By Benjamin Miles
I. Introduction to Bankruptcy Fraud
Although many foreign legal scholars praise the U.S. bankruptcy system for its effectiveness in providing a fresh start for individuals or businesses in financial distress, the American public largely has lost faith in the system because of its perceived misuse by businesses seeking to evade debt obligations. From 2016 to 2020, American business and non-business entities collectively filed more than 3.6 million bankruptcy petitions.[1] Billions of dollars of debt obligations have been reduced, extinguished, or otherwise restructured as a result of the filings, which in turn can have negative consequence on the economy. Furthermore, the misuse of the bankruptcy system by some individuals and businesses has further eroded public trust in the process.
In at least 10% of the cases, high-profile debtors, both individuals and businesses, have filed for bankruptcy claiming that they are under financial constraints, only to emerge wealthy after discharge from liabilities.[2] For example, in 2016, 50 Cent filed for bankruptcy after being ordered to pay $7 million to a woman who accused him of posting a sex tape of her online.[3] However, it was later revealed that he had assets worth more than $10 million and was using bankruptcy as a strategic move to reorganize his finances and avoid paying the full amount of the judgment.[4] In addition, Hertz and JC Penney[5] both filed for bankruptcy in 2020 due to the substantial drop in travel demand caused by COVID-19. Later, it was revealed that the executives of both companies received millions in bonuses right before declaring bankruptcy and that some debt had been transferred to a subsidiary not included in the bankruptcy filing.[6] These stories undermine the public’s confidence in the bankruptcy system.[7]
10% of all bankruptcy filings are fraudulent, according to a Department of Justice report.[8] This means that a significant number of people are abusing the bankruptcy system, which can harm creditors who may not receive what they are owed. In turn, this can create ripple effects throughout the economy as creditors may be forced to lay off employees or even close their businesses due to financial loss. Also, lower trust in the system may mean people are less likely to lend money or do business, leading to an overall drop in economic activity and investment.
In 18 U.S.C. § 152,[9] Congress defines bankruptcy fraud as the act of intentionally and fraudulently (1) hiding or concealing assets to prevent forfeiture, (2) filing misleading claims in relation to the need for bankruptcy protection, (3) making false statements under oath in multiple jurisdictions in an attempt to defeat the creditors’ interests, (4) presenting fails claims against the debtor’s estate, (5) receiving and concealing a debtor’s assets with the aim of defeating creditors’ claims, (6) receiving, giving, offering, or attempting to obtain financial reward or compensation for refraining from performing the duties of a court-appointed trustee, and (7) destroying, mutilating, or falsifying records that would shed light into the debtor’s assets or financial affairs.
The legal definition of bankruptcy fraud covers many different ways that businesses or individuals can cheat the bankruptcy system.
This article analyzes different types of bankruptcy fraud, its prevalence in both small and large businesses, case studies, and the overall consequences of fraudulent behavior in bankruptcy.
II. Types of Bankruptcy Fraud
The most common types of bankruptcy fraud include skimming, looting, bust out, and bleed out. Skimming occurs when a business owner(s) intentionally drains cash flow from the business while the business defaults on obligations to suppliers and creditors. The business owner(s) siphons revenue to personal accounts or related companies and then claims business losses. After, the owner will transfer or sell the business to a new entity that will proceed to file for bankruptcy to avoid personal liability for the debts and obligations incurred by the original business. In the process, the debtor avoided obligations to creditors while the original debtors are left with unpaid debts.[10] Tom Petters provides a real-life instance of this type of bankruptcy fraud, in which he orchestrated a massive Ponzi scheme by soliciting funds from investors to buy and resell electronic goods to big-box retailers, such as Costco and Sam’s Club. Petters and his associates misappropriated investor funds to finance their extravagant lifestyles instead of using them as intended. Once the scheme was discovered, Petters transferred ownership of PCI to a new entity, which subsequently filed for bankruptcy, leaving original creditors with unpaid debts. Consequently, Petters evaded personal liability for the original company’s debts and obligations, resulting in his eventual conviction on multiple counts of fraud and a 50-year prison sentence.[11]
