Bankruptcy and Fraud: The Ties That Bind?

Five Key Findings

The study, which analyzed SEC Accounting and Auditing Enforcement Releases relating to 139 public companies with revenues greater than $100 million and bankruptcy filings of 519 such entities, had five key findings:

• Nine percent of Bankrupt Companies were the subject of SEC enforcement releases alleging financial-statement fraud, compared with only 3% of Non-Bankrupt Companies.
• Thirty-five percent of the companies that were the subject of SEC enforcement releases for financial-statement fraud filed for bankruptcy, compared with 14% of similar companies that were not the subject of such enforcement releases.
• Sixty-nine percent of financial-statement fraud enforcement releases relating to Bankrupt Companies were issued by the SEC within three years after the subject companies' bankruptcy filings. Fewer than one in seven (14%) were issued before the companies filed for bankruptcy.
• Bankrupt Companies were twice as likely as non-Bankrupt Companies to have more than 10 alleged fraud schemes and at least 1.5 times as likely to have six to 10 alleged fraud schemes.
• The top three industries for companies over $100 million in revenue that were issued financial-statement fraud enforcement releases were consumer business, TMT (technology, media and telecommunications), and manufacturing.

We explore each of these findings and their implications in greater depth below. An explanation of the study methodology appears in the sidebar below.

Greater Likelihood of Fraud

It should be no great surprise that companies that file for bankruptcy protection are more likely to be alleged by the SEC to have committed financial-statement fraud in the years prior to bankruptcy. Covering up deteriorating operating performance is one of the classic motivations for financial-statement fraud. However, corporate executives, boards of directors and audit committees may be surprised that fraud allegations are three times as likely for Bankrupt Companies.

Economic stress can put managers under great pressure to achieve goals and “save the company.” In-house counsel may be able to provide valuable advice ahead of time, reminding executives to resist the temptation to resort to manipulating accounting records and advising executives not to put managers under such pressure that they do the same.

Greater Likelihood of Bankruptcy

Companies that are the subject of SEC enforcement releases related to financial-statement fraud are at more than double the risk of bankruptcy. Fraud allegations can quickly diminish confidence among lenders, vendors and customers, adversely impacting cash flow and making bankruptcy protection potentially essential. In-house counsel who become aware of allegations of financial-statement fraud at their company should keep the possibility of bankruptcy in mind. The more time a company has to prepare its filing, the stronger the debtor's position can potentially be.

Bankruptcy May be Just the Beginning

More than two-thirds of the SEC's enforcement releases related to financial-statement fraud at companies that file for bankruptcy are issued within three years after the subject companies' bankruptcy filings. This means that SEC inquiries can be active when a petition is filed, when management should be focusing on renegotiating contracts with vendors and customers, or preparing for transactions that offer the company new hope. In-house counsel may be so distracted by SEC inquiries that they are unable to support management's turnaround activities as effectively. Using outside counsel skilled in resolving SEC investigations may allow in-house counsel to focus on reorganization issues that outsiders may not be able to manage effectively.

More Alleged Fraud Schemes

Chart 1 below shows the greater likelihood of a larger number of fraud schemes alleged for Bankrupt Companies with revenue over $100 million, as compared with non-Bankrupt Companies. Some companies that file for bankruptcy protection have misstated their financial statements for years. Covering up such frauds can become increasingly difficult and insidious, as perpetrators are driven to devise new schemes to spread the fraud out in an attempt to avoid detection. In-house counsel at troubled companies should consider studying the company's most recent fraud risk assessment and discussing with the company's director of internal audit areas of potential vulnerability to financial-statement fraud where additional preventive and detective measures might be appropriate in this new environment.

Which Industries Are Affected Most?

Some industries are much more vulnerable to the intersection between fraud and bankruptcy. Chart 2 below shows that the consumer business industry had the greatest number of companies with revenue over $100 million receiving enforcement releases. That industry also has the highest proportion of such companies that file for bankruptcy ' 50%.

In the study, “consumer business industry” includes retail, wholesale and distribution, consumer services, consumer products, travel, hospitality and leisure, and health plans. With so many retailers now experiencing a significant drop in sales, retail bankruptcies appear to be surging, potentially putting additional pressure on the wholesalers and vendors further up the supply chain.

The “technology, media and telecommunications” category followed consumer business quite closely in terms of the number of companies that were alleged by the SEC to have committed-financial statement fraud, but only 11 of the 37 companies in question filed for bankruptcy protection, suggesting possibly a greater resiliency to fraud allegations in that industry.

