A new study from Deloitte reveals that there is a high correlation between bankruptcy and fraud. With economic conditions likely to drive more companies to consider filing for bankruptcy protection, one potential concern is whether the greater scrutiny that generally results, could lead to claims of fraud against the company and its executives.

“In the past few years, many 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 have little other recourse than to seek recovery from non-traditional sources such as challenging potentially fraudulent conveyances, seeking recovery under D&O (Director and Officer) policies, and filing other (non-bankruptcy) litigation,” said Sheila Smith, national service line leader, Reorganization Services, Deloitte Financial Advisory Services LLP.  “This strategic shift has raised risks for directors, officers, and senior management and increased the importance of fraud detection.”

Key findings:

• Companies filing for bankruptcy protection are three times more likely than non-bankrupt companies to face enforcement action by the SEC relating to alleged financial statement fraud.
• Companies that were issued financial statement fraud-related SEC Enforcement Releases were more than twice as likely to file bankruptcy protection as those not issued one.
• Approximately one in seven financial statement fraud SEC Enforcement Releases issued to companies that filed for bankruptcy protection were issued prior to their bankruptcy filings. These situations may provide a warning signal of potential bankruptcy filing.
• Bankrupt companies receiving SEC Enforcement Releases were twice as likely as non-bankrupt companies to have more than 10 alleged financial statement fraud schemes – and at least 1.5 times more likely to have six to 10 alleged fraud schemes than non-bankrupt companies.

Ten Things About Bankruptcy and Fraud
Deloitte Forensic Center
November 2008