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:
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:
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:
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:
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:
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.
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 dmayer@pattonboggs.com.
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