Keeping Your Business Interest in Chapter 7

It is the duty of a Chapter 7 trustee to collect and reduce to money the property of the estate....
Keeping Your Business Interest in Chapter 7

It is the duty of a Chapter 7 trustee to collect and reduce to money the property of the estate.  To accomplish this, the Chapter 7 trustee has the power to sell property of the estate that has value for the benefit of creditors.  In Arizona, business interest generally are not exempt and any person with a business interest contemplating a Chapter 7 bankruptcy must consider both the risks and consequences to ongoing business operations.  Likewise, debtors should consider the expected value of the business interest to the estate before filing bankruptcy since many debtors will be interested in buying back the business from the estate or should otherwise consider a Chapter 13 bankruptcy.

Practical Considerations Regarding Administration of Business Interests in Bankruptcy

A Chapter 7 trustee has three alternatives regarding business interests in Chapter 7 proceedings: sell the interest, liquidate the entity or abandon the interest back to the debtor.  There are a number of factors that determine which course of action the trustee will likely take.

For operating businesses, the amount of effort and length of time to sell the business interest weighs heavily in the trustee’s decision to sell the asset.  The trustee can operate the business of the debtor for a limited period of time with permission of the court if they can establish that operation is in the best interest of the estate and consistent with the orderly liquidation of the estate.  11 U.S.C. § 721.  This is generally not a desirable option for a Chapter 7 trustee with respect to the vast majority of business interests.

Personal service businesses (i.e., businesses that depend substantially on the personal services or labor of the debtor) usually have little value to the estate.  In most Chapter 7 cases, the individual is the only asset of any business.  The entity has little value to third parties because nothing prevents the debtor from starting a new business and competing against the same business that the trustee is seeking to market and sell.  Other types of businesses such as entities with real estate, operating restaurants, or businesses with significant inventory can be of more interest to a Chapter 7 trustee.

However, the rights and powers of the trustee and course of action chosen depend largely on the structure of the entity and/or type of entity which are outlined in more detail below.

Types of Business Interests

  • Sole Proprietorships

For debtors who have not formally formed a valid business entity and operate as “dbas”, then the debtor personally owns the property of the business and the estate is entitled to administer business equipment, inventory, accounts receivable and anything else of value.  Debtors should look to the tools of the trade exemption to protect some or all of any business equipment.  In Arizona, the tools of the trade exemption covers $5,000 in the value of business equipment and can limit the value of the business to the estate.  A.R.S. § 33-1130(1).  The best course of advice for clients with unincorporated businesses contemplating bankruptcy is that they incorporate before filing Chapter 7 or otherwise file a Chapter 13 if the tools of the trade exemption is insufficient to give adequate protection to the business assets and avoid liquidation.

  • Corporations, LLC and Partnerships

Corporations, LLCs, and partnerships are separate entities from the debtor and the entity owns the equipment, inventory, and accounts receivable.  For purposes of ease, this article will collectively refer to such interests as LLCs because they are the most common and the principles discussed are generally the same between the different business entities.

The debtor’s interest (which subsequently becomes property of the estate) is either the membership interest in an LLC along with any corresponding rights or powers given to the debtor.  The trustee, therefore, in the vast majority of situations, can or will only sell the shares or membership interest and not actively manage or liquidate the business.  This business interest consists of both the economic rights (right to share of profits) and management rights (voting rights and decision-making authority).

  • Single Member Entities

A debtor’s membership interest is the personal property of the member.  If the debtor owns 100% of the LLC, the membership interest is transferred to the estate under 11 U.S.C. § 541(a) upon the filing of bankruptcy.  Where there are no other members, there are no limitations under the bankruptcy code or Arizona law that prohibit a Chapter 7 trustee from governance of an entity, including decisions regarding liquidation of the entity’s assets.  The Chapter 7 trustee will become a substituted member for both the economic interest and the management interest without limitation.  Debtors should be prepared to bid for their entity to the extent it has value and they wish to retain it.

  • Multi-Member Entities

The rights and obligations of a trustee with regard to multi-member entities and the consequences to ongoing business operations are more complicated.  Partnership relationships, such as are contained in LLC operating agreements, may include both an executory contract and a nonexecutory property interest in the profits and surplus.  An executory contract is, in its most simplest terms, a contract that requires the debtor to take some affirmative action to be entitled to payment.  If a contract is executory, the bankruptcy trustee has the option of either assuming the contract if it is in the best interests of the estate, or rejecting the contract if not.  A typical executory contract is where a debtor is a manager of an LLC and has affirmative duties in order to receive compensation or distributions.

1. Economic Interests

The economic interest in profits and surplus is always property of the estate under Section 541(a) for both single and multi-member LLCs.  In re Cutler, 165 B.R. 275, 280 (Bankr. D. Ariz. 1994).  This effectively means a debtor should list his business interest (i.e., economic interest) on Schedule B for personal property and list the potential management interest on Schedule G for executory contracts.  The Chapter 7 trustee has the right to sell the economic interest to the highest bidder.

