Bankruptcy. The word brings a heavy sigh and a roll of the eyes to those directly responsible for managing a consumer loan or credit card portfolio at a financial institution. Consumer loans are generally considered to be any loan that is not secured by a mortgage, with a preponderance of those being unsecured (personal) or automobile loans. Bankruptcy comes in several forms (chapters) and can affect every type of loan, but it is the unsecured loan/credit card and the Chapter 7 bankruptcy that causes the most losses. Smaller community banks and credit unions especially suffer from bankruptcy due to their limited market share and revenue generating capacity.
When it comes to bankruptcy, Chapter 7 and Chapter 13 are the two predominant chapters. Chapter 7 is often referred to as a liquidation plan. The debtor alleges insufficient income and assets to meet their debt, above and beyond the normal living expenses of food, shelter, clothing and transportation. The ultimate objective of a Chapter 7 is to obtain a discharge, which is the legal absolution of a debt. Chapter 13 is a repayment plan normally filed for a debtor to pay loan arrears over time on secured debt, usually the mortgage(s) and car loan(s). Unsecured debt may also be included in a Chapter 13 filing, but the percentage allocated for repayment generally amounts to nothing more than throwing the dog a bone, with the majority of the debt written-off. For the most part, the lender is protected under both chapters on their secured debt to the extent of the equity in the collateral. This article, however, is not designed to provide a tutorial on the bankruptcy code, but rather to explore how a financial institution can effectively analyze a debtor’s Chapter 7 filing. That filing may contain errors in the debtor’s favor, omissions, misrepresentations, fraud, or a combination thereof, leading to your particular debt being declared non-dischargeable. The Chapter 7 could also be dismissed, withdrawn or converted to a Chapter 13. Obtaining a loan through fraudulent means is non-dischargeable under the bankruptcy code — with possible criminal charges attached. So is intentionally hiding and disguising assets, such as conveying them to another party prior to filing.
The Chapter 7 process begins with a debtor hiring an attorney who usually specializes in debtor bankruptcy representation, although the debtor is allowed to file on his or her own behalf. At the time of filing a trustee is appointed (known as an interim trustee under the code) to administer the case. The trustees are attorneys who either reside or practice within the jurisdiction where the bankruptcy case is filed. They are paid a fee by the court for their service. Twenty-one (21) United States Trustees across the nation monitor the interim trustees. A meeting of creditors is then scheduled, approximately 30 to 40 days after filing.
Upon receipt of a bankruptcy notice you should immediately obtain a copy of the debtor’s petition and schedules. You can obtain them through Public Access to Court Electronic Records (PACER). PACER can be accessed at www.pacer.gov. It is an inexpensive service that charges a minimal fee for each page viewed and printed. There is no charge for setting up the service. Every document filed with the court for the life of the bankruptcy will be recorded on PACER.
The petition and schedules will provide you with the income, expenses, assets and liabilities of the debtor, along with other information such as safe deposit boxes, previously closed financial accounts or any business owned over the last several years. You are now in a position to begin your review.
Analyzing the Petition and Schedules
The first step after obtaining the petition and schedules is to perform a deliberate line-item review of every page. Pay particular attention to Schedule I (Current Income of Individual Debtor[s]) and Schedule J (Current Expenditures of Individual Debtor[s]). The statement of monthly net income at the end of Schedule J will provide you with the remaining disposable monthly net income of the debtor, either a negative or minimal positive amount. The irony about this is that the debtor obviously strives to show a lack of disposable income for their debt; however, Schedule J deals specifically with normal living expenses as previously mentioned. So when a debtor claims to have a negative cash flow it begs the question of how they are able to survive on a month-to-month basis.
Most debtors who file Chapter 7 are employed at the time of filing, and if a joint filing (generally husband and wife) at least one of them is usually employed. Something to initially hone in on is the amounts allocated for payroll deductions. Amounts being deducted for 401K and 403B tax-deferred savings plans are voluntary deductions and disposable income. Some debtors may have extremely large deductions, well above what should be deducted for the purpose of determining monthly net income. Most schedules will have the payroll deductions broken down (federal and state income taxes, social security, health insurance contributions, savings plans, etc.), but some may just have a lump sum listed. Whether the debtor’s attorney intentionally attempted to disguise the voluntary deduction, was lazy, sloppy or naïve about savings plans is a separate discussion. Depending on whether the debtor has health insurance contributions included, a tip-off for investigating a lump sum amount is when it exceeds 20 to 25 percent of the gross income.
