Zero Tolerance for Commercial Bankruptcy Fraud: Bankruptcy Metrics Dictate that Forewarned Is Forearmed
BAPCPA clearly evidences zero tolerance for fraud and criminal conduct. Debtors and debtors' counsel should take no solace from the past. The "mirror, mirror, on the wall" posturing regarding accounting and bankruptcy fraud may be ended once and for all5 because the provisions of BAPCPA as found in §§1104(e) and 1112(b) have the necessary teeth to take a bite out of bankruptcy fraud.
We see in §1104(e) a powerful new mandate for U.S. Trustees and the courts to remove those who engage in criminal conduct as well as board members who countenance it, so that a trustee can be appointed and the criminals prosecuted for the benefit of creditors. We are suggesting that counsel to the commercial debtor voluntarily cooperate and root out criminal conduct by fraudsters and gross mismanagement, rather than have the commercial debtor face the sanctions of §1104(e) or 1112(b), and that creditors take an active part and provide the information to assist the U.S. Trustee in the enforcement efforts.
Chronicle on the Frauds
Three years after the enactment of "The Corporate and Criminal Fraud Accountability Act of 2002 (Act),"6 the spectacular displays of accounting and bankruptcy fraud continue. The Act governs the destruction, alteration or falsification of records upon federal investigation and bankruptcy, and provides that "whoever knowingly alters, destroys, mutilates, conceals, covers up, falsifies or makes a false entry in any record or document...with the intent to impede, obstruct or influence the investigation" can expect a 20-year sentence. Also, the provisions of 18 U.S.C. §1520 address the destruction of corporate audit records, and "any accountant who conducts an audit of an issuer of securities...shall maintain all audit or review workpapers for a period of five years."
Perhaps the most succinct comment on accounting and bankruptcy fraud comes from Warren Buffett, the investment entrepreneur, when he said "earnings can be pliable as putty when a charlatan heads the company reporting them." Lest any of us forget, commercial debtors are managed and controlled by individuals.
Impact of §1104(e)
The new §1104(e) provides an opportunity for creditors to have a greater impact on the course of a chapter 11 case. Once the case is filed, the creditor should amass the information (hard copy documents and electronic), including the credit files, if not already done, as soon as possible on the debtor and contact its attorney immediately. Remember, the key word is the "information" about the debtor, because unsupported accusations by creditors will not suffice.
If a creditor, and the more of them the better, has information that could constitute reasonable grounds for suspicion that the persons in charge of a debtor, defined as the current members of the governing board, chief executive officer or chief financial officer, participated in actual fraud, dishonesty or criminal conduct in the management of the debtor or in its public financial reporting, and the creditor gives this information to the Office of the U.S. Trustee, the U.S. Trustee must move for the appointment of an operating trustee.
The attorney will be able to obtain a copy of the bankruptcy schedules and monthly operating reports, which the creditor can review with its attorney. A comparison of the information (financial statements, e-mail, electronic communications and the creditor's files) with the bankruptcy schedules and operating reports may show discrepancies, and perhaps, in some cases, major discrepancies. A review of the information, including electronic documents and communications, may even show questionable and/or fraudulent activity.
If any of the above is present, the creditor should discuss the information with its attorney so that the creditor and attorney can decide if they possess enough to convince the U.S. Trustee that there are "reasonable grounds" to suspect wrongdoing. If there are, the issue must be brought before the bankruptcy court, which may appoint a trustee or even convert the case to one under chapter 7.
Although §1104(e) was enacted in response to the recent notorious cases, it is not difficult to foresee that the new section will be used in smaller cases to benefit creditors. Again, those dealings with commercial debtors are likely to include e-mails and attached files consisting of financial data, credit applications, etc. Creditors should routinely preserve the electronic information, as this can point to the telltale signs of insolvency, impending chapter 11 and increasingly later payments, along with unkept promises. Remember, the "devil" is generally found in the details of the electronic information found on computers.
That is not to say that taken as a whole, the Bankruptcy Code did not supply the powers necessary for the U.S. Trustee and the courts to stop villainous insiders; §1104(a) provides the authority needed to challenge company leadership and move for appointment of a trustee. Section 1104(a) may be better in some ways for creditors because under §1104(e), only the U.S. Trustee can utilize §1104(e), whereas any party in interest may move for appointment of a trustee under §1104(a) if fraud, dishonesty, criminal conduct, or even incompetence or gross mismanagement, can be shown.
Section 1103(c)(4) extends the prerogatives of §1104 to an official committee, and §1104(a) has always been viewed as sufficient authority to remove debtor's management for a wide range of corporate sins, including those that might arguably subject the managers/perpetrators to criminal prosecution.7 As the Fourth Circuit noted, §1104 was intended to cover a "wide range of conduct,"8 and the section is broad enough to include criminal conduct.
