The overlooked factor

A business can legitimately sell its outstanding invoices for a percentage of their face value to receive money quickly to expedite cash flow. The process allows nearly $3 trillion in transactions per year worldwide. However, invoice factoring is vulnerable to fraudsters. This case shows red flags and susceptibilities.

Gary Todd Smith had a problem. The Fayetteville, North Carolina, firm that he managed was losing money — fast. For four decades, Smith Advertising (which Smith’s father, Gary Truman Smith had created), had been prosperous. But profits for the business, which also had a branch in Sarasota, Florida, began to decrease in the mid-2000s partly because of the principals’ excessive salaries and then the financial crisis.

Advertising work slowed, but the bills piled up. Banks were stingy with lending. An external CPA advised that the business could cut their executive salaries, or they could declare Chapter 11 bankruptcy and restructure. Unfortunately, the Smiths’ greed and pride wouldn’t permit them to do either. In 2007, they decided to engage in fraud — only temporarily, they thought — and then they’d be financially solvent after payments would resume. (See Father and Son Sentenced for Fraud, FBI NEWS, July 19, 2019, and Advertising Executive Sentenced To Forty Years In Federal Prison For Fraud Scheme, U.S. Department of Justice, Dec. 6, 2018.)

As an FBI agent on the case, I had a front-row seat to the Smiths’ machinations to avoid losing their firm and perpetuate their comfortable lifestyles. They needed better cash flow, so they turned to alternative methods of raising capital, such as “invoice factoring,” in which a business sells its outstanding invoices — accounts receivable — to a third party (the “factor”) at a discounted rate. The business raising the cash receives most of the money sooner than it would from its customers, and the factor has the right to collect the entire face value of the invoice when it becomes due — typically in 30 to 90 days. The longer a customer takes to pay an underlying bill, the less money the factor pays the business, which is called “recourse factoring.” (In “non-recourse” factoring, the factor bears the loss if the customer doesn’t pay the invoice amount.)

Invoice factoring works if the accounts receivable are legitimate, but in 2007, Smith Advertising began to create fraudulent invoices that stated various clients — often real companies — owed them money. Smith Advertising opened post office boxes throughout North Carolina and Florida to conceal its crimes. It also created some 60 real email addresses for fake companies in case the factor wanted to contact customers to send bill reminders or check on the quality of the advertising company’s work. Only Smith Advertising would receive the factor’s emails.

Smith Advertising also fraudulently used “bridge,” or short-term, loans to raise money, according to my interviews with the Smiths’ CPA and proffer interviews of the Smiths. Advertising agencies use this type of loan to buy ad space from media outlets that the agencies eventually sell to their clients. The loans provide upfront capital and bridge the time between when they purchased the spaces and when they sell them. Newspapers and other media offer ad spaces at pre-pay discounts that allow ad agencies to make profits on creative work from clients. (Also see How An Agency Makes Money From Advertising? Advertising Crossing.)

Smith’s typical spiel would be something like, “I need $50,000 for a project for seven days. After seven days I will pay you 7% return plus your principal.” Smith would strongly encourage and entice lenders to roll over their principals into another deal so Smith would pay back as little money as possible. (See Smith Advertising partners charged with fraud in federal court, by Michael Pollick, Herald-Tribune, May 8, 2014.)

Similar to invoice factoring, Smith premised the bridge loans on a lie — Smith Advertising didn’t buy ad space once it received bridge-loan money but used it to keep the firm afloat, support the Smiths’ lifestyle and pay back previous investors, Ponzi-style.

This scam worked for about eight months until in 2009 the first factor (factor No. 1) discovered the fraud and told Smith Advertising that it needed to pay back all of the lent money it borrowed or the factor was going to report it to the FBI. In other words, the factor said, “Get me my money, or your guys go to jail.”

To solidify his position, factor No. 1 compelled the Smiths to disclose all their assets and liabilities plus write and sign a full confession in which they described how they pulled off the fraud. Factor No. 1 held the disclosure and confession in his back pocket just in case the Smiths didn’t settle their debt and he had to go to court.

Smith Advertising had no money of its own and no legitimate way to come up with the owed $4.6 million. So, the firm found new marks in Sarasota. (See Smith Advertising partners charged with fraud in federal court, by Michael Pollick, Herald Tribune, May 8, 2014.)

