The proper operation of the bankruptcy system depends upon the honesty of debtors. Complete financial disclosure by debtors is required, and those who seek the shelter of the Bankruptcy Code must not play fast and loose with their assets or with the reality of their affairs.

Indeed, the Bankruptcy Code and the Federal Rules of Bankruptcy Procedure are designed "to insure that complete, truthful, and reliable information is put forward at the outset of the proceedings, so that decisions can be made by the parties in interest based on fact rather than fiction."

Notwithstanding the fundamental requirement of debtor honesty, at times either temptation or contempt - or both - result in debtors filing false or incomplete information with the court, attempting to hide their assets, transferring their assets to friends and relatives, and even bribing creditors and bankruptcy trustees from taking certain action. Dishonesty among debtors in failing to completely disclose their financial affairs undermines the civil bankruptcy system, and certain dishonest acts committed by debtors may even constitute bankruptcy crimes under 18 U.S.C. sections 151-157.

The criminal bankruptcy statutes are not concerned with individual loss or even whether certain acts caused anyone particularized harm. Rather, the statutes establishing the federal bankruptcy crimes "seek to prevent and redress abuses of the bankruptcy system."

To this end, the bankruptcy statutes criminalize voluntary, intentional and fraudulent abuse. In particular, 18 U.S.C. Section 152(1) criminalizes a debtor's "knowing" and "fraudulent" attempt to conceal from a bankruptcy trustee or "other officer of the court" any property "belonging to the estate of a debtor."

The penalty for a violation of Section 152 can be a fine, a term of imprisonment of not more than five years, or both. The extent by which the courts are willing to extend the reach of Section 152(1) - and thus criminalize an expansive degree of conduct - is exemplified by the fairly recent decision by the 6th U.S. Circuit Court of Appeals in United States v. Wagner.

An Overview of Section 152(1)

From the time when our first bankruptcy statute was enacted in 1800 until the present, Congress has provided criminal penalties for the abuse of the bankruptcy process. Indeed, criminal sanctions for bankruptcy fraud are designed to "set basic rules [of behavior] for participation in the civil bankruptcy process." Today, the principal statute for bankruptcy crimes is 18 U.S.C. Section 152.

The primary objective of Section 152 is to prevent and punish efforts by a debtor to avoid the distribution of any part of a bankruptcy estate that should otherwise be distributed. The concealment of assets arguably is the most significant bankruptcy crime - it is easily violated, and unless the bankruptcy court or the bankruptcy trustee (if one is appointed) has sufficient cause to believe a concealment of assets has been committed or otherwise receives a "tip" that a debtor is concealing assets, such concealment can remain undetected.

In order to prove the concealment of assets, it is incumbent upon the government to demonstrate the following four elements:

The existence of a bankruptcy case under Title 11 at the relevant times;

The property allegedly concealed was property of the bankruptcy estate at the relevant times;

The defendant concealed the property from a trustee or other officer of the court during the relevant period of time; and

The defendant concealed the property knowingly and fraudulently.

By definition, the crime of concealment of assets cannot occur prior to the existence of a civil bankruptcy case. However, the concealment of assets is a "continuing offense;" in other words, if a debtor initially conceals his or her property before the bankruptcy case and continues to conceal the property after the filing of the petition, a violation of Section 152(1) has occurred.

Moreover, with respect to the value of any concealed property, Section 152(1) contains no "materiality" or "substantiality" requirement. That is, the value of the concealed property is not an essential element of the conduct criminalized by Section 152(1). In addition, the element of "intent" required by Section 152(1) will rarely be, if ever, provable by direct evidence.

Consequently, the crime of concealment is most often proved through circumstantial evidence, which consists of "adducing evidence that the acts constituting the concealment were not accidental, and that they were logical steps in a progression of other acts the defendant performed which resulted in concealment."

Furthermore, courts have routinely declared that the term "conceal" or "concealment" is not limited to physical secretion, but also encompasses any action "to prevent the discovery of or to withhold knowledge of" the existence of such property by refusing or failing to divulge pertinent information.

Finally, under Section 152(1) the concealment need not be for the debtor's own use; the fact that the debtor does not directly profit from the concealment of assets is of no moment.

The Cautionary Tale

In United States v. Wagner, Harry Herbert Wagner Jr., a real estate developer from Ohio, in the mid-1970s developed Edgewood Estates, a 300-acre subdivision containing 156 rental units. Wagner also built six "smart houses," which were outfitted with electronic devices that automated various household chores. Approximately 20 years later Wagner experienced difficulties in making his regular multiple mortgage payments, and in 1999 he ceased making monthly mortgage payments to several of his lenders.

The lenders subsequently commenced foreclosure proceedings. As a result, Wagner filed a pro se Chapter 11 bankruptcy petition, which stayed the various foreclosure proceedings. Based upon falsehoods and fraudulent conduct committed by Wagner during the pendency of his Chapter 11 case, the Office of the U.S. Trustee successfully moved the bankruptcy court to convert Wagner's Chapter 11 case to a Chapter 7 bankruptcy case.

