Commercial Fraud Task Force Committee Meeting Minutes

2007 Winter Leadership Meeting

The Commercial Fraud Task Force Committee held a meeting at the ABI Winter Leadership Conference on Friday, Dec. 7, 2007. Co-chair Frank Monaco, introduced his fellow co-chairs, Jack Seward and Sheryl Toby. The meeting was well attended and followed by a joint presentation of the Commercial Fraud Task Force and Bankruptcy Litigation Committees.

Moderator Frank Monaco introduced the members of the panel and provided a brief outline on the program presentation: a mock hearing to approve the appointment of a chapter 11 trustee, or in the alternative, an examiner. Hon. Barry Russell (C.D. Calif.) presided. The panelists included Diana Adams (U.S. Trustee for Region 2) as the U.S. Trustee movant. Jordan Siev, formerly at Anderson Kill & Olick and now with Reed Smith, represented the unofficial creditors committee and also supported the motion, which was opposed by the debtor, represented by Brian Walsh (Bryan Cave). Joining in the opposition was Deirdre A. Martini, formerly at CIT Group and now managing director at Wachovia Capital Finance, representing the official committee of unsecured creditors (which is dominated by holders of commercial paper). Dramatic testimony was offered by Cyrus Pardiwala, U.S. restructuring advisory services leader and partner of PricewaterhouseCoopers LLP, who portrayed the witnesses for both sides as well as the CPA for the moving party seeking the trustee and also the evil twin CPA for the debtor seeking to remain in possession. The case was loosely based on the New Century Financial case, and the presentation was well-received by all attendees.

Factual Background of the Mock Hearing[1]

Financial Supermarket Inc. (FSI) is a roll-up of various businesses in the financial industry. Its founder and CEO, Eddie “No Money Down” Johnson, built the company through acquisitions over the past five years. FSI conducted an initial public offering of its stock 18 months ago, at which point Johnson’s ownership interest in the company was reduced to 10 percent. At the time of its chapter 11 filing last month, FSI’s operations included a subprime mortgage lender and servicer, a chain of upscale pawnshops in major cities, a factoring company specializing in the receivables of Chinese toy manufacturers, a finance company with a portfolio of loans to plaintiffs’ lawyers secured by potential contingency fees in silicosis lawsuits, and a qualified intermediary providing custodial services to parties conducting like-kind exchanges under §1031 of the Tax Code of environmentally contaminated properties.

FSI’s bankruptcy filing was prompted by several factors. First, the company announced two months ago that it was restating two years’ worth of financial statements. According to FSI’s press releases and filings with the Securities and Exchange Commission, certain employees in FSI’s accounting department made inaccurate entries in the company’s books over a two-year period. The restated financials reflected net income that was approximately 50 percent lower than in the original financial statements. FSI promptly terminated the employees directly responsible for the misstatements, but its controller and chief financial officer remain with the company. FSI also engaged a Big Four accounting firm to investigate and to report to the company’s audit committee about improving its internal controls. That firm has not completed its investigation. In the meantime, a prominent financial newspaper has reported that the CFO was involved in the misstatements and suggested that Johnson was at least aware of them. The newspaper did not identify its sources.

Second, FSI made substantial loans to NMD Productions LLC, a company owned by Johnson. NMD has invested in several feature films and documentary projects, but none are expected to be ready for theatrical release before 2010, and the loans will not produce cash flow for FSI before that time. Johnson and NMD claim that these loans—which totaled approximately $50 million at the time of the bankruptcy filing—were properly authorized by FSI and its board of directors. Several members of the board were quoted in the newspaper article mentioned above as saying that they’ve never heard of NMD. The loans were disclosed in FSI’s audited financial statements, but Johnson’s ownership of NMD was not.

Finally, conditions in the economy generally and in FSI’s industries in particular have resulted in a liquidity crunch. Among other things, FSI relied heavily on securitization of its mortgages and issued substantial amounts of commercial paper to fund its retail operations, and these sources of funding essentially disappeared.

