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Check 21 and Fraud


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

Say Goodbye to Bust-Outs?

A frustrating aspect of a credit professionalís job is being ensnared in a planned insolvency or bust-out. Even a sophisticated credit professional who may sense credit risk with a particular account, and sell only on COD, yet may find a debtorís check bounce and that the goods delivered to the debtor vanish (along with the proceeds from the sale of the goods). While payment by check is viewed as a cash sale, a check can bounce and the goods already have been delivered. Unfortunately for the credit professional who is being pressured to release goods with payment by check may have to wait days for the check to clear. The recent enactment of a federal law may change this.

On October 28, 2004, the Check Clearing for the 21st Century (Check 21 Act), federal legislation affecting all states, went into effect. Check 21 changes the method that checks are processed in the United States, as well as changes the technology of check payment and acceptance. With Check 21, financial institutions may process checks electronically, instead of transporting the paper checks. With checks being processed electronically, checks are expected to clear promptly, not in days. Indeed, a vendor may be promptly notified by the bank of an NSF check. What is the impact of Check 21 and reducing the risk of a bust-out? bad check laws? What steps does a vendor take to enforce the bad check in light of Check 21?

Overview of Check 21

Approximately 75 percent of trade credit transactions are conducted by check. Check 21 focuses on the delay caused by a paper check being transported through the banking system.

Check 21 permits the depository bank, if it so chooses, to ďtruncateĒ the original check. Truncating a check means to take the check out of physical circulation by transforming it using a computer scanner into a digital image, also known as a substitute check. This digital image becomes the legal equivalent of the original check, provided it meets the criteria set out in the legislation. Truncating the check permits banks to process the digital image for payment in hours rather than days. As a result of image technology, delays attributable to weather or air travel are gone.

The Bust-Out In Action

A bust-out is a scheme devised to defraud vendors of their merchandise through the use of planned bankruptcies and business failures. 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 bust-out operators is to create a fake corporation (a fast, inexpensive task), establish a payment historycredit account with severalone or more vendors. With, make small purchase orders, and pay within invoice terms on the multiple trade historylimited credit provided. In this way, the bust-out operator establishes good credit (i.e., credibility) with vendors. Bust-out operators have found that having a Fortune 500 company as a reference can go a long way towards avoiding thorough credit checks.

Vendors become unwitting participants to a bust-out when they do not conduct thorough credit checks of new customers. A vendorís resources to do so often limited, while increasing competition in many fields has pushed large numbers of vendors to relax their credit standards. Unsuspecting companies of any size, including Fortune 500 companies, are vulnerable to bust-out schemes.

Some large companies have sophisticated credit departments, yet even some of these become lax when an order involves five-digit or six-digit amounts. The bustout 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. The bust-out operator then sells the goods at steepbig discounts in return for immediate cash, and files for bankruptcy liquidation or merely disappears. Far from being experienced businessmen who have stepped over the line in their business decisions, bust-out operators are usually members of criminal rings that operate for the sole purpose of defrauding vendors.

Reduced Risk of Goodbye To Bust-Outs with Check 21?

With Check 21, vendors may be able to confirm whether the check is good prior to releasing the shipment or while the goods are in transit as a result of cutting the float. With Check 21, the credit professional may find receiving a check akin to a customer paying by credit card. While a payment by check will not result in a simultaneous transfer of funds, with Check 21 it may allow the supplier to avoid being ensnared in a bust-out.

Further, as the vendor may insist on cash in advance sale, Check 21 will assist the vendor. In a potential bust-out, the credit professional may find the customer (as well as its sales force) pressuring them to release the goods prior to the check clearing the bank. Check 21 may ease the pressure of holding the order given that the vendor should get prompt notice of the check clearingóor not.

A common way for an unscrupulous businessperson to take advantage of a vendor is a bust-out scheme. A bust-out scheme is devised to defraud vendors of their merchandise through the use of planned bankruptcies and business failures. Bust-out schemes are usually orchestrated in two stages.

In the first stage, the usual practice of bust-out operators is to create a fake corporation, establish a credit account with one or more vendors, place small purchases, and pay within invoice terms on the limited credit provided. In this way, the bust-out operator establishes good credit (i.e., credit worthiness) with vendors.

