Deceit in Bankruptcy 1 Running head FALSE STATEMENTS

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					                                              Deceit in Bankruptcy   1

Running head: FALSE STATEMENTS & FALSE CLAIMS IN BANKRUPTCY




                          Deceit in Bankruptcy:

                      False Statements and Claims

                          under Title 11 of the

                            Bankruptcy Code



                           Donald L. Scanlon



                   ECM 621 - Advanced Economic Crime

                    ECM 622 - Law of Economic Crime

                             Utica College




                             April 28, 2006
                                                        Deceit in Bankruptcy                 2

                                           Abstract

        The number of bankruptcy cases filed in the United States has doubled in the last

ten years to about 1.8 million cases per year. Every bankruptcy causes losses to

creditors that are eventually passed on to ordinary citizens in the form of higher prices

for goods and services. The FBI estimates that about 10% of these cases are

fraudulent; however, there are only about 100 convictions for bankruptcy fraud each

year. Few studies have been done regarding bankruptcy, resulting in a limited

availability of factual data about the characteristics of the cases filed or the true

incidence of fraud.

         This paper discusses several sections of the federal criminal code that pertain

to crimes committed in relation to bankruptcy filings or proceedings, primarily 18 U.S.C.

§152.

        The author makes a number of recommendations for improving the bankruptcy

system in the United States including gathering more useful data, as well as quickly

identifying and adjudicating those cases with little likelihood of fraud, abuse, or financial

recovery for the creditors. Of the remaining cases, tools will be suggested to efficiently

identify suspect areas in petitions and related documents for further investigation and

audit. Also proposed are methods of dealing with fraudulent cases in the “post 9/11”

environment when criminal investigative and prosecutorial resources for this type of

crime are limited.
                                                                     Deceit in Bankruptcy                               3

                                          Table of Contents

Abstract.................................................................................................................2

Table of Contents..................................................................................................2

Introduction ...........................................................................................................6

Size and Scope of Bankruptcy Fraud....................................................................7

History of Bankruptcy in the United States..........................................................10

Structure of the Bankruptcy Courts .....................................................................12

      United States Bankruptcy Court...................................................................12

      The appellate system...................................................................................13

The Crimes .........................................................................................................13

      18 U.S.C. § 152(2)- False Oath or Account .................................................15

      18 U.S.C. § 152(3)- False Declarations .......................................................17

      18 U.S.C. § 152(4)- False Claims ................................................................18

Bankruptcy and Organized Crime .......................................................................19

Impact of Identity Fraud, USA PATRIOT Act and Terrorism ...............................20

      Identity fraud ................................................................................................20

      USA PATRIOT Act.......................................................................................21

      Terrorism......................................................................................................22

Anecdotal Information .........................................................................................23

      People whose occupations catch the public’s attention ...............................23

      Prominent businessman ..............................................................................23

      Exploring consumer bankruptcy in Utah ......................................................24

      Acquitted murder suspect Robert Blake.......................................................25

Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 ................27
                                                                  Deceit in Bankruptcy                              4

      Improved collection of statistics ...................................................................27

      Audit of debtors............................................................................................27

      Increased participation by the FBI and US Attorney ....................................30

      Greater responsibility of attorneys ...............................................................30

Other Federal Laws Frequently Used in Bankruptcy Cases................................33

      18 U.S.C. § 1001 – Statements or Entries Generally...................................33

      18 U.S.C. § 1029 – Credit Card Fraud.........................................................33

      18 U.S.C. § 1341 – Mail Fraud.....................................................................33

      18 U.S.C. § 1343 – Wire Fraud....................................................................34

      18 U.S.C. § 1621 - Perjury ...........................................................................34

      42 U.S.C. § 408 – Misuse of a Social Security Number..............................34

Sarbanes-Oxley Act of 2002 ...............................................................................35

State Statutes......................................................................................................36

Other Remedies ..................................................................................................36

Analysis of Bankruptcy Crime Cases ..................................................................39

      United States v. O’Donnell 539 F.2d 1233 (1976)........................................39

      United States v. Ellis 50 F.3d 419 (1995).....................................................40

Major Case - Murray Packing Company .............................................................42

      The takeover ................................................................................................42

      Starting the scam .........................................................................................42

      Executing the scam......................................................................................43

      Pulling the trigger .........................................................................................43

      The outcome ................................................................................................43

Link Diagram-Murray Packing Co. ......................................................................45
                                                                   Deceit in Bankruptcy                               5

Risk Analysis.......................................................................................................46

      The risks ......................................................................................................46

             Credit risk..............................................................................................46

             Operational risk.....................................................................................46

             Reputational risk ...................................................................................46

             Legal risk ..............................................................................................47

             Strategic risk .........................................................................................47

      Existing solutions .........................................................................................47

             Creditor organizations...........................................................................47

             Bankruptcy system ...............................................................................48

Recommendations for Future Implementation ....................................................48

      Development of a comprehensive bankruptcy database .............................48

      Determine the national priority of bankruptcy fraud......................................50

      Analyze each new petition when it is filed....................................................51

      Authentication of the identity of petitioners...................................................52

      Verification of financial data .........................................................................53

      Increased use of punitive civil sanctions ......................................................54

      Potential limitations on implementation........................................................55

Conclusion ..........................................................................................................55

References..........................................................................................................56

Appendix I – Glossary (Selected)........................................................................63
                                                      Deceit in Bankruptcy                  6

                                       Introduction

       Every bankruptcy means that someone is not getting paid money owed to them.

Although most unpaid creditors are governmental agencies and businesses, the

ultimate victims are everyday citizens who must make up for these losses through

higher taxes and higher prices for goods and services. This crime generally involves

concealing assets, making false oaths or statements and making false claims against

the estate of a debtor.

       This paper makes frequent use of the term “bankruptcy system.” This is used as

an inclusive term encapsulating the entire bankruptcy process including the U.S.

Bankruptcy Court with its judicial officers and employees, the Office of the United States

Trustee, private trustees and members of the bankruptcy bar. The actions of this group

are governed by statute, case law and the established Rules of the Bankruptcy Court.

       11 U.S.C. § 303 provides for an involuntary bankruptcy in which three or more

creditors holding claims against a debtor join forces to initiate a bankruptcy proceeding

against him. This can be a time consuming and costly process for the creditors and

exposes them to significant risk. Therefore, only a very small number of cases are filed

each year (Bernstein & Friedland, 2005). The author has chosen to limit references in

this paper to voluntary bankruptcy situations, although the same crimes discussed in

this paper can occur in involuntary cases.
                                                      Deceit in Bankruptcy                 7

                           Size and Scope of Bankruptcy Fraud

         Bankruptcy is an increasing problem in the United States. Between 1994 and

2005, the number of bankruptcy filings has grown by 114% to about 1.8 million as

shown in Table I.

         The reader is cautioned that the number of filings in 2005 may be an aberration

resulting from petitions filed in advance of the effective date of the Bankruptcy Abuse

Prevention and Consumer Protection Act of 2005. This Act stiffened the rules for

individuals filing bankruptcy and induced many to file before the October 17, 2005

effective date. A CNNMoney.com report (Sahadi, 2006) notes that a survey by the

National Association of Consumer Bankruptcy Attorneys (NACBA) found that year-to-

date bankruptcy filings in early 2006 are down 75% from the same period in 2005. This

decline is not expected to continue as more consumers and attorneys become familiar

with the new law. A story in the Deseret Morning News (2006, April 6) reports on a

study by Lundquist Consulting Inc., a financial consulting firm located in Burlingame,

California. Their analysis shows that the number of bankruptcy filings is moving back to

historical rates. While the intention of the 2005 act was to encourage consumers to pay

off their debts rather than simply having them eliminated by a Chapter 7 liquidation, the

opposite seems to be occurring—the percentage of filings under Chapter 13, the

repayment plan, is actually decreasing, while the percentage of Chapter 7 filings is

increasing. The study also showed that about 97% of debtors have no ability to repay

their debts. Lundquist cautioned that the long-term effects of the new law are not yet

clear.
                                                         Deceit in Bankruptcy               8

Table I



Bankruptcy Filings By Year

                                         Number of Filings

Year                   Non-Business           Business           Total

1994                           780,455              52,374         832,829

1995                           874,642              51,959         926,601

1996                         1,125,006              53,549       1,178,555

1997                         1,350,118              54,027       1,404,145

1998                         1,398,182              44,367       1,442,549

1999                         1,281,581              37,884       1,319,465

2000                         1,217,972              35,472       1,253,444

2001                         1,452,030              40,099       1,492,129

2002                         1,539,111              38,540       1,577,651

2003                         1,625,208              35,037       1,660,245

2004                         1,563,145              34,317       1,597,462

2005 *                      1,748,421             34,222        1,782,643
         * Fiscal year ended September 30, 2005
(United States Department of Justice, Total bankruptcy filings..., n.d.), (Administrative
Office of the U.S. Courts, n.d.) United States Department of Justice, Business cases
filed..., (n.d.)