Prior to bankruptcy, FSI’s board of directors consisted of eleven members, including Johnson, the CFO, the COO and the president of the company, plus seven outside directors. Most of the outside directors were asked to serve by Johnson as the company prepared for its IPO, although two of the seven joined the board after the company went public. An independent director serves as chairman of the board, and the audit and compensation committees consist only of independent directors. As FSI prepared for bankruptcy, Johnson and the CFO jointly interviewed financial advisory firms that were recommended by other board members and by FSI’s bankruptcy counsel. They eventually recommended to the board that the company retain Robert Righteous of Phig, Leaf & Co. as CRO. The board approved the recommendation unanimously, with Johnson and the CFO abstaining, and directed the company’s counsel to enter into an engagement letter with Righteous. That letter, which was executed two days before the bankruptcy filing, provides that Righteous will have the sole authority to manage FSI until the effective date of a plan of reorganization. Each of the company’s officers and directors countersigned the engagement letter. Although Righteous has the power to fire the officers, he has chosen for now to keep them on the payroll reporting to him because of their substantial experience with FSI’s business and the industries in which it operates. The directors have not met since the engagement letter was signed.

FSI is a party to lawsuits in a number of jurisdictions. Several plaintiffs have filed class actions against the company arising out of its mortgage lending and other operations. After the financial restatement, other plaintiffs filed class actions under the securities laws against the company and its officers and directors. Derivative lawsuits against the officers and directors are pending in federal and state courts and involve claims of breach of fiduciary duty, fraud and gross mismanagement. Newspapers also have reported that current and former FSI employees have been seen entering and leaving a federal courthouse in Johnson’s home town, where a crusading U.S. attorney is believed to be conducting a grand-jury investigation into FSI’s compliance with the Pawnshop Proprietors’ Proscribed Policies and Procedures Act of 1997.

Two days after FSI filed for bankruptcy protection, the U.S. Trustee filed a motion for the appointment of a trustee (or alternatively an examiner). The debtor and the official committee of unsecured creditors (which is dominated by holders of commercial paper) oppose the motion. An unofficial committee of trade creditors and mortgage-industry players supports the U.S. Trustee’s position. No equity committee has been appointed at this point in the case.

The Hearing on the Motion

After the parties made opening arguments, the U.S. Trustee presented its case in support of the motion. The U.S. Trustee relied on the SEC filings, the debtor’s press releases, copies of the complaints filed against the debtor, its officers and directors and finally newspaper reports. The unofficial creditors’ committee presented testimony of its accountant, based on a preliminary review of discovery materials. He testified that the quality of internal controls was open to question, and the controller, who was a good friend of Johnson, was in charge of accounting. Furthermore, the documentation of the NMD Loans was insufficient. Hotline calls implicated Johnson and the CFO in various misstatements. He was then subjected to the cross examination by the debtor and the official creditors’ committee attorneys.

The debtor then presented the testimony of Righteous. His understanding was that he had full management power and fiduciary duty. He also believed that Johnson and the CFO had substantial institutional knowledge valuable to the debtor and its estate for at least the time being. The debtor faces difficult economic and market conditions and continuity of personnel. Furthermore, his firm has had decades of experience with turnarounds and bankruptcies including cases involving allegations of significant fraud. The testimony of a Big Four accountant hired by the audit committee was also presented. The accountant testified that an investigation was currently ongoing; there was no evidence to date that anyone other than terminating employees was involved or aware of misstatements; hotline callers had been unwilling to be interviewed or allowed their names to be used; and internal controls may have been weak during the period of misstatements but have been strengthened since that time.

Judge Russell, in a well-reasoned opinion, ruled in favor of the movants and appointed a trustee. Judge Russell stated that although it was a difficult decision, he was erring on the side of caution in appointing a trustee given the allegations of accounting fraud and mismanagement. After the conclusion of the hearing, the floor was opened to questions from the audience as well as Frank Monaco, the moderator. The presentation went well and the panelists received numerous accolades from the audience.

