BLEEDOUT AS A TYPE OF BANKRUPTCY CRIME:

A V 1 CEU 4 A lo• BLEEDOUT AS A TYPE OF BANKRUPTCY CRIME: COMPARISON OF RUSSIAN AND US LAW by Olga Sukhorukova LL.M. SHORT THESIS COURSE: Comparative Bankruptcy Law PROFESSOR: S.J.D., Tibor Tajti Central European University 1051 Budapest, Nador utca 9. Hungary CEU eTD Collection © Central European University March 30, 2012 EFTA01130893 EXECUTIVE SUMMARY This paper focuses on the bleedouts - fraudulent scheme used in bankruptcy proceedings aimed at depletion of assets. After the sort overview of the role of bleedouts in the system of bankruptcy crimes, the thesis deals with the definition of the bleedout bankruptcy scheme and its distinctive features. The historical introduction to the evolution of fraudulent schemes regulation is made. The civil and criminal provisions regulating the bankruptcy schemes in both countries are scrutinized. Taking the US law as t he pattern the comparison analysis of US and Russian regulation is made in order to elaborate the possible improvements of Russian law on fraudulent bankruptcy schemes. The findings of thesis on modification of Russian bankruptcy law are of vital importance in the light of Russian civil law reform and increased number of the liability avoidance among parent companies. CEU eTD Collection EFTA01130894 Table of Contents CEU eTD Collection Executive Summary Introduction 1 1.1. The role of bleed-out in the system of bankruptcy crimes. 5 1.2. The USA history of bleed-out regulation 9 1.3. The Russian history of bleed-out regulation 11 Chapter 2: US regulation of the bleedouts 15 2.1 Civil regulation of bleedout scheme in the USA 15 2.1.1. Preconditions of civil liability 16 2.1.2. Fraudulent intent 17 2.1.2.1. Actual Fraudulent Intent [Section 548 (A) (1) USC; UFTA § 4 (A) (1): UFCA § 7] 18 2.1.2.2. Constructive fraud [§ 548 (a) (2) U.S.C. 11] 19 2.2. Criminal regulation of bankruptcy fraud in the USA 21 2.2.1. Concealment of assets: 18 U.S.C. § 152 (1) 21 2.2.2 Fraudulent pre-bankruptcy transfers: 18 U.S.C. §152 (7) 24 2.2.3. Bankruptcy Code: 18 U.S.C. §157 26 Chapter 3: Russian law on bleedouts 29 3.1. Russian Civil regulation of bleedouts 29 3.1.1. Avoidance of suspicious transactions 30 3.1.2. Avoidance of transaction aimed at the change of the payments schedule 32 3.2. Russian Criminal regulation of bleeouts 33 Conclusion 40 Bibliography 42 EFTA01130895 CEU eTD Collection INTRODUCTION In every country the bankruptcy system is based on the perception that "a debtor will make full disclosure of all assets and liabilities so that the final disposition is in accordance with the requirements of the law."' However in high profile bankruptcy cases it is common for the debtor to try to defraud the assets or discharge liabilities.2 The debate today is how to eliminate bankruptcy fraud. Today in the era of the economic crisis and the instability of society as a whole, bankruptcy law plays a vital role in balancing between the interests of debtors and creditors. There are two main ways in which countries manage to do this. The bankruptcy system of the US is designed to "protect a debtor by giving him or her fresh start. free from creditor's claims, and to ensure equitable treatment to creditors who are competing for a debtor's assets."3 The US world known concept of the fresh start in bankruptcy coexists with the powerful right of trustee to avoid fraudulent transactions. This is one of the reasons why US bankruptcy law is regarded as the most developed and balanced one. Even though the US Bankruptcy law is not perfect, as evidenced by a number of huge finical bankruptcy scandals', it serves as a pattern law for many foreign reforms. In Russia the lifelong continental law stigma still prevails — bankruptcy is the worst option for the person or legal entity. The attempts of legislators to implement the US bankruptcy law in 1992 failed. Neither the society nor practitioners were able to accept the different 1 Brown, Joe B.; Netole, Brian: Taliani Rasnak, Sandra: and Tighe. Maureen. Identifying Bankruptcy Fraud. p. 1 (accessed March 20. 2012) http://www.crfonline.org/orc/pdf/ref11.pdf 2 Wickouski. Stephanie. Bankruptcy Crimes. 3rd ed. Washington. D.C: Beard Books, 2007. p. 1. 3 West's Business Law: Text and Cases - Legal, Ethical. International. and E-Commerce Environment. 9th Edition p.581 4 See: Haberly. Todd. 2002 "The Enron Bankruptcy" (accessed March 20. 2012) httpi/www.plu.edu/—enron/Haberly.pdf : "Lehman Brothers Holdings Inc" The New York Times, March 7, 2012 (accessed March 20. 2012) http://topics.nytimes.com/top/news/business/companies/lehman_brothers_holdings_inc/index.html: Isidore. Chris "GM bankruptcy: End of an era" A service of CNN "Fortune and morEy': June 2, 2009 (accessed March 20, 2012) http://money.cnn.com/2009/06/01/news/companies/gm_bankruptcy/ 1 EFTA01130896 CEU eTD Collection paradigm. Furthermore the implementation of the US law caused a conflict between the Bankruptcy statute and the Civil Code (that was in fact reception of the German law). The reform of early 2000 returned the Bankruptcy Code of Russia to its civil roots. However it did not solve all the problems. Today the Bankruptcy law of Russian Federation still lacks balance and efficiency especially in the area of bankruptcy abuses. In both countries the majority of bankruptcy abuses are single crimes that are regulated by one article (e.g. false statements or assets concealment). However a single transaction is not effective in the case where the company wants to conceal all of its assets. It is common is practice that entities are sequentially making false statements. use insider transactions to deplete the assets, commit mail/wire fraud and start fictitious bankruptcy proceeding. Companies are creating bankruptcy schemes, combination of transactions that allow transferring all the assets and escaping liability for debts. Nowadays the most complicated scheme is called bleed-out. It involves long lifespan companies, hundreds of sophisticated transactions and intercorporate transfers. All these actions have one goal — to deplete the assets of the company. In the USA in 2010 the detected corporate bleed-outs constituted 1% among bankruptcy connected crimes. Though this figure seems to be insignificant the situation with bankruptcy schemes is dramatic. The percent of false statement crimes was 38,2 %, asset concealment was 30,2 To. bankruptcy schemes were 20,7 %.6 In fact 90,1 % of bankruptcy crimes are involved in fraudulent schemes. In Russia the number of bankruptcy connected crimes increased from 548 to 701 in 2009.6 The data is evidence that the fraud became common. Successful completion of the scheme is possible due to the enormous number of civil and criminal statutes that regulate bankruptcy abuses. Conflicts of laws and complicated 5 See: Criminal Referrals by Type of Allegation. Fiscal Year 2010 p. 6 (accessed March 21. 