U.S. Trustee Audits on Debtor Bankruptcy Filings

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.

Comments

[Doug]

I would have to assume that the UST uses the phrase "material misstatement" in the same way auditors do when reviewing financial statements pursuant to GAAP, which is to say a misstatement is material when it is large enough to cause a reasonable observer to alter their opinion of the situation.

For example, if a debtor is unemployed and schedules I and J show a deficit of $2,500, but it turns out that they overstated their car insurance expense by $300, it doesn't matter. They're still insolvent, and lack the means to effectuate a Chapter 13.

On the other hand, if line 51 of a debtor's Form B22A shows 60 month disposable income of $7,000, and the audit reveals that they overstated their telecommunications expense on line 32 by $30, (and the person in question has more than $28,120 in unsecured debt), than a presumption of abuse arises, and this $30 discrepancy is material even though it is only 10% of the size of the misstatement cited above.

By the way, of the material misstatements that I have seen, errors on Form B22 have been the cause of all of them. (It really should come with better instructions on some of the things you can't do; e.g. if the amount of your monthly rent exceeds your IRS Housing and Utilities Standards on line 20A, you cannot input the discrepancy on line 21).

[Patches]

I wonder if it is such a big problem, how many of the the cases that had material misstatements were denied a discharge because of them?

And what the heck does immigration offenses have to do with bk? It's only 1% but wth?

[Bob Lawless]

Doug, your definition is certainly reasonable and a possibility, but I am suspicious that is the standard that is being used. It would be nice to have more information from the UST instead of having to guess.

[Patches]

It's still changing right? The instructions would change district by district..opinion to opinion. So, say you flunk....means test.......theres a Kentucky fried mouse I've heard of... 36 month 0% plan.... anyone seen one?

Oh Bob.. it's not in writing but believe me they let you know. If it's not done right enough times you get nice one on one attention. Seriously though, knowing the person on the other end long enough helps....in organization only...obviously.

[Ken D]

I have been fortunate enough not to have to deal with audits in my own cases, but anecdotal evidence indicates that many such findings would be disputed by the debtor as to materiality, or simply the accuracy of the auditor's characterization. There does not appear to be any useful mechanism to challenge such an accusation, unless a motion adverse to the debtor is filed. If anyone wants to pursue this, a trove of specifics could probably be turned up through NACBA.

[Doug]

Bob,

It would seem strange for the parties that drafted BAPCPA to use such a well-known accounting term but intend it to have an entirely different definition than what it is typically given without explicating this somewhere. Given the fact that the UST doesn't conduct the audits but instead contracts with private accounting firms would seem to lend weight to this (though I don't know if the debtor that cannot compute his car insurance premium that I cited in my post would be given a free pass).

More importantly though, "material misstatement" just sounds like fraud, as you indicated in the second paragraph of your post, even though unintentional errors are probably the cause of the overwhelming majority of them. The statistic that 1 in 5 debtors files a fraudulent bankruptcy petition would be a great number to throw around, along with the concept of the so-called "bankruptcy tax", coming from a credit card industry lobbyist retained to bring about BAPCPA II. Of course, that was back in an era when banks could portray themselves as victims and the expansion of credit as the engine of our rising prosperity.

[FJP912]

The report says that the audits look at "the debtor's originally filed bankruptcy papers." How many of these errors or omissions ate cleared up by amendment after the 341 meeting, and the case proceeds merrily along with no further problems? A lot, I suspect.

As a creditors' lawyer I see many mistakes in Ch. 7 and 13 filings. Self employed debtors account for many of them. A very common error is to omit the lease for the business premises from Schedule G. Is that material? If the business is incorporated there is almost sure to be confusion about what is personal debt and what is business. Is that material? Once again, these things get cleared up in most cases.