Some words of caution are necessary with respect to §1104(e), because by invoking the word "criminal," the section commensurately invokes a higher standard of proof than is required in a purely civil context. As it once read, the only level of proof required for §1104 was "clear and convincing evidence."9 In contrast, a finding of criminal liability must be made "beyond a reasonable doubt."10 If, in the exercise of authority under §1104(e), the U.S. Trustee cites "criminal conduct" as cause for appointment of a trustee under §1104(a), then it must be supported by a higher degree of proof—beyond a reasonable doubt—than what was required to accomplish the same results under §1104(a), for which a preponderance of the evidence is sufficient.
Impact of §1112(b)
Even if the information provided by the creditor does not rise to the level of fraud, dishonesty or criminal conduct under §1104(e), it may constitute gross mismanagement. Under the new §1112(b), if there is evidence of gross mismanagement, the court must convert or dismiss the case unless such relief is not in the best interests of creditors and the estate. Any attempt by insiders during the debtor-in-possession phase to "return the computers" under §365 or "to allow the destruction of the electronic books and records" may be grounds to invoke §1112(b).
The Insolvent Public Company
Regardless of the accounting audits, Securities and Exchange Commission (SEC) investigations and several prosecutions, the accounting and bankruptcy frauds never stopped after Enron and WorldCom. The record shows they have continued to such a degree that they have become commonplace and may be considered by many to be the norm. The recent collapse of Refco was described in the New York Times11 as "the fourth-largest filing in United States history" and that the "insiders collected $1 billion before Refco collapse[d]."
The Insolvent Nonpublic Company
Creditors should ask themselves what exactly they expect regarding the likelihood of accounting and bankruptcy fraud for commercial debtors that are not public companies. Creditors and their attorneys are among the most important resources available for the U.S. Trustee for the detection of accounting and bankruptcy fraud of nonpublic commercial debtors. After all, nonpublic commercial debtors are not responsible to SEC or Sarbanes-Oxley regulations, and when creditors believe they have been cheated by the commercial debtor, they need to take appropriate action and come forward with the information.
ABC, §303 and the Charlatan Beware
The days of utilizing the assignment for the benefit of creditors (ABC) provisions under state laws as the preferred escape path for the nonpublic commercial debtor and insiders who need to slip away into the night—and where the attorney fees are not controlled, provided the charlatan can successfully escape the creditor's reach—may be ending.
The enormous digital footprints left by charlatans are not likely to be erased anytime soon, and creditors and their attorneys can make use of one of the most underutilized provisions in the Code—the involuntary bankruptcy provisions found in §303.
Commercial debtors and insiders can try as hard as they may, but given the potential availability of digital information from creditors, the U.S. Trustee and the courts may have the evidence necessary under §1104(e) to stop the charlatans at their own game.
A recent study indicated that the decline in the number of business (commercial) bankruptcies is a direct result of debtor attorneys using bankruptcy software because the normal defaults settings are set for "consumer" case, and not a business case, and that may very well be true.12 We are not aware of any past research study on the use of the ABC, and further investigation of this practice may enable the bankruptcy metrics to conclude that commercial debtors that fail and then fade away undetected are often orchestrated for the benefit of those attempting to avoid the requirements of the Code, and the ABC generally does not benefit the creditors. This may be some cause for concern, and may also explain the decline in reported business (commercial) bankruptcies.
What Creditors Should Expect
The new Code sections provide new opportunities for the appointed trustee to do a more thorough investigation of a debtor. If the U.S. Trustee receives information from creditors that the persons in charge of a debtor participated in fraud, dishonesty or criminal conduct, the U.S. Trustee will give that information to the appointed trustee, whether that is a chapter 11 or 7 trustee.
When a trustee is appointed by the U.S. Trustee, he or she needs to become knowledgeable about the debtor as quickly as possible, and receiving information from creditors is of enormous help to the trustee. The trustee will focus on protecting the debtor's computers, as this is mandatory for finding electronic evidence and because it deals with the electronic books and records, as well as related financial information. This is vital because e-mail and electronic communications exchanged between parties often seek comments,13 contain attached files,14 discuss the financial affairs of the debtor15 and have valuable metadata (data about the data) information16 that may disclose the existence of accounting and bankruptcy fraud and benefit the creditors.