          The United States Trustee, a part of the Department of Justice, sponsors a

program to prevent fraud and abuse. A 2003 audit of this program by the Inspector

General of the U.S. Department of Justice, (2003) reports that the Federal Bureau of

Investigation (FBI) estimates that 10 percent of bankruptcy filings are fraudulent; the
                                                        Deceit in Bankruptcy                9

primary problem being the failure to disclose all of the debtor’s assets. The report goes

on to state “UST Program officials have stated that no one within the bankruptcy

community has a true sense of how pervasive fraud is within the bankruptcy system.”

The program is also unable to accurately determine the number of criminal referrals that

are made to the Department of Justice for prosecution and the conviction rate with any

certainty. This is due to an overwhelming number of errors detected during the audit.

However, for purposes of this paper, the numbers, no matter how rough they may be,

are indicative of the paucity of criminal prosecutions. The data indicates that between

fiscal year 1995 and fiscal year 2003, 6,090 referrals were made to the Justice

Department resulting in 482 convictions (includes other dispositions equivalent to a

conviction). The report further notes that since the September 11, 2001 attacks,

bankruptcy fraud has not been a priority within the Department of Justice with resources

shifted to combating terrorism.

       Extrapolating the above data indicates that the probability of a fraudulent

bankruptcy filer actually being convicted is very small. This is illustrated as follows:

       Approximate number of filings per year                            1.8 million

       Approximate number of filings 1996-2003                         11.3 million

       Estimated number of fraudulent filings-10%                        1.1 million

       Number of cases referred to DOJ                                         6,090

       Number of convictions                                                   482

       Probability of a fraud case being

              referred to the Justice Dept.                                    .54%

       Probability of being convicted                                          .04%
                                                       Deceit in Bankruptcy                   10

         The Department of Justice’s policy is to prosecute high profile cases (Heston,

1998). Therefore, it is safe to conclude that, unless a person is a high-profile target

(attorney, CPA, trustee, well-known personality, etc.) there is little likelihood that they

will face prosecution.

         Who are the victims of bankruptcy fraud? Frequently the government is a major

victim because under specific circumstances, federal income taxes are dischargeable.

In addition, the Internal Revenue Code gives some breaks to a taxpayer who is in

bankruptcy. The other victims are creditors who are denied satisfaction of debts

because of a fraud. As noted above, all Americans are the indirect victims of bankruptcy

fraud.

                         History of Bankruptcy in the United States

         Before the first bankruptcy laws were enacted in 16th century England, debtors

were simply imprisoned until they, or their friends and relatives, came to some

resolution with the unpaid creditors. Early English law primarily provided a mechanism

whereby creditors could legally obtain and sell a debtor’s assets in partial settlement of

their claims. Under this system, the debtor lost all his assets and was not discharged

until his debts were fully paid. The system was so harsh that, at one time, a debtor

could be pilloried and have his ears cut off (Tabb, 1995).

         In 1705, Parliament changed the law to allow a debtor to retain some of his

property and, if he cooperated with the system, be discharged from the unpaid balance

of his debts. To discourage fraud, a debtor could be put to death if he was

uncooperative, although this provision was rarely invoked. This law would eventually

become the basis for early American bankruptcy laws (Bankruptcy's History, n.d.).
                                                     Deceit in Bankruptcy                11

       Congress was given the power to promulgate bankruptcy laws by Article I,

Section 8 of the United States Constitution, which provides, “The Congress shall have

power to ... establish ... uniform laws on the subject of bankruptcies throughout the

United States.”

       In 1800, Congress adopted much of the British law in effect at the time as the

basis for bankruptcy law in the United States. They did, however, eliminate the death

penalty provisions. Over the next one hundred years, this law evolved, eventually

allowing a person to voluntarily bankrupt (Tabb, 1995).

       The first permanent beginning of bankruptcy law in the United States came with

the Bankruptcy Act of 1898—allowing specific exemptions and providing full discharge

from debt. During the Great Depression, many changes were made—primarily affecting

business bankruptcies. In 1978, Congress passed another Bankruptcy Act which

remained largely intact until 2005 (Bankruptcy's History, n.d.).

       On April 20, 2005, President Bush signed into law Senate Bill 256, the

“Bankruptcy Abuse Prevention and Consumer Protection Act of 2005” which became

effective on October 17, 2005—several months before this paper was written. The

potential impact of this legislation will be discussed in subsequent sections of this paper.

       Throughout the history of humankind, when people with conflicting interests are

involved in a business or other transaction, some participants will attempt to take unfair

advantage of another. While the bankruptcy system is designed to equitably distribute

the assets of a debtor among creditors, some people try to interfere with this process in

dishonest and deceitful or fraudulent ways. Bankruptcy fraud is addressed in 18 U.S.C.
                                                       Deceit in Bankruptcy                12

§ 152, which “attempts to cover all of the possible methods by which a bankrupt or other

person may attempt to defeat the Bankruptcy Act” (Tighe, 1998).



                            Structure of the Bankruptcy Courts


United States Bankruptcy Court

       Bankruptcy cases are venued in a special court established solely to adjudicate

bankruptcy cases. There are bankruptcy courts in each of the ninety-four judicial

districts in the United States. Each court has one or more bankruptcy judges who are

judicial officers of the District Court in which the court is located. The judges are

appointed to 14-year terms by the U.S. Court of Appeals having jurisdiction over the

judicial district. The most recent bankruptcy act has changed the bankruptcy judges’ title

to Bankruptcy Referee (a title that they held before the 1978 Act). The judge has

decision making authority over all matters in their court although they have very little

day-to-day involvement in most cases (U.S. Courts, n.d.).

       In most instances, bankruptcy cases are administered by the Office of the United

States Trustee, an officer of the Department of Justice with the responsibility for the

expeditious resolution of bankruptcy cases according to the law. In Alabama and North

Carolina, this duty is handled by the bankruptcy court. Most smaller cases are actually

administered by private practice attorneys, accountants and professional trustees under

contract to the U.S. Trustee. Larger cases are generally handled directly by the U.S.

Trustee’s office.
                                                       Deceit in Bankruptcy                   13

The appellate system

       The first level of appeals from the bankruptcy court is either to the district court

or, optionally, to a bankruptcy appellate panel (BAP) available in five judicial districts

where the case is heard by a panel of three bankruptcy judges from outside of the

judicial district from which the appeal originated.

       From this point, the appellate process is to the circuit court of appeals and finally,

the United States Supreme Court (The Third Branch 2004).



                                       The Crimes

       The codified portion of bankruptcy criminal law is very brief in comparison to

current legislation. The entirety of Title 18, United States Code, §§ 152 to 157 is less

than two pages long, in contrast to the most recent bankruptcy legislation, the

Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, which runs to 512

pages. Because of this, bankruptcy law has grown and evolved to its current state

primarily through the development of case law.

       The Criminal Resources Manual (United States Department Of Justice, 1997)

presents an excellent discussion of each of the individual subsections of § 152.

       18 U.S.C. § 152 “attempts to cover all of the possible methods by which a

bankrupt or other person may attempt to defeat the Bankruptcy Act through an effort to

keep assets from being equitable distributed among creditors.” (Emphasis provided)

Moreover, “18 U.S.C. § 152 was enacted to serve the important interests of

government, not merely to protect interests who might be harmed by prohibited

conduct” (Stegeman v. United States, 1970).
                                                      Deceit in Bankruptcy                 14

       The criminal provisions of bankruptcy are designed to assure honest

administration in bankruptcy proceedings and to distribute to the creditors as large a

portion of the bankrupt’s estate as possible (United States Department of Justice,

United States Attorney’s Manual, 1977, October).

       All of the crimes described in § 152 require that the act be done “knowingly” and

“fraudulently.” An inadvertent error, mistake or act done out of ignorance does not

support a criminal violation. The statutory requirement that the acts be performed

“knowingly” requires only that the acts be voluntary and intentional with specific intent;

there is no need to show that the defendant knew that he was breaking the law (United

States v. Zehrbach, 1995).

       The term “fraudulently” means that the act was done with the intent to deceive or

cheat any creditor, a trustee, or bankruptcy judge. This usually has the purpose of

benefiting either the perpetrator or another person. The intent can also be to harm or

cause loss to some person. The intent to defraud goes far beyond the intent to avail

oneself of the protections and benefits of the bankruptcy laws. Characteristics of

criminal intent center on the use of deceptions and cheating. Frequently, fraudulent

behavior will be evidenced by an individual continuing to use and retain the benefit of

their assets while simultaneously shielding them from creditors. Anything less is

generally a civil matter (Tighe, 1998). Intent is usually demonstrated by the actions of

the person. The following are examples of indications of fraudulent intent:

          •   The hurried formation of a new corporation after a debtor company has

              filed Chapter 11.

          •   Diversion of assets before a trustee is appointed.
                                                      Deceit in Bankruptcy                  15

          •   Removal of carpeting belonging to a landlord—showing intent to start a

              new business with old business assets (Tighe, 1998).

       In order to prevail, the government must show that the defendant performed the

acts charged either in bankruptcy or in contemplation of bankruptcy. While the former is

reasonably straight forward, “in contemplation” requires the subjective judgment of the

trier of fact—generally a jury unless the defendant has waived his right to a jury trial,

accepting a bench trial in its place, in which case the judgment would be made by a

judge. Examples of actions made in contemplation of bankruptcy include:

          •   Secret deals among the officers of a financially weak company (United

              States v. Martin)

          •   Defendant’s efforts to collect legal fees from a client he knows is

              considering bankruptcy (United States v. Butler).


