Companies Filing for Bankruptcy, and SEC Fraud Enforcement Actions

A Look at the Study

The Deloitte Forensic Center and Deloitte's Reorganization Services group published results of the study, “Ten Things About Bankruptcy and Fraud,” in November 2008. The study analyzed bankruptcy filings between 2000 and 2005 and financial statement fraud-related SEC Accounting and Auditing Enforcement Releases (AAERs) issued from 2000 through 2007 for companies with reported revenues of at least $100 million. All of the AAERs dealt with activities that allegedly occurred before the bankruptcy filings.

Researchers analyzed the bankruptcy filings of 1,009 publicly traded companies that filed for Chapter 11 bankruptcy protection. Companies that reported revenues of less than $100 million for the fiscal year that immediately preceded the bankruptcy filing were then removed from the list. In total, researchers analyzed filings pertaining to 519 bankrupt companies and 2,919 public, non-bankrupt companies, with revenue of at least $100 million for at least one fiscal year between 2000 and 2005, and 383 AAERS issued to 352 companies.

The companies that received AAERs were categorized into nine industries: aviation and transport services; consumer business; energy and resources; financial services; life sciences and health care; manufacturing; public sector; real estate; and technology, media, and telecommunications (TMT).

For the analysis, only final AAERs that alleged financial statement fraud, excluding releases that dealt solely with auditors, among others, were considered. The full report is available at www.deloitte.com/forensiccenter.

The Facets of Fraud

AAERs often describe more than one alleged fraud scheme active in a company during a given period. Twelve categories were used to classify the nature of the financial statement fraud alleged in the AAERs: aiding and abetting; asset misappropriation; bribery and kickbacks; goodwill; improper disclosures; investments; manipulation of accounts receivable; manipulation of assets; manipulation of expenses; manipulation of liabilities; manipulation of reserves; and revenue recognition.

Fraud cuts across various business sectors and many notable bankruptcies have been tainted by alleged fraud. In the troubled company arena, fraud can range from the simple to the complex. It generally is one of two broad types: self-dealing or financial statement manipulation.

In self-dealing situations, senior management with a vested interest may look for ways to extract value from the company to the detriment of other stakeholders. Financial statement fraud may occur under the pretext that the perpetrators were seeking to enhance the company's results and condition to benefit the shareholders and creditors, all under the illusion that what they were doing was not itself wrongful conduct.

Notably, a recent U.S. Second Circuit Court of Appeals ruling offers an unsympathetic view of claims that acting with the intention of benefiting the company somehow insulates alleged perpetrators from findings of wrongful conduct. The court said that even if an insider is acting purportedly to benefit the company, a bankruptcy judge must consider the intent of that individual. If the intent was personal benefit, the fact that actions taken had an indirect salutary benefit to the company does not exculpate the person.

Who May Commit Fraud?

While it is hard to generalize about financial statement fraud perpetrators, in our personal experience they have sometimes been observed to have larger-than-life personas. Often they are important, influential, and respected members of their community. Some may have made significant charitable donations. Public reaction to the SEC's allegations of financial statement fraud may include anger, skepticism and strong support for the business champions who have brought jobs and other benefits to the local community. Only when all the details come out may some people be convinced that such apparently good people did such bad things.

Apparent Linkages Between Fraud and Bankruptcy

As mentioned, the study found that bankrupt companies were three times more likely than non-bankrupt companies to be issued financial statement-fraud AAERs by the SEC. Of 519 bankrupt companies analyzed by Deloitte researchers, 48 (9%) were issued AAERs. Of 2,919 non-bankrupt companies, 91 (or 3%) were issued AAERs.

Companies issued financial'statement-fraud AAERs were more than twice as likely to file for bankruptcy as those not issued one. Of 139 publicly traded companies with revenue greater than $100 million that were issued AAERs, 48 (35%) filed for bankruptcy between Jan. 1, 2000 and Dec. 31, 2005. Of 3,299 publicly traded companies with revenue greater than $100 million that were not issued AAERs, only 471 (14%) filed for bankruptcy during the same period.

Interestingly, multiple instances of alleged fraud in the same company also appear more likely in bankrupt organizations. Bankrupt companies receiving AAERs were twice as likely as non-bankrupt companies to have more than 10 alleged financial statement fraud schemes and at least 1.5 times as likely to have six to 10 alleged fraud schemes.