Conclusion

As the economy continues to be weak, corporate bankruptcy filings are expected to surge. In-house counsel may need to prepare for the possibility of such a filing and consider taking additional steps to help prevent and detect financial-statement fraud, which has historically quite often preceded bankruptcy.

Study Methodology

The Deloitte Forensic Center analyzed the bankruptcy filings of 1,009 publicly traded companies that filed for Chapter 11 bankruptcy protection between Jan. 1, 2000, and Dec. 31, 2005. Eliminating companies with annual revenue of less than $100 million resulted in 519 “Bankrupt Companies” that served as the study group in this analysis.

The researchers also identified 3,163 companies that were publicly traded (as of June 2008) and had reported annual revenues of at least $100 million during the Investigation Period. Companies that filed for bankruptcy protection between Jan. 1, 2000, and May 31, 2008 were removed, resulting in a control group of 2,919 public, “Non-Bankrupt Companies.”

SEC Accounting and Auditing Enforcement Releases (AAERs) issued from Jan. 1, 2000, through Dec. 31, 2007, were reviewed. For the analysis, only final AAERs that alleged financial-statement fraud, excluding releases that dealt solely with auditors, among others, were considered. This filtering resulted in 383 AAERs issued to 352 companies. Of these 352 companies, 48 qualified as Bankrupt Companies and 91 as Non-Bankrupt Companies, as defined above.

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Toby J.F. Bishop ([email protected]), a member of this newsletter's Board of Editors, is director of the Deloitte Forensic Center, and Sheila Smith ([email protected]) is the national leader of the Reorganization Services group, both at Deloitte Financial Advisory Services LLP.

As economic turmoil continues, many companies face erosion of revenues, pressure for cost containment, and diminished liquidity. Filing for bankruptcy protection is sometimes part of the solution. In-house counsel should, among other things, consider the potential impact of current economic pressures on financial controls and the risk of fraud during a restructuring, when headcount is reduced, morale is eroded, and risk mitigation can inadvertently take a back seat to the day-to-day focus of management.

A 2008 study by the Deloitte Forensic Center and Deloitte's Reorganization Services group found that companies filing for bankruptcy protection (“Bankrupt Companies”) are three times as likely as non-Bankrupt Companies to face enforcement action by the SEC for financial-statement fraud allegedly committed pre-petition. Conversely, companies that were the subject of SEC enforcement releases related to financial-statement fraud were more than twice as likely to file for bankruptcy protection than companies that were not.

In the current environment, factors such as a shortfall in assets, lack of debtor-in-possession financing and absence of potential buyers may make liquidation the only recourse in bankruptcy. With fewer dollars to satisfy claims, creditors may resort to litigation, alleging fraud as a means for obtaining recoveries. This could lead to additional exposures for directors and officers at companies facing bankruptcy. In-house counsel should consider how the findings of the study might apply to their companies, and what steps they can take both to reduce the likelihood of fraud in the pre-petition phase and to reduce the opportunity for third parties to pursue allegations of fraud successfully.

Five Key Findings

The study, which analyzed SEC Accounting and Auditing Enforcement Releases relating to 139 public companies with revenues greater than $100 million and bankruptcy filings of 519 such entities, had five key findings:

• Nine percent of Bankrupt Companies were the subject of SEC enforcement releases alleging financial-statement fraud, compared with only 3% of Non-Bankrupt Companies.
• Thirty-five percent of the companies that were the subject of SEC enforcement releases for financial-statement fraud filed for bankruptcy, compared with 14% of similar companies that were not the subject of such enforcement releases.
• Sixty-nine percent of financial-statement fraud enforcement releases relating to Bankrupt Companies were issued by the SEC within three years after the subject companies' bankruptcy filings. Fewer than one in seven (14%) were issued before the companies filed for bankruptcy.
• Bankrupt Companies were twice as likely as non-Bankrupt Companies to have more than 10 alleged fraud schemes and at least 1.5 times as likely to have six to 10 alleged fraud schemes.
• The top three industries for companies over $100 million in revenue that were issued financial-statement fraud enforcement releases were consumer business, TMT (technology, media and telecommunications), and manufacturing.

We explore each of these findings and their implications in greater depth below. An explanation of the study methodology appears in the sidebar below.

Greater Likelihood of Fraud

It should be no great surprise that companies that file for bankruptcy protection are more likely to be alleged by the SEC to have committed financial-statement fraud in the years prior to bankruptcy. Covering up deteriorating operating performance is one of the classic motivations for financial-statement fraud. However, corporate executives, boards of directors and audit committees may be surprised that fraud allegations are three times as likely for Bankrupt Companies.

