Fraud in Factoring and Invoice Finance

All forms of lending fall into two basic types: secured and unsecured. If a loan is unsecured, there is no underlying asset that the lender can get their hands on, should the borrower default on the repayments.

If a loan is secured, there is an underlying asset that is used as collateral for the loan. If the borrower defaults on the loan repayments, the lender takes possession of the asset and converts it into money to repay the loan. A classic example is a mortgage on a property. If the mortgage holder is unable to repay the mortgage, the lender will take possession of the property. Another example is a hire purchase arrangement to buy a car. If you fail to make the repayments, you can wave goodbye to the car!

Factoring companies must be aware of the likelihood of fraud occurring and protect themselves through a range of defensive measures.

When it comes to factoring / invoice finance, the asset is the outstanding invoices. The “loan” in this case is the Funds in Use balance, which is increased when advances (out-payments) are made to the client in respect to approved invoices assigned to the factoring company. The loan is repaid when the customer of the client (the debtor), pays the invoice, thus reducing the Funds in Use balance. At any point in time, the value of the outstanding approved invoices should be greater than the Funds in Use. If all else fails, the factoring company, should be able to repay the Funds in Use by collecting all of the outstanding invoices - the asset that secures the loan.How secure are factoring companies that they will get their money back? There are three negative scenarios when it comes to the debtor paying back the invoice: won’t pay, can’t pay, nothing to pay.

Won’t Pay: If a debtor refuses to pay an otherwise legitimate invoice, this is generally some sort of dispute that needs to be resolved by the client with its customer.

Can’t Pay: If a debtor can’t pay due to financial difficulties, this begins as overdue invoices, but eventually leads to bad debts. These are either covered by the factoring company (non-recourse agreement, bad debt protection) or they are client-risk (recourse agreement), which means that the factor assigns the debt back to the client and offsets it against other, good invoices, assigned by the client (new good collateral, replaces the old bad collateral). Credit insurance may also have its part to play in this scenario.

Nothing to Pay: This is when we get into the realms of fraud. If the client has fabricated a fake invoice, the factoring company may advance money to the client, but there is no underlying real asset to secure that advance of funds (the loan). Invoices have due dates, which are normally at least a month after the invoice was raised, sometimes several months. The first indication that the invoice was fake would occur when the factoring company tries to get paid by the debtor, which could be several months after the invoice was financed. Another possibility is that the invoice wasn’t fake, and the debtor did pay the invoice. However, rather than the money being paid to the factoring company, the funds were directed elsewhere, typically to the client, but there is also the possibility that a criminal intercepted the invoice and overrode the bank details. When the factoring company seeks payment from the debtor, the debtor simply responds “but I’ve already paid the invoice!”.

All kinds of fraud have tell-tale signs that factoring companies can use to defend themselves. Good processes, sophisticated computer systems and well trained employees are key to this defence. Unfortunately, this is often portrayed as a victimless crime. Factoring companies are reluctant to pursue fraudsters or publicise fraudulent activity. If a person is prosecuted for fraud, the process can take years and the penalties may be minor. As in most things, in life, prevention is always better than cure.

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