I am sure that I am not alone in noticing that my commercial-corporate bankruptcy practice has involved a far greater number of fraud cases than I ever anticipated. In the last few years, I have had five bankruptcy debtors plead the Fifth Amendment at their §341 meetings, two of whom currently reside in federal penitentiaries, and yet this is supposedly an extremely rare occurrence. Reading financial information carefully, asking for more historical records and communications between the parties and attempting to comprehensively understand a relationship are now my first steps, not just reviewing the promissory note, the security agreement and the perfection of the liens. In this way, the possibility of fraudulent conduct is more likely to be apparent earlier on in my assessment of a new matter, which hopefully will give me an opportunity to minimize damage and protect any assets that may exist.
To give an example, a bank client sent me a notice of a chapter 11 filing for a customer and asked that I review the loan documents, address cash collateral issues and all the usual things that need to be done when a business reorganization case is first filed. Almost as an aside, the bank officer told me that this case was unusual because there was no prior indication at the bank that the borrower was in any kind of financial difficulty, and in fact, the first inkling of a problem came from just one missed payment, followed closely by the bankruptcy filing itself. In most commercial loans, the bank is aware of it when the borrower begins experiencing financial difficulty because the reports start reflecting eroding collateral and/or increasing losses even before payments are missed. Thus, such loans are transferred to the workout arm of the bank for further dealings even before payments become a significant problem.
In the post-Enron world, I was suspicious immediately and so asked for the rest of the bank’s files, in addition to the loan documents themselves. The borrower’s primary assets were health care receivables from governmental agencies and, according to the monthly borrowing base reports, hovered around $4.0 million consistently over the several years of the loan, thus appearing to provide ample security for the bank’s $1.5 million obligation. The bankruptcy schedules, filed just three weeks after the last borrowing base report was submitted to the bank, showed that the company’s receivables were in fact only $700,000. This was beyond “not good.”
Nonetheless, in part because the borrower’s sole shareholder was also a private client (i.e., wealthy) borrower and was a well-respected member of the community, and in part because we knew that the benefit of the doubt is always given to debtors in the early days of the case, we decided to give the borrower a little bit of leeway and agreed to a tightly controlled cash collateral order. The debtor immediately bounced a check in the cash collateral account, and we immediately moved for the appointment of a trustee – before the meeting of creditors even occurred. In the first few weeks of the case, we also learned that the debtor was in fact the successor (more likely, the alter-ego) of our original borrower, and that there was an affiliated entity that also had significant bank loans. These facts, coupled with the discrepancy in the receivables and the bounced check, led the debtor to consent to the appointment of the trustee for both affiliated bankruptcy cases the day of the §341 meetings. Ultimately, with the trustee’s help, it was later learned that the two “affiliates” were also essentially alter-egos and that four banks had been defrauded for about $10 million by making loans based on the same over-inflated alleged collateral. The trustee was able to conduct and then sell the core business operations, thus salvaging about $1 million in total assets.
Meanwhile, the principal of these companies exacerbated the spotlight she was already under by filing a personal bankruptcy, and then was caught literally hiding hundreds of thousands of dollars worth of antiques from her own bankruptcy trustee. Given the various corporate and personal antics, she is presently incarcerated in a federal prison.
The point to the story is twofold. First, we all need to be more vigilant in assessing the true financial condition of bankrupt debtors. By concluding that there was fraud involved in my case early on, we were able to prevent any further losses and preserve the (admittedly insufficient) assets that did exist. Second, expect the unexpected. But of course, you knew that already!