One of the biggest challenges for a financier managing a factoring agreement is invoice fraud. Under a recourse factoring agreement if the financier accepts an invoice for early payment and that invoice turns out to be fraudulent and no payment is forthcoming in 30, 60 or 90 days there is little that can be done to recoup the money of the funders other than to start expensive legal proceedings. This post will look at the different types of invoice fraud.
Premeditated Fraud
This is where an invoice is submitted which is known to be fictitious. This type of fraud is the rarest, but also the costliest.
One-Off Fraud at the Beginning of Factoring
The largest payment in factoring is the early payment or prepayment. A factoring firm will typically pay between 80% and 90% of an invoice within 48 hours of accepting the invoice for factoring. If the invoice has payment terms of 30 days. It gives criminals 28 days to vanish. They set up a fictitious company with fictitious books and apply for a factoring facility. If accepted they then raise an invoice for a large sum of money, submit the invoice for factoring, take the prepayment and then disappear. Obviously due diligence is done by the financier but it is possible to fake a trading history and a customer base.
Alternatively, the company could be real but the owner or director decides to flee with the funds given as a prepayment on an invoice to a country with no extradition treaties with the country where the crime took place. While the police might not apprehend the culprit, it might be possible to recover the stolen funds through applying legal pressure on the company on whose behalf the funds were raised, as it is the genuine company that holds the responsibility for the debt not the fugitive.
Fraud Over a Period of Time
This is the long game for fraudsters. They set up a legitimate company that applies for a factoring facility. They then set up fictitious companies using the names of family and friends. They do the background work to provide each fictitious trading partner with bank accounts, addresses, trading history etc. They pay the majority of invoices that their partner in crime puts forward for factoring, but every now and again default on the payments. This seems a more realistic con but over time the invoice financier will suspect fraud is being systematically perpetrated. At this stage a deeper delve into the debtor companies will expose the scam.
Fresh-air Invoicing
As the name suggests the invoice is created out of fresh air; that it does not relate to any trade in goods or services. The selling company and the debtor company could both be legitimate companies with a history of business. However, the invoice that is submitted for prepayment is fictitious. In many cases the debtor company is controlled by the same scammers working for the supplier company. They can further muddy the waters by issuing a credit note.
In a weaker version of fresh-air invoicing the invoice could be raised on an expected order. This is fraudulent because the money ‘lent’ via factoring is for a, as yet, fictitious transaction. Here are two examples to illustrate these types of invoice fraud.
Example 1
Here is how a fresh-air invoicing scam can be committed.
Company A is a genuine business. It raises an invoice for £20,000 against a delivery to Company B. Company B is a genuine company owned by the son-in-law of Company A’s owner. Company A applies for an invoice finance facility and submits the £20,000 invoice in question to the financier controlling the factoring facility. The financier does a check and discovers a delivery note relating to the transaction. They then do a telephone check about the delivery and again find nothing untoward, so they release the prepayment funds of £16,000.
When the time comes for the invoice in question to be paid Company A produces a credit note for £20,000 from Company B, and thus the invoice is removed from the sales ledger, and all appears superficially above board.
Example 2
Here is how a fresh-air invoice scam can be committed by invoicing before an order has been made.
Company A and Company B have a genuine trading relationship. However, Company A is running into severe cash flow problems. Company A is expecting their usual order from Company B of £10,000 in one week’s time, but they cannot wait for the order. So, Company A raises an invoice for the usual £10,000 to be paid by Company B. However, they don’t give this invoice to Company B, but instead submit it to their invoice financier for prepayment. Since Company B regularly buys from Company A the financier sees nothing untoward and approves prepayment.
One-week later Company B does make an order for £10,000 worth of goods from Company A. The fictitious trade now appears genuine, and the discrepency in the finances of Company A appears squared away, especially if Company B agrees to a reduction of payment time by one week.
This is fraud as a fictitious invoice was originally raised. The fraud could lead to financial loss if Company A finds that even with the illegally gained prepayment, it cannot fulfil Company B’s order and it ceases to trade. The factoring firm will have no joy in recouping its losses from Company B because the trade was never completed.
Using Different Bank Accounts
In this scenario the payments go into an alternative bank account, not the bank account used by the invoice financier. The client of the factoring firm receives a cheque and puts the cheque into their own account. Alternatively, the buyer is instructed to make payment by bank transfer to an account that is different to the trust account set up by the financier for invoice discounting.
Under an invoice discounting facility, the seller receives the prepayment of 80% of the value of the invoice. They also receive 100% when the original invoice is paid.
Here is an example to clarify this type of fraud.
