August/September 2004

II. How Electronic Data Can Assist in Determining Whether to Bring a Recharacterization Claim or in Defending a Claim Seeking to Recharacterize Debt to Equity

A. An Overview of Electronic Data
Electronic data can be found nearly every-where you look in business today, and that is true in bankruptcy. Robert C. Furr, Esq. Editor for the National Association of Bankruptcy Trustees pointed out in his summer 2003 column of NABTalk “There are no filing cabinets full of records that are easy to digest. Rather, there is a mass of computers, hard drives, software, CD ROMS, etc., from which we have to try to figure out what happened to this debtor.”

A debtor’s electronic books and records and related financial information are the core of the debtor’s business, and can reveal, if properly restored, information that can lead to the recovery of hidden assets and provide valuable information about claims against the debtor’s creditors, board members, share-holders, employees, insiders, and others.

A comprehensive discussion of the discovery, recovery and use of electronic/digital information (“e-data”) is beyond the scope of this article.¹ This section has as its core just one premise: Understanding that e-data likely exist and that e-data in conjunction with physical hard copy documents will show the true substance of the transaction under scrutiny related to the proposed recharacterization claim or in defending the claim.

B. About Digital Evidence
The debtor’s e-data can help you find out more about its business and assets, than the debtor ever intended for you to know. Professionals working for the benefit of creditors, trustees, committees, examiners, employees, shareholders, insiders, co-defendants, and other parties in interest in a bankruptcy case, will want to become familiar with this and the need for using digital forensic accounting technology in bankruptcy cases. This technology uses sophisticated e-data retrieval and discovery methods to unleash the electronic information of a debtor. This is nearly compulsory for finding electronic/digital evidence, because it deals with the books and records and related financial information created and stored on computer hard disk drives, and other digital devices.² These concepts equally apply to those parties defending the recharacterization claim.

E-data exists because more than 92% of all information is created in digital form.³ As you probably now know, getting rid of e-data is not as simple as point and click. As the many former WorldCom, Anderson, and Enron employees have learned, “delete” never meant “erase.” People are more open and frank in e-mail and instant messaging than they would otherwise.⁴

In the Kevco case e-mails discovered on the defendants’ hard drives supported the allegations by the chapter 11 liquidating agent that defendant former officers of the debtor wrongfully took trade secrets and breached their fiduciary duties in setting up a competing company.⁵ An investigation into the facts about possible recharacterization claim or in defending the claim should always consider e-mail, including related attachments and instant messaging as a source of e-data.⁶

Many software programs create a type of e-data called “metadata.” Metadata is information about the e-data. The metadata may show, for example, if the e-data was changed or backdated after creating the original document or after filing a lawsuit (other methods of detection are available). Most word processing documents, spreadsheets, database files, presentation files, and other files contain this embedded information. Metadata information is not shown on the physical hard copy documents. All parties need to be aware producing physical hard copy documents will leave out the critical information that can help make the case for a recharacterization claim or in defending the claim.

C. Turnover of Books and Records
In Chapter 7 cases, the discovery of digital e-data is simple. The hardware, software, and all data, contained on the debtor’s computers and other digital devices is property of the estate under Bankruptcy Code section 542(a) and (e). Similarly, if a trustee has been appointed in a chapter 11 case, the trustee may demand access to all the debtor’s computer and digital devices, information, and data storage.⁷ Under section 521(4) of the Code, the debtor must surrender to the trustee “all property of the estate and any recorded information, including books, documents, records, and papers relating to the property of the estate....” The parties involved in a recharacterization claim need to consider the possibility that e-data may exist on leased computers and digital devices.⁸

D. Deliberate Destruction of E-Data
Deleting the debtor’s digital books and records, financial documents, including financial statements and supporting information should never be considered the ordinary thing to do.
Although no major e-data decisions have been decided by bankruptcy courts, the role of electronic e-data in bankruptcy litigation has become increasingly important. Recently, a former Ernst & Young partner and manager were charged with accounting fraud in the NextCard, Inc. bankruptcy.⁹ The accountants, who audited NextCard’s books, are alleged to have destroyed and altered the electronic documents for NextCard’s 2000 and 2001 financials and electronic workpapers to hide losses and make it look as if all documents were the product of a clean audit.¹⁰ It was reported that a second manager saved a copy of the original electronic files on another hard disk drive as a precaution.