18 U.S.C. § 152(2)- False Oath or Account

A person who “knowingly and fraudulently makes a false oath or account in or in relation

to any case under title 11.”

       The elements of a false oath violation have been defined as:

          •   The existence of a bankruptcy proceeding;

          •   A statement made under oath;

          •   The statement must be material;

          •   The statement must be false; and

          •   The statement was made knowingly and fraudulently.          (Metheany v.

              United States, 1968)
                                                      Deceit in Bankruptcy                 16

       This subsection addresses false statements made under oath in any type of

bankruptcy hearing including a court hearing, an examination under Rule 2004 or a

section 341(a) meeting of the creditors. The term “oath” is the common oath (i.e., “Do

you solemnly swear that the testimony...”) administered to a witness by the court in

everyday testimony.

       The threshold issue is the factual truth of a statement and is defined as “a

statement or assertion which is known to be untrue when it is made or used” (United

States v. Young, 1964). Absent fundamental ambiguity or imprecise questioning, the

meaning and truthfulness of a defendant’s answer when questioned under oath in a

bankruptcy proceeding is a judgment to be made by a jury.

       Materiality of a statement is broadly interpreted meaning that the false statement

bears a relationship to a bankrupt’s financial condition and transactions, discovery of

assets, prior bankruptcies and any other matter associated with the bankrupt’s estate.

Materiality relates to the degree of relevance and the relative importance of a statement.

Statements concerning the bankrupt’s social security number, past bankruptcies, and

past names are material. The courts have held that “materiality does not require a

showing that creditors are harmed by the false statements....Materiality is...established

when it is shown that the inquiry bears a relationship to the bankrupt’s business

transactions or his estate...or concerns the ‘discovery of assets, including the history of

a bankrupt’s financial transactions’” (United States v. O'Donnell, 1972). In past years,

the courts determined that the question of materiality should be decided by the court,

not the jury. However, the Supreme Court reversed this line of cases in 1995 (United

States v & Gaudin, 1995). After this decision, the United States Attorney (United States
                                                        Deceit in Bankruptcy                17

Department of Justice, United States Attorney’s Manual, 1977, October) determined

that it was better practice to submit the materiality question to the jury.

       The term “false account” is not defined by statute, but is generally interpreted to

mean “an accounting” or financial report (United States Department of Justice, United

States Attorney’s Manual, 1977, October). Examples include periodic reports, reports of

income and expenses and the like. This topic is infrequently mentioned in the reviewed

literature.


18 U.S.C. § 152(3)- False Declarations

              A person who “(3) knowingly and fraudulently makes a false declaration,

      certificate, verification, or statement under penalty of perjury as permitted under

      section 1746 of title 28, in or in relation to any case under title 11;”

       This subsection was added to the Bankruptcy Code in 1976 in order to align the

code with the newly created 28 U.S.C. § 1746, which authorized the use of unsworn

statements made under penalty of perjury, but not under oath. Section 1746 provides

the familiar declaration:


       I declare (or certify, verify, or state) under penalty of perjury that the foregoing is

       true and correct.

       Executed on (date).                 (Signature).


       This subsection is closely related to 18 U.S.C. § 152(2) relating to false oaths.

When Congress implemented this subsection, its intention was to leave Subsection 2

unchanged. Therefore, the elements of a violation of Subsection 3 are the same as a

Subsection 2 violation with the only difference being the subsection relates to false
                                                         Deceit in Bankruptcy             18

statements as opposed to false oaths (United States Department of Justice, United

States Attorney’s Manual, 1977, October). Because many of the documents in a

bankruptcy case are submitted under penalty of perjury, the reach of this subsection is

much broader than Subsection 2.

         Typical prosecutions for false statements often include failure to include various

assets, misrepresentations as to income or other financial matters, and false statements

regarding bids for the property of a debtor. Omission of relevant information is an

offense prosecutable as a false statement; although, prosecutions for omissions are

much more difficult to sustain than cases involving affirmative false statements (Tighe,

1998).

         Although they can be associated with all types of bankruptcy frauds, false

statements are most commonly made in connection with concealment of assets. Tighe

(1998) notes that at least eight years ago, fraudsters were increasingly using false

statements as the final step in an identity fraud.


18 U.S.C. § 152(4)- False Claims

                A person who...knowingly and fraudulently presents any false claim for

     proof against the estate of a debtor, or uses any such claim in any case under title

     11, in a personal capacity or as or through an agent, proxy, or attorney’...shall be

     fined..., imprisoned..., or both.

         The elements of a false claims violation are:

            •    The bankruptcy proceedings had commenced;

            •    The defendant presented or caused to be presented a proof of claim in the

                 bankruptcy;
                                                      Deceit in Bankruptcy                19

          •   The proof of claim was false as to a material matter; and

          •   That the defendant knew that the proof of claim was false and acted

              knowingly and fraudulently (United States v. Overmyer, 1989).

       A claimant can assert claims against an estate whether or not it is reduced to a

judgment, whether liquidated or unliquidated, fixed or contingent, matured or

unmatured, disputed or undisputed, legal or equitable, and secured or unsecured. Since

the truthfulness of a claim is generally obvious, the defendant’s state of mind at the time

of filing becomes the key issue. A good faith belief is a complete defense to a charge

under this subsection (United States v. Connery, 1990). A claim may be asserted in

good faith even though it is inaccurate or erroneous, successfully disputed by the debtor

or disallowed by the court. Prosecutions under this subsection appear to be infrequent.

       In addition to these specific crimes under Section 152, the government has other

tools, both criminal and civil, at their disposal. Frequently, while committing some of the

crimes related to bankruptcy, perpetrators will violate other federal and state laws. The

Racketeering Influenced and Corrupt Organizations Act (“RICO”) defines bankruptcy

crimes as “racketeering activity” allowing for prosecution under that statute.



                             Bankruptcy and Organized Crime

        Internet research leads to very little information on this subject, although the two

are sometimes mentioned together. This leads this writer to believe that most situations

involving organized crime are dealt with as an ordinary criminal matter, rather than

bankruptcy matters. This could be because the field of bankruptcy law is quite distinct

from the field of criminal law. Professional practitioners are usually specialists in one or
                                                      Deceit in Bankruptcy                20

the other and do not seem to crossover on a regular basis. Occasional mention is made

of the involvement of organized crime in a bankruptcy scheme called a “bust out” which

is the subject of a major case which has been well documented by Edward J. DeFranco

(1973). Although this case took place in 1961, the underlying principles of the crime are

still in use today:

   • The infiltration of a legitimate business by organized crime

   • Buying large amounts of product from unsuspecting suppliers

   • Selling the merchandise and collecting the proceeds

   • Absconding with the cash

   • The business files for bankruptcy protection

   • The suppliers are left with worthless accounts receivable



                 Impact of Identity Fraud, USA PATRIOT Act and Terrorism


Identity fraud

       Some bankruptcy cases involve a typical scenario wherein an innocent person’s

identity is stolen and used for a period of time to obtain credit. Because the perpetrators

do not pay the subsequent bills, creditors begin to pursue them. One of the “solutions” is

to file bankruptcy using the victim’s name and social security number. This, of course

leads to destruction of the true victim’s credit. A paper by Jane E. Limprecht of the

Executive Office of the U.S. Trustees (n.d.) notes that identity fraud is a factor in a

significant number of bankruptcy cases. She described some of them as:
                                                       Deceit in Bankruptcy                   21

          •   Filing for bankruptcy using the identity of another—parent, sibling, child,

              other relative, spouse, ex-spouse, “significant other,” past or present

              business associate, friend, neighbor, etc.

          •   Incurring debt using a fraudulent identity, and then filing bankruptcy for

              that “person”

          •   Transferring property to the name of a friend or relative, then filing

              bankruptcy in that person’s name to avoid foreclosure

          •   Use of a fictitious identity

          •   Transferring a fractional interest in real property to an innocent person,

              without their knowledge, to halt foreclosures utilizing the automatic stay to

              such actions in bankruptcy.

       Although the U.S. Trustee’s Office can provide limited help to a victim, they are

generally advised that it would be in their best interest to obtain counsel, at their own

expense, to protect themselves.


USA PATRIOT Act

       Bankruptcy is almost a world of its own, and as such, is insulated from some of

the realities (i.e. terrorism) of modern life in the United States. Excluding the potential

for increased information sharing among the various agencies of government, the USA

PATRIOT Act has little direct effect on the bankruptcy system. A possible benefit to the

integrity of the system is the “know your customer” provisions of the Act that require

financial institutions to establish minimum standards for customer identification at

account opening. This could make it somewhat more difficult to conceal cash assets in

a bankruptcy proceeding by making it more difficult to open different accounts in an
                                                       Deceit in Bankruptcy                  22

assumed name. In addition, the USA PARTRIOT Act makes it easier for law

enforcement to obtain bank and other financial records.


Terrorism

       Although one does not generally associate multi-national terrorism and

bankruptcy crimes, there are occasional indirect impacts.

