk management needs to be embedded in an organization’s DNA in the form of written policies, defined responsibilities, and on-going procedures that implement an effective program. There needs to be a clear role for the Board and top management in setting these policies with reporting in place to convey the required information about the program and its performance to them. The tone from the top will be reflected in the perception of fraud prevention and detection throughout the organization.

It is important to have a responsible person with adequate resources and access to top management running the program. This person should be charged with designing and evaluating the program, and for communicating it throughout the organization as appropriate. Since organizations vary greatly in complexity, inherent risk, and size, there is no one-size-fits-all program, but all programs will address issues such as:

  • Roles and responsibilities
  • Fraud awareness
  • Conflict disclosure
  • Fraud risk assessment
  • Reporting procedures
  • Whistle-blower protection
  • Investigation process
  • Corrective action
  • Quality assurance
  • On-going monitoring

2. Fraud Risk Assessment

The foundation for the prevention and detection of fraud is a structured risk assessment that addresses the actual risks faced by the organization as determined by its purpose, industry (products or services), complexity, scale, and exposure to network risks. The goal of the assessment is to determine the type, likelihood, and potential cost of risks in a traditional expected value framework. This allows the organization to tailor program efforts toward cost effective mitigation, which may include a greater or lesser toleration of a specific risk.

Assessing fraud risks necessarily involves looking at how employees—including top management—interact with the resources of the organization. Their incentives and opportunities compose one of the legs of the Fraud Triangle that is mostly determined by the organization itself. As such, the risk assessment effort has to be very clear and detailed about how controls, policies, and procedures interact with specific roles. It is important to note that the sources of these risks may be external as well as internal, especially in highly networked and data dependent operations.

3. Fraud Prevention

Preventing fraud is far preferable to detecting it after the fact. In practice, the same systems and controls established to prevent fraud may help in detecting it (e.g., segregation of duties for a certain procedure may help boost the chances that someone will be in place to report potential fraud).

However, prevention is rooted in a culture of fraud awareness, understanding common policies and procedures, a safe harbor for whistleblowers, and continuous communication about the importance of fraud prevention from the top on down. When everyone knows that fraud is possible and a serious problem for which the organization has developed detection mechanisms, it is less likely to occur.

4. Fraud Detection

Controls, monitoring, and reporting promote faster detection of fraud. Key detection measures include a whistleblower policy, reports designed to highlight potential and common indicators of non-standard outcomes over time, and other controls that alert people to potential fraud. It goes without saying that installing these indicators will have no effect if they are not monitored.

5. Monitoring and Reporting

Creating information that does not get to the right person to take action is useless. One of the key elements in the initial planning for a fraud prevention program is to set up responsibilities and processes to ensure that timely information is reported to someone who can address a problem. These systems trigger responses that have strong legal implications, so one of the essential components is review for legal rights of affected parties and compliance with applicable law.

Fraud can be taken down a notch, even if it cannot be completely eliminated. A systematic program following these five principles is the place to start.

 FRAUD FACTORING ASPECTS

WHAT IS THIRD PARTY FRAUD?

This is a fraud committed by people outside an employee employer relationship. They can be committed against individuals, businesses, companies, the government or any other entity. Third party frauds are not as common as occupational frauds, but on average each fraud is for a larger amount.

Some third party frauds are not meant to remain hidden forever. Some only remain hidden long enough for the fraudster to make their get-away. The fraudster may not care if the fraud is eventually discovered as they do not have a continuing relationship with the victim and they cannot be found.

WHAT IS FACTORING FRAUD?

Factoring fraud is a fraud committed against a debt factoring company by one of its customers. The aim of the fraud is to obtain money from factoring fictitious debtors, by forwarding false invoice to the factoring company. This fraud is meant to remain hidden for the long term – at least as long as the business relationship between the parties lasts. This paper deals with some ways factoring companies can be defrauded.

INVOICE FACTORING COMPANIES AND FRAUD: WHAT YOU NEED TO KNOW

It seems like everywhere you look, invoice factoring companies are on the rise popping up all over the internet. A simple search for invoice factoring companies on a major search engine, for instance, will yield you some 373K results. Unfortunately whenever a business sector experiences dramatic growth, some people out there choose to take advantage of this it by committing fraud for their own financial gain.

SUBMITTED INFLATED OR PHONY INVOICES TO FACTORING COMPANIES

SUBMITTED By far the most common type of factoring receivables fraud is committed by the creation of phony invoices supported by equally phony supporting documents. Software and graphic programs enable invoices to be created with relative ease enabling a copycat business invoice to go undetected. Other times a company with an established relationship with the invoice factoring company may try to slip in a fake invoice in the hopes that the invoice factoring company will trust them therefore foregoing the usual verification and background proceedings. They might seek $8000 when the actual invoice is only $800 and blame it on a clerical error. Unfortunately, they sometimes succeed if the invoice factoring company skips portions of the verification process because they rely too heavily on the established relationship.