As a result of the conversion, the court appointed a Chapter 7 trustee to liquidate Wagner's assets. To this end, the trustee went to Wagner's office and informed Wagner that he was assuming control of Wagner's assets and business operations. The bankruptcy trustee forwarded a letter to Wagner's tenants, informing them that all rents were to be paid to the trustee, rather than to Wagner.

Almost inexplicably, Wagner declared that he would not cooperate with the bankruptcy trustee. Several days later, Wagner wrote a letter to his tenants, claiming that "all rents were still payable to him and that failure to pay rents 'as usual' could result in the cessation of maintenance and lawn care."

As if this conduct were not enough, Wagner then committed an act that resulted in a criminal conviction under Section 152(1) and a prison sentence of six months. At the time of the conversion to Chapter 7, three of Wagner's six "smart" houses were unoccupied and on the market for sale. The trustee hired a real estate company to sell the homes, and in doing so, changed the locks to effectuate this goal.

Undeterred, Wagner directed one of his employees to change the locks again and to return a single key for each home only to Wagner. As a result, the real estate company was not able to show one of these homes to a prospective buyer.

When called on to explain his actions, Wagner claimed that he changed the locks because there had been a rash of break-ins at the three houses and he wanted to control all the outstanding keys to halt any future incidents. The government, on the other hand, presented evidence at trial demonstrating that Wagner changed the locks specifically to interfere with the bankruptcy trustee's sale efforts.

Wagner was thereafter indicted in the U.S. District Court for the Northern District of Ohio for, inter alia, concealing assets in violation of Section 152(1) by changing the locks on the homes that became assets of the bankruptcy trustee upon the conversion to Chapter 7 of the code. After trial, the jury found Wagner guilty of violating Section 152(1); the court subsequently sentenced Wagner to a prison term of six months.

Wagner appealed his conviction. On appeal, he argued that the act of obstructing a trustee's access to real property, and thus potentially hindering the sale of that property, does not amount to "concealment" under Section 152(1). The 6th Circuit disagreed, concluding that by depriving the trustee access to the houses, even "for only a short amount of time," Wagner concealed the value of the properties. The fact that the bankruptcy trustee knew of the existence of the homes was not dispositive, because, according to the 6th Circuit, "mere awareness of the property does not concomitantly reveal the property's value." In so concluding, the 6th Circuit stated as follows:

"Without access to the inside of the home, no prospective buyer could accurately assess the worth of the house and place a bid, which in turn prevented the Trustee from learning the value of the house and accordingly disposing of the estate.

It would be no different if Wagner revealed to the Trustee the existence of a cache of diamonds in a locked box, but refused to give the Trustee the key to open the box, preventing a buyer (and consequently the Trustee) from assessing whether the diamonds were of pristine cut, color, and clarity such that they were worth $100,000 or were instead low-grade diamonds worth only $10,000. Like diamonds, the value of the smart house, as embodied in the sale price, cannot be known until a purchaser bids on the house, which provides the only true measure of the house's value.

"Few rational buyers would purchase a home without seeing the inside first. Thus, limiting access to the inside of the house effectively precluded any potential purchaser from making an informed decision, which in turn prevented the Trustee from learning the true value of the house. Such actions constitute concealment of an asset."

While the appellate court's analogy of real property to a cache of diamonds may have been imperfect, the ultimate holding is sensible given the bankruptcy system's reliance on the availability of accurate financial information and the need to objectively evaluate the entirety of a debtor's bankruptcy estate.

Limiting the definition of concealment under Section 152(1) to instances of "secreting" or "withdrawing" property from sight would prove too rigid and formalistic in the context of real property. To be sure, and as the court of appeals recognized in Wagner, a debtor's use of physical force to prevent a trustee from approaching the debtor's property, or the intentional marring of property to reduce its value to buyers, hinders and obstructs a trustee's efforts to marshal and distribute property of the estate just as much as preventing the trustee from discovering the value of the property.

The decision in Wagner, therefore, serves as a useful cautionary tale for debtors: Any act (later adjudged to be intentional and fraudulent) taken by a debtor to frustrate a trustee's efforts to account for property of the estate threatens the integrity of the "larger" bankruptcy system and could result in a great deal more than just the dismissal of a debtor's petition.

Rudolph J. Di Massa, Jr., a partner at Duane Morris, is a member of the business reorganization and financial restructuring practice group. He concentrates his practice in the areas of commercial litigation and creditors’ rights. He is a member of the American Bankruptcy Institute, the American Bar Association and its business law section, the Commercial Law League of America, the Pennsylvania Bar Association and the business law section of the Philadelphia Bar Association.

Michael D. Sousa practices with the firm in the area of bankruptcy law. Sousa served as judicial clerk to Rosemary Gambardella and to Donald H. Steckroth, both of the U.S. Bankruptcy Court for the District of New Jersey; to William J. Martini of the U.S. District Court for the District of New Jersey; and to John E. Wallace Jr., of the New Jersey Superior Court- Appellate Division. He is currently completing an LL.M. in bankruptcy from St. John's University School of Law, where he was named the American Bankruptcy Institute Scholar.

Reprinted with permission from The Legal Intelligencer, © ALM Media Properties LLC. All rights reserved.