Looting is another prevalent type of bankruptcy fraud. In looting, a business with existing debt obligations transfers assets to new entities without any obligation to creditors. To defeat the interests of creditors in the original business, the wrongdoer sells the failing company to a straw buyer at a low price.[12] Looting may even occur under the nose of the trustee or judge when the debtor asks for approval to sell all of his assets to a buyer he claims is a disinterested party. Though the purchase price may seem adequate on its face, the terms governing the sale are often skewed in the purchaser’s favor. The terms may preclude the debtor from advertising the sale and impose an unusually high termination fee if the debtor fails to honor the agreement. The overall aim of the scheme is often to fraudulently defeat the interests of creditors.[13] In 2009, Creditors of Magna Entertainment Corp accused Canadian billionaire, Frank Stronach, of looting the company before it filed for bankruptcy. They claim that Stronach used his control of the company’s majority shareholder to transfer over $125 million to his own businesses, including valuable assets and payments that were rightfully owed to the creditors. This is an example of looting bankruptcy fraud, where a failing company transfers valuable assets to new entities without any obligation to creditors, leaving them with unpaid debts.[14]
A bustout scheme involves setting up a seemingly legitimate business with the intention of defrauding creditors. In a bustout, the fraudster quickly amasses a large amount of credit by purchasing goods or services on credit from multiple suppliers, before marking up the prices of these goods and selling them. Then, the fraudster will drain the cash and assets from the business. Finally, the fraudster will file for bankruptcy, leaving the suppliers with little or no chance of recovering the money they are owed.[15] According to the FBI, an investigation into a bust-out scheme is ongoing and has revealed that an individual acted as a credit card ‘bust-out’ recruiter. As a recruiter, the suspect targeted individuals experiencing financial or personal difficulties, usually from the same ethnic group, and convinced them that he had contacts with credit card companies who could help them escape their fiscal problems. The suspect then had the recruits provide their personal information and sometimes their existing credit cards, which were used to charge for merchandise, cash advances, and airline tickets. To increase the credit limits, the recruits paid off the credit cards with bad checks and then charged up to their limits a second time. This cycle continued for two to three billing cycles before the credit card companies froze the accounts and started the collection process. The suspect advised the recruits to file for bankruptcy when their debts piled up, resulting in the discharge of any outstanding debts. The investigation into the suspect is still ongoing, according to the FBI.[16]
The “bleed out” is a type of fraud similar to the bustout but involves a gradual depletion of a business’s assets over time. Typically, an insider of the business takes control and uses different strategies such as diverting funds into personal accounts, making unauthorized loans or investments, or gradually stealing small amounts of cash or inventory to drain its resources slowly. Unlike a bustout, the fraudster may prolong the operation to steal more money. Early warning signs of a bleed out include insider transactions, such as loans, and complicated financial transactions.[17] Kerisiano Sili Sataua, who was the chief of staff to American Samoa’s former governor, admitted to defrauding the U.S. Territory of American Samoa, the United States Department of Education (USDOE) and other federal agencies of at least $61,000. Sataua admitted that beginning in 1999 and continuing until July 2003, he illegally gave contracts to his friends and their companies and receiving over $9,000 in cash and goods from them. He also confessed to taking food and goods from the ASDOE School Lunch Program that were meant for feeding children in the American Samoa public school system.[18] This provides a glimpse of what a bleed-out scheme can entail on a smaller scale.
