Laughing All the Way to the Poor House: Cases of Bankruptcy Fraud

January 2009

IN THIS ISSUE

— Hard Times and Financial Crime: The Basics of Bankruptcy Fraud
— Other People’s Money: How Creditors can Detect a Potential Bankruptcy Fraud
— In the next issue

GREETINGS!

Welcome to the January 2009 edition of our newsletter! In this issue, we’ll discuss indicators that a company — whether a client, a vendor, or business partner — entering bankruptcy is not all that is appears to be.

HARD TIMES AND FINANCIAL CRIME: THE BASICS OF BANKRUPTCY FRAUD

There’s a reason the adage about a few bad apples spoiling the whole bunch continues to ring true: whether we’re discussing employee conduct, taxpayer behavior or a company’s ability to pay its creditors, many participants play by the rules. Those that do not, however, throw the entire system into flux as it adjusts to understand and regulate them. With bankruptcies (and federal bailouts) reaching seismic levels in 2008, it seems like a good time to review the red flags that a bankruptcy may not be a company’s last resort to stay operative or as a means of paying off debts via liquidation.

In the past, we have been familiar with “bust out” bankruptcy scams where perpetrators will rent office space, hire employees (although typically only a few, often relatives or friends), and buy significant, possibly excessive, amounts of inventory on credit. After establishing a good credit history for, say, the first six months of operation, often selling inventory at steep discounts if the buyer will pay cash up front. (This type of scheme work best for high volume retail sales products, like prepaid gasoline or telephone cards.) having pocketed the cash from the sales, the scammer then defaults on his credit obligations, files for bankruptcy and leaves creditors high and dry.

OTHER PEOPLE’S MONEY: HOW CREDITORS CAN DETECT A POTENTIAL BANKRUPTCY FRAUD

At least 10 percent of all bankruptcy petitions “contain some elements of fraud,” according to U.S. Justice Department data provided by the Internal Revenue Service. Although new and creative ways to perpetrate these frauds are cropping up every day, there are signs you can look out for to see if a client or partner (once again, particularly in a high-volume retail space) may be prone to this kind of fraudulent behavior.

Many times individuals or businesses will create shell companies, both within the United States and abroad, to hide assets (whether cash obtained from vendors as in the example above, or legitimate payments funneled out of the company.) For domestic subjects, a cross-reference of businesses with an individual’s personal address history (and, importantly, that of his immediate and extended family) can likely turn up a number of limited partnerships or other entities which may hold the title to personal property or even other, legitimate businesses.

If the subject claiming bankruptcy is a client or business partner, a review of annual report filings may yield good interview subjects as well, such as former business partners or shareholders. Similarly, a review of an individual’s personal history, such as civil litigation, can yield key informants, such as former spouses. By digging into a bankruptcy filer’s personal and professional past, you can detect their motives of hiding funds from inclusion in bankruptcy, as well as their opportunities to do so over time. A Certified Fraud Examiner can review public documents and any internal company records to determine the patterns of fraud, both those that were realized and any that were planned but later scuttled.

IN THE NEXT ISSUE

In the February 2009 issue, we’ll revisit an old favorite by analyzing Ponzi schemes in the wake of the massive, ongoing scandal regarding financial adviser Bernie Madoff.