The Governments Approach to Fraud-Induced Bankruptcies of Large Public Companies

Journal Issue

Feb 2006

Column Name

Affairs of State

Citation

ABI Journal, Vol. XXV, No. 1, p. 12, February 2006

Bankruptcy Code

1104

1106

Topic Tags

Fraud

Public Companies and Claims Trading

Journal HTML Content

Companies do not always simply fall into
insolvency because of bad business plans or unforeseen market trends.
Sometimes they are pushed by accounting fraud, embezzlement or other
crimes. From massively convoluted frauds at WorldCom and Enron to
outrageously brazen schemes at companies such as Allou Healthcare,
public companies can suffer traumatic financial injury from criminal
conduct that significantly complicates the analysis of a
debtor’s assets and claims against it and creates a large number

of interested parties that are competing for the same or similar
information. The Deputy Attorney General (DAG) stands at the
crossroads of criminal, civil and policy decisions in the Department
of Justice (DOJ). As, effectively, the Chief Operating Officer of the
DOJ, the DAG ultimately supervises all U.S. Attorneys and all U.S.
Trustees, as well as the Criminal and Civil Divisions and the
DOJ’s Office of Legislative Affairs. The appointment
of examiners in the Enron and WorldCom bankruptcies marked the
beginning of a more assertive attitude toward a thorough investigation
of a debtor’s affairs where fraud played a central role in the
debtor’s insolvency. The Bankruptcy Code has long made available

the appointment of an examiner to investigate the sources of the
insolvency and legal claims for and against a chapter 11 debtor. In
more serious cases, the Code also provides for the appointment of a
chapter 11 trustee to assume the additional duties of managing the
debtor’s business. The recent amendment of §1104(e) of the
Code makes it mandatory for a U.S. Trustee to file a motion for the
appointment of a chapter 11 trustee “if there are reasonable
grounds to suspect that current members of the governing body of the
debtor, the debtor’s chief executive or chief financial officer,

or members of the governing body who selected the debtor’s chief

executive or chief financial officer, participated in actual fraud,
dishonesty, or criminal conduct in the management of the debtor or the

debtor’s public financial reporting.” These
developments ensure that in the future more bankruptcies will undergo
the searching analysis of an examiner or trustee. In aid of ultimately
producing important clarity and transparent justice, these
developments also portend greater procedural complexity that will not
only require a mastery of bankruptcy practice, but also a detailed
knowledge of the inner workings of governmental investigations, as
well as the interplay between the two. Balancing Interests

in WorldCom The bankruptcy of telecommunications
giant WorldCom in 2002 was the largest insolvency in American history,

and it brought with it an unprecedented level of notoriety and public
interest in the legal resolution on all fronts. A criminal prosecution

and an SEC enforcement action, venued in the Southern District of New
York, soon competed with the bankruptcy case conveniently located in the

same district. Congress subpoenaed a number of the debtor’s
employees, and congressional investigators interviewed many other
people. The SEC enforcement proceeding produced a “corporate
monitor” that was appointed by and reported to the U.S. District

Court for the Southern District of New York. The WorldCom corporate
monitor was authorized to oversee the ongoing operations of the
company.2 In the midst of these
developments, the U.S. Trustee sought the appointment of an examiner.
The bankruptcy court complied, appointing former Attorney General
Richard Thornburgh to the post. While an officer of the bankruptcy
court, and ultimately responsible to the bankruptcy court to deliver
his reports, the WorldCom examiner was directed to coordinate his
actions with the DOJ, the SEC and the corporate monitor. As a
practical matter, this required that two different arms of the DOJ,
each with different missions and priorities—the prosecutors of
the U.S. Attorney’s Office and the bankruptcy supervisors of the
U.S. Trustee’s Office—to find a modus vivendi while

juggling the needs of regulators, Congress and, of course, creditors
and other interested parties. The DOJ had to wrestle with
the different interests and competencies of the various investigating
agencies. Because the DOJ’s primary mission is the enforcement
of federal law with an emphasis on criminal enforcement where
appropriate, the DAG decided that ensuring the success of the criminal

investigation must come first, followed by assisting where possible
(and certainly not hampering) the SEC’s parallel regulatory
investigation. Once these enforcement needs were fulfilled, the Office

of the Deputy Attorney General (ODAG) encouraged its prosecutors and
the SEC’s investigators to support the examiner and the
bankruptcy court in the effective resolution of the bankruptcy case. In

