July/August 2011

The Detection of Change: Technology Advances in the Management of Risk

Ever since commercial lending was identified as one of the most appropriate financial products to support rapidly growing companies, lenders everywhere have suffered at the hands of fraudsters. It is almost an inevitable consequence of financing dynamic collateral such as accounts receivable.

Fraud — Can you prevent it? The answer to this question is of course, No! But you may be able to enhance the way you can detect it more quickly.

Ever since commercial lending was identified as one of the most appropriate financial products to support rapidly growing companies, lenders everywhere have suffered at the hands of fraudsters. It is almost an inevitable consequence of financing dynamic collateral such as accounts receivable.

Many prudent lenders implement systems and processes within their organization to try and ensure that when a bad debt arises, they give themselves the best chance to collect out their lending exposure. This is the right thing to do and highly recommended, but the ability to collect out is dependent upon two key conditions.

The first is that your client is basically honest, even though circumstances may have driven him to “bend the rules” to get access to more funding to support his business. The second is that the invoices you are offered as collateral for financing are indeed valid invoices, and in the event of the demise of your client, can be collected out by payments from debtors.

A Desperate Man

In such situations, the client can often be described as under pressure, opportunistic and desperate to do anything that may keep his business alive. It is often said that desperate people will do desperate things.

In many education sessions that we deliver to inexperienced client managers in the industry, we work on real case studies and ask the managers to take the role of the client principal. When presented with the situation that the business they are managing desperately needs more cash to pay their workers’ salaries by the end of the week, almost everyone confirms that they would raise an invoice to their factor for goods that have not yet been delivered.

They realize very quickly that if they are prepared to raise the invoice themselves in such circumstances, any client under similar pressure would do exactly the same. And the worrying aspect of such client situations is that the client principal would still believe in his own mind that he had not committed a fraud.

Often the client principal takes advantage of the account manager put in place to build a meaningful relationship with the client and to ensure the client is satisfied with the service being provided and has access to sufficient funding to support his business. When the pre-invoicing fraud occurs, the account manager is often persuaded that the client had intended to advise him of the rule bending, and the fraud is rationalized in the mind of the account manager because the client subsequently “confessed.” We define this as emotional fraud, and unfortunately we have seen many examples of it in our long experience in the industry.

In this fraudulent lifecycle, the first step sees the client under pressure, which forces his behavior of trying to find ways to obtain additional funding. The second step is when the client identifies the opportunity, such as raising an invoice for undelivered goods (fresh air invoicing) to his factor. The third step is when the client rationalizes his behavior in his own mind, as he truly believes that he is entitled to do anything to keep his business afloat.

As market conditions remain tough, more and more businesses will begin to struggle and create pressure on client facilities, thereby enhancing the potential frequency of such desperate emotional frauds.

Career Fraudster

This is the other type of fraudster. The career criminal that sets up his bogus business with the express intention of defrauding any lender it is to advance funds. Regrettably, we have seen many examples of such frauds in the numerous client cases we have analyzed over the years.

But worryingly, what we have seen develop in the last 12 months is the “sophisticated fraudster,” who builds a client company with the express intention of understanding the rules of how a commercial lending company works. Once this is understood, the client can then provide the lender with exactly which data is required to obtain funding.

Often the fraudulent client learns the rules at one lender and then moves to another, claiming that he has suffered from poor service, had a bad relationship with the client manager or any number of other spurious reasons to convince the incoming lender that his company is worth having as a client. The real reason behind this move is often that he has “learned the rules” from the outgoing lender and intends to make full use of his knowledge as a client of the incoming lender.

It is much more difficult for a commercial lender to detect fraudulent activity in such a situation, as quite often the outward appearance of the client’s performance can be deceiving, with many of the normal key indicators suggesting that the client is performing well. With a large portfolio of clients to manage, is very easy for the client manager to overlook such indicators and concentrate his efforts on those clients exhibiting deteriorating performance.

This is where self-built risk management systems and processes, which are often heavily reliant upon manual intervention, can enhance the possibility of failing to identify changes in the client’s behavior quickly enough.


Because of tremendous technological advances in recent years, lenders have improved their links with their clients allowing them to submit invoices for financing in “soft copy format” using client access systems, with some even developing software to extract data direct from client accounting systems. Client advances or prepayments are often calculated automatically by an operational system, using sophisticated rules-based calculations.

The majority of these technological advances are introduced in the interests of productivity, to ensure that the factoring company is running “lean and mean.” The inevitable move towards higher client/staff ratio merely encourages less physical interaction with clients.

Yet still many lenders continue to rely on Excel spreadsheets, which are time consuming to produce, prone to error from erroneous manual data input and inconsistent in their analysis, as their principle risk management tool. This situation therefore increases the possibility that something will get missed by the client manager and a bad debt will ensue.

The lender does not have a monopoly on improving its technology. Fraudsters have also expanded their use of applications and systems to support their attempts to obtain funds by deceitful means. Today clients can have PCs that can create bogus invoices, which in turn create bogus sales ledgers, create false proof of delivery documents and even create websites for bogus debtor companies. The advances in telephone technology in recent years has also assisted fraudsters in providing bogus verifications of debt, and even to move funds between bank accounts using Internet technology.

It is therefore essential to have proven systems in place to “back up” the client manager’s manual assessment to make sure changes in client behavior are detected at the earliest possible opportunity. The use of specific software applications to analyze risk in a portfolio of clients using sophisticated and well tested algorithms and measures makes best use of technology in the fight against client fraud.

Using technology to put lenders “on the case” earlier in the fraudulent cycle is the most effective use of skill and time. Addressing the problem earlier gives lenders the best chance of collecting out.

We have a saying in our business that, “Risk management is about the detection of change.” Frauds get successfully perpetrated and losses occur because something changed and it was missed by the relationship manager.

We would therefore recommend most forcibly that any lender should adopt the “four eyes” principal when assessing a client or debtor performance. The second viewpoint of a manager who is detached from the client relationship can be invaluable when trying to detect fraudulent activity by a client.

This approach offers a lender some protection at least in avoiding emotional frauds. We would also recommend that any procedures and processes established by a lender should be developed, followed closely and improved continuously.

A customer of ours once advised that, “He started every working day from the perspective that every one of his clients was out to defraud him.” This is maybe an extreme approach but developing a healthy cynicism about the quality of your client will always stand you in good stead.

And finally, because of the enormous growth of the industry in recent years while market conditions have been very favorable, we now have a generation of client relationship managers and risk managers who have never worked in market conditions such as we experience today. Constant education and support for client managers in these difficult times should be one of the highest priorities of any factoring company today.

Remember: A fraudulent client has to get lucky only once, but you have to stay lucky every working day.

Jeff Jacobs can be reached at 702-914-0455 or by e-mail at jjacobs [at] riskfactor-solutions [dot] com.

RiskFactor Solutions Limited specializes in helping commercial lenders avoid the situations described in this article. The company has over 25 years’ experience in developing risk management solutions for the commercial finance industry. With a unique unrivalled database of over 50,000 real cases, the company’s “intellectual property” has been developed by focusing on nothing else but solving risk management problems. With interfaces already developed to many of the packaged computer operational systems used by lenders in the USA, RiskFactor are ready and able to work with clients to help avoid the devastating effect a fraud or unseen bad debt can cause to a business.