Bankruptcy

U.S. Trustee Audits on Debtor Bankruptcy Filings

By Bob Lawless

In March, the Executive Office of the U.S. Trustee (EOUST) released its annual report on audits of individual chapter 7 and chapter 13 cases. The audits identified a "material misstatement" in 22% of the cases examined for fiscal year (FY) 2009. The 2005 changes to the bankruptcy law require these audits and the EOUST annual report. The "material misstatement" rate for FY 2009 is similar to previous reports--21% in FY 2008 and 30% in FY 2007. The rate of "material misstatements" suggested both a public policy issue and a research methodology issue.

On public policy level, a system where 1 in 5 bankruptcy files has a "material misstatement" could be troubling. The problem is that we don't know exactly what a "material misstatement" means because the criteria have not been publicly identified. When an audit identifies a "material misstatement," both the bankruptcy court and creditors are notified. Understandably, the EOUST does not want to tip off how its auditors determine a "material misstatement" anymore than the IRS wants to let taxpayers know how much they can cheat before triggering a tax audit. All we know is what the EOUST tells us: "A material misstatement indicates the audit produced information that challenged the accuracy, veracity, or completeness of a debtor's petition, schedules, or other filed bankruptcy documentation."

If 1 in 5 bankruptcy filers are making materially misleading statements about assets, debts, or income, that might suggest widespread bankruptcy fraud. The EOUST also reports its enforcement activities and criminal referrals, and these reports suggest a much, much lower rate of bankruptcy cases with possibly fraudulent debtor behavior. On the other hand, I suspect that most of the "material misstatements" are failure to check a box (like the small-business box as discussed a while back) or entirely complete a bankruptcy form (the Statements of Financial Affairs are notoriously incomplete). While these omissions are hardly laudable, they do not raise the specter of widespread fraud in the bankruptcy filings. To the extent consistent with its audit directives, it would be really helpful if the EOUST could provide some more detail on what it means for its auditors to flag a "material misstatement."

The EOUST's report flagged a research methodology issue as well. Researchers use the bankruptcy court files for measures of debtor's assets, liabilities, and income. If the error rate is 1 in 5, my first reaction was that it could call into question the integrity of these measures. Upon further reflection, I wondered if that was true. First, it would depend on what a "material misstatement" means. Second, as one of my colleagues is fond of reminding us, "as compared to what?" Consumer finance is a notoriously difficult area to research because, absent the cost and unlikelihood of being able to access a consumer's private financial records, one must generally rely on consumer self-reporting. The error rate might be and probably is even higher for self-reported figures. The bankruptcy files come with indicia of reliability such as the penalty of perjury for knowing falsehoods and threat of an audit.

As a postscript, I have to note that the EOUST is auditing 1 of every 1,000 bankruptcy cases. Congress directed audits in at least 1 in 250 cases. Over three years ago, I pointed out how the congressional audit standard was unworkable as the EOUST's experience has shown.

Full post as published by Credit Slips on May 19, 2010 (boomark / email).