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How to Identify and React to Fraud in the COVID-19 Era
May 28, 2020
As we have learned through our ghosts of recessions past, the vast majority of those who become unable to pay their debts in economic downturns are honest, but unfortunate, debtors. That said, we also have learned that an appreciable number of debtors start taking drastic measures to preserve their assets and associated lifestyles during these times, sometimes engaging in a shell game designed to conceal or otherwise understate their assets when creditors start knocking on their door. As we anticipate a wide-ranging economic recession stemming from the COVID-19 pandemic, we can expect more of the same in the coming months. In fact, the types of debtors that are inclined to commit fraud have probably started already.
What does this look like? Like most lawyers, we will say first, somewhat jokingly, that it depends. Some debtors have been concealing their assets from creditors for years. They are seasoned and skilled. They may have already falsified financial statements and disclosures. They may have set up trusts or used family members as vehicles for alleged "ownership" of assets. Other debtors are new to the practice. Once they realize that a bankruptcy is inevitable, they start transferring money from one bank account to another (or from a bank account to a mason jar in their shed, and, before you ask, yes, we have seen this). They put valuables into safety deposit boxes or other places where creditors might not look.
For businesses, the answers become more complicated. Plenty of business types, for example, have multiple affiliated entities working in tandem in a common enterprise. In the energy industry, this is commonplace. One company pays the employees; another company buys (or mines) the coal; another company cleans the coal; another company sells the coal; another company owns the loading areas; another company owns the trucks; and so on and so forth. These business arrangements lend themselves to concealment. One entity might have claimed it owned certain equipment two years ago, but, suddenly--and for dubious reasons--now that same equipment is owned (and was allegedly always owned) by a sister company. Money from product sales or service provision gets put into different accounts than usual. Perhaps a new company with a different registered agent and different primary address gets created.
In these current times, we already are seeing signs of this type of fraud. Indeed, in some instances, we already are hearing stories of debtors obtaining CARES Act PPP loans and using the money for other purposes. This is an entirely new type of fraud because these loans are given without collateral and without personal guaranties. So the small percentage of debtors inclined towards fraud and concealment might feel emboldened. What, after all, is the creditor's remedy?
That answer is unfortunate, because the remedy is often litigation. Debtors caught in the act do not generally give up their goods easily. The good news, however, is that if they engage in this type of chicanery, chances are high there are spoils worth chasing. Otherwise, the debtor would not have engaged in the fraud in the first place. As a result, we are not generally advising litigation unless there has been enough activity to suspect strongly that the end game is recovery well beyond the cost of the chase.
How do we spot this fraud though? Well, sometimes it is pretty easy. We routinely advise our clients (and members of the financial industry in general) to collect as much financial information from their clients are they can. If a creditor has done so, then we have a baseline for comparison. For debtors who play loosely with the truth, they generally will overstate assets when seeking to obtain money. Conversely, when the walls close in, they often will understate assets when seeking to avoid repaying that money. In these cases, recently collected financial information will show substantial discrepancies.
In other cases, particularly where the debtor holds one or more deposit accounts with the creditor, unusual transactions will begin. They may start small. You might see in-person cash withdrawals in the few thousand dollar range. Behind the scenes, the debtor is often taking money to start new accounts elsewhere to avoid your setoff rights and to hide the trail of money from you. Then, they might start taking bigger chunks out, either via in-person withdrawals, or through checks drawn on the account payable to companies or person(s) with whom the debtor has no prior history of dealing. Obvious red flags include large checks written to companies with slight variations on the borrowing entity's name, large checks written to cash, and large checks written to family.
More sophisticated and experienced fraudsters have other ways to game the system. They might create new trust accounts for "estate planning," or they might slightly increase otherwise-routine intercompany transaction amounts in amounts that are not noticeable at first but start to add up quickly. They might start shuffling inventory around or selling it in bulk, maybe to insiders, maybe to third parties. Regular collection of inventory volumes, accounts-receivable rolls, and balance sheets (particularly audited figures) can help a creditor identify this type of creditor-avoidance technique early.
Once we spot this fraud, how can we react to it? Again, there are plenty of options in the toolkit. If the evidence is crystal clear, then we generally recommend against alerting the debtor that you know. Instead, freezing what you can (i.e., deposit accounts) and exercising your setoff rights where you can consistent with loan documents, deposit account agreements, and state law, and pursuing a preliminary injunction should provide the ammunition needed to either halt the activity or to force an evasive debtor into bankruptcy. Alternatively, where the fraud is big enough and the assets concealed substantial enough to justify it, the appointment of a receiver can preserve the status quo. In both situations, creditors want to tailor the relief from the court specifically to allow for several things. First, the creditor wants to ensure that the order for relief would allow for clawback from third parties (particularly as yet unknown affiliate companies of the debtor) and, in the case of a receivership order, allow for the receiver to commence bankruptcy for the entities over which he or she is given control.
Once a bankruptcy petition has been filed, creditors again have options. Objecting to the filing of a case, seeking a conversion to Chapter 7, objecting to discharge or dischargeability of a debt are generally viable options in these circumstances. After all, bankruptcy is designed to protect the honest, but unfortunate, debtor we first mentioned. It is not, however, designed to protect debtors who conceal assets or are not otherwise forthcoming with their assets and financial history either before, during, or after the filing of a bankruptcy petition.

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