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Fraud in Factoring and Invoice Finance
By: Lendscape - www.lendscape.com
Fraud is one of the most serious risks a factoring or invoice finance provider faces. As funding is advanced against invoices, a determined fraudster can extract real money against receivables that do not exist or have already been paid. In this article, we'll look at why invoice finance is exposed to fraud, the main ways it occurs, the warning signs to watch for, and how good processes and systems keep losses to a minimum.
Secured and unsecured lending – where invoice finance sitsFraud is one of the most serious risks a factoring or invoice finance provider faces. As funding is advanced against invoices, a determined fraudster can extract real money against receivables that do not exist or have already been paid. In this article, we'll look at why invoice finance is exposed to fraud, the main ways it occurs, the warning signs to watch for, and how good processes and systems keep losses to a minimum.
All lending falls into two broad types: secured and unsecured. Unsecured lending has no underlying asset the lender can recover if the borrower defaults. Secured lending is backed by collateral – a mortgage is secured on a property, a hire purchase agreement on the vehicle – which the lender can take and sell to recover the debt if repayments stop.
In factoring and invoice finance, the collateral is the client's outstanding invoices. The “loan” is the funds in use balance: it rises when the lender makes advances (out-payments) against approved invoices assigned to it and falls when the debtor pays. At any point in time, the value of approved outstanding invoices should exceed the funds in use, so that – if all else fails – the lender can clear the balance by collecting the invoices. That security only holds if the invoices are real, unpaid and collectable. Fraud attacks exactly that assumption.
Won't pay, can't pay, nothing to pay
There are three reasons a debtor might not settle an invoice, and only one of them is fraud.
Won't pay: The debtor disputes an otherwise legitimate invoice and is essentially a commercial dispute between the client and its customer, and it needs to be resolved between them.
Can't pay: In short, the debtor is in financial difficulty and overdue invoices eventually become bad debts. These are either absorbed by the lender under a non-recourse agreement or bad debt protection, or passed back to the client under a recourse agreement and offset against other good invoices the client has assigned – new good collateral replacing the old, bad collateral. Credit insurance can mitigate this risk.
Nothing to pay: This is where fraud begins. There is no genuine receivable behind the advance, so when the lender comes to collect, there is nothing to collect.
Why is invoice finance exposed to fraud?
Fraud can be driven by business pressures that push an otherwise perfectly respectable business owner to game the system to meet short term cash needs. This is where we typically see pre-invoicing or disputes caused by incorrect invoice amounts, with resultant credit notes to remedy them. Of course, this is a slippery slope for the business, which can soon spiral out of control. Bad news for both the client and the lender.
What lenders fear most is premeditated fraud. Organised criminals are sophisticated, do their homework, and increasingly have the benefit of AI to enable them to fabricate scenarios that are challenging for lenders to detect. These bad actors understand the mechanics of receivables finance, the weak points in a lender's defences, and the likely rewards of a successful fraud – frauds running into several million dollars are not unheard of. Rigour at the onboarding stage is paramount to avoid these traps. If it looks fishy and smells fishy, it probably is fishy, so throw it back in the sea for somebody else to catch (this is an actual quote from the Head of Sales for a leading Invoice Finance provider).
How does fraud happen in invoice finance?
Because invoices typically fall due weeks or months after they are raised, fraud often goes undetected until the lender tries to collect – by which point the money has long since been advanced. Most schemes fall into a handful of familiar patterns.
Fabricated invoices: Also known as “fresh-air” invoicing: the client raises a fake invoice for goods or services that were never supplied. The lender advances funds against it, but no debtor will ever pay because the underlying trade never actually happened. In extreme examples, the trade, the debtor, and the previous payments are all fabricated to create the illusion of legitimacy.
Pre-invoicing: The trade is real, but the client bills before the goods are delivered or the work is done, so there is no valid receivable behind the advance yet. It can look like an honest timing error, which is exactly what makes it easy to hide.
Duplicate financing: The same invoices are pledged to more than one lender, so two funders each believe they hold the same collateral but only one of them can be repaid once the debtor pays. This is more likely in markets where clients may legitimately work with multiple factors.
Misdirected payments: The invoice is genuine and the debtor does pay – but the money goes somewhere other than the lender. Often it is diverted to the client's bank account; sometimes a criminal intercepts the invoice and alters the payee bank details. When the lender chases payment, the debtor responds, reasonably, “I've already paid this invoice.”
The warning signs are rarely subtle once you know what to look for:
- Sudden growth in invoice volume or value that outpaces the client's apparent trading capacity
- A high concentration of funding tied to one or a small number of debtors
- Round-sum invoices, or invoices lacking purchase orders, delivery notes or other supporting documentation
- Debtors who are difficult to verify independently, share addresses or contact details with the client, or only ever respond through the client
- A rise in disputes or credit notes
- Payment performance that slows or deteriorates in a way that does not match the debtor's profile
- A perfect pattern of invoicing and payment that looks too good to be true – this could be hiding an early stage fraud.
Fraud in invoice finance is too often treated as a victimless crime and providers can be reluctant to pursue fraudsters or publicise losses; prosecutions take years and penalties can be light. For those reasons alone, prevention is far more valuable than recovery. Rigorous KYC processes, strong verification processes, regular audits, well-trained staff who know what to look for, and advanced lending systems that use high quality, granular data to monitor concentrations, debtor behaviour and transactions in real time are the most effective defence. The earlier an anomaly is surfaced, the smaller the loss – and as in most things in life, prevention is always better than cure.
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