Identifying Bankruptcy Fraud
By Joe B. Brown, Brian Netoles, Sandra Taliani Rasnak, and Maureen Tighe

The bankruptcy system is designed to give an individual or a company a chance to
reorganize their affairs, or if reorganization is not possible, to equitably distribute the
non-exempt assets of the debtor among the creditors. This is often referred to as “a
fresh start”. The amount of money a creditor will receive in a case will range from
nothing in many cases to 100 percent in a few cases. In every case there will be
significant delays from the time a bankruptcy petition is filed until the case is closed
and all creditors receive final payment.

The bankruptcy system is based on the theory that a debtor will make full disclosure
of all assets and liabilities so that the final disposition is in accordance with the
requirements of the law. Unfortunately, at times both debtors and creditors try to
obtain more than they are entitled to under the Bankruptcy Code. There are a number
of criminal statutes that prohibit this type conduct.

Although concealing assets or making false statements in a bankruptcy proceeding
make up the majority of bankruptcy frauds, there are a number of fraud schemes that
are more complicated or are primarily designed for reasons other than maximizing
the retention of assets in bankruptcy. Such schemes often use the automatic stay
provided by the Bankruptcy Code to conceal an earlier crime, maximize profit from an
ongoing fraud scheme or buy time while the perpetrator finds a way to avoid victims or
leave town.

A comprehensive list of fraud schemes will be presented in two articles. Within each
fraud category examples of schemes will be presented, with red flags to look for, and
courses of action to be pursued if a scheme is encountered. Again, keep in mind that
this is a list of common warning signs in a fraud scheme. Many of these factors may
be present in situations where there is no fraud, so do not jump to conclusions simply
based on these warning signs.

Identifying Bankruptcy Fraud–Part 1 covers common fraud schemes involving
bankruptcies and debtor fraud. Identifying Bankruptcy Fraud–Part 2 will focus on
creditor fraud and professional fraud. Included in both articles is a list of warning
signs of banruptcy fraud.
Common Fraud Schemes Involving Bankruptcies

Bustouts
A bustout is conducted by a company that is set up to fail from the outset. The operator
obtains merchandise from creditors, disposes of the goods (usually for cash) and
does not pay suppliers. A bustout can also be conducted by buying an existing
company and using that company’s good credit to obtain goods, without the intent to
pay, and then disposing of the goods immediately for cash.

Examples Of Bustouts
Distributors of Consumer Products (including cigarettes, diapers, etc.): Company
operates for a short period of time and establishes good credit ratings with large
consumer goods manufacturers. Orders increase suddenly, and payments are not
made. Lulling techniques are used to forestall creditors. Goods are sold to retailers at
below cost for cash. Afterwards, a bankruptcy petition is filed. Schedules filed by the
debtor after the bankruptcy filing report trade debt owed to consumer products
manufacturers with inventory unusually low compared to the date the debt was
incurred.

Retail Bustouts:
The merchant rents retail space and does not pay rent or suppliers.
He files bankruptcy to stop eviction and to gain additional time to run the illegal
operation. Oftentimes, retail stores are part of the distributor bustouts because they
provide outlets for the consumable goods. (Examples include retail jewelry stores,
oriental rug stores and discount stores.)

Tax Bustouts
: An individual operates a series of businesses in the same industry
and never pays taxes. He usually files Chapter 11 bankruptcy for the company just
prior to or at the time the IRS files a lien on the debtor's assets. He operates the
business for a brief period of time while in Chapter 11 before the case is converted or
dismissed. He starts a new business with the debtor's assets. (Examples include
restaurants and employee leasing services.)

Credit Card Bustouts:
Individuals contemplating bankruptcy run up large consumer
credit card debt and then file bankruptcy. The purchases and cash advances occur
within a short period of time. Frequently, the same individual files bankruptcy several
times, using false social security numbers and aliases. Or the fraudulent perpetrator
assumes another person's name or social security number. False statements are
usually made on credit applications, and the assets acquired from the fraud are
concealed when the bankruptcy is filed.

Travel Agency Bustouts:
Travel agency opens and secures authorization plates from
the airline cooperative agency to write tickets. After paying the first few bills, a
tremendous number of tickets, often overseas tickets, are written and not paid for.
These tickets are sold for cash in bargain sales. Travel agency may also report the
authorization plates stolen and then continue the scheme. Authorization plates and
blank ticket stocks are often missing when the trustee or airline tries to recover.
Red Flags/Common Characteristics
·
Company with a short life
Well-established company with good credit recently taken over by a new group
trying to hide the change in ownership
Fraudulent financial statements
False credit references
No receivables listed on schedules (cash basis operation)
Inventory scheduled is very low
Warehouse full of high-volume, low-cost items
Disproportionate liabilities to assets
Mainly temporary employees
Fake social security numbers used to obtain credit
Leased equipment
Few local creditors, and unsecured debt is primarily comprised of trade creditors
Lulling letters to creditors (mail/wire fraud)
No corporate bank account, or existing account has no funds
Cash paid up front to rent location
Same individuals involved in previous "failed companies”
Unusual banking activities (check kiting, bank fraud, money laundering and
structured transactions)
Schedules and statement of financial affairs are incomplete or not filed
Person unfamiliar with debtor's operations testifies at 341 meeting of creditors
Taxes not paid
The same attorney repeatedly represents these types of debtors Civil Responses To Consider
Immediate appointment of a Chapter 11 trustee
Immediate appointment of a "gap" trustee for involuntary cases
Motion to compel filing of schedules and statement of financial affairs
Motions designed to expedite debtor's compliance with 704 duties, i.e., 2004
exams prior to 341 meeting of creditors; motions to compel immediate filing of list
of bank accounts, inventory and creditors. Seek contempt if orders are not obeyed
Adversaries to freeze bank accounts and prevent further disposition of estate
assets
Adversaries against insiders for preferences and fraudulent conveyances
Objections to discharge in individual bustout cases
Motion to dismiss and prohibit the re-filing of the case
Waiver by the trustee of attorney/client privilege of corporate debtor's counsel

Criminal Responses To Consider
Mail Fraud, 18 U.S.C. Section 1341
: Misrepresentations to suppliers and the use of U.S. mail. Wire Fraud, 18 U.S.C. Section 1343
: Misrepresentations to suppliers and the use of interstate wires.

