Written By: Scott Blakeley, Esq. – Blakeley LC

Recently The Wall Street Journal (WSJ) featured the article, “Bust-Out Swindlers Appear to Be Busting Out All Over.” The article states that bust-out schemes have risen by between 30% and 50% in five years, reaching all-time highs in the past year. The WSJ article also discusses how bust-outs are directed at all sizes of companies and cut across all industries. It sends the message that no supplier is immune from a bust-out.

THE BUST-OUT IN ACTION

A bust-out scheme is a device to defraud suppliers of their merchandise through the use of planned bankruptcies and business failures. Bust-out schemes are orchestrated in two stages. The first stage may be characterized as laying the groundwork for the bust-out, and the second stage as execution. Within the first stage, the common practice of bust-out operators is to create fake corporations (a fast, inexpensive task), make small purchase orders, and pay within invoice terms on the limited credit account provided, thereby establishing good credit (i.e., credibility) with suppliers. Bust-out operators have found that having a Fortune 500 company as a reference can go a long way in avoiding thorough credit checks. Suppliers become unwitting participants to a bust-out as they often lack the resources and time to conduct thorough credit checks of new customers. Increasing competition in many fields has also pushed large numbers of suppliers to relax their credit standards. Unsuspecting companies of any size, including Fortune 500 companies, are all vulnerable to bust-out schemes. Although large companies have sophisticated credit departments, some become lax when an order involves five-digit or even six-digit amounts (which is small change for multi-million-dollar enterprises). The bust-out operator sells the merchandise–often to legitimate businesses–at a steep discount, and uses the cash to pay for prior orders, until he decides to execute the bust-out.

The second stage of the bust-out, the execution, has the operator placing large orders on open account with as many suppliers as possible, selling the merchandise at big discounts in return for immediate cash payment, and filing for bankruptcy liquidation or merely disappearing. Bust-out operators generally are not businessmen who have stepped over the line in their business decisions, but rather are members of criminal rings who operate for the sole purpose of defrauding suppliers.

A SUPPLIER’S DUE DILIGENCE

Central to credit executives avoiding a bust-out is due diligence. There are common red flags in each bust-out which credit executives should attempt to identify in credit transactions so as to limit their risk of selling into a bust-out. These red flags include: (1) the fake company has a name similar to a well-established company; (2) the financial statements (if the operator will even provide them) shows unusually large profits; and (3) merchandise is delivered to an address other than the business address; and (4) a large order following a history of small orders.

There are several steps credit executives can take to protect themselves. Those steps include: (1) keep the supplier’s credit functions and sales functions separate; (2) pay a visit to the new customer during business hours and observe sales behavior; (3) visit the customer when the business is closed; (4) ask for a personal guarantee; and (4) discuss the account with other suppliers in the industry group.

LEGAL REMEDIES

Due diligence is critical for a supplier because cost-effective, successful legal remedies are limited. When a supplier sells into a bust-out, it is extremely difficult to recover its goods or to satisfy a money judgment against the bust-out operator. Where the business failure does not involve a bankruptcy filing, a supplier’s prejudgment remedies, such as writ of attachment or replevin, generally are not successful as the merchandise has been disposed of. And the bust-out operator has likely disappeared. Even if the bust-out operator can be tracked down, he usually does not have any easily traceable assets to satisfy a judgment. A supplier may be able to establish other claims against the operator, such as breach of fiduciary duty (where the operator is an officer of a company) or RICO claims. However, again, these theories generally do not put money back in the supplier’s pocket and can be expensive to develop. A supplier’s strongest legal rights may be against the buyers of the discounted goods. If a supplier can identify its goods that are in the hands of a buyer purchasing from a bust-out operator, and the supplier can establish that the buyer did not purchase the merchandise in good faith (i.e., the buyer knew or should have known the transaction was fraudulent and thus was not a bona fide purchaser) the supplier may have a claim against the buyer.

Where the business failure includes a bankruptcy filing, a supplier’s legal remedies are again limited. Perhaps the supplier can convince the bankruptcy trustee of the failed business to pursue the buyers of the discounted merchandise under a fraudulent conveyance theory. But the trustee would need funding from suppliers to pursue such litigation. A supplier 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. But the supplier still faces the problem of locating the operator’s assets. Perhaps the most effective tool of ridding the industry of bust-out operators is to refer the bust-out to the Office of the United 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 establishes new criminal penalties for any person who fraudulently uses a bankruptcy filing to discharge debts.

The WSJ article sends a warning that credit executives must be especially vigilant with furnishing credit to new accounts. Credit executives must also closely monitor existing accounts for the red flags noted above. Perhaps these steps will help the credit executive avoid selling into a bust-out and joining the ranks of defrauded suppliers.

Scott Blakeley is a founder of Blakeley LC, where he advises companies around the United States and Canada regarding creditors’ rights, commercial law, e-commerce and bankruptcy law. He was selected as one of the 50 most influential people in commercial credit by Credit Today. He is contributing editor for NACM’s Credit Manual of Commercial Law, contributing editor for American Bankruptcy Institute’s Manual of Reclamation Laws, and author of A History of Bankruptcy Preference Law, published by ABI. Credit Research Foundation has published his manuals entitled The Credit Professional’s Guide to Bankruptcy, Serving On A Creditors’ Committee and Commencing An Involuntary Bankruptcy Petition. Scott has published dozens of articles and manuals in the area of creditors’ rights, commercial law, e-commerce and bankruptcy in such publications as Business Credit, Managing Credit, Receivables & Collections, Norton’s Bankruptcy Review and the Practicing Law Institute, and speaks frequently to credit industry groups regarding these topics throughout the country. He is a member on the board of editors for the California Bankruptcy Journal, and is co-chair of the sub-committee of unsecured creditors’ Committee of the ABI.Scott holds an B.S. from Pepperdine University, an M.B.A. from Loyola University and a law degree from Southwestern University. He served as law clerk to Bankruptcy Judge John J. Wilson. He is admitted to the Bar of California.