The trustee will, for example, also prevent the use of §365 (Motion to Reject Unexpired Leases) to facilitate the return of the debtors' leased computers and digital devices, including any laptops and PDAs used by the insiders.17 Before the debtors' divisions, subsidiaries, profit centers or assets are sold, the trustee will protect the electronic books, records and financial information for future recovery and possible litigation. The trustee will then promptly determine, for example, the following:
- who has the electronic books and records and financial information, including insiders, custodians, accountants, attorneys, computer consultants and others
- whether any computers been removed from the debtors' premises, and if so, when that was done
- whether the insiders have laptops, PDAs and other computers and digital media in their possession, and where they are now
- the e-mail addresses of the insiders and key employees
- the computer passwords used by insiders and employees.
The trustee will then:
- have the digital forensic accounting technologist investigate the debtor's computers, PDAs, laptops and digital devices and make forensic images of the same
- investigate to determine if the debtor or insiders sold or disposed of any desktop systems, laptop computers, PDAs or digital devices prior to the filing
- determine if the debtor has leased computer equipment containing the business and financial records, including e-mail and financial information on hard disk drives, PDAs, laptops and digital devices
- investigate to determine if the debtor and insiders voluntarily turned over computers that were collateral under the UCC.
Knowing that there are allegations of wrongdoing will reinforce the necessity for the trustee to have the commercial debtor's and insiders' computers examined by an e-sleuthing18 expert in the discovery and recovery of the debtors' electronic books and records and related documents for the trustee. One of the co-authors of this article (a chapter 7 panel trustee) has had such a case involving a converted chapter 11 that initially appeared to be a "no-asset case" that originated prior to Enron. The recovery of electronic books and records, deleted files and back-dated documents by another of the co-authors of this article led to the substantial recovery of assets for creditors without the expense of trial in the bankruptcy court against several insiders, demonstrating that "often the most incriminating digital evidence of the commercial debtor and insiders will be discovered and a settlement reached."
Investigation of the digital evidence may involve completing the following:
- Trace hidden assets from start to finish.
- Identify and reveal digital evidence related or pertaining to possible claims against boards of directors for breach of fiduciary duty, fraud, theft, conversion and unjust enrichment.
- Detect and uncover unusual transactions, including money and property transfers and complex related-party activities.
- Identify and reveal digital evidence related or pertaining to possible claims against preferred shareholders for breach of contract and fraud.
- Expose facts and circumstances relating to issues of substance over form that could not otherwise be documented.
- Uncover fraudulent accounting activities.
- Discover undisclosed business or business activities to which assets may have been shifted.
- Detect hidden documents, including the ability to trace related activities.
- Identify and expose digital evidence related or pertaining to possible claims against auditors for breach of contract, breach of fiduciary duty, aiding and abetting a breach of fiduciary duty, fraud and negligent misrepresentation, professional negligence and securities fraud.
- Discover and expose digital evidence related or pertaining to possible claims against underwriters for breach of fiduciary duty, aiding and abetting a breach of fiduciary duty, claims of breach of contract, fraud and negligent misrepresentation, and securities fraud.
- Detect the back-dating of vital documents leading to possible fraudulent conveyance actions.
Remember, it is not difficult for insiders, officers, employees and accountants of the commercial debtor to hide financial information from auditors, and that is especially true for the nonpublic company, for which only "conventional" methods to uncover accounting and bankruptcy fraud are used; in fact, it takes place more times than anyone cares to admit.
How is that done? Easily. Digital "back door" accounting tools, invisible attachments, encryption and digital steganography19 ("stego") all play their part in assisting self-dealing insiders and their accomplices.20 Stego is pure digital stealth that requires no assembly. Beware of the use of stego software, because digital stealth files (the second set of books) could be hiding anywhere. Most alarming is that digital steganography software21 and other malicious software cannot be detected by accountants using conventional audit tools.
Searching for digital anomalies, recovering deleted files and locating encrypted documents, as well as stealthy financial information, is essential in any investigation of accounting and bankruptcy fraud involving the commercial debtor. Most often, encrypted files and hidden information will likely provide confidential information that the commercial debtor and insiders are concealing. Digital evidence often provides e-clues that could expose fraudulent accounting and bankruptcy fraud and point to fraudulent conveyances that can be recovered for the creditors. As Willie Sutton reportedly said, when asked why he robbed banks, "that's where the money is." Creditors should take an active role in the chapter 11 case when the creditor suspects that the debtor and its principals have been less than honest, and should immediately contact the U.S. Trustee.