Importantly, the study did not look into whether fraud played a role in the bankruptcy of the companies in the study or whether the bankruptcy process could itself be the reason the alleged fraud was uncovered. It may be that companies experiencing financial difficulties are more vulnerable to both bankruptcy and financial statement fraud. On the other hand, it may be that financial statement fraud is simply more likely to be revealed at bankrupt companies due to the added transparency and scrutiny brought about through the bankruptcy process.

Fewer than one in seven (14%) of the AAERs were issued before companies filed for bankruptcy protection. Although this is a small proportion, these situations may provide a warning signal of a potential bankruptcy filing.

Industries Affected by SEC Fraud Allegations

Over the course of the 2000s, various industry sectors have taken center stage with respect to bankruptcies and alleged fraud investigations. Early in the decade, telecommunications companies experienced financial deterioration, headlined by such names as WorldCom and Global Crossing, as well as high tech companies. Today, retail and consumer products companies appear to be at greatest risk as consumer demand shrinks and tight credit persists.

The largest proportion (30%) of companies issued AAERs in the study were in the consumer business sector. Of 42 consumer business companies that received AAERs, 21 (50%) filed for Chapter 11.

Technology, media, and telecommunications (TMT) companies represented the second highest industry sector for AAER issuance at 27%. Of 37 TMT companies that received AAERs, 11 (30%) filed for Chapter 11. Manufacturing ranked third with 22 companies (16%) being issued AAERs, seven (32%) of them in bankruptcy.

Company Size and Fraud Risk

Larger bankrupt companies appear to be more likely to be the subject of SEC enforcement releases relating to alleged financial statement fraud than smaller ones. Ten percent of the bankrupt companies issued AAERs had revenue of $10 billion and above compared with only 1% of bankrupt companies not issued AAERs. Thirty-five percent of the bankrupt companies issued AAERs had revenue of $1 billion to $10 billion, compared with 18% of those not issued AAERs. The smaller bankrupt companies studied, those with revenue of $100 million to $250 million, were least likely to be the subject of these SEC enforcement releases. This size category encompassed 21% of bankrupt companies issued AAERs and 37% of bankrupt companies not issued AAERs.

It should be noted that the larger the bankrupt company, the greater the likelihood of scrutiny that may be given to its finances, with various committees probing into its financial condition. Additionally, regulators and investigative agencies may dedicate more resources to allegations of wrongdoing at larger entities due to the potentially greater public impact.

Fraud Trends

Bankruptcy filings by U.S. publicly traded companies trended sharply downward through the middle of the present decade after peaking in 2001. Through 2007, filings by companies with revenue exceeding $100 million dropped from 126 in 2001 to about 25 annually from 2005 to 2007.

The number of alleged financial statement fraud-related AAERs issued by the SEC increased significantly beginning in 2002 amid Sarbanes-Oxley passage and greater enforcement resources. Since 2003, approximately 20 companies each year with revenue exceeding $100 million have been the subject of such AAERs, compared with just seven in 2000 and 2001.

While bankruptcies declined over the study period, today's economic conditions portend a probable resurgence. Looking to the future, financial services and real estate companies hit hard by the collapse of financial markets, declines in consumer demand, and lower retail sales appear likely to face a higher risk of bankruptcy filings and, potentially, alleged fraud revelations.

The Importance of Trust

In the past few years, some companies have created highly leveraged balance sheets with many layers of debt. When such a highly leveraged company files for bankruptcy protection, its creditors may in some situations have little other recourse than to seek recovery from non-traditional sources such as challenging potentially fraudulent conveyances, seeking recovery under directors' and officers' liability insurance policies, and filing other litigation. This potential for a strategic shift may raise risks for directors, officers, and senior management, increasing the importance of proactive fraud detection.

In this environment, trust is critical. The fraud allegations of late 2008 highlight the importance of earning and maintaining the trust of investors, regulators, lawmakers, and the public. One way to do that is to continue moving toward greater transparency and stronger anti-fraud programs. Management can also instill confidence and integrity through constant, open communication that strengthens trust and relationships.

A Growing Priority

Troubled companies can benefit from recognizing their potentially heightened risk of regulatory enforcement actions and taking steps to prevent, deter and detect fraud promptly.

Toby Bishop is the director of the Deloitte Forensic Center for Deloitte Financial Advisory Services LLP.

Companies that are entering or in danger of entering bankruptcy can potentially suffer in a variety of ways. Financial losses for investors and employees. Declines in worker performance and morale. Customer defections. And in extreme situations, liquidation. Some companies entering bankruptcy may well find themselves facing yet another disturbing reality: They may have to address acts of financial statement fraud allegedly committed along the way to Chapter 11.

