What is Third Party Fraud?
This is a fraud committed by people outside an employee employer relationship. They can be committed against individuals, businesses, companies, the government or any other entity. 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 make their get-away. The fraudster may not care if the fraud is eventually discovered as they do not have a continuing relationship with the victim and they cannot be found.
What is Factoring Fraud?
Factoring fraud is a fraud committed against a debt factoring company by one of its customers. The aim of the fraud is to obtain money from factoring fictitious debtors, by forwarding false invoice to the factoring company. This fraud is meant to remain hidden for the long term – at least as long as the business relationship between the parties lasts. This paper deals with some ways factoring companies can be defrauded.
Major Headings
Description of Factoring Fraud
For Example
Lessons to be Learned
Description of Factoring Fraud
Types of factoring arrangements
Debtor factoring is the selling of or the borrowing against trade debtors by cash poor businesses. Businesses do this to generate cash flow before their debtors are due for collection. Generally when an invoice is factored, a percentage of the face value of the invoice is paid immediately by the factoring company to the business. The balance of the face value (less the fees etc.) is paid when the debt is collected.
The factoring relationship is generally conducted in one of two ways. The factoring company may:
(a) buy the debtor from the business; or
(b) lend money to the business secured against the debtor.
Whether the factoring company buys or lends against the debtor invoice will not affect whether the fraud is possible or not. What will affect the fraud is whether the factoring company has any role in collecting the debts. The factoring company may or may not take any role in the collection of the debtors.
1. Factoring company collects debts
If the factoring company has a role in collecting the debts, the debtor will know that a factoring company is involved. This usually only happens when the ownership of the debt passes to the factoring company, but even then factoring companies often leave the actual collection process to the business. The important part of this particular relationship is that the debtor knows that their debt has been factored and pays the factoring company directly.
The major benefit is that the factoring company will become aware of whether the invoice is real or not, or collectable or not, when the debt is due for collection. Also the factoring company will usually have the right to verify factored invoices directly with the debtor. This relationship between the factoring company and the debtor reduces the opportunity for fraud as the factoring company has direct knowledge of debts and collections.
The downside of the factoring company taking an active role is that it is expensive (the downside for the factoring company) and the debtors may feel uneasy dealing with a business that factors it debts (the downside for the business). Because of this it is not uncommon for the collection process to be done entirely by the customer and without the debtor’s knowledge that their debt has been factored. This opens the avenue for fraud.
2. Customer collects the debts
In this relationship the factoring company takes no role in collecting the debtors and the debtors are probably not aware of the factoring agreement. The customer collects the debtors and accounts to the factoring company at the end of each month, providing the required reports detailing the invoices collected and new invoices to be factored. The balance of the money owed by or owing to the factoring company is paid.
The major difference is that the factoring company has no direct knowledge of collections and no independent verification of the invoices that it has factored. They are reliant on the information provided by their client, the business. This opens the system to fraud. It is this type of relationship that is described in this paper.
How is the fraud done?
A factoring agreement has three parties:
1. The factoring company (usually a finance company)
2. The business that issues and factors the invoices with the factoring company (the customer)
3. The debtor who owes the money to the customer
If the factoring company has no direct knowledge of collections, their dealings with their customer will revolve around two types of reports. One will detail new invoices to the factored (money to be paid to the customer) and the other will detail collections of previously factored invoices (money to be paid to the factoring company). Money will usually flow between the factoring company and the customer based on the net amount in these two reports.
There is no communication between the debtor and the factoring company. The factoring company is relying on its customer being truthful and not falsifying the information in these reports. It will generally not conduct any independent verification of debts or collections.
Creating a false invoice
This fraud is based on factoring false or inflated invoices. Completely false invoices can be created easily on a personal computer and cheap printer. They can be created to look like they have been issued by legitimate debtors (the factoring company would recognize the debtor’s name as other invoices from this debtor have been factored and paid), or fictitious debtors with invented details.
These false invoices are added to the list of real invoices to the factored. This is easy when there is no direct communication or verification between the factoring company and the debtors. The money is paid for these false invoices.