Since the 1980s, Smith Advertising had done substantial work in Sarasota, including for the Sarasota Tourist Association. The Smiths knew many of the key players and successful business people in the area, and they used these connections to pitch their supposedly alternative method of raising capital for a “new concept of market advertising.” Similar to many financial frauds and scams, the Smiths glossed over weak fundamentals with such florid prose as, “The dislocation of the credit markets combined with the growing demand from clients has capped Smith’s access to capital and inhibits its ability to grow,” according to the Smiths’ solicitation letter to prospective investors obtained by law enforcement during the execution of a search warrant. (See the May 8, 2014, Herald Tribune article by Michael Pollick.)

In October 2009, the Sarasota-based individuals created a company to solicit investors and act as a feeder fund to Smith Advertising. This new company, factor No. 2, bought out factor No. 1’s interest and picked up where they left off by unwittingly continuing to fund Smith Advertising’s fake new plans. Sadly, factor No. 1 had deceived factor No. 2 in Sarasota to pull off this deal.

Before factor No. 2 assumed funding for Smith Advertising, it insisted on speaking with factor No. 1 to check Smith’s creditworthiness and character. Factor No. 1 didn’t want to communicate with factor No. 2 at all, but he eventually told him Smith Advertising was a good client, and he’d dropped it purely as a business decision, which wasn’t true.

Factor No. 1 later lied to law enforcement that he was surprised about Smith Advertising’s further fraud against factor No. 2. He said he’d never seen anything in the Smiths’ character to foretell the crimes.

The Smiths now had another bite of the apple. For a second time, they could decide between deceit and truth with a new factor. You probably can guess which road they chose.

Negative $12 million bank balance

In 2010, the money began to roll in. According to my interviews of local and nationwide investors, they were convinced that someone who wore a Rolex, belonged to the right country club and spoke in hushed tones about a “very safe family and friends deal with guaranteed ROI of 10%” must know what they’re doing. Many of the Sarasota investors were middle-class folks who gave their life savings.

Adding fuel to the wildfire of Smith’s deceit, factor No. 2 failed to live up to its promises to its pooled investors and, according to promissory agreements, failed to “inspect and approve all invoices” or collect payment “directly” from Smith’s clients.

Perhaps appropriately, this relatively simple scheme almost unraveled through the simplest of due diligence. One day in October 2011, a Sarasota investor in Smith Advertising called a municipality that was listed on an account receivable and attempted to verify its authenticity. The municipality said it had no knowledge of this supposed invoice and, in fact, the amount due was more than the entire annual budget of the municipality. This investor wisely withdrew his money from the fund but didn’t alert law enforcement or others. Smith had given the investor a bogus explanation and threatened to sue him for slander.

The Ponzi scheme finally imploded about four months later on Jan. 25, 2012,  when another investor deposited checks representing loan paybacks from Smith Advertising totaling approximately $14.8 million. The bank returned the checks for non-sufficient funds, accused the investor of check kiting and sued civilly. (See Smith Advertising partners charged with fraud in federal court, by Michael Pollick, Herald-Tribune, May 8, 2014.)

Smith then tried to convince the victim’s bank to change a negative $12,489,358.59 bank balance to a positive $12,489,358.59 by erasing the minus sign and emailing that screen shot to the bank. Smith attached a forged accompanying email that included an explanation, purportedly by Smith’s bank, that said, “It appears it was a clerical error. … It was our fault. If you want to send them thru a second time, they will be honored.”

At its height of the fraud in 2011, about $171 million moved through Smith Advertising’s bank account. Approximately 150 investors lost $63 million, and the Smith Advertising bank account was at a $169.8 million deficit when it finally shut its doors in 2012. (See Smith gets 40 years in prison for Ponzi-type scheme, by John Hielscher, Herald-Tribune, Dec. 7, 2018.)

Like many white-collar criminals, the Smiths had been admired and prominent members of their communities, but their decision to engage in fraud would change that forever. On Dec. 6, 2018, Gary Todd Smith, then 49, pleaded guilty to wire fraud and mail fraud charges and was sentenced to 40 years in federal prison. The court also ordered Smith to forfeit $63 million. His father, Gary Truman Smith, then 74, pleaded guilty to conspiracy to commit wire fraud charges and was sentenced in January 2019 to five years in federal prison.

The Smiths only apologized to the court and their victims through their attorneys.

Over the course of the weeklong sentencing hearing for Gary Todd Smith in December 2018, the judge heard from more than 50 victims who described the devastation wrought upon their lives by Smith’s massive fraud scheme. (He’d victimized more than 100 targets throughout the United States and Canada.) They suffered bankruptcies plus loss of homes, retirement funds and their children’s education funds. (See the sidebar, Smiths’ fraud duped trusting community members who had modest incomes.)

