Fraud infecting commercial-loan agreements

Zeke had been in business for more than 10 years leasing golf carts to country clubs and other groups who enjoyed the sport in the Midwest. On the surface, his financial statements looked solid — thanks to a crooked CPA. But, in reality, Zeke was losing money each year, and he was resorting to commercial-loan fraud to keep afloat.

Here’s an example of how Zeke gamed the system until he was caught. Zeke’s customer, a country club called Lucky Star, wants to replace its old fleet of 60 golf carts with new ones, which they rent to golfers each day. Zeke agrees to lease the carts for $360,000 over five years plus an option in Lucky Star’s favor to purchase the carts for $150,000 when the lease expired.

Zeke then goes to a financial institution and borrows the money to buy the golf carts from the manufacturer on similar terms to the lease agreement with Lucky Star. The bank takes the lease agreement as collateral and then submits a Uniform Commercial Code (UCC) filing with the secretary of state, listing the 60 golf carts’ serial numbers as collateral. Because golf carts aren’t titled vehicles, the state doesn’t do title searches. The bank has the responsibility to ensure that no one else has filed a UCC statement listing the golf carts’ serial numbers as collateral. But during Zeke’s 10 years in business, nobody checked to make sure that he hadn’t double-listed the serial numbers on another UCC statement. That was until Zeke’s new honest comptroller detected similar UCC filings and reported the suspicious activity to one of the banks, which called in the FBI.

Investigators found that Zeke had pledged golf cart leases to multiple banks and other lessors. Payments on the debts became untenable. When the business went bankrupt, the debts totaled more than $10 million, and the value of all collateral, including leases and golf cart inventory, was less than $5 million. The FBI presented the case to the U.S. attorney who declined to prosecute because he believed it would be too complicated for a jury.

Zeke’s name is fictional, but this is a real-life case and just one example of how fraud can play out between borrower and lender.

Pressure can push borrowers and lenders to the brink

Zeke probably didn’t initially set out to defraud banks. But when a commercial-loan borrower has difficulty making loan payments the situation can become a cat-and-mouse game. The lender tries to protect its interests, and the borrower attempts to keep its business afloat by delaying payments, obtaining additional financing from the same bank or another, or devising intricate schemes that delay the inevitable. This high-pressure situation can easily cross the line into fraud for the lender or the borrower. Commercial loan fraud can take different forms. Below are some of the types of fraud that we’ve seen.

Fraud by banks against borrowers

These are the least common type of commercial-loan frauds because there are fewer banks than borrowers. Here’s what we’ve seen when a bank isn’t dealing in good faith with a borrower:

1. A borrower is fully extended on their loan and is having cash-flow problems. The bank says it will work with the borrower if they’ll take money out of their retirement fund, which will reduce the loan balance. Ordinarily, by law, a bank can’t access a borrower’s retirement funds. But once the borrower has withdrawn their retirement funds and reduced the loan balance the bank won’t work with the borrower but will call the loan.
2. Again, a borrower is fully extended on their loan and is having cash-flow problems. The bank asks the borrower for additional collateral before it will continue to work with them. But once the borrower provides additional collateral the bank won’t work with the borrower but calls the loan.
3. Once again, a borrower is fully extended on their loan and is having cash-flow problems. The bank tells the borrower that if they get a guarantor such as a parent or sibling the bank will continue to work with them. But after the bank gets a guarantor, it will call the loan and force the guarantor to pay any shortfall.

In these examples the bank is improving its position without providing any additional consideration. Because nothing the bank tells the borrower is in writing, rarely could the borrower force the bank to deliver or be penalized for their behavior.

The borrower should get everything the bank says it will do in writing prior to the borrower dipping into retirement funds, providing additional collateral or obtaining a guarantor.

Fraud by bank employees against their banks and borrowers

Bank’s funds diverted to bank employee instead of going to borrower

This type of fraud is commonly executed by a bank employee on a client. The employee will usually choose a client whom they’re familiar with and who doesn’t keep good records. The fraudster employee will transfer an advance on a commercial or construction loan advance against the borrower directly either to a bank account controlled by the fraudster or indirectly through an invoice from a company controlled by the employee.

The bank or the borrower can catch this type of fraud early by comparing the amount of the loan balance on the bank’s books with the amount of the loan balance on the borrower’s books. They should always match.

Obviously, the bank and the borrower must be religious about checking their books. And someone other than the fraudulent bank employee must be communicating with the borrower to confirm loan advances.

Shrinkage of a borrower’s collateral after being seized by a bank

Another type of fraud performed by bank employees happens after the bank has taken control of a distressed borrower’s collateral. A bank should dispose of a distressed borrower’s collateral in a manner that maximizes its value and then use the proceeds to reduce the amount owed to the bank. But if controls aren’t in place, crooked employees can steal the borrower’s collateral or sell it to relatives and friends at below-market rates.

Signing a commercial-loan agreement can be a nerve-wracking experience for business owners.

