Spotting fraud during the bankruptcy

process: Top red flags

CPAs will need to be vigilant against potential fraud as post-pandemic bankruptcies begin to
rise.

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:

Hidden or undervalued assets

Concealing or misrepresenting assets is one of the most common types of bankruptcy

fraud, according to Laura Day DelCotto, Esq., the owner and founder of Kentucky-
based law firm DelCotto Law Group PLLC.
"Bankruptcy fraud is actually quite rare," she said. "When it does happen, it almost always
involves failing to list something as an asset on one of the schedules, or flat-out lying."

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."

Messy or misleading financial records

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."

Recent transfers of cash or high-value assets

Another red flag is the recent transfer of money, property, or other high-value assets to

close family members or friends. Any transfer made two to six years (depending on the
state) before the bankruptcy filing can be subject to scrutiny during the bankruptcy process,
according to DeGraw.

"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.

Recent departure of key staff

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."

Similarly, if people in key decision-making roles — such as the CFO, a director, or partners

in the business — leave in the period leading up to a company filing for bankruptcy, it can
be a red flag. "It's an indication that something may be going on that they didn't want to be a
part of anymore, and they are distancing themselves from the situation," said DeGraw.
"There could be a perfectly good reason — but it's a sign that additional scrutiny is needed."

Preferential payments to creditors

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.

In a corporate bankruptcy, any payment to "insiders" — usually people who occupy

positions in the higher levels of management — or their close relations within a year of
being declared insolvent will raise red flags, Woodward said.

"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."

About the author

Malia Politzer is a freelance writer based in Spain.