Factoring red flags

Companies seeking financing have legitimately used invoice factoring to provide cash-flow stability during uneven revenue collection. In 2018, factoring accounted worldwide for an estimated $2.91 trillion in account receivables — a 9% growth over 2016. (See the Factors’ Chain International Annual Review 2018.) However, as we’ve seen, invoice factoring is susceptible to fraud. As in the Smith Advertising case, the simplest way is to create fake invoices. A fraudster can easily set up a fake company and, for customer victims, create fake email and snail-mail addresses, websites and phone numbers.

Lending factor companies’ due diligence requires — at a minimum — authenticity verification of underlying invoices. Other red flags to look for include:

• Hesitancy by the business to provide full identifying information for the customer.
• Negative credit history for the business and/or principals.
• Criminal history of the business’ principals.
• Incomplete financial statements.
• Failure to provide tax returns.
• A rush to obtain factor financing regardless of the terms.

Takeaways

First, we were able to build a great investigative team early on between the U.S. Secret Service and the FBI. Secret Service Special Agent Tony Magos, one of the best white-collar crime agents with whom I’ve worked, was the co-case agent with me. Our team allowed us to “force-multiply.”

Second, we were able to conduct productive interviews of witnesses and co-conspirators early in the investigation. Often fraud examiners mistakenly wait too long before going overt. This runs the risks of allowing more victimization and depletion of assets. If you interview subjects early, they’re not going to obliterate the paper trail by destroying financial records, and you’ll discover emails possessed by third parties.

Often, you’ll find one person with inside knowledge who’s willing — if not eager — to unburden themselves and talk to the good guys.

Third, we had the benefit of an excellent prosecutor (Assistant U.S. Attorney General Tom Palermo, now a state judge in Florida).

Fourth, “Don’t let the perfect be the enemy of the good.” These frauds are complex with multiple avenues you can explore. However, once you have a prosecutable case or fireable offense, pull the trigger and take action.

(See "Smiths’ fraud duped trusting community members who had modest incomes" at the end of this article)

The author wishes to thank FBI Special Agent Jay Stone for his great assistance with this article. – ed.

Thomas Baugher, J.D., CFE, is the supervisor of the FBI office in Sarasota, Florida, and an adjunct professor of business law at the University of South Florida. Baugher and Special Agent Jay Stone, along with two U.S. Secret Service agents, received the Tampa Region Financial Crimes and Inspectors General Council Award for Special Achievement in a Complex Financial Crime Investigation for this case. Baugher was the recipient of the Hubbard Award for the best Fraud Magazine feature article in 2015. Contact Baugher at trbaugher@fbi.gov.

Smiths’ fraud duped trusting community members who had modest incomes

A victim of the Smith Advertising bridge-loan scheme lost her life savings. Another lost her home and moved into a shed on her son’s property. An elderly man confined to a wheelchair lost more than $100,000, and some victims declared bankruptcy. (See "Father and Son Sentenced for Fraud," FBI NEWS, July 19, 2019.)

The Smiths conned many wealthy lenders but also community members with modest incomes.

“This is not just a crime about money. These were people with real lives who were lied to and deceived, and they paid a real price,” said Special Agent Jay Stone, who investigated the case out of the FBI’s Tampa Field Office, along with the U.S. Secret Service. [When the FBI promoted the author of this article to supervisor of the Sarasota office, Stone took over the case. – ed.]

“It was a loan fraud, but it operated somewhat like a Ponzi scheme, with money coming in to repay those who previously loaned money to the Smiths,” Stone said.

“There was a ‘boiler-room’-type aspect to the solicitation of lenders,” according to the criminal complaint filed jointly by the FBI and the Secret Service. (See "Smith Advertising partners charged with fraud in federal court," by Michael Pollick, Herald-Tribune, May 8, 2014.)

“For example, Todd Smith might contact a prospective lender and offer that person (or entity) an opportunity to ‘invest’ $50,000 for seven days and that they could earn 7% or a flat rate for making the loan,” the complaint states.

“Frequently, Todd Smith would also offer the investor a ‘renewal’ of the loan,” according to the complaint. The cooperating source estimated the pool of lenders at 300 people. (See Smith Advertising partners charged with fraud in federal court, by Michael Pollick, Herald-Tribune, May 8, 2014.)

According to the FBI NEWS article, Stone advised that if anyone approaches you with a similar type of sales pitch, proceed cautiously and carefully research any investment option. For example, Stone says, instead of thinking of this opportunity as an investment, investors could have asked Smith why they weren’t using traditional bank loans.

“Once you know a bank won’t loan someone money, you’re giving someone a high-risk loan, so it’s buyer beware,” Stone said. “People should always do their due diligence in investing.”