Counsel would file a motion to prevent spoilage of the digital evidence early in the case if destruction of the digital information was threatened.¹¹

E. Results of Restoring E-Data
Clearly, e-data is of no value if counsel and professionals cannot view it. Like a forensic medical examination, the analysis of the digital innards of the parties and others can yield valuable financial information. The trustee or plaintiff/defendant would want the digital forensic accounting technologist to prepare an asset profiling report that will document the results of the discovery, recovery and analysis of e-data from all sources under scrutiny and related recharacterization claim.

It is at this juncture the e-data has been amassed and indexed for alpha/numeric text, phrases, terms, numbers, symbols, passwords, electronic commerce, special purpose words that relate to the debtor’s or insider’s business, including dates and times that refer to any document or actions created or performed on computers and digital devices. The resulting indexed e-data from all sources, including previously deleted e-mails, instant-messages, documents, financial statements, books and records, spreadsheets, files, folders, directories and logical hard drives discovered in unallocated space provides unlimited search abilities and this critical information then becomes available for inspection and further examination.

The specific e-data documents discovered, recovered and retrieved during the search and analysis phase of the investigation for the recharacterization claim or assisting in defending the claim may include some of the following examples:

Loan from insider shown as capital on debtor’s deleted interim financial statements
Deleted e-mail indicating insider took capital stock without consideration and treated the amount “invested” as a secured loan to be ahead of the unsecured creditors.
Deleted e-mail which reveal the nature of the transactions with insiders
Deleted financial statement of the insider treated loan to debtor as capital
Loan actually received from insider before creation of loan documentation
Deleted e-mail show loan was to have been a capital contribution
Corporate minutes discuss loan from insider and granting security interest
Debtor was undercapitalized and insolvent before loan from subsidiary/parent
Deleted loan documentation not created until shortly before the Ch 11 filing
Debtor insolvent before receiving loan from insider
Accounting entries for loan to parent were backdated before the Ch 11 filing
Financial statements and documentation show adequate capitalization
Deleted corporate minutes discuss additional capitalization and not a loan
Creditors notified that stockholders made an additional capital contribution
Financial statements showing insider loan were found to have been backdated
Loan not previously disclosed; carried as a negative asset on books and records
Debtor was adequately capitalized and solvent before and after loan
Corporate minutes do not discuss granting security interest (unrecorded)
Deleted corporate minutes indicated parent to provide additional capitalization

The discovered, recovered and retrieved e-data documents could become the crux of any successful recharacterization claim or assist in defending the claim. Conversely, after the examination of the digital forensic evidence, both time and property of the estate will not be wasted on a recharacterization claim that lacks merit or in defending such a claim.

F. Relevance of E-Data
Trustees, creditors, board members, shareholders, employees, insiders, and others do not want to produce or receive millions of pages of irrelevant information when facing a potential recharacterization claim or in defending the claim.

In short, much can be done to reduce the cost of digital discovery of e-data, and to allow both parties the opportunity to informally develop e-facts in an efficient and cost-effective manner if the parties initially work towards that end. As is often the case, the digital evidence becomes compelling on its face and when the parties understand the digital evidence, many parties will want to settle the dispute before it reaches court.

Conclusion
Recharacterization claims are being brought with more and more frequency and creativity. Understanding what is needed in order to determine whether to bring such a claim, or knowing what is important to analyze in defending such a claim is crucial.

In the digital age, the digital forensic accounting technologist experienced in bankruptcy matters is essential in the search for digital evidence related to a recharacterization claim or in defense of the claim. Without the proper knowledge, skills, and a full array of digital forensic tools on your side, you are at a disadvantage against those who will use the best of this technology.