Broke or Dishonest? Uncovering alter ego companies

Chrysler’s and GM’s recent bankruptcy filings were very public examples of a much broader insolvency trend that cuts across all industries and market capitalizations. Most companies filing for bankruptcy accurately represent their assets. But a small percentage of filers that claim to have little or nothing to offer creditors aren’t being honest. Instead, they’ve diverted resources to an alter ego company or are hiding their connection to a much healthier corporate parent.

If your clients have claims against bankrupt businesses or are involved in litigation with purportedly poor defendants, you might want to look into the existence of an alter ego company. Uncovering and proving this type of fraud can be difficult, but forensic accounting experts know how to expose such schemes. Conversely, forensic experts can help defendants prove that any alter ego accusations are unfounded.

Someone’s hiding something
Alter ego companies are, in a nutshell, fake businesses set up by parent companies with something to hide. Typically, owners divert assets, such as inventory and accounts receivable payments, from the parent to the alter ego before the parent lands in bankruptcy court. Alter ego schemes are also commonly used to hide assets in marital dissolutions and shareholder disputes.

If no legal connection between the two companies exists or can be proven, the alter ego’s assets are protected. If the relationship can be established, however, claimants or plaintiffs may be able to hold the other entity or its shareholders liable. Laws vary by state, but most require evidence of a unity of interest between the corporation and the other person or entity — indicating that they have no separate existence and that allowing the corporate fiction of a separate entity would, under the specific circumstances, sanction fraud or promote injustice.

Proving an alter ego case can be complicated by the fact that it’s perfectly legal for corporations to limit risk by setting up separate, subordinate businesses. But even if they’re wholly owned by the parent, legal entities maintain their own corporate structures and function independently in terms of sales, billings, assets and management.

Smelling a rat
Experts look for a variety of signs that may indicate the existence of an alter ego company. For example, red flags go up if both companies:

  • Operate out of the same location,
  • Have similar names,
  • Use the same letterhead or Web site,
  • Sell identical products,
  • Pay each other’s expenses,
  • Follow the same policies and procedures, or
  • Share officers and directors or outside advisors.

Forensic accountants also examine the number and nature of “related party” transactions which, to be legitimate, must not include special or favorable terms and conditions. Otherwise, these transactions may represent a route for diverting money from the bankrupt or defendant company — thereby making it insolvent and judgment-proof.

When the alter ego is a defendant, experts might look at when the parent incorporated the subsidiary. They also investigate whether the parent has recently pulled cash out of its subsidiary or deposited the subsidiary’s accounts receivable in its own bank account.

Popular in troubled times
Alter ego scams aren’t new, but in times of widespread financial distress they — as well as other fraud schemes — are more common. If you suspect an alter ego is interfering with your ability to recover what’s due a client, ask a forensic specialist to investigate. Not only can these experts establish relationships between companies, but they also can help explain in court how such complex associations attempt to defraud creditors and plaintiffs.