addition, ODAG was mindful that it needed to assert the claims of the
United States as a creditor and to provide necessary access to
information for Congress. ODAG met regularly with
counterparts from the SEC’s Division of Enforcement to both
interface with the SEC’s investigation and coordinate with the
corporate monitor. Separately, ODAG met with congressional staff to
broker their concerns over the subpoenaing of witnesses and documents
in aid of Congress’ inquiries. ODAG developed
ordering principles that provided a rough guide to the distribution of

information among the many interested governmental parties. First, ODAG
recognized that all parties had a legitimate claim to information for
use in the various proceedings such that, to the extent that a witness

or documentary evidence could be shared without endangering the
investigations, they would be. Driving this analysis was the
understanding that while the prosecutors were working diligently to
build a criminal case against individuals, the SEC already had filed a

civil case and the examiner was under an ongoing and pressing duty to
file periodic reports with the bankruptcy court. Second, ODAG

reached an agreement with the SEC that the criminal prosecutors would
have the first claim on information—that is, prosecutors could
decide whether a given witness should be allowed to speak only to the
criminal investigators, to the criminal investigators and the SEC, or
to the examiner as well. Furthermore, the prosecutors could limit the
scope of interviews by others by excluding particular topics. This
required the ODAG to ensure, for example, that the examiner’s
reports did not contain information that would prematurely disclose
information discovered by the criminal investigators that they were
seeking to use to advance the criminal prosecutions. As a mutual
accommodation, on several occasions the prosecutors and the SEC
permitted the examiner to interview government witnesses on the
condition that the examiner delay the publication of the information
derived from these interviews until its release would no longer threaten

to undermine the government
investigations.3 ODAG also agreed
on behalf of both the U.S. Attorney and the U.S. Trustee that the SEC
would have the second claim on all information and the right to protect

its civil enforcement action against the premature disclosure of
information through the examiner. Thus, where the SEC had developed
information in support of its parallel but separate investigation, it
would enjoy the same rights of priority that the criminal prosecutors
had vis-à-vis the examiner. Finally, ODAG was
continuously sensitive to the need to tread a careful line with regard

to the exchange of information between the examiner and the prosecutors.

The strict limitations of grand jury
secrecy4 prevented the disclosure to the
examiner of information developed through criminal subpoenas. That
included not only grand jury testimony, but subpoenaed documents as
well as any information directly derived from testimony or
documents. On the other side, ODAG was concerned that the
transmission of information from the examiner to the prosecutors would

spur the allegation that the examiner acted as an agent of the
prosecutors. Had the prosecutors provided information to the examiner
or directed the examiner as to his inquiries, a criminal defendant
might argue that information produced to the examiner, whether via
interview or writings, was somehow improperly obtained through a
deceptive use of civil process or insufficiently disclosed pursuant to

18 U.S.C. §3500. Moreover, that perception would have undermined
the inde-pendence of the examiner, whose first duty was to the
bankruptcy court. In combination, these perceptions could have impeded

the examiner’s investigation by chilling witnesses who might
have otherwise been forthcoming with the examiner. ODAG addressed this
concern by personally managing the ground rules for contact between
the examiner and the prosecutors, serving as a filter and buffer
between parties who needed to cooperate but who also required some
degree of separation. The Examiner’s Role in the
Context of a Government Investigation The WorldCom and
Enron bankruptcies provide significant insight as to what an examiner
can do in the context of a large commercial bankruptcy with significant

criminal and regulatory investigations. First and foremost, the
examiner is charged with the responsibility to “investigate the
acts, conduct, assets, liabilities and financial condition of the
debtor, the operation of the debtor’s business and the
desirability of the continuance of such business, and any other matter

relevant to the case or to the formulation of a
plan.”5 Furthermore, the examiner must

prepare a report covering “any fact ascertained pertaining to
fraud, dishonesty, incompetence, misconduct, mismanagement or
irregularity in the management of the affairs of the debtor, or to a
cause of action available to the
estate.6 Second, an examiner must
operate with the skill of a diplomat. While they are invested with the

authority of the bankruptcy court, they must still contend with other
parties often aggressively competing for the same information. An
examiner must understand who those other parties are, what they want and

what tools they can apply to accomplish their objectives. Because an
examiner is in a procedurally weaker position than the government
investigative agencies, an examiner must adapt his or her
investigation to the realities of the circumstances of the case to
successfully complete their mission. Prosecutors and Other

Investigators The most powerful among the investigating
parties are the prosecutors. A prosecutor’s primary
responsibility is to seek punishment for criminal acts, such as
securities fraud or embezzlement that can harm businesses and deepen
the woes of failing companies. In this process, prosecutors also will
seek redress for fraud victims—creditors and shareholders
alike—but not necessarily subject to the priorities established
in the Code. Prosecutors need information to build their
criminal cases, and the law equips them with powerful tools to both
obtain the required information as well as protect such information
from disclosure to potential defendants and other interested parties.
The threat of prosecution can induce the debtor and individuals with
knowledge of the suspected fraud to supply prosecutors with information
that may be withheld from other interested parties in the initial
phases of a bankruptcy case. Finally, prosecutors can seek and most
often receive—even before an indictment is issued—a court
order staying proceedings in any other action to the extent that such
proceedings may interfere with the criminal investigation.