2012) hilp://www.justice.gov/ust/eapublic_affairs/reports_studies/docs/criminal_report_fy2010.pdf 6 Arzyakova. Irina. Impenktion of the term 'malicious bankruptcy" in practice (accessed March 26, 2012) http://science- bsea.narod.ru/2011/ekonom_2011_1/arzyakova_nesov.htm 2 EFTA01130897 CEU eTD Collection procedural rules facilitate liability avoidance. Neither the law nor scholars address the business reality. Practice shows that a uniform and comprehensive attitude is necessary. Despite the fact that bankruptcy schemes have existed for centuries, academic literature on this subject matter is almost absent. Although legal scholars have extensively developed the concept of fraudulent transactions' and bankruptcy crime,8 there is relatively little research on the bankruptcy fraudulent scheme as a single phenomenon. Certain attempts were made by Stephanie Wickouski and Joe Brown et al. Russian scholars are indifferent towards the bankruptcy scheme problem. Prof. Wickouski made an extensive research on bankruptcy crimes and gave a small overview on each type of fraudulent scheme. However her approach based in separate analysis of bankruptcy offences is not enough for a deep and profound understanding of the problem. The significant research on different types of bankruptcy schemes was made by J. Brown et al. Though the work covers the majority of possible fraudulent actions it can not be regarded as a fundamental research but rather a descriptive overview. Furthermore absence of comparative study on this issue disables to attain a deeper knowledge on bleed-outs and prevent systematic unification and harmonization of law. This research is aimed at elimination of the gaps existing in the literature today. By using the comparative method of analysis the paper focuses on the scrutiny of the US and Russian civil and criminal regulations on fraudulent bankruptcy. Considering the US bankruptcy law as a pattern, the elaboration of practical suggestions on improvement of the Russian legislation on this matter will be made. The issue of bleed-outs is analyzed in four chapters. Chapter 1 covers some preliminary considerations crucial for the understanding of the problem. It focuses on the concept of bleed- 7 See: King. Lawrence P. Creditors' Rights. Debtors' Protection. and Bankruptcy. 3rd ed. Casebook Series. New York: M. Bender. 1996; Glenn. Garrard. Fraudulent ConveyanTs and Prete/eras. Reprint of the revised ed. New York©: Baker, Voorhis, 1940. Buffalo, N.Y: W.S. Hein, 2001: Stumvoll. Erica. "Avoidance of Transfer: Section 548." Emory Bankruptcy Devebpments Journal 3. (January 1. 1986): 389. LexisNexis Academic: Law Reviews. EBSCO host (accessed March 18.2012). See: Ibid. No 2 3 EFTA01130898 out. determines the distinctive features of the legal phenomenon and provides the definition of the bleed-out as a bankruptcy crime. Furthermore Chapter 1 gives the historical overview of the legal statutes that regulated bankruptcy abuses in the USA and Russia. The Chapter will facilitate the deeper understanding of the problem and will serve the departing point for the following studies. CEU eTD Collection The second chapter focuses on the examination of the US statutes that regulate bleed- outs. The chapter is divided into two sections where the civil and criminal provisions are scrutinized separately. I refer to several issues: what tests do the US courts use in order to determine the concealment of assets; whether the intent of the company is important; what is the scope of managers' liability for fraudulent actions. The chapter also evaluates the drawbacks of the US law and reasons of why the bankruptcy frauds are still possible. The third chapter deals with Russian legislation on bankruptcy schemes. The major focus is on the interaction of criminal and civil regulations. The procedural issue of fraud avoidance is examined: what terms are used to describe bankruptcy abuses, which party is entitled to claim the transaction fraudulent. The chapter is based on comparison of the US concept of bleed-out and fraudulent transaction and existing Russian legislation. It will be shown that criminal and civil rules should be applied cumulatively. The present separate attitude of legislators towards bankruptcy regulation gives birth to successful concealment of assets. This result is undesirable by both state and society. Therefore the thesis suggests that regardless the difficulty in unification of bankruptcy law, a single act should be designed. It should regulate both civil and criminal issues of bankruptcy abuses. 4 EFTA01130899 CHAPTER 1: THE PHENOMENON OF BLEED-OUTS AND THE COROLLARY PROBLEMS Bleed-out is a business reality now as well as other bankruptcy schemes. It is regulated by the system of different rules that cooperate. duplicate or conflict with each other. Before considering the particular rules on bleed-outs it is necessary to define the bleed-out as a bankruptcy phenomenon. to determine the distinctive features of the fraudulent scheme and to give the historical background of legal regulation. The chapter will first establish the role of bleed-out in the system of bankruptcy crimes and indicate the peculiarities of this fraudulent scheme. Thereafter, the historical overview of the US legal statutes on bankruptcy abuses is made followed by examination of Russian laws since XI century. CEU eTD Collection 1.1. THE ROLE OF BLEED-OUT IN THE SYSTEM OF BANKRUPTCY CRIMES. The majority of the bankruptcy crimes constitute only one type of violation, although there are number of fraudulent schemes that are "more complicated or are primarily designed for reasons other than maximizing the retention of assets in bankruptcy." 