Fraud Magazine , Summer 06 by Jim Marasco & Paul Warren, Esq.

Time is of the essence when trying to recover assets after the death of a suspect of a bankruptcy. Assets need to be secured and the facts need to be determined quickly. Here’s how to do it. The Securities and Exchange Commission (SEC) was closing in on Sam fast. Two weeks prior to his required appearance to answer an SEC subpoena, the girlfriend he lived with discovered the suicide note in their house when she went home on her lunch break. She directed the police to his lake house where she guessed he would be. The police discovered a black Chevy Tahoe that was parked in his garage with the engine running. As the police attempted to break down the garage door, Sam calmly walked out of the Tahoe in which he had been reclining and waved to them through the garage window. He signaled for them to go around to the front of the house as he walked into the house through the garage. Seconds later, he ended his life with a 40 caliber handgun. As the authorities secured the scene, the SEC was already calling the lake house, trying to confirm the rumor they had just heard 500 miles away. At the request of the SEC, The U.S. District Court placed Sam’s nine closely held companies under receivership. The receiver, Paul Warren (co-author of this article and clerk of the court for a U.S. bankruptcy court), promptly filed a Chapter 7 bankruptcy case for each of the companies. Most of the entities operated in the financial services industry, solicited investor funds for subsequent reinvestment, and offered guaranteed returns. The lone manufacturing operation was placed as an operating Chapter 7 entity and remained fully operational until the trustee found a suitable purchaser. Warren immediately retained the services of a forensic accountant and fraud examiner, James Marasco (also co-author of this article). Together, we spent the next four months following the trail of money and tracking down the assets of these entities. What the SEC initially believed to be a $3 million to $4 million investor fraud scheme quickly mushroomed to a $15 million Ponzi scheme with more than 400 investors looking for return of their money. Here we describe the approaches and techniques we used to recover potential assets plus the lessons we learned.

The high points

• The most difficult part of recovering assets of a deceased individual or bankrupt entity is the lack of cooperation.
• Reconstructing accounting records in a flexible electronic format is invaluable when recovering assets.
• A consolidated proof of cash produces the telltale evidence that helps answer the proverbial question all fraud examiners are asked: “Where did all the money go?”

Securing and categorizing the records

The receiver and our forensic accounting team immediately gained control of the former company headquarters, changed the locks and security codes, and called the place home for the next four months. We froze the entities’ bank accounts, which prevented any outstanding checks from clearing. We photographed all parts of the facility before we did anything. We reviewed records for each entity and noted the specific location in the office where we discovered each document. We created a map of the office and copied or scanned essential records and indexed them. We also copied computer hard drives and printed pertinent files, and we noted the computers from which they were printed. During this important phase, we quickly handed newly discovered entities to the receiver to be filed as bankruptcy cases, which ensured an orderly liquidation process. Interestingly, Sam was a careful keeper of notes, receipts, bank statements, and other records that greatly assisted our efforts to establish the breadth of the fraudulent scheme and the flow of assets.

Exhaustive interviewing

As we were reviewing the records, we began interviewing individuals. We first interviewed key employees of the entities; then external accountants utilized by Sam; and finally, business associates, partners, and friends. (In addition to the interviews, we regularly communicated with spurned investors who wanted to tell their stories.) The information gathered from the interviews and other conversations would become the crux in the asset recovery process and the recreation of the Ponzi scheme, which was necessary in determining the proper order of priority in distributing the assets.

Securing Sam’s assets

Lucky for us, most of Sam’s physical assets were confined to a local geographic area. A simple review of the decedent’s will and county clerk’s records showed that he owned three residential homes and a couple of commercial buildings including the one we now occupied. A motor vehicle check turned up five registered Corvettes, one Ferrari, two Harley Davidson motorcycles, a couple Jet Skis, a leased Cadillac, and an SUV. We also learned where Sam maintained his four-seat Cessna airplane. We confirmed these assets and the existence of others against insurance policies, collaborations through interviews and personal on-site visits of his properties. Once we found the location of these vehicles, we secured them for future liquidation. We allowed the leased automobiles to be repossessed. As we reviewed Sam’s personal records and interviewed others we discovered that he had amassed a rare coin collection. We found the combination numbers in his records that opened a safe in a back-alley storage garage that contained the coins. We also secured his collection of sports memorabilia and artwork in his office. Those we interviewed told us of Sam’s affection for fine jewelry including his two gold Rolex watches, either of which he always wore. We checked the police statements and discovered that he wasn’t wearing a Rolex at the time of his death. We called his live-in girlfriend who confessed that she had kept the two watches. She said she had given them to Sam as gifts but she agreed to turn them in. We also recovered guns and cash, and we closed out his credit card accounts, which business partners, former employees, and friends were still using. One friend charged the cost of her child’s college tuition to one of Sam’s credit card accounts the same day that Sam died. Interview subjects also told us that Sam had leased bank safety deposit boxes, which contained some additional personal belongings and records.

