How lenders can protect themselves
Fraud is a major problem for the global economy. In the UK alone, fraudsters cost the economy an eye-watering £130bn in 2019, and the economic uncertainty caused by the pandemic has only increased the risk of individuals and companies falling victim to fraudulent activity. Lenders providing invoice finance are no exception. They are common targets of fraud, presenting a threat not only to the lenders themselves, but also to businesses which may struggle to survive without financial support if invoice financiers become more reticent to lend.
The good news is that there are ways to combat invoice finance fraud. The first step is understanding the different forms that fraud can take, and then invoice finance providers must implement the right technical and administrative processes to protect themselves against fraudsters. This will not only benefit invoice financiers, but also legitimate businesses, and ultimately the economy as a whole.
Circumstantial versus premeditated fraud
Invoice finance fraud comes in two main forms: circumstantial and premeditated. Circumstantial fraud generally arises from businesses experiencing unfavourable financial pressure. If cashflow becomes an issue, struggling business-owners may be tempted to raise invoices early, with the aim of securing some urgently needed liquidity.
This practice of early invoicing, or ‘pre-invoicing’, can lead to real problems, even when business-owners anticipate completing the underlying business transaction in the near future. Although this is motivated by genuine optimism, this practice, unfortunately, often leads to a vicious circle, in which businesses repeatedly resort to the same short-term solution to an underlying cashflow problem, eventually, simply fabricating ‘fresh air’ invoices in order to keep their business afloat.
The other type of fraud prevalent with invoice finance is premeditated fraud, which, unlike circumstantial fraud, is a form of organised crime. Here, fraudsters attempt to exploit weaknesses in lenders’ due diligence processes by creating sham businesses with fabricated customers, to create the illusion of a real businesses with genuine trade.
Once signed up with an invoice finance provider, the criminals give the appearance of sales and receipts of a business that is apparently doing well, convincing the lender to advance funds against invoices in support of their client. Meanwhile, the criminals recycle the advances received to give the impression of real cashflows. The threat may not materialise until it is too late, and the fraudsters abscond with their ill-gotten gains, with significant consequences for the lender.
Both forms of invoice finance fraud involve borrowers issuing false invoices in an attempt to obtain cash from lenders, and are a constant threat, at the best of times. Thankfully, there are measures lenders can take to help identify and mitigate against fraud by employing the right tools, processes and protections.
Spotting the signs
Understanding the different types of fraud is the first step, but it is in taking further steps to prevent fraud in the first place that savings can actually be made.
Circumstantial fraud can be difficult to detect, not least because lenders may be cautious about potentially compromising their relationships with borrowers. However, keeping an eye on borrowers’ business performance, and keeping abreast of any changes in their circumstances, is simply a matter of due diligence. Businesses facing less favourable circumstances are more likely to chance an early invoice or fake invoice, so invoice financiers should remain alert and aware of this risk.
Premeditated fraud can also have tell-tale signs. As a rule, if something seems too good to be true, it usually is. Sales ledgers with perfect records should therefore invite further questions. Likewise, factors and discounters should investigate borrowers whose business involves mostly or entirely new customers, as this is another sign of potential fabrication. Relationships between companies, no matter how tenuous, need to be investigated.
Putting protections in place
Due diligence during the on-boarding stage of clients is critical to avoiding fraudsters. Credit teams must be fully empowered to say “no” even when there is pressure to “do deals”. There have been recent cases where a dubious business has been turned down by numerous invoice finance providers only to pop up in the portfolio of another with disastrous consequences.
Providers need to invest in technology, people and processes so they exude professionalism, control and confidence. A provider that seems lackadaisical, with slack processes and outdated systems, is asking for trouble. Clients will be tempted to “game the system” and if they get away with it once, they will do it again and again.
Verifying invoices is an important part in preventing fraud, made more difficult in the UK due to the prevalence of confidential invoice discounting. Technology is available to run shadow ledgers, with data extraction from the client’s accounting system, what we call “Open Accounting”. Granularity of data allows a sampling approach to be implemented to at least make the client aware that their trade flows are under scrutiny. Applying algorithms such as Benford’s law, can expose anomalies requiring more investigation. Third parties can be engaged to contact the client’s customers to verify that the debt is genuine. Effectively, invoice discounters can provide factoring-like controls, provided they have the data and the resources available.
Regular field audits (or increasingly desktop audits) again put a business under the spotlight to establish the legitimacy of the business. Open Accounting combined with Open Banking, provides a window into the financial transactions of the business that can augment the auditing process and help uncover questionable activity.
The limiting factor in almost all of these processes is human error. Indeed, even well-trained staff can miss the occasional warning signs when managing a diverse portfolio of clients. This is why lenders are increasingly turning to sophisticated invoice finance technology to mitigate the risk of fraud as far as possible.
Author: Kevin Day, CEO of HPD LendScape
