02.03.2021 | Articles

Why Do We Care About Fraud by A Borrower?

By Richard E. Gentilli, James M. Liston, David C. Phalen, Brian F. Plunkett

Borrower fraud is a recurring problem for lenders, particularly in difficult economic times.  In this installment of our “Why Do We Care” series, we will look at examples of borrower fraud and red flags to be on the lookout for and we suggest both some precautionary steps that can be taken and what to do if fraud is discovered.

Typically, borrower fraud arises as a result of asset overstatement, liability understatement, improper revenue recognition, fraudulent financial reporting schemes, or the misappropriation of assets.  In the course of our practice, we have run into some unusual examples of fraudulent schemes by borrowers.  Some of the more unusual examples include:

  • We have seen lenders being scammed through use of inflated appraisals, either by way of forgery and alteration or appraiser collusion with a borrower.  This has led us to recommend that lenders only accept appraisals directly from the appraiser, not from a borrower and that if in doubt lenders conduct a simple Google or background check of the appraiser to see if he/she appears to be legitimate.
  • We have seen situations where borrowers recorded fictitious inventory purchases in their company’s accounting system or reported fictitious sales reported on their company’s books supported by false invoices.  Ordinarily a field exam might reveal this, but vigilance for phony records and account verification letters should be a matter of course as part of a lender’s due diligence.
  • We have even seen a situation where a borrower overstated rental income from apartment buildings on certified rent rolls and federal tax returns and then provided these to the lender as support for inflated revenue figures.  The borrower was able to submit tax returns with the inflated income figures because of large loss carry forwards that negated any tax liability from such overstatements.  This type of fraud is extremely difficult to spot, although if the reported revenues from a property seem too good to be true, further due diligence may be warranted.

From these examples it is clear how sophisticated and creative borrower fraud can be.  One prophylactic measure a lender can take is to look for “red flags,” which may suggest fraud. Examples of red flags include:

  • Complex webs of multiple related businesses in multiple jurisdictions and/or overly complex inter-company transactions.
  • Unexpected and unexplained resignation of CFO, bookkeeper, auditors, attorneys or restructuring professionals.
  • Protracted and suspicious delays in financial reporting.
  • Sudden significant and unexpected reported sales increase with no apparent change in circumstances.
  • “Unusual” sales and shipping documents for accounts, multiple invoices for the exact same amount of product, significant invoices all to a single customer, sudden and substantial invoices to a new customer.
  • Increased use of “credits” to clear accounts.
  • Employees being barred from talking to examiners or auditors.
  • An apparent absence of an internal code of ethics.
  • Substantial gifts and gratuities among insiders and payment of substantial personal expenses.
  • Excessive management control of both internal and outside auditors.
  • Substance abuse or gambling problems involving senior management or an association with people who have these problems.
  • Frequent, unexplained changes in service providers or vendors.
  • Unusual terms in payoff letter from a previous lender, such as disclaimers concerning the borrower, its business, financial condition, creditworthiness, etc.

If you believe you have detected fraud on the part of a loan applicant, it obviously would not be prudent to make the loan.  If the fraud relates to an existing borrower, prompt retention of counsel and swift protective action is the best way to minimize the bank’s losses.  Of course, in all circumstances a Suspicious Activity Report should be filed as mandated by law.

A lawyer retained to act in the face of apparent fraud will likely promptly file suit, seeking injunctive relief to prevent further bad actions or dissipation of assets, seeking attachments of available assets, asserting fraudulent transfer claims against recipients of diverted funds or assets and perhaps even seeking the appointment of a receiver (or if in bankruptcy, appointment of a trustee).

If possible, a lender should seek to gain control over the borrower’s computer hard drives and other electronically stored records, as these will contain much relevant information about the fraud and the recipients of diverted assets.  Retaining a forensic computer specialist to review this electronically stored data is often appropriate.  Such a specialist will also check to see if scrubbing or erasure software was run on the computer to try to permanently delete electronic data, which would constitute powerful evidence that a fraud was committed in any litigation.  

Retaining a lawyer with experience in dealing with fraud situations is the key.  The lawyer will help retain needed experts and help focus and direct the steps needed to protect the lender and pursue recovery from all available sources.  As certain segments of our economy continue to struggle, the possibility of fraud becomes more likely.  It is incumbent upon lenders and their team to be vigilant and proactive in such situations. 

This communication is for informational purposes only and should not be construed as legal advice on any specific facts or circumstances.

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