Five Steps to Evaluating Vendor Financing Risks in a Volatile Market

by David G. Mayer May/June 2010
Vendor fraud — whether by oversight or an intentional act — is especially harmful to the equipment leasing industry in general and to vendor finance programs in particular. Patton Boggs’ attorney David Mayer returns to offer five steps designed to prevent or limit reputational and economic damage in evaluating, structuring, funding and operating vendor finance programs.

In an economic downturn, short-term survival may outweigh long-term economic considerations for vendors/manufacturers (vendors) or for lessors or other equipment financiers (funders) in vendor leasing/finance programs. Vendor fraud — whether by oversight or an intentional act — is especially harmful to the leasing industry in general and to vendor finance programs in particular. Consequently, funders in vendor financing transactions necessarily re-examine their standards of identifying, measuring and mitigating risk in vendor financing programs.

The following five steps may prevent or limit reputational and economic damage in evaluating, structuring, funding and operating these programs:

Step 1: Perform Extensive Diligence on Vendor and Lessee Creditworthiness
Funders should reassess their reliance on mechanical risk management technology, which cannot replace independent judgment. Pure electronic processes for small- and middle-ticket transactions may mislead lessors in this environment of higher risk. Funders should also routinely look farther back than 18 months in assessing vendor and lessee creditworthiness. To accomplish their objective, lessors should:

  • Scrutinize lessees in high-risk industries that have either stopped funding or reassess early warning signs of financial distress. Funders should monitor industry projections and review the vendors’ profit and loss numbers. Even safe bets deserve a second look.
  • Identify lessee performance risks involving, for example, the type and extent of equipment use, the compliance with maintenance and insurance requirements and the payment of associated taxes when due. Funders have become especially sensitive to vendor operations that:
    • offer lengthy product guarantees,
    • sell to risky customers (showing credit, industrial, financial or operational distress),
    • fail to perform up to expectations of their customers/lessees,
    • report recurring operating losses,
    • experience continuous working capital deficiencies,
    • fund despite unlikely renewals of a lessee’s primary credit lines,
    • engage in legal proceedings with financial institutions or customers/lessees,
    • lose key customers and/or suppliers and/or face cash demands of trade creditors and
    • face potential work stoppages by production or service employees tied to the products and services affected by the funder.
  • Enforce objective standards in credit and equipment acceptance with all applicable documentation in place (fully signed, reviewed and retained in safe files).

Step 2: Limit Undisclosed Vendor Financing Arrangements
In an undisclosed vendor leasing arrangement, funders or vendors do not typically inform lessees of the funder’s financing arrangement with the vendor (or a vendor’s captive leasing company). Especially in a tough economy, undisclosed relationships may tempt a vendor (or a vendor’s captive leasing company) to withhold relevant information, especially that which relates to the lessees’ financial distress.

To protect from non-disclosure of adverse financial issues, funders more frequently:

  • Negotiate for disclosed lessee-lessor relationships. In other words, funders can minimize the potential to be harmed by adverse actions or the inaction of the vendor (or a vendor’s captive leasing company) by disclosing the funder’s existence to the lessee even if the vendor (or the vendor’s captive leasing company) continues to service the account with the lessee. Disclosure allows funders to control the lessee’s direction of the payments without misleading the lessee or taking undue credit risk to the vendor. Vendor misstatements may expose funders to grave financial consequences.
  • Require vendor’s personal and/or corporate guaranties to improve the likelihood of performance by vendors of their obligations, representations, warranties and indemnities in the vendor program agreement.
  • Ensure the vendor has the right to transfer service agreements to a third-party funder of the lease and/or the equipment to improve or maintain residual value of the equipment if the lessee fails to maintain the service agreement.
  • Insist on receiving timely financial statements, certifications and other reports on the vendor and the end-user lessee to spot potential for defaults or advance recognition of a need to restructure a lease or even the vendor agreement between a funder and the manufacturer/vendor. Funders no longer rely simply on non-payment as a trigger to find out too little too late to recover from a distressed debtor situation.

Tip: Funders should establish a strong relationship with vendors/manufacturers. Nurturing the relationship is critical as a way to manage risk of fraudulent actions or lack of transparency to a vendor’s business.

Step 3: Confirm Product Technology Works as Warranted
Even seemingly legitimate vendors can present warranty compliance risk. Take the now infamous example of Norvergence and the millions earned with a product called the “Matrix.” Founded in 2001, the telecom company pitched its product as able to deliver unlimited broadband, landline and cell phone service with no per-minute charges.

