Bankruptcy Needn't Become a Haven for Frauds

When, in trying to get a bank loan approved, does the otherwise innocent "puffing" of asset values and minimizing of liabilities on financial statements lose its innocence and become misrepresentation?

Perhaps it is when borrowers attempt to repudiate all responsibility for their obligations and seek to get away without repaying a loan by filing under Chapter 7 or Chapter 11 of the federal Bankruptcy Code.

Just looking at my own case portfolio, I have a number of lawsuits where banks are aggressively challenging individuals who are filing Chapter 7 or 11. These debtors seek to discharge their obligations - that is, to simply walk away without repaying a cent of their loans.

What these would-be "fast dancers" had better be aware of is that they cannot discharge their debts by filing for bankruptcy if the debts they incurred are related to taxes, alimony, or debts obtained by fraud or the use of false financial statements.

Taking Off the Gloves

Furthermore, they had better recognize that their friendly neighborhood banker, who they thought was too nice or too passive to come after them, is now on the offensive and is vigorously pursuing the bank's rights under the law.

With bottom lines tighter than ever before, with increased scrutiny by both regulators and shareholders, and with prudent or regulator-mandated reserves for possible loan losses higher than ever before, banks can ill afford to be as indulgent as they once might have been in ignoring such abuses of the system.

Perhaps most important, the banks are being supported in their efforts by the courts.

Ruling Favors Lenders

Earlier this year, the U.S. Supreme Court handed down a decision unformly asserting that the burden of proving fraud in declaring debts nondischargeable in bankruptcy is by "a preponderance of evidence," not the more stringent "clear and convincing evidence" standard routinely used by many courts.

This is good news for lenders, because they undoubtedly will find themselves faced with a larger number of alleged bankruptcy cases worth pursuing in the courts. These cases almost always involve false financial statements - and false financial statements and fraud go hand in hand.

A Case of Misrepresentation

Let me give you a typical example of what I'm talking about. In one case my firm currently has before the courts, we are challenging a defendant's right to discharge his debts by filing a Chapter 7 liquidation - he would give up all his assets to discharge all of his liabilities.

We believe the "preponderance of evidence" when presented in open court will show that he obtained his bank loans fraudulently and manipulated the system over and over for his own self-interest, to a point where he wants it to appear he has no assets with which to discharge his $2 million obligation to my bank client. Let me cite a few highlights.

The defendant, a closely held mortgage company and its 50% owner, had a $1 million warehousing line of credit with the bank. The mortgage company had been given this line of credit to draw against for the sole purpose of financing first mortgage closings on specific home purchases. The loan would be repaid to the bank when the mortgage was sold to a predetermined permanent investor. The draw against the line of credit was represented to be fully secured by the mortgage or an assignment of the mortgage being financed.

So far this sounds good. But the waters muddy quickly. We found that the customer had entered into another warehousing line of credit agreement with another bank and, we allege, improperly began using both lines of credit, including using one mortgage to secure two loans.

Multiple Lines of Credit

Similarly, warehouse lines of credit with at least one other financial institution were drawn upon by the mortgage company to satisfy obligations at the bank.

In effect, warehouse credit potentially was available to be used by the mortgage company two and three times with corresponding draws against different lines of credit without any intent to have a permanent investor purchase the mortgage.

We also have uncovered records disclosing that in further violation of its agreement with the bank, the mortgage company routinely used monies advanced by the bank for purposes other than the funding of third-party mortgages.

How the Money Moved

Among other things, the mortgage company used the funds to reduce the mortgage company's debt on the warehouse line of credit maintained at another bank. The funds were also used to provide operating capital to the mortgage company, which in turn was advanced to corporate officers as loans, without any promissory notes or other terms of repayment.

And some of the money was used to pay the personal debts of the mortgage company's officers, including the owner of 50% of the company, and his wife.

We discovered that the owner of the mortgage company had used the bank's warehouse line of credit to distort the company's book value to increase by $700,000 the company's working capital. This was apparently done because the shareholders had insufficient funds available to contribute to the company to enable it to meet its minimum capital requirements for licensing by the state of New Jersey.

At that point, its mortgage brokerage license would have been terminated and it would have been unable to sell mortgages to the Federal National Mortgage Association, the Federal Home Loan Mortgage Corp. and other government agencies.

False Assurances

To show a decrease in liabilities and an increase in shareholder contributions to capital, the owner of the mortgage company apparently falsely represented to the bank that the transfer of a corporate obligation to himself and his 50% partner was needed for tax purposes - a commonly used tax loophole.

The owner assured the bank that nothing would change either in the manner of warehousing loans or in the security pledged to the bank. He also agreed to pledge mortgages on his and his 50% partner's personal residences as further security to induce the bank to accept their personal obligations.

To improve his company's assets on its balance sheet, the records reviewed to date suggest he fabricated a "typical" mortgage loan to allow a draw down on the bank's warehouse line of credit with the intent that the draw down would be contributed as working capital to his company.

The anticipated result would be an improvement of the company's assets on its balance sheet, as there would be no corresponding increase in the company's liability, since the warehouse line of credit simultaneously had become a personal obligation of the owner.

This "typical" mortgage loan was fabricated for his mortgage company partner, with a false assignment of that mortgage.