9 Companies can use bankruptcy schemes in order to conceal earlier crimes or maximize the profit of insiders. Another goal can be to "buy time" in order to find a way to "avoid victims or leave town."10 The above mentioned goals can be achieved through fraudulent bankruptcy schemes that are regulated by both criminal and civil law. The key issue in understanding of the bankruptcy scheme is the combination of transactions concluded with the one main purpose — to hide the assets and to defraud creditors. It is possible due to enormous number of acts that regulate bankruptcy abuses. Companies know where the law is imperfect and use it for its own fraudulent interests. Legislators are improving bankruptcy statutes. However the approached is initially wrong. Instead of cooperation between 9 Ibid. 1. p. 1 10 Idem. 5 EFTA01130900 CEU eTD Collection specialists in the civil and criminal aspects of bankruptcy separate reforms are made. It is not enough to eliminate the gaps in bankruptcy acts. The necessity of comprehensive approach towards bankruptcy schemes in general and, bleed-outs. in particular, is clear. The most common bankruptcy schemes are "bleed-outs", "bust-outs", "looting" and "skimming"". Though bleed-out is similar to bust-out it is regarded as the most sophisticated type of fraudulent bankruptcy scheme. Distinctive features of bleed-outs are (1) involvement of a long life span corporation (2) depletion of assets (3) over long period of time (4) through sophisticated transactions. Typically creditors are "blind" and not aware that there is a certain type of assets concealment. They rely on the long lifespan of the company or involvement of huge hedge funds. At the time when the value of the company is drained, creditors get nothing but the "bubble" of the entity. From the analysis of case law there are several bleed-out indications. Insider transactions as well as "capital infusion characterized as loans", or tax manipulations are typical transfers that can lead to assets concealment i2..For instance the company uses leveraged buyout or gets investment from people without previous business experience both prior and during bankruptcy proceeding. Capital infusions of corporate officers suddenly renamed "loans" and paid back. Depletion of pension funds by sudden deduction of workers contributions for health care and retirement with the subsequent conversion by debtor is also common. Certain actions can cumulatively indicate bankruptcy scheme. Changes of ownership or in accounting or cash flow practices for no apparent business reason ("sudden decrease in inventory; sharp increase in aged receivables") 13 in combination with excessive salaries and bonuses could form bleed-out. Brown et al provide a typology of bleed-outs:14 11 Ibid. No. 2. p. 10 12 'dem., p. 11 13 Ibid. No. 1. p. 4 14 Idem., p. 5 6 EFTA01130901 CEU eTD Collection 1. "Corporate Raider Bleed-outs": A stable long life span entity with liquid assets is acquired in a leveraged buyout. Such assets usually include a large pension fund and/or "profit sharing fund". The initial purpose of the company operation can be business transactions for the purpose of profit. However in some point the company exists only to allow the insiders to loot the company. Afterwards the company applies for voluntary bankruptcy procedure or starts the reorganization that allows insiders to complete the scheme. Business transfers are complicated and purposefully confusing. Even though the creditor eventually realized what happened it is almost impossible to prove the fraudulent conveyance actions. This type of bleed-out is common in all industries.16 2. "White Knight" Bleed-outs: In order to raise money the company hires a business consultant — the "white knight". He/she gets the shares or bonds of the company that allow taking the control over financial operations. "White knight" uses his position to "convert company assets.'"e It can be failure to "pay withholding taxes, to make pension fund contributions, diversion of receivables. paying personal expenses with company funds, taking excessive salary and bonuses and. in some situations, paying false invoices to entities or individuals related to the consultant."' 7 3. Parallel Entities: A company with a long life span faces financial problems. The owners of the company establish a new entity in the same industry. Prior bankruptcy proceeding debtor sells assets to a new legally independent company for a price below its value. By these means insiders "bleed out" the company by transferring debtor's inventory and receivables to the new company. Furthermore the clients of the debtor can be also lured by the factual successor. In fact insiders squeeze all possible assets of the company by purchasing goods or services for the new entity. These types of transactions violate the assets distribution rule contained in every 15 Idem. 16 Idem. 17 Idem., p. 5 7 EFTA01130902 CEU eTD Collection Bankruptcy Code. Eventually outside creditors receive nothing. Lawyers are usually involved in the scheme. 4. Assignment for the Benefit of creditor (ABC)/Insider Saks: This type of bleed-out is similar to the previous one. Assets of the debtor are sold to newly established and undisclosed company for inadequate consideration. The secured creditor approves the transaction because "its security position improves if the new company is debt free."1' Unsecured creditors get no assets to satisfy its claims. Involuntary bankruptcy proceeding terminates the scheme. Company is liable for misrepresentations. 19 Though the most common bankruptcy schemes are known there is no unified act that can cover all the transactions made by corporation in order to deplete the assets. The judges and bankruptcy trustees are forced to follow the long and complicated procedure of transaction avoidance. Furthermore fraudulent actions of the company can be penalized by both civil and criminal law. Not only company itself is liable but also the long-standing owners or insiders can face criminal personal liability. The uniqueness of Bankruptcy law is that it involves different disciplines of the law. "Bankruptcy has its own clear, but distinct, criminal and civil components." 