Send in the SWAT Team Investigating Embezzlement from Bankruptcy Trust Funds

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Apr 2000

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On January 11, Tricia Mendoza of Norwalk, Calif., was sentenced to one year in prison and

ordered to pay almost $250,000 in restitution for embezzling from a chapter 13 trustee

operation.<a href="#2" name="2a">2</a> Mendoza was the receptionist in the trustee office's, as well as the person

responsible for updating the trustee's computer files to reflect changes in creditors' addresses,

assignments of claims between creditors, and other modifications in the designation of

disbursements. As a result of her position, Mendoza was able to rig the trustee's computer

system to send creditor payments to an address that she controlled by changing creditors' names

and addresses to the name and address of an accomplice.

When the embezzlement was discovered by a co-employee, the U.S. Trustee Program (USTP)

sent a reconstruction team to inspect the trustee's computer files and financial records. The

team discovered that Mendoza began embezzling in 1996. It was discovered that Mendoza not

only embezzled $180,000 in creditor disbursements by manipulating the computer system, but

that she also stole tens of thousands of dollars in cashier's checks and checks that were payable

to "cash."

Each year, more than $4 billion flows through the offices of chapter 7, 12, and 13 bankruptcy

trustees.<a href="#3" name="3a">3</a> These funds represent debtor payments deposited into trust accounts or funds from

liquidated assets, as well as the interest that accumulates on those trust balances. Some estate

funds are received by the trustee within a short period, as in a chapter 7 liquidation, while

other payments are received monthly for up to five years, as in a chapter 13 case. In a typical

chapter 13 case the funds may stay in the trust account for only a month or two before being

distributed, while in a chapter 7 case the funds may remain undistributed until all assets are

liquidated and all relevant court actions reach final disposition.

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<big>Investigating the loss, reconstructing the actions leading to the

loss and taking remedial actions all involve a substantial

investment of time and effort by the USTP, the trustee, the

trustee's employees, banks, creditors and debtors.

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Given the scope of money received and distributed through the bankruptcy system, it is critical

to take steps to ensure the safety of those funds. Consequently, the USTP and the private trustees

have imposed a variety of safeguards to protect this money from improper diversion.

Frequently, the trustee is the lone signatory on the trust account, thereby restricting their

employees' ability to issue checks. Other internal controls have also been established in the

trust operation to ensure that no employee has too much access to the funds, the books or the

computer records. Moreover, trust funds are subject to periodic audits by the USTP or

independent auditors.

<h3>Theft from the Trust: Rare But Serious</h3>

Because of the many safeguards imposed by the private trustees and the USTP, theft from a

bankruptcy trust operation is rare. Yet theft still occurs, and its potential for growth could

increase with the upward trend in cases under administration and dollars flowing through the

system.

Thefts from bankruptcy trust operations take various forms, reflecting the amount of money at

stake and the different ways in which funds enter the bankruptcy system: Funds may be

misappropriated and not disbursed to the proper creditors, parties or debtors; bankruptcy

estate assets may be misappropriated prior to being secured by the trustee; or checks may be

written on the estate or trust account payable to an unrelated third party.

An emerging area of concern is check forgery, most often by a party not connected with the

bankruptcy system. A distribution check to a creditor may be stolen from the mail or from its

final destination. With today's advanced print and imaging technology, a check to a creditor can

be scanned and then altered and re-issued. If trust check stock is improperly stored, a thief may

steal that stock and forge the trustee's name.

The most effective method for preventing fraud and embezzlement is through controls

implemented by the USTP, the trustee and the trustee's bank, all of which act as significant

deterrents and means for catching fraudulent activities in the trust operation. The USTP works

closely with trustees to develop a variety of oversight mechanisms to provide disincentives for

thefts, or to quickly discover and identify losses when a theft does occur. Trustees submit a

variety of reports to the USTP, and several embezzlements have been detected through the

review of these reports.

The USTP also relies on tips from attorneys, debtors, creditors and other members of the

bankruptcy community to identify situations requiring investigation. This kind of assistance

from the bankruptcy system's primary "customers" is essential in uncovering inappropriate

activities.

<h3>Investigating Allegations of Loss</h3>

1) Preliminary Assessment

When an allegation is received, the USTP immediately commences a preliminary assessment to

determine whether it is likely that a loss occurred. Depending on the allegation, this

preliminary investigation may include interviews with the trustee, the trustee's staff or

outside professionals.

Local USTP bankruptcy analysts‹accountants who frequently are certified public accountants or

have graduate accounting degrees‹may review specific case files or reports submitted by the

trustee and submit inquiries to the banks. Within a few days, the U.S. Trustee will determine

the likelihood of a loss to estate assets. If the U.S. Trustee determines that there was no loss, the

inquiry is ended.