III. Legal Consequences
Section 727(a) of the U.S. Bankruptcy Code (11 U.S.C.) outlines the circumstances under which the discharge of debtors from their debt obligations will be invalid. The provision states a debtor will be discharged from his debt obligations, unless there is evidence suggesting that (1) the debtor is not an individual; (2) the debtor has transferred, mutilated, concealed, or destroyed his assets with the aim of defrauding or otherwise defeating the claims of his creditors within 12 months of filing the bankruptcy petition or after filing the petition; (3) the debtor has gone out of his way to conceal falsify, mutilate, or destroy the records of information that would have revealed the true state of his financial affairs; (4) the debtor has intentionally and fraudulently made false claims under oath or withheld information from the trustee; (5) the debtor has failed to give a satisfactory account of the circumstances leading to the loss of the assets; (6) the debtor has disobeyed court orders related to the bankruptcy petition, the debtor has committed any of the previously enumerated actions within one year of filing the petition, (7) the debtor has received a discharge within six years of filing the petition.[19]
Under Section 152 of the U.S. Bankruptcy Code, debtors that conspired in bankruptcy fraud, face the risk of a fine, or a five-year prison term, or both.[20] The Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) of 2005 further describes consequences of bankruptcy fraud. Courts can delay the debtor’s discharge if a civil or felony charge instituted against him has a high likelihood of success,[21] and revoke the discharge when the debtor fails to offer a satisfactory account of the misstatements in his asset audit.[22]
IV. Prevalence
Despite a steady decline in overall bankruptcy filings in recent years, security agencies have not reported a similar drop in the incidence of bankruptcy fraud.[23] The Department of Justice Reauthorization Act states that the Executive Office of the United States Trustee has a duty to prepare and publish an annual report on all criminal referrals submitted by the United States Trustee Program. In a 2021 report, the Executive Office for United States Trustees reported that it submitted 2,489 and 2,244 bankruptcy-related criminal referrals in the 2020 and 2021 financial years, respectively.[24] Given that 21,655 businesses filed for bankruptcy in 2020, this figure on bankruptcy fraud suggests that 11.49% of the bankruptcy filings in 2020 were fraudulent. The Executive Office for United States Trustees revealed that bankruptcy fraud ranked among the top five most criminal referrals in 2021. According to the Executive Office for the United States Trustees, the most common allegations among the top five referrals included concealment (19.8%), bankruptcy fraud (20.9%), identity theft (21.5%), and tax fraud (52.0%).[25]
V. Bankruptcy Fraud Among Large Corporations
Among large corporations, the desire to defraud creditors and to conceal financial impropriety incentivize bankruptcy fraud. Some infamous corporations like WorldCom and Enron committed bankruptcy fraud for these reasons.[26] In the case of WorldCom, the telecom giant aggressively expanded through a number of acquisitions in the late 1990s and early 2000s.[27] But many of these acquisitions ended up being unprofitable, which caused the corporation to suffer large losses. WorldCom used dishonest accounting techniques to hide these losses and keep up the image of financial soundness. For instance, the business misclassified operating costs as capital expenditures, inflating its reported earnings.[28] Also, after purchasing MCI Communications, WorldCom inflated the value of MCI’s assets on its balance sheet, which allowed it to increase its reported earnings.[29] These fraudulent practices helped WorldCom to report strong financial results for several years. However, they were eventually exposed in 2002 when the company disclosed that it had inflated its earnings by $3.8 billion through accounting fraud. This led to a major scandal and ultimately the bankruptcy of WorldCom.[30]
In the case of Enron, senior figures concealed and destroyed documents that would have revealed the true state of their financial affairs immediately after the company filed for bankruptcy.[31] The senior executives believed that destroying the documents would allow them to conceal their criminal conduct and create room for them to successfully defraud creditors and investors. Then, Enron filed for bankruptcy while it owed creditors and investors more than $694 million. However, the court noted that the company’s assets were insufficient to offset the debt. Therefore, it gave investors the leeway to pursue claims against corporations that received billions in fraudulent transfers from Enron in the years leading to the bankruptcy.[32]
VI. Bankruptcy Fraud Among Small Corporations
For smaller businesses, the desire to defeat the interests of creditors is the primary reason for bankruptcy fraud. Small businesses may engage in bankruptcy fraud when company personnel notice that they are unable to satisfy their debt obligations. Bankruptcy fraud becomes a means for small business owners to avoid debt obligations but continue operating other, more profitable businesses.
In United States v. Sabbeth[33], Sabbeth Industries filed for bankruptcy on December 28, 1990. Sabbeth, the proprietor of Sabbeth Industries, was the company’s landlord. At the time of filing for bankruptcy, Sabbeth Industries owed Sabbeth more than $2 million, but his debt was subordinated to that of secured creditors. One of the secured creditors discovered that Sabbeth had withdrawn more than $1.75 million from June 1, 1990 to December 28, 1990. Sabbeth argued that taking money from the company was not bankruptcy, since its purpose was to clear an antecedent debt. The court rejected this argument and ruled that Sabbeth withdrew the funds in contemplation of bankruptcy and in an effort to defeat the claims of creditors. In each of these cases, the courts ordered the imprisonment of the individuals found guilty of engaging in bankruptcy fraud. The rulings affirmed courts’ willingness to imprison debtors who violate the country’s Bankruptcy Code by committing bankruptcy fraud.
