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Recent weeks have seen several headline-grabbing instances of alleged financial frauds, leading directly to the bankruptcies of the First Brands and Tricolor corporate enterprises. Both companies are alleged to have engaged in deceptive off-balance sheet financing and double-pledging of collateral, tumbling into bankruptcy after these issues came to light. While their lenders will have to seek their recourse in costly and lengthy bankruptcy proceedings, the cases serve as sobering reminders to lenders of the critical importance of vigilant oversight and the need for transparency into their borrowers' activities in today's active and complex lending environment.
For lenders and their professionals, implementing robust anti-fraud standards is a best practice. This post examines two key activities that lenders can employ to effectively minimize the risk, and losses, of a borrower's fraud: conducting "field exams" and commissioning quality of earnings (or QOE) reports. While often reserved for new financings, these can also be implemented at the first signs of distress or during the course of a workout.
A field exam is a detailed, on-site review of a borrower's books, records, and operating practices. Unlike a desk-based audit, a properly conducted field exam gives a lender an unvarnished, independent third-party look into their borrower's assets, such as accounts receivable, inventory, and other critical collateral. While often limited to asset based financings (where loan availability is limited by the value of the collateral), field exams can be useful in leveraged facilities as well, to provide a more complete picture of a lender's collateral.
Field exams allow lenders to verify the actual existence and value of collateral. For example, with respect to inventory, an examiner will conduct physical counts of product, review inventory documentation, and check records against supporting invoices. If discrepancies emerge—such as inventory volumes not matching reported figures or missing documentation supporting sales—these can be red flags of potential manipulation. Similarly, field exams can uncover fictitious receivables, undisclosed liabilities, or even fraudulent vendor relationships. An examiner may discover a pattern of inflated sales through related-party transactions or recognize that receivables are heavily concentrated among questionable customers.
Field exams should be scheduled at regular intervals or in reaction to material changes in borrower performance. Lenders can expand the scope of exams during periods of heightened risk (e.g., declining sales, unusual financial activity) and/or upon transfer to the lender's workout group. Of course, borrower cooperation is critical for a successful field exam, given the need for access to books and records and premises for inspections. Indeed, the fact that a borrower resists an exam, or fails to cooperate with the examiner, might itself be an indication that greater scrutiny and caution is required.
Quality of earnings reports provide lenders with a deeper understanding of a borrower's financial health and the integrity of their reported earnings. Typically performed by a specialized accounting or advisory firm, such a report analyzes the sources, consistency, and sustainability of earnings by scrutinizing accounting policies, cash flows, and adjustments for non-recurring transactions. A QOE report might, for instance, expose subtle forms of earnings manipulation such as premature revenue recognition, aggressive capitalization of expenses, or inclusion of one-time gains as regular income. For example, an analysis can reveal whether an unexpected increase in profitability is the result of operational improvements or temporary, non-recurring factors. They often dig deeper than standard audits, providing lenders with actionable adjustments and recommendations. The importance cannot be overstated—according to press sources, a QOE report was among the first indicators of potential fraud at First Brands.
Field exams and QOE reports are indispensable elements of a proactive diligence strategy. Field exams provide direct validation of a borrower's collateral, reducing the risk of asset-based fraud, while QOE reports deliver critical insight into the quality and sustainability of reported earnings. While not practical in all situations, these practices provide an opportunity to identify issues, perhaps before they ripen into significant losses for the lender.
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