Lenders, usually through their legal counsel and/or compliance and risk departments, retain forensic accountants to uncover hidden assets when faced with a borrower’s default and failure to comply with stipulated loan obligations.  Such loans are generally collateralized through the borrower’s pledge of real estate, accounts receivable, inventory and other business or personal assets.

Attempts to protect this collateral are made through binding legal provisions in loan agreements, the filing of Uniform Commercial Code (UCC) statements and obtaining personal guarantees from actual owners of the business.  However, as evidenced by our litigious society, not all borrowers are created equal and make good on their promise to repay.  As many banks have experienced, certain borrowers, especially those in financial distress, have intentionally diverted or fraudulently conveyed assets pledged as collateral to avoid repossession in default.

Forensic accountants typically get involved in these matters on a reactive basis, usually after payments have ceased and questions get raised as to the state and fate of the collateral pledged to secure repayment.   Nonetheless, if the lender takes certain precautions to protect their collateral before, while and after funds are committed, the scenario that plays out could look drastically different.

Lenders should perform and document the following basic procedures and results when deciding whether to take on new business, extend credit, call the loan, or modify the terms of the existing loan agreement:

• Perform a detailed analysis of the customer’s current and historical accounts receivable and accounts payable activity;
• Perform an independent physical inventory count and require that it be valued conservatively, reserving for any obsolete or slow-moving items;
• Develop financial benchmarks and identify trends based on historical data and industry statistics for comparison to current and future financial performance;
• Regularly exercise the right to physically inspect and examine the borrower’s books, records and collateralized assets in order to independently verify information furnished by the borrower;
• Consistently monitor the borrower’s compliance with the financial reporting requirements outlined in the loan agreement, such as the timely delivery of: (1) properly completed and executed borrowing base certificates; (2) monthly and annual financial statements; (3) federal and state tax returns; and (4) other schedules and reports.

Taking these steps provides added comfort that lending practices are based on properly-valued, legitimate collateral, quickly convertible to cash in the event of default.

More specifically, a detailed analysis of the borrower’s accounts receivable and accounts payable activities should raise questions regarding certain actions of the borrower, including but not limited to the following:

• Does the borrower continue to sell products to certain customers that have significant and aged accounts receivable outstanding?
• Does the borrower engage in business with undisclosed related-parties?
• Does the borrower’s ability to operate rest on the performance of one or two critical customers or suppliers?
• Is the borrower’s business seasonal, or heavily impacted by current or foreseeable economic trends?

Ratio analysis, using at least three years of verifiable financial data can shed some light on the borrower’s ability to: (1) turn short-term and long-term assets into cash to cover debt obligations; (2) measure the efficiency of management in the employment of resources to generate profits; and (3) survive as a viable business enterprise for an extended period of time.  Financial ratios such as the current ratio, quick ratio, receivables turnover ratio and debt-to-equity ratio, among a variety of others, are powerful tools to use when analyzing the financial health of the borrower throughout the lending life-cycle.  The borrower’s financial ratio results should be compared to those of prior years, in addition to those of other organizations operating in the same or similar industries.  The results of the above procedures, taken individually and together, can help lenders develop a focused approach to evaluating the financial strength of the borrower and its likelihood of default.

Another step to consider taking is a public record database search of the borrower, along with major customers and suppliers, especially if their business is transacted in multiple locations or geographies.  Further investigation into the ownership structure of customers with an unusually high volume of returns resulting in large sales credits is certainly warranted.  The purpose of conducting this forensic exercise is to determine if the borrower has an undisclosed ownership interest in an entity with which it transacts business.  Such related parties could include the borrower’s landlord that holds title to the office and/or warehouse facilities leased by the borrower, or a fictitious customer that appears to transact business with the borrower in the normal course but really for the purpose of increasing the borrower’s accounts receivable balance to inflate its purported collateral position.

It is critical that appropriate due diligence efforts and loan monitoring activities be carried out by lenders, before, while, and after funds are committed.  The procedures noted above, if performed early and often, can help to provide the lender with an accurate account of its collateral position specific to loans in its portfolio, as well as a mechanism for assessing the risks and rewards associated with taking on new business or extending additional credit to existing borrowers.  However, if serious internal and/or external failures result from inadequate due diligence and/or loan monitoring efforts, the term breaking the bank could take on a whole new meaning.

When it comes to loan monitoring services or identifying, tracing and recovering collateralized assets associated with distressed loans, consider enlisting the help of Mercadien’s qualified forensic and litigation support professionals. If you have any questions or would like further information please do not hesitate to contact me at fpina@mercadien.com or 609-689-9700.