Behind the Bankruptcy

Fraud Examiners Need to Look Beyond the Records in Bankruptcy Cases

By By Herbert J. Cleveland, CFE

(The information contained in this article is intended to supply the reader with some bankruptcy fraud basics. Consult your attorney before investigating any bankruptcy cases.)  

An enterprising developer built an apartment complex. After a time, he sold the property for a profit to a limited partnership of his friends with himself as the general partner. Eventually, the developer had some financial problems, could not pay his personal bills, and filed for a Chapter 7 bankruptcy. On paper he was broke but his creditors were suspicious. They hired me to do due diligence. After weeks of searching I found evidence that the developer was far from destitute; he had squirreled away $400,000 that rightfully belonged to his creditors. This was a solid case of bankruptcy fraud.

Corporations or individuals heading toward bankruptcy often try to conceal assets from clamoring creditors. Fraud examiners sometimes are hired to locate hidden assets, “preferences,”1 and fraudulent settlements by conducting investigations and searches that often include public and proprietary computer files. But unless they ask the hard questions, look beyond the facts and figures, and work to put themselves “into the deal,” they may miss not only the nuances of the case but also the concealed holdings.

In the case of the devious developer, I discovered that after he had sold his apartment complex, he allowed the corporation to die by not paying the franchise taxes. He then did something odd: he transferred his interest in the “dead” corporation to his brother. It was all perfectly legal but extremely curious. Why would he make the effort to transfer stock from a dead entity that had no apparent assets?

I found the answer tucked away in old state district court records. Five years earlier, the “dead” corporation had sued an insurance company for $400,000 because of water damage from a frozen pipe during construction of the apartment complex. Because the apartments had long transferred out of the corporation to the limited partnership, the only remaining potential asset was the money from the insurance litigation, which the bankrupt developer hoped to place in his brother’s possession. No corporate liabilities would have transferred to the brother even though the franchise tax had not been paid.

The docket sheet from the lawsuit revealed a recent positive finding for the plaintiff corporation and a notice that the insurance company had chosen not to appeal. With this information, the bankruptcy trustee attached the $400,000 to pay creditors. The developer was not charged with fraud but neither was he granted his coveted Chapter 7 bankruptcy discharge of debts. He now would have to pay his outstanding debts like the rest of us. (See the end of the article for definitions of bankruptcy terms.)

Clients in bankruptcy cases – generally creditors – want detailed analyses drawn from all sources. Fraud examiners are trained to provide the answers by looking in unusual places and asking questions other investigators may not consider. They will go beyond the facts to scrutinize the names and signatures of witnesses; dates and locations of signed and notarized documents; parties’ addresses; and recipients of recorded documents, terms, amounts, and specific collateral – all of which provide clues to irregularities and outright fraud.

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