VII. Adverse Impact of Fraud on the Bankruptcy System
High-profile bankruptcy filings have led to a loss of public confidence in the fairness of the bankruptcy system. The use of Chapter 11 protection by major corporations, such as WorldCom and Enron, to conceal evidence of criminal activity has fueled suspicion that the bankruptcy system is tainted.[34] The fraud by attorneys, creditors, and debtors has undermined the integrity of the bankruptcy system and contributed to the development of the belief that the bankruptcy system aims to protect debtors at the expense of creditors and investors.
In addition to undermining confidence in the bankruptcy system, bankruptcy fraud heightens the cost and length of bankruptcy proceedings. The Enron case offers an illustration of the negative effect of bankruptcy fraud on the cost and length of proceedings. In the Enron case, the financial and legal fees associated with investigating bankruptcy fraud and other crimes exceeded $700 million.[35] The recent bankruptcy case involving Energy Future Holdings encompassed the recruitment of financial consultants, bankruptcy fraud investigators, and lawyers.[36] Claims of fraud lengthened the proceedings related to the bankruptcy of the $42 billion energy corporation. As a result, when the case was settled in 2016, Energy Future Holdings expended over $1 billion in fees to lawyers and other professionals. These hefty costs highlight some of the challenges that spring from bankruptcy fraud.
Along with the documented challenges, bankruptcy fraud makes the bankruptcy process complicated. The process of filing for Chapter 11 protection involves the swift and efficient assessment of the debtor’s assets to determine the extent of his eligibility for discharge. With the onset of bankruptcy fraud, the process becomes complex and inefficient.[37] The process shifts from the swift evaluation of the debtor’s financial affairs, to a complex assessment of the debtor’s actions, to identify evidence of constructive or intentional fraud. This often involves the production of evidence to support the view that the debtor orchestrated a transfer, concealment, or document destruction with the aim of defrauding, delaying, or hindering creditors. The courts go through the painstaking process of assessing the debtor-transferee relationship, the consideration paid for the fraudulent conveyance, the debtor’s previous actions of bankruptcy, and the degree of secrecy in the transactions.[38] Allegations of bankruptcy fraud complicates the process further by forcing courts to engage in lengthy proceedings targeted at determining whether the debtor has committed any of the offenses outlined in the US Bankruptcy Code.
VIII. Recommendations
While I acknowledge the importance of courts and creditors improving their existing measures to prevent bankruptcy fraud, including conducting thorough investigations, requiring documentation, and imposing stricter penalties, I believe that the most effective approach to prevention would be to enhance the Trustee Program.
The Trustee Program plays a critical role in safeguarding the credibility of the Federal bankruptcy system. Its primary function is to oversee the actions of bankruptcy parties and private estate trustees, with a focus on identifying instances of bankruptcy fraud and abuse. Through its monitoring and investigative efforts, the Trustee Program ensures that the bankruptcy process is conducted in a fair and honest manner, and that the rights of all parties involved are protected.[39]
From my perspective, the most effective approach to preventing bankruptcy fraud is to enhance the Trustee Program as its staff are in the “front lines” of the fight against fraudulent activities. They meticulously investigate every case using their expertise to quickly spot potential instances of fraud and prevent them from occurring.
One key area of improvement for the Trustee Program, is to raise public awareness about the repercussions of bankruptcy fraud, in order to discourage potential fraudsters and promote ethical behavior. Los Angeles has earned a reputation as the epicenter of bankruptcy-related criminal activity in the US, further exacerbated by the rarity of criminal enforcement of bankruptcy laws in the city.[40] Prioritizing public awareness nationwide, but especially in Los Angeles, could lower the rate of bankruptcy fraud nationwide. The Trustee Program has a number of options for achieving this goal, including speaking with the media to draw attention to the problem of bankruptcy fraud and publishing opinion articles in publications. Furthermore, conducting an informational campaign employing PSAs, pamphlets, and social media, can help the general public comprehend bankruptcy fraud and its effects. Last but not least, the Trustee Program can work with regional law enforcement organizations to raise awareness of bankruptcy fraud and create coordinated tactics to stop and punish fraudulent behavior.