Economic stress can put managers under great pressure to achieve goals and “save the company.” In-house counsel may be able to provide valuable advice ahead of time, reminding executives to resist the temptation to resort to manipulating accounting records and advising executives not to put managers under such pressure that they do the same.

Greater Likelihood of Bankruptcy

Companies that are the subject of SEC enforcement releases related to financial-statement fraud are at more than double the risk of bankruptcy. Fraud allegations can quickly diminish confidence among lenders, vendors and customers, adversely impacting cash flow and making bankruptcy protection potentially essential. In-house counsel who become aware of allegations of financial-statement fraud at their company should keep the possibility of bankruptcy in mind. The more time a company has to prepare its filing, the stronger the debtor's position can potentially be.

Bankruptcy May be Just the Beginning

More than two-thirds of the SEC's enforcement releases related to financial-statement fraud at companies that file for bankruptcy are issued within three years after the subject companies' bankruptcy filings. This means that SEC inquiries can be active when a petition is filed, when management should be focusing on renegotiating contracts with vendors and customers, or preparing for transactions that offer the company new hope. In-house counsel may be so distracted by SEC inquiries that they are unable to support management's turnaround activities as effectively. Using outside counsel skilled in resolving SEC investigations may allow in-house counsel to focus on reorganization issues that outsiders may not be able to manage effectively.

More Alleged Fraud Schemes

Chart 1 below shows the greater likelihood of a larger number of fraud schemes alleged for Bankrupt Companies with revenue over $100 million, as compared with non-Bankrupt Companies. Some companies that file for bankruptcy protection have misstated their financial statements for years. Covering up such frauds can become increasingly difficult and insidious, as perpetrators are driven to devise new schemes to spread the fraud out in an attempt to avoid detection. In-house counsel at troubled companies should consider studying the company's most recent fraud risk assessment and discussing with the company's director of internal audit areas of potential vulnerability to financial-statement fraud where additional preventive and detective measures might be appropriate in this new environment.

Which Industries Are Affected Most?

Some industries are much more vulnerable to the intersection between fraud and bankruptcy. Chart 2 below shows that the consumer business industry had the greatest number of companies with revenue over $100 million receiving enforcement releases. That industry also has the highest proportion of such companies that file for bankruptcy ' 50%.

In the study, “consumer business industry” includes retail, wholesale and distribution, consumer services, consumer products, travel, hospitality and leisure, and health plans. With so many retailers now experiencing a significant drop in sales, retail bankruptcies appear to be surging, potentially putting additional pressure on the wholesalers and vendors further up the supply chain.

The “technology, media and telecommunications” category followed consumer business quite closely in terms of the number of companies that were alleged by the SEC to have committed-financial statement fraud, but only 11 of the 37 companies in question filed for bankruptcy protection, suggesting possibly a greater resiliency to fraud allegations in that industry.

Conclusion

As the economy continues to be weak, corporate bankruptcy filings are expected to surge. In-house counsel may need to prepare for the possibility of such a filing and consider taking additional steps to help prevent and detect financial-statement fraud, which has historically quite often preceded bankruptcy.

Study Methodology

The Deloitte Forensic Center analyzed the bankruptcy filings of 1,009 publicly traded companies that filed for Chapter 11 bankruptcy protection between Jan. 1, 2000, and Dec. 31, 2005. Eliminating companies with annual revenue of less than $100 million resulted in 519 “Bankrupt Companies” that served as the study group in this analysis.

The researchers also identified 3,163 companies that were publicly traded (as of June 2008) and had reported annual revenues of at least $100 million during the Investigation Period. Companies that filed for bankruptcy protection between Jan. 1, 2000, and May 31, 2008 were removed, resulting in a control group of 2,919 public, “Non-Bankrupt Companies.”

SEC Accounting and Auditing Enforcement Releases (AAERs) issued from Jan. 1, 2000, through Dec. 31, 2007, were reviewed. For the analysis, only final AAERs that alleged financial-statement fraud, excluding releases that dealt solely with auditors, among others, were considered. This filtering resulted in 383 AAERs issued to 352 companies. Of these 352 companies, 48 qualified as Bankrupt Companies and 91 as Non-Bankrupt Companies, as defined above.

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Toby J.F. Bishop ([email protected]), a member of this newsletter's Board of Editors, is director of the Deloitte Forensic Center, and Sheila Smith ([email protected]) is the national leader of the Reorganization Services group, both at Deloitte Financial Advisory Services LLP.