The Importance of Conducting Borrower Background Checks in Asset-Based Finance

by Bill Papazian
Bill Papazian
Founder and
Managing Member
Lightstone Solutions

By verifying the accuracy of financial information and assessing the credibility of borrowers via thorough due diligence and background checks, asset-based lenders can make informed decisions and protect themselves against fraudulent activities.

The escalated risk of borrower fraud in asset-based finance makes conducting borrower background checks more important than ever, as such checks are essential for making informed lending decisions, mitigating risk and protecting lenders from fraud and foreseeable default. Background checks also can help ensure that loans are granted to creditworthy individuals or businesses, increasing the likelihood of successful
repayment.

RISKY BUSINESS

Compared to other forms of secured lending, asset-based lending can be particularly susceptible to fraud, especially when prospective — and existing — borrowers experience unpredictable cash flow slowdowns and other financial troubles such as judgments, liens, lawsuits and other liabilities.

Although asset-based lenders typically verify and monitor collateral, when a business hits hard times, some borrowers ignore covenants and look for unethical and creative ways to make payroll and pay vendors, liabilities and operating expenses until business (hopefully) improves. The unfortunate solution for an unethical borrower may involve some form of fraudulent borrowing or continued borrowing against nonexistent accounts receivable and/or inventory. To cover their tracks, perpetrators of this fraud may create two sets of books, create false purchase orders and invoices and even fill their warehouses with empty boxes purportedly holding inventory.

DUE DILIGENCE? YES, DO DILIGENCE

Unfortunately, as the ABF sector has become more competitive and the field more crowded, vying for prospects has caused some lenders to yield to the temptation of watering down verification procedures and borrower background check standards. This is equally true with renewal commitments, with lenders allowing existing borrowers to coast through the underwriting process in order to avoid the risk of losing them to the competition.

Careful lenders always conduct pre-loan site visits and may even have their own serial numbers welded on equipment rather than just asking for a photo. Knowing that an asset actually exists and an invoice has the lender’s name on it can help prevent a borrower from taking out several loans on the same asset or from borrowing against phantom assets. Anything less than rigorous verification standards and periodic site visits leaves the door wide open to fraud and can prove costly in the event of default.

WHY DO BACKGROUND CHECKS IF THE ASSETS ARE VERIFIED?

Some lenders don’t do much (if any) background check due diligence on a client company or its principals under the rationale that all that matters is the asset and its residual value. Other lenders merely rely on a national database screen or credit report as a substitute for a thorough background check. Such an approach not only invites fraud but also allows riskier borrowers through the door.

Background checks form a basis upon which lenders may assess the creditworthiness, character and reliability of borrowers. By checking their background, lenders can evaluate borrowers’ financial history and payment behaviors and identify any potential red flags. This information is essential to making informed lending decisions and minimizing the risk of fraud and unforeseen default.

Although conducting background checks on owners and principals of companies is critical, limiting checks to these parties only presents inherent risk. After all, more often than not, the borrower is the business. Examining the company’s history and reputation in an in-depth a fashion, as one would with its owners and principals, is essential to a thorough due diligence process. Additionally, business background checks involve looking into factors such as the company’s years in operation, its industry track record, customer reviews and any past legal or regulatory issues. This can help asset-based lenders gauge the company’s reliability and credibility.

ASSESSING CREDITWORTHINESS

Credit risk is one of the most significant risks associated with an ABF transaction. A typical borrower may not be as strong financially as other commercial borrowers, may operate in a volatile or seasonal industry or may be experiencing overly-rapid growth. Characteristics such as high leverage, unpredictable cash flow, limited working capital and changing collateral place such borrowers at heightened risk of default.

Background checks can provide lenders with valuable insights into a borrower’s financial history, including its credit score, payment behaviors and existing debt obligations. This information can help asset-based lenders discover any past fraud, evaluate the potential risk of future fraud and determine a borrower’s ability to manage its financial commitments responsibly.

EVALUATING RISK

Background checks can also reveal potential red flags, such as previous or pending bankruptcies, defaults or legal issues that could impact a borrower’s ability to meet loan obligations, as well as the lender’s ability to collect, regardless of security in the collateral.

On a tangible level, a background check will delve into the existence of any encumbrances on the assets to establish whether there are pre-existing liens, judgments, public filings or UCC filings that could affect the collateral. This can help a lender determine if there are any prior claims or obligations that could affect its ability to recover its investment in case of default and avoid scams such as double pledging assets.