Something to initially hone in on is the amounts allocated for payroll deductions
Although extremely rare, you may stumble across a Schedule I where a debtor has an excessive amount of payroll deductions, as high as 75 percent, almost exclusively for federal and state income taxes. Why would anyone in his or her right mind be doing that? It certainly raises the question of whether the debtor is making additional income; and rather than go through the trouble of making estimated tax payments structures their payroll deductions to compensate for it. It also leads to the follow-up question of where is this additional income on Schedule I and/or is it money laundering? An individual earning legal or illegal unreported income may be living off it, thus allowing their entire paycheck to go to the government — laundered in the form of a tax refund.
As you begin to compare the information in the petition and schedules to the information on the loan application, the crux of what you are looking for is any material misrepresentation(s) that favorably influenced your decision to approve the loan, and/or assets and income not disclosed or substantially different from what was stated in the loan application.
Examples of the above would be a loan application which shows a debtor who owns a significant amount of tax-exempt bonds, several acres of land, has a second or third source of income, or who may be receiving child support or alimony; items that are not listed in the filing. People who file for bankruptcy for the first time (repeat filings are growing rapidly) are totally unfamiliar with the process and rely on their attorney for guidance. The attorney is only as good as the information provided, or sought, at consultation. Debtors often lie or withhold information for a variety of reasons, often because of tax evasion concerns or just plain ignorance. The above mentioned bonds may be simply stuffed in a file cabinet in the debtor’s home, out of sight and out of mind — or intentionally left out.
A filing that reports an annual income of $40,000, and a loan approval that was based on a tax return showing an annual income of $100,000 for that same year, goes right to the heart of a possible fraudulent document.
A more pedestrian example would be a debtor who reports a negative monthly net income of $200 on Schedule J. The loan application lists a second net income of $400 per month for serving on a local government zoning board, income not reflected on Schedule I. The position began in January, the loan originated in February, and the bankruptcy was filed in November. While the zoning board pay stub is in the loan file and the extra income is used to calculate the debt to income ratio (DTI), a W-2 would not be generated until at least January of the following year. This additional income would not be reflected on the debtor’s current tax return on the date of the filing since their employment began in the same calendar year as the filing. Unless the debtor volunteers this information at the time of filing, it would be extremely difficult for their attorney, or the Chapter 7 trustee, to recognize this omission from any related financial documents in connection with the filing. This discovery would now change the monthly net income from a negative $200 to a positive $200, maybe not enough to affect the filing on its own, but when coupled with any further discovery a more favorable basis for a challenge may arise.
In one particular case a bank had a customer who would routinely borrow against a stock certificate of 500 shares. Instead of releasing the certificate every time the loan was paid off, the bank would just maintain it in its vault, the certificate, in effect, acting as revolving collateral. This went on for years with the 500 shares always sufficient to collateralize the amount the customer applied for under the bank’s underwriting guidelines. Eventually, the customer applied for a larger loan with 600 shares now required for collateral. The customer brought an additional certificate for 1,500 shares to replace the one for 500. Since the customer was in no rush to sell the stock, and because breaking the larger certificate into smaller ones would require time, it became a moot point to the customer that the loan was over collateralized. The bank was certainly glad to have more than sufficient security especially if there was a sudden catastrophic downturn in the market. The customer, in fact, let the bank continue to retain possession of the 500 shares.
A year later the price per share of the smaller certificate is more than enough to satisfy the loan. The customer sells the stock, pays off the loan, and in fact receives several thousand dollars from the sale. The customer simultaneously requests the larger certificate be released, a certificate worth $60,000. Two months later the customer files for Chapter 7, which includes a large credit card balance at the same bank. Luckily for the bank, the collection officer is diligent enough to realize that the certificate for the 1,500 shares is not listed in the filing. Further investigation uncovers that the shares were sold several weeks after being released, which was several weeks prior to the filing. The proceeds were then transferred to a close relative. The bank objected and the court ruled that the transfer be set aside. The debtor, facing bankruptcy fraud charges through the United States Trustee, was able to retrieve the funds, resulting in all creditors being paid in full.
Finally, do not limit your review to just the loan application(s) of the debt(s) in question. A comprehensive review of the entire customer relationship with your institution should be undertaken, especially loan applications from previously paid loans and any available tax returns. A tax return may show dividend income from various stocks, yet the filing shows no corresponding information. A filing that lists no safe deposit boxes, when your debtor has a current or recently closed box at one of your branches, will certainly peak the interest of the trustee, not only because of the false statement but more importantly for what may be inside. If time allows, or your review points in that direction, you may wish to look-over documents of relatives and business associates to determine if any inconsistencies or joint ownership of assets exist, assets they listed but your debtor did not.