2° On the one hand, attomeys dealing with bankruptcy law lack of the criminal law background. It keep them from deep understanding of the criminal consequences of actions made within bankruptcy proceeding. Lack of knowledge and skills does not promote cooperation with prosecutors investigating the conduct nor help to recognize the techniques used by them. On the other hand, "white collar criminal practitioners almost never have the background in bankruptcy law. its regulations and nuances, to understand or appreciate potential defenses that may arise."2' Furthermore. prosecutors prefer to use familiar offenses such as fraud, perjury, bribery, embezzlement rather 18 Idem. i9 Idem., p. 6 a Ibid. No. 2. p. ix 21 Idem. 8 EFTA01130903 than using the Bankruptcy Criminal Code. This situation leads to. first, a conflict of criminal and civil laws and. second. to a number of gaps that allow corporations to leave creditors without money they are entitled for. CEU eTD Collection 1.2. THE USA HISTORY OF BLEED-OUT REGULATION In the USA actions, committed by the corporation within the bleed-out scheme, fall under a number of statutes. "The predicate for American bankruptcy law is found in the bankruptcy clause to the constitution, which empowers Congress to pass uniform laws on the subject bankruptcy." 22 Bankruptcy Code regulates the whole bankruptcy procedure. For the purposes of this thesis the most important is Title 11 that regulates the automatic stay by trustee. In fact § 362 Title 11 USC allows the trustee to avoid fraudulent transactions and take the assets of the debtor back. Furthermore, a number of fraudulent transfer acts prohibits depletion of debtor's property. The predecessor of the modern fraudulent transfer statutes was the statute of Elizabeth (13 Eliz. C.5 (1571)).23The Act was applicable to conveyance intended "to delay. hinder or defraud creditors and others of their just and lawful actions. suits, debt". Nowadays the Statute of Elizabeth constitutes the common law of many state jurisdictions. 24 Since 1920 the Uniform Fraudulent Conveyance Act (UFCA) is offered to be signed by the states. Eventually 26 states adopted UFCA including New York and New Jersey, and "its provisions were incorporated into the Federal Bankruptcy Act."25 In fact the concept of the fraudulent conveyance was introduced by UFCA.26 Though UFCA did not cover all the issues 22 wen, p, 6 23See: King, Lawrence P. Creditors' Rights. Debtors' Protection. and Bankruptcy. 3rd ed. Casebook Series. New York: M. Bender. 1996. 24 Glenn. Garrard. Fraudulent Conveyances and Preferences. Reprint of the revised ed. New Yorkth: Baker. Voorhis, 1940. Buffalo. N.Y: W.S. Hein, 2001. p. 103 25 The National Conference of Commissioners on Uniform State Laws. Fraudulent Transfer Act Summary (accessed March 12. 2012) http://uniformlaws.org/ActSummary.aspx?title=Fraudulent%20Transfer%20Act 26 ldem. 9 EFTA01130904 CEU eTD Collection connected with fraudulent conveyance, it gave to the law "a certainty which it does not now possess."21 Another problem connected with UFCA was that "each State which adopts the Uniform Law leaves in effect such principles as her courts have established save as the Act may plainly cut across the line." 28 Consequently courts had to deal with both state and case law. In 1979 the Conference of Commission on Uniform State Laws was gathered in order to revise UFCA. The Commission numerated five reasons to modify the law:29 1) The Bankruptcy Code enacted in 1978 significantly changed the provisions on fraudulent transfers which reduced the correspondence of federal law and the Uniform Act. 2) There was a necessity to determine the consistence of both Acts on the issue of dividend distribution. 3) The Uniform Commercial Code promoted the superiority of security transfers over unsecured creditors. 4) Debtors and trustees "avoided foreclosure of security interests by invoking the fraudulent transfer section of the Bankruptcy." 30 5) Since 1983 according to the Model Rules of Professional Conduct it was forbidden for a lawyer "to counsel or to assist a client in conduct that the lawyer knows is fraudulent.' 4' The Uniform Fraudulent Transfer Act was adopted in 18 states including California, Texas and Florida.32 The roots of criminal prosecution of the bankruptcy abuses took place in bankruptcy statute of 1800. According to this statute the perjury of the bankruptcy assets was criminalized. The next Act enacted in 1857 resembles the majority of criminal provisions in current Title 18 of 27 Ibid. No. 24. p. 101 28 Idem., p. 102 29 Uniform Fraudulent Transfer Act, National Conference of Commissioners on Uniform State Laws. July 27 — August 3.1984. with Prefaratory Note and Comments. Chicago, Illinois, p. 1 38 Idem., p. 2 31 Idem. 32 Ibid. No. 23. p. 324 10 EFTA01130905 U.S.C. Significant modification of bankruptcy legislation was made in 1898. The Bankruptcy Act 1989 remained in force until 1979 and laid the foundation for modern provisions. During the Great Depression of the 1930-es the necessity to change the bankruptcy law arose due to corruption in business bankruptcies. The 1937 amendments included the Borah Act which "prohibited fee fixing agreements in bankruptcies and receiverships.' 