[1]The underlying factual background for the FSI case was developed as a collaborative effort by the panelist, moderator and committee co-chairs.

2007 Annual Spring Meeting

On April 14, 2007, ABI’s Commercial Fraud Task Force Committee met in conjunction with the 2007 Annual Spring Meeting in Washington, DC. The panel presented “Understanding Debtor Responsibilities in Consumer and Business Cases: Providing Electronically Stored Information.

Co-chairJack Seward announced the addition of eight contributing editors for the committee’s e-newsletter and that, after many years of service, Co-chair Sandra Rasnak would be leaving the committee. Francis A. Monaco, Jr.  of Monzack and Monaco, PA (Wilmington, Del.) and Sheryl L. Toby  of Dykema Gossett PLLC (Bloomfield Hills, Mich.) have joined as co-chairs of the committee.

The panel was comprised of moderator Bruce L. Weiner of Rosenberg Musso & Weiner, LLP (New York), Lee Barrett of Forshey & Prostok LLP (Fort Worth, Texas), Michael D. Fielding of Blackwell Sanders Peper Martin LLP (Kansas City, Mo.), Patricia B. Fugée of Roetzel & Andress (Toledo, Ohio), David P. Leibowitz, of Leibowitz Law Center (Waukegan, Ill) and a chapter 7 trustee, and Jack Sewardof Jack Seward & Assoc., LLC (New York). The panel covered the responsibilities that bankruptcy counsel and professionals have to make use of electronically stored information and how to find the assets in the 21st century for the estate, along with the responsibilities of the debtor and debtor counsel with practical use and application for debtor’s counsel, panel trustees and creditors and creditors’ counsel as it relates to §§707, 542 and 727, Rule 9011 and 18 U.S.C.

Jack Seward introduced our topic by discussing electronically stored information and its importance in bankruptcy cases, and drew on his experience as a digital forensic accounting technologist by discussing why electronically stored information is often the only information in a bankruptcy case and how that information can be recovered even if the debtor tried to hide or remove it. David Leibowitz then gave two fact patterns based on actual cases he handled as a trustee where the debtor tried to conceal information, including electronically stored information. The panel used the fact patterns to discuss the various roles of attorneys in a bankruptcy case.

The panel designated Lee Barrett and Michael Fielding to be our debtor’s attorneys. Michael discussedhow he would advise a debtor before and after filing about ESI and the attorney’s role in preserving ESI and protecting the privileged nature of electronically stored attorney-client communications. The attorney’s ethical duties regarding ESI in bankruptcy proceedings, including what does an attorney do if you discover that your client has attempted to delete ESI and the ESI may lead to assets, was discussed by Lee Barrett and led to many questions from the audience and a spirited discussion by all panel members.

The need to discuss ESI issues with a client before a bankruptcy petition was addressed.  Patricia Fugée, our creditors’ counsel, discussed what an attorney for creditor should do to collect and preserve information, including ESI, as that job begins long before a bankruptcy filing. She said she advises her clients to start collecting and preserving information when the creditor enters into the financial relationship with a borrower, including saving all e-mails and e-mailed documents. She also explained that in her experience, after a filing she uses the documents and communications received at the time of the loan and compares them to the bankruptcy schedules and other filings in the case, including requests for use of cash collateral. This is important, because often there are contradictions between the information at the time of the loan and the information at and during the filing, and those contradictions may lead to discoverable information and even to a motion to appoint a trustee.

David Leibowitz,a panel trustee in Chicago, explained how a trustee collects and reviews information, including ESI.  He discussed some of the trustee cases that he has handled where ESI was important, including one case where he used ESI to find several related businesses that the debtor failed to disclose. Following up on using ESI, Bruce Weiner discussed a case that Jack Seward worked on where the debtor’s principals tried to remove documents from the computers at 4:00 a.m. the day after the case was converted to chapter 7, and most, if not all, of those documents were recovered and led directly to assets for the estate.

