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CHAPTER 4 Ethical and Legal Considerations in Financial Distress This chapter explores some ethical and legal issues pertaining to liability, responsibility, corporate organization, and fraud that affect distressed companies. Beyond bad luck, bad management, and bad economic conditions , some Chapter 11 petitions filed by companies and individuals are frauds. Their purpose is to misuse the Bankruptcy Code to relieve the debtor of legally binding financial obligations. The cost of these frauds is borne by society as a whole. This chapter examines a range of fraud and near-fraud activities, as well as other issues that elicit ethical and legal concerns when firms in financial distress file for bankruptcy. Consumer Fraud Consumer fraud typically involves the abuse of credit cards. Credit card fraud is relatively easy to perpetrate and is rarely prosecuted. Instead, creditors absorb their losses because the amount of damages to any single creditor are generally insufficient to warrant the investment of much time or effort in the bankruptcy court. Visa's losses in 2001 amounted to 7ยข on every $100 of transaction, a staggering amount with $2.3 trillion in transactions (Lyons 2002: 82). Legal officials generally look the other way because it is difficult for them to distinguish between willful acts of fraud and poor financial judgment. Individuals intent on defrauding credit card companies acquire multiple credit cards from different issuers. Goods are purchased with each card up to its maximum credit limit. Since the consumer is relatively asset-free and with limited income, he/she is unable to repay this debt and files for bankruptcy. 1 In some cases, the debtor sells the acquired goods and diverts the cash to other purposes. Credit card companies mail out unsolicited credit cards because the loss ratio from frauds is 121 122 Principles of Corporate Renewal infinitesimally small compared with their ordinary profits. Modifications to the Bankruptcy Code that have been discussed since the late 1990s would force wage earners at the midpoint of income to repay a portion of these charges. An even more insidious fraud scheme uncovered on the West Coast goes one step further.2 Before filing for Chapter 11, the person sends a bad check (i.e., from an account with an insufficient balance) to the credit card company as payment. Unaware that the check will bounce, the company dutifully records the payment in its computer system and clears the account for more transactions. By carefully timing these activities , the person purchases goods equaling twice his/her credit limit, which he/she sells at a discount for cash before filing in bankruptcy court. A person who commits "simple" credit card fraud and who files a Chapter 11 petition is likely to be relieved of responsibility for those obligations by the bankruptcy court. Thousands of persons, overlooking those who got into credit trouble through ignorance or because their circumstances changed, have defrauded society of as much as $50,000 each in this manner. If the fraud is not prosecuted, the only penalty is that for a period of seven years it is virtually impossible for the individual to acquire new credit cards.' A credit card company may file an involuntary Chapter 11 petition against an individual who defaults on payment obligations. If the individual is notified of impending bankruptcy court hearings and is told to attend and represent his/her own interest but does not show up, then his/ her obligations to the credit card company are not relieved, though he/ she is relieved of debts to other creditors. Business Fraud The commercial version of credit card fraud is called a bust-out (Schifrin 1994). In a bust-out, a person forms a corporation, builds goodwill with suppliers by ordering and punctually paying invoices, then recoups funds by selling the goods at a discount to other vendors or customers. After creating enough trust, the criminal places a massive order, disposes of the goods, and then declares bankruptcy or simply vanishes. Few assets remain, and creditors recover nothing. Experts estimate that bust-out losses surpass $1 billion per year. Even the largest companies succumb to this fraud; for example, General Motors suffered a loss in excess of $100 million from a dealer who sold cars to the public but never paid for them. Competitive industries under pressure to accept new customers without adequate credit checking are Ethical and Legal Considerations in Financial Distress 123 the most susceptible to a bust-out. One defense is to avoid supplying relatively new customers with an unreasonable quantity of goods. Beyond...

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