Following closely behind the prosecutors are the SEC and other
regulators—including the CFTC, FCC, FERC and state regulatory
authorities. These regulators have significant independent power over
businesses and associated individuals. For example, most federal
regulators can issue administrative subpoenas for testimony under oath

and can require the production of documents on pain of fines or
sanctions including debarment from conducting business with the U.S.
Government. Regulators often operate in tandem with prosecutors,
although they shrink from complete parallelism for reasons including
grand jury secrecy and the desire to maintain regulatory independence.

Subject to the automatic stay provisions of the Code, regulators often

enjoy the power to bring enforcement proceedings against a debtor that

proceeds separately from the bankruptcy case and may be filed in a
different district. Moreover, because regulators operate with civil,
rather than criminal, enforcement power, their burden of proof at
trial is lower and their scope of scrutiny may be broader than that of

the prosecutors. Congress has evinced its interest in
fraud-provoked bankruptcies. Subsequent to the bankruptcy filings by
WorldCom and Enron, congressional investigators sought to interview
employees and former employees of those companies. Congressional
committees issued subpoenas for public testimony and the production of
documents. Congress’ role in these matters is self-defined.
While it may develop new legislation, its retrospective inquiry
seeking information about suspected fraud competes with prosecutors,
regulators and all other interested parties that are seeking the same
or similar information. Conclusion The
fraudulent nature of the contemporary mega-bankruptcies and the recent
revision to the Code requiring U.S. Trustees to move for the
appointment of a chapter 11 trustee in cases of suspected fraud,
coupled with the principle of seeking examiners in appropriate cases,
will produce an increasing number of bankruptcies that attract the
searching analysis of an independent review—in addition to any
prosecutorial or regulatory investigation. That trend requires
practitioners in the financial restructuring arena to remain aware of
the possibility of the appointment of a trustee or examiner and to be
sensitive to the dynamic of parallel, if not competing,
investigations. If the federal government continues to juggle these
enforcement priorities wisely, it can produce markedly positive results

for creditors and shareholders as well as the public at large.
<hr><h3>Footnotes</h3><div class="para259"> 1 Prior to
joining the Eastern District, Mr. Hruska was the Senior Counsel to
U.S. Deputy Attorney General Larry Thompson, where he coordinated the
creation and implementation of the President’s Corporate Fraud
Task Force, supervised the drafting of the Department of
Justice’s (DOJ) corporate prosecution principles (commonly known

as the “Thompson Memorandum”), and directed the
DOJ’s contribution to the criminal provisions of the
Sarbanes-Oxley Act. Among his many tasks at the DOJ, Mr. Hruska was
personally responsible for the coordination of the myriad of
governmental agencies in their criminal and civil prosecution in the
WorldCom case. </div><div class="para259"> 2 SEC v. WorldCom Inc., 2002 WL 1788032 (S.D.N.Y. Aug. 2, 2002) (order of the
U.S. District Court for the Southern District of New York appointing
the corporate monitor); SEC v.
WorldCom Inc., 2002 WL 31748604
(S.D.N.Y. Aug. 27, 2002) (order of the U.S. District Court for the
Southern District of New York expanding the corporate monitor’s
duties to include supervision of ongoing company business practices).

</div><div class="para259"> 3 Testimony of
Bankruptcy Examiner Richard Thornburgh before the Senate Judiciary
Committee, July 22, 2003, available at <a href="http://judiciary.senate.gov/testimony.cfm?id=%20%20%20%0D%0A%0D%0A846&a…
846&wit_id=2440</a>. </div><div class="para259"> 4 Fed. R. Crim. P. 6(e). </div><div class="para259"> 5 11 U.S.C. §§1106(a)(3) and 1106(b).

</div><div class="para259"> 6 11 U.S.C.
§§1106(a)(4)(1) and 1106(b).

Journal Authors

Andrew C. Hruska

H. Slayton Dabney

Samuel S. Kohn

Journal Date

Wednesday, February 1, 2006 - 12:00

Bankruptcy Rule

2006

none