       U.S. Senator Charles E. Schumer of New York, in a 2003 press release,

discusses the impact of terrorism causing decreased ridership on U.S. airlines after the

9-11 attacks. He notes that this has accelerated many commercial air carriers’ plunge

into bankruptcy. This has made a significant economic impact on New York due to

reduced tourism and airline traffic. (Schumer, 2003).

       An interesting article by Roy Korte, an assistant attorney general in Wisconsin

(Korte, n.d.), relates a disruptive tactic employed by anti-government extremists, who he

labels as terrorists. These individuals file baseless liens against public officials and

follow-up by filing fraudulent involuntary bankruptcy petitions listing these officials as

“delinquent creditors” in order to cause financial problems for the officials. These

officials are then forced to hire legal counsel in order to petition the bankruptcy court

asking for dismissal of the cases. These actions have a negative impact on the victims’

credit rating and some officials have suffered harm long after the case has been

dismissed. All of this requires time and money to resolve. The petitioners in these cases

have also unsuccessfully attempted to assert that criminal cases against them should

be stayed during the pendency of the bankruptcy proceedings.
                                                     Deceit in Bankruptcy                 23

                                  Anecdotal Information

       The recent bankruptcies by major corporations (e.g., Enron, Worldcom, etc.)

have received a large amount of media coverage; however, they comprise a very small

percentage of the bankruptcies filed each year. Other than those notable cases,

bankruptcy is not a very high profile process or of interest to many people. Therefore,

newspaper articles relating to fraud are limited. Most appear to be reprints of press

releases from the Department of Justice reporting on successful prosecutions. This is in

keeping with the department’s policy of “...prosecuting several exemplary cases...”

(Heston, 1998). The outcome (always successful) of these cases is then publicized to

act as a deterrent to others.


People whose occupations catch the public’s attention

       One such case related the story of the owner of an adult entertainment business

in Atlanta, who hid $4 million in assets. He was convicted of concealment of assets and

making a false oath. The article goes on to mention the maximum sentence for these

crimes—10 years imprisonment and a $500,000 fine. This story was not particularly

newsworthy; however, it was carried by the Associated Press Wire Service (2005).

Other press releases are similar in content and involve an attorney and his wife, a

Baptist minister and other defendants whose professional status will attract attention.


Prominent businessman

       Two articles appearing in the St. Louis Post-Dispatcher (Shinkle, 2004), (Shinkle,

2005) chronicle the 2004 case of a businessman in Chesterfield, Missouri. The

defendant, Jeffrey B. Polinsky, was accused of mail fraud, wire fraud and making false
                                                      Deceit in Bankruptcy                24

statements in a bankruptcy proceeding. Polinsky, a paper wholesaler, was accused of a

classic “bust out” scheme where he purchased paper from various paper

manufacturers, sold it to legitimate customers, collected for the paper sold, then, rather

than pay his suppliers, diverted the money for personal use, then filed for bankruptcy

protection. Polinsky’s fraud problems arose from two written statements that he made

during his bankruptcy. The government alleged that in the first, he significantly

underreported the amount of money that his company had paid him in the previous year

and in the second, he stated that he had not transferred any money within one year of

bankruptcy. The government alleges that he had “diverted substantial money and

property.” In 2005, Polinsky pled guilty to one count of mail fraud, was required to forfeit

what was left of the money that he diverted. In addition, he was sentenced to 33 months

in prison. Interestingly, his attorney said he was pleased with the sentence. The United

States Attorney’s Office, of course, told the press what a good job they were doing of

protecting the public. As previously noted, this author questions the validity of

bankruptcy conviction statistics, speculating that, perhaps, cases are prosecuted as

crimes other than violations of 18 U.S.C. § 152. This case exemplifies this position.


Exploring consumer bankruptcy in Utah

       Another interesting article appeared in The Salt Lake Tribune (Oberbeck, 2005).

The article notes the scant likelihood of being prosecuted for bankruptcy fraud across

the United States. The article reports self-serving statements by the U.S. Attorney’s

office in which they tell the public what a good job that they’re doing in dealing with

these offenses. Surprisingly, the article ends by noting that Utah has the highest per

capita incidence of bankruptcy in the United States with one out of every 37 households
                                                        Deceit in Bankruptcy               25

filing each year. For the year ended October 30, 2005, 21,385 bankruptcies were filed,

up 21 percent from the previous year. As noted earlier, the reader is cautioned that

2005 statistics might be anomalous given the large number of filings in advance of the

effective date of the Bankruptcy Abuse Prevention and Consumer Protection Act of

2005.

        Interestingly, a research project of the Utah Foundation (2004) followed up on a

report by two Utah State University researchers, Lown and Rowe (2002), that delves

into the reason behind Utah’s high prevalence of bankruptcies and has determined that

the problem seems to be related to Utah’s religious and sociological base. They have

enumerated the following characteristics:

           •   Utah has the highest average family size in the U.S. resulting in:

                  o Largest average house size in the nation

                  o High cost of child rearing

                  o Highest average number of vehicles per household.

           •   Wages in Utah are only 82% of the national average.

           •   High rate of charitable contributions.

           •   Above average divorce rate; but, among the lower 10% of households

               headed by a single woman. This is because of a high re-marriage rate.


Acquitted murder suspect Robert Blake

        A bankruptcy case that has the possibility of fraud was filed by actor Robert

Blake on February 3, 2006. In the filing, he listed as his biggest liability the $30 million

judgment against him from a wrongful death suit won by his deceased wife’s family after

Blake was acquitted of murdering Bonny Lee Bakley. He also listed among his debts a
                                                       Deceit in Bankruptcy                26

$1,274,783 federal tax assessment as well as a $334,337 state tax assessment. His

assets were estimated at between $100,001 and $500,000.

       Attorney Eric Dubin, who represented Bakley’s family, disputes Blake’s financial

situation, saying “The concept of Robert Blake doing everything he can to avoid paying

was highly anticipated. And, we’re ready for it.” Dubin stated that Blake had spread his

assets in a number of corporations. The private investigator who worked with Blake in

the criminal case disputes this, claiming that Blake lives off of his pension (Associated

Press, 2006).

       If Dubin is correct, Blake could eventually be charged with violation of 18 U.S.C.

§ 152(1)—knowingly and fraudulently concealing assets in contemplation of bankruptcy,

18 U.S.C. § 152(3)—knowing and fraudulently making false statements (signing

bankruptcy documents) under penalty of perjury and 18 U.S.C. § 1519—knowingly

making false statements in bankruptcy. Should he continue to make these statements at

his first court appearance and the Section 341 meeting, they would be made under

oath. This could be a violation of 18 U.S.C. § 152(2)—knowingly and fraudulently

making false oaths in bankruptcy.

       It seems quite possible that Blake has some assets, as most plaintiffs’ attorneys

would not pursue a wrongful death suit, which normally are contingent fee cases, unless

he felt fairly certain that the respondent had the ability to pay and could not bankrupt on

a judgment. Unlike most bankruptcy filings, this case has at least one creditor who is

keenly interested and will surely follow it, scrutinize all of the documents filed, and,

possibly, conduct an independent search for hidden assets. It will be interesting to see
                                                      Deceit in Bankruptcy                 27

how this case develops in coming months. Given the U.S. Attorney’s propensity to

prosecute high profile cases, Mr. Blake would seem to be a likely target.



          Bankruptcy Abuse Prevention and Consumer Protection Act of 2005

       The Act, largely at the behest of credit card companies, is designed to make it

much harder for consumers to eliminate their debts under Chapter 7. The “consumer

protection” features of the act are more difficult to determine; however, that discussion

is beyond the scope of this paper. One portion of the Act, Title VI-Bankruptcy Data has

the potential to make a major impact on bankruptcy crime.


Improved collection of statistics

       As noted earlier, there are few, if any, accurate statistics regarding bankruptcy

and bankruptcy fraud. Chapter 6 of title 28, United States Code was amended by a new

Section 159 that requires that the clerk of the district court or the clerk of the bankruptcy

court keep detailed records covering a number of different aspects of cases that are

under the court’s supervision. If the mandated records are kept regularly and accurately,

it will allow researchers to understand the various aspects of bankruptcy much better

than is the current case. Even if the recordkeeping is less than perfect, the statistics

derived from examining these records will certainly be better than those that are

available today.


Audit of debtors

       Section 603 mandates that the United States Trustee administer an audit

function. The code specifies that procedures be implemented to randomly audit at least
                                                       Deceit in Bankruptcy                 28

one of every 250 (.4%) bankruptcy petitions filed by individuals in each judicial district,

as well as those petitions showing above average variances from the average for

income and expense schedules. This will probably prove to be difficult without good

baseline data that will be needed to make the comparisons. The law mandates that

these audits be performed by independent certified public accountants and licensed

public accountants in accordance with generally accepted auditing standards, although

the United State Trustee has an option to develop an alternative procedure to facilitate

the audits. Considering that 1.78 million bankruptcies were filed by individuals in 2005,

this law requires that about 7,130 audits be performed annually. This program has the

potential to make a major impact on the incidence of fraudulent bankruptcies in several

ways:

           •   Detecting fraudulent cases

           •   If correctly implemented, data from these audits can be used to develop a

               comprehensive database of bankruptcy related data for future research

               and to provide for a method of statistically “scoring” future cases to identify

               cases requiring in depth analysis

           •   Instill a degree of fear into potential fraudsters that their case may be

               audited

        Of course, not only will the Trustee’s office be required to recruit and retain a

sufficient number of accountants to perform these audits (either under contract or as

employees) but an adequate work force to manage and administer the audits plus the

needed facilitates and support services. In order for this program to be effective, the
                                                         Deceit in Bankruptcy            29

Federal Bureau of Investigation and Office of the United States Attorney will need

sufficient capacity to investigate and prosecute and suspected criminal cases.

