Debt Factoring Frauds

What is Third Party Fraud?

This is a fraud committed against someone or some business by people other than their employees. They can be committed against individuals, businesses, companies, governments etc. 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 get away. The fraudster may not care if the fraud is eventually discovered as there is no continuing relationship with the victim and they have made their getaway.

What is debt factoring?

Factoring - in its most simple terms - is the raising of finance against trade debtors. Businesses sometimes have cash flow shortages, but have large amounts tied up in trade debtors and have to wait to collect these monies. Debt factoring is a method of obtaining money from the debtor's ledger, before the debt is collected.

Factoring agreements have a variety of styles and this paper does not go into the differences of individual arrangements.

How is factoring done?

A business has a debt that is not yet collectable and needs cash. A factoring company will pay them a percentage of the debt amount when it is factored. The balance of the monies, less commissions and charges, are paid when the debt is collected. The business has immediate use of a large part of the amount, with the remainder paid when collected. The exact details and the amounts will vary from agreement to agreement, but the basic underlying formula remains fairly constant.

What are the alternate methods of factoring?

There are two basic methods used. The factoring company may:

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

They also have a choice of their level of involvement in collecting the debts. They may:

(a) collect the debt themselves; or
(b) stay behind the scenes, and allow the business to collect the debtors.

Why would the business collect the factored debtors?

The factoring company and the business may want the business to collect the debtors as:

1. the cost for the factoring company to conduct this function could be large, and
2. the business's customers may go elsewhere if they knew that the business was factoring its debts.

The collection and banking of the debtor's monies may be left entirely to the business, with regular reports and remittances being forwarded to the factoring company.

What are the issues with the factoring company staying behind the scenes?

Whenever a party does not have an active participation in a transaction, they must in some part rely on the information from and honesty of the other party. Problems will arise if the business owners are not honest.

The factoring company will probably receive a report each month detailing the outstanding invoices, the new invoices to be factored and the amounts collected and written off. Depending on the balance of the monthly activity, they will either receive a payment at the end of the month or forward further monies to the business.

The point is that the factoring company is reliant upon the business for this information. This streamlining of the process is what the dishonest business owner needs to be able to commit the fraud. If the information forwarded to the factoring company can be falsified, the fraud can be committed.

What do factoring companies do?

Factoring companies do not just sit back and hope for the best. They conduct audits, but the extent and timing of the audits can be influenced by how the account is going. If the business provides copies of all outstanding invoices, has few un-collectable invoices and pays all amounts on time, the audit process is likely to be less stringent and less frequent than for a problem account. Ironically the more the fraud is committed and the better the account superficially looks - the easier it is to get away with the fraud.

How is the fraud committed?

The fraud is done by the business giving the factoring company false invoices to factor. A new false invoice is submitted at a later date as the original false invoice becomes due to be collected. The factoring of the new false invoice provides the money to pay the original false invoice.

If the business is handling collections and providing information to the factoring company, the fraud may be relatively easy to commit. If the factoring company does the collection process the scheme is more likely to be discovered and a lot more difficult to commit, but it can still be done.

How does the fraud remain undetected?

The more reliance that the factoring company places in the business owners, the better chance that a fraud will go unnoticed. On one hand it is sensible for the factoring company to allow the business to do as much work as possible in collecting the monies, as it keeps costs down. On the other hand, it reduces controls.

The system is self perpetuating. As more false invoices are factored and repaid (with the resultant increase in the fees charged) the profile of the business as a good customer will increase. As the profile increases and turnover increases, the less attention will usually be paid to the process and this creates a safer environment to conduct the fraud. That is, the bigger and more often the fraud, the easier it is to get away with.

The fraud usually cannot be ended, as the factoring company is expecting to be repaid the monies paid to the business. Unless the business can repay these monies from a legitimate source, they will have to keep committing the fraud in order to pay due monies.

FOR EXAMPLE

Based on a true story.

ABC was in the transport industry. It had a factoring arrangement with XYZ Factoring. It collected the due monies from factored invoices and remitted these to the XYZ along with new invoices for factoring. The balance of the monies to be paid and collected were remitted by one party to the other. XYZ was aware that the transport industry did not always pay on a 30 day basis, so was not concerned when an invoice went above its 30 day limit.

The business was not doing well and required some funds. The director of ABC found that he could generate a fictitious invoice from a regular customer and submit to XYZ it for factoring. The usual amount under the agreement was paid to ABC for this false invoice. When the time came to 'collect' the debt and pay back the factoring company, there were insufficient monies to make up the difference. ABC issued another false invoice from the same customer, collected these monies from XYZ and used them to pay the first invoice.

ABC increased the amount of the false invoices and became more creative with false customers. Every month or so, the debts would be rolled over with new false invoices, and all outstanding amounts 'paid' to XYZ, though ABC never had to find the money, the new false invoice provided it. XYZ saw that ABC's business was growing and considered them as a good customer. All amounts were paid on time. They were not aware at that stage that they were being paid with their own monies.

The scheme fell apart when XYZ did an audit. They called the customer in relation to one of the invoices that had been submitted for payment and found that the invoice was never issued to them. That lead to further checks and the fraud was detected.

LESSONS TO BE LEARNED

1. Factoring is based on the business creating false invoices to its customers and submitting them for factoring. The factoring company will need to monitor these invoices and conduct audits, at least on a random basis.

2. The more that the factoring company knows the end customers and has the right (or expectation) to check the invoices, the less likely that a false invoice will be issued or go unnoticed. Detection can be as simple as calling the debtor and verifying that an invoice is correct.

3. The factoring company may have the debtor monies paid directly to them, bypassing the business. This will highlight false invoices and false customers. As the relationship is built between the factoring company and the end customer, there will be less concern with requests for verification of invoices.

Disclaimer
The enclosed information is of necessity a brief overview and it is not intended that readers should rely wholly on the information contained herein. No warranty express or implied is given in respect of the information provided and accordingly no responsibility is taken by Worrells or any member of the firm for any loss resulting from any error or omission contained within this fact sheet.

Acknowledgment
The material in this Fact Sheet was sourced from various publications including those listed in the Reading List on the Fraud Awareness page on this website.

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Last Updated: 20.3.2008