The quintessential example of the above was a recently divorced debtor who listed a monthly rent of $1,500 on her Schedule J at her new residence. The address turned out to be her parents’ home where she was living. The bank also held the mortgage on the property, which was paid by an automatic transfer from the parents’ account, an account funded from their own paychecks. Even though the debtor claimed she was giving her parents the monthly rent in cash, neither the debtor, nor her parents, could provide any substantive proof. The case was ultimately dismissed.
Unfortunately, years ago debtors were required to list all debts and assets, but times have changed. Competition, and the cost of doing business, has driven most financial institutions to streamline their unsecured/credit card applications to name rank and serial number. This certainly gives the creditor less information with which to work.
Reviewing Deposit Accounts
Where bankruptcy and anti-money laundering (AML) can cross paths is when the debtor has a deposit account, preferably a checking account, with your institution. A checking account can paint a picture of an individual worthy of an FBI profile. It can also expose transactions and activity that are inconsistent with the filing. An example of this would be significant cash deposits by your customer in addition to the direct deposit of their payroll check, which rules out the likelihood of cashing a paycheck somewhere else then depositing the proceeds into your institution. Depending on the amount of cash deposited, your AML compliance department may already be monitoring the situation. A common theme is a debtor making a cash deposit at the beginning of each month, which may be indicative of rental income. The above scenario can be even more incriminating if the deposit is a third party check and the memo section has the words “monthly rent” written across it. As mentioned previously, a debtor may not be disclosing this to their attorney because they are not reporting the rental income on their tax return.
Further red flags could be a debtor writing a check each month to another bank, referencing “beach house share” in the memo section. This would lead one to believe that the debtor is contributing to a mortgage payment on a beach home, which is nowhere to be found in the filing. Checks payable to expenses associated with a stable may suggest the debtor has an ownership interest in a racehorse. A check payable to the tax receiver of a rural county, in a state a thousand miles away, may mean your debtor owns a large tract of land. A monthly automatic clearing house (ACH) charge for a dock rental indicates that the debtor may have some type of ownership interest in a boat.
All deposits, withdrawals and wire activity should be reviewed for a year prior to the filing. Windfalls, such as funds from a lawsuit settlement, deposited up to a year before the filing, should be reflected in the filing. Any custodial account of the debtor needs to be examined. People routinely use custodial accounts as a secondary account for anything you can think of, not realizing that once the money is deposited it can only be legally used for the benefit of the minor. Often, it is just for segregating funds for financial discipline, such as saving for the property tax bill. Just as often it may be to try and disguise a source of funds. If the deposit was the previously referenced rental income or lawsuit settlement the entire complexion of the filing could change.
In one comical case a bank customer withdrew four cashier’s checks from his savings account, for $20,000 apiece, six months prior to filing. All four checks were payable to the customer. When the bank investigated to determine where the checks were deposited they discovered they were never cashed. Turns out the customer was holding them in his wallet and waiting to deposit them after his discharge.
Credit Card Activity
Similar to a checking account, a person’s credit card charges can also give tremendous insight into an individual’s lifestyle, habits, hobbies and predilections. The charges can also provide an indirect avenue for discovering assets and/or additional income.
People have been known, on occasion, to purchase an automobile with their credit card, titling the vehicle in a relative’s name. They then list the credit card in their filing as an unsecured debt eligible for discharge. If the creditor fails to review the credit card charges the debtor may very well get away with perpetrating a huge fraud.
All deposits, withdrawals and wire activity should be reviewed for a year prior to the filing
Running up charges in excess of $500 within 90 days prior to filing, known as the presumption period under the code, for any single luxury item can give rise to the presumption of fraud, potentially making the debt non-dischargeable. The same applies to cash advances with the parameters being $750 within 70 days.
Running up those same charges at any time, then immediately paying them in full, can also be a sign of additional income. It is also a textbook example of money laundering. Someone who makes payments totaling $30,000 during the year when their filing reports a gross income of $45,000 per year makes little sense and warrants a review about where those credit card payments are originating.
Meeting of Creditors
Since bankruptcy stays (ceases) all communications with a debtor, the purpose of the meeting of creditors is to allow any creditor the opportunity to question the debtor(s) directly. The Chapter 7 trustee also asks the debtor certain questions, but the major difference is that a creditor may have information that the trustee is not aware of. The meeting of creditors is not mandatory and unless your review produces some serious questions it may not be worth attending. Showing up and complaining that the debtor is inflating some of their expenses, which can be subjective, will, fall on deaf ears.
