What To Do When You Expect a Debtor Has Committed Bankruptcy Fraud

The U.S. bankruptcy system is generally an efficient mechanism for companies and individuals seeking to restructure their debts and obtain a fresh start. However, the effectiveness of the bankruptcy system relies on integrity and fairness—both of which may be undermined by filers with ill intent. When a debtor has engaged, or continues to engage, in some kind of misconduct, parties in interest have many options for seeking redress.

One of the purposes of the U.S. trustee program is to monitor bankruptcy crimes and protect against abuse. Individuals who suspect that a debtor is committing bankruptcy fraud may raise those allegations with the U.S. Trustee’s office. The U.S. Trustee program regularly makes bankruptcy-related criminal referrals the U.S. Attorney’s office.

According to statistics put out by the office of the U.S. Trustee, the most common crimes referred to the U.S. Attorney’ s office include tax fraud, false oaths, and other bankruptcy fraud schemes.^[1] However, the U.S. Code criminalizes additional bankruptcy-related misbehavior, including concealment of assets, bribery, embezzlement, and knowing disregard of bankruptcy laws or rules. See 18 U.S.C. §§ 152-158.

Perpetrators of bankruptcy crimes can expect to receive hefty criminal sentences. For example, in December 2024, a real estate developer in Chicago received nearly 13 years in prison for his participation in an embezzlement conspiracy.^[2] Just last month, an individual in New Orleans was sentenced to 27 months in prison for various bankruptcy and non-bankruptcy crimes.^[3]

Creditors may also take some actions on their own. For example, if a creditor suspects that a debtor’s filings were inaccurate or incomplete, the creditor may appear and ask questions at the debtor’s 341 meeting, where the debtor must testify under oath.

In some instances, creditors may want to take a more aggressive approach. For example, in a chapter 11 case, where a debtor usually continues to operate its business in the ordinary course, a creditor may move for the appointment of a chapter 11 trustee. If a chapter 11 trustee is appointed, the trustee will take over the operation of the debtor’s business and make decisions about the estate’s property. If a debtor’s fraud is ongoing, a chapter 11 trustee may be an effective way to prevent further mismanagement or depletion of estate assets.

A court will grant a party in interest’s motion for a chapter 11 trustee for cause, including fraud, dishonesty, incompetence, or gross mismanagement. The court may also order the appointment of a chapter 11 trustee when it is in the best interest of creditors, equity security holders, or other interests of the estate.

The appointment of a trustee is the exception in chapter 11 cases. Alternatively, a creditor may seek the appointment of an examiner. Although the appointment of an examiner is also somewhat rare, pursuant to the Third Circuit’s ruling in In re FTX Trading Ltd.^[4], the appointment of an examiner is mandatory if a party in interest requests one and the debtors have more than $5 million in fixed, liquidated unsecured debt. As a result, it may be easier for a creditor to obtain the appointment of an examiner than a chapter 11 trustee.

The role of an examiner is usually much more limited than the chapter 11 trustee. Typically, an examiner will be tasked with investigating different kinds of fraud, mismanagement, or other irregularities within a debtor’s business. The examiner will also publicly file a report with the results of his or her investigation, and will sometimes recommend if claims should be brought against the debtor’s current or former insiders and others. The examiner’s investigation will be funded by the estate.

The bankruptcy system has multiple mechanisms for safeguarding the integrity of the system. Creditors who suspect that a debtor may be committing some kind of misconduct should evaluate all of their options before proceeding.

[1] https://www.justice.gov/ust/media/1384561/dl?inline; https://www.justice.gov/ust/page/file/1592296/dl?inline; https://www.justice.gov/ust/media/1248631/dl?inline.

[2] https://www.justice.gov/usao-ndil/pr/real-estate-developer-sentenced-nearly-13-years-prison-embezzling-millions-failed.

[3] https://www.justice.gov/usao-edla/pr/chinese-national-sentenced-bankruptcy-fraud-and-violations-federal-controlled.

[4] 91 F. 4th 148 (3d. Cir. 2024)