43 In 1970 the Congress established the Commission on the Bankruptcy Laws of the United States in order to revise the current legislation. The rationale for modification was ineffectiveness of the law and "dual administrative and adjudicative roles of the bankruptcy code." 3` In fact the Commission suggested a completely new bankruptcy code. One of the main goals of the 1978 Act was to avoid fraud and abuses in the bankruptcy system 3s In 1992 high priority was given to the aggressive prosecutions of bankruptcy crime by the United States Department of Justice (DOJ).36 It resulted in a dramatic increase in the number of criminal prosecutions in bankruptcy area. Nowadays Uniform States Code (Title 18) stipulates the crimes under which the actions of the company during bleed out scheme fell. Despite the existence of statutes different in nature and level of establishment the US bankruptcy system is acknowledged as one of the most effective and balanced in the world. The avoidance of bankruptcy trustees should be regarded as the achievement of the US legislators in the area of combating fraudulent abuses. CEU eTD Collection 1.3. THE RUSSIAN HISTORY OF BLEED-OUT REGULATION Regulation of Russian bankruptcy law is similar to the US law. There are 3 main periods of legislation development: prerevolutionary, Soviet. the modern37 Up to XIX century 33 Ibid. No. 2. p. 6 34 Idem., p. 7 35 Idem., p. 8 36 Idem., p. 1 37 Mamaev. Stepan. "Formation and development of Bankruptcy law in Russian Federation ': Zakon i Poryadok No 11 (2003). p. 11 11 EFTA01130906 CEU eTD Collection Bankruptcy law in Russia was badly developed, it lacked systematization and integrity. The very first act that regulated bankruptcy proceedings was "Russkaya Pravda" — the uniform code of XI century. Among other regulations there were articles establishing punishment for malicious bankruptcy when the debtor concealed assets or was hiding himself from paying debts.38 Subsequent acts were aimed at the development of bankruptcy procedure and establishment of priority rules. The most significant statues were Bankruptcy Charter (1740), Rule in bankrupts (1800). Charter of business insolvency (1832). The latter differentiated insolvency and bankruptcy and established the hybrid test for insolvency (the amount of debts should be more than the amount of assets available and the debts are not paid).39 During the Soviet period there was no bankruptcy legislation of private companies because there was no private property. However the Civil Code of 1922 included the articles dealing with void transactions. In 1970-es legislators faced with necessity to regulate bankruptcy proceedings of the state owned corporations. A number of Decrees was enacted. However the bankruptcy law of that period protected not the creditors or debtors but the mutual economic interest as such. According to the law of that period state corporations were released from any responsibility for its debts.4° Modern period of Russian bankruptcy legislation started in 1992 by enacting the President Decree No 623 on "Support and reorganization of the insolvent state entities and application of special proceedings.'"" The Decree was followed by enactment of the Bankruptcy Act in November 19, 1992. The Statute was an attempt to implement the US existing laws on bankruptcy. However the implementation of the law was partial and did not achieved its goals. Moreover it lead to collision with the Civil Code that was in fact the copy of the German Civil law. In fact Russian legislators were trying to combine American pro-debtors approach with 33 See: Stepanov. Vasily. Bankruptcy in Russia. Franz. England, Germany. Moscow: 1999 Ukolov. Vladimir. Omarova, Anna. Bankruptcy of financial companies. Moscow: 1999. 33 Makishev. Konstantin. Historical overview of bankruptcy procaclure. St. Petersburg: 1871. p. 97.210-307 40 See: Lebedev. Peter. "Liquidation of state companies due to their insolvency". ESU No 49 (1924) 41 See: Gilinsky, Sergey. Business Law. Moscow: 2002 12 EFTA01130907 CEU eTD Collection German one favoring creditors. Bankruptcy Act 1992 was ineffective and allowed companies to deplete assets legally. Furthermore the regulations did not correspond to the business relations that took place those days. These factors were reasons to modify the law. In 1998 a new Federal Statue "on Bankruptcy" was adopted. It was an attempt to adjust prerevolutionary bankruptcy system to contemporary business reality. The provisions on reorganization of the company within bankruptcy proceeding were "borrowed" from the US Bankruptcy Code. The 2002 revision of the Statute regulated the details of the bankruptcy abuses, including invalidity of fraudulent transactions, powers of the trustee to return all assets of the debtor to the bankruptcy estate. The latest changes in the law were made in November 2, 2011 and supplemented the regulation with new rules on the Bankruptcy of financial institutions. The Civil Code, as well as a number of statutes that regulate different types of companies, is involved when the court decides on bankruptcy case. The definition of the debtor, creditor and obligations of the parties are stipulated in those act. Bankruptcy Statute is not the only legal source that regulates the transactions that fall under the bleed-out scheme in Russia. Since 2002 the Criminal Code includes a number of special crimes connected with Bankruptcy. The aim of the articles is to protect the rights of the creditors by collecting all the assets of the company. In case where the bankruptcy was caused due to the actions of the owners of the company or the management personal liability can be imposed. Among offences criminalized in Russia there are illegal actions during bankruptcy proceedings (Art. 195), malicious bankruptcy (Art. 196), fictitious bankruptcy (Art. 197).42 To conclude, the modern Russian bankruptcy law is characterized as the complicated complex of different statutes with different legal nature. The absence of unified logical legislation allows the companies to abuse the rights and bleed out the assets. The need for reformat is clear. 42 See: Brilliantov, Alexander. Comments to Criminal Code of Russian Federation. Prospect: St. Petersburg. 