Cash Flow Exclusive / May 2015

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1 Ralf Bieler Co-Founder, President, CEO Cash Flow Exclusive, LLC My 2 Cents on Fraud & Protection for Small-Ticket Factors Fraud happens! And the banking and financial services industry is the one with the most hits. But don t throw in the towel just yet. Small-ticket factors can do a lot to manage and mitigate their risk. T he Association of Certified Fraud Examiners (ACFE) estimates that the typical organization loses 5% of revenues each year to fraud. If applied to the 2013 estimated Gross World Product, this translates to a potential projected global fraud loss of nearly $3.7 trillion. The overall median loss caused by the frauds amounted to $145,000. Yet, the banking and financial services industry has the greatest number of reported cases with a median dollar value loss of $200,000.* IF CROOKS SEE A CHANCE TO GET YOU, THEY PROBABLY WILL OR AT LEAST TRY No matter which industry we look at, every single business faces the risk of fraud, but if you own a small-ticket factoring business or are thinking about starting one, you will soon realize that a decent fraud protection policy has pretty much the same effect as a sleep-number bed. You simply sleep better and wake up more relaxed. (* Source: The Association of Certified Fraud Examiners, Inc. s 2014 Report to the Nations on Occupational Fraud and Abuse.)

2 But can you really prevent fraud? Probably not. If crooks see a chance to get you, they probably will or at least try. Particularly, if they are professionals with a clever scheme to defraud trusting factors. However, as a small-ticket factor i.e., someone who buys only small receivables fraud is one of those things we know exist, but we don t really expect it to happen to us. Fraud is really something the larger factoring companies have to worry about. Makes sense, does it not? Why would con artists take the risk of being caught defrauding small-ticket factors, where the loot amounts to a few thousand dollars, whereas with the same fraud they could make hundreds of thousands or more, by defrauding the big guys? You wouldn t want to work for peanuts either, if gold nuggets were just around the corner, now, would you? Small-ticket factors are fairly safe, when it comes to fraud. They are insulated by thug-logic and common criminal sense. Or are they? Some small time crooks figure that smallticket factors are less sophisticated and vigorous in their fraud protection procedures and therefore have sucker written all over their forehead. SMALL-TICKET FACTORS HAVE INDEED SUFFERED SEVERE LOSSES DUE TO FRAUD It is true that small-ticket factors are less attractive targets than larger factoring organizations, but this does not mean fraud never happens. Small-ticket factors have indeed suffered severe losses due to fraud. Of course, due to the nature of the business, the dollar amount of their losses just has fewer zeros. The good news though is that most of those cases were not very sophisticated schemes and could have probably been prevented by using good, old common sense and the Reagan-doctrine of trust but verify. Following proper procedures, not breaking their own rules, and adhering to a stringent due diligence process will go a long way, too. Now, let s look at some situations that can make a small-ticket factor vulnerable to fraud.

3 Right off the bat, I can think of two risks that can open the small-ticket factor s door to fraud. However, they can easily be avoided. 1. The Big Bucks Bait Small-ticket factors normally deal with small receivables and low purchase volumes. However, business may be slow, or they may have additional funds they would like to get into the market. Along comes a great deal that promises a lot more revenue than what they are used to. Since it is so tempting, they focus only on the opportunity and downplay the risks. They ignore their usual limits and increase their exposure risk. If all goes well, congratulations. If this big opportunity just happened to be the fraudster s bait, they may have just killed their business. The protection: Don t let greed kill you. Stick with your core business. Buy only small receivables and volumes that won t wipe you out, if a transaction goes south or if the client turns into a con artist. Don t ever over-expose yourself, and fly below the attractiveness radar of a fraudster. Always. No exceptions. 2. The Good Samaritan Syndrome Mr. small-ticket factor also tends to be Mr. Niceguy. He (or she for that matter) usually wants to help everyone, every time. If scammers sense this, Mr. Niceguy really does have defraud me now written all over his or her forehead, and fraudsters will use it to their advantage. They ll either feed the factor a sob story to appeal to his or her bleeding heart or find reasons to rush them into a deal, trying to shorten the due diligence process. They may also have a story or a business process so complex or convoluted that Mr. Niceguy is either quite impressed or somewhat intimidated. REMEMBER: YOU NEVER LOSE MONEY ON A DEAL YOU DON T DO The protection: Trust your instincts and use common sense. Just say No to a deal, when No is the answer you want to give. Don t let anyone cajole or rush you into a deal, and don t do business with anyone who makes you suspicious or even uncomfortable.

