Anatomy of a Fraud: Playing Defense to Minimize Losses
Joseph Iannuccilli, founder and CEO of Sound Shore Financial, recounts a memorable fraud uncovered by his field examination firm, and illuminates why a field exam is key to avoiding or minimizing loan losses for a lender. In this case, the lender noticed availability tightening, receivable turnover dramatically increasing and the loan balance rising.
The following case incorporates several elements of fraud. It illustrates how the field exam is the most important defense we have to avoid, or at least minimize, major loan losses caused by fraud, our biggest nemesis. Borrowers can be cunning; therefore, in classified or deteriorating credits, we should assign examiners who have years of experience and exposure to liquidations of receivables and inventory.
A domestic manufacturer was getting battered by overseas competition. The company embarked on a plan to reinvent itself by focusing its production on a new line of specialized items that had higher margins, barriers to entry and were not impacted by lower-cost imports. This proved to be a good idea until quality issues led to reworking of production, resulting in higher manufacturing costs. Rather than sitting down with the lender to discuss the situation and attempt to work out solutions to the issues, the borrower went down the wrong road and began to perpetrate a fraud.
After a period of time, the lender noticed availability tightening, receivable turnover dramatically increasing and the loan balance rising. The lender was in effect financing losses, not growth. Other signs of trouble included late issuance of receivable agings and financial statements. Instead of weekly advances, the borrower was requesting daily advances. The lender declared a default. Wisely, the lender ordered a field exam approximately 45 days after the last recurring exam, and selected our firm.
Before commencing field work, we always receive the lender’s insights and special instructions, regardless of the borrower’s risk rating. In this case, we also held thorough conversations with the chief credit officer. And in all of our testing, we looked at as much third-party, supporting data as possible. This is the recurring theme of field exams. We never want to rely too heavily on the borrowers’ records.
Our initial focus and priority was to perform shipping and cash application tests, and invoice verifications directly with the customers.
Usually, the shipping test includes a review of the signed bill of lading (BOL) only. In this case, our testing required tracing the shipment to documents from the common carriers. We attempted to match true ship dates to invoice dates, and compared weights amounts billed, noting irregularities and finding evidence that the borrower was prebilling.
Some third-party carriers’ shipping documents indicated goods had been delayed by weeks. Other records were not available, leading us to believe goods had not been shipped at all. In examining borrower-supplied BOLs, we observed many of the signatures had similar handwriting. On several large invoices, the BOLs had all been signed by the same individual on the same date, indicating “Tom” had driven to Miami, Dallas, Indianapolis and Los Angeles on the same day.
We also examined customer purchase orders. We found many POs were calling for releases at a later date, or there were no POs available. When egregious findings such as these occur, the field exam firm owner or senior manager at should get intimately involved in directing the remainder of the exam, and communicating with the lender’s senior credit personnel.
At this juncture, the lender directed us to dig deeper and perform a forensic exam. The lender also asked for recommendations on how to increase monitoring, and minimize losses.
We moved forward with an examination of cash receipts. We matched remittance advices from the customer to invoices purged from the system and, in all cases, found that payments were applied to the oldest column, regardless of the date of the original invoice. We also discovered that the largest customer showed invoice dates on remittance advices that were much later than the “billed date” assigned to the lender. This substantiated the prebilling, as the customer was not recognizing the invoice until the “receiving date.”
We also analyzed bank statements from a blocked account, comparing the deposit date to the date of application. We found that invoices were being purged from the system several days after the deposit was made. This reduced the loan balance, but not the collateral balance, which further inflated the collateral and the overadvance.
During our examination of operating accounts, we found no conversion of receivable collections. We did, however, question some very large disbursements with even amounts. As it turned out, these payments were made to borrower principals, and booked as “Loans Receivable From Shareholders.” The ownership, resigned to the fact that they were on a sinking ship, resorted to unjust self-enrichment to salvage personal wealth at the expense of the lender.
The lender supplied us with an email verification revealing no material variance from the largest customer. However, we discovered a different URL for the customer in our own direct emails. We confronted the IT manager, who admitted the borrower had created a fictitious email similar to that of the customer.
Our phone calls to the customer’s accounts payable department attempted to verify invoices and balances. And using the borrower’s online access to the customer’s portal and accounts payable department helped pinpoint problems.
The least reliable method is examining payment methods on a sample of invoices. Payment information should resemble the terms of sale or prior turnover of the customer’s pay pattern. Payments, alone, do not substantiate the validity of invoices at the time of billing.
Next, we attempted to determine the value of the inventory by identifying products that would be available to fulfill purchase orders. Looking back to the expanded ship test, we saw a material amount of product on prebilled invoices backed by POs calling for shipment at a later date.
We sampled a very large percentage of these invoices and found that, in most cases, the finished goods inventory was not in the plant. Even worse, raw materials itemized in the bills of material required to complete the orders were not in stock. By analyzing the purchase journal, we ascertained this was due to key vendors holding up shipment until past due invoices were paid. A spread of the most recent payable aging indicated that the current column had shrunk drastically. This supported the fact that material flow could not be sustained for timely production.
Further, in our plant tour, we noted a substantial amount of paper stock, segregated and in unopened rolls. When we inquired of the warehouse manager, he disclosed that the inventory was shipped by the vendor on consignment and, therefore, title had not passed to the borrower. Examiners should especially expand their test of vendor invoices to look for consignment in printers, contract manufacturers or “fillers,” as consigned goods are commonplace in these types of borrowers.
As was the situation in this case, examiners should attempt to communicate with staff members other than the CFO or controller. Warehouse or administrative staff can reveal important information about the collateral.
Rather than remaining at the borrower’s office for a protracted period of time, we held a preliminary exit interview with managers, who eventually admitted some of their wrongdoing, including that the CFO had signed BOLs, and maintained a separate set of books to track the true receivables and inventory.
We were subsequently informed that a local CPA firm had issued an audited statement while all this was occurring. The borrower was the firm’s largest client, and the CPA had relied solely on subsequent payments to audit the receivables. To justify inventory, the borrower padded works-in-process and finished goods with exorbitant levels of labor and overhead through a standard cost system. The borrower also included — at full cost— damaged, returned inventory that had only scrap value.
Although painful to the lender, which ended up taking a loss, the situation could have been worse if permitted to fester. Frauds such as these can be perpetrated by people who are desperate to keep their business afloat, believing that they will repay the lender whole at a later date. In more rare cases, individuals premeditate a scheme to commit fraud with the intent to divert funds into owners’ greedy hands. In either case, we cannot stop fraudulent practices, only contain them at the earliest stage possible.
Joseph Iannuccilli is founder and CEO of Sound Shore Financial.