What prevents companies from simply screwing everyone and paying off their owners debt free?

March 23, 2010 8:12 PM

What prevents companies from simply screwing everyone and paying off their owners debt free?

What are the rules and/or regulations that prevent an U.S. company, such as a Limited Liability Company, from accumulating debt with no intention of coming good on it?

For example, what prevents me from, or holds me liable for, starting a company thats purpose is to acquire debt to my own personal benefit, i.e. buys me a house, car, or such, and then simply go out of business?

posted by doomtop to Law & Government (14 answers total)

The creditors could "pierce" the LLC and come after you personally if they could show that the LLC was a sham and/or undercapitalized, which it sounds like it would be in your hypothetical. The key legal phrase is "piercing the corporate veil."
posted by Mid at 8:18 PM on March 23, 2010

Also, fraudulent transfer. When a company goes out of business, creditors can go after people who removed assets from the corporation within a certain time period before the corporation became insolvent.
posted by Mid at 8:20 PM on March 23, 2010

Veil-piercing aside, creditors are also often reluctant to loan money to businesses that are saddled with debt that outweighs their assets (and have no obvious means of earning money).

And when they do loan money to buy a house, car, etc., the creditors often demand to retain what's called a "security interest" in the item purchased. That means that if you can't pay your loan, they get to take the stuff. I would be very surprised if anybody would lend your sham LLC money to buy a car without retaining the right to claim the car if you didn't pay.
posted by willbaude at 8:24 PM on March 23, 2010

Even though LLCs and other corporations can theoretically borrow money that only the LLC would owe, in practice very few banks will actually lend money to small businesses unless the owners also put up a personal asset (house etc.) as collateral. It's not until a corporation is well-established with its own credit history and assets that banks will lend money to just the corporation.
posted by Jacqueline at 8:28 PM on March 23, 2010

Yeah, you would not be able to get an unsecured loan for a business with no operating income and no equity. You would have to personally put up your home or other assets to secure the loan.
posted by Rhomboid at 8:29 PM on March 23, 2010

Also, vendors usually require you to sign to agree to be personally responsible for debts or loans.
posted by Ironmouth at 8:30 PM on March 23, 2010

Exactly what I was looking for, Mid. Thank you!
posted by doomtop at 8:42 PM on March 23, 2010

I think Willbaude, Jacqueline and Rhomboid probably have most of the explanation (though everything Mid said is right, too). Simply put, you need to put up a security to take out most loans. The risk of losing that security interest is generally what motivates people not to try to steal loaned money. What Mid describes is how banks or other creditors would go after those security interests, or, if the security were no longer there (or fraudulently offered in the first place), otherwise make good on the debt.
posted by Conrad Cornelius o'Donald o'Dell at 9:19 PM on March 23, 2010

There's a common mafia scam called a "bust out" that works along these lines. The mob acquires control over an established business with lines of unsecured merchant credit, usually controlling it informally, through the owner owing them money off the books. Then they max out all the credit lines they can, sell off all the merchandise they get with it on the cheap, and leave the business to go into bankruptcy. The classic last act of the scam, as seen in Goodfellas, is to torch the premises for the insurance money.
posted by strangely stunted trees at 9:38 PM on March 23, 2010

What a lot of people don't realize is that the scenario you describe is indeed close to how many "companies" operate. A lot of PR bullshit, a little window dressing with an office or two, a few employees, very LARGE paychecks to the company principles and the scam can be pulled for a number of years.
posted by telstar at 12:52 AM on March 24, 2010

A small company I am familiar with recently (post financial crisis) tried to obtain a corporate credit card, and no issuer would provide one without a personal guaranty from one of the principals of the business, unless the business generated at least, say, $5 million in annual revenue and met other financial hurdles. Even Citibank wouldn't provide a credit card, and the company had over $1 million in cash at the time in a checking/savings account with Citibank.

I'd assume that bank loans work the same way.
posted by jameslavelle3 at 4:26 AM on March 24, 2010

strangely stunted trees: "There's a common mafia scam called a "bust out" that works along these lines. The mob acquires control over an established business with lines of unsecured merchant credit, usually controlling it informally, through the owner owing them money off the books. Then they max out all the credit lines they can, sell off all the merchandise they get with it on the cheap, and leave the business to go into bankruptcy. The classic last act of the scam, as seen in Goodfellas, is to torch the premises for the insurance money."

Was just coming in here to say this. Also see The Sopranos, esp the Davey Scuttino bust-out and the allusions to the wayback bust-out of Satriale's, which eventually became the Soprano family's "home base"
posted by jckll at 7:22 AM on March 24, 2010

Most banks aren't going to lend anything to a small business until it's been operating for at least 2-3 years and has balance sheets to demonstrate income.
posted by spaltavian at 7:48 AM on March 24, 2010

What stops people from maxing out their credit cards and retiring to a desert island? Two things -- laziness and the inability to get enough money to do that.
posted by jrockway at 6:16 AM on March 26, 2010