4 Stay away from deals you don t understand, and verify a sob story thoroughly, before you swallow it hook, line, and sinker. Remember: You never lose money on a deal you don t do. While complete risk elimination is not possible, smart safeguards will put the odds in your favor or at least provide sufficient damage control. Let s look at some typical cases of fraud, and let s put them into two groups: A) Unintentional Fraud The term fraud may not even be completely appropriate, since unintentional fraud happens as a result of an honest mistake or oversight, while actual fraud is committed with premeditation. Unintentional fraud occurs, when the client erroneously receives and unintentionally keeps a customer payment for a factored invoice, or when the client mistakenly factors the same invoice twice, or mistakenly overcharges the customer and submits this invoice for factoring. The operative words in these cases are unintentional and mistakenly. Obviously, mistakes happen, but when they do, they do not cause any harm, because no malice was intended and they are easily resolved. Of course, all of the above would constitute truly fraudulent behavior, if the client did it on purpose and with the intention to receive more money from the factor than he actually was due. The protection: Ensure that clients are aware of the procedures to be followed if they mistakenly receive a customer payment for a factored invoice. You might also consider a financial penalty for repetitive mistakes. Technology can help as well: Good factoring software will catch duplicate invoices and not allow them into the system. And finally, verify invoices with the debtor before advancing funds against them. B) Intentional Fraud Intentional Fraud occurs when clients take premeditated actions to deceive the factor. Here are three typical examples of intentional fraud:

5 1. Redirection & Conversion Clients instruct their customers to send payments to them (not to the factor), and then deposit the checks into their own account without notifying the factor. 2. Intentional False Billing Client factors fictitious invoices Client factors invoices for incomplete work Invoices sent to the factor differ from invoices sent to the customer Client factors invoices twice Client overcharges to factor larger invoices Client factors invoices to existing companies that are not actual customers though Client factors invoices to fictitious companies 3. Fictitious Companies / Identity Theft Client company does not exist, and all invoices and customers are fictitious Client company does not exist, and fictitious invoices are sent to existing businesses (client and customer are in collusion and back each other) Client pretends to work for an existing company and factors fictitious invoices to either existing or non-existing companies The protection: Fraud protection and general risk management for a small-ticket factor go hand in hand. First, small-ticket factors must have a good understanding of the entire scope of all potential risks. Secondly, they need to know how best to avoid or mitigate them. IT IS OFTEN A FEELING THAT RAISES THE FIRST RED FLAG, RATHER THAN A RATIONAL REASON This requires a sound due diligence process and an intimate familiarity with the available resources. Perhaps one of the best fraud protection and risk management tools small-ticket factors have is their gut feel and common sense. Do not accept deals or clients with which you feel uncomfortable. I use the word feel here intentionally, since it is often a feeling that raises the first red flag, rather than a rational reason.

6 Likewise, do not ever get involved in a deal or industry you do not understand. If it sounds too good to be true or too convoluted, it probably is. Factoring certain industry specific receivables requires expert knowledge and special procedures. Leave those to the experts. Stick to your guns. Only factor small receivables, and set yourself concentration (exposure) limits per client, customer, and invoice. Do not exceed them for opportunistic reasons or because of greed. Build and maintain reserves to cover potential customer short- or nonpayments and write-offs. Before accepting a client, do your homework and due diligence. Conduct a pre-qualification interview and have prospects submit a written application together with supporting documents. Check public records for company details and ensure that the company is in good standing. Search for bankruptcies, liens, legal proceedings, and judgments against the company. Conduct a credit and background check on the owner and all directors of the company. Search for criminal history, bankruptcies, liens, legal proceedings, and judgments against any of them. Look for character issues. While a record for traffic violations may not necessarily be a showstopper (if it s limited to a few parking and speeding tickets), someone who doesn t pay child support should at least give you pause. If he doesn t even take his responsibility towards his children and their mother seriously, how likely will he be to honor his commitments to his factor when push comes to shove? Get a copy of the driver s licenses and social security cards of the owner and all directors of the company to ensure they are who they say they are. Check for inconsistencies between the information within the pre-qualification interview, application, and supporting documents, and the results of your public records search. Does everything match? Were they forthcoming about all details, or did they withhold information? Once you are satisfied with the information regarding the client and their company, you want to look at their customers to determine whether they are creditworthy companies. The

7 pertinent reports are available from agencies such as Dun & Bradstreet. WHEN CONTACTING A CUSTOMER FOR THE FIRST TIME, ALWAYS USE PUBLIC RECORDS TO VERIFY THEIR CONTACT DETAILS AND PHONE NUMBER You can also do this as your first step, and if you find that the customers are not up to your standards for factoring, you can save the entire due diligence on the client. Once all is said and done and you are already factoring, the next fraud protection tool to use on an ongoing basis is the invoice verification process with the customers. A special tip: When contacting a customer for the first time, always use public records to verify their contact details and phone number. Use this number to call their company; then ask for the person you are looking for. Summary Eliminating all risks is impossible. But avoiding greed-driven decisions and using gut feel and good common sense combined with a sound due diligence process and best practice risk mitigating procedures can help reduce the risk of fraud to an acceptable level. How much ongoing due diligence is sufficient for a small-ticket factor is hard to say. This will vary and depend on the experience with the client and its customers, the size of the transactions, and the factor s exposure level and risk tolerance. But having sound processes and procedures in place and being disciplined enough to adhere to them consistently is probably one of the biggest contributors to the success or failure of any small-ticket factoring business. To your success, Ralf Bieler Co-Founder, President, Chief Executive Officer Cash Flow Exclusive, LLC Ralf@CashFlowExclusive.com