Fraud by banks against third-party vendors

In a case in which I (Stone) was a court-appointed Chapter 11 trustee, a bank had perpetrated a multimillion-dollar fraud against a third-party creditor. The bank got away with it and promoted the employee who committed the fraud to bank president.

When this borrower took out a $2.5 million-dollar loan, he secured it with receivables that the bank thought had equal value. But more than half of the receivables were fraudulent, the borrower had debts in excess of $5 million and most of their listed assets were fraudulent. So, the chances that the borrower would pay the amount back, if the bank called the loan, were slim.

A third-party vendor of the borrower happened to tell the bank it was considering extending inventory on credit to the borrower in excess of $3 million in addition to their existing inventory on credit of $2 million. Seeing an opportunity, the bank employee told the vendor that the borrower was a great customer, and it shouldn’t have any concerns about being repaid. The vendor delivered the extra $3 million inventory on credit, and the borrower subsequently sold the inventory at approximately his cost; the bank then seized the funds out of the bank account and paid down its $2.5 million-dollar loan, which left the third-party vendor high and dry.

In the bankruptcy proceeding, the bank employee probably committed perjury by saying that he’d never talked to the third-party vendor and hadn’t endorsed the advance of inventory to the borrower. The vendor couldn’t prove that it had relied on the lender’s endorsement, so the bank got to keep the $2.5 million they swept from the borrower’s bank account, and the vendor took the entire loss. The vendor’s position would’ve been strengthened if it had received the endorsement from the bank in writing.

Fraud by borrowers against banks

The primary reason this is the most common type of commercial-loan fraud is because the number of borrowers is much greater than the number of banks. (That is, one bank could make thousands of loans to borrowers.) In this type of fraud, a borrower experiences a business downturn that causes cash-flow problems and results in it having difficulty meeting the most basic loan requirements, such as making payments to the bank as scheduled in the loan agreement. The borrower feels the pressure to engage in fraudulent activities to delay making payments or to get additional loan advances. Here are some typical frauds of this type:

Borrowing base certificate fraud

A bank lends to a borrower an amount of money equal to a percentage of receivables, inventory and work in progress (partially finished goods that have yet to be completed). For example, the advance could be 70% of receivables, 60% of inventory and 40% of work in progress or any other percentages as agreed.

The borrower would report to the bank fraudulent amounts in any of these areas and prepare financial documents that appear to support the advance. The bank must ensure that the borrower’s provided documents are accurate.

Financial statement fraud

Borrowers are required to provide lenders with financial statements of operations that contain no material inaccuracies. When a borrower has taken out a loan supported by business operations, it could feel pressured to give the bank fraudulent financial statements and/or delay providing them.

Again, the bank must perform vertical and horizontal analyses of these statements to ensure they’re accurate and timely. These should include ratio analysis and comparison of accounts in the financial statements to accounts known by the bank such as deposits and loan balances. A good database management system with checklists and financial analysis tools allows the bank to keep track of their commercial customers.

Borrower sells bank’s collateral

Another ridiculous case example we worked was a bankruptcy fraud in which a bank lent funds to a bankrupt farmer secured by his dairy cattle. Because the bank lent the funds after the bankruptcy, it had a priority interest. The bankrupt borrower, who had a gambling addiction, sold most of his cattle so he could still visit the casinos. However, because he was such a generous guy, he invited his neighbors to let their dairy cows graze on his property. Whenever the bank audited the farm to check on collateral for a $1 million loan, they always saw lots of cows.

Letter-of-credit fraud

A bank issues a letter of credit and gives it to a borrower’s vendor to guarantee the vendor will get paid when the vendor delivers goods to the borrower. If the borrower has previously issued letters of credit to vendors but now the borrower’s financial situation has worsened so the bank won’t issue a new letter of credit, the borrower might be tempted to forge a letter of credit by copying a previously issued letter and changing the date, dollar amount and vendor.

Or a bank employee might be tempted to forge a letter of credit and give it to the borrower if the employee thinks the borrower is just experiencing a temporary cash-flow problem, and the letter will help the borrower recover.

The borrower might have bribed the bank employee, or the employee might genuinely want to help the borrower out of a tight spot. (See “Case of the empty crates - Finding a solution to letter-of-credit fraud,” by Milind Tiwari, CFE, Fraud Magazine, November/December2021.)

High-pressure tension

Signing a commercial loan agreement can be a nerve-wracking experience for business owners who often face an uncertain future and can’t always comply with the terms of the deal. Banks, in turn, can simply call the loans whenever they “in good faith” deem themselves insecure.

Once borrowers can’t meet loan agreement terms, they just want to keep their businesses afloat and banks need to ensure they don’t incur losses. The intense pressure can cause any of the parties to cross the line and engage in fraud.

Banks must have controls in place to prevent the frauds we list in the column and effective database management systems to ensure borrowers comply with loan covenants and analyze the financial statements of borrowers to ensure they’re a fair presentation of borrowers’ business operations.

Roger W. Stone CFE, CPA, is owner of Management Accounting Services. Contact him at rstone@financialstatements.net.

Philip Duffy is a retired senior vice president of commercial lending. Contact him at philduffy6789@gmail.com.