However, if it is determined that a loss may have occurred, the matter is evaluated to determine

the best course of action. For example, if the evidence supports allegations that the trustee was

involved in the loss of estate assets, the U.S. Trustee may consider immediately filing in

bankruptcy court a motion to remove the trustee from the cases assigned to him or her to ensure

that the remaining assets are protected from theft.

Certain additional actions may be immediately necessary to safeguard estate assets. Estate

accounts may be frozen to eliminate the opportunity for further theft, and suspect staff may be

placed on leave.

2) Full-scale Investigation

Following the preliminary assessment, the Executive Office for the U.S. Trustee (EOUST) will

coordinate a full-scale investigation to verify the defalcation and to determine the exact nature

and amount of the loss. The USTP devotes significant resources to such a project.

Typically, a full-scale investigation is conducted by a team of USTP bankruptcy analysts

temporarily reassigned from field offices around the country. The type of investigation

conducted by the USTP is based in part on whether the allegations involve cases under

chapter 7, 11, 12 or 13.

The most thorough type of investigation reviews each case for diversions of assets from the

estate and for embezzlements of assets later in the administration of the case. The average

caseload for a chapter 7 panel trustee is 165 cases; a standing chapter 13 trustee's caseload

averages 4,450 cases. Unless there are obviating factors, the investigation team reviews every

open chapter 7 or chapter 11 case administered by the trustee. In an investigation of chapter 13

cases, the investigation team seeks to identify the scheme. In this way, the cases to be reviewed

are narrowed to those that could have been affected. Additionally, computer reports from the

trustee operation's database are relied upon to identify problem areas.

When misappropriations or other improper actions are discovered in a chapter 7 or chapter 11

case, the team of accountants reconstructs the trustee's records. Receipts and disbursements

from the estate accounts are reconstructed from bank records. This information is compared

with the official court file for the bankruptcy estate, with the trustee's file, and with other

pertinent information. Any inconsistencies are further researched.

The reconstruction team also looks for any other unaccounted for funds in the bank records,

such as a court-ordered sale where no funds were received, or a letter in the trustee's file

indicating a sale or turnover of bankruptcy assets to the trustee that were not entered on the

trustee's asset ledger for the bankruptcy estate. The team surveys debtors and debtors'

attorneys to determine whether all estate assets were liquidated and funds properly accounted

for by the trustee. Additionally, professionals such as auctioneers or brokers will be surveyed

regarding work they performed for the trustee or his employee.

In a large chapter 7 trustee defalcation that occurred several years ago, a team of USTP analysts

spent several weeks examining all the bank records and case files associated with the 60 open

cases being administered by the trustee. The investigation was precipitated by audit findings of

unexplained withdrawals of estate funds and by complaints from creditors. Findings of irregular

activity in the open cases led the team to review a number of closed cases. Every asset was

traced to final disposition; every case file was perused for references to unscheduled assets,

deposits from potential buyers of assets and tax refunds. The team requested financial records

directly from the bank and discovered that the trustee had altered copies of financial records in

the case file to mislead auditors. Each lead was followed up, requiring significant bank records

requests, written and oral correspondence to third parties to confirm transactions, and tracking

of the flow of funds between estates and to the personal benefit of the trustee. When the

investigation concluded, the team had documented estate losses exceeding $1.7 million.

When a loss occurs in a chapter 13 trust operation, the team reconstructs fraudulent activity as

in a chapter 7 investigation. However, because it might not look at each case individually, the

team initially relies on what is known about the means of the theft, and then looks at suspect

procedures that could allow other forms of theft to occur. Among other items, the team looks at

the trust operation's segregation of duties and its handling of returned items, debtor receipts,

funds turned over to the court registry account and outstanding checks. The team may analyze

the trust operation's database to examine non-confirmed cases more than 180 days old, cases

older than 60 months, cases with large funds on balance, cases with a negative balance of funds

on hand, and questionable cases that may be shell or suspense accounts.

Unusual discrepancies also will be investigated. The team will review inconsistencies between

the court's list of open chapter 13 cases and the trust operation's open case list. Similarly, the

team will investigate deviations between the court's registry account and the trust operation's

ledger of funds turned over to the court's registry account. The team also will examine

differences between the payee name on a disbursement check and the name of the claimant as

recorded in the proof of claim. An adjustment to computer records that changes an institutional

creditor to an individual creditor also will be reviewed.