Company A has raised an invoice for £20,000 which they submit for invoice discounting. They receive £18,000 in a prepayment from the invoice finance company involved. On the due date, the director of Company A receives the full payment of the original invoice as a cheque and puts it into the company account NOT the account set up by the invoice financier. Thus, company A has received the prepayment (£18,000) and the full payment (£20,000), thus accumulating £38,000 from an invoice worth £20,000.
Legal Points
Under a disclosed factoring agreement, the debtor is informed through a Notice of Assignment that the invoice must be paid into an account controlled by the invoice financier. This notice should be included in all invoices subject to factoring as well as in the monthly statements. Moreover, all invoice finance agreements include a trust clause that specifies that all payments are held ‘in trust’ for the invoice financier. Any person who disregards this clause, wittingly or unwittingly, is personally responsible to repay the funds that are misappropriated.
Withholding Credit Notes
Here’s how this fraud works. Company A receives an order from a customer for machine parts. The order is filled and the invoice duly dispatched. At this point, Company A applies for invoice finance and gets 80% of the invoice value as a prepayment. However, a couple of weeks later the customer queries the order as it has received the wrong machine parts. To rectify the problem Company A issues a credit note to its customer so that the original invoice is cancelled.
The law is broken when Company A doesn’t inform its invoice financier that a credit note has been issued against the original invoice. Company A do this because they don’t want to return the prepayment.
Before long, credit control checks done on behalf of the invoice finance company unearth the fact that the machine parts were returned. At this point, Company A comes clean and reveals the existence of the credit note. The ledger is rectified and all’s well that ends well. However, if Company A goes bust before the credit note is officially tallied on the company accounts, then the invoice finance company has made a prepayment against a non-existent invoice.
Manipulating Data to Commit Fraud
Invoice finance companies rely on accurate data to successfully manage their business. Changing data through forging documents or altering documents can result in invoice finance companies losing money. Here are the ways data can be manipulated to defraud a factoring firm.
Credit Limit Document
An invoice financer will set credit limits on their clients which will be based on the credit insurance of the clients. If the insurer sends their documentation to the company applying for invoice finance rather than directly to the invoice financier, they are in a position to alter these documents to make it appear that they are covered by insurance for larger amounts than is in fact the case.
Proof of Delivery
An invoice financier managing a factoring facility for their client will need to see a proof of delivery document before they accept an invoice for factoring.
It is not difficult with today’s technology to forge a proof of delivery document to get a prepayment on a fictitious invoice. For this reason, it is preferable for the invoice financier to check directly with the debtor that a delivery has been made.
Manipulating the Sales Ledger
This is the age-old fraud of having two sales ledgers – the genuine one, and the one shown to the invoice financier. This is done because the invoice financier will avoid offering invoice finance on invoices that are outstanding by 90 to 120 days. Statistically speaking, the longer an invoice goes unpaid the less likely it will ever be paid. The client of the factoring firm knows this and the invoice financier knows this. Thus, a false ledger is created to move invoices from the 90 to 120 days outstanding column to the 30 days outstanding column. Thus, the invoices with low probability of being paid are suddenly made to look like safe bets.
Manipulating Stock Data
Many factoring firms will also offer stock finance or asset based lending. This is where a prepayment is made against stock in the warehouse of a client with the legal understanding that the final payment is made when the stock is sold. To run such a financing facility detailed information about the stock is required.
There are a number of ways that the data about stock can be falsified:
- Claiming you have more stock than you really have;
- Misreporting the type of stock as some types of stock are not suitable for financing;
- Misreporting the age of the stock;
- Claiming uncompleted stock is completed; and,
- Misreporting about obsolete or out-of-date stock.
The solution to stock data manipulation is for the financier to use an independent auditor to verify the claims made about stock from their client.
In Summary
Criminals who commit fraud are often as smart as the people paid to detect fraudulent behaviour. Due diligence into companies (that they are legitimate and independent from their customers) and into owners and directors (what is their history in business? do they carry personal debts? have they been in financial trouble before? do they have a criminal record? do they lead a lavish lifestyle?) all needs to be thoroughly investigated within the limits of the laws regarding privacy.
The main types of invoice fraud are:
- Fictitious invoices;
- Partially fictitious invoices that inflate the value of the goods or services sold; and
- Pre-invoicing where an invoice is submitted for factoring before an order is made.
The other main area for invoice fraud involves manipulating data to falsify credit insurance data, proof of delivery data, invoice age and stock data in the case of stock finance.
Finally, the new weapon against invoice fraud is AI and machine learning that can analyse data and identify unusual behaviour and possibly suspect invoices. Blockchain technology to track deliveries and prevent alterations to logistical information will be vital going forward in the fight against invoice fraud and stock fraud.