2. Management Interests

An LLC’s operating agreement (or a corporation’s bylaws or a partnership agreement) will determine whether the debtor’s management interest is an executory contract governed by Section 365 of the bankruptcy code.  If the debtor has little or no obligations to the LLC in order to receive distributions (such as significant outstanding decisions, affirmative duties a debtor is required to perform, cash calls, etc.), then the debtor’s contract with the LLC is not an executory contract and Section 365 does not apply.  The majority of cases and courts have found that operating agreements are not executory contracts and deal with management interests under Section 541(a) of the bankruptcy code.

Regardless, if an operating agreement is an executory contract, a Chapter 7 trustee has sixty (60) days after filing to either assume or reject the contract.  11 U.S.C. ¶ 365(d)(1).  If assumed, the Chapter 7 trustee can vote and take other governance actions as permitted by Arizona law and the operating agreement.  However, Section 365 makes any assumption subject to other restrictive provisions of Arizona law which requires the consent of the other members prior to assumption.  Essentially, a Chapter 7 trustee cannot assume an executory contract if the other member(s) do not consent to the trustee as a new member of the entity.  For this reason, most if not all executory contracts with respect to LLC interests are rejected.  If the operating agreement is rejected, the management rights fall to the other members.

If the management interest is not an executory contract, it becomes property of the estate under Section 541(a) and the Chapter 7 trustee can exercise management rights.  Arizona law provides that:

The assignment of an interest in a limited liability company does not … entitle the assignee to participate in the management of the business and affairs of the limited liability company or to become or to exercise the rights of a member, unless the assignee is admitted as a member….  An assignee that has not become a member is only entitled to receive, to the extent assigned, the share of distributions, including distributions representing the return of contributions, and the allocation of profits and losses, to which the assignor would otherwise be entitled with respect to the assigned interest.”

A.R.S. § 29-732.  This statute does not prevent the Chapter 7 trustee from exercising any rights as the Chapter 7 trustee is not an assignee but rather steps into the debtor’s shoes and succeeds all rights under the operating agreement.  In re First Protection, Inc., 440 B.R. 821, 830-31 (BAP 9th Cir. 2010).  However, A.R.S. § 29-732 does apply if the Chapter 7 trustee sells the interest to a third party.  In that instance, any purchaser is receiving only the economic interest and has no rights to vote or manage the business without the consent of the other members or partners.

Setting Expectations: Valuing the Business Interest in Advance

A trustee’s decision on how to, or whether to, administer a single-member business interest is typically based on a review of the balance sheet for most types of businesses.  Profit and loss statements are not always the best valuation method as the debtor is not required to continue working for the entity during the period that the trustee is soliciting interest for a sale and nothing prevents the debtor from starting a competing business and soliciting former clientele.

A trustee’s analysis of a multi-member business, whether it be a corporation, LLC or partnership usually turns on a review of the profitability on the tax returns (1120s or K-1s) since the Chapter 7 trustee’s management rights are limited.  If a business is profitable, the trustee will usually seek offers for the interest which often involves reaching out to the debtor or the other members in hopes of an offer for the benefit of the estate.  Purchasers of these interests in Arizona should acknowledge that they are purchasing the economic interest only unless the other members all agree to admit the new member.  These risks should be priced in when making a bid.

Third Party Member’s Rights

Other non-debtor members cannot invoke any provision of an operating agreement that expels members upon filing for bankruptcy or forced buy-out provisions upon insolvency.   These clauses are referred to as ipso facto clauses because they become operative upon the debtor’s bankruptcy filing and are invalid under Section 541(c)(1)(B).  Any attempt to invoke these provisions would also likely violate the automatic stay.

Summary
  1. Assets of a sole proprietorship are property of the estate unless the tools of the trade exemption applies.
  2. There are no limitations on a Chapter 7 trustee in administering a single member entity and the Chapter 7 trustee can either sell the interest or liquidate entity assets after paying entity liabilities and distribute the net proceeds to the Chapter 7 estate.
  3. If a debtor is a managing member of a multi-member LLC, that management interest is likely to be seen as an executory contract. The other members are unlikely to consent to the trustee’s management, and without this consent, the Chapter 7 trustee has no input on ongoing management of operations.
  4. If an operating agreement is not an executory contract, the management interest is property of the estate under Section 541 and the Chapter 7 trustee can vote. However, any sale of such interest is subject to A.R.S. § 29-732 and the purchaser does not obtain management rights without the consent of the other partners.
  5. The economic interest is property of the estate under Section 541 in all scenarios and the estate, and third party purchasers from the estate, are entitled to a share of future profits.
  6. Debtors should know in advance the reasonable value of their business depending on the business structure and consideration of the type of business, the balance sheet and profit and loss statement and should discuss the foreseeable value and options with experienced bankruptcy counsel in advance of filing.

If the trustee does not sell the business interest or liquidate the business as outlined in more detail below, the property will either re-vest in the debtor upon the closing of the estate or if otherwise abandoned prior to the closing of the estate.

Conclusion

Most often, a debtor’s business interest will have little value to the estate and will re-vest in the debtor upon the closing of the case if not abandoned prior to the closing.  However, for those business interests which do have value, debtors should know in advance the likely value and discuss those consequences to ongoing business operations or otherwise consider filing a Chapter 13 to protect those interests.  Speak with an Arizona bankruptcy attorney in advance to go over any issues that may arise.

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