Bankruptcy and Fraud: The Ties That Bind?

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.