Bankruptcy Bonanza: How the Great Recession Changed the Courts

Thomas J. Shroyer

Thomas J. Shroyer
Thomas J. Shroyer
One byproduct of the Great Recession is the historic expansion of power by U.S. bankruptcy courts. In addition to the unilateral voiding of the first secured position of bond holders in the General Motors bankruptcy, judges in bankruptcy court have recently created an immensely powerful and brand new jurisprudence based on the explosion of Ponzi fraud cases.

Like most expansions of the legal system, the gigantic scale of the multi-billion dollar Ponzi schemes that were exposed by the financial crisis in 2008 cried out for relief. The bench and bar of the bankruptcy courts responded by adopting expansive theories of recovery under a new set of "claw back" rules and something called "Ponzi damages." The courts have even been allowing assets of the bankrupt company, pledged for payment to secured and unsecured creditors alike, to be used to finance lawsuits for the non-bankruptcy claims of fraud victims against third parties.

By now, you have likely guessed where this is heading. In their zeal to pay Ponzi victims as much of their losses as possible, bankruptcy courts and their trustees have been pummeling professionals of all stripes for their alleged failure to discover and then "blow the whistle" on the schemes, no matter how innocent the professional engagement or attenuated the damages.

Trustees -- unbounded by normal fiscal constraints as they have the right to use bankruptcy assets for their war chest -- compound these new laws for maximum effect by joining their altogether odious claims for "malpractice" (which are required to be brought in the name of the fraudster) with claims for the enormous damages incurred by entirely blameless victims into "bet the firm" settlement leverage.

The legacy of this is that bankruptcy trustees now have "sue the CPA" (and the lawyers, bankers, appraisers, and insurance agents, etc., who dealt with the failed entity) at the top of their routine checklist for disposing of cases.

The implications

The implications of these developments for the public accounting professional are profound, as they impose a level of exposure for consequential damages that can easily dwarf any risk management (i.e., malpractice insurance) program and threaten firm capital.

Following this introduction, we will cover these in future installments of this message. In the meantime, we conclude by noting that since the bankruptcy trustee "stands in the shoes" of the CPA's defunct client, the busy professional working with a highly-leveraged or financially-challenged client should be mindful that "your client" might end up being lawfully impersonated by an aggressive lawyer with strong connections to the bankruptcy court -- and greatly empowered to throw you under the bus.

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