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When Your Bankrupt Customer
Fails to Cooperate

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By Scott Blakeley Esq.
Reprinted by permission from Trade Vendor Quarterly Blakeley & Blakeley LLP

Debtor Prison Retuns?

Your distributor customer that you've made a significant first-time credit sale refuses to respond to your e-mails and phone calls regarding the delinquent account. You suspect the debtor has provided you with false information on the credit application, including false references. Your salesperson's e-mail reports that the customer's warehouse is closed and the inventory apparently gone. You sense a bust-out or planned insolvency. Vendors file an involuntary bankruptcy petition under Chapter 7. You notify the interim bankruptcy trustee of your findings. The bankruptcy trustee investigates and prepares to question the debtor's principal regarding asset transfers. The principal fails to attend the First Meeting of Creditors, and refuses to attend the Rule 2004 examination set by the trustee. What can vendors do, in working with the bankruptcy trustee, to uncover assets, especially with a recalcitrant debtor?

A bankruptcy court in the DFJ Italia case recently directed local law enforcement to arrest a recalcitrant principal of a corporate Chapter 7 debtor for failing to appear at a First Meeting of Creditors and failing to attend a Rule 2004 Examination, so that the principal would appear at these examinations. The principal was suspected of orchestrating a scheme to defraud creditors and investors, although the principal had not been formally charged. Has debtor prison returned? This article focuses on the recalcitrant debtor in a Chapter 7 liquidation that may have orchestrated a bust-out, and methods vendors may obtain financial information about the debtor, including unusual transfers of assets that may lead to recovery and payment of vendors' claims.

The Bust Out

A bust-out is a scheme devised to defraud vendors of their goods through the use of planned insolvencies, bankruptcies and business failures. The bust-out operator obtains goods on credit purchases with the intent of not repaying the debts. Bust-out schemes are usually orchestrated in two stages. The first stage may be characterized as laying the groundwork for the bust-out and the second stage as execution.

In the first stage, the usual practice of a bust-out operator is to create a fake corporation (a fast, inexpensive task), establish a credit account with one or more vendors, make small purchase orders, and pay within invoice terms on the limited credit provided. In this way, the bust-out operator attempts to establish good credit, and credibility, with vendors. The bust-out operator often chooses a company name sounding much like a well-established company to further add credibility. Bust-out operators have found that having a Fortune 500 company as a reference can go a long way towards avoiding thorough credit checks.

Unsuspecting vendors of any size are vulnerable to bust-out schemes. The bust-out operator takes possession of the goods, then sells it at a steep discount - often to legitimate businesses. The cash from the sale is used to pay for prior orders, until it is time to execute the bust-out.

In the second stage of the bust-out, the execution, the operator places large orders on open account with as many vendors as possible. He or she then sells the merchandise at big discounts in return for immediate cash payment, and files for bankruptcy liquidation, or attempts to disappear with the cash. Vendors may join together and file an involuntary petition to force the debtor to disclose financial information about prepetition transfers.

Getting Information About Your Bankrupt Customer's Assets

The Bankruptcy Code and Rules provides several ways for vendors to obtain information about a debtor, including pre-bankruptcy transfers. Indeed, a bankruptcy filing provides vendors with an opportunity to piece together a debtor's pre-bankruptcy transfers, and the bankruptcy laws, such as preference and fraudulent conveyance laws, may allow vendors to recapture these transfers. The Bankruptcy Code and Rules also provide for procedures to obtain financial information from a recalcitrant debtor, or the principal of the debtor.

Bankruptcy Schedules

With its bankruptcy petition, a debtor files its bankruptcy schedules of assets and liabilities, list of executory contracts and leases and statement of financial affairs. A court may extend the time to file schedules. The statement of financial affairs requires a debtor to respond to questions and lists the debtor's financial condition and asset transfers prior to the bankruptcy petition. The bankruptcy schedules and statement of financial affairs are signed under penalty of perjury. It is important for a debtor to provide an accurate schedule of assets and liabilities, as a debtor that intentionally files false bankruptcy schedules may be found to have committed a bankruptcy crime. If a vendor is dealing with a recalcitrant debtor that refuses to file schedules, the bankruptcy court may order a trustee to prepare them. A debtor that invokes the fifth amendment privilege against self incrimination may refuse to turnover financial information that would be used to prepare bankruptcy schedules and statement of financial affairs. Whether a bankruptcy court may have a debtor arrested to compel responses to questions regarding the debtor's financial condition may be unclear.

First Meeting Of Creditors

The Bankruptcy Code requires a debtor, or a designated representative of a corporate debtor, to appear at the First Meeting of Creditors and be questioned by the U.S. Trustee and creditors under penalty of perjury. In a Chapter 7, the bankruptcy trustee questions the debtor, along with creditors. With a corporate debtor, the court may designate its officers, directors or stockholders as the party to be examined. The debtor usually states the reasons for the bankruptcy filing and responds to questions as to the debtor's assets and liabilities. Creditors are usually only given a brief time to question the debtor. The bankruptcy trustee will recommend that a creditor conduct a Rule 2004 Examination for extensive questioning. A debtor may invoke the fifth amendment privilege against self incrimination at the meeting.

Rule 2004 Examination

A Rule 2004 examination of the debtor permits broad questioning into the debtor's financial affairs. The scope of the Rule 2004 examination may include the debtor's financial condition, property, assets and liabilities, and matters affecting the administration of the bankruptcy estate. The broad scope has been labeled a "fishing expedition". A vendor must get a bankruptcy court order to conduct such examination.

