The Problem of Fraud in Invoice Finance

Experience suggests that the issue of fraud in invoice finance remains a persistent problem.  Inherent in the operation of the sale of receivables is the temptation for unscrupulous or desperate directors to create ‘fresh air’ invoices, which do not represent the product of any genuine trading (or sometimes which exaggerate the extent of otherwise genuine trading), whether from the start of the facility or during times of poor trading. This is especially so where the company’s customers are not notified about the existence of the facility (such as in invoice discounting, rather than disclosed factoring arrangements), and so there are no means for the financier independently to check the veracity of the invoices in question with the customer.

Other forms of fraud are well-known to financiers in the invoice finance world.  The directors may for example be tempted not to give notice of assignment to their customer (where there is a disclosed facility), with the effect that a genuine debt gets paid directly by the customer as well as being financed by the financier.  Other forms of fraud include the sale of receivables which are deemed by the agreement to be ineligible for funding (for example, because of the creditworthiness of a particular customer).  Sometimes, if the client and a customer have a close working relationship, the customer may agree to credit notes being issued in respect of invoices which are marked for payment to the financier, in favour of fresh invoices which purport to require payment to the client.

Absent oversight or auditing by the financier, the best means of seeking to ensure protection against fraud remains the careful drafting of the finance agreement and ancillary guarantees and indemnities.  Considerations include:

1. A clear suite of representations and warranties covering a variety of topics, ranging from the genuineness of the receivables sold through to their enforceability under the terms of the contract with the customer.
2. Automatic repurchasing obligations if ineligible receivables are sold to the financier. This gives rise to a liability in debt from the client to the financier and negates the need for any claims of rescission to be made by reason of the misrepresentations and breaches of warranty.  Such obligations should also be backed by an indemnity from the client to the financier for such amounts.
3. Similar repurchasing obligations in the event that it is discovered that there has been any interference with receivables sold to the financier, such as the issue of credit notes.
4. If thought practicable and desirable, obligations requiring the provision of more than merely the basic details of invoices sold pursuant to the finance agreement (for example, in the form of a sales ledger). Such obligations can require the client to provide not just copies of the invoices sold, but also the underlying contracts and other documents between the client and its customer, such as purchase orders.  While this creates a greater administrative burden on the financier, such safeguards considerably lessen the prospect of fraud occurring.
5. Alternatively, periodic audit requirements by an external party of a selection of debts sold to the financier during a given audit period.
6. The creation of a clear trust in favour of the financier in respect of the proceeds of any receivables financed by the financier and which are received by the client, whether or not the financier is responsible for collections.
7. Personal guarantees and indemnities being given by the directors of the client, with an emphasis on obligations of indemnity rather than guarantee due to the limited nature of the defences which can be run by the directors.

It is impossible completely to negate the risk of fraud occurring in any invoice finance arrangement, but careful drafting should aim to lessen the risk and simplify the potential claims available to financiers, especially in the event of the insolvency of the client.  Otherwise, financiers are left with launching difficult and costly proceedings against the client and its directors, including claims in deceit, conspiracy or procuring breach of contract.   It is always worth making sure that invoice finance agreements are tailored to the business of any given financier’s client – there is usually no ‘one size fits all’ approach.

Contact our Invoice Finance Team.