Chapter 5 THE ROLE OF THE FORENSIC ACCOUNTANT IN FRAUDULENT TRANSFER LITIGATION

• Jurisdiction: United States

Chapter 5 THE ROLE OF THE FORENSIC ACCOUNTANT IN FRAUDULENT TRANSFER LITIGATION

S. Gregory Hays

Financial distress and fraudulent activity often result in debtors attempting to shelter assets from legitimate creditors.¹⁶ Fraudulent transfer law provides a remedy to unwind or avoid and recover a transfer of property by the debtor, and is governed by 11 U.S.C. §§ 544, 548 and 550 and state fraudulent transfer statutes often adopting either the Uniform Fraudulent Conveyance Act or Uniform Fraudulent Transfer Act.¹⁷ The primary purpose of fraudulent transfer law "is to prevent valuable assets from being transferred away from debtors in exchange for less than fair value, leaving insufficient funds to compensate honest creditors."¹⁸

A plaintiff may attempt to avoid a fraudulent transfer pursuant to two theories of recovery. First, a transfer of an interest of the debtor in property or an obligation may be avoided as an actual fraudulent transfer if the plaintiff establishes that the transfer was made with the actual intent to hinder, delay or defraud any creditor of the debtor.¹⁹ Second, regardless of actual intent, a plaintiff can avoid and recover a transfer of an interest of the debtor in property or an obligation as a constructively fraudulent transfer if the plaintiff establishes that (1) the debtor received less than reasonably equivalent value in exchange for the transfer; and (2) the debtor (a) was insolvent when the transfer was made or obligation incurred or became insolvent as a result of such transfer or obligation; (b) was operating or about to operate with property constituting an unreasonably small amount of capital; (c) intended to incur debts beyond the financial ability of the debtor to pay as such debts matured; or (d) made the transfer or incurred the obligation outside the ordinary course of business to or for the benefit of an insider.²⁰

The role of a forensic accountant in fraudulent transfer litigation will vary depending on the circumstances of a case. A forensic accountant can generally influence the outcome of a case by assisting in the unraveling of a well-disguised fraudulent scheme. Forensic accountants investigate, identify and interpret documentary evidence and assist in the development of case strategies. Forensic accountants also analyze potential claims and interpret and communicate their findings.

Although certain fraudulent transfers are easy to identify, many others are difficult for attorneys, trustees and creditors to identify because the evidence of such transfers is often hidden within voluminous documents, off-book transactions or complex transactions that are not easily understood. A forensic accountant is often initially engaged to reconstruct records and identify, investigate and trace potential fraudulent transfers for the benefit of defrauded creditors. Upon identifying potential fraudulent transfers, forensic accountants communicate findings to appropriate parties and continue to play a critical role by assisting in the documentation of prima facie elements of a fraudulent transfer claim and addressing potential defenses. Forensic accountants also serve as expert witnesses and assist counsel in the discovery process, and may also serve a role in preparation of rebuttal positions in response to reports by any experts of the opposing party.

I. Identification of Fraudulent Transfers

To begin the potentially time-consuming task of identifying and documenting fraudulent transfers, a forensic accountant will generally attempt to freeze the available evidence and assets of the debtor and review available information for red flags indicating that the debtor may have fraudulently transferred assets. Next, as discussed later in this chapter, a forensic accountant will compile pertinent financial and nonfinancial documents, reconstruct books and records as necessary, and use available information to develop a database of all transactions uncovered by the forensic accountant. During and after the creation of a database of all known transactions, a forensic accountant can proceed with the process of analyzing data and tracing potential fraudulent transfers.

