– The Value of Physical Asset Verification

Originally published in the Monitor, Nov/Dec 2006, Vol. 33, No. 10

By Katherine Dunwell and Matt McCoy

In a leasing environment with low default rates coupled with reduced margins due to price competition, lessors and funding sources may be reluctant to increase due diligence and risk management overheard. Moreover, the chief compliance officer has become a key role in larger funding sources, brought on by the challenges of internal compliance in a Patriot Act and OFAC environment. Recent high-profile fraud cases such as Norvergence and Allserve have also drawn further legal attention to the leasing industry, creating momentum behind legislation to further increase the accounting and due diligence responsibilities place on equipment lessors.

The default rate among leases remains at about 2%, which can add a level of false comfort when looking at fast-moving application-only deals. The increased use of credit scoring and other internal scoring models have served leasing companies well in terms of managing their risk in the current market. Much o the strong portfolio performance results are due in large part to the diligence of credit mangers across the board.

Funding sources have discovered that the majority of defaults in a strong-credit environment don’t have an easy-to-pinpoint predictor. A number of qualitative concerns can lead to a default. Some causes of default, such as fluctuation in gas prices or a change in the lessee’s marketplace can be almost impossible to foresee. By taking a close look at he risk factors that are often exposed during a third party inspection, lessors can more clearly assess how to train their funding specialist on what circumstances trigger a physical inspection of the equipment, and whether an inspection should be repeated during the life of the lease.

The leasing industry is familiar with “classic” fraud situations where a vendor colludes with a lessee to defraud the lessor on equipment price or condition, or an applicant fronts the application for a non-qualifying friend or relative. If a potential lessee does not meet that credit standards, a family member or neighbor may attempt to acquire the lease for them. Fraudulent transactions are often artfully structured, with the applicant fully aware of standard application discrepancies that trigger further examination by a lessor. Many of these misrepresentations pass the scrutiny of the most seasoned funding specialist.

For example, a vendor and a lessee may try to present a piece of used equipment as new or overstate the value of the equipment. Historically, the inflated payment to the lessee or vendor translated into kickbacks to the vendor or the lessee. More importantly, these transactions have a higher potential of resulting in delinquencies or defaults. Whether by default or reduction in residual value, any profit on the lease can be lost. Without a physical inspection of the asset, the fraud will most likely go undiscovered until either the lessee falls into a delinquency or at the end of the lease.

Providing inaccurate equipment information is also a common form of misrepresentation. An incorrect brand or model number could dramatically affect the value of the equipment. More importantly, an incorrect serial number on lease documentation and UCC filings may prevent the lessor from recovering the equipment. Even a variance as simple as an address discrepancy can be a potential risk factor. A fraudulent applicant may attempt to get a deal funding by using a neighboring business suite to misrepresent the location and use of the equipment. Although the equipment was physically present at the inspection in fact it actually belonged to a totally separate part in an adjacent office and was being misreported in the lease application. The physical address was only a couple of digits different than the actual address, but this small discrepancy exposed a much larger fraud.

In an example of an equipment discrepancy, a lessee approaches a vendor to acquire equipment for his new business. The equipment value when new is $100,000, and when the lessee tells the vendor that he cannot afford the payments, the vendor offers a piece of used equipment for $60,000. The lessee asks the vendor to list the new value of $100,000 on the invoice, offers the vendor $5,000 for his trouble and keeps the additional $35,000 as working capital to make his lease payments and get his business off the ground.

Unfortunately for the lessor, the invoice is complete and appears to match the values on the lease; so on paper, the deal appears legitimate. This lessee may make it through the entire term of the lease without a late payment. At the end of the lease, the lessor is forced to account for a piece of equipment with significantly less residual value than expected. The lessee committed fraud before the funding ever took place, and the fact that he never missed a payment makes the deal no less a fraud.

At the later stages of a lease, it is possible that the equipment is no longer in use. The asset may be sitting idle, cannibalized for parts, traded in for new equipment or worse. In many cases, the lessee is still making lease payments but the equipment has been illegally sold. It is possible that the lessor will not be able to locate the buyer and there is a high likelihood that the equipment was sold under another name. This type of fraud often includes theft and fencing of equipment on a substantial scale. How can lessors reduce this risk? Fund the lease and build a price for a post-funding inspection at some point during the life of the lease in the documentation fees.

Other risk factors for a lease can be derived by additional review of the potential lessee. Questions to ask before funding include whether the business looks like a going concern, whether the business type fits the area where the business is located, and the length of time the business has been operating at the location, and whether the parties representing the lessee appear willing even “too accommodating” to the inspector. If the lease is for health care equipment, does the location appear to be a legitimate medical office? Does the signage match the business name?

Do negative answers mean that this transaction should not be funded? Not necessarily. The lessee may be legitimately moving to the location in the next few weeks, pending the completion of the build-out. Regardless, the results of the inspection often prompt the lessor to either deliberately slow the funding down to further verify the credit or to ask additional questions.

At first blush, taking the time to ask more questions, or arranging for an inspection does not always seem like a viable option as lessees demand ever-faster approvals, and application can often easily reapply to another source. However, funding sources that are willing to enhance the due diligence process for lessees, brokers, and vendors will ultimately improve portfolio performance and mitigate the potential losses for funding sources and lessors.