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THE DISAPPEARING DEBTOR
Robert S. Bernstein, Esquire

PART 1: Ownership Structure

What happens when a business debtor closes up shop one day only to appear the next day under a slightly different name without going through bankruptcy? How does that happen and what do creditors do?

To answer that question, we need to review what ownership is, how debt is created and whether creditors have rights to attack property in a name other than the original customer. We attempt to do so in this four-part series. Should you have specific questions, please contact Bob Bernstein at bob@bernsteinlaw.com.

Someone asked how businesses shut down only to reopen nearby (or in the same location) under a slightly different name. There are a number of ways that can happen and several things a creditor can do about it. This series will address many of those issues.

To fully address the question, we need to first review different forms of ownership of businesses. A business is a sole proprietorship, a partnership, a corporation, a limited liability company or a trust. There is no such thing as "Jo's Car Repair" other than one of those. If Jo runs this car repair service out of her garage with some tools and a little bit of equipment and Jo has not created any sort of registered entity for it, then she is personally liable for the debts. Here, Jo probably owns the assets of the business, since Jo's Car Repair has no existence apart from Jo.

If Jo Smith and Fred Jones start a business together and they run it separately from their personal finances, they are probably a partnership, even though they have not registered it anywhere. It is still a distinct entity. In a partnership, the partners are generally liable for the debts of the partnership. They could register the partnership, but the same liability holds true. If they create a Limited Partnership, then the limited partners (having only invested money and not being involved in management) would probably not be liable beyond their investment. There must be at least one general partner in a limited partnership, and the general partner(s) would be liable for the partnership debts. Sometimes property of a partnership is owned in the names of the individual partners, although a partnership can hold title to property.

If they create a corporation, known as Jo's Car Repair, Inc., they have created another kind of entity, one that is intended to shield the shareholders and officers and directors from personal liability for business debts, so long as they follow the corporate rules. Likewise, with a Limited Liability Company or a Limited Liability Partnership, the members are generally not liable for the debts of the entity. Each of the limited liability entities (corporation, LLC, LLP) have special rules and special purposes and cannot be treated in detail here. Each of these entities can own the business assets.

In some states, business trusts are created to hold property and operate businesses. They act very much like the other limited liability entities. If you have a situation with a trust as a customer or debtor, please consult your counsel as to the consequences.

Even though the business entities can own the business assets, there could be other holders (partners, shareholders) who could individually own the assets. This becomes important when the assets turn up somewhere else. If your customer (e.g. the corporation) doesn't own the equipment, it is not available to service your debt later, no matter whose hands it is in.

PART 2: Debt Structure

What happens when a business debtor closes up shop one day only to appear the next day under a slightly different name without going through bankruptcy? How does that happen and what do creditors do?

To answer that question, we need to review what ownership is, how debt is created and whether creditors have rights to attack property in a name other than the original customer. We attempt to do so in this four-part series. Should you have specific questions, please contact Bob Bernstein at bob@bernsteinlaw.com.

How your debt is created is very important in an analysis of your rights when your customer disappears one day and reappears in a different form the next.

Most credit is open account, which is another way of saying "unsecured." It is created by a sale of goods or services on credit, with the customer promising to pay later. If the customer doesn't pay, there is simply a right to sue, but usually no right to get the goods or services back. In order to have some greater right, the debt must either be in a special class (e.g. construction) or must be created with special rights (e.g. secured). A secured debt is one for which the creditor has rights (a lien) to recover specific property. For a full explanation of security interests, please see the series at A SHORT SERIES ON SECURITY INTERESTS FOR CREDIT MANAGERS.

If the creditor has a security interest in the assets of Jo's Car Repair, Inc., there is a much greater likelihood that the creditor can follow the secured property whether it turns up the next day at Jo's Garage, Inc. Sometimes, depending upon the business the customer is in, the customer may have the right to see secured inventory in the ordinary course of business, free and clear of the security interest.

The creation of a security interest is relatively easy when the account is set up, even if you are selling services that, of course, disappear after the sale. Consider taking a lien on other assets of the customer (equipment, inventory, real property). Since there are specific rules on how to create a security interest, it is important that you follow the right steps to make your lien effective. Once created, it is also important that you inspect your secured property occasionally. After all, if you never do an inventory check, it is more likely the inventory will not be around when you really need it.

