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The Dangers of Business Loan Fraud

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Amid recent headlines about government surveillance, the ongoing Syrian Civil War, and the latest pointless celebrity news, business loan fraud just isn’t covered much or discussed in depth.

But unfortunately for the countless struggling businesses in the nation, business loan fraud may have a lot more impact than imagined.

In fact, the repercussions of business loan fraud crimes may very well be causing the economy to continue its all-too-slow pace towards recovery.

No Borrowing, No Growth

As the proverbial phrase goes, “you need money, to make money” and nothing grows an economy better than people and businesses spending money. This holds true for the current situation that the nation’s economy is in. Businesses need money in order to expand their operations and hire additional employees. Of course, if business loan fraud runs rampant, then lending will be the last thing on lenders’ minds.

When banks and lenders are victimized by fraud it causes a cascade of ripples that affect others who may or may not be involved. For example, following being victimized by fraud, banks may become downright draconian in their lending policies, preventing otherwise trustworthy clientele from accessing credit.

“The more fraud that occurs, the more skeptical and cautious lenders will be,” said Arora.  “This will impact lending parameters and the amount of time it takes to approve a loan. The fraud perpetrated by others can negatively impact honest small business owners in search of capital.”

How Fraud Happens

Unfortunately for lenders, at times their own staff is to blame for permitting business loan fraud.

Rohit Arora, CEO of Biz2Credit, found that the people who research loan applications are not necessarily highly skilled in their duties. As a result, they make mistakes and fail to identify which applicants should not be given business loans.

Aside from credit union employee mistakes, there are actually several ways in which business loan applicants themselves can commit fraud. One of the most common methods is simply overstating revenue, in essence lying outright.

“When a potential small business borrower overstates his revenue, it presents an untrue picture of his or her financial situation,” said Arora. “The same occurs when someone underestimates his or her cost structure or hides a lien that has been placed on a property. When fraud occurs, banks will be making lending decisions based on faulty information.  It thereby increases lender risk, which hurts both borrowers and lenders in the long term.”

When banks tighten their standards or simply refuse to lend out money, small businesses lose out. As Americans are painfully aware, small businesses are the lifeblood of the economy and responsible for the bulk of employment gains.

The Fraud Triangle

According to Mark A. Olson, special counsel for Archer Norris, business loan fraud can be described as a “fraud triangle.”

The triangle’s three points are the fraudster, the target, and the distracted guardians. While most discussions about business loan fraud focuses on the actual fraudster, more attention deserves to be paid to one “corner” of the triangle in particular, due to their propensity for failure.

The distracted guardians tend to fail in one of two ways. The first is when they do not use proper lending controls and procedures. The other is when there is an actual lack of guardians, possibly due to staffing cuts or limited hiring budgets for underwriters.

Just as in the credit crisis, a lack of attentive guardians can lead to mismanaged lending. As a result, banks have tightened lending standards.

Olson’s “fraud triangle” can better be explained with his example of how the Broome County Federal Credit Union failed.

Like any other credit union, the Broome County Federal Credit Union offered business loans to members and local businesses. Like a wounded gazelle, the credit union caught the eyes of two hungry predators, a mother and son who formed a fraudster team. Using forged documents to fake collateral for the business loans, the mother and son took the credit union for $14 million. Their forgery proved so convincing that not even the credit union’s underwriters noticed the fraud until it was too late.

The scenario at Broome County Federal Credit Union can be broken down into the three corners of the fraud triangle. The target was the credit union. The fraudster was the mother and son team. Finally, the distracted guardians were the underwriters at the credit union who got deceived by the forged documents. Had the underwriters done their due diligence, the mother and son would not have stolen millions of dollars.

In Olson’s experience, when lenders are victimized by business loan fraud, they simply stop lending. As a result, businesses cannot obtain capital and often grind to a halt. As evident after the credit crisis, banks simply stop lending to small businesses and the economy as a whole dries up.

“There have been small businesses that see rational opportunities for growth,” said Olson. “But they cannot get loans to finance it. They cannot get capital even though their track records, financials and projections would have been readily accepted under normal underwriting standards. Not the loose standards that led to the credit crisis.”

Without financing, theses small businesses end up not growing as much or as fast they could. Some even end up stagnating.

Safeguards and Recourse

Amid all the danger posed by business loan fraud, it is comforting to know that there are defenses against it and also forms of recourse that victims can use should they be defrauded.

