Companies facing fraud-based liabilities can file a Chapter 11 bankruptcy to rehabilitate and restructure the business and address fraud claims asserted against them. A Chapter 7 liquidation is also available to a company considering liquidation in light of fraud claims, but a Chapter 7 Trustee appointed in a Chapter 7 case may cause hardship for management and/or shareholders if fraud-based litigation is commenced by the Chapter 7 Trustee. Before seeking bankruptcy protection, directors, owners, and officers of corporations should consult with experienced counsel to discuss the special nuances of fraud-based bankruptcies.
The trustee appointed in the bankruptcy case, the debtor-in-possession, and creditors' committees typically use the avoidance powers of Chapter 5 of the Bankruptcy Code, as well as civil and criminal government actions, to pursue financial wrongdoing. With that said, the US Trustee and other government prosecutors may also bring charges against corporate debtors under bankruptcy fraud statutes, most commonly prosecuted under sections 152 and 157 of title 18 of the US Code.
US Code Section 152
Section 152 criminalizes the knowing and fraudulent concealment of assets, bribery, and making false statements under oath before and during bankruptcy proceedings. These proscribed actions extend to creditors who present any false proofs of claim against the estate. The term "fraudulently" in the context of section 152 means that the action was taken with the intent to deceive; for example, a debtor intentionally omitting several luxury vehicles from the list of the company's assets may be a materially false statement under section 152.
US Code Section 157
While section 152 focuses on fraud within the bankruptcy case, section 157 criminalizes the use of actual or fictitious bankruptcy proceedings to further a larger fraudulent scheme outside of the bankruptcy case. A notable case involving the use of the Bankruptcy Code to further a fraudulent scheme outside of bankruptcy occurred in California. There, John Milwitt represented himself as an attorney who could provide legal services to tenants who were struggling with their landlords. Milwitt, who was not an attorney, defended several tenants in unlawful detainer actions filed against them by their landlords, and collected fees despite never having appeared in court on the tenants' behalf. Milwitt then filed bankruptcy petitions on behalf of several tenants without their knowledge or consent, listing the landlords and other fabricated entities as creditors. He filed petitions in order to exploit the Bankruptcy Code's automatic stay, which halted collections efforts and actions brought against each of the tenant-debtors by their respective landlords. As a result, Milwitt was indicted on six counts of bankruptcy fraud in violation of section 157, (though the conviction was ultimately reversed) due to his attempt to use the bankruptcy process to further a fraudulent scheme outside of bankruptcy.
Turning again to fraud-related liabilities that lead companies into bankruptcy, securities law violations and financial reporting fraud are common examples of such liabilities. Financial reporting fraud involving earnings manipulations by senior management and making untrue statements of material fact or omitting material information to persuade and influence actions of prospective investors are violations of the Securities Exchange Act of 1934, which could lead companies into bankruptcy.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