The panel and the audience agreed that every bankruptcy attorney has new opportunities and responsibilities in our “digital age,” and we all need to learn about ESI and the new ethical issues raised by ESI. Keep watching the eNewsletter for more on this topic and for information on our next panel presentation, which will be at ABI’s Winter Leadership Conference in December.

2006 Winter Leadership Conference

On Dec. 1, 2006, ABI’s Commercial Fraud Task Force and Ethics Committee met in conjunction with the 2006 Winter Leadership Conference in Scottsdale, Ariz. A well-qualified panel discussed protection of the attorney-client privilege and other “secrets” in the digital age. The topic was timely in that amendments to the Federal Rules of Civil Procedure related to discovery of electronically stored information and protection of the attorney-client privilege regarding such information went into effect on December 1. 

The panel was comprised of moderator Jayne South, general counsel for EPIQ Systems; U.S. Magistrate for the District of New Jersey, Judge Ronald J. Hedges (Newark, N.J.); Ira L. Herman of Thompson & Knight LLP (New York); and Steve Katzman, U.S. Trustee for Region 15 (Los Angeles).

In the meeting, Judge Hedges took the lead in presenting a helpful PowerPoint presentation that outlined the key issues faced by attorneys in dealing with discovery of digital information or “e-discovery” and indicated the following.

“Business bankruptcies will have to quickly adapt to the provisions for electronically stored information (ESI) found in the amended FRCP that became law on December 1, 2006…Like most judges, I expect litigants to understand their electronic discovery obligations.”

Hon. Ronald J. Hedges

In today’s highly technological world, valuable information is stored on computers and issues of preserving, accessing and reviewing the information are difficult. Federal Rules of Civil Procedure 16, 26, 33, 34, 37 and 45 were amended and must be understood by practitioners involved in litigation. The panel explained that “document discovery” in Rule 34 includes “data or compilations.” Under Rules 16 and 26, the parties must meet and confer regarding issues relating to disclosure of electronically stored information (ESI) and how the attorney-client privilege can be preserved in the event of inadvertent disclosure. Form 35 of the FRCP requires that the parties describe how they propose to handle the disclosure of ESI. This can certainly be difficult due to the volume and dynamic nature of ESI. Nevertheless, Rule 26(a) does require that a copy of or description by category and location of all ESI and other discoverable information must be provided. In addition to discussion of the Rule changes and the practical issues involved, the panel discussed the Sedona Principles – 14 principles published by the Sedona Conference Working Group in 2003 and revised in 2006 – which offer practical guides for the bench and bar in the production of ESI and other documents.

Regarding privilege waiver, the inadvertent disclosure of privileged information presents tremendous problems. Even though parties can reach an agreement on how such unintentionally disclosed information will be handled, such as return of the information to the producing party, such an agreement may not protect the information from waiver as to other third parties. The panel discussed the practical problems in trying to “contract” around privilege waiver and the problems associated with a waiver.

Finally the panel addressed the issue of how ESI is produced – the form of production- and the issues related to spoliation and loss of ESI. Because companies and individuals may have a procedure for regular deletion of ESI, Rule 37 provides that a court may not impose sanctions for failure to provide ESI lost as a result of the good faith operations of an electronic information system. 

It is clear that the production of ESI will present many new and difficult challenges as litigation proceeds in the bankruptcy courts and other federal courts. Attendees of the panel presentation received a helpful primer on issues they need to become very familiar with. The chairs thanked the speakers and attendees and for their participation.

2006 Annual Spring Meeting

The Alternative Dispute Resolution and Commercial Fraud Task Force Committees held a joint panel presentation at ABI’s 2006 Annual Spring Meeting in Washington, D.C. entitled “Impact of Commercial Bankruptcy Fraud on the ADR Process: How to Avoid The Perfect Bankruptcy Fraud!"