A recent Deloitte study found that companies filing for bankruptcy protection were three times more likely than non-bankrupt companies to face enforcement action by the Securities and Exchange Commission (SEC) relating to alleged financial statement fraud. In addition, companies so cited by the SEC were more than twice as likely to file for bankruptcy protection as those not cited.

With economic conditions likely to further increase the volume of corporate bankruptcy filings, companies can benefit from understanding their potential exposure to allegations of financial statement fraud that may be asserted by the SEC. Consideration of potential fraud issues may be a prudent aspect of preparations for companies facing bankruptcy, as well as for their constituents.

A Look at the Study

The Deloitte Forensic Center and Deloitte's Reorganization Services group published results of the study, “Ten Things About Bankruptcy and Fraud,” in November 2008. The study analyzed bankruptcy filings between 2000 and 2005 and financial statement fraud-related SEC Accounting and Auditing Enforcement Releases (AAERs) issued from 2000 through 2007 for companies with reported revenues of at least $100 million. All of the AAERs dealt with activities that allegedly occurred before the bankruptcy filings.

Researchers analyzed the bankruptcy filings of 1,009 publicly traded companies that filed for Chapter 11 bankruptcy protection. Companies that reported revenues of less than $100 million for the fiscal year that immediately preceded the bankruptcy filing were then removed from the list. In total, researchers analyzed filings pertaining to 519 bankrupt companies and 2,919 public, non-bankrupt companies, with revenue of at least $100 million for at least one fiscal year between 2000 and 2005, and 383 AAERS issued to 352 companies.

The companies that received AAERs were categorized into nine industries: aviation and transport services; consumer business; energy and resources; financial services; life sciences and health care; manufacturing; public sector; real estate; and technology, media, and telecommunications (TMT).

For the analysis, only final AAERs that alleged financial statement fraud, excluding releases that dealt solely with auditors, among others, were considered. The full report is available at www.deloitte.com/forensiccenter.

The Facets of Fraud

AAERs often describe more than one alleged fraud scheme active in a company during a given period. Twelve categories were used to classify the nature of the financial statement fraud alleged in the AAERs: aiding and abetting; asset misappropriation; bribery and kickbacks; goodwill; improper disclosures; investments; manipulation of accounts receivable; manipulation of assets; manipulation of expenses; manipulation of liabilities; manipulation of reserves; and revenue recognition.

Fraud cuts across various business sectors and many notable bankruptcies have been tainted by alleged fraud. In the troubled company arena, fraud can range from the simple to the complex. It generally is one of two broad types: self-dealing or financial statement manipulation.

In self-dealing situations, senior management with a vested interest may look for ways to extract value from the company to the detriment of other stakeholders. Financial statement fraud may occur under the pretext that the perpetrators were seeking to enhance the company's results and condition to benefit the shareholders and creditors, all under the illusion that what they were doing was not itself wrongful conduct.

Notably, a recent U.S. Second Circuit Court of Appeals ruling offers an unsympathetic view of claims that acting with the intention of benefiting the company somehow insulates alleged perpetrators from findings of wrongful conduct. The court said that even if an insider is acting purportedly to benefit the company, a bankruptcy judge must consider the intent of that individual. If the intent was personal benefit, the fact that actions taken had an indirect salutary benefit to the company does not exculpate the person.

Who May Commit Fraud?

While it is hard to generalize about financial statement fraud perpetrators, in our personal experience they have sometimes been observed to have larger-than-life personas. Often they are important, influential, and respected members of their community. Some may have made significant charitable donations. Public reaction to the SEC's allegations of financial statement fraud may include anger, skepticism and strong support for the business champions who have brought jobs and other benefits to the local community. Only when all the details come out may some people be convinced that such apparently good people did such bad things.

Apparent Linkages Between Fraud and Bankruptcy

As mentioned, the study found that bankrupt companies were three times more likely than non-bankrupt companies to be issued financial statement-fraud AAERs by the SEC. Of 519 bankrupt companies analyzed by Deloitte researchers, 48 (9%) were issued AAERs. Of 2,919 non-bankrupt companies, 91 (or 3%) were issued AAERs.

Companies issued financial'statement-fraud AAERs were more than twice as likely to file for bankruptcy as those not issued one. Of 139 publicly traded companies with revenue greater than $100 million that were issued AAERs, 48 (35%) filed for bankruptcy between Jan. 1, 2000 and Dec. 31, 2005. Of 3,299 publicly traded companies with revenue greater than $100 million that were not issued AAERs, only 471 (14%) filed for bankruptcy during the same period.