Collecting a false invoice
The next part of the fraud is dealing with the false invoice at the time that it should be collected and paid to the factoring company. This is usually solved by a simple ‘lapping’ scheme – committing a later fraud to hide an earlier fraud. A new false invoice is created and factored. The money from that new false invoice is used to ‘pay’ the money owed to the factoring company for the earlier false invoice. As both the new factored invoice and the collection of the old invoice are reported to the factoring company at the same time, they will usually simply be netted off. Effectively no money changes hands.
As the first false invoice appears to have been collected, it will not appear suspicious. As the first fraud is eliminated (the invoice has been collected), there is little chance that this particular fraud will be uncovered at a later date. Because the dealings between the factoring company and the customer revolve around the two reports and the netting of amounts owed, the money from the false invoice never actually has to be paid – one report will create a new debt, the other remove the old debt. This system can be conducted indefinitely, in theory at least.
Depending on what information the factoring company wants attached to its reports, the false invoices themselves may not even need to be physically created. As long as the entries look legitimate in the reports and in line with past business, they may be factored.
Growth of the scheme
Ironically, the more the fraud is done and the larger the amounts involved, the more successful and more profitable the customer may look to the factoring company. The factoring company will be making more money from the relationship (albeit from factoring false invoices).
The fraud may begin with one of two small amounts, but can grow as the factoring company becomes used to the increased amount of factored debt and the regularity of payment. The more false invoices that are factored and lapped (i.e. paid) the greater the perceived turnover and fees earned by the factoring company, and the better and more profitable the customer appears.
As the customer’s standing with the factoring company improves, the checks and control over the arrangement may actually decrease. The factoring company will start to trust the customer and this makes the fraud even easier to commit.
For Example
Mr S ran a barely profitable trucking transport company that suffered from cash flow problems. The industry is known for long periods for payment and the company had to regularly wait 90 days to have invoices paid. Mr S entered into a factoring arrangement to generate cash flow. The factoring company played no role in collecting debtors, it allowed the customer to collect the money and report on a monthly basis.
The debtors paid the company was usual. At the end of each month the company factored new invoices and reported the collections and new factoring to the factoring company. It off-sett the two amounts and paid or collected the balance. This system of reports and offset payments worked fine for many months and the relationship between the parties became stronger.
One day a truck broke down and the company needed $40,000 to repair it, but the company did not have the money. Mr S created a false invoice to one of its regular customers for $50,000 and this invoice was added to the list of invoices for factoring. The factoring company paid 80% of the invoice (the required $40,000) under the terms the factoring agreement and the money was used to fix the truck.
Later the company needed the money that should have been collected from the false invoice. It still did not have the money, so Mr S created an other false invoice and factored it. The money from the second invoice was offset against the money owed from the first invoice. The records showed that the first invoice was collected and the required money paid to the factoring company. The company had bought some time.
That seemed all too easy. Mr S decided that he wanted a new car, so created an other fictitious invoice and factored it. He now had the money for the new car and, if the system stayed in place, would never have to actually pay for it. More false invoices were created from both real and fictitious customers in ever increasing amounts to cover the factoring costs. The factoring company saw the increase in the business and noted that all these invoices were paid on time. The company appeared to be a good customer and invoices were factored more readily at better rates.
The scheme was found when the factoring company decided to randomly audit the ledger that it had factored and discovered that a number of the invoices were not real. By the time that the fraud was discovered, there were more fictitious invoices factored than real ones.
Lessons to be Learned
1. Factoring fraud is possible when the factoring company has no control or direct knowledge about the collection of debtors.
2. Random audits of debtor’s invoices and collections should highlight problems. The factoring company will obtain details of factored invoices and details of the payments made directly from the debtors and compare these to the details obtained from the customer. False customers will easily be highlighted and false invoices under real debtor’s names will be unknown to the debtor.
3. The aim of the fraud is to maintain a communication gap between the factoring company and the debtors. If the factoring company does not satisfy itself that the debtor is genuine before factoring an invoice, if it does not check that the actual invoice is valid, or if it does not ensure that the payment is being received from an actual debtor, there is a chance that the fraud will be conducted.
4. The more the fraud is undertaken and the higher the volume of the false transactions, the better the customer looks and the less the factoring company may monitor the position.