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.
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