A lender that only relies on a national database search or credit report for such information, as opposed to a thorough background check, is assuming significant risk. For example, on a nationwide level, a significant number of county clerks, county recorder’s offices and Secretary of State UCC filings offices are not searchable on the internet and require manual searches by an experienced background investigator. National databases and credit reports will not capture such filings and, with respect to filings they do capture, only offer a cryptic summary of the encumbrance as opposed to the actual document. Moreover, national databases often will not provide reliable information as to whether an encumbrance still exists or has been satisfied, released or lapsed. National databases are not meant to be relied on to make a credit or underwriting decision; in fact, such a disclaimer is often made by the database itself.

On an intangible level, a thorough background check can establish the bankruptcy and civil litigation history that a borrower is or was a party to as well as how such proceedings could legitimately increase the risk of fraud or unforeseen default. Some important questions to ask in these cases include: What were the circumstances of a previous bankruptcy? Did the trustee bring adversary proceedings based on fraud or other debtor misconduct? Was a receiver or forensic auditor appointed? Is there civil litigation or regulatory proceedings history in which allegations of fraud were made against borrower? Has there been litigation with an asset-based lender in which fraud or other
unethical behavior was alleged? A national database or credit report, as opposed to a thorough background check, often will offer zero insight or information to answer these questions.

IDENTITY THEFT, FRAUDULENT DOCUMENTATION AND OTHER RED FLAGS

Background checks allow lenders to verify a borrower’s identity using a passport and/or driver’s license, ensuring that a borrower is who they claim to be. This can help prevent cases of identity theft. In addition, background checks can help lenders detect fraudulent documentation provided by the borrower, such as falsified financial statements, inflated asset valuations or misleading information about creditworthiness. By thoroughly reviewing the borrower’s background, lenders can identify any material inconsistencies or discrepancies, raising red flags and prompting further investigation.

Some additional red flags that may indicate fraudulent activity may include patterns of suspicious financial behavior, multiple bankruptcies, a serial default pattern, frequent name changes or involvement in legal disputes related to financial matters. Vigilance in identifying these warning signs via a background check can allow asset-based lenders to implement necessary precautions and avoid falling victim to fraud.

Among the red flags listed in the previous paragraphs, a common one that a background check can help expose is inconsistent or inaccurate information in a borrower’s provided information, such as mismatched addresses or address history, incorrect social security number or date of birth, conflicting employment history and discrepancies in financial statements. These discrepancies can raise suspicions of potential fraud. A borrower may also intentionally conceal liabilities by omitting or hiding existing liabilities or outstanding debts from its financial statements. A background check can reveal these undisclosed debts or legal disputes that could impact the borrower’s ability to repay the loan.

Negative news about a borrower or its principals can be damaging information and take on multiple forms, ranging from printed and televised sources to online content like websites, blogs and social media. In the context of ABF, a thorough background check should include research about a borrower and its principal’s public reputation and media coverage. News media research can provide detailed insight into a borrower’s background and network. It also may uncover any connections to fraud, money laundering, tax evasion, terrorism or other financial crimes, affecting the subject’s overall risk profile.

CRIMINAL BACKGROUND CHECKS

Beyond standard background checks, conducting criminal background checks on borrowers can help identify any past fraudulent activities or involvement in financial crimes such as money laundering, check fraud, counterfeiting, identity theft, embezzlement, loan scams, credit card fraud and phishing. Prior criminal history will only be discovered through a thorough criminal background check that includes prior and present counties of residence. The information uncovered in a criminal background check is crucial when assessing a borrower’s integrity and trustworthiness. If a borrower has a history of fraudulent behavior, lenders can take appropriate measures to protect themselves from potential fraud, although for many asset-based lenders, any such finding would appropriately be a non-starter.

Beyond financial crimes, a thorough criminal background check will identify other crimes of concern such as violent crime, theft, battery, assault and sex offenses. Would an asset-based lender really want to lend to a borrower with such a history, let alone collect in the event of default?

An additional consideration that a criminal background check will help ensure against is whether a borrower is or was previously involved in a criminal enterprise. An asset-based lender would not want to loan to a criminal enterprise for a variety of reasons, including accomplice liability and inability to enforce collection due to illegal loan purposes, not to mention the moral and ethical considerations.

A criminal background check also can help determine whether a borrower is affiliated with known terrorists or members of organized crime or sanctioned entities, money launderers or fraudsters, narcotics traffickers, participants in shell banks and other categories of interest. The world continues to change rapidly and with it, so does the rising risk levels for asset-based lenders. •

Bill Papazian is founder and managing member of Lightstone Solutions, an investigative and regulatory consulting firm specializing in U.S. and international background and reputational due diligence on borrowers, investment targets, potential business partners and others. Papazian is happy to address any questions about this article and may be contacted at [email protected]