Increasing the Trustee Program’s resources is another important way to improve it. The Trustee Program should lobby for more federal funding to support its mission and activities at the local, state, and federal levels. The Trustee Program should beef up its training programs with additional funds or current funds to improve the skills and knowledge of the staff. They will be better equipped to detect attempts at bankruptcy fraud if they have a better understanding of bankruptcy law and forensic accounting.
IX. Conclusion
The American public has lost faith in the bankruptcy system because some businesses are taking advantage of it to avoid their financial responsibilities. Many companies and individuals are fraudulently filing for bankruptcy, causing billions of dollars in debt to be discharged, which harms the economy. Additionally, the revelation that wealthy debtors are using bankruptcy as a strategic plan to reorganize their finances and not pay their debts, has resulted in a decline in the public’s confidence in the bankruptcy system. We must enhance the Trustee Program by incorporating the recommendations mentioned above. By doing this, we can ensure that the bankruptcy system serves its intended goal of giving those who are having financial difficulties a fresh start, while safeguarding creditors and fostering economic stability in general. By implementing these measures, we can decrease the prevalence of bankruptcy fraud, reestablish the system’s integrity, and ultimately regain the public’s trust and confidence. This process may be time-consuming, but it is possible if we make the necessary improvement to the Trustee Program and ensure that it functions fairly.
[1] Annual Bankruptcy Filings Fall 29.7 percent, United States Courts, https://www.uscourts.gov/news/2021/01/28/annual-bankruptcy-filings-fall-297-percent (last visited Feb 26, 2023).
[2]Wickouski, Stephanie. Bankruptcy Crimes. New York, NY: Beard Books, 2007.
[3] Svati Kirsten Narula, The Bizarre Sex Tape Feud That Drove 50 Cent Into Bankruptcy. Quartz (2015), https://qz.com/452099/the-bizarre-sex-tape-feud-that-drove-50-cent-into-bankruptcy (last visited Apr 16, 2023).
[4] Jethro Nededog, “50 Cent Asks For a Reduction in $7 Million Judgement After He Says He’s Too Broke to Pay.” Business Insider, https://www.businessinsider.com/50-cent-asks-for-reduction-in-7-million-judgment-2016-1 (last visited Mar 23, 2023).
[5] Jack Kelly, “J.C. PENNEY Executives Given Millions of Dollars in Bonuses Days Before it Filed for Bankruptcy.” Forbes (2020), https://www.forbes.com/sites/jackkelly/2020/05/18/jc-penney-executives-given-millions-of-dollars-in-bonuses-days-before-it-filed-for-bankruptcy/?sh=26e0a41354d5 (last visited Mar 23, 2023).
[6] Rachel Premack, The CEO of Hertz Will Get a $700,000 Payday as His 102-Year-Old Company Crumbles Into Bankruptcy. Business Insider, https://www.businessinsider.com/hertz-bankruptcy-ceo-top-executives-giant-payday-2020-5 (last visited Mar 23, 2023).
[7] Id.
[8] Office of the Inspector General. The U.S. Trustee Program’s Effort to Prevent Bankruptcy Fraud and Abuse. 2003. U.S. Department of Justice: Office of the Inspector General. 10 February 2023.<https://oig.justice.gov/reports/OBD/a0317/exec.htm#:~:text=The%20Federal%20Bureau%20of%20Investigation,to%20fully%20disclose%20their%20assets.>.
[9] Overview of 18 U.S.C. 152 Violations, The United States Department of Justice (2020), https://www.justice.gov/archives/jm/criminal-resource-manual-840-overview-18-usc-152-violations (last visited Mar 23, 2023).
[10] Recognizing Bankruptcy Fraud and Using Experts to Deal With It, Legal Research Tools From Casetext, https://casetext.com/analysis/recognizing-bankruptcy-fraud-and-using-experts-to-deal-with-it (last visited Mar 23, 2023).
[11] Minnesota Man Sentenced to 50 Years in Federal Prison for Orchestrating $3.7 Billion Ponzi Scheme, FBI (2011), https://archives.fbi.gov/archives/minneapolis/press-releases/2010/mp040810.htm (last visited Apr 16, 2023).