       An interesting legal clash may occur when the audit provisions of the Act run up

against the Fourth Amendment. In order to complete an audit in a commercial context,

under generally accepted auditing standards, the auditor needs access to a significant

amount of data supporting a client’s financial statements. An audit is generally

performed upon the request of the client who is willing to cooperate with the auditor

because it is beneficial to him. Such is not the case in a bankruptcy situation. Although

a debtor risks denial of discharge by not cooperating with auditors, he has no other

motivation to cooperate. In the case where a petitioner chooses not to cooperate, these

could become forensic audits equivalent to those done in the investigation of criminal

cases. As such, they will tend to become very time consuming and expensive. Section

727 of Title 11, U.S.C. was amended to provide, “... a failure to make available for

inspection all necessary accounts, paper, documents, financial records, files, and all

other papers, things, or property belonging to the debtor that are requested for an

audit...” could lead to dismissal. Attempted imposition of this penalty could lead to

protracted legal actions, further clogging the courts.

       The Inspector General of the Department of Justice (2003) has noted that the

most common bankruptcy frauds involve the failure to disclose all of a petitioner’s

assets. How will full disclosure be verified? Could the debtor be required to open up his

home to inspection by an auditor in his quest to verify the accuracy of his listing of

assets and liabilities? How much privacy does the Fourth Amendment provide?

Clearly, a search warrant is required to search a private residence. This requires
                                                       Deceit in Bankruptcy                 30

probable cause that a crime has been committed. Historically, the Supreme Court has

been very reluctant to cross this barrier (Taylor, 2005). The sense of public debate has

been to balance unlimited access to a bankrupt’s property for purposes of

administration against protection of the debtor’s personal and financial privacy. The

courts have tried to maintain the integrity of the bankruptcy system against the

bankruptcy system’s goal of giving debtors a fresh start. This is yet another area for

protracted litigation.


Increased participation by the FBI and US Attorney

       Section 158 of the Act mandates that the Attorney General designate both an FBI

agent and an Assistant United States Attorney in each judicial district to investigate and

prosecute bankruptcy fraud. While these mandates at least give the appearance that

Congress’ intent is to give a higher priority to bankruptcy crimes, they come at a time

when the resources of the Department of Justice are increasingly being focused on the

terrorist threat at the expense of economic crime investigations and prosecutions

(Swibel, 2004). This author is concerned that with this shift in resources, our

government’s increasing emphasis on terrorism and budget constraints may render this

initiative unfulfilled by failure to commit sufficient resources, both tangible and financial,

to address this issue.


Greater responsibility of attorneys

       Another provision of the Act, Section 319, Sense of Congress Regarding

Expansion of Rule 9011 of the Federal Rules of Bankruptcy Procedure, sounds
                                                      Deceit in Bankruptcy                  31

ominous in requiring that any attorney signing a bankruptcy document is representing to

the court that he has made “...reasonable inquiry to verify that the information...is—

         well grounded in fact; and

         warranted by existing law or a good faith argument for a modification or reversal

         of existing law.”

         While much has been written about this provision and its effect on attorneys, and

indirectly, the accuracy of information provided by debtors, it appears to some writers

(Sommer, H. J., 2005) to be text that changes nothing in the practice of bankruptcy law

before the effective date of the Act. The words “reasonable investigation” has

supplanted “reasonable inquiry.” The author goes on to discuss two treatises, Moore’s

Federal Practice and Collier on Bankruptcy that use the word interchangeably. Moore,

using a quote from Moore’s Federal Practice, states that “An attorney may rely on

objective reasonable representations of his or her client.”

         Sommer’s article presents an unusually candid commentary on the new law from

his perspective as Editor in Chief of Collier on Bankruptcy, the leading legal treatise on

the subject. This author finds the quote both interesting and worthy of inclusion in this

paper.

              From its Orwellian title, an example of deceptive advertising if ever there

     was one, to the last of its 512 pages, the bankruptcy bill recently passed by

     Congress presents numerous challenges to attorneys who represent consumer

     debtors. How such terrible legislation came to be passed by Congress is a story of

     money, political mean-spiritedness, and intellectual dishonesty...
                                                         Deceit in Bankruptcy                   32

       Mr. Sommer goes on note that, in his opinion, the law was written by lobbyists

“...with limited knowledge of real-life consumer bankruptcy practice....It is a credit to the

bankruptcy bar that no true expert in bankruptcy participated.” His conclusion is that the

bill is so poorly written that it will be litigated for years and many of its provisions will

never come to pass.

       Sommer continues with his observations that the law will be less effective for

some debtors and totally inaccessible to others. Interestingly enough, many higher

income individuals will be better off because of larger exemptions for retirement and

education savings accounts. There is no doubt that the cost of bankruptcy will increase

for everyone.

       An unrelated survey by the National Association of Consumer Bankruptcy

Attorneys (NACBA) (Sahadi, 2006) showed that only 3% of potential consumer

bankruptcy filers have the means to pay back any of their debt, meaning that they are

destined for a Chapter 7 liquidation rather than a Chapter 13 repayment plan. This is

consistent with a 1998 survey by the American Bankruptcy Institute where the number

was pegged at 3% to 3-1/2% The NACBA survey also showed that the overwhelming

portion of bankruptcy filers were in dire financial straits because of reasons beyond their

control—medical crisis and job loss followed closely by divorce. These statistics lead

the writer to question the effectiveness of the new bankruptcy procedures that will push

more debtors into Chapter 13 repayment plans.

       When this legislation was under consideration in Congress, many legislators

were concerned that the new requirements would leave a whole class of debtors

hopelessly buried in debt with no way out. According to the legislative staff of
                                                        Deceit in Bankruptcy                  33

Congressman Peter DeFazio (D-Oregon), Congress has received no feedback on the

effectiveness or problems related to this legislation at this time.



                Other Federal Laws Frequently Used in Bankruptcy Cases

       In addition to the criminal bankruptcy statutes, there are a number of generic

criminal statutes available to the government. (Ainsworth & Calo, 2003):


18 U.S.C. § 1001 – Statements or Entries Generally

       This section criminalizes the falsification, concealment, or cover up, by any

devise, a material fact. It also prohibits the making of a false, fictitious, or fraudulent

statement or representation. It also criminalizes the making or use of any materially

false, fraudulent statement or entry. Violation of this section is punishable by a fine or

imprisonment of up to five years.


18 U.S.C. § 1029 – Credit Card Fraud

       This statute provides penalties for charging $1,000 on one unauthorized credit

card in one year or possessing more than 15 fraudulent cards.


18 U.S.C. § 1341 – Mail Fraud

       This statute provides a fine of up to $1,000,000 and imprisonment for not more

than 30 years for the use of the Postal System or a commercial interstate carrier to

devise any scheme or artifice to defraud.
                                                      Deceit in Bankruptcy               34

18 U.S.C. § 1343 – Wire Fraud

       This statute provides a fine of up to $500,000 and/or imprisonment of up to 20

years for the use of wire, radio, or television in interstate or foreign commerce to devise

any scheme or artifice to defraud.


18 U.S.C. § 1621 - Perjury

       This section criminalized the making of a false statement after having taken an

oath to be truthful. It provides for a fine and/or imprisonment of up to five years.


42 U.S.C. § 408 – Misuse of a Social Security Number

       Prohibits the fraudulent use of the social security number of another by

representing it to be his own. This section provides for a fine and/or imprisonment of not

more than ten years.

       Depending on the situation, numerous other crimes may have also been

committed including tax fraud, securities fraud, bank fraud, insurance fraud, as well as a

host of other federal offenses. These may be discovered in the course of investigating a

suspected bankruptcy fraud.

       The variety of laws under which bankruptcy criminals can be prosecuted makes it

difficult to determine the number of bankruptcy frauds that are eventually prosecuted.
                                                      Deceit in Bankruptcy                35

                                Sarbanes-Oxley Act of 2002

       The Enron and similar frauds and irregularities at some of the largest companies

in the nation were the genesis of The Sarbanes-Oxley Act of 2002 and its component

act, the Corporate and Criminal Fraud Accountability Act of 2002. These were intended

to restore public confidence in the countries businesses and, specifically, the accounting

profession. Therefore, most provisions of the Act deal with corporate responsibility and

accounting issues, as well as securities fraud. A little known provision of this legislation

has the potential to make a major impact on the prosecution of bankruptcy fraud.

