Is it illegal for a business in bankruptcy to en masse forgive client debts?

Factual Questions
1

In this thread about a person’s credit card being charged 30 days late, this question came up, and I did not want to clutter up that thread with a possible derailment.

http://boards.straightdope.com/sdmb/showthread.php?t=801136

[QUOTE=Schnitte]

[QUOTE=md2000]
My wife’s hairdresser was going into bankruptcy. He’d held off dumping his credit card machine for a few weeks. When it looked like the bank would take it all instead without making an appreciable dent in his situation, he erased the machine - his customers were more important than the bank.
[/QUOTE]
What the hairdresser did there sounds highly illegal. Was there any sort of legal follow-up, such as prosecution?
[/QUOTE]

To me it sounds like a a large scale version of when a restaurant decides to give a good customer a free dessert, or an old friend refusing another’s money and giving him the business’ service for free.

Is such small scale debt forgiveness illegal? Is large scale debt forgiveness illegal? Is there a legal difference between straight up giving a service for free vs never fully processing their credit cards, or later on having the business “charge back” the card to fully/partially reimburse the customer’s payments? Does it change legality when the bankruptcy process is involved?

Thanks for your insight in advance.

2

(Depending on your bankruptcy law). Forgiveness of debts is legal, but

The debt still exists: normally debts that are forgiven in the period immediately before bankruptcy can still be considered/clawed back by the bankruptcy administrator…
So what we are looking at here is destruction of records. Destruction of financial records is normally illegal. It’s illegal in bankruptcy: it’s illegal the rest of the time too.

The length of time you have to keep financial records depends on individual laws that depend on a lot of things. It is extremely unlikely that the “Example” was in a jusrisdiction that made it legal to destroy financial records in that circumstance.

3

Since the post that triggered the OP’S question came from me, I thought I’d chip in my thoughts that were behind my post in that other thread.

As soon as you’re bankrupt, you’re not fully in control of your business anymore. That is because the purpose of the business changes: It’s not there to make money for yourself, it’s there to maximise the liquidation value of the business so that the creditors are paid off to the maximum extent possible. These sort of considerations justify restricting the business owner’s powers over his own business. What is more, duties of the business owner don’t kick in once the bankruptcy proceedings have formally been initiated and a liquidator appointed who take control of the assets; normally the owner is under a duty to refrain from things that would defraud the creditors once he becomes aware of the fact that bankruptcy will follow. Which is fair, cince forgiving debt under such circumstances would, in effect, amount to giving away other people’s (the creditors’) money, rather than your own.

Such considerations are common to pretty much all bankruptcy regimes everywhere, because the fundamental situation is the same everywhere. How such principles are implemented differs from country to country. A typical way of implementing it would be the clawback that Melbourne described: In the insolvency proceedings, creditors can apply to have certain transactions, such as debt forgivings, annulled so that the forgiven debt can be seized as an asset of the company in liquidation.

4

As I understand the situation, while the hairdresser was in financial difficulty, but before he filed bankruptcy, he failed to submit credit card charges for collection, and then erased the records to hinder collection during bankruptcy.

Under US bankruptcy law, there are several legal consequences that could result from this (assuming it is detected).

First, payments or debt forgiveness outside of the ordinary course of business within 90 days before the bankruptcy filing can be are considered avoidable preferences that can be “clawed back.” If the business had a regular practice of “comping” certain services (e.g. every 10th haircut) continuing that practice would not be an avoidable preference. Simply not charging in the run-up to bankruptcy, however, would be a preference and the the charges not made (assuming that they can be determined) should be reinstated in the bankrutpcy.

Second, if the unsubmitted charges were made during a period when the business was legally considered insolvent and/or they were made with the actual intention to hinder their collection, they would likely be considered a “fraudulent conveyance,” and could be reinstated on that basis. If the hairdresser were operated as corporation or other business entity, there is a chance that the individual(s) in charge could be held personally liable.

Third, because of the failure to submit the charges and/or the destruction of records, there is a possibility that the debt to the creditor that was harmed could be found to be non-dischargeable. That is to say that the amount owed to that particular creditor might not be discharged in the bankruptcy, and the hairdresser could have to pay it even after he went through bankruptcy.

Fourth, also because of the failure to submit the charges and/or the destruction of records, the entire bankruptcy could be dismissed or the court could deny bankruptcy discharge for all of the hairdresser’s debts.

Fifth, mainly for the destruction of records, the hairdresser could be criminally prosecuted for bankruptcy fraud.

All this would depend on the facts and circumstances, the magnitude of the unbilled charges compared with the rest of the assets and debts, the attitude of the trustee, the creditor and the other parties.

5

This might be analogous if the person that ran the business didn’t own it. If I’m the manager of a restaurant that you own, and I’m giving out free food to all my friends and losing money, you’re going to be pissed.

6

Would the customers be liable for the value of the haircut as “income” under these circumstances?

7

If they receive a Form 1099-C, “Cancellation of Debt” from the creditor. The entire amount of the cancelled debt, which could have occurred many years ago, is transferred to the debtor as income.

This is a favorite trick of collection agencies after they spend a few dollars on dunning letters. They probably bought the debt for 10 cents on the dollar, failed to collect anything, and now they can write off the entire amount (possibly). And the debt they bought has been inflated with interest charges from the original creditor. They do have to cease collection attempts for 12 months in order to file the 1099-C

So that $500 credit card debt you stopped paying years ago is suddenly $2000 worth of taxable income.

The person who receives the 1099-C has recourse, the tax forms contain worksheets to reduce the amount of taxable income based on the debtor’s (lack of) present day assets.

And even though they filed a 1099-C against the debtor, the collection agency is not prohibited from more collection attempts.

Dennis

8

Posting from Canada, where md2000 posted from. Some differences in terminology, but I agree with Billdo’s post: good chance that type of conduct would be considered a fraudulent preference, and the trustee in bankruptcy would likely have some recourse against the bankrupt.

Not meant as legal advice, of course, but just to comment on a matter of public interest. Anyone going through bankruptcy should seek legal advice about their personal situation.

9

This is the personal experience I had with a similar issue.

I was doing consulting work for a company for several years. I’d send them an invoice every month and they’d pay it within a few weeks. Then at one point they filed for bankruptcy, although they continued to operate the business and I continued to do work for them. About a year after that, I got a letter from the lawyers handling the bankruptcy, demanding that I return about 3 months of the money they had paid me after the bankruptcy filing. I don’t recall the exact legal verbiage (and I’d have to dig the papers out of some boxes in the garage to find out), but their basic argument was the company had paid me too quickly after my invoices were received, thereby giving me preferred treatment over their other creditors. I had to get my lawyer to submit proof that during this time they had paid me on the same schedule they had always done, and the issue was dropped.

A couple points are interesting – that merely paying early, not even deferring debt, was a problem, and that I, the creditor, apparently was being held financially responsible for the company’s alleged misdeed.

–Mark