A. Freeze Evidence and Assets

Given that evidence may disappear or be more difficult and expensive to locate as time passes, time is of the essence in investigating fraudulent transactions. In an attempt to preserve evidence and prevent further misappropriation of assets, a forensic accountant in a case involving a Ponzi scheme or other fraud should move to immediately close accounts (in instances where the client is a bankruptcy trustee who has control over accounts of the debtor) or take action to freeze the accounts (in instances where the client is a receiver or trustee and may not have complete control over accounts of the debtor). Delay in the entry of a freeze order or closing of accounts will often result in additional tracing being required, lost assets and potentially reduced recoveries.

B. Red Flags of Potential Fraudulent Transfers

The presence of certain red flags may indicate that the debtor fraudulently transferred assets to defraud creditors. Forensic accountants should look for red flags such as (1) disorganized or incomplete books and records; (2) bankruptcy schedules that are incomplete, missing information or assets of the debtor, or are heavily revised; and (3) evidence of unrecorded transactions such as transactions shown in banking records that are not reflected in the books of the debtor.²¹ Red flags may also consist of an unusual amount of cash transactions or an increase in financial activity, loans, payments or asset transfers involving insiders of the debtor such as officers, shareholders, affiliated entities and relatives. The presence of unnecessary webs of complexity involving either transactions or intricate corporate structures and relationships is also a red flag.²²

A growing number of large chapter 11 cases involve entities that utilize a centralized cash-management system (CCMS) whereby divisions or subsidiaries of complex corporate entities upstream cash to an account of the parent entity and subsequently have expenses paid by the parent entity. The presence of a CCMS is another red flag that may lead to fraudulent transfer litigation in a bankruptcy involving the parent debtor.²³ Upon identifying red flags, further investigative work may be straightforward or involve in-depth analysis of documents, numerous interviews and other extensive tasks.

II. The Need for a Database

A. The Importance of a Database

Building an accurate and complete database of all relevant transactions is critical in complex cases involving a significant number of accounts or transactions. The database will consist of account, access and transactional data that will be linked together to document the relationships between transactions and the party or parties who controlled the accounts. The user of the database can chart where and when transactions originated, who authorized the transactions, what happened in a transaction, and where funds and assets flowed. The database will initially be used to (1) track the flow of funds and assets to, from or on behalf of the debtor being investigated; (2) assist in any required reconstruction of the books and records of the debtor; and (3) analyze transactions involving assets of the debtor.

B. Building the Database

The process of building a comprehensive database of all known transactions begins with collecting pertinent financial and non-financial documents. After the identification of relevant accounts, data from available bank, credit and investment statements and other pertinent sources is verified and used to develop a database of all transactions uncovered by the forensic accountant. As information from the account statements is input into the database, each account is balanced between the database and the statement to ensure that all known transactions involving the debtor are included in the database. Both debits and credits from the statement are input as a double-entry system of accounting to reconcile back to the statement. The double-entry system assists in following the flow of funds between applicable accounts and ensures that the database reflects all funds and assets flowing into and out of the debtor. As with any investigation, more leads, questions and information will surface during and as a result of the construction of the database.

C. Use of Database as a Reference

The database will serve as a reference source to assist in responding to inquiries or requests by counsel or other parties and provide supporting documentation for exhibits that may be used when communicating findings. A forensic accountant is often requested to assist counsel in various situations such as depositions by accessing the database during testimony and identifying related transactions in other entities. By having quick access to a reliable database and the supporting documents electronically, the forensic accountant can provide great value to the pursuit of fraudulent transfer litigation.

III. Collecting Data

The process of collecting accurate data is crucial to (a) obtaining relevant information to be included in the database and (b) identifying relevant accounts and potential off-book transactions involving the debtor. Counsel may participate in the data-collection process by issuing subpoenas for the production of documents and records, but the forensic accountant will generally take the lead role in the collection of banking data. Banking data to be used in the database originates from (a) books, documents and records of the debtor either provided by the debtor or obtained from on-site collection; (b) third parties; and (c) documentation maintained by financial institutions.

The role of the party employing the forensic accountant or the nature of the action will dictate what is needed to access the necessary data. For example, if the employing party is the trustee of the estate...