Small Business Financial Distress and the "Phoenix Syndrome" - A Re-evaluation

In a typical phoenix syndrome scenario, a small business entrepreneur who controls the financially distressed Company A registers Company B, to which the assets of Company A are transferred in what appears to be fraudulent conveyance. Company B serves as a vehicle through which the business is kept running, without the pressures of the business creditors. If necessary, the entrepreneur will also register Company C and repeat the process. The law usually considers the execution of a phoenix syndrome scheme (phoenixizing) to be fraud against Company A's unaware creditors. Two major problems undermine, however, the efficient regulation of phoenix syndrome schemes. First, although criminal sanctions are available, phoenixizing entrepreneurs are not regularly prosecuted and are usually only subject to monetary sanctions (e.g., personal civil liability to creditors). Because defrauders tend to be judgment proof, the result is sub-optimal deterrence. Second, lawmakers have not considered a more sympathetic explanation to account for the phoenix syndrome phenomenon: an entrepreneur resorting to a phoenix syndrome scheme might actually be arranging for a last-resort home-made bankruptcy proceeding, that is, the entrepreneur might be mimicking the role of a formal bankruptcy stay on unsecured creditors' collection efforts, against the background of a cost prohibitive formal bankruptcy proceeding. Put simply, the phoenix syndrome scheme is, occasionally, a poor man's bankruptcy proceeding. Deterring a phoenixizing entrepreneur attempting to rescue a viable business is, of course, unwarranted, as the result is viable businesses being lost. These two problems of under-deterrence and over-deterrence mandate a re-evaluation of the manner in which phoenix syndrome schemes are regulated. Obviously, the main question concerns implementation: How can good entrepreneurs, attempting to rescue a viable business, be separated from bad ones, who attempt to defraud or to rescue a non-viable business? The paper discusses and evaluates several solutions. Copyright (c) 2012 INSOL International and John Wiley & Sons, Ltd.