       Although Sarbanes-Oxley did not modify 18 U.S.C. § 152, it added a new

section, 18 U.S.C. § 1519, which appears to be in direct response to the actions of the

failed accounting firm, Arthur Anderson, destroying records related to their audits

before they could be obtained by the Securities Exchange Commission. Section 18

U.S.C. 1519 reads as follows:

       Whoever knowingly alters, destroys, mutilates, conceals, covers up, falsifies, or

       makes a false entry in any record, document, or tangible object with the intent to

       impede, obstruct, or influence the investigation of proper administration of any

       matter within the jurisdiction of any department or agency of the United States or

       any case filed under title 11, or in relation to or contemplation of any such matter

       or case, shall be fined under this title, imprisoned not more than 20 years, or

       both.

       A result, prosecutors can charge dishonest debtors for multiple crimes for the

same conduct. The new law expands the law of bankruptcy crimes in several ways.

Section 152 requires that a person “knowingly and fraudulently” engage in specified
                                                        Deceit in Bankruptcy                 36

acts to be convicted of a bankruptcy crime. Section 1519 removes the “fraudulently”

qualification by only requiring that the defendant “knowingly” act with “intent to impede,

obstruct, or influence” a bankruptcy case.

       Secondly, the Act add a “...in contemplation of...” clause to the definition of the

various bankruptcy crimes. This will bring acts such as introducing a fraudulent, yet

signed, tax return or making a baseless claim against an entity with the knowledge that

the entity to whom the claim is made will soon be filing a bankruptcy petition.

       Lastly, the penalties under 18 U.S.C. § 1519 are much harsher than those under

18 U.S.C. § 152. The new law quadruples the potential imprisonment from five to twenty

years (Pearson, 2003). The impact of this legislation remains to be seen.



                                       State Statutes

       Often state fraud and other laws are violated as a part of a course of conduct

including bankruptcy fraud. As frequently happens in these situations, the Department

of Justice defers prosecution to the state level. Disposition of bankruptcy fraud cases in

this manner as well as prosecution under federal statutes other than bankruptcy may

inadvertently skew the statistics sited earlier in this paper that show a very low rate of

criminal prosecutions under 18 U.S.C. § 152.

                                     Other Remedies

       The initiation of a bankruptcy fraud case can be from two sources. First, although

unlikely, is through an independent investigation by the government. The second, and

more likely source, is from a party with an interest in the bankruptcy case complains to

the United States Attorney. This includes trustees, creditors, or court officers within the
                                                      Deceit in Bankruptcy               37

bankruptcy system. During the course of a bankruptcy, it is not uncommon for

allegations of misappropriation, asset concealment, conflicts of interest or other

fraudulent behavior to become apparent to a judge or trustee. Should that person have

a reasonable belief that the bankruptcy laws have been violated, they are mandated to

initiate a criminal investigation (Ogier & Williams, 1998).

       A quotation cited by Heston (1998) is taken from a 1987 publication by the

Criminal Division of the Department of Justice publication, Investigation and Prosecution

of Bankruptcy Fraud 1 (1987), clearly delineates the status of bankruptcy fraud and

prosecutions:

            In many areas, resort to bankruptcy is seen as a license to steal by

     defrauding the bankruptcy system. This problem is aggravated by large dollar

     declination policies which preclude prosecution of the smaller frauds, particularly

     individual bankruptcies. State authorities are often reluctant to step forward and to

     prosecute the smaller fraud cases because they quite properly view bankruptcy as

     a particularly federal responsibility, and because state criminal statutes rarely

     apply to bankruptcy matters, When bankruptcy fraud becomes particularly

     widespread in a district, strong consideration should be given to waiving

     temporarily the local declination policies by prosecuting several exemplary cases

     which do not otherwise meet the normal district standards.

       The layman’s version of this statement could be summarized as “If you are going

to lie and cheat in bankruptcy, don’t be greedy. Pigs get fed. Hogs go to market. Unless

you are a lawyer, accountant or high profile person, you’re likely to walk.”
                                                     Deceit in Bankruptcy                   38

       Bankruptcy crimes must be referred to the Department of Justice where they are

investigated by the Federal Bureau of Investigation then, if warranted, prosecuted in

United States District Court by the Office of the United States Attorney. As noted earlier

in this paper, few of the cases referred to the Department of Justice in this matter are

eventually prosecuted. More immediately available in the bankruptcy system are

punitive civil remedies which can be imposed by the Bankruptcy Court (Heston, 1998,

Winter). These include:

                     Denial of overall discharge, or, for the exception of specific debts

                     from a discharge. If the debtor’s discharge is denied, either in whole

                     or in part, creditors may pursue the debtor for those portions of the

                     debt not paid in the bankruptcy proceeding.

                     Appointment of a trustee or examiner by the court. Useful in a

                     Chapter 11 case, where the management of a debtor business

                     would be removed from the debtor-in-possession and assigned to a

                     trustee.

                     Dismissal of the case. This can happen by either a motion from the

                     U. S. Trustee or the court itself. This removes the debtor from all

                     protections of bankruptcy.

                     Conversion of the case from a Chapter 11 or Chapter 13 case to a

                     Chapter 7 case. Chapter 11 cases usually involve businesses

                     where the owner or managers of the bankrupt are allowed to

                     continue to manage the company as a debtor-in-possession. In

                     Chapter 13, individual debtors are allowed to repay their debts over
                                                       Deceit in Bankruptcy                39

                    a period of time. Both of these situations can be very beneficial to

                    debtors. A conversion strips the debtor of these benefits and forces

                    a case into a straight liquidation.

                    Avoiding and recovery powers of trustees. With these tools, the

                    trustee can void certain pre-petition and Chapter 11 debtor-in-

                    possession transfers for the benefit of the estate.

                    Equitable subordination. A process that allows a bankruptcy court

                    to rearrange the priority of claims of creditors. The effect of this

                    would to reduce the payment priority of a claim of a creditor who

                    has attempted to take unfair advantage of the bankruptcy system.

                    This could mean that the payment to a creditor would be eliminated

                    or reduced.

                    Sanction powers of bankruptcy judges. This allows a judge to enter

                    an order for contempt of court which would be forwarded to a

                    district court for adjudication.



                             Analysis of Bankruptcy Crime Cases


United States v. O’Donnell 539 F.2d 1233 (1976)

Facts: Appellant, O’Donnell overstated his earning capacity in a bankruptcy proceeding

by stating that he was employed by a specific company when, in truth, he knew that he

was not employed by that company. He was charged and convicted of violating 18

U.S.C. § 152(2)—knowingly and fraudulently making a false oath as to a material matter
                                                       Deceit in Bankruptcy                 40

in a bankruptcy proceeding. He contends that to constitute material false statements, he

would have to minimize his earning capacity.



Issue: Does the potential impact of a false statement on creditors constitute a factor in

determining the materiality of the statement to the case?



Decision: The United States Court of Appeals for the Ninth Circuit rejected the

appellant’s position.



Reasoning: Materiality does not require a showing that creditors are harmed by a false

statement. Matters are material if they pertain to the extent and nature of a bankrupt’s

assets including the history of his financial transactions. Materiality is also established

that the inquiry bears a relation to a bankrupt’s business transactions, his estate, or

concerns the discovery of assets. Statements designed to secure adjudication by a

particular bankruptcy court are also material. In this case, the statements concerned his

ability to acquire assets and may have induced the court to decide the matter in a

method advantageous to him.


United States v. Ellis 50 F.3d 419 (1995)

Facts: Appellee Ellis filed eight bankruptcy petitions in an eleven-year period. Three of

the petitions resulted in the discharge of his debts, while the others were dismissed for

different reasons. Mr. Ellis’s petitions that resulted in discharges were filed using

different social security numbers on each petition. In each of his filings, Ellis simply left

blank questions regarding previous bankruptcies. Additionally, applied for loans and
                                                     Deceit in Bankruptcy                   41

insurance policies using different social security numbers. His support for these

applications included altered W-2 forms. He was tried and convicted of violating 18

U.S.C. § 152(3)—knowingly and fraudulently making a false declaration in a bankruptcy

case. Ellis’ challenge to his conviction is that simply not answering specific questions

does not constitute “making a false statement.”



Issue: Is the defendants failure to answer questions on a bankruptcy petition constitute

a “false statement” under § 152?



Decision: The United State Court of Appeals for the Seventh Circuit determined that

failure to answer questions on a bankruptcy statement constitute “making a false

statement.”



Reasoning: In United States v. Lindlholm, 24 F.3d 1078, the Ninth Circuit determined

that “...an omission is the equivalent of a false statement.” The Court noted that in the

context of others subsections of 18 U.S.C. § 152, the failure to list various assets of a

corporation on a schedule of assets prepared in conjunction with a bankruptcy

constituted an omission sufficient to support a conviction for bankruptcy fraud. The

Court further noted that in order to appropriately dispose of a petition, the bankruptcy

court must first be provided with an accurate record of a debtor’s financial affairs. The

courts depend upon the accuracy of information filed with bankruptcy petitions. The fact

that Ellis was able to obtain three Chapter 7 discharges in a seven-year period is ample

evidence of the need for full and complete disclosure. Therefore, to be faithful to
                                                      Deceit in Bankruptcy               42

Congressional intent, misleading omissions must be treated in the same manner as

blatantly false statements.



                           Major Case - Murray Packing Company

       In the early 1960s, Murray Packing Company, located in New York, was a

legitimate business. The company supplied meat, poultry and eggs to wholesalers in the

restaurant and food industries. It was struggling financially and short of working capital.