PART 3: Fraudulent Transfers

What happens when a business debtor closes up shop one day only to appear the next day under a slightly different name without going through bankruptcy? How does that happen and what do creditors do?

To answer that question, we need to review what ownership is, how debt is created and whether creditors have rights to attack property in a name other than the original customer. We attempt to do so in this four-part series. Should you have specific questions, please contact Bob Bernstein at bob@bernsteinlaw.com.

When we talk about a fraudulent transfer, we generally do not mean a "criminal fraud." Usually, a fraudulent transfer occurs when a debtor intends to hinder, delay, or defraud a creditor, or transfers property under certain conditions to another person without receiving reasonably equivalent value in return. The classic case is the fellow who transfers his car to his cousin for $1.00 (or no consideration at all), thinking he will be able to avoid his creditors. Most of us know that such a transfer can be avoided (reversed) if attacked within the appropriate Statute of Limitations.

Other examples of fraudulent transfer include transfers of business inventory or assets to a third person (even if that is a corporation "owned" by the original debtor) or even that "sale" of assets for less than their fair value. If the business doesn't have any creditors, then there are probably no fraudulent transfers. In other words, this generally only works if the customer is in debt when the transfer is made. Although they are not our topic here, even seemingly innocent transfers can be fraudulent (and be avoided by creditors). If a couple transfers property into a trust for the benefit of their children while they are indebted, there are circumstances where creditors may be able to get to the money in the trust, since it was transferred without receiving equivalent value in return.
The concept of fraudulent transfers also is found in many bankruptcy situations, where the Trustee (or the Official Creditors' Committee in the Chapter 11) can invoke the law of fraudulent transfers to recover assets for the benefit of the Estate.

PART 4: Conclusion: What Creditors Can Do

What happens when a business debtor closes up shop one day only to appear the next day under a slightly different name without going through bankruptcy? How does that happen and what do creditors do?

To answer that question, we need to review what ownership is, how debt is created and whether creditors have rights to attack property in a name other than the original customer. We attempt to do so in this four-part series. Should you have specific questions, please contact Bob Bernstein at bob@bernsteinlaw.com.

Sometimes, there is nothing creditors can do, practically. There are remedies, which we will discuss here, but the cost may not be reasonable for an individual creditor to undertake.
When your customer (debtor) closes down and reappears a few hours, days or weeks later in a slightly different form, move fast. While there may be a two-year (or longer) Statute of Limitations on fraudulent transfers in many states, there is a practical limitation. If your debtor is a "bad guy," there is a good chance that this new business may disappear and reappear in yet another form. The longer it goes, the harder it gets. If there are actual assets of the customer in the hands of the new business, it is easier to trace. If time allows the business to sell the inventory and buy new or turn over the customer list or something like that, it becomes more difficult.

Assuming cost is not an issue, get immediately to your counsel to review the situation. There are options. The simplest thing may be to sue the customer and get a judgment. Once you obtain a judgment, you may be able to attach or levy upon assets in the new entity on the theory that they still belong to the old entity. Of course, if they are both sole proprietorships of contain the same partners, it is pretty much a "no-brainer." If ownership is not identical, it may take some work, but you should be getting someone's attention by the action.

Another option is to sue the new entity to recover the fraudulent transfer. This is an action directly against the current owner of the assets. In that action, one goal is to have the Court order the transferee to return the property to the customer. Another is to end up with a judgment against the new entity (which now presumably has assets). Once obtained, that judgment can be collected from the business.

A third way of approaching it would be to get together the necessary number of creditors to file an Involuntary Bankruptcy against the customer. Once an Order for Relief is entered and a Trustee appointed, the Trustee should be able to be convinced to use his powers to go after the property in the hands of the new business. While this may be more powerful and, thus, more effective, it is an action on behalf of all creditors, not just those bringing the Petition. The benefits, after expenses, are shared by all creditors.

Whatever the remedy you choose, it is far easier if you, the creditor, are diligent and watchful over your customers. Have a credit policy that is effective enough to learn of these sorts of transfers promptly. It does little good to learn about them six months or a year after they occur. At that point the horse is not only out of the barn, but has left the pasture!