How to prevent factoring and invoice finance fraud during the current COVID-19 crisis

In the current period of economic uncertainty, increasing pressure on businesses is making fraudulent activity an ever-present risk for lenders – a trend not only troubling for the affected company or companies, but also for the wider economy. In particular, corporate fraud has the potential to dissuade banks from lending - a dangerous outcome during a global crisis which has significantly constrained liquidity and limited funding for businesses.

Each year, fraud costs the global economy over US$5 trillion. However, fraud committed by companies accessing asset-based finance solutions, particularly those which rely on invoices, such as factoring and supply chain finance, can be especially difficult to catch. It is not uncommon for these instances of fraud to go undetected for years. It emerged last year, for example, that directors from a UK electrical goods wholesaler submitted £550,000 worth of false invoices from 44 false debtors to their factoring company over the span of 18 months before they were caught.

However, by implementing the correct processes and staff training, combined with sophisticated fraud prevention technology, factors can remain vigilant and detect the human and data related signs of fraud as they arise.

Circumstantial and premeditated fraud

Fraud in the factoring industry broadly falls into two categories: circumstantial and premeditated. The former generally happens when struggling businesses need cash urgently, but the necessary funding cannot be made available. As a result, opportunistic business-owners may produce an invoice slightly early and submit it to their factor for an advance payment.

This kind of fraudulent ‘pre-invoicing’ behaviour can be incredibly difficult for lenders to identify. And, while it may be committed by a borrower intending to legitimately raise the invoice, it can quickly evolve into a much greater problem of ‘fresh air’ invoicing, as the business-owner will likely continue to face the same underlying cashflow problem.

Unlike circumstantial fraud, premeditated fraud is a form of organised crime. Here, criminals target factors by creating fake businesses to represent the cash-limited supplier and its customer(s). To portray these businesses as legitimate, fraudsters create fake invoices to extract advances from the factor; they then use this money to ‘pay off’ the invoices, effectively recycling the factor’s cash, generating the appearance of real cashflows and a growing business. This is all seems fine until such time as the fraudsters go for ‘the kill’, take the money and disappear.

Preventing factoring fraud

Fortunately, all types of fraud have tell-tale signs, it is simply a matter of having the correct processes, technology and training in place to detect and interpret these signs correctly.

An effective first step in avoiding fraud is to address what can often be the weak link: the human factor. Potential clients should be carefully scrutinised and undergo the required KYC and AML checks. Once onboarded, clients should be regularly audited to ensure that their circumstances have not changed such that they may be tempted to commit fraud.

Verification of invoices is a further key step that can protect lenders. Verification itself could involve a physical review of the documentation or e-invoicing, although, naturally, it is not always realistic for lenders to verify all invoices. Sampling, therefore, is a common solution, with lenders often employing verification by value and by payment terms, while applying Benford’s Law and random sampling are two further methods.

Sophisticated factoring technology, increasingly deployed by lenders, also provides a further safeguard by means of data analysis and trend tracking. A large volume of new debtors or a significant increase in sales can all be tell-tale signs to alert staff. Again, manpower can act as a constraint on these checks and assigning risk scores can provide a less burdensome way for teams to track trends.

Finally, setting in place additional lines of defence, including introducing the “four-eyes” principle and rigorous audit tracking, can serve as useful guards against collusion and human error – particularly important as teams manage ever growing portfolios.

There can be no doubt that the current pandemic and resulting pressure on businesses creates an environment ripe for fraud – lenders must be prepared. Factoring is especially vulnerable, but advances in receivables finance technology, combined with the right training and realistic checks can ensure that fraudsters do not slip through the cracks