Spotting fraud during the bankruptcy process: Top red flags

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.

To comment on this article or to suggest an idea for another article, contact Drew Adamek, a JofA senior editor, at Andrew.Adamek@aicpa-cima.com.

AICPA resources

Articles

• “Becoming a Fraud Fighter,” JofA, July 9, 2020
• “New Options for Small Business Bankruptcies,” CPA Insider, March 30, 2020

Podcast

• “How to Help Clients Who Are Considering Bankruptcy,” May 8, 2020, AICPA Personal Financial Planning Section

Conference

• AICPA Forensic & Valuation Services Conference, Nov. 9—11

FVS Section and ABV credential

For AICPA members, membership in the Forensic and Valuation Services (FVS) Section provides access to specialized resources in the forensic and valuation services discipline areas. Visit the FVS Center at aicpa.org/FVS. Individuals with a specialization in business valuation forensics may be interested in applying for the Accredited in Business Valuation (ABV) credential. Information is available at aicpa.org/ABV.