Behind the Bankruptcy: Looking Beyond the Records in Bankruptcy Cases

(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.

Consider these additional examples:

The Friendly Divorce 

A search of district court divorce files and county grantor/grantee records revealed that less than three months prior to filing for bankruptcy, a husband and wife conveniently obtained a divorce settlement involving the release of the family’s 2,000-acre ranch to the wife. The bankruptcy court considered the divorce agreement “preferential.” The court ruled that the wife’s settlement amount should be limited to the homestead acreage – the house and 160 acres – because it was not in a city. The bulk of the acreage was returned to the bankrupt’s estate to benefit the unsecured creditors. (If a bankrupt person has a city lot as his homestead, the maximum protected land is one acre.)

This was an instance in which the interests of the divorced wife paralleled those of her ex-husband. The more she could get from the divorce settlement and protect from creditors the more she could help her ex-husband re-start a business and perhaps begin a partnership between them.

The Friendly Banker 

I discovered county court grantor/grantee records showing that prior to his bankruptcy, a man had negotiated with a large creditor bank to provide financing to a buyer of one of his properties. The sales proceeds would retire the debt on a large unsecured loan of the bankrupt man in which the bank was an unsecured lender.

Because this arrangement was made within 90 days of the bankruptcy filing, the court-appointed bankruptcy trustee ruled that the monies from the transaction should have been placed into the creditors’ pool of money instead of being used to pay off the bankrupt person’s other debt to the bank.

The Limited Partner 

Prior to filing a bankruptcy petition, one of the limited partners of a failing business approached the partnership’s bank and negotiated to restructure his debt relationship. By attempting to do so, the limited partner, as evidenced through transaction documents I examined from the county court grantor/grantee filings, made decisions as if he was a general partner.

By assuming this role, the court ruled that he should be liable for the debts as though he were a general partner and was required to pay monies to the creditors’ pool as though he had always been a general partner in that limited partnership.

The IRS Prepayment 

In another case, I searched the personal and business files of a bankrupt man and found that he had pre-paid almost $1 million in taxes to the Internal Revenue Service because he “anticipated” a large income. He planned to wait for two or three years for the bankruptcy proceeding to abate (and become dormant or completed) whereupon he would file an amended return claiming a refund for an overpayment with interest.

The creditors deserved to receive their portion of that money but had they gone directly to the IRS they would have been rebuffed because the IRS seldom cooperates with creditors merely on the basis that they have not paid. Also, IRS agents are subject to criminal penalties if they share private taxpayer information even if, as in this case, the taxpayer is using the IRS to hide, hold, and eventually receive back monies that belong to creditors.

The key to recovery in this instance is dependent upon the thoroughness of the bankruptcy trustee to ensure that all tax returns which are filed on any activities of the bankrupt person be obtained and identified as estate assets. The use of the IRS pre-payment of taxes when the taxpayer is not in bankruptcy makes the hiding of assets almost undetectable by creditors.

The Untraceable Account 

In one case, I examined the business and financial records of a bankrupt person and discovered that he had hidden cash in the non-interest bearing accounts of relatives, partners, and some friendly corporations. Without direct access to the bankrupt person’s old records, these accounts virtually were untraceable because the computer usually only picks up the first or second authorized signer. The bankrupt person was the fourth signatory on most of the accounts.

Through the trustee I obtained copies of the actual signature cards for the accounts, and was able then to verify the bankrupt person’s account relationships.

The Assumed Name Account 

By investigating business and financial records (office memos, bank records, balance sheets, and source and application of fund statements), I discovered a bankrupt man had hidden assets in a bank account under an assumed name. Many states only index the assumed name and not the filer so that if a creditor wants to find out if an individual is operating under a trade name or assumed name, it cannot be traced unless you can identify the trade or assumed name. Also, many states allow filing of an assumed name at the county level, so bankrupt individuals can set up accounts under an assumed name in an adjacent county. It is unlikely that accounts under assumed names will be connected with the owner if no other business dealings occur in that county.

Art and Collectibles 

A businessman purposely undervalued his art collection before he filed for Chapter 7 bankruptcy. I discovered the undervaluation by looking at his insurance policies and using two reputable galleries to determine the true value of the pieces. Paintings by known artists often have a scheduled value per square centimeter. Also, auction houses can estimate the value of collectibles within peer groups. The liquidation value of art and collectibles is generally 35 percent to 40 percent of appraisal value.