In the second stage of the bust-out, the execution, the operator places large orders on open account with as many suppliers as possible. He or she then sells the merchandise at steep discounts in return for cash, and often merely disappears. Traditionally the best way for credit executives to avoid a bust-out scheme was conducting a thorough investigation of the company. Check 21 will substantially thwart efforts of unscrupulous businesspersons.

With Check 21, suppliers may be able to confirm whether the check is good prior to releasing the shipment, or while the goods are in transit. With Check 21, the credit professional may find receiving a check akin to a customer pay ing by credit card. While a payment by check will not result in a simultaneous transfer of funds, with Check 21 it may allow the supplier to avoid being ensnared in a bust out.

A Vendorís Due Diligence

Even with the arrival of Check 21, due diligence is crucial for the credit professional wishing to avoid a bust-out. There are red flags in a bust-out that a credit professional should attempt to identify in the course of their transactions. This can limit the risk of selling into a bust-out. Common red flags include a fake company name that is similar to the name of a well-established company. Another flag is unusually large profits depicted on the income statement -- if that statement is even provided. Indeed, it may be delivered to an address other than the business address. Finally, a large merchandise order following a history of small orders should raise a question for a credit professional dealing with a relatively new vendor.

There are several steps credit executives can take to protect themselves. These steps include: keep the vendors credit functions and sales functions separate; visit the new customer during business hours and observe sales behavior; visit the customer when the business is closed; ask for a personal guarantee; and discuss the account with other vendors in the industry group.

Downside with the Bust-out In the event the vendor has released the goods into a bust-out, the vendor can expect to suffer losses, as successful, costeffective legal remedies are limited for a vendor. After a vendor has sold into a bustout, it is extremely difficult to recover the goods or to satisfy a monetary judgment against the bust-out operator.

When the business failure does not involve a bankruptcy filing, a vendorís prejudgment remedies, such as a writ of attachment or replevin, generally are not successful as the goods have been disposed of. And the bust-out operator has likely disappeared. Even if the bust-out operator can be tracked down, he or she usually does not have any easily traceable assets to satisfy a judgment. A vendor may be able to establish other claims against the operator, such as breach of fiduciary duty (where the operator is an officer of its company) or RICO claims. Again, however, these claims usually do not put money back in the vendorís pocket. They can be expensive to develop.

A vendorís strongest legal rights may be those against the buyers of the discounted goods. If a vendor can identify its goods that are in the hands of a buyer who has purchased from a bust-out operator, and the vendor can establish that the buyer did not purchase the merchandise in good faith (i.e., the buyer knew or should have know the transaction was fraudulent and thus was not a bona fide purchaser), the vendor may have a claim against the buyer.

Check 21 Will Help the VendorWhen the business failure includes a bankruptcy filing, a vendors legal remedies are also limited. The vendor may be able to convince the bankruptcy trustee of the failed business to pursue the buyers of the discounted merchandise under a fraudulent conveyance theory. The trustee would, however, need funding to pursue such litigation. A vendor may attempt to block the discharge of its claim in the bankruptcy by filing a complaint to determine the dischargability of its debt where the operator has filed an individual bankruptcy. In either situation, the vendor still faces the problem of locating the operators assets.

Even with the arrival of Check 21, credit professionals must be vigilant for red flags indicating a risk of a bust out. Although Check 21 may provide the credit professional with an early warning of an NSF check, if the goods have been shipped and cannot be reclaimed, the vendor will likely be unable to recover the goods. However, with Check 21 and a cut in the float time Another means of combating a bust-out is to refer the bust-out to the United States Attorney s Office, the District Attorney, of if the case is in bankruptcy, 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 bankruptcy crimes. The Bankruptcy Reform Act of 1994 established new criminal penalties for any person fraudulently using a bankruptcy filing to discharge debts.

The warning implicit in the WSJ article is that credit executives must be especially vigilant when furnishing credit to new accounts. Credit executives must closely monitor existing accounts for the red flags mentioned above. Perhaps these steps will help the credit professional avoid selling into a bust-out by simply holding the order until receiving notice the check has cleared -- and joining the ranks of defrauded vendors.

 
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