The recent Mendoza embezzlement was discovered when the trustee's office received a call from

a debtor's attorney about his client's case. Based on this call, one of the trustee's employees

reviewed the case file, which revealed a problem with the assignment of a secured institutional

claim to an individual third party. Review of the claim and the payment record for the claim

showed misdisbursements to a third party. Further review from queries run on the trust

operation's database to find references to the third party revealed similar activity in other

cases.

The U.S. Trustee immediately sent several accountants to the trustee's office to work with the

chapter 13 trustee. While the trustee knew an employee was involved, no one knew who it was.

Local USTP analysts and the trustee queried the trustee's database, looking for all payments to

the third party, any employees or any family members of employees. The third party's bank

records were obtained and reviewed for deposits of trust funds. Within several days, with the

assistance of the U.S. Attorney's Office and the FBI, Mendoza was identified as the employee

involved in the theft.

The USTP sent in a four-member investigation team drawn from throughout the country.

Working with local personnel, the team examined the trust operation's internal controls.

Controls on access to sensitive areas of the trust operation's database had been purged,

apparently inadvertently, allowing the receptionist to create a fictitious creditor and change

creditor names from already existing claim holders to the name of the fictitious creditor. This

was done before the trust operation made its monthly disbursements. During the monthly

disbursement runs, misdisbursements were made to the fictitious creditor. After the monthly

disbursement run was completed, the name of the claimant was changed back to the correct

party.

During the reconstruction, the team discovered copies of two cashier checks in Mendoza's

personal files. Review of the relevant case file disclosed that the checks were returned to the

debtor because the checks showed an improper payee. However, no payments were later

recorded in the case file receipts ledger for the months noted on the cashier's checks. The team

verified with the bank that the cashier's checks were endorsed with the name of a third party

known by Mendoza and had been deposited into the third party's personal bank account. This

opened a new avenue of investigation.

The team then analyzed the procedures for processing debtor payments. Special and overnight

deliveries and walk-in payments by debtors were processed by Mendoza or by the person sitting

at the front desk at the time. The trustee's procedures required the person acting as receptionist

to post the receipt to a daily receipts register maintained as an electronic file in the computer

system. The team analyzed the electronic register for improper reversing entries. Receipts

were traced back to the case file to determine if they were posted to a debtor ledger. A statistical

sample of approximately 600 active debtors and debtors' counsel received a confirmation letter

on payments made in their cases. The team also secured the bank records of Mendoza and her

accomplice to identify additional debtor payments that were stolen.

3) Referral to the U.S. Attorney

In the Mendoza case, the U.S. Attorney's Office and the FBI were actively involved throughout the

USTP's investigation of the embezzlement. The U.S. Attorney and the FBI were informed early on

because the perpetrator had not been identified, and it was feared the theft would continue unless

law enforcement officers intervened.

More typically, the U.S. Attorney's participation begins when the U.S. Trustee formally refers

the case at the end of the investigation. The reconstruction team prepares a final report

documenting its findings, with all evidence attached as exhibits. The U.S. Trustee transmits a

referral letter to the U.S. Attorney, along with the investigative report.

USTP personnel involved in the investigation often assist the U.S. Attorney in prosecuting the

alleged perpetrator. This assistance may include actions such as obtaining records, analyzing

financial records, providing briefings, and acting as expert witnesses at grand jury hearings or

court proceedings.

<h3>Conclusion</h3>

Fraud and embezzlement in private trustee operations are rare. However, when they occur, the

loss of money can be significant. Investigating the loss, reconstructing the actions leading to

the loss and taking remedial actions all involve a substantial investment of time and effort by

the USTP, the trustee, the trustee's employees, banks, creditors and debtors. It is only this kind

of cooperative work that keeps fraud in check and preserves confidence in the bankruptcy

system.

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<h3>Footnotes</h3>

<a name="1">1</a> Ms. Hallowell serves as Chief, Standing Trustee Branch, in the Executive Office for United States Trustees' Office of Review and Oversight. Mr. Sorgaard is a Senior Bankruptcy

Analyst in the U.S. Trustee Program's San Francisco office. The views expressed in this article are those of the authors and do not necessarily represent the views of, and should

not be attributed to, the Department of Justice or the U.S. Trustee Program. <a href="#1a">Return to article</a>

<a name="2">2</a> See Jan. 12, 1999, press release issued by Alejandro N. Mayorkas, U.S. Attorney for the Central District of California. <a href="#2a">Return to article</a>

<a name="3">3</a> Executive Office for U.S. Trustees. Data does not include North Carolina and Alabama. Data is not available on chapter 11 cases. <a href="#3a">Return to article</a>

Journal Authors

Martha Hallowell

Michael Sorgaard

Journal Date

Saturday, April 1, 2000 - 12:00