Putting Humpty Dumpty back together again

We determined that accurate records of Sam’s business entities didn’t exist. His external public accountant never produced formalized financial statements but merely prepared corporate tax returns based on records prepared by Sam’s in-house bookkeepers. At this point, we decided to recreate each entity’s transactional history from inception to the present. None of the entities were in existence longer than four or five years, which made this task manageable. We recreated financial statements for each entity and produced an overall cash flow analysis for each entity’s existence by using the available general ledgers, canceled checks, deposit tickets, investor records and charge card statements. (See chart on page XX.) After we completed the cash flow analysis for each entity we consolidated them into one overall analysis, which helped us trace all the investor funds that originally flowed into Sam’s possession, the accounts into which they were deposited, and the purposes of those funds. We used these analyses not only to find additional assets but subsequently to complete tax return filings. They were also the basis of litigation support to the bankruptcy trustee in the next step of this process. Once we placed these entities under the jurisdiction of the bankruptcy court, the trustee had a firm measurement date from which to begin using the bankruptcy trustee’s avoiding powers. Avoiding powers allow the trustee to undo or reverse certain inequitable transactions. Based upon our analyses, the forensic accountants identified the “preferential transfers” (transfers to creditors that give that creditor a preferential position over another). In addition, we supplied the trustee with documentation proving preferential payments (actual disbursements made to certain creditors favoring them over others) that were made from each of the entities within the 90-day period preceding the bankruptcy filing. Together, we determined the disbursements the entities made outside the ordinary course of business. The trustee then began the process of recovering these payments from the respective parties as voidable transfers. From our records, we also summarized voidable transfers and payments made within one year prior to the bankruptcy for transactions involving affiliates, related parties and insiders. For a trustee to prove a transfer to be void, he must prove that it was made within a certain defined time period to, or on account of, an antecedent debt without consideration and allows a creditor to recover more than he would under a Chapter 7 distribution. We made sure that we meticulously preserved and copied evidence of these transactions because adversary proceedings in bankruptcy court, which were necessary to entitle the trustee to any recovery, could take years. And we used the preserved evidence to formulate our cash flow analyses to prove that each of the entities was insolvent during most of their existence and that Sam used a Ponzi scheme to stay afloat. None of the entities ever generated enough cash flow from their intended operating purposes to support general operations. The entities relied exclusively on the funds flowing in from new investors. We successfully collected money from early investors who had cashed out at the expense of later investors during the preferential period and we recovered retainer payments to attorneys for representing Sam and his associates in defending the SEC action.

Wrestling over life insurance

The most significant asset we located included five whole life insurance policies with proceeds totaling $5.2 million. Sam had purchased these policies a few years before his death, which satisfied the restrictions of the policies’ “suicide provisions” and so were eligible for collection. The receiver filed timely claims but, unfortunately, a few weeks before Sam’s suicide, Sam had changed the beneficiaries on these policies to include his multiple girlfriends and close business associates. Therefore, the estate and closely held corporations were due to receive nothing from these policies. After a two-year legal battle, the courts decided that almost 90 percent of the insurance proceeds were owed to the injured investors. The schedules and analyses we had prepared supported the trustee and SEC’s claim that, since their inception these policy premiums were paid from investor funds and could have never been funded from the operating cash flow of Sam or his entities.