[12] A person who buys something on behalf of another person in order to circumvent legal restrictions or enable fraud.
[13] Wickouski, Stephanie. Bankruptcy Crimes. New York, NY: Beard Books, 2007
[14] Creditors Claim “Looting” of Magna Entertainment, Reuters (2009), https://www.reuters.com/article/magnaentertainment/creditors-claim-looting-of-magna-entertainment-idUSN2231743120090722 (last visited Apr 16, 2023).
[15] Wickouski, Stephanie. Bankruptcy Crimes.
[16] SARs Assist in Bankruptcy Bust-Out Scheme Investigation. | FinCEN.gov, https://www.fincen.gov/index.php/resources/law-enforcement/case-examples/sars-assist-bankruptcy-bust-out-scheme-investigation (last visited Apr 16, 2023).
[17] Wickouski, Stephanie. Bankruptcy Crimes.
[18] John Hendrickson, Defendant Pleads Guilty in Case Involving Fraud Scheme in American Samoa (2005), https://www2.ed.gov/about/offices/list/oig/invtreports/wdc012005.html (last visited Apr 16, 2023).
[19] 11 U.S. Code § 727(a)
[20] 11 U.S.C. § 152(9)
[21] 11 U.S.C. Section 727(a)(8)
[22]11 U.S.C. Section 727(d)(4)
[23] Annual Bankruptcy Filings Fall 29.7 Percent, United States Courts, https://www.uscourts.gov/news/2021/01/28/annual-bankruptcy-filings-fall-297-percent (last visited Feb 26, 2023).
[24] Report to Congress: Criminal Referrals Fiscal Year 2020 – justice.gov. https://www.justice.gov/ust/page/file/1431611/download (last visited Mar 24, 2023).
[25] Report to Congress: Criminal Referrals by the United States Trustee. https://www.justice.gov/ust/file/criminal_report_fy2018.pdf/download (last visited Mar 24, 2023).
[26] Robert A. Weisberg et al., Fraud and the Bankruptcy Code, The Handbook of Fraud Deterrence 271–350 (2015).
[27] Worldcom – Chronology – the Worldcom-Wall Street Connection – frontline pbs, https://www.pbs.org/wgbh/pages/frontline/shows/wallstreet/wcom/cron.html (last visited Mar 27, 2023).
[28] Complaint: Sec v. Worldcom, Inc., https://www.sec.gov/litigation/complaints/comp17829.htm (last visited Mar 27, 2023).
[29] Adam Hayes, The Rise and Fall of Worldcom: Story of a Scandal Investopedia (2022), https://www.investopedia.com/terms/w/worldcom.asp (last visited Mar 27, 2023).
[30] Id.
[31] In re: Enron Corp. Justia Law, https://law.justia.com/cases/federal/district-courts/BR/295/21/2020671/ (last visited Feb 26, 2023).
[32] Id.
[33] U.S. v. Sabbeth, Justia Law, https://law.justia.com/cases/federal/appellate-courts/F3/262/207/607872/ (last visited Feb 26, 2023).
[34] Donald J. Smith, Perspectives: Hidden Debt: From Enron’s Commodity Prepays to Lehman’s Repo (2011), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1934998 (last visited Feb 26, 2023).
[35] Curriden, Mark. EFT Bankruptcy Legal and Financial Advisor Fees to Near $1 Billion. 2018. Texas Law Booklet. 10 February 2023 <https://texaslawbook.net/efh-bankruptcy-legal-financial-advisor-fees-to-near-1-billion/>.
[36] In re: Energy Future Holdings Corp. Justia Law, https://law.justia.com/cases/federal/appellate-courts/ca3/19-3492/19-3492-2021-03-15.html (last visited Feb 26, 2023).
[37] Robert A. Weisberg et al., Fraud and the Bankruptcy Code, The Handbook of Fraud Deterrence 271–350 (2015).
[38] Id.
[39] U.S. Trustee Program, The United States Department of Justice (2023), https://www.justice.gov/ust (last visited Mar 28, 2023).
[40] Paul Kiel, How to Get Away with Bankruptcy Fraud ProPublica (2017), https://www.propublica.org/article/how-to-get-away-with-bankruptcy-fraud (last visited Mar 28, 2023).
