What Should You Do If You Suspect Dishonesty or Fraud by a Corporate Debtor in a chapter 11 Bankruptcy Case?

Suppose you suspect that a corporate chapter 11 bankruptcy debtor has knowingly and willfully failed to disclose pertinent information on the schedules or statement of financial affairs, stolen property from a bankruptcy estate or defrauded a trustee or judge in connection with a bankruptcy. Your best course of action will depend upon whether you are counsel for the debtor, a trustee or examiner, a creditor, or counsel for the creditors’ committee. Unfortunately, there are few cases that suggest a course of action when a person suspects or discovers fraud in connection with a chapter 11 bankruptcy case. However, there are some statutes and rules that provide some guidance.

Attorneys for the Debtor-in-Possession

When an attorney for a corporate debtor-in-possession (DIP) discovers fraud, that attorney must act in accordance with his rules of professional conduct. In 42 states, those rules are based on the Model Rules of Professional Conduct promulgated by the American Bar Association. There are two seemingly conflicting rules that are implicated when a chapter 11 debtor’s counsel detects fraud in a bankruptcy case.

Model Rule 1.6 provides that, with certain exceptions, an attorney is prohibited from revealing any information relating to the representation of a client. Even if an attorney knows that his client has committed a fraud or even a crime, the attorney is generally not allowed to disclose that information.

Model Rule 3.3(b) provides that, “A lawyer who represents a client in an adjudicative proceeding and who knows that a person intends to engage, is engaging or has engaged in criminal or fraudulent conduct related to the proceeding shall take reasonable remedial measures, including, if necessary, disclosure to the tribunal.”

The attorney discovering fraud in a chapter 11 case has the difficult task of reconciling these rules. This reconciliation is made worse by the fact that it is not clear in chapter 11 practice that the client is the DIP and not the bankruptcy estate itself.[1] Thankfully, the rules do not necessarily require immediate disclosure of the fraud to the bankruptcy court, but require such disclosure “if necessary.”

A first step would be for the lawyer to confront the DIP with the fraud and request that the fraudulent conduct be undone or disclosed in such a way that there is no injury to the estate. Where the DIP is a corporation, the lawyer is required to discuss the fraud with the board of directors if corporate officers refuse to take action to rectify the situation. Model Rule 1.13(a).

If the DIP refuses to rectify the fraud, the lawyer might then be tempted to disclose the fraud to the bankruptcy court. However, that may cause counsel to violate Model Rule 1.6. Some commentators have suggested a procedure that allows the fraud to be discovered without forcing the attorney to disclose confidential client communication.

The attorney could quit the representation by doing a “noisy withdrawal.” Discussed in ABA Formal Opinion 92-366, a noisy withdrawal is a withdrawal from the representation of a client that is accomplished by the lawyer disavowing any work that the lawyer has done for the client.

An emergency petition to withdraw by the attorney for the DIP, including a statement that the reason for the withdrawal is that the attorney can no longer represent the DIP without violating the Rules of Professional Conduct, is likely to get the attention of one of the other parties in the bankruptcy or the bankruptcy judge, leading to investigation of the fraud without the lawyer being forced to disclose client confidences.[2]

Some states do not follow the Model Rules and a discussion of the appropriate procedure in every state is beyond the scope of this article. Each practitioner should consult their local rules prior to taking any action.

Failure to take action might lead to allegations that the attorney participated in the fraud. While the Rules of Professional Conduct will protect a lawyer from being required to disclose fraudulent conduct, they will not protect a lawyer who actually participates in the conduct. See, for examples, United States v. Center, 853 F.2d 568 (7th Cir. 1988) (attorney convicted of bankruptcy crime for participating in altering the debtor’s records and transferring a property right to create a setoff against an undisclosed asset); United States v. Brown, 943 F.2d 1246 (10th Cir. 1991) (attorney conspired to defraud the United States by concealing assets, financial transactions and records of his client in a bankruptcy proceeding).