At the suggestion of one of their salesmen, Joe Pagano, the company borrowed $8,500

from Jo-Ran Trading Company at 1% per week interest. Jo-Ran was owned by a

gentleman named Peter Castellana. Of course, Murray was unable to make the

required payments on the loan which kept growing.


The takeover

       As a condition of continuing the loan, Castellana insisted that Pagano be made

an executive for Murray with broad financial powers. Using his new power, Pagano

initiated the scam.


Starting the scam

       Pagano entered into a series of transactions with Pride Wholesale Meat and

Poultry Company—controlled by Castellana. Concurrently, he began making a large

number of relatively small purchases from a number of suppliers around the country.

Most of the product was sold to Pride Wholesale who paid Murray promptly allowing the

suppliers to be paid in a timely manner. This lasted for a couple of months before the

next step was initiated.
                                                     Deceit in Bankruptcy                 43

Executing the scam

       Purchases increased thirteen-fold within a 2-3 month period, with most of the

product continuing to be sold to Pride Wholesale. Castellana continued to pay promptly

but began to arbitrarily take discounts on the purchases so that most of the product was

being sold at or below cost. At the same time, Pagano was draining the bank account

on a regular basis by writing checks payable to “Cash” in an amount that eventually

totaled $745,000. As a result, Murray was unable to pay its suppliers in a timely

manner. The company continued to string them along with assurances that they would

get their money, “the check is in the mail,” etc. Because these assurances were given

by the original owners of the company with whom the creditors had a long relationship,

they shipped even more merchandise without getting paid.


Pulling the trigger

       Finally, the original owners of Murray called in their attorney who suggested that

they go to their creditors, tell them of Pagano’s appropriation of the money and try to

settle their claims at a large discount. This was unsuccessful and three of the creditors

filed an involuntary petition, putting the company into bankruptcy.


The outcome

       The creditors literally received pennies on the dollar when the matter was finally

settled eight years later. After protracted legal maneuvering, the major actors were

convicted of bankruptcy fraud in District Court.

       This case is an example of a classic “bust out” bankruptcy fraud. A “merchant”

buys small amounts of merchandise from suppliers—always paying on a timely basis.
                                                    Deceit in Bankruptcy              44

Over time the size of the orders increases greatly and they become much more

frequent. At the same time, payments on account become increasingly slower to the

point where no payments are made. Many times the supplier must be cajoled through

this process and convinced to ship ever increasing amounts of merchandise without

receiving payment. Meanwhile, the merchant is busy selling the merchandise and

diverting the proceeds outside of the business. By the time that the supplier determines

that he can no longer conduct business on this basis, the merchant has closed his store

and left town leaving the suppliers “holding the bag.” (DeFranco, 1973)
                      Deceit in Bankruptcy   45

Link Diagram-Murray Packing Co.
                                                         Deceit in Bankruptcy                 46

                                         Risk Analysis


The risks

      In any bankruptcy, the net result of the process is that creditors (usually

businesses) are only paid a portion, at best, of money that is owed them by bankrupt

debtors. This presents a number of risk areas against which creditors must protect

themselves.

   • Credit risk

            The obvious and greatest risk that creditors face is credit risk, the possibility

   that a debtor will be unable to meet his obligations (Credit risk, n.d.). While there is

   credit risk in any financial transaction resulting in a debtor-creditor relationship, by

   the time that a debtor is in bankruptcy there is a very high probability that the creditor

   will suffer a financial loss.

   • Operational risk

            Operational risk is the possibility that breakdowns in internal controls and

   corporate governance lead to losses through error, fraud, failure to act in a timely

   manner or some other action that exposes the company to inordinate risk (Bank for

   International Settlements, 1998). Generally, the credit and collection systems and

   controls are not sufficient or have been bypassed. This could be related to attempts

   to overstate earnings, meet sales goals, collusion with purchasers to defraud the

   seller, or any number of fraudulent schemes.

   • Reputational risk

            Reputational risk is the potential that negative publicity, whether true or not,

   will cause damage to an entity’s customer base and consequently, its revenues and
                                                       Deceit in Bankruptcy                  47

   profits (Federal Reserve Bank Of Chicago, n.d.). Bank risk managers rate

   reputational risk as the biggest risk to the market value of their companies and sixth

   as a risk to earnings (Williams, 2005). This risk is related to the prominence and size

   of the companies involved.

   • Legal risk

           Legal risk is the risk attributable to uncertainty due to legal actions or

   uncertainty in the applicability of laws and regulations (Legal risk, n.d.). This could

   be either the added cost of pursuing a claim in bankruptcy or defending litigation

   related to the case. This has occurred with Citibank and J.P. Morgan, both of whom

   have agreed to make large settlements in the Enron bankruptcy.

   • Strategic risk

           Strategic risk is the risk that an action or inaction by an entity will be of such a

   magnitude that the ability of the business to function as a going concern is at risk

   (bankersonline, n.d.). This would occur if a company allowed a customer’s account

   balance to get so large that the inability to collect that amount could test the

   company’s ability to survive.


Existing solutions

       At present, solutions lie at two levels:

   • Creditor organizations

       This solution relies on credit granting organizations to establish sufficient credit

and collection policies and controls to minimize their exposure to bankruptcy losses,

whether legitimate or fraudulent. This is currently the first line of defense and will likely

continue as such into the future.
                                                       Deceit in Bankruptcy                48

   • Bankruptcy system

       The detection of bankruptcy fraud can originate from two sources. First, although

unlikely, is through an independent investigation by the government. The second, and

more likely source, is when a party with an interest in a bankruptcy case complains to

the United States Attorney or other court officer.

       During the course of a bankruptcy, it is not uncommon for allegations of

misappropriation, asset concealment, conflicts of interest or other fraudulent behavior to

become apparent to a judge or trustee. Should that person have a reasonable belief

that the bankruptcy laws may have been violated, they are mandated to initiate a

criminal investigation (Ogier & Williams, 1998).



                      Recommendations for Future Implementation


Development of a comprehensive bankruptcy database

       In the early phases of research for this paper, it became increasingly obvious that

while there is an abundance of generalized knowledge about bankruptcy, there is little

specific knowledge of the topic. The Inspector General of the United States Department

of Justice (2003) was unable to identify reliable factual data on the subject owing either

to failure to attempt to collect statistics or errors in the collection procedures. Because of

this, decisions regarding the bankruptcy system and those who seek protection are

made without full knowledge. A good example of this type of ill-informed decision-

making is the passage of the Bankruptcy Abuse Prevention and Consumer Protection

Act of 2005. Clearly, some debtors abuse the system by either incurring large amounts

of consumer debt immediately before filing or filing serial bankruptcies in which they
                                                      Deceit in Bankruptcy                  49

repeatedly file for protection and elimination of debts. The occurrence of this type of

abuse was frequently cited as a reason why the 2005 Bankruptcy Act was needed.

Supporters of the legislation advanced the position that such abuses were widespread.

Other research indicated that the vast majority of filers are victims of high medical bills,

job loss, and the breakdown of marriages. In order to make appropriate decisions,

lawmakers must know the facts. This situation must be improved. This will require

collection of adequate reliable financial data on every bankruptcy case that is filed and

compilation of the information into a national database. An example of data that could

be collected includes:

          •   Income of the petitioner

          •   Types and amounts of debt, e.g., credit card, mortgage, medical debt,

              mortgages, etc. This would include an analysis of secured and unsecured

              debt.

          •   Assets and types of assets held by the debtor.

          •   Education level

          •   Petitioner’s health

          •   Petitioner’s employment status

          •   Previous filings

       By collecting this type of data, a clearer analysis of the bankruptcy problem will

be possible. A model for this type of system would be the data collection system used

by the Internal Revenue Service. The Taxpayer Compliance Management Program

(TCMP) randomly selects a number of tax returns for a very thorough audit during which

every entry on the return is verified. As a result of this process, the IRS has a very
                                                      Deceit in Bankruptcy              50

comprehensive cross-section of all tax returns filed. This program allows them to

determine a number of relationships between reported amounts appearing on tax

returns. Use of this technique has allowed them to determine, for example, the average

charitable contributions of a person whose income falls within a specific range, the

average travel and entertainment expense for a CPA who earns $125,000 per year, etc.

This information is valuable for at least two purposes:

   • Determining the characteristics of the system and having valid information for

       decision-making purposes.

   • Providing a “yardstick” for evaluating other cases as discussed below.

       Sections 158 and 603 of the Bankruptcy Abuse Prevention and Consumer

Protection Act of 2005 require that the Department of Justice collect and analyze a

variety of statistical information designed to allow for better management of the

bankruptcy program. The studies required under these sections are somewhat narrow

and may only be of limited use. To be truly effective, this program must be expanded to

its full potential, gathering significant amounts of data in an organized manner.


