Conniving in a Crisis: As Bankruptcies Mount, Frauds May Follow

Welcome to the July 2020 edition of our newsletter!  In this issue, we’ll examine the signs of bankruptcy fraud and how to protect yourself if a client enters bankruptcy.

 Here today, gone tomorrow: Signs of Bankruptcy Fraud

A wave of corporate and personal bankruptcies has begun to wash over the country in the wake of the onset of coronavirus, most notably by major retailers but also encompassing other companies and individuals.  The human toll of these filings is significant, even for those companies that are seeking to reorganize and ultimately return to operation in some form.  In this crisis, as with all others, there will be those seeking to exploit the panic.  Here are some signs to watch out for if your client suddenly stops paying their bills or alters their behavior in other ways that suggest financial stress – such as suddenly not returning telephone calls.

One area of concern is the use of personal loan guarantees by officers or members to backstop loans made to the company.  In a recent case involving a restaurant chain, we saw that an executive personally guaranteed millions of dollars in loans with the single-purpose limited liability company set up to manage each individual restaurant.  After the companies entered bankruptcy, the individual did as well, leaving the lenders and other creditors to sort out who was responsible – and how they would pay – via the bankruptcy court, which often moves at a deliberate pace.  For lenders, waiting months or years to get paid often isn’t feasible.  Similarly, companies that provide “factor” financing based on a borrower’s receivables may find themselves out of luck, especially since the receivables in a service company like a restaurant are items like sales of meals – difficult to achieve in the current environment of shutdowns and half-full, socially distant establishments.

Certain types of bankruptcy fraud can carry certain hallmarks.  In a “bust out” fraud, for instance, a company will suddenly appear and order large sums of inventory – we previously investigated such a company selling prepaid telephone minute cards, in the era before widespread cell phone use.  The company rented an office space – deciding not to pay rent after a short while – bought inventory on credit, including with the vendor, and began sales.  Within three months, the entire operation was shut down, leaving behind an entire office of records simply left by employees as they came in for their last day of work.  If you have a customer who appears suddenly, without any track record – even if they’re recommended by a legitimate client in good standing – proceed with caution and check the background of the individuals involved. The company itself may be meant to disappear as quickly as it came to be, with your unpaid-for inventory gone too.

In other instances, company insiders will lever a company up with debt and misuse that debt for their own personal gain – such as leasing or buying cars in the company’s name but for the sole use of its president, then failing to make payments.  While insider frauds are harder to detect, a strong customer relationship may be the best indicator that something is wrong.  If anyone involved in the business relationship notices lavish spending or other changes, it may be a sign that the company is being pillaged for the benefit of insiders.

When all sense of equilibrium is shattered, the natural reaction is to panic.  But as companies try to maintain as normal an operation as possible, they should be wary and proceed with caution while trying to remain optimistic about the longer term.  Being aware of some of the initial signs of a bankruptcy fraud can help avoid painful surprises later.