When a fraud has been committed by a regular client using factoring accounts receivables, the client will generally commit fraud again and again using new fake invoices to pay off old fake invoices. And so the fraudulent factoring services cycle will continue until the offending company gets caught or absconds.

SPOT FACTORING REQUIRES DOUBLE, TRIPLE CHECKING

Other times, the fraudulent activity may be associated with spot factoring also called single invoice factoring, where a company seeks to get financing per a one-time-only agreement. In this instance, the company seeking invoice factoring is less likely to establish a lasting relationship with the factoring company and more likely to take the money and run. The con in spot factoring may work with a company setting up an entirely fictitious business with phony records and credit histories and even a staged verifier who provides made-up information to the factoring company to “verify for accuracy.”

RELATIONSHIPS CAN NOT REPLACE VERIFICATION FOR INVOICE FACTORING COMPANIES

Of course, due diligence, thorough verification, and corroboration are the keys for a factoring business to avoid becoming victims of such a scheme. Though persecution of such fraudsters does happen like the Arrow Trucking Fraud Case, fraud can be a difficult, labor-intensive claim to prove depending on the size and multitude of the scam.

So any client that is reluctant to provide identifying information to the invoice factoring company could be suspicious. Because account receivables factoring is based upon expediency, a client could try to take advantage of this by rushing the company through the process in hopes they won’t pay too close attention to the documentation. Yet taking short cuts should never take the place of verification, and those companies who skip this crucial step are putting themselves at risk

MAJOR HEADINGS

Description of Factoring Fraud
For Example: Lessons to be Learned

Description of Factoring Fraud

TYPES OF FACTORING ARRANGEMENTS

Debtor factoring is the selling of or the borrowing against trade debtors by cash poor businesses. Businesses do this to generate cash flow before their debtors are due for collection. Generally when an invoice is factored, a percentage of the face value of the invoice is paid immediately by the factoring company to the business. The balance of the face value (less the fees etc.) is paid when the debt is collected.

The factoring relationship is generally conducted in one of two ways. The factoring company may:

(a) buy the debtor from the business; or
(b) lend money to the business secured against the debtor.

Whether the factoring company buys or lends against the debtor invoice will not affect whether the fraud is possible or not. What will affect the fraud is whether the factoring company has any role in collecting the debts. The factoring company may or may not take any role in the collection of the debtors.

1. Factoring company collects debts

If the factoring company has a role in collecting the debts, the debtor will know that a factoring company is involved. This usually only happens when the ownership of the debt passes to the factoring company, but even then factoring companies often leave the actual collection process to the business. The important part of this particular relationship is that the debtor knows that their debt has been factored and pays the factoring company directly.

The major benefit is that the factoring company will become aware of whether the invoice is real or not, or collectable or not, when the debt is due for collection. Also the factoring company will usually have the right to verify factored invoices directly with the debtor. This relationship between the factoring company and the debtor reduces the opportunity for fraud as the factoring company has direct knowledge of debts and collections.

The downside of the factoring company taking an active role is that it is expensive (the downside for the factoring company) and the debtors may feel uneasy dealing with a business that factors it debts (the downside for the business). Because of this it is not uncommon for the collection process to be done entirely by the customer and without the debtor’s knowledge that their debt has been factored. This opens the avenue for fraud.

2. Customer collects the debts

In this relationship the factoring company takes no role in collecting the debtors and the debtors are probably not aware of the factoring agreement. The customer collects the debtors and accounts to the factoring company at the end of each month, providing the required reports detailing the invoices collected and new invoices to be factored. The balance of the money owed by or owing to the factoring company is paid.

The major difference is that the factoring company has no direct knowledge of collections and no independent verification of the invoices that it has factored. They are reliant on the information provided by their client, the business. This opens the system to fraud. It is this type of relationship that is described in this paper.

HOW IS THE FRAUD DONE?

A factoring agreement has three parties:

1. The factoring company (usually a finance company)
2. The business that issues and factors the invoices with the factoring company (the customer)
3. The debtor who owes the money to the customer

If the factoring company has no direct knowledge of collections, their dealings with their customer will revolve around two types of reports. One will detail new invoices to the factored (money to be paid to the customer) and the other will detail collections of previously factored invoices (money to be paid to the factoring company). Money will usually flow between the factoring company and the customer based on the net amount in these two reports.

