How “phoenix” companies abuse bankruptcy protection and defraud creditors

According to S&P Global, there have been at least 230 corporate bankruptcy filings thus far in 2023 (through early June). That’s more than twice the number of filings over the same period in 2022. Such growing numbers represent bad news for the companies involved, obviously, but also potentially for their vendors, customers and other business partners.

Although bankruptcy can be a valid business tool, it can also enable dishonest business owners to cheat their creditors and then launch a new business. Do whatever you can to steer your business clear of these “phoenix” companies.

Driven into the ground

Phoenix companies earn their name because they rise from the ashes of failed companies, often trading on the goodwill of the original businesses. Here’s how a phoenix company scheme might work: A company’s owner buys goods on credit, purposely drives the company into the ground and then buys its assets back from liquidators at knockdown prices. The owner subsequently returns to the same line of business. Some operators repeat the process multiple times — as often as they can get away with it.

These companies usually are undercapitalized from the start, and they almost always leave a trail of unpaid debts to mark the end of their short life spans. Unfortunately, unsuspecting creditors may sell goods to the new company (that retains the old name) under the impression they’re dealing with the original business. Meanwhile, creditors of the original company remain unpaid.

Looking for red flags

It’s legal for an insolvent company to sell its assets to another party at market value and it’s legal to sell a business to existing management. So it’s hard to know whether a company’s decision to sell assets is made in good faith or is an effort to avoid liability. It’s even harder to prove that a bankrupt company unable to satisfy creditors has actually funneled assets into a new business.

Forensic accounting experts can investigate a business owner’s background and the company’s history, taking industry into consideration. (Phoenix companies are more common in such sectors as construction and hospitality.) They look for certain red flags — for example, evidence that the defunct company’s owner deliberately ran up debts before declaring bankruptcy or made selective payments to creditors that later went on to supply the new entity.

Vet business partners

If you don’t already, thoroughly vet potential customers before extending credit and don’t pay suppliers up front unless you know they’re honest and reliable. If one of your business partners files for bankruptcy and claims it can’t repay creditors, work with an attorney and forensic accountant to investigate.

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