The Matrix, however, was not what it appeared to be; it was no more than a firewall and router, incapable of providing Internet service on its own — a fraud. Norvergence simply bought services from companies such as Sprint or Qwest Communications, and then re-branded and resold the services under its own name. In June 2004, when Norvergence was forced into bankruptcy, more than 7,200 lessees were locked into leases totaling approximately $230 million. In subsequent settlements, well-known lessors agreed to write-off more than $53.9 million of Norvergence debt.

Funders may accept the representations and products of well-known and creditworthy vendors, but, chastened by Norvergence and the like, funders either refuse to enter vendor programs or fund unless they confirm that the vendor’s product works as warranted. To do so, funders may:

  • Conduct a site visit on every significant deal to confirm the equipment has been installed and is operational.
  • Run technology testing on the asset to assure that it operates in accordance with specifications and the vendor representations of its functionality.
  • Interview other product users to confirm positive experience with the product and that no claims have been asserted against the lessors or the manufacturer/seller.
  • Hire or use an equipment specialist to evaluate the operations, viability and market appeal of the asset.

Step 4: Look for Strong Vendor and Lessee Management
Present market instability requires funders to look deeper than ever into the quality of a vendor’s management team as well as its economic and credit strength. Funders often dedicate time to become familiar with the vendor’s plan for overcoming present market challenges and the current viability of the company. Management should exhibit a deep understanding of the relevant marketplace, including the competition’s strengths and weaknesses and the lessee’s buying habits and preferences — in order to meet strict criteria established by vendors and investors for quality management.

Many funders, lenders and lessors use the age-old concept of evaluating creditworthiness of borrowers by the “5Cs.” Funders can apply these concepts to other enterprises with obligations to meet, such as the obligation of a vendor or vendor-leasing subsidiary to each of their customers. The 5Cs are as follows:

  1. Character (reputation) — prime determinate of a borrower’s willingness to repay a loan or meet an obligation (arguably the most important element in any business relationship).
  2. Capacity(cash flow) — ability of the organization to generate liquidity to pay its debts.
  3. Capital (real net worth) — the real tangible net worth as support for repayment.
  4. Collateral (security) — assets available to collateralize an obligation or debt.
  5. Conditions (economic environment) — systemic market risk and recession, high-risk industries and related businesses.

Tip: Especially with new vendor leasing programs, as a vendor or funder, you should ramp up your program slowly so you get some real-world experience with the lessees and equipment involved in your program. This experience will assist you in identifying and resolving potential problems in your program and incorporating the benefits you receive by taking reasonable business risks. Use common sense as you apply each of the 5Cs.

Step 5: Mitigate Potential Fraud Risks
In a down economy, short-term survival measures may increase the potential for fraud. To investigate potential fraud scenarios funders should:

  • Hire a third party to conduct an in-depth study or audit of the vendor’s financial processes, including assessing the potential for fraud,
  • Monitor bank transactions. Watch for duplicative, overstated or understated transactions and
  • Apply the lessons learned from fraud cases such as Norvergence, Le-Nature’s (cooked books) and others to avert potentially similar schemes in your transactions. See “Does Le-Nature’s Fraud Case Show When No Amount of Diligence Is Enough?” Business Leasing and Finance News (Dec. 2006) for more extensive tips on averting fraud schemes. For a list of types of fraud schemes in vendor leasing programs, see “Types of Fraud,” Lease Police (2007).

In the current down market, lessors, funders, vendors and even lessees often (but not always) look for red flags, which may indicate that a vendor leasing or financing transaction is not all that it is cracked up to be. Realistically, small-ticket and mid-ticket deals do not have the size necessary to merit in-depth due diligence. The parties should, in all events, use risk management procedures as a way to withstand or avert errors or financial mistakes.

Even when the parties conduct extensive due diligence, their efforts may not be enough to fully mitigate risk, especially to stop those who intend to commit fraud. But, if the parties fail to do appropriate due diligence and test the 5Cs in these troubled markets, the potential for fraud may not be the only challenge they encounter.

Thanks to Jaynacia L. Abraham, an associate in the Dallas office of Patton Boggs for contributing to this article; and thanks to Brad Gunstad, executive vice president and general counsel at TCF Equipment Finance, Inc. for editing this article.

David G. Mayer is a partner of Patton Boggs LLP in the firm’s Dallas office. He devotes substantial time to developing and financing wind farms and gas storage facilities, and buying, selling and financing various types of equipment and facilities. He is admitted to practice law in New York, California and Texas. Mayer founded Business Leasing News, now called Business Leasing and Finance News (BLFN), a quarterly e-newsletter in its ninth consecutive year of publication. He is the author of Business Leasing for Dummies (2001). Mayer can be contacted at 214-758-1545 or via e-mail at

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