Bankruptcy Fraud
18 U.S.C. Section 152
: Concealed assets or false statements.
Classic bustout" or planned bankruptcy where goods are moved out the back door with the
plan of filing for bankruptcy are usually charged as concealment "in contemplation of
bankruptcy."

Bankruptcy Fraud,
18 U.S.C. Section 157
: If any act of the fraud occurs after October 22, 1994, this statute may be used. The use of bankruptcy must aid the fraud scheme in some way. Delaying creditors, allowing the debtor to continue to operate or covering up the scheme are examples. The statute will be easier than the use of 18 U.S.C. 152, "concealment" or "in contemplation", because it allows a fuller statement of the scheme. False statements under oath are the same under either statute, although
157 will allow a broader description of the fraud.
Use of False Social Security Number, 42 U.S.C. Section 408
: If used to obtain credit or in bankruptcy filing.

Credit Card Fraud, 18 U.S.C. Section 1029
: One thousand dollars or more charged
on one unauthorized card in one year, or possesses more than 15 fraudulent cards.Tax Fraud
, 26 U.S.C. Sections 7201-7203: Failure to pay withholding taxes, other taxes, or to file returns. IRS should be notified so they may investigate.

Bleedouts
A bleedout is similar to a bustout. It usually involves an existing company and
a depletion of assets by insiders over a relatively long period of time. There are
concealed assets or false statements in this situation. Long-standing owners or
corporate raiders can be perpetrators of the crime.

Examples Of Bleedouts
Corporate Raider Bleedouts:
A stable company with very liquid assets, such as a
large pension and/or profit sharing fund, is acquired in a leveraged buyout. The
company is operated for the sole purpose of allowing the insiders to loot the
company. A Chapter 11 is filed to allow the insiders to complete their scheme.
Business transactions are complex and purposefully confusing, which makes
fraudulent conveyance actions expensive and difficult to prove. This type of scheme is
used in all types of industries.

"White Knight" Bleedouts:
A business consultant is hired by a troubled business to
assist it in acquiring new financing and streamlining operations. On occasion, the
"white knight" is given an ownership interest in the business. The consultant takes
control of the financial operations of the business and uses his position to convert
company assets. Often this includes failing to pay withholding taxes, failing to make
pension fund contributions, diversion of receivables, paying personal expenses with
company funds, taking excessive salary and bonuses and, in some situations, paying
false invoices to entities or individuals related to the consultant.
Parallel Entities:

A long-standing company experiences financial problems. Insiders
of the company create a new business in the same industry just prior to or soon after
the bankruptcy filing. In some cases, the debtor sells some of its assets to the new
entity for a fraction of their value just prior to the bankruptcy. The non-debtor entity is
usually not disclosed. The insiders operate the debtor until they have successfully
transferred the debtor's inventory, receivables, customers and goodwill to the new
company. In addition, the insiders may use the debtor to purchase goods and
services for the new company with the intent of never repaying the Chapter 11
administrative creditors. This is usually a lawyer-assisted fraud.
Assignment for the Benefit of Creditor (ABC)/Insider Sales:

These cases include non-bankruptcy workouts in which misrepresentations are made to creditors (mail fraud) and the assets are sold to undisclosed insiders for inadequate consideration. The secured creditor agrees to the transaction because its security position improves
if the new company is debt free. The scheme usually terminates in an involuntary
bankruptcy.

Red Flags/Common Characteristics
Recent changes of ownership/new players
People with no prior involvement in the business have money transferred to them,
both pre-petition and during the bankruptcy
Changes in accounting or cash flow practices for no apparent business reason
Payment stream to a certain creditor suddenly balloons
Sudden decrease in inventory; sharp increase in aged receivables
Inventory, equipment and machinery are sold a short time before the case is filed
Capital infusions of corporate officers suddenly renamed "loans" and paid back
Excessive salaries and bonuses
Complicated asset transfers with no apparent purpose
Depleted pension funds
Leveraged buyouts
Employee contributions for health care and pension funds have been deducted
and converted by the debtor
A new company is formed just prior to or immediately after the bankruptcy case is
filed Civil Responses To Consider
Motion to appoint a Chapter 11 trustee, an examiner or an involuntary "gap" trustee
Extensive 2004 exams
Require debtor to provide pension fund documents and bank statements for the
pension fund prior to the 341 meeting of creditors
Convert case to a Chapter 7, rather than dismissal
Fraudulent conveyance actions
Criminal Responses To Consider
Mail Fraud, 18 U.S.C. Section 1341
: Misrepresentations and the use of U.S. mail.
Wire Fraud, 18 U.S.C. Section 1343
: Misrepresentations and the use of interstate
wires.
Bankruptcy Fraud, 18 U.S.C. Section 152
: Pre-petition transfers, concealed assets, or false statements to the court at the 341 meeting of creditors or in court filed

Bankruptcy Fraud

Joe Brown

Which Debts Do I Still Owe after Bankruptcy?

Alternative to Bankruptcy

Fannie Mae Flex Modification Program aimed at stopping foreclosures.

Loss Mitigation Post HAMP

How to Stop Foreclosure

Fighting A Foreclosure