Bankruptcy Trustee, Judge or Creditor

If a bankruptcy trustee, judge or other judicial officer detects fraud on the bankruptcy estate, that person should obviously report the fraud to the appropriate investigators. A federal statute (18 U.S.C. §3057) provides the mechanism for a judge, receiver or trustee to report fraud. Such a judicial officer, having reasonable grounds for believing fraud has occurred or should be investigated, is required to report to the U.S. Attorney all of the facts and circumstances of the suspected fraud. The U.S. Attorney is then required to inquire into the facts, report them to the judge and convene a grand jury if it appears probable that an offense has been committed. If the U.S. Attorney believes that an investigation or prosecution is not warranted, he is required to report the facts to the Attorney General for his direction.

As long as the judge or trustee is acting in his official capacity in making the report to the U.S. Attorney, he will generally enjoy absolute immunity from suit by the debtor for slander, defamation or malicious prosecution. See In re Bryan, 308 B.R. 583 (Bankr. N.D. Ga. 2004); In re Heinsohn, 231 B.R. 48 (Bankr. E.D. Tenn. 1999) affirmed 247 B.R. 237 (E.D. Tenn. 2000).

A creditor does not have the right to request that a bankruptcy court to make a report to the U.S. Attorney under §3057. See In re Valentine, 196 B.R. 386 (Bankr. E.D. Mich. 1996). However, disclosure of what the creditor knows to the U.S. Trustee should achieve essentially the same result, since the U.S. Trustee’s Office would then report the information to the appropriate authorities. The U.S. Trustee perceives the collection of information about bankruptcy fraud to be part of its mission to oversee the bankruptcy system and will request information about the case and the nature of the fraud. A list of the information the U.S. Trustee will request is located on the agency’s website at http://www.usdoj.gov/ust/eo/fraud/index.htm.

However, a creditor making a report will not have the same immunity from future suit as a trustee or judge. Such a creditor would need to be aware that the creditor may be sued for malicious prosecution if the person they are accusing of fraud is later acquitted in a criminal proceeding and may face a lawsuit for slander, libel or other defamation even if there is no criminal proceeding instigated against the debtor.

Obviously, a creditor would never want to attempt to require a debtor to do something in exchange for the creditor not disclosing the fraud. Such conduct is a federal crime. See 18 U.S.C. §873 (Blackmail – “Whoever, under a threat of informing, or as a consideration for not informing, against any violation of any law of the United States, demands or receives any money or other valuable thing, shall be fined under this title or imprisoned not more than one year, or both.”)

Finance Turnaround Professionals

A less clear situation exists when a fraud is discovered by a financial consultant or accountant employed by the DIP under 11 U.S.C. §327. The nature of the work that such professionals do often puts them in a unique position to detect fraud.

Generally, a person who has knowledge of the commission of a felony under U.S. law will be guilty of the commission of the crime of misprision of a felony if they conceal the information about the felony from the authorities. See 18 U.S.C. §4.

Whoever, having knowledge of the actual commission of a felony cognizable by a court of the United States, conceals and does not as soon as possible make known the same to some judge or other person in civil or military authority under the United States, shall be fined under this title or imprisoned not more than three years, or both.

18 U.S.C. §4. While it is not clear from the text of the statute, an act of concealment is required for prosecution. See U.S. v. Johnson, 546 F.2d 1225 (5th Cir. 1977)(An essential element of the offense of misprision of felony is concealment, and mere failure to report a felony is not sufficient to constitute a violation under 18 U.S.C. §4). Such acts of concealment include suppression of evidence, harboring of the criminal, intimidation of witnesses or other positive act designed to conceal from the authorities commission of the felony. Bratton v. U.S., 73 F.2d 795 (10th Cir. 1934).

While the activities of a normal financial professional in a bankruptcy case will not constitute a concealment of fraud, a financial professional will want to avoid risk by taking quick action upon discovering information that might indicate a fraud. The financial professional should immediately notify counsel and the appropriate officer for the DIP or the board of directors if necessary. If sufficient remedial action is not taken to cure the fraud, a financial professional should consult the professional’s own legal counsel to help him determine whether the he should resign and/or disclose the fraud to the U.S. Trustee. The financial professional’s counsel will help the professional assess the risk of his being viewed as concealing the fraud.

Promptly taking the right steps in response to detecting a possible fraud will help to place the blame for the fraud on the persons perpetrating it and not implicate creditors or professionals of the bankruptcy estate.