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Spotting Fraud During The Bankruptcy Process
Spotting Fraud During The Bankruptcy Process
By Malia Politzer
October 1, 2020
The COVID-19 pandemic has plunged the world into the worst economic downturn since
the Great Depression, according to the International Monetary Fund. In addition to more job
losses, financial experts are anticipating an avalanche of bankruptcies in the coming
months, as individuals and businesses default on payments owed.
The U.S. bankruptcy system is designed to help individuals and businesses snowed under
by debt get a fresh start. For this system to work, those filing for bankruptcy have to be
completely transparent and disclose all their assets and liabilities so the trustee can
distribute the nonexempt assets among creditors as fairly as possible.
Bankruptcy fraud occurs when debtors deliberately try to lie or misrepresent themselves on
the schedules they are required to file during the bankruptcy process.
Because each document is thoroughly vetted by multiple parties — including the bankruptcy
trustee, a judge, and the debtors' and creditors' lawyers — it's relatively uncommon for
people to attempt to deliberately commit fraud in bankruptcy, according to Ken DeGraw,
CPA/CFF, a partner in Forensic & Valuation services at Withum, a global public accounting
firm, and a member of the AICPA Forensic and Valuation Services (FVS)
Executive Committee.
Far more common is for the bankruptcy process to reveal other forms of financial fraud that
individuals or business owners might have engaged in to avoid financial ruin, he said.
"The circumstances of COVID-19 have created the perfect fraud triangle," said DeGraw.
"The shutdown has put tremendous pressure on individuals and businesses that are
struggling to survive, and that desperation can drive the people with opportunity to
rationalize committing fraud."
Here are some of the top red flags that accountants should look out for that can indicate
potential fraud:
For example, if someone had a vacation home in another state but didn't disclose it, that
would be considered fraud. An undervalued asset, on the other hand, would be if the debtor
disclosed the vacation home, but claimed that it was worth less than the market rate.
"It's the person who puts a watch on their schedule of assets and values it at $1,000, but
then it turns out that the watch was actually a Rolex," she said. "That's fraud, and it's
considered a criminal offense."
When filing for bankruptcy, misleading income or financial statements can put individuals
and organizations of all sizes at risk of being charged with fraud. For example, in the case
of an individual filing for bankruptcy, the failure to disclose income from freelance work
could be considered fraudulent.
Similarly, businesses with misleading payroll records (for example, workers paid in cash
who are not listed as employees) or that are otherwise missing key financial documents
should raise red flags.
Other red flags include inconsistencies between financial statements and recent tax returns,
which can be an indication that a debtor is attempting to underreport assets or artificially
inflate liabilities.
"Businesses that are struggling can be more aggressive with their tax filings," DeGraw said.
"That cash struggle can manifest in tax fraud, which then gets dragged out during the
bankruptcy process."
"You need to look at someone's balance sheet and their banking records and look for the
movement of assets," he said. "One of the classic cases might be a house that someone
sells to their son or daughter for a dollar."
If the transferred asset was exchanged for less than its market value, the bankruptcy trustee
may be able to void the transaction as fraudulent — even if the person filing wasn't aware
that what they were doing is improper.
"Sometimes debtors will try to transfer property to friends or family, to protect it," said
Elizabeth Woodward, CPA/CFF, the director of Forensic Accounting and Litigation Support
at Kentucky-based firm Dean Dorton and chair of the AICPA Forensic and Litigation
Services (FLS) Committee. "They may not know they are committing fraud."
In a corporate bankruptcy, fraudulent transfers can also take the form of "bleedouts" —
which take place "when a company that is in trouble starts moving assets, customers,
processes, and even equipment to a new corporate entity, leaving the old one to die on the
vine," according to DeGraw.
Red flags that can signal a bleedout may be in process include money transfers to people
with no prior involvement in the business, a sudden decrease in inventory, loans to related
entities, or the formation of a new company or entity immediately before or after a
bankruptcy is filed.
If a business filing for bankruptcy has had a recent exodus of employees working in the
finance department or of high-level executives, it can be a red flag.
"We've run into a whole bunch of cases where the financial staff are the first people to be
fired, as management tries to put a Band-Aid on the problem," DeGraw said. "In the
meantime, all the records become really chaotic."
When filing for bankruptcy, there are often certain financial commitments that a debtor might
prefer to pay sooner than others (for example, loans to family or friends). However,
bankruptcy law prohibits the debtor's favoring one creditor over another, and any such
payment made in the 90 days leading up to the bankruptcy can be recalled by the trustee.
"Some of the red flags indicating transfers to insiders might be if an executive gave money
to the company and was paid interest, or if they were paid back more quickly than
outsiders," Woodward said. "Any bonuses paid to executives in the period leading up to the
bankruptcy could also raise red flags."
SEEK EXPERT ADVICE
To avoid running into problems, Woodward said CPAs shouldn't be afraid to discuss
bankruptcy with their clients and should urge them to reach out to a good bankruptcy lawyer
as soon as it becomes clear that they may be heading for insolvency.
"The bankruptcy process is there to give people a second chance," she said. "It's a legal
process, and not something that people need to be afraid of."