In another case, a Texas oil man hit hard times when oil prices dove in the mid-1980s. He purposely undervalued his assets to mislead creditors by excluding a significant art collection on loan to a Dallas art museum. I found not attachable assets in his financial statements, but a search of Texas metropolitan newspapers produced articles, which featured the oil man’s loaning of the $1 million art collection When questioned, the oil man said he forgot that he owned the paintings. The artwork was recovered by the trustee and placed in the creditors’ pool as an asset.

The Chapter 7 Shuffle – No Asset Case 

A corporation filed for Chapter 7, and the next day the principals started a new and nearly identical corporation in the same location with furniture, office materials, and telephones in place, and a list of identical clients. The bankrupt corporation paid off delinquent rent on the office space with money that should have gone to other creditors. The landlord then negotiated a new lease and the new corporation continued as usual. After I found this evidence in secretary of state corporate records, I referred the information to the bankruptcy trustee.

The ‘Pro se’ filing of Chapter 13 Bankruptcy 

A near-bankrupt person, who was being harassed by collection agencies, began a pro se Chapter 13 bankruptcy by filing and providing a list of creditors. (Pro se is defined as “appearing for oneself, as in the case of one who does not retain a lawyer and appears for himself in court.”2) However, he did not submit a plan with the courts and ignored any further notices from them to appear for bankruptcy hearings.

He continued to conduct business as usual while his creditors, having received bankruptcy notices, assumed the bankruptcy action had begun and stopped trying to collect. The creditors’ accounting departments then would write off the debt from their books. By filing for bankruptcy but ignoring all further court notices, this person was able to give the appearance of bankruptcy, get the bill collectors off his back, and continue with his business. I have investigated similar businesses that were under financial pressure and have found evidence of psuedo-bankrupt persons’ pro se actions in federal district bankruptcy court when creditors became persistent.

Stacking the Creditors’ Committee Prior to Filing Under Chapter 11 

A real estate developer owned many abutting tracts of land that he had purchased separately. He wanted to have the parcels rezoned to allow him to proceed with a major commercial project. Several banks were involved in primary financing and many of the original landowners retained a second or third mortgage position on the properties. However, land prices dropped significantly and the developer’s dream for the major project crashed, because the creditor banks at the time did not have enough available cash or assets to assist in negotiating a long-term workout arrangement.

The developer knew he had to go into Chapter 11 protection. He negotiated and successfully delayed the banks from proceeding with foreclosure by offering lesser settlements and workout scenarios. At the time, he asked friendly creditors – associates, related corporations, even relatives – to file second, third, fourth, and fifth mortgage positions on the various properties with the strategy of increasing the number of secured friendly creditors.

His plan of reorganization would allow the friendly secured parties to have control of as many as four of the secured voting classes.3 This would hold the larger first lien banks hostage both by the class approval voting and in forming a creditors’ committee, which would vote for delays and cram downs (by which the court forces secured creditors to take less money than they might be entitled because of lowered appraisal values). I discovered this evidence in county grant/grantee, bankruptcy records, and county appraisal district records.

Conclusion 

These few cases show that clients in bankruptcy cases need more than simple verification of submitted bankruptcy schedules. Creditors need accurate depictions of debtors’ assets, financial profiles, and transaction histories of debtors to maximize the amount of the liquidation proceeds or to develop a meaningful workout strategy. Technology simplifies the search process but scrutinizing fraud examiners have to find the real stories behind the records.

Endnotes 

1 A “preference” connotes a judgment by the bankruptcy court trustee that a creditor will be paid ahead of other creditors because of developments in a case. When a bankruptcy occurs, monies are dispersed in this order: 1) administrative and trustee fees; 2) Internal Revenue Service and other government agencies; 3) secured creditor claims (such as loans that were made with real estate as collateral); 4) unsecured creditor claims in which no collateral was pledged such as credit cards, utilities, etc.
2 Black, Nolan, Nolan-Haley, Black’s Law Dictionary, West Publishing Co., 1990, St. Paul, Minn.
3 In a bankruptcy action, a debtor’s plan of reorganization must be approved by a creditors’ committee comprised of representatives from administrative and trustee bodies, governmental agencies, secured creditors, and unsecured creditors. (See endnote No. 1.) The debtor can only benefit from having friendly creditors on the committee such as associates, related corporations, and relatives. 

Herbert J. Cleveland, CFE, is president of Profile Information Services Inc. in Austin, Texas. He is a former president of the Austin Chapter of the Association.

SIDEBAR 

Finding the Facts 

Following is a typical discovery process using public records and proprietary databases.