Interestingly, multiple instances of alleged fraud in the same company also appear more likely in bankrupt organizations. Bankrupt companies receiving AAERs were twice as likely as non-bankrupt companies to have more than 10 alleged financial statement fraud schemes and at least 1.5 times as likely to have six to 10 alleged fraud schemes.

Importantly, the study did not look into whether fraud played a role in the bankruptcy of the companies in the study or whether the bankruptcy process could itself be the reason the alleged fraud was uncovered. It may be that companies experiencing financial difficulties are more vulnerable to both bankruptcy and financial statement fraud. On the other hand, it may be that financial statement fraud is simply more likely to be revealed at bankrupt companies due to the added transparency and scrutiny brought about through the bankruptcy process.

Fewer than one in seven (14%) of the AAERs were issued before companies filed for bankruptcy protection. Although this is a small proportion, these situations may provide a warning signal of a potential bankruptcy filing.

Industries Affected by SEC Fraud Allegations

Over the course of the 2000s, various industry sectors have taken center stage with respect to bankruptcies and alleged fraud investigations. Early in the decade, telecommunications companies experienced financial deterioration, headlined by such names as WorldCom and Global Crossing, as well as high tech companies. Today, retail and consumer products companies appear to be at greatest risk as consumer demand shrinks and tight credit persists.

The largest proportion (30%) of companies issued AAERs in the study were in the consumer business sector. Of 42 consumer business companies that received AAERs, 21 (50%) filed for Chapter 11.

Technology, media, and telecommunications (TMT) companies represented the second highest industry sector for AAER issuance at 27%. Of 37 TMT companies that received AAERs, 11 (30%) filed for Chapter 11. Manufacturing ranked third with 22 companies (16%) being issued AAERs, seven (32%) of them in bankruptcy.

Company Size and Fraud Risk

Larger bankrupt companies appear to be more likely to be the subject of SEC enforcement releases relating to alleged financial statement fraud than smaller ones. Ten percent of the bankrupt companies issued AAERs had revenue of $10 billion and above compared with only 1% of bankrupt companies not issued AAERs. Thirty-five percent of the bankrupt companies issued AAERs had revenue of $1 billion to $10 billion, compared with 18% of those not issued AAERs. The smaller bankrupt companies studied, those with revenue of $100 million to $250 million, were least likely to be the subject of these SEC enforcement releases. This size category encompassed 21% of bankrupt companies issued AAERs and 37% of bankrupt companies not issued AAERs.

It should be noted that the larger the bankrupt company, the greater the likelihood of scrutiny that may be given to its finances, with various committees probing into its financial condition. Additionally, regulators and investigative agencies may dedicate more resources to allegations of wrongdoing at larger entities due to the potentially greater public impact.

Fraud Trends

Bankruptcy filings by U.S. publicly traded companies trended sharply downward through the middle of the present decade after peaking in 2001. Through 2007, filings by companies with revenue exceeding $100 million dropped from 126 in 2001 to about 25 annually from 2005 to 2007.

The number of alleged financial statement fraud-related AAERs issued by the SEC increased significantly beginning in 2002 amid Sarbanes-Oxley passage and greater enforcement resources. Since 2003, approximately 20 companies each year with revenue exceeding $100 million have been the subject of such AAERs, compared with just seven in 2000 and 2001.

While bankruptcies declined over the study period, today's economic conditions portend a probable resurgence. Looking to the future, financial services and real estate companies hit hard by the collapse of financial markets, declines in consumer demand, and lower retail sales appear likely to face a higher risk of bankruptcy filings and, potentially, alleged fraud revelations.

The Importance of Trust

In the past few years, some companies have created highly leveraged balance sheets with many layers of debt. When such a highly leveraged company files for bankruptcy protection, its creditors may in some situations have little other recourse than to seek recovery from non-traditional sources such as challenging potentially fraudulent conveyances, seeking recovery under directors' and officers' liability insurance policies, and filing other litigation. This potential for a strategic shift may raise risks for directors, officers, and senior management, increasing the importance of proactive fraud detection.

In this environment, trust is critical. The fraud allegations of late 2008 highlight the importance of earning and maintaining the trust of investors, regulators, lawmakers, and the public. One way to do that is to continue moving toward greater transparency and stronger anti-fraud programs. Management can also instill confidence and integrity through constant, open communication that strengthens trust and relationships.

A Growing Priority

Troubled companies can benefit from recognizing their potentially heightened risk of regulatory enforcement actions and taking steps to prevent, deter and detect fraud promptly.

Toby Bishop is the director of the Deloitte Forensic Center for Deloitte Financial Advisory Services LLP.