When a company goes bankrupt, honest owners or directors do everything they can to hold creditors’ losses to a minimum. When it becomes clear the business can’t be saved, they halt trading (in the case of public companies), hire professional advisors to help guide them through bankruptcy proceedings and generally arrange for orderly liquidation.
Less scrupulous people use somewhat different tactics. They may deliberately sell off assets so there isn’t enough left of the company to justify creditors bringing in turnaround or bankruptcy experts. Worse, they may attempt to profit from bankruptcy. Knowing how to spot these businesses — sometimes called “phoenix” companies — can help prevent you from getting burned.
A Rose is a Rose
Owners of a bankrupt company might sell the assets to themselves as owners of a new company that’s in the same or related business. The new company may even have the same or a similar name. There’s nothing wrong with such companies if some or all of the directors or owners buy the assets at fair market value and use them to attempt to build a financially strong successor business.
There’s something wrong, however, if the principals intentionally ran the old company into the ground to avoid liabilities. It’s also wrong to transfer assets to the new, phoenix company at below-market value shortly before or immediately after the demise of the original business. Those are just some of the signs that fraud is afoot.
Smelling a Rat
Other red flags may be apparent to those who look carefully. For example, phoenix companies often are formed with minimal share capital. Also be suspicious when:
- A company opens its doors either immediately before or within a year after the failed company has publicly stated its imminent demise,
- Some or all of the directors and other senior executives and many employees of the debtor business now work for the new company,
- A number of preferential payments are made to creditors of the insolvent company before it goes out of business so that those creditors will be more willing to supply the new company, and
- Substantial liabilities are left in the insolvent company when the new business is formed.
Before agreeing to do business with these new companies, potential customers and suppliers should check business references, scrutinize directors’ and owners’ backgrounds, and learn why the original business failed.
Catching the Perpetrators
While there are civil and criminal remedies for creditors to pursue against phoenix companies, unsecured creditors of the bankrupt business are most likely to suffer. Creditors are most likely to spot potential phoenix activity early, but they may not take action after operators of the business pay outstanding bills in an effort to keep supply lines open.
It’s hard to enumerate the incident of phoenix company fraud, in part because bankruptcy fraud often is perpetrated in conjunction with other crimes. Because fraud investigations can be complex and time-intensive, bankruptcy fraud may not be included in indictments if evidence of tax fraud or embezzlement is sufficient for criminal convictions.
Phoenix companies are most common in certain industries — including construction, transportation, hospitality and clothing. Of course, that doesn’t mean phoenix companies don’t crop up in other industries. No sector is immune to fraud.
The good news about phoenix companies is that they can generally be spotted and their damage contained. The better news is that more stringent government regulations and heightened financial scrutiny of companies and the people who run them is making it harder for them to get off the ground in the first place.