Determine the national priority of bankruptcy fraud

       Although it may seem unfortunate at times, the United States only has a finite

amount of resources to devote to law enforcement activities. Many areas are worthwhile

candidates to receive significant tools to address their issues, be it child pornography,

illegal drugs, terrorism or any number of other areas. When the bankruptcy is better

understood, both in terms of size and scope, the country as a whole, through Congress

and the Executive branch of our government, should determine the relative priority of

bankruptcy fraud as compared with other crimes to determine an appropriate allocation
                                                       Deceit in Bankruptcy               51

of assets (both money and personnel) to be employed to combat this crime. It could

very well be that the societal risk of bankruptcy fraud will pale in relation to drugs,

violent crime, and terrorism. Should this be the case, then the priority of bankruptcy

fraud will be downgraded and it will be allocated fewer resources. If this is the case, the

prevention, detection and prosecution of bankruptcy fraud will remain below ideal levels.

This is no different than local law enforcement emphasizing drunk driving enforcement

at the expense of lesser enforcement of other laws.


Analyze each new petition when it is filed

       This recommendation assumes that a national database as described above is,

at least, partially implemented. With this tool, all new petitions should be “scored”

against the proposed national database in an attempt to identify those filings warranting

additional scrutiny. This process would be very similar to the IRS’ Discriminate Function

program where each return that is filed is “scored” against the TCMP generated

database as described above. This process would analyze various ratios, apply

Benford’s law (a data analysis technique dealing with the frequency of various first and

second digits in a set of numbers), etc. in order to detect potentially incorrect,

fraudulent, or abusive filings. The nature of these tests cannot be determined until a

comprehensive statistical model is established. A part of this procedure would be to

winnow out true “no asset” Chapter 7 cases, which now comprise in excess of 85% of

all filings. These cases, if legitimate, have no recoverable assets and, therefore, no

chance that creditors will receive any compensation from the estate. These cases must

be quickly and accurately identified so that they may be adjudicated with the least cost

to the bankruptcy system. This will allow the courts and trustees to concentrate their
                                                        Deceit in Bankruptcy                52

efforts on pursuing cases that are either fraudulent or have some hope of asset

recovery.


Authentication of the identity of petitioners

       As discussed earlier in this paper, there is some incidence of identity fraud within

the bankruptcy system, although the size and impact of this fraud remains unknown.

This fraud takes two forms:

            •   A fraudster assumes the identity of an innocent victim, making various

                purchases, including real estate and motor vehicles, under this assumed

                identity. Of course, few, if any, payments are made on the related debt.

                Finally, when the collection efforts become too intense, the perpetrator

                files a bankruptcy petition, fraudulently identifying himself as the

                unknowing victim.

            •   Multiple bankruptcies are filed by the same person with each containing a

                variation of the perpetrator’s true name and Social Security Number. Each

                of these filings is done for fraudulent purposes.

       To help prevent these frauds, the true identity of the filer must be verified. While it

is simple to require that anyone filing a bankruptcy petition present a photo ID, it is

equally simple for a fraudster to obtain a fake ID. Verification of one’s identity by the

bankruptcy court is as thorny an issue for them as is the verification of identity by a

commercial entity. The courts could employ the same methods, as do commercial

enterprises, such as review of data from multiple sources including credit bureaus,

comparison of fingerprints to national databases, etc. While this would be, at least,

somewhat effective, the cost of this process becomes an issue. With the vast majority of
                                                      Deceit in Bankruptcy                  53

bankruptcy cases being “no asset” Chapter 7 cases, with debtors often struggling to

garner the legal and filing fees required to file their cases, charging them for this

process would be yet another roadblock. Bankruptcy trustees in “no asset” cases are

paid a nominal fee of about $60 for each case that they handle, so expecting them to

pay is not realistic. This leaves the taxpayers with the financial burden of identity

verification. This expense is subject to a cost-benefit analysis, with the results being

unclear at this time.


Verification of financial data

       In order to attain a reasonable level of compliance with the current bankruptcy

statutes, some level of auditing is required. This is analogous to the situation that the

IRS faces—if some verification is not done on at least a test basis, the level of

compliance with the Internal Revenue Code will be low. The procedure followed by that

agency would be a good place to start in designing a program for the bankruptcy

system where all filings are “scored” against a national database as previously

described with those cases scoring out of the normal range selected for manual review

and possible audit.

       Actual auditing of filings is done on both a selected basis based on scoring the

petitions and others are randomly selected for review. Presently, the vast majority of

IRS audits are aimed at specific items on a return (e.g, travel expense for a business,

reported gross profit, unusual relationships between numbers, etc.) so that only a

portion of a return is reviewed.

       While comparison to systems and procedures utilized by the IRS is attractive, the

differences in missions of these agencies present potentially insurmountable problems.
                                                      Deceit in Bankruptcy                 54

In the case of the IRS, collection of tax revenue is at stake. The IRS tries to conduct

audits only where there is a significant probability that the examination will be

profitable—the revenue collected as a result of the procedure will exceed the costs

involved in performing the examination. This is why the probability of a self-employed

professional earning $200,000 per year being audited is significantly higher than that of

a person working for wages and earning $20,000 per year. Within the bankruptcy

system, the possibility that revenue will be generated to offset the costs of such

enforcement is virtually non-existent.


Increased use of punitive civil sanctions

       When studying bankruptcy fraud, the reader gets the definite impression that

relatively small instances of deceit and outright fraud may simply be disallowed by the

U.S. Trustee or the Bankruptcy Court without the imposition of meaningful sanctions. As

Heston (1998, Winter) discussed, there are a number of punitive civil sanctions that can

be imposed by the court, some of which can have significant repercussions. For

example, these could include either partial or full denial of discharge, wherein the court

permanently bars the discharge of specific debts in the instant or any future action,

allowing creditors to pursue a debtor who no longer enjoys the protection of the court.

Equitable subordination allows the court the authority to rearrange the priority of claims

within the bankrupt’s estate. The effect would be to deny or reduce payment to a

creditor that would otherwise be paid in order to assure equitable treatment of all

parties.

       The benefit of these types of actions is that, being civil in nature, they do not

require the participation of either the FBI or the U.S. Attorney’s Office. While the
                                                       Deceit in Bankruptcy                55

penalized party could appeal the court’s ruling, it seems unlikely that there would be a

large number of such appeals. Increased use of these sanctions would likely reduce the

incidence of attempted abuse.


Potential limitations on implementation

       The author realizes that the recommendations contained in this paper are

generally couched in such terms as cost-benefit analysis; however, it is believed that

failing to do so is unrealistic. While the prevention and detection of bankruptcy fraud is a

laudable goal, the reader has to examine the costs required to do so and the related

benefits to our society as compared with alternative expenditures of taxpayer dollars.



                                         Conclusion

       Implementation of the provisions of the Bankruptcy Abuse Prevention and

Consumer Protection Act of 2005 Act is an appropriate first step toward reducing the

incidence of bankruptcy fraud, and the economic damage caused to innocent victims. At

this time, it is far too early to determine whether these provisions will be given sufficient

priority and adequate financial and operational resources by our government to be

effective. The reality is that the priorities of the federal government are being

increasingly focused on terrorism and violent crime in terms of both financial and human

resources. Therefore, the relative importance of bankruptcy reform as well as fraud

deterrence and enforcement are political questions to be resolved at the highest levels

of our government. It is quite possible a determination will be made that the risks related

to bankruptcy fraud pale in comparison with others and that the status quo for detection

and prosecution of these crimes will be maintained in the foreseeable future.
                                                    Deceit in Bankruptcy              56

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                                                      Deceit in Bankruptcy                 63

                             Appendix I – Glossary (Selected)

       Chapter 7 – A full liquidation of the bankrupt’s estate. The trustee collects and

sells the non-exempt assets of the estate and distributes the proceeds to the creditors.

This is the most common type of bankruptcy.

       Chapter 11 – The reorganization of a debtor (generally a business) that allows it

to continue to operate the business under the supervision of a trustee, using future

profits to pay creditors. Under this chapter, the debtor can shed, subject to the approval

of the court, labor contracts, pension plan obligations, leases and some debts. Most

notable bankruptcies in recent years (Enron, K-Mart, United Airlines, etc,) have availed

themselves of this option.

       Chapter 13 – An adjustment of the debts of an individual. In this process, some

debts are paid and some discharged.

       Federal Rules of Bankruptcy Procedure – The codified rules of the United States

Bankruptcy Courts established by the Supreme Court under the authority of Congress.

       Rule 2004 – A provision of the Federal Rules of Bankruptcy Procedure that

allows parties in interest, upon court order, to examine any entity regarding acts,

conduct, property, liabilities and financial condition of a debtor. (United States

Bankruptcy Court, n.d.)

       Section 341(a) hearing – The initial informational meeting between the debtor,

trustee, and creditors, if they choose to attend, where the trustee asks the debtor basic

questions regarding the case. No action is taken at this meeting which is frequently

skipped by the creditors.
                                                      Deceit in Bankruptcy              64

       Trustee – A private person (frequently an attorney or accountant) or company

who administers a bankruptcy for a fee under the general supervision of the United

States Trustee. The trustee’s fee us generally based on a percentage of the assets that

are liquidated.

       United States Bankruptcy Court – A part of the U.S. District Courts devoted to

supervising and litigating bankruptcy cases. In most smaller cases, the Courts

involvement is very limited, leaving the bulk of the work to the trustees.

       United States Trustees – An arm of the Department of Justice charged with

administrating the bankruptcy system. This office frequently administers very large

bankruptcies.