"Harry, have you had any luck getting money out of Joe Prichard?"

"Funny you should ask me that, Pete. I was just about to call him to see what was going on."

Harry Dunn ran an engine repair business, and Pete White distributed business forms and supplies. Both had done business with Joe Prichard's lumber yard for years.

"Well, good luck," Pete told Harry. "I've been trying to reach him for two weeks, and he's never around. I think there's something very fishy going on."

Editor's Note: This article originally appeared in the Credit & Collection Manager's Letter, which Credit Today purchased in 2006.

"Have you gone over there to try to see him?"

"I was there this morning," Pete replied. "The girl in the office said he was out of town and won't be back until next week."

"Maybe he's just taking a little vacation," Harry suggested.

"Yeah, right, on our money. And that's not all. While I was there a truck from Northend Lumber was being loaded up with all kinds of stock."

"Northend? That's run by Joe's old partner, isn't it?"

"That's right. And if you ask me, I think they're still partners. I think they're going to pull everything out and stick us with our bills."

"Maybe we should put him into bankruptcy," Harry suggested. "He owes me about $3,000. What's he owe you?"

"About the same," Pete replied.

What are Pete and Harry's options?

Click "Next" for the answer.

Answer and Analysis

The most obvious option open to Pete and Harry is to institute suit for the balance due. The problem is that it may take some time to obtain a judgement, and by that time Joe may have accomplished what they suspect he intends to do. As we all know, there are some unscrupulous businesspeople who will see the handwriting on the wall and spend considerable time devising a method to extract the monies from the business without paying their creditors.

One such device that is often used is known as the "friendly creditor." A businessperson does business with a friend whom he does not pay or have any intention of paying. The friend institutes a suit and obtains a judgement. In the meantime, the businessperson liquidates his assets and uses the money recovered by the corporation to pay himself individually. Sometimes he takes a great deal of pains to make sure these payments have an appearance of legality. Other times, he just issues checks to himself personally through the business.

His plan is simple. After the corporation has disposed of all marketable assets, the friendly judgment creditor engages a marshal or sheriff to conduct a sale of all the remaining assets. Whatever is left over, the landlord throws out on the street, and, for all intent and purposes, the business has disappeared off the face of the earth.

If any of the aforementioned facts can be proven, a suit for fraud can be brought against the individual owner of the business--if he can be found. But even if he can be found, the suit could go on for years. In addition, the individual would vigorously defend such a suit because if a judgment for fraud is obtained, the individual could not avail himself of the bankruptcy laws and would have a stigma on his credit report. Furthermore, there is a possibility of a criminal prosecution, depending upon the circumstances of the fraud.

Another option open to the creditors is the filing of an involuntary petition. An application may be made to the court for a trustee, and the trustee will take possession of all the property of the business, sell it in an orderly manner under the bankruptcy laws, and pay off the legitimate creditors on a pro rata basis.

To file an involuntary petition, the creditor must show that the debtor is not paying debts as they mature. The key is not whether the debtor is insolvent or has liabilities exceeding assets but whether the debtor is able to pay the debts as the bills are presented to him. An involuntary petition may be filed by three or more creditors who hold non-contingent, undisputed claims (indebtedness) totaling at least $10,000 due from the bankrupt debtor. If the creditor or creditors hold security for the debt, such as an automobile or a mortgage on a residence, the indebtedness must be $5,000 more than the value of the security (automobile, property). The claims must be subject to simple calculations that value the claims over $10,000 and must not be subject to offset which may reduce the amount owing to less than $10,000.

If the total number of creditors is less than 12, one or more creditors with over $10,000 indebtedness due from the bankrupt may file an involuntary petition.

The debtor may contest the filing of an involuntary petition and may operate the business. However, the court may appoint a trustee to run the business during the proceeding to contest the filing of the involuntary petition.

A business debtor may be placed in involuntary bankruptcy under Chapter 7 or Chapter 11. If a creditor should file an involuntary petition in bad faith or to harass or embarrass a debtor, the creditor may be liable to the debtor for damages, costs and attorneys fees if the petition is dismissed by the court.

The individual creditor who files an involuntary petition should consult only with experienced bankruptcy counsel. If only one credit files, and the petition is dismissed, the creditor's exposure to liability is significant and damages could be significant as well. The creditor and his lawyer must proceed with caution.

Most cases are filed under Chapter 7, known as straight bankruptcy. Chapter 7 may be used by individuals, corporations, partnerships, and associations. The purpose of Chapter 7 is to collect all the assets of the debtor, sell the assets and convert them to cash, and then distribute the cash on a pro rata basis to the creditors.

A corporation or person can file a Chapter 11 known as Reorganizations, which can be commenced either voluntarily or involuntarily. The debtor continues to operate the business as a "debtor in possession" as long he runs the business in good faith and accounts to the court for all business transactions.

Nevertheless, in both Chapter 11 and Chapter 7 under the circumstances in the above scenario, the creditors would make an application to court and have the court appoint a trustee to either liquidate the business under Chapter 7 or to operate the business under Chapter 11 for the benefit of the creditors. The trustee acts as a fiduciary for the benefit of all creditors, secured or unsecured. The trustee has the right to appoint attorneys, accountants, and other professionals and to do whatever is needed to preserve or protect the assets of the debtor. The trustee can also sue on behalf of the bankrupt's estate or to set aside certain liens or preferences which affect the estate.

In this case the trustee would have the right to commence a suit against the individual owner of the business to recover any monies that were inappropriately paid by the corporation. The individual owner would also have to turn over all the books and records to the trustee and furnish a complete accounting to the trustee of the operations of the business.

While this may seem to be a somewhat difficult procedure, sometimes it is the best procedure in situations where creditors suspect that the business is deliberately and intentionally defrauding its creditors. Consultation with experience counsel is recommended. Sometimes the results are startling and this option should never be overlooked.

Editor's Note: The above article originally appeared in the Credit & Collection Manager's Letter, a newsletter purchased by Credit Today in 2006. This article originally appeared prior to 2000.