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Bankruptcy Fraud

California CPA January/February 2010

Reporting, Responding to Fraudulent Activity in Bankruptcy Case
By Marc S. Cohen, Eeq. & Alicia Clough, Esq.

With the recent rise in bankruptcy filings, stronger enforcement of bankruptcy fraud laws is likely to elevate the CPA’s role in investigating civil and criminal bankruptcy fraud. CPAs may find themselves asked to serve as examiners or trustees in bankruptcy cases, or to serve on creditors’ committees, a situation in which they will be called upon to investigate a corporate debtor’s financial affairs. Clients may also seek assistance in recovering assets from a debtor suspected of fraud. Thus, it behooves CPAs to familiarize themselves with some of the common aspects of bankruptcy fraud.

Bankruptcy filings have risen dramatically in the United States in the wake of the economic downturn. Indeed, individual bankruptcy filings for the 12-month period ending March 31 were up 33.3 percent over the previous 12-month period, according to the Administrative Office of the U.S. Courts. The National Bankruptcy Research Center reported that in July alone, more than 125,000 new filings were recorded—the highest monthly total since Congress enacted new bankruptcy laws in 2005.

This increase in bankruptcy petitions has been accompanied by an increase in bankruptcy fraud. The most common types include concealing assets, filing serial bankruptcy cases and making fraudulent transfers. The U.S. Department of Justice estimates that 10 percent of all bankruptcy petitions contain some elements of fraud. Thus, CPAs and financial professionals must educate themselves on the remedies and courses of action—civil and criminal—available to them once they have identified indications of fraud.

Civil Responses
If you suspect fraud in a Chapter 11 bankruptcy case, consider seeking the immediate appointment of a Chapter 11 trustee. The trustee displaces the management that got the debtor in its financial predicament and is vested with broad rights and powers to oversee the debtor’s financial affairs. It is appropriate to seek appointment of a Chapter 11 trustee if you suspect that any party in control of the debtor was dishonest in managing the debtor or in preparing the debtor’s financial reporting.

The appointment of a Chapter 11 trustee is considered an extraordinary remedy, requiring a showing of fraud, dishonesty, incompetence or gross mismanagement either before or after the bankruptcy filing.

If the situation is dire, and you suspect a debtor is attempting to quickly conceal or transfer assets, it can be appropriate to seek the immediate appointment of an interim “gap” trustee. Any party in interest can request the appointment of a trustee or examiner at any time prior to confirmation in a Chapter 11 case. On motion by a party in interest or the U.S. Trustee, and after notice and a hearing, a bankruptcy court will order the appointment of a case trustee for cause.

If a debtor fails to file the requisite financial documents with the court, as is often the case when individuals or entities improperly use the bankruptcy process as a shield, it may become necessary for a party, including any creditor, to file a motion to compel the debtor to comply with the Bankruptcy Code’s filing requirements.
Further motions designed to expedite the debtor’s compliance with Sec. 704 of the Bankruptcy Code, which sets forth the debtor’s duties and obligations to furnish information, also may be required.

For example, Bankruptcy Rule 2004 allows any party in interest to take an examination—much like a deposition—of any entity so long as the examination relates to the conduct, property or liabilities of the debtor. The rule also allows parties in interest to compel production of documents. If the debtor operates a business, the examination may relate to the operations and the desirability of continuing the business.

The rule is broad and can be a useful tool for parties seeking to investigate the debtor’s financial condition prior to the 341(a) meeting of creditors—a meeting run by the Office of the U.S. Trustee, at which creditors and parties in interest may ask the debtor questions concerning the debtor’s assets and debts. Although the Bankruptcy Code requires that the 341(a) meeting of creditors must take place within 60 days after the filing of the case, a motion to conduct a Rule 2004 exam may be needed sooner if a debtor is showing signs of fraudulent behavior.

Another available mechanism is a motion to compel the debtor’s immediate filing of its list of bank accounts, inventory and creditors. Once you have obtained an order in connection with any of these motions, you can seek contempt if the orders are not obeyed.

In certain circumstances, it may be advisable to initiate an adversary proceeding to freeze a fraudulent debtor’s bank accounts and prevent further disposition of estate assets. Adversary proceedings against insiders to regain preferences and fraudulent conveyances are often advisable in those Chapter 11 cases where it appears that a debtor has improperly transferred assets to its insiders.

