Detecting Fraud in Bankruptcy Proceedings by Richard A. Pollack, CPA
According to the Administrative Office of the U.S. Courts, the total number of bankruptcy filings in 2020 decreased nearly 30 percent from the prior year, despite the impact of the COVID-19 pandemic. By contrast, the total number of Chapter 11 reorganization filings during the same period increased 18.7 percent from 2019, while the number of filings among businesses with assets of more than $100 million rose even more dramatically. Too often, however, these matters involve fraudulent activities – committed either by the management team to intentionally conceal assets or defraud creditors or by an employee unbeknownst to senior executives. Although these schemes typically involve a web of complex relationships and transactions that make detection a challenge, legal counsel must be on the lookout for clues indicating a potential fraud occurred before the matter reaches the bankruptcy trustee.
Following are 10 of the most common forms of fraud that occur in commercial bankruptcies.
Cash Diversions – To shield money from becoming a part of bankruptcy proceedings, a business that is contemplating or has already entered bankruptcy takes cash payments from accounts receivables, tax refunds or other corporate financial sources and deposits the money into another account that is typically held in the name of a company executive or a related party.
Excessive Compensation and Benefits – Prior to filing bankruptcy, a company pays its owners, managers and/or relatives out-of-the-ordinary and often excessive salaries or bonuses that not only over-compensate the executives but also reduce the company’s assets in bankruptcy proceedings.
Rogue Inventory Practices – To reduce reported profits, conceal assets and avoid forfeiture to creditors, a company ships inventory to another location or sells it at no charge or at a reduced price to related entities.
Off-Book Schemes – To conceal assets, a company does not record all of its transactions or assets in financial statements.
Alter Ego Companies – Prior to filing bankruptcy, management sets up another company and shifts assets and income to the new business in order to deplete the assets, but not the liabilities, of the original company.
Phantom Employees – Creating non-existing employees, entering their names of payroll and “paying” them along with the company’s legitimate staff is most common among companies that hire temporary workers.
Ponzi Schemes – A company attracts investors with the promise of unusually high returns and pays those initial investors principle plus interest using the funds provided by later investors.
Accounts Receivable Lapping – A company or one of its employees misappropriates a customer payment and conceals the embezzlement by applying legitimate payments from another customer to the original account.
Vendor Fraud – A perpetrator over-purchases, inflates prices or steals inventory and often creates fictitious invoices to try to conceal the fraud.
Kickbacks – A form of bribery in which an employee takes money from a vendor in return for funneling business to the vendor. This may take the form of fraudulent invoices and can result in the company being left with excessive inventory or being over-billed and paying a premium for goods.
While detecting these common schemes is feasible, piecing together the hidden clues and connecting the dots to find and prove the root cause takes time and keen financial investigation. Complicating this task is the tendency for financial records to be manipulated and evidence to become lost or destroyed over time. For this reason, legal counsel should start investigations early and consider partnering with an experienced forensic accountant.
About the Author: Richard A. Pollack, CPA/ABV/CFF, ASA, CBA, CFE, CAMS, CIRA, CVA, CGMA is director-in-charge of the Forensic and Litigation Support practice with Berkowitz Pollack Brant, where he has served as a litigation consultant, expert witness, court-appointed expert, forensic accountant and forensic investigator on a number of high-profile cases. He can be reached at the CPA firm’s Miami office at (305) 379-7000 or via email at info@bpbcpa.com.
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