Lenders should truly “know their customers” in order to protect themselves from falling victim to business loan fraud. By knowing the business, the owners, and the project in detail, business loan lenders avoid overlooking details that could reveal an applicant is a fraudster.

“In short, kick the tires, check for dents, and make sure the engine runs well,” said Olson.

Of course, not all lenders do this, hence stories about business loan fraud.

Should a lender fall victim to fraud, they are advised to conduct an internal investigation. While their legal department handles the lawsuit, an internal discussion of the mistakes that led up to the fraud will help prevent a repeat of the same events. Ironically, fraudsters can sometimes be pressured to make amends, assuming they get caught.

“Once caught, they may be motivated to sustain the secrecy and try to preserve whatever is left of their reputations,” said Olson. “Sometimes a payment plan with real collateral by a suitably repentant borrower can succeed.”

Naturally, federal and state governments, along with law enforcement, frown upon criminal business loan fraud and pursue it diligently in court.  

But as well-meaning as federal and state law enforcement can be, they are often slow to respond to and resolve actions against business loan fraudsters. To make up for that gap in time, some companies, such as online payment service company WePay, prefer a more proactive approach to business loan fraud.

WePay’s Vice President of Risk John Canfield told loans.org that his company often faces the key challenge of identifying whether a merchant really is who they say they are. To help with that discernment, WePay utilizes a risk engine called Veda that validates identities by tying users to an online social identity. In essence, it works by “vetting” a person’s accurate identity via available online data.

“For example, we look at whether a prospect has a Facebook or other social media account and if so, how long and rich that account's history is,” said Canfield. “Because of this data, which is typically hard to fake, we are able to accurately validate the identity of a merchant without needing a long application process.” 

It is beneficial for consumers that more companies like WePay are using advanced technology to combat business loan and identity fraud, but to really grasp the dangers of commercial fraud it is necessary to closely examine a past case.

A Cautionary Case

Jason Shinn, a licensed attorney in Michigan, has been representing startup companies and various businesses for years. In his time as an attorney, he has conducted fraud disputes. One case in particular proves just how destructive fraud can be.

Shinn was representing a company that was seeking to borrow several million dollars. He and his clients met with a business loan broker who was allegedly reputable due to his past success with Chinese investments. But regardless of the broker’s reputation, Shinn did what he always does: he sought to verify the the broker’s credibility by reviewing the broker’s past investors. The evidence revealed a number of concerns that prompted Shinn and his client company to insert termination clauses into the contract, which had to later be utilized once the broker proved to be less than reputable.

Even though the broker is still in operation, Shinn views the whole affair almost as a pyrrhic victory.

“Because of the initial skepticism, we were able to limit any monetary loss,” said Shinn. “However, we did waste a substantial amount of time and resources relative to meetings, engaging in due diligence activities relative to potential investors, and negotiating and drafting associated documents.” 

Currently, no decision has been made whether to pursue litigation against the broker but Shinn feels that this cautionary case speaks volumes to the danger posed by lurking fraudsters. He offered up key advice for avoiding business loan fraud problems.

“First, it is imperative to enter negotiations with a healthy balance of skepticism and good-faith,” he said. “You don’t want to ‘kill’ a potential deal by insulting the party across the table’s integrity, but you cannot blindly accept every representation offered by that party. In my experience a ‘trust, but verify’ approach is a good perspective to have.”

Shinn’s second piece of advice was that solid due diligence should be almost virulent in its spread across the background of a company or potential investors. He urges that this due diligence be performed as early as possible prior to contracts and other obligations.

During the case he and other researchers checked the business loan broker’s background where they discovered a number of lawsuits along with sparse support for the broker’s claimed success. This discovery prompted the creation of the termination clause. 

“Third, it is very beneficial to have a team in place with the right players in order to maximize the negotiation process and ultimately obtaining terms favorable to your company,” said Shinn.

These right players should include individuals who have experience with finance and legal matters. Ideally, they should also be in management or company owners who understand the underlying business or technologies to be commercialized.

Unfortunately, there was another victim in this cautionary tale: the state of Michigan. Already reeling from a gutted auto industry, Michigan and its desperate people no doubt could have used the growth brought about by Shinn’s client borrowing business loans for expansion. Growth for companies means jobs for people, and people with jobs spend money that fuels the economy.

Until lenders and companies no longer greatly fear fraud, the economy will continue to move sluggishly. As job growth remains slowly but steadily growing, the nation as a whole will have to adapt to a future of wary commercial lenders who wish they could lend more easily.