There is no communication between the debtor and the factoring company. The factoring company is relying on its customer being truthful and not falsifying the information in these reports. It will generally not conduct any independent verification of debts or collections.

CREATING A FALSE INVOICE

This fraud is based on factoring false or inflated invoices. Completely false invoices can be created easily on a personal computer and cheap printer. They can be created to look like they have been issued by legitimate debtors (the factoring company would recognize the debtor’s name as other invoices from this debtor have been factored and paid), or fictitious debtors with invented details.

These false invoices are added to the list of real invoices to the factored. This is easy when there is no direct communication or verification between the factoring company and the debtors. The money is paid for these false invoices.

COLLECTING A FALSE INVOICE

The next part of the fraud is dealing with the false invoice at the time that it should be collected and paid to the factoring company. This is usually solved by a simple ‘lapping’ scheme – committing a later fraud to hide an earlier fraud. A new false invoice is created and factored. The money from that new false invoice is used to ‘pay’ the money owed to the factoring company for the earlier false invoice. As both the new factored invoice and the collection of the old invoice are reported to the factoring company at the same time, they will usually simply be netted off. Effectively no money changes hands.

As the first false invoice appears to have been collected, it will not appear suspicious. As the first fraud is eliminated (the invoice has been collected), there is little chance that this particular fraud will be uncovered at a later date. Because the dealings between the factoring company and the customer revolve around the two reports and the netting of amounts owed, the money from the false invoice never actually has to be paid – one report will create a new debt, the other remove the old debt. This system can be conducted indefinitely, in theory at least.

Depending on what information the factoring company wants attached to its reports, the false invoices themselves may not even need to be physically created. As long as the entries look legitimate in the reports and in line with past business, they may be factored.

GROWTH OF THE SCHEME

Ironically, the more the fraud is done and the larger the amounts involved, the more successful and more profitable the customer may look to the factoring company. The factoring company will be making more money from the relationship (albeit from factoring false invoices).

The fraud may begin with one of two small amounts, but can grow as the factoring company becomes used to the increased amount of factored debt and the regularity of payment. The more false invoices that are factored and lapped (i.e. paid) the greater the perceived turnover and fees earned by the factoring company, and the better and more profitable the customer appears.

As the customer’s standing with the factoring company improves, the checks and control over the arrangement may actually decrease. The factoring company will start to trust the customer and this makes the fraud even easier to commit.

For Example

        I.        Mr S ran a barely profitable trucking transport company that suffered from cash flow problems. The industry is known for long periods for payment and the company had to regularly wait 90 days to have invoices paid. Mr S entered into a factoring arrangement to generate cash flow. The factoring company played no role in collecting debtors, it allowed the customer to collect the money and report on a monthly basis.

  II. The debtors paid the company was usual. At the end of each month the company factored new invoices and reported the collections and new factoring to the factoring company. It off-sett the two amounts and paid or collected the balance. This system of reports and offset payments worked fine for many months and the relationship between the parties became stronger.

  III.  One day a truck broke down and the company needed $40,000 to repair it, but the company did not have the money. Mr S created a false invoice to one of its regular customers for $50,000 and this invoice was added to the list of invoices for factoring. The factoring company paid 80% of the invoice (the required $40,000) under the terms the factoring agreement and the money was used to fix the truck.

  IV.   Later the company needed the money that should have been collected from the false invoice. It still did not have the money, so Mr S created an other false invoice and factored it. The money from the second invoice was offset against the money owed from the first invoice. The records showed that the first invoice was collected and the required money paid to the factoring company. The company had bought some time.

 V.   That seemed all too easy. Mr S decided that he wanted a new car, so created an other fictitious invoice and factored it. He now had the money for the new car and, if the system stayed in place, would never have to actually pay for it. More false invoices were created from both real and fictitious customers in ever increasing amounts to cover the factoring costs. The factoring company saw the increase in the business and noted that all these invoices were paid on time. The company appeared to be a good customer and invoices were factored more readily at better rates.

 VI. The scheme was found when the factoring company decided to randomly audit the ledger that it had factored and discovered that a number of the invoices were not real. By the time that the fraud was discovered, there were more fictitious invoices factored than real ones.

 

Lessons to be Learned

1. Factoring fraud is possible when the factoring company has no control or direct knowledge about the collection of debtors.

2. Random audits of debtor’s invoices and collections should highlight problems. The factoring company will obtain details of factored invoices and details of the payments made directly from the debtors and compare these to the details obtained from the customer. False customers will easily be highlighted and false invoices under real debtor’s names will be unknown to the debtor.

3. The aim of the fraud is to maintain a communication gap between the factoring company and the debtors. If the factoring company does not satisfy itself that the debtor is genuine before factoring an invoice, if it does not check that the actual invoice is valid, or if it does not ensure that the payment is being received from an actual debtor, there is a chance that the fraud will be conducted.