2010 13 EFTA01130908 Despite the differences in the US and Russian approaches the common tendency is the dramatic increase of the importance of bankruptcy legislation. The fact that bankruptcy is a comprehensive legal institution that is rooted in civil and criminal law makes the regulation incredibly difficult. Conflict of criminal and civil rules in the regulation of the bleed-out as a bankruptcy crime gave birth to the gaps in law that allow corporations to leave creditors without money they are entitled for. Furthermore it should be taking into account that bankruptcy has moral, social and legal aspects. In fact it is the society that determines whether the conduct will fall under the criminal system or under civil regulation. In such conditions it is the obligation of the legislators to find the balance that will correspond to the business and social reality. In next chapter I will analyze the US bankruptcy statutes in order to understand how the US created a balanced and efficient bankruptcy system that reflects the society needs. CEU eTD Collection 14 EFTA01130909 CHAPTER 2: US REGULATION OF THE BLEEDOUTS As it was stated in Chapter 1 of this thesis bleed-outs in the USA are regulated by both civil and criminal law. First section of this Chapter will examine how the US Bankruptcy Code establishes the rights of the trustee on avoidance of fraudulent transactions. The articles of USCA and UFTA are also considered. It will be illustrated how the court defines what does the fraudulent transfer/ conveyance means and how to determine it. For the trustee to return the assets of the company in bankruptcy procedure it is necessary to apply all acts mentioned above. The second section will be devoted to the criminal law regulation of bankruptcy fraud on the basis of Title 18 of the U.S.C. is applicable. In order to give the comprehensive analysis of the bleedout as a combination of transactions that is governed by different areas of law, both civil and criminal regulations will be considered in this Chapter. CEU eTD Collection 2.1 CIVIL REGULATION OF BLEEDOUT SCHEME IN THE USA The primary goal of the Bankruptcy Code is "to provide equality of distribution of the debtor's assets to creditors. This is accomplished through pro rata treatment of similarly situated creditors and disgorgement of fraudulent and preferential transfers.i43 An efficient and equitable bankruptcy system requires the disclosure of all property and liabilities of the debtor to the creditors and the court. The debtor must "not conceal or transfer assets which are property of his bankruptcy estate.i4f Equality in bankruptcy case means that the treatment of creditors and distribution of assets is equitable. Each claim "receives the same treatment as other claims with the same priority and legal rights."4s The core right that allows the trustee to avoid fraudulent transactions and maintain equitable treatment of the creditors is the strong arm clause that is allowed under Section 544- d3 Ibid. No. 2. p. 17. See also: Begier v I.R.S.. 496 US 53.58 (1990) 44 Ibid. No. 2. p. 18. 45 Idem., p. 19 15 EFTA01130910 548 of the US Bankruptcy Code. The Statute "grants the trustee the right to step into the shoes of other people, hypothetical and actual."46 In fact the Bankruptcy Code includes several types of avoidance power. First, the right to act according to non-bankruptcy law as if the trustee is one of the creditors. For example under Section 544 (a) the trustee has a right of hypothetical lien creditor. Section 544 (b) entitles the trustee to avoid "(1) any transfer of debtors interest in property or (2) any obligation incurred by the debtor, that an actual creditor holding an allowed unsecured claim could avoid under applicable non-bankruptcy law.i47 Second, the power to avoid preferential claims in multiple creditors cases (Section 547). Third. the right to act as creditors outside the bankruptcy. The third group of rights is of the essence for the scrutiny of bleedouts. It allows the trustee to avoid fraudulent transactions and conveyance (Section 548). CEU eTD Collection 2.1.1. Preconditions of civil liability In order to avoid the transaction certain preconditions are necessary: (1) the insolvency took place: (2) there was a transfer of assets. There are several tests in order to establish insolvency. The UFCA establishes the hybrid test, i.e. comparison of the "present fair market value of the debtor's assets with the amount the debtor will need to pay his probable liability on debts as they mature.'48 According to § 2 of the UFTA a debtor is insolvent "if the sum of its debts is greater than that of its assets at a fair valuation."49 Moreover, in § 2 (b) of the UFTA contains provision that a debtor who is not paying its debts at the date of its mature is insolvent. In fact the creditor needs to present evidence that the debtor is not paying its debts at a due date. The burden of proving that there is no insolvency lies on debtor. The Bankruptcy Code includes the equivalent balance sheet test. d6 Adler, Barry E. Cases. Problems. and Materials on Bankruptcy. 4th ed. University Casebook Series. New York: Foundation Press Thomson/West, 2007, p. 275 47 § 544 11 U.S.C.(accessed on March 29, 2012) http://www.law.cornell.edu/uscode/text/11/544 48 Tabb. Charles Jordon. Bankruptcy Law: Principles. Policies. and Practice. Cincinnati. Ohio: Anderson Publishing Co, 2003. p. 328 d9 § 2 of the UFTA. p. 8 (accessed on March 12, 2012) htlp://www.law.upenn.edu/bIl/archives/ulc/fnact99/1980s/ufta84.pdf 16 EFTA01130911 In practice the fraudulent transfer may take different forms, e.g. formation of a one-man corporation or transfer with the price below its market value. Acts on fraudulent transactions elaborated two general terms — "transfer" and "conveyance". The 11 U.S.C. § 101(54) contains a number of examples what should be regarded as "transfer". This definition is questionably broader than the definition of "conveyance" contained in UFCA. Under the UFCA (§ 3) there is a difference between fair consideration "needed for an absolute transfer and that needed for a security transfer.' The most descriptive definition is given in UFTA (§1(12)): 'Transfer" means every mode, direct or indirect, absolute or conditional. voluntary or involuntary, of disposing of or parting with an asset or an interest in an asset, and includes payment of money. release, lease, and creation of a lien or other encumbrance. To conclude both transfer and convenience are actions aimed at transaction of assets that includes monetary obligations. CEU eTD Collection 2.1.2. Fraudulent intent The intent of transaction is the core element that should be proven in order to find the company liable for fraudulent bankruptcy scheme. According to Section 548 of the Bankruptcy Code "The trustee may avoid any transfer of an interest of the debtor in property, or any obligation incurred by the debtor. that was made or incurred on or within one year before the date of the filing of the petition/6' From the wording of the section the avoidance power shall take place if (A) actions were made with actual intent "to hinder, delay or defraud creditors", (B) (i) the transaction was made for "less than a reasonably equivalent value" and (B) (ii) 52: (I) "The debtor was insolvent or became insolvent as a result of the transaction; (II) The debtor was engaged in business and the debtors capital remaining after the transaction was unreasonably small for that business; or (III) The debtor intended to incur debts beyond his ability to pay them as they matured. 