In medieval times, pseudoscientists engaged in the practice of alchemy, attempting to transform base metals into gold. In 21st-century legal practice, alchemy is a debtor/creditor science, with the skilled business litigator being able to turn an otherwise hopeless debtor situation into gold for the creditor client.

Consider the following hypothetical: Client has sold widgets to XYZ Corp. on credit, relying upon a credit application and financials submitted by XYZ. XYZ has maxed out at the $250,000 credit limit. Client continues to sell XYZ on a COD basis for the next month, but finds out only after the fact that checks for the most recent $100,000 in COD deliveries fail to clear due to insufficient funds. When Client next contacts XYZ, there is no response, as the doors have been closed. Now owed $350,000, and with no apparent ability to collect from XYZ, what recourse does Client have?

Even in the absence of any personal guarantee, Client may well have recourse against XYZ’s principals under any of the following theories:

  • If the principals were responsible for submitting a credit application or financial statements on behalf of XYZ that they knew to be fraudulent, they may be held personally liable for inducing Client to rely on that fraudulent information.
  • If the principals knowingly caused XYZ to issue checks to Client that they knew would not clear, they may be held personally liable for the amount of such checks.
  • If the principals drew excessive compensation, distributions or dividends during the time that XYZ was indebted to Client, they may be personally liable to repay.
  • If the principals diverted assets of XYZ to third parties, they may be personally liable for the value of the diverted assets.
  • In certain circumstances involving an analysis of a multitude of factors, there may be a “piercing of the corporate veil” to hold the principals personally liable for corporate obligations of XYZ.

Another potential avenue of recourse is against the accounting firm serving XYZ. If XYZ’s financial statements were relied upon by Client in extending credit, and if the financials were negligently or fraudulently prepared to inflate the overall net equity and/or profitability of XYZ, the accounting firm may be held liable to the extent they understood that the financials were being shown to Client, or that Client fell within a class of creditors likely to receive the financials.

Yet another potential avenue of recourse would be against a party receiving a fraudulent transfer of assets from XYZ. It is not at all unusual for financially distressed companies to transfer assets for less than fair consideration in order to conceal the assets from certain creditors. Generally, a fraudulent transfer is a transfer for less than fair consideration. The transferee may be held liable to pay the client the difference between the value of the property transferred and the value actually paid to XYZ.

To the extent that secured creditors and equipment lessors are claiming priority as to available assets, there should be an examination of the relevant documentation. Secured creditors and equipment lessors make mistakes from time to time in their documentation and filings, and such mistakes can serve to nullify their claims of priority, potentially freeing assets for Client to pursue. In addition, inquiry should be made especially of secured creditors as to other collateral that may be available to them to satisfy their claims. Secured creditors are obligated to marshal assets so as to not prejudice unsecured creditors.

Where the secured creditor is a principal or affiliate of XYZ, there may well be grounds to attack the purported security interest. Even if the loan documentation was properly done, if the loan was extended when XYZ was undercapitalized, the loan may be recharacterized as an equity contribution, with the secured claim being nullified.

Even if XYZ is now defunct, action should be taken on behalf of Client against XYZ to attach any assets that may be available, to obtain a money judgment, and to obtain access to XYZ’s books and records to investigate potential causes of action against the principals and third parties.

Where the Client has limited means and does not want to throw good money after bad, it should consider taking action to put XYZ in receivership. A court then appoints a professional to serve as Receiver, taking control of the assets of XYZ and pursuing potential claims against principals and third parties. The Receiver serves for the benefit of all creditors, being compensated from available funds of the debtor’s estate.