Footnotes
1 Robert J. Musso represents creditors in bankruptcy and is a chapter 7 panel trustee in the Eastern District of New York. He may be contacted at (718) 855-6840 and by fax at (718) 625-1966. Return to article
2 Bruce Weiner represents creditors and trustees in bankruptcy. He may be contacted at (718) 855-6840 and by fax at (718) 625-1966. Return to article
3 Daniel A. Austin is a contributing editor for Norton Bankruptcy Law and Practice, 2d by Thompson West and often represents creditors and debtors in chapter 11 cases. He may be contacted at (724) 255-6535. Return to article
4 Jack Seward is a contributing editor for Norton Bankruptcy Law and Practice, 2d by Thompson West and the ABI Journal's Straight & Narrow column. A digital forensic accounting technologist in New York and veteran of many years of forensic accounting and electronic data sleuthing, he provides litigation support, including e-discovery for bankruptcy, insolvency, judgment enforcement, and discovery and recovery using computer forensics. Mr. Seward is a member of the New York Economic Crimes Task Force and has written and spoken extensively on the subject of protecting and retrieving digital electronic information. He may be contacted at (917) 450-9328 and by fax at (212) 656-1486. Return to article
5 "How to Avoid the Perfect Bankruptcy Fraud," presented by Jack Seward at the Pennsylvania Institute of Certified Public Accountants, 2005 Forensic & Litigation Services Conference at Valley Forge, Pa., on Nov. 14, 2005. Return to article
6 18 U.S.C. §1519. Return to article
7 See, e.g., Appeal of DWG Corp. (In re Sharon Steel Corp.), 871 F. 1217 (3rd Cir. 1989) (management engaged in insider loans and breach of fiduciary duty, transferring vast assets away from the debtor to avoid creditors during the bankruptcy). Return to article
8 Committee of Dalkon Shield Claimants v. A.H. Robbins Co, 828 F.2d 239, 242 (4th Cir. 1987). Return to article
9 In re Clinton Centrifuge Inc., 85 B.R. 980 (Bankr. E.D. Pa. 1988). Return to article
10 See Ngan Restaurant Inc. v. Official Committee (In re Ngan Restaurant Inc.), 195 B.R. 593, 597 (S.D.N.Y. 1996) (cause for appointment of a trustee in a chapter 11 case as a sanction for criminal conduct must be established beyond a reasonable doubt).Return to article
11 Morgenson, G. and Anderson, J., Business Day Section C-1, New York Times, Thursday, Oct. 20, 2005. Return to article
12 Lawless, Robert M. and Warren, Elizabeth, "The Myth of the Disappearing Business Bankruptcy," California Law Review Inc. Supported by a grant from the Ewing Marion Kaufman Foundation. Return to article
13 Including, but not limited to, corporate officers, corporate directors, audit committee members, current employees, past and dismissed employees, current and past auditors, financial advisors, workout and turnaround consultants, loan liquidators, mergers and acquisitions, tax accountants, offshore partners, investment bankers, lending institutions, leasing companies, appraisers, potential buyers, real estate brokers, credit managers, insurance companies, ASP vendors, computer consultants, related parties and insiders. Return to article
14 Including, but not limited to, loan documents, audit reports, internal financial statements, financial investigations, changed financial statements, spreadsheets, accounting reports, journal entries, pro forma financial statements, budgets and forecast, trend statements, management reports, customer information, vendor information, tax returns, taxpayer identifications numbers, real estate ownership, joint venture agreements, inventories, contracts, leases and database files. Return to article
15 Including, but not limited to, out-of-trust, bogus customers and invoices, insider transactions, capitalization of loans, back-dating transactions and documents, transfer of property, write-down of assets, related-party transactions, future recovery of bad debts, side agreements, sale of inventory, offshore entities, off-balance sheet accounts and entities, planned bankruptcy, insolvency, obtaining credit during insolvency, payments to creditors, financial representations during insolvency, fraudulent conduct, executory contracts, accounting fraud and notice from whistleblowers. Return to article
16 Including, but not limited to, the author, name, initials, company name, computer name, name of the computer network server or the hard disk drive where the document is saved, file properties, summary information about the document, names of the last 10 document authors, document revisions, document versions, template information, hidden text and comments, and type of document (Word, Excel, PowerPoint presentation, etc.). Return to article
17 Seward, J., "What You Need to Know about a Debtor's Leased Computers," LJN's Equipment Leasing Newsletter, Law Journal Newsletters, December 2003 (http://www.ljnonline.com). Return to article
18 Seward, J. and Austin, D., "E-sleuthing and the Art of Electronic Data Retrieval: Uncovering Hidden Assets in the Digital Age," ABI Journal, Part I (February 2004), Part II (March 2004) and Part III (April 2004). Return to article
19 Originates from the Greek word for writing or hiding secret messages and has been around for more than 2,500 years. Return to article
20 Seward, J., "Digital Stealth Secrets and the [Sarbanes-Oxley] Act," LJN's The Corporate Compliance & Regulatory Newsletter, Law Journal Newsletters, March 2004 (http://www.ljnonline.com). Return to article
21 Jack Seward hosted a two-day training on discovery of digital steganography at the offices of the U.S. Secret Service NYC/Brooklyn in December 2003. Return to article