4. The more the fraud is undertaken and the higher the volume of the false transactions, the better the customer looks and the less the factoring company may monitor the position.

Eight Risks to manage when Buying Trade Receivables

One way to compare receivables financing structures is to analyze how – and how well – they handle the transaction risks that keep lenders awake at night.

Any lender who looks at supplier receivables as its principal means of repayment is concerned with 8 types of risks:

  1. Supplier fraud risk – the risk that the PO or invoice presented to the lender for financing may be fake or multiplicative or may have been altered;
  2. Receivable title risk – the risk that the supplier may have already assigned or pledged the receivable to another financial institution;
  3. Receivable transfer risk – the risk that applicable law may not allow the lender to take good and marketable title to the receivable, free and clear of third-party claims, or that it may require the lender to take actions it was not aware it was required to take;
  4. Dispute risk – the risk that the buyer may claim that the goods or services provided by the supplier did not satisfy the requirements of the PO; this is a broad term that covers a number of different risks and possible claims against third parties, but our analysis doesn’t necessitate that level of granularity;
  5. Discount risk – the risk that the buyer won’t pay the full amount of the invoice for reasons other than the supplier’s performance in connection with the transaction at hand – the buyer may, for instance, take discounts for supplier nonperformance of prior transactions, may take discounts in the ordinary course of its business (some large retailers for instance are known to return to their suppliers goods that don’t sell) or may hold back a portion of the payment as retainage (standard in the construction industry, for instance);
  6. Payment delay risk – the risk that the buyer won’t pay in a timely fashion;
  7. Payment direction risk – the risk that the buyer will make the payment to the supplier or some other party instead of the lender; and
  8. Buyer credit risk – the risk that the buyer won’t pay due to financial inability.

 Recourse Factoring vs. Non-Recourse Factoring

Knowing the difference before making an investment

Businesses looking for quick access to cash flow generally turn to factoring their invoices. Factoring is often defined as the selling of a companies account receivables at a discount to a Factoring Company who assumes the risk of the account debtors. As the debtors are settling their accounts, the factoring company will then receive payments until all the outstanding invoices have been paid. The debtor is also required to pay a transaction fee to the factor regardless if all invoice payments have been collected.

There are two options to consider when choosing a Factoring Financing: Recourse and Non-Recourse factoring.

Recourse: Recourse Factoring is when a company sells it’s invoices to a factor, with the promise that the company will buy back any uncollected invoices. The factor does not take the risk of any uncollected invoices. 90% of factors are recourse to avoid the high risk of unpaid accounts.

Recourse Factoring provides more of an advantage for Lenders because the lender is capable of going after the borrower, if any of the clients account debtors defaults. There is less risk involved for the lender, and more for the applicant since they are on the hook on any uncollected payments.

On the other hand from a borrowers perspective, recourse factoring is more affordable, but requires the company to absorb the risk of any uncollected invoices. If your company is looking to factor and you have good solid account debtors then recourse factoring might be a better option for you.

Non-Recourse: First things first, Non- Recourse is NOT A LOAN, it is more closely referred to as a secured debt of collateral.

In Non-Recourse factoring, a company sells their accounts receivable to a factor, whom then supplies the cash needed to cover the invoices. The difference with non-recourse as opposed to recourse factoring is that the company has no liability with any uncollected invoices. The factor absorbs all the risk. Because non-recourse cold be a higher risk for lenders, the transaction fee sometimes could be higher.

From a lender’s perspective, Non-Recourse is a high-risk transaction. The main reason for the high-risk is the possibility of fraud. Fraud is easily the biggest risk to any factoring lenders, which is why factors take a great deal of time to research a business and how credit worthy their customers are before providing them with non-recourse factoring.

Non-recourse factoring is usually more expensive for businesses because the lenders are the ones who are assuming all the liability. Most invoice factoring companies charge between .5% and 1% more for non-recourse factoring.

This can be a more appealing approach to borrowers because they do not hold the risk of losing everything they own except the collateral they initially put on the loan.
The other advantage of Non-Recourse factoring could also be that fact that it acts like credit insurance for your business. Credit insurance (which insures receivables if they go bad) is really only feasible and available to very large companies. That is because it is expensive and not affordable to the small business doing $10 Million or less in gross revenue. So non-recourse factoring acts like credit insurance in that if any account debtor goes bad or does not pay, you can sleep well at night knowing that you don’t have to pay back the factor so long as there is no fraud involved. The business essentially “insured their receivables when they factored them with a non-recourse factoring lender.

 



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