Over the past year, bankruptcy fraud has been repeatedly splashed across headlines following the successful prosecution of several multimillion-dollar cases. As a consequence, bankruptcy fraud investigations may begin to sound routine and straightforward. In reality, recognizing and proving bankruptcy fraud is a difficult and time-consuming process. Even a detailed inquiry may result in a dead end and ultimately yield more questions than answers.
The majority of bankruptcy fraud allegations involve the concealment of assets from the bankruptcy court and appointed representatives. Activities that will likely lead to a charge of bankruptcy fraud include:
- Diversion of funds from the debtor to a non-debtor prior to the filings
- Failure to report all means of income by the debtor on bankruptcy filings
- Undervaluing non-exempt assets in a manner which prohibits them from being liquidated
Searching for these activities can be difficult in any fraudulent context. Scrutinizing debtors who are concealing the true value of their assets becomes even more problematic in the bankruptcy setting. For example, of the 44 bankruptcy fraud investigations initiated in 2014 by the Internal Revenue Service1, only 12 indictments were filed, of which only eight cases resulted in sentencing.
Consider the most common challenges that confront financial investigators and forensic accountants in cases of alleged bankruptcy fraud:2
Uncooperative and Disgruntled Debtors
Filing for bankruptcy is often the culmination of a series of damaging events for the debtor. If a trustee feels that an examination of a debtor’s financial activity is necessary, it often falls on the investigator to work directly with the debtor. Debtors are typically in a state of distress and prefer to move through the bankruptcy process as quickly as possible while attempting to stabilize their financial status. The last thing they want to deal with is a forensic investigation into their financial affairs. This can lead to an adversarial relationship, and as a result debtors can be antagonistic, refuse to respond to requests for documentation, and sometimes exhibit threatening behavior in order to avoid the investigation. In many cases, the more stubborn the debtor is, the higher the likelihood of unveiling deceptive activity.
Seeming Lack of Available Funds for a Comprehensive Forensic Investigation
When debtors file under Chapter 7 bankruptcy, they often have limited non-exempt assets. These assets are used by the bankruptcy trustee to pay professional fees and distribute the remaining funds to creditors. At the beginning of a matter, the trustee usually performs a cost/benefit analysis to determine if bringing in accounting experts is worth the cost. In many cases, the answer should be a resounding “Yes!” Experienced professionals can look at a set of transactions and diagnose whether or not a financial investigation is warranted. If the accountant finds that “low hanging fruit” exists, these assets are often the first to be collected by the trustee, thus limiting the financial cost to the estate while maximizing the return. For matters that require a deeper understanding, accountants will carefully consider what aspects of a case need to be analyzed and focus their efforts there. This process limits the fees incurred while bringing about the best possible return on the trustee’s investment in an expert.
Missing and/or Incomplete Records
Commonly, debtors lack the customary financial records needed for an investigation. Although the bankruptcy trustee has the power to file subpoenas to recover records, this process can take weeks or months. In addition, the absence of supporting documentation severely hinders the ability to actually prove that the concealment of assets has occurred. In an ideal forensic inquiry, the accountant has access to complete and reliable business records with little interference by the client. Unfortunately, this scenario is more the exception than the rule in a bankruptcy investigation. Thus, the gathering of information from independent outside sources (banks, customers, vendors, etc.) is an integral step in the fact-finding process.
The timeline in a bankruptcy investigation can often be a double-edged sword. On the one hand, the trustee commonly has two years from the petition date to file adversarial proceedings in an attempt to recover assets. This period would appear to give the financial investigator a sufficient amount of time to review records, take depositions and fully investigate a set of suspicious transactions. On the other hand, the more time goes by, the less likely it is that a discovered asset will be available for recovery. For example, assume a debtor transferred a significant amount of money to a family member before the bankruptcy filing. The trustee takes 18 months to explore this transfer due to insufficient business documentation and a disinclined debtor and finally decides to file suit to reclaim this money. However, in the meantime, it is likely that the family member disposed of the funds and is unable to recompense the trustee. In this situation, a delay in the timeline led to a missed opportunity for an avoidance action against a related party.
Bankruptcy fraud requires specialized forensic investigative skills
Forensic accountants investigating potential bankruptcy fraud need to possess three critical skills:
- Case and Time Management
In a typical financial investigation, the client suspects that a loss or theft has occurred and instructs the investigator to scrutinize specified areas. The opposite often occurs in a bankruptcy as the trustee generally does not know what potential assets may have been concealed and is relying on the financial investigator to uncover hidden assets. The related litigation may span several years and demand a high level of case- status management. Additionally, knowing when to stop investigating a suspect area is essential for effective time management.
- Basic Familiarity With the Debtor’s Business
For many assignments, possessing a fundamental understanding of a target’s specific line of work is not a prerequisite for a successful investigation. In bankruptcy probes, the opposite can be true. The investigator should be fairly knowledgeable regarding the debtor’s type of business and typical vendors that are used in that industry. In addition, familiarity with key financial ratios commonly used in the trade is significant when analyzing tax returns and business records.
- Analytical Thinking and Investigative Mindset
An accountant who is exploring the potential concealment of assets must often uncover obscure information and piece together a complex puzzle. Records may be unavailable or incomplete, and debtors tend to be unaccommodating. The forensic accountant must be able to read between the lines and demonstrate when deceptive financial transgressions have indeed occurred.
The world of bankruptcy fraud is fraught with uncooperative debtors, incomplete records, a seeming scarcity of assets to fund comprehensive forensic investigations and compressed timeframes. Although these investigations are challenging, the recovery of hidden assets benefits all parties harmed by the concealment. By engaging financial investigators and forensic accountants with proven experience in bankruptcy matters as soon as possible after the filing, trustees can best protect everyone’s interests.
2 These situations pertain primarily to cases filed under Chapter 7. This type of bankruptcy is the most severe in that it normally requires a complete liquidation of the debtor’s non-exempt assets. A trustee is appointed to manage the case process and oversee the insolvency. After liquidation, the resulting value is used to pay the creditors and any professional fees.