Creating a Robust Risk Management Program

Reprinted from NewsLine, a Publication of the United Association of Equipment Leasing, Winter 2008, Vol. 35, No. 1 (pages 20, 22, and 44)

By Greg Froomer

Fraud in the finance and leasing industry has made big headlines in recent days. Complex schemes involving fake vendors and lessees, phony invoices, and nonexistent equipment are changing the way in which many approach doing business. Beyond simply inspecting the equipment to be financed or leased, vendor verification inspections and lessee site inspections are becoming an industry standard, increasingly accepted by the parties involved as a necessary precaution to doing business and minimizing risk.

Finance at its essence is risk-based. Individual contracts exposed to fraud can result in losses in the tens of thousands of dollars. Large ticket transactions or portfolios can be exposed to millions of dollars of loss if a proper due diligence program is not in place. The cost effectiveness of on-site inspections makes them a truly valuable addition to a due diligence program, especially in circumstances where the cost of inspection can be passed onto the debtor or lessee. There are several excellent companies in the inspection services community that perform on-site inspections and vendor verifications, providing a critical due diligence component to the industry. In the equipment finance and leasing environment it is key to have a robust due diligence program in place to minimize risk.

Site Inspections

A site inspection is a survey of the debtor/lessee’s business location and does not typically involve an equipment inspection. A narrative report confirms information provided in the credit application, ensuring accuracy in documentation and helping to paint a clear picture of the business. General observations of the interior and exterior condition of the business and its neighborhood are noted, as are suspicious characteristics that do not support what the business purports to be. Accurate information, including verification of phone numbers and physical address, years in business and current operability of the business are confirmed at the time of inspection.

A site inspection can offer the peace of mind that comes from better knowing your customer. Red flags of all types can become apparent with the completion of a site inspection. Other aspects of a business can be uncovered such as a rundown or dilapidated location, a customer that is unsatisfied with the equipment, general issues such as inadequate parking or ingress/egress, customer counts and adequate signage at the place of business. Typically site inspections are performed at pre-funding to ensure the customer is who they claim to be. However, it is becoming more common to perform post-funding site inspections to document that the business continues to operate and utilize the equipment after the initial inspection.

Vendor Inspections

Vendor inspections are a cost effective means to help ensure the legitimacy of the supplier of the equipment being financed or leased and can be an important step in preventing fraud. Much of the fraud seen in recent months has involved disingenuous or nonexistent vendors. An inspection provides cost effective verification of a vendor’s physical location, including a written narrative of observations made at the location, helping to ensure the vendor is legitimate.

A vendor inspection can provide clarity as to what kind of business the vendor is operating (manufacturer, distributor, or dealer), its overall operating condition, and observations of the brands in stock. Critical information such as the business name, years in operation, additional locations, and general appearance are also noted. An inspection will uncover red flags such as vendors related to the debtor/lessee, those working out of a home instead of a professional business, vendors that have no show rooms or products on display, and vendors in areas geographically far from the debtor/lessee. A vendor inspection can be carried out incognito so as not to alarm or upset the vendor, providing the client with valuable information. Or they can be done as an announced visit whereby an inspector can request specific information from the vendor such as customer references and provide them to the client to further ensure legitimacy. Verification of the vendor location helps to ensure the vendor is a legitimate supplier and not simply an empty office with a phone line and a desk.
Why Vendor and Customer Site Inspections Make Sense?

It is estimated that 65% of inspections uncover erroneous information of some kind. In most cases these discrepancies may be as simple as an incorrect customer phone number, address, or business name. In many instances, critical information such as equipment model, year, or serial numbers are found to be incorrect. Although some of these discrepancies are the result of intentional fraud, the majority are the result of unintentional errors or typos in credit applications, documentation, or equipment invoices. Errors in documentation might never be corrected if not for on-site, third party verification.

It is important to remember that equipment inspections alone are not always enough to maximize the risk to your investment. A combination of equipment, lessee site, and vendor inspections can be key to a robust risk management program. Requesting a vendor inspection as soon as possible is a good way to avoid falling into a fraudulent deal if the vendor is unknown, they supply unfamiliar equipment, or if they are in a significantly different geographic area than the debtor/lessee. An on-site inspection of the business will help to ensure the legitimacy of the debtor/lessee while uncovering errors in the lease documentation. Additional site inspections after funding takes place can help to ensure the customer is legitimate and their business is still in operation. Incorporating “spot checks” into a portfolio due diligence program is an effective way of minimizing risk in your investment while sending a clear message to would-be defrauders.

Looking Forward

The finance and leasing industry is encouraged to examine its diligence policies to ensure they meet the current risk metrics. It is our expectation that due diligence failures of the past can be recognized and avoided in the future by a vigilant and proactive movement toward knowing your transactions event better and measuring risk accordingly.