Bankruptcy (or liquidation) can be a valid business tool when used properly. Unfortunately, it can also enable less-than-honest business owners to profit at the expense of their creditors. Such is often the case with “phoenix” companies.

Rising from the ashes

Phoenix companies earn their name because they rise from the ashes of failed companies, 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 business into the ground and then buys its assets back from liquidators at knockdown prices. The owner then returns to the same line of business. Some operators repeat the process multiple times — as often as they can get away with it.

These shady 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.

Legitimate or not

It’s perfectly legal for an insolvent company to sell its assets to another party at market value. It’s also legal to sell a business to existing management. How, then, do you know whether a company’s decision to sell assets is made in good faith or is an effort to avoid liability? And how can you prove that a bankrupt company unable to satisfy creditors has actually funneled assets into a new business?

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

Don’t become a victim

To avoid becoming a creditor of a fraudulently bankrupt company, watch whom you do business with. Before extending credit, ask for references and verify that the customer has a record of paying its bills.