Another powerful tool is to file objections to the dischargeability under 11 U.S. Code Sec. 523(a)(2), which prohibits discharging a debtor’s debt if the debtor made false representations or committed some other fraud regarding its own financial condition, or the condition of one of its insiders. While such objections are typically filed by creditors whose loans were improperly procured, it may fall upon you as a CPA to pursue this remedy in certain cases involving schemes by companies that were set up to fail from the outset.

It may also be appropriate to file a motion to dismiss the bankruptcy case and prohibit the debtor from re-filing the case. These motions can be based on a variety of actions that appear to be attempts to abuse the bankruptcy process, including fraud.

Bankruptcy fraud may also involve a debtor attempting to take advantage of certain protections afforded by criminal procedure or state privilege laws. Notably, a debtor entity’s financial officers may contend that the correspondence with the company’s general counsel is protected by attorney-client privilege. To prevent such abuses, a CPA may ask the trustee to seek a waiver of the privilege.

If a criminal investigation is pending against a debtor, it may be advisable to request that, as part of any plea agreement, the debtor agrees to waive his discharge in bankruptcy or, if the debtor is convicted after trial, that the entire bankruptcy debt be imposed as restitution.

A CPA may also want to bring alter ego or constructive trust action against a debtor’s principals. Alter ego claims, also known as “piercing the corporate veil,” allow a court to disregard the separate and distinct nature of a corporation to hold the company’s shareholders directly liable for the corporation’s debts. Factors courts consider to determine if alter ego claims exist include inadequate capitalization of the corporation, noncompliance with corporate formalities and whether shareholders exercised control of the corporation so that the corporation no longer had an independent identity.

A common practice in Chapter 11 proceedings is to form or seek appointment of a creditors’ committee. Such committees can be formed informally, before a bankruptcy case has been filed. An informal committee is particularly useful if a CPA suspects an investor fraud scheme has been, or is being, carried out. In those circumstances, it is advisable to coordinate communication among investor creditors, such as telephone hotlines, investor informational meetings and notices to creditors that are complete and understandable.

If a bankruptcy has already been filed, contact the Office of the U.S. Trustee regarding appointment of a creditors’ and equity security holders’ committee pursuant to 11 U.S. Code Sec. 1102.

Criminal Responses
The most notable criminal practices in bankruptcy cases are concealment of assets or similar fraud committed in contemplation of bankruptcy. However, criminal activities in bankruptcy take many forms, as defined by Title 18 of the U.S. Code, secs. 152 and 157.

For the purposes of the bankruptcy statutes, “conceal” does not mean merely to secret or hide assets. It also means to prevent the discovery of the asset or to withhold knowledge of the asset. Thus, because a debtor has an affirmative obligation to list all estate property in the debtor’s schedules, failure to list an asset on the bankruptcy schedules can constitute concealment under the statute. Moreover, the concealment of property belonging to a bankruptcy estate can take place before or after the bankruptcy is filed.

CPAs should report criminal bankruptcy fraud to the Office of the U.S. Trustee. The U.S. Trustee Program is a component of the DOJ with a mission that includes promoting the integrity and efficiency of the bankruptcy system by enforcing bankruptcy laws. Among its responsibilities is identifying fraud and abuse in bankruptcy filings. Reporting instructions are available on the program’s website.

When reporting fraud, a CPA can increase the likelihood of further investigation and possible criminal prosecution by providing supporting documentation and specific
factual information to the U.S. Trustee.

It’s important to identify the type of asset that was concealed and its estimated value—or the amount of any unreported income, undervalued asset or other omitted asset or claim.

The IRS Criminal Investigation’s Bankruptcy Fraud Program also investigates bankruptcy fraud cases and, if necessary, recommends some of those cases to the DOJ for prosecution. The IRS has a vested interest in pursuing bankruptcy fraud because it’s often one of the main creditors.

In 2008, the IRS initiated 25 bankruptcy fraud investigations. Of those, 10 prosecution recommendations were made, and 16 individuals were sentenced.  
Reporting instructions are available online. Additional reporting instructions and resources, including explanations and sample indictments related to specific bankruptcy crimes, are available on the DOJ’s website.

Know Your Role
CPAs should alert law enforcement promptly if they suspect criminal activity in a bankruptcy or receive a tip regarding such activities. According to the Office of the Inspector general, nearly half of the bankruptcy fraud referrals to law enforcement resulted from tips. Various law enforcement agencies rely on CPAs to bring criminal behavior to light, especially in the ever-growing area of bankruptcy fraud.  

Marc S. Cohen, Esq., and Alicia Clough, Esq., are bankruptcy attorneys in the Los Angeles office of Kaye Scholer LLP.