The Bankruptcy Court's Power To Jail A Recalcitrant Debtor

What if an individual debtor, or the principal of a corporate debtor, fails to attend the Rule 2004 examination or attend the First Meeting of Creditors, especially if the party is accused of orchestrating a bust-out. What may vendors do, in working with a bankruptcy trustee, to uncover assets?

In DFJ Italia, three creditors filed an involuntary bankruptcy petition against the debtor. The debtor was alleged to have orchestrated a Ponzi scheme. The bankruptcy trustee noticed the principal of the debtor for a Rule 2004 examination to obtain information regarding the debtor's assets and information regarding transfers of assets. The principal did not show for the examination. The First Meeting of Creditors was convened. The bankruptcy trustee designated the principal as the debtor. The principal did not show up. The bankruptcy trustee requested the bankruptcy court to issue a warrant for the arrest of the principal so that the U.S. Marshal could apprehend the principal. The principal had not been charged with any criminal activity associated with the business. The bankruptcy court agreed with the trustee, issuing a warrant for the arrest of the principal and charging the principal for willful evasion of service of the Rule 2004 examination and First Meeting of Creditors.

The bankruptcy court's order provided that if the principal was found outside 100 miles of the bankruptcy court, the principal was to be brought by law enforcement before the nearest U.S. Magistrate Judge, Bankruptcy Judge or District Court Judge. The court's order also provided that a bond hearing would be set, under Title 18 of the U.S. Code, commonly referred to as the bankruptcy fraud provision, wherein the court would establish the conditions of the principal's release. The principal was arrested and spent the night in jail. The next day the U.S. Marshal escorted the principal to a bankruptcy court hearing.

The bankruptcy court exercised its powers pursuant to Bankruptcy Rule 2005. That Rule provides that a party in interest alleging that an examination of the debtor is necessary for the administration of the bankruptcy estate and that the debtor is attempting to evade the examination, or has evaded service of the examination, the bankruptcy court may direct law enforcement, such as a marshal, to bring the debtor before the court. Where a debtor has failed to abide with the Rule 2004 examination order and meeting of creditors, such meetings constitute orders for examination which may be compelled under Bankruptcy Rule 2005. Rule 2005 also provides that a court may fix the conditions of a debtor's release, once apprehended, to assure attendance of the examination.

Working With The Bankruptcy Trustee,
U.S. Trustee and U.S. Attorney To Uncover Assets

Besides the bankruptcy court, a vendor has other parties to assist with the asset investigation. The Bankruptcy Code grants the Chapter 7 trustee authority over all of the debtor's assets. The trustee is vested with the primary responsibility to undertake an immediate investigation into the debtor's assets and liabilities, including uncovering transfer of assets and misconduct which might have led to the bankruptcy filing. The trustee also has the obligation to institute litigation to collect assets of the estate. It is not for the vendors themselves, but rather the trustee, to pursue causes of action on behalf of the estate.

While the Bankruptcy Code clearly provides the trustee with broad powers to collect assets of the estate, there may be a conflict facing trustees: on the one hand, trustees are expected to handle cases more efficiently and to conclude cases more quickly, while on the other hand, trustees are still burdened with a large case load that does not permit them to devote time to properly investigate each case. Trustees are not employees of the government. Rather, they are attorneys, accountants or business people who are compensated as trustees by receiving a nominal flat fee for each no-asset Chapter 7 case they conclude, and, in asset Chapter 7 cases with a distribution to creditors, a percentage of all money disbursed for each estate. The compensation structure does not provide an incentive to pursue assets where substantial investigation is required and recovery is speculative, as they take these types of cases essentially on a contingency.

Thus, to attract the trustee to pursue assets in a so called no-asset Chapter 7, even a bankruptcy where a debtor is suspected of a bust-out, vendors may be required to fund the trustee's recovery efforts. Vendors must decide whether they are willing to spend "fresh" money to attempt to recover assets. This analysis requires a balancing of the value of the assets sought to be recovered (if known), after liquidation, with the estimated costs to locate and recover the assets. The difficulty with the analysis is determining "how deep the bodies are buried," e.g., how well has the debtor hidden the assets.

Another means of combating a bust-out is to refer the bust-out to the United States Attorney's Office and the Office of the Untied States Trustee. The U.S. Trustee is an adjunct of the Justice Department and has the responsibility of working with the U.S. Attorney's Office to investigate bank-ruptcy crimes.

NACM's Loss Prevention Department may also assist vendors in a bust-out. The Loss Prevention Department alerts members of questionable businesses or suspected frauds in progress, as well working with law en-forcement agencies on behalf of members.

Answers To Unaccounted For Assets From The Bankrupt Customer

A bankruptcy judge will not stand for a debtor that does not comply with court orders and the duty to disclose financial information. A Chapter 7 debtor, or princi-pals of the corporate Chapter 7 debtor, that may have orchestrated a bust-out may at-tempt to go "underground" to avoid investigation and refuse to cooperate with the bankruptcy trustee, vendors and the bankruptcy court. While using a criminal-type procedure in a bankruptcy proceeding and arresting a debtor for failing to attend a bankruptcy examination and Meeting of Creditors may be extraordinary, a bank-ruptcy court may use these powers to compel a debtor to cooperate. This may be an avenue for a vendor to consider if possibly ensnared in a bust-out and the debtor refuses to cooperate and provide financial information.

Reprinted by permission from Trade Vendor Quarterly Blakeley & Blakeley LLP Spring 01

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