Bookkeeping Legerdemain

The bank, relying upon the customer's representations that the "closing" was like all other warehouse extensions of credit, loaned the customer an additional $700,000. Then, we believe, the customer used the $700,000 to falsely inflate the amount of his company's cash at yearend, solely to improve illegally its balance sheet to meet the minimum capital requirement guidelines for licensing by the state.

We assert that this manipulation of a fully secured corporate obligation into an unsecured personal obligation - a significant transaction effected without the approval of the bank's board of directors - was part of a scheme orchestrated by the owner to falsify his mortgage company's financial statements and, in the process, to defraud the bank of an additional $700,000.

Needless to say, the mortgage company appears insolvent and without tangible assets. There are no warehouse mortgages or personal mortgage of the owner from which the bank might recover some of its loss. And the individual owner has filed Chapter 7 in a last-ditch attempt to discharge in full an admitted $2,000,000 obligation to our client.

Where the Borrower Stumbled

An ironic twist to the case, and one that may prove critical to the bank's success in the case, is an apparent material misrepresentation made on the credit application of the debtor early on in his relationship with the bank.

The seemingly innocuous question, present on every typical bank application, sought disclosure of judgments against the debtor. The response was the debtor's check mark in the box designated "no."

As the bank eventually was to learn during discovery in the bankruptcy fraud case, the debtor had a judgment of approximately $180,000 against him, which he knowingly had failed to disclose on his credit application.

And that judgment the bank now knows arose from the debtor's personal guarantee of a bank loan to another mortgage company. That mortgage company had filed for bankruptcy amidst widespread allegations of double and triple pledging of mortgages that were used to borrow against various bank warehouse lines of credit - exactly the type of fraud that my client says caused it to lose $2,000,000!

Had the bank only known, it likely never would have done business with this company and its owner.

Overvalued Security

In another case that I am handling and that is pending in the bankruptcy court, a bank customer who has filed for protection from creditors under Chapter 7 submitted a financial statement that underrepresented the secured debt against his personal residence, which the statement had valued at $495,000.

The financial statement also listed accounts receivable due to the debtor of $212,000 and other assests totaling $50,000. Needless to say our client, the bank, incredulously learned upon the debtor's bankruptcy filing that the lien in front of its lien was $295,000, not $195,000 as the debtor had represented, and the value of the residence had plummeted to $300,000.

The accounts receivable were nonexistent and the debtor's petition in bankruptcy now listed the erstwhile $50,000 worth of personal assets as having a value of less than $2,500. The approximately $350,000 the bank thought it had lent as a secured loan was at risk of being discharged inits entirety.

An Agressive Challenge

The bank lost no time and immediately had us file a complaint objecting to the husband and wife debtors' attempt to discharge their almost $350,000 obligation to our client.

We agressively conducted depositions of the husband and wife team that led to disclosure of further information in support of the bank's claim of fraud. For example, part of the bank's loan - $250,000 - was not used for business purposes as the debtor had represented it would be, but instead was reloaned to a third party unrelated to the debtor.

Setting to one side the blatant misrepresentation of the purpose of the loan, that loan by the bank's debtor to a third-party represented a potential asset of the bankruptcy estate, assuming it could be collected from the third party's assets, but it had not been listed as an asset in the original bankruptcy petition.

The material nondisclosure alone may prevent the debtor's discharge in bankruptcy. And it was disclosed only after the bank had filed its complaint in the bankruptcy and had sought the husband's and wife's depositions.

Debts to Family Members

The wife's deposition revealed that the debtors owed thousands of dollars to family members that intentionally had been omitted when they filed their petition and whom the debtors hoped to repay while other creditors received nothing.

They hoped to repay the family members apparently from the approximately $60,000 annual salary the wife continued to receive from a prominent New York law firm, even after having filed for bankruptcy,

The last and perhaps most disturbing example of this recent trend in, or maybe logical extension of, white-collar crime is a bankruptcy case I am involved with that was filed in New York.

There, a man who was at the same time an accountant, lawyer, and self-professed oil and real estate speculator/mogul submitted a financial statement to a bank my firm is representing. Thisindividual sought to induce the bank to lend $175,000 to a partnership in which this soon-to-be-debtor was a general partener and the one guaranteeing the loan.

The House Security that Wasn't

Personal financial statements had been provided to the bank covering several years. These statements listed the value of the debtors' personal residence as growing in value from $260,000 to $400,000.

It therefore came as a complete shock to the bank when under oath in the bankruptcy the debtor testified for the first time that his personal residence had been transferred to his wife some 16 years ago, and therefore its substantial equity was unavailable to satisfy the bank's claim!

Is there a moral to these stories of misguided attempts to use improperly first the banking system and then the bankruptcy courts to borrow and use, but not repay, substantial sums of money? Probably not.

Yet, while these dealings undeniably have a devastating impacton banks and their shareholders, it is the average hardworking business person, enterpreneur, and prospective new homeowner who legitimately need financing who will suffer when they find banks overly cautious or even unable to make new loans.

The end will come, but at a cost, when banks commit their resources to pursuing aggressively nondischargeable complaints in bankruptcy and when the vast majority of bankruptcy judges heed the Supreme Court's warning that bankruptcy court is no longer the safe haven it might once have been.

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