The panel included: Irving E. Walker of Saul Ewing LLP in Baltimore, Kristin Mihelic of Spector Gadon & Rosen PC in Philadelphia and Patricia Brown Fugee of Roetzel & Andress in Toledo, Ohio.

Chief Judge Barbara J. Houser of the U.S. Bankruptcy Court for the Northern District of Texas and co-chair of the ADR Committee, and Jack Seward of Jack Seward Associates LLC in New York, co-chair of the Commercial Fraud Task Force Committee, made a short introduction regarding the mission statement of their respective committees and welcoming active participation by those in attendance at this years ASM.

The presentation covered the following topics:

• Bankruptcy court jurisdiction over alleged fraud perpetrated on another court
• Electronically-stored information under the new proposed FRCP
• Uncovering fraud by debtors and insiders in the digital age

The committees thank the panelists for making this informative information available along with acknowledging the efforts of Kathleen P. Makowski of Saul Ewing LLP for assistance in preparing the material regarding the recent decision by the district court in Tennessee, which addressed the "fraud on the court" issue.

Comments received from those attending, included “this was the best information at the ASM” - Judge (Ret.) Roger M. Whelan.

2005 Annual Spring Meeting

Those members in attendance were fortunate to have participated in excellent discussions that followed the presentation “Single Family Bankruptcy Fraud Investigations” by Patrick S. Layng, U.S. Trustee Programs, Criminal Enforcement Unit and Kevin J. Whalen, Senior Special Agent, Criminal Investigations Division, Office of Investigation, U.S. HUD.

The presentation was directly related to Bankruptcy Fraud and with an emphasis on the investigative areas by EOUST and HUD. Specific issues relating to fraud and FHA Single Family Insured Loans were discussed, along with the common HUD/FHA fraud schemes that included the following:

  • Bankruptcy Fraud
  • SSN/Identity Fraud—Verification of Employment & Income
  • Appraisals, Earnest Money and Closing Costs
  • Property Flipping, Equity Skimming, Equity Theft and Payoff Diversion

Examples and the process used by many of the fraudsters often included the Mortgagor obtaining multiple properties under multiple aliases and then files bankruptcies to forestall foreclosure. The impact of these types of fraud increase FHA defaults, HUD foreclosures, legal costs and waste of HUD funds and hurt low-income homeowners.

All bankruptcy professionals need to be aware of these schemes, because these frauds are taking place daily, and to communicate with the U.S. Trustee, Ch. 7 Trustee and HUD-OIG when specific situations come to your attention.

The committee thanks the EOUST and HUD for making this informative and necessary information available.

The planning of events and materials for 2005–06 is underway. Everything and anything related or pertaining to commercial fraud in bankruptcy arena is the purpose of the committee and we openly solicit your comments and suggestions.

2004 Winter Leadership Conference

With a topic of legal and strategic issues to consider from both a debtor and creditor prospective when fraud is suspected in the current legal and regulatory environment, this presentation is of interest to a broad spectrum of ABI members including those who represent chapter 11 debtors, secured creditors, trustees and anyone who has to deal with identifying and addressing fraud issues. Guest speakers were Ross O. Silverman of Katten, Muchin, Zavis & Rosenman, Chicago and Brian P. Netols of the same firm. Mr. Silverman and Mr. Netols are both former Assistant U.S. Attorneys for the Northern District of Illinois. Ross recently served as the Examiner in the United Airline Case. Both have tremendous experience in the white collar financial crimes arena. Their practice focuses on civil litigation, primarily assisting their clients in identifying civil wrongdoing within and outside their clients’ organizations.