50 Ibid. No. 48. p. 329 5' § 548 11 U.S.C.(accessed on March 29. 2012) hhp://www.law.cornell.edu/uscode/text/11/548 52 all Recourse Manual No. 57 (accessed on March 29, 2012) hhp://www.justice.gov/usao/eousa/foia_reading_room/usam/title4/civ00057.htm 17 EFTA01130912 It is common to call the possibility stipulates in Section 548 (1)(A) as an actual fraud and Section 548 (1)(8) — constructive fraud.53 Moreover similar provisions can be found in UFTA and UFCA. 2.1.2.1. Actual Fraudulent Intent [Section 548 (A) (1) USC; UFTA § 4 (A) (1): UFCA § 7J There are 2 preconditions to apply Section 548 (A) (1): transfer should take place within one year of bankruptcy, and with actual intent "to hinder. delay or defraud". Consequently the trustee should proof these two elements. If the question of the one year requirement is easy to define, the intent to "to hinder, delay or defraud" is difficult to determine. The standards for establishing actual intent have scarcely changed since the statue of 13 Elizabeth (1570). The courts relay on so called "badges of fraud" in order to establish the fraudulent intent of the debtor. Though "badges of fraud" in fact are combinations of circumstances and facts a number of badges are widely acknowledged as indications of fraudulent intent." One of the first cases that summarized the badges of fraud was Twym's Case55 where the court found the transfer fraudulent and established a number of circumstances that indicated itCEU eTD Collection the gilt was general, of all property; (the debtor] retained possession of the properly supposedly transfers and treated it as his own; the transfer was made in secret; the transfer was made while C's suit was pending against (the debtor]; Twyne held property in trust for (the debtor]; the deed contained a recital that the gilt was bona tide. The nowadays standard for Section 548 (A)(1) applicability is that the intent to hinder should be proved by clear and convincing evidence.57 On the basis of later cases and provisions of UFTA and UFCA it is possible to determine some extra badges: 53 Stumvoll. Erica. "Avoidance of Transfer: Section 548." Emory Bankruptcy Developments JoumaI3, (January 1. 1986): 389. LexisNexis Academic: Law Reviews. EBSCOhost (accessed March 18. 2012). 54 Ibid. No. 48. p. 395 55 Twine's Case 3 Coke Rep. 80b, 76 Eng. Rep. 809 (Star Chamber 1601) 56 Idem. 57 In rp Metro Paper. In:. 8 B.C.D. 1027 (Bankr. D.D.C. 1982) 18 EFTA01130913 transfer to a family member or another "insider" transfer without consideration transaction for less then full consideration insolvency of the debtor at the time the transfer was made.58 One of the most important indications of fraudulent intent is insufficient or inadequate consideration for the transfer. In case In re Matcus5° the court held that "valuable property had been gratuitously transferred for inadequate consideration (for less than fair market value): and. therefore. a presumption arose that such transfer was accompanied by actual fraudulent intent."60 The circumstantial evidence that indicates the fraudulent intent of the debtor is still the same: the adequacy of consideration and possible relations between the debtor and other third parties. 2.1.2.2. Constructive fraud I§ 548 (a) (2) U.S.C. 11] CEU eTD Collection The next step in evolution of fraudulent bankruptcy law was made by enacting § 548 (a) (2) U.S.C. 11. According to this section no proof of actual fraudulent intent is necessary. There are two distinct principles on which the constructive fraud is based. First, constructive fraud is used in order to substitute the actual fraud in case where the actual intent is hard to proves'. The second justification for constructive fraud is that the nature of certain transactions is harmful.. Such transfers are questionable, and should be set aside. In fact constructive fraud is a "form of strict liability designed to redress creditor injury."62 Prof. Tabb elaborated three forms of constructive fraud 63 53 See: Shapiro v. Wilgus 287 US 348 (1932); Alan Drey Co. v. Generation. Inc. 22 III App. 3d 611.317 N.E. 2d 673 (1974): Dean v. Davis 242 U.S. 438 (1917) 59 In re Marcus 45 Bankr. 338 (S.D.N.Y. 1984). 6/3 Ibid. No. 43 el Ibid. No. 48. p. 406 62 Idem. 63 Idem. 19 EFTA01130914 1. A transfer in exchange for less than reasonably equivalent value by a debtor who is insolvent or who is rendered insolvent by the transferu. 2 A transfer in exchange for less than reasonably equivalent value by a debtor with unreasonably small capital remaining after the transfer.65 3. A transfer in exchange for less than reasonably equivalent value by a debtor who is about to incur ctbts beyond the debtor's ability to pay as they mature. 