Public Records 

• Federal level: civil, criminal, and bankruptcy courts; U.S. Coast Guard (boat registration) and Federal Aviation Association (aircraft registration)
• State indices: secretary of state, [corporate, partnership, Uniform Commercial Codes (UCC), trade names], state comptroller (franchise, good standing with the state, sales and use tax, hotel occupancy tax), state commissions [savings and loan, banking, insurance, medical, railroad (oil, gas, and water)], and motor vehicle ownership and liens
• Superior and district level: civil court (divorces, equities, contracts) and criminal court
• County level: small claims court, grantor/grantee (deeds and deeds of trust, UCCs, tax liens, judgments, agreements, powers of attorney, releases), assumed names, oil and gas leases, tax property valuation or percent market valuation, property description, homestead exemption, and probate court
• City/township level: voter registration, tax assessor, utilities, and motor vehicle ownership

All 50 states have unique secretary of state record-keeping systems as do the counties within each state. Do not assume data is gathered and dispensed in similar ways at state, county, or township levels. Always ask the clerk what information may be obtained; you might be pleasantly surprised. For example, the Connecticut town assessor’s office keeps a “grand list” that shows automobile ownership. Other areas around the country may only keep these records at the state level (Connecticut keeps them at both the city and state levels).

Proprietary Databases  

• Information Resource Service Company: IRSC is a nationwide informational resource providing addresses, aircraft searches, assumed business names, bankruptcies, judgments and liens, business and consumer credit, civil suit filings, criminal filings, corporate/limited partnerships, death records, motor vehicle registrations, education/employment verification, federal court records, OSHA inspections, property, social security verification, UCC detail, and more. Most reports cost from $7 to $15. The range is from $5 to $120.
• PACER: Public Access to Court Electronic Records (PACER) provides access to civil, criminal, and bankruptcy court records in federal districts. This system furnishes limited case information including parties, file dates, type, status, and docket sheets. Fee is about 65 cents per minute.
• Westlaw and LEXIS-NEXIS: Westlaw and Lexis-Nexis both have extensive legal research databases that offer an unlimited variety of information for both federal and state levels, criminal and civil litigation on both federal and state levels, including bankruptcies, international reports, and more. Connect times may vary depending on the number of libraries accessed such as banking or all state libraries. Fees are based upon subscriber contacts.
• Information America: Information America is a vast database, which provides the same type record access as Westlaw and LEXIS-NEXIS. The company charges fees for subscriptions, connect times, and the number of records checked.

SIDEBAR  

Bankruptcy Vocabulary 

Following are definitions from Black’s Law Dictionary of the types of bankruptcies and partnerships found in “Behind the Bankruptcy.” 

Chapter 7 (straight bankruptcy) 

A proceeding designed to liquidate the debtor’s property, pay off his or her creditors, and discharge the debtor from his or her other debts. It can either be voluntary (started by the debtor himself or herself) or involuntary (started by the debtor’s creditors).

Chapter 11 (business reorganizations) 

When a debtor business entity realizes that it will become insolvent or will be unable to pay its debts as they mature, it can petition for reorganization under Chapter 11 of the Bankruptcy Code. The debtor business normally is permitted to continue its operations under court supervision until some plan of reorganization is approved by two-thirds of the creditors. If the business is insolvent at the time a petition for reorganization is filed, a majority of the shareholders must also approve the plan. If agreement cannot be reached, then the court will supervise liquidation proceedings for the business as in any other situation of bankruptcy.

Chapter 13 (wage earner’s plan) 

Under Chapter 13 of the Bankruptcy Code, any insolvent debtor who is a wage earner (earns wages, salary, or commission) can formulate and file a plan with the court that provides the debtor with additional time to pay off unsecured creditors. The debtor’s plan must provide that future earnings will be subject to the supervision and control of the trustee until these debts are satisfied. A plan made in good faith and acceptable to the unsecured creditors will be confirmed by the court. Should the wage earner ultimately be unable to pay the debts, Chapter 7 liquidation is still an available alternative.

Partnership 

A business owned by two or more persons that is not organized as a corporation. A voluntary contract between two or more competent persons to place their money, effects, labor, and skill, or some of all of them, in lawful commerce or business, with the understanding that there shall be a proportional sharing of the profits and losses between them.

General Partnership 

A partnership in which the parties carry on all their trade and business, whatever it may be, for the joint benefit and profit of all the parties concerned, whether the capital stock be limited or not, or the contributions thereto be equal or unequal. One in which all the partners share the profits and losses as well as the management equally, though their capital contributions may vary.

Limited Partnership 

A partnership consisting of one or more general partners, jointly and severally responsible as ordinary partners, and by whom the business is conducted, and one or more special partners, contributing in cash payments a specific sum as capital to the common stock, and who are not liable for the debts of the partnership beyond the fund so contributed.