2003 Annual Spring Meeting

Approximately 20–25 people attended a speech given by Robert R. Calo, U.S. Trustee Program Regional Criminal Fraud Coordinator for Regions 3 and the Southern and Eastern Districts of New York. The speech was entitled: “Updates on Identity Theft and Bankruptcy, U.S. Trustee Criminal Fraud Referrals and Civil Enforcement Program.” The speech focused on fraud and theft schemes commonly seen in bankruptcy cases and the warning signs or “red flags” for each type of fraud scheme. Crimes focused on included concealment, identity theft, and credit bust-out schemes. The speech also focused on the civil enforcement tools and criminal statutes available to combat bankruptcy fraud, the success of the U.S. Trustee civil enforcement program to date and the hiring of regional criminal fraud coordinators to help combat criminal misconduct.

2001 Winter Leadership Conference

The Commercial Fraud Task Force addressed fraud by professionals in bankruptcy-related matters, led by Steve Katzman of Albert, Weiland & Golden of Mesa, Calif., and Sandi Klein, Assistant U.S. Attorney, C.D. Calif. About 20 people attended the meeting. The speakers focused their remarks on how professionals commit fraud in bankruptcy cases. Examples discussed were how professionals conceal assets in their own bankruptcy cases, engage in fraud to cover up mistakes they have made in the representation of their clients, and acting as co-conspirators with their clients or other professionals in committing a crime, such as assisting in the concealment of assets or using the bankruptcy system to perpetrate other frauds. In addition, the panelist discussed several criminal cases including U.S. v. Gellene. The next subcommittee meeting will address parallel proceeding, investigating fraud and tracing assets.

2000 Winter Leadership Conference

Our committee had about 40 people in attendance. Speakers on the program were Ross Silverman, Partner, Katten, Muchin & Zavis. Mr. Silverman served as an Assistant U.S. Attorney in the Northern District of Illinois before joining Katten, Muchin. Mr. Silverman specializes in complex litigation including civil RICO actions. Tom Kadotani, is a Senior Bankruptcy Analyst with the U.S. Trustee Office in Phoenix. Before joining the Program, Mr. Kadotani was a FBI agent. I was the third member of the panel.

The focus of our panel was how to investigate civil fraud concerns on behalf of your client. When to refer your findings to law enforcement, and how to make a meaningful referral. A handout was distributed at the meeting. It highlighted the speakers comments, and provided suggestions on how to proceed with a financial fraud investigation.

The panelists answered many questions from the audience relating to a variety of topics such as parallel proceedings issues, ethical responsibilities when representing a corporate debtor where the insiders are suspected of wrongdoing, the conflict between civil and criminal forfeiture actions and the bankruptcy system, and how to handle investor fraud cases. Several members of the audience also asked for advice on how to deal with problems they were currently dealing with in their cases.

2000 Annual Spring Meeting

The task force discussed the search for a new chair for 2000–01, as well as possible topics for future educational programs. Also discussed was the potential effect of bankruptcy reform proposals on debtor’s counsel, particularly the burden of debtor’s counsel being required to verify schedules and statements of financial affairs. In addition, the task force discussed the problems with the bankruptcy fraud referral system and a possible educational program on the law of parallel bankruptcy and criminal proceedings.

1999 Winter Leadership Conference

The Commercial Fraud Task Force made a presentation titled, “Bankruptcy Fraud: The Federal Response,” by Graig Peyton Gaumer of the Department of Justice in Sioux Falls, S.D. and Maureen Tighe, a Region 16 U.S. Trustee in Los Angeles. The Task Force discussed the problem of bankruptcy fraud, including a discussion of the elements of criminal bankruptcy fraud, a review of statistics gathered by U.S. Trustees concerning district-by-district prosecutions over the past 10 years, and what creditors’ attorneys can—or should—do when they learn of fraud by a debtor or another creditor. The issue of the risk of being sued for malicious prosecution for making a criminal referral was brought up, as was the risk of being considered part of a conspiracy if the attorney is silent. Parallel proceedings issues were touched upon. Ideas for future educational programs were discussed, including the need to include civil fraud issues. The Task Force welcomes new members.