Digging deeper in other places

Our review of Sam’s filed personal tax returns revealed that Sam had a habit of over-withholding his federal and state income taxes, which resulted in a sizable refund each year. At the time of his death, he hadn’t filed his prior and current year personal returns. After we reconstructed the necessary financial records, we had these returns prepared, which revealed nearly $150,000 of available refunds. These returns were filed before the statutory periods expired and the refunds were received by the estate. We also found brokerage account statements, which were ultimately placed under control of the receiver, that revealed tens of thousands of dollars in mutual fund and common stock investments. Correspondence in the office files and on the computers helped us discover hundreds of thousands of shares of restricted penny stock in various companies. We promptly contacted the transfer agents and they titled the shares to the receiver.

Recovering loans that were made

As we traced the cash flow analyses of some of the entities, we discovered that Sam had a habit of investing equity (using investor funds) in small closely held companies and subsequently assumed personal control and ownership when the companies didn’t repay the “loans.” We found that he had loaned hundreds of thousands of dollars to various organizations and individuals including former employees. The information we recovered from Sam’s computers and a review of the general ledgers produced loan amortization schedules and recurring payments flowing into the entities. We prepared written summaries of this activity for each loan including the terms of the loans. The trustee used this information to begin negotiating with each party for repayment. When disputes arose, we went back to our records and, in some instances, called upon former employees for their insight and recollection.

Challenges encountered; lessons learned

The most difficult part of recovering assets of a deceased individual or bankrupt entity is the possible lack of cooperation. Most of the assets we recovered came at the expense of others. Like a game of musical chairs, when the Ponzi scheme ceased many of the affected participants, both innocent and involved, were left without chairs. Revised beneficiaries (those who were added two weeks before Sam’s suicide), former business partners, and employees were all found to have attempted to personally profit or eliminate the possibility of a personal financial loss during the period of confusion surrounding Sam’s death and bankruptcy. We quickly secured assets and determined the facts. For example, one day after Sam’s suicide, we discovered that his primary bank had transferred money across various corporate entity accounts in an attempt to recover overdrafts from any other accounts where cash was available. We also investigated two former employees who had charged thousands of dollars on the corporate charge card during the weekend of Sam’s funeral to pay their personal debts. These employees appeared to be attempting to obtain “repayment” of some debt they believed to be owed to them. Once you’ve secured assets, the receiver and trustee must be cognizant of the ‘prudent investor rules,’ (the federal government implements these rules to ensure that the trustees aren’t risking an estate’s bankruptcy funds by taking unnecessary risks or keeping those funds in a non-income producing account) which specify that assets under custodianship be properly invested and balance risk and return. For instance, the trustee had an obligation to review if Sam’s high-risk Internet mutual funds were an acceptable investment now that this money needed to be secured for future distribution. We also needed to verify the existence of any valid and recorded security interests on assets before anything was liquidated. We found that reconstructing accounting records in a flexible electronic format was invaluable when recovering assets. Sometimes, we were asked to produce disbursements sorted by date or by entity. Other times, checks written to specific parties across all entities were required. In the end, a consolidated proof of cash produced the telltale evidence that helped answer the proverbial question clients ask all fraud examiners: “Where did all the money go?”

Here’s practical advice for finding assets postmortem

• Time is of the essence . Don’t hesitate to act. Assets disappear fast. Secure what you can as fast as you are able.
• Gather all pertinent records. You can always review them at a later date, but obtain as much as you can while records are still available.
• Work closely with an attorney. It helps to have an attorney on your team working closely with you. We were able to file entities into bankruptcy, obtain subpoenas, and use other trustee powers by having a close relationship with both the receiver and trustee.
• Document everything . While these cases may start off as an asset recovery, they may end up in litigation later on as people refuse to give back what they have received. Litigation may take years and having good records and documentation can refresh your memory as to what happened.
• Interview. Don’t underestimate the value of interviewing individuals. You can learn as much from interviewing people as you can from examining records.
• Follow your instincts. What doesn’t look or smell right probably isn’t. Investigate all leads that you receive from your record examination and interviews.

James I. Marasco, CPA/CFF, CFE, CIA Jim is a partner at EFPR Group. He brings more than 18 years of public accounting and auditing experience. He is a full-time management consultant and travels extensively throughout the country while leading StoneBridge Business Partners (an EFPR Group affiliate company). This article was co-authored by Paul R. Warren, Esq., a clerk of the court in the U.S. Bankruptcy Court of the Western District of New York. Article republished with the permission of Fraud Magazine.