When the Bankruptcy Trustee Suspects Fraud

Here's how bankruptcy trustees investigate fraud, and what they'll do if they find it.

You can count on the bankruptcy trustee taking action if it appears that a fraudulent act could deprive creditors of money they’re entitled to receive. If warranted, the trustee might also refer the matter for criminal prosecution. In this article, you’ll learn what to expect if a trustee suspects fraud.

(If you’d like to start with the basics, read What Is Bankruptcy Fraud?)

How Fraud Comes to the Trustee’s Attention

One of the primary roles of the bankruptcy trustee is to protect the interests of creditors—and the trustee takes steps to do so at every stage of the bankruptcy process.

For instance, the bankruptcy case begins when a debtor fills out the official bankruptcy paperwork and files it with the court. The trustee assigned to the matter will then review the paperwork and compare it to additional documentation—such as bank statements, paycheck stubs, and tax returns—supplied by the debtor (often referred to as 521 documents).

Also, all debtors must attend at least one hearing called the 341 meeting of creditors. At that meeting, the trustee will verify the debtor’s identity and take further steps to ensure the accuracy of the petition. For instance, the trustee will ask whether the debtor:

  • included all income (and qualifies for bankruptcy relief)
  • listed all assets and property (didn’t transfer or hide property in an attempt to avoid paying creditors).

Creditors can also attend the meeting and ask questions—and in fact, they often provide the trustee with additional information. For instance:

  • a lender might want information about an inaccurate loan application
  • the state attorney general could inquire about the finances of a suspect company
  • an ex-spouse might ask questions about undisclosed income or property, or
  • a business partner might ask about the location of company funds or property.

These situations and others can often tip off a trustee to potential fraud.

What Will a Trustee Who Suspects Fraud Do?

When allegations of fraud enter into a bankruptcy matter, the next step usually involves obtaining information through discovery. Once the trustee has enough evidence, the case will move into litigation (an adversary proceeding—more below).

Rule 2004 Examinations

A trustee who suspects fraud but doesn’t have sufficient evidence to bring the matter before the court can compel testimony and document production from just about anyone through a Bankruptcy Rule 2004 examination. The scope of the examination is broad enough to allow inquiry into any action that could be considered fraud in a bankruptcy case.

For instance, Bankruptcy Rule 2004 authorizes the bankruptcy trustee to examine:

  • the acts, conduct, property, liabilities or financial condition of the debtor
  • any matter which may affect the administration of the bankruptcy estate, or
  • any matter which may affect the debtor's right to a discharge.

Adversary Proceedings

Once the trustee has gathered enough evidence to support a case, the trustee can file a lawsuit against the appropriate party. Under most circumstances, the trustee will file the lawsuit called an adversary proceeding in the bankruptcy court.

The point of an adversary proceeding is to gain money for creditors (as opposed to prosecuting a crime—see below). The trustee can use an adversary proceeding to:

  • set aside fraudulent transfers (transfers for less than full value) and recover the property from the person or entity who received the transfer (learn more about prebankruptcy transfers of property)
  • obtain turnover of hidden or undisclosed property from whoever is in possession of the property
  • object to or revoke the discharge of a bankruptcy debtor who has hidden assets or attempted to transfer assets out of the reach of the trustee
  • recover property from employees or officers who have wrongfully taken assets of businesses in bankruptcy
  • recover property that has been wrongfully seized by creditors, and
  • determine the validity, priority, and extent (amount) of liens fraudulently placed on bankruptcy assets.

Adversary proceedings are similar to lawsuits filed in other courts but proceed to trial much more quickly. The trustee can serve the initial pleadings—the summons and complaint—by first class mail. This eliminates the need to chase down someone who is avoiding service. The trustee can sue anyone in an adversary proceeding, not just debtors and creditors.

(For more information, see Adversary Proceedings in Bankruptcy.)

Stopping the Depletion of Assets: Temporary Injunctions

In cases where the trustee has sufficient evidence to show that assets will be depleted or transferred to the irreparable harm of creditors, the trustee can seek emergency relief called a temporary restraining order or a temporary injunction. The order allows the trustee to take possession of the assets pending the outcome of the adversary proceeding and can be granted without first notifying the person in possession of the assets if the trustee can show that notifying them would likely result in the depletion of the assets. However, a full hearing with notice generally takes place within ten days of the original order.

Bankruptcy Crimes

Most bankruptcy crimes involve fraud and are punishable by fines and incarceration Examples of bankruptcy crimes include:

  • filing false claims
  • knowingly concealing assets
  • making false oaths
  • bribery
  • embezzlement, and
  • filing fraudulent petitions.

When a bankruptcy trustee suspects a fraud that constitutes a bankruptcy or other federal crime, the trustee makes a criminal referral to the Office of the United States Trustee. The matter is then passed along to the United States Attorney or the Federal Bureau of Investigation or other appropriate federal agency for investigation. Like other federal crimes, the United States Attorney prosecutes these cases in the federal courts.

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