66 The amount of consideration for the transaction is determinative in constructive fraud applicability. In fact all statutes require the transaction to have fair consideration and reasonably equivalent value. "Fair consideration" is determined in the UFCA and includes good faith as well as fair equivalence. The U.S.C. 11 and the UFTA remove the requirement of good faith, and use the term "reasonably equivalent value."67 The term "value" means "property, or satisfaction or securing of a present or antecedent debt of the debtor."68 It is determined at the date of transfer; subsequent valuation or reduction in value is irrelevant. "Reasonably equivalent value" is determined by market conditions.69 Though all three acts are similar the section § 5 (b) UFTA contains a separate type of constructive fraud, i.e. a preference to an insider. CEU eTD Collection To summarize civil fraudulent bankruptcy regulation consists of different statutes both in its nature and level of application (federal and state). Even though there are a number of discrepancies the majority of provisions contained in the Bankruptcy Code. the UFTA and the UFCA overlap. The successful applicability of the law is also based on evolutionary progressive development of provisions and the right of the courts to use all available legal means in interpretation of the debtor's conduct. 64 See: 11 U.S.C. § 548 (a)(2)(A) & (B)(i): UFCA §4: UFTA § 5a fi5 See: 11 U.S.C. § 548 (a)(2)(A) &(B)(ii); UFTA § 4(a)(2)(i): UFCA § 5 66 See: 11 U.S.C. § 548 (a)(2)(A)& (B) (iii): UFTA § 4 (a)(2)(ii): UFCA § 6 67 Ibid. No. 23. p. 324 68 See: Bustamonte v. Johnson. 934 F.2d 662 (5th Cir. 1991): In re Linen Warehouse. Inc.. 100 B.R. 856 (Bankr. W.D. Tx. 1989): In re Still. 124 B.R. 24 (N.D. Tx. 1991), aff'd. 963 F.2d 75 (5th Cir. 1992) 69 See: In re Ozark Restaurant Equipment Co.. 850 F.2d 342 (8th Cir. 1988) 20 EFTA01130915 2.2. CRIMINAL REGULATION OF BANKRUPTCY FRAUD IN THE USA Criminal provisions of the US bankruptcy frauds are contained in the U.S.C. Title 18.'° The U.S.0 Title 18 is aimed at prevention and redress of abuses of the civil system. The importance of the bankruptcy crimes was highlighted by the US Congress decision aimed at criminalization of abuse in the bankruptcy system. Furthermore in a landmark case United States v. Shapiro the court ruled "The object of Congress in passing this criminal statute was to punish those debtors who. although wanting relief from their debts, did not want to surrender what property there was to creditors."71 Hence, in order to address the issue of bleedout as a criminal offence this section of thesis concentrates on 3 bankruptcy crimes that constitute the "heart" of the fraudulent scheme. First, the analysis of the concealment of assets (18 U.S.C. §152 (1)) is presented, followed by the fraudulent pre-bankruptcy transfers (18 U.S.C. §152 (7)) examination. The last section of this part deals with bankruptcy fraud (18 U.S.C. §157). CEU eTD Collection 2.2.1. Concealment of assets: 18 U.S.C. § 152 (1) Concealment of assets is regarded as the most common bankruptcy crime. According to 18 U.S.C. § 152 (1) "A person who - knowingly and fraudulently conceals from a custodian, trustee. marshal, or other officer of the court charged with the control or custody of property, or, in connection with a case under title 11, from creditors or the United States Trustee, any property belonging to the estate of a debtor."n The primary objective of U.S.C. § 152 (1) provision is to prevent and punish debtor's efforts to avoid concealment of his bankruptcy estate.73 The common objectives of concealment are: 1) to hide the failure "to disclose an asset 70 United States Code, Title 18 (accessed on March 29. 2012) http://www.law.cornell.edu/uscode/texV18 71 United States v. Shapiro, 101 F.2d 375, 379 (7th Cir.), cert. denied, 306 U.S. 657 (1939) 12 § 152 (1), 18 U.S.C. (accessed March 28. 2012) http://www.law.cornell.edu/uscode/text/18/152 13 Stuhky v. Hyatt 667 F2d 807 (9th Circ.): Bankr. L. Rep. P 68.588 (1982) 21 EFTA01130916 CEU eTD Collection during a bankruptcy case" and 2) to defraud creditors.Th In practice both goals are succeeded by single actions. In order to apply U.S.C. §152 (1) it is necessary to proof four elements of this crime: (1) a concealment (2) which is knowing and fraudulent (3) of property of the estate of a debtor (4) in a bankruptcy case. The wording of the section on concealment has not been substantially changed since the previous Bankruptcy Act of 1898. Therefore, the definition of concealment made by courts under the 1898 law as well as the interpretation of the section is still applicable. Under the provisions of the Bankruptcy Act 1989 concealment was defined as "secreting, falsifying. and mutilating." 75 In United States v. Mathies case the court determined that concealment also take place when "hiding or withdrawing from observation, or covering or keeping from sight." According to the current law provision concealment includes "any actions that impede a bankruptcy trustee's ability to distribute assets of the debtor to the debtor's creditors."" This definition is broad. and conduct defined under prior law as concealment also falls under the modern provision. Intent is the core element of this crime. The court should find that the concealment was "knowing and fraudulent". If the concealment was accidental or took place due to innocent mistake then there is no intent and consequently no crime. In case the concealment was not accidental. the knowing and willful intent is presumed. Intent to deceive is considered as fraudulent.78 An intent to defraud the bankruptcy court or hinder the bankruptcy proceeding is not required:79 74 Ibid. No. 2. p. 29 75See: Goghlan v. United States. 147 F.2d 233 (8m Cir. 1945): US v. Schireson, 116 F.2d 881, 884 (3rd Cir. 1940) 76 United States v. Mathies, 203 F. Supp. 797 (W.D.Pa. 1962) 77Ibid. No. 2. p. 28 78 United States v. Diorio 451 F2d 21,23 (2r4 Cir 1971)) ?Ibid. No. 2. p.30 22 EFTA01130917 CEU eTD Collection The problem with intent can arise in case when the debtor transfers some assets in the period between trustee appointment and the date when the court order on this issue take effect. If the transaction is within ordinary course of business no fraudulent intent presents. However if the only purpose of transfer is "to keep funds or assets away from the trustee's administration" the § 152 (1) is applicable.80 Assets concealed should constitute the property of debtor or a bankruptcy estate. The value of concealed property is not significant. It is not always clear, however, what should be determined as a property within the meaning of the § 152 (1). According to 11 U.S.C. §