While the trustee performs the required due diligence to determine that the petition and schedules accurately reflect the debtors financial position, the trustee’s real job is ensuring there are no overt misrepresentations on the surface, that the required filings are in place and that any assets of the estate are liquidated and distributed among the creditors. Many trustees, though, have large caseloads and are not able to scour the debtor’s financial records to ensure the accuracy of the filing down to the last penny. Trustees are also guided by their own interpretation of the meaning of due diligence.
While fraud is the common term used to describe any questionable entry or oversight in the filing, it is important to remember that while the trustee will demand an explanation he or she is not your advocate in the process. Ultimately, the trustee will have to make a final determination as to what exactly is going on, the degree of material misrepresentation, amounts involved and accompanying circumstances often dictating the next move. The petition and schedules may simply need to be amended, or the trustee may move to dismiss the case or seek conversion to a Chapter 13. Referral to the United States Trustee for prosecution for fraud may also be part of the equation. The bankrupt and their attorney may even decide to withdraw their filing, discretion being the better alternative to what may happen next.
Contesting the Bankruptcy
You have the right to contest a bankruptcy by either motion or through an adversary proceeding. Both are actions in the bankruptcy court where a bankruptcy judge makes the final decision. In a perfect world, and as a matter of cost effectiveness, the Chapter 7 trustee would bring an action to enforce any of the remedies previously outlined. While the Chapter 7 trustee must also prove his or her case, their opinion as the case administrator and court officer, carries substantially more weight than that of a creditor. The first thing to be cognizant of is that as a creditor you are not bound by any decision of the trustee not to act on your behalf. If you are dealing directly with the trustee in an effort to save legal fees, the second thing to be aware of is the deadline to file an objection to the discharge. While the trustee may be considering your allegations, do not be lulled to sleep. Should the date pass there may be no recourse or an additional expense for the court to reconsider opening the case. As the deadline approaches, have your attorney prepared to file a motion to extend the time to object.
You have the right to contest a bankruptcy by either motion or through an adversary proceeding
The circumstances under which you should proceed by motion or adversary proceeding is best determined in consultation with your attorney. There are several factors to consider. Are you objecting to prevent the discharge of just your particular debt or because of false or misleading information not necessarily related to your debt? In the case of your own debt a creditor must convince the court that misrepresentation or fraud led to a loan being approved that otherwise would have been denied. Conversely, if you are objecting on the basis of a totality of circumstances, abuse, and/or hidden assets, your objection acts on behalf of all the creditors involved in the bankruptcy. The inherent problem here is that you become the only creditor footing the legal bill. If the case is dismissed, your ability to pursue and recover the debt remains alive. If the case is converted to a Chapter 13, or if the debtor subsequently files a Chapter 13, you may have just thrown good money after bad, since the pro rata share of recovery may end up being far less than the cost of the objection.
Fraudulent documentation, as previously touched upon, makes the strongest case for objection. An all too often scenario is a loan applicant who provides leases showing significant rental income. The applicant even produces bank statements showing a monthly deposit that matches the lease rent. Based on that rental income the loan meets the DTI and is approved. Subsequently, after default and filing, an investigation determines that the leases are phony and that the bank statements reflect the same recycled cash. Not only do you have a winning case against discharge but one worthy of a suspicious activity report (SAR).
Prior to contesting a bankruptcy, you may consider having your attorney write to debtor’s counsel advising of the impending action and outlining your case. After weighing the strength of your claims, debtor’s counsel may not like their chances in court, leading to a possible settlement or reaffirmation.
While not as titillating as the song by Lady Gaga, you may discover some misrepresentation in the filing that is not substantial enough to warrant the expense of further action, but may be worth the cost of a letter intimating further action. To put it in layman’s terms, it’s a bluff. Occasionally, a debtor’s attorney may be reluctant to take a chance on the creditor actually proceeding, factoring in the additional time and expense to defend a client who may not be able to pay any further.
This article focused on Chapter 7 of the bankruptcy code since the number of Chapter 7 filings far exceeds those of Chapter 13. Most Chapter 13s however, provide for either minimal or no repayment of unsecured debt, leaving the creditor no better off than if the debtor had filed a Chapter 7. Many creditors look at a Chapter 13 as something being better than nothing. While that may be true do not throw in the towel so fast. The same principles of review, and eventual decision to contest, also apply to a Chapter 13.
Discharge of Creditor
Bankruptcy losses are a cost of doing business. Unfortunately, the system is weighted so heavily against the creditor that contesting an action, even when you believe you have a strong case, can leave you shaking your head in bewilderment. When politicians argue over middle class tax cuts I sometimes have to laugh. With bankruptcy, we have had it for decades. The moral of the story is simple. When a customer files for bankruptcy, instead of waiving the white flag, start searching for the red ones.