Chapter 7 Trustee and Your Business: 6 Things They Take Over on Day One

When you file Chapter 7, a trustee is appointed by the U.S. Trustee’s Office to examine your affairs and come after the assets your creditors want. That’s six things:

• Your ownership stake and business assets.
• The books and records, even your company computer files.
• Money customers owe you.
• Contracts and leases.
• The right to claw back payments you made before filing.
• The company’s attorney-client privilege.

The trustee has the job of turning nonexempt property into cash for creditors. Federal law spells out 12 duties for the case trustee. You’ll meet the trustee in person at the creditors’ meeting, 21 to 40 days after you file.

How much the trustee gets depends on structure. In a sole proprietorship or DBA, you, personally, own the business property: Equipment, inventory, receivables. There is no legal distinction between the company and the owner. A ”tools of the trade” exemption may protect some assets.

If you own 100 percent of the LLC, the 100 percent passes to the bankruptcy estate when you file. The trustee becomes ”substituted member” of the LLC. So he gets both the profits and the management rights, without limits. If you are the only member of the LLC, no one can stop the trustee from selling your interest or from “winding up” the LLC and selling off its assets. If you want to keep the LLC, be ready to bid for it.

What happens when you file bankruptcy in an LLC with other members depends on the operating agreement. You always lose the economic interest -- your share of profits. But management rights can be dicey. If the agreement is an executory contract, it falls under Section 365 of the bankruptcy code, which requires the trustee to assume or reject the contract within 60 days of the bankruptcy filing. If the trustee decides to assume, the other members must agree or it doesn’t happen. Most agreements are rejected. Management remains with the other members. A buyer from the trustee gets the profit share but no vote. And a clause expelling a bankrupt member is invalid. Your co-owners also can’t use a clause forcing a buyout when a member goes broke. Such clauses are invalid, and trying to enforce one would likely violate the automatic stay.

The Trustee’s Tasks

One of the Chapter 7 bankruptcy trustee’s main jobs is to collect anything that should go to your creditors. So you have to hand over not just your property but the books, documents, records and papers about it. That means computer files, too.

A customer might owe the company a bill for goods or services it received before you filed. When you file, the money becomes property of the estate. The customer must pay the trustee, not you, unless he has a right to offset it.

If you have contracts or equipment leases and both sides are performing, the trustee has 60 days to decide whether to assume them or reject them. If he does nothing, he’s treated as having rejected them, unless the court extends his deadline.

The trustee can also recover payments on old debts. Here he has two tools. The first targets transactions made while insolvent within 90 days of filing, with a one-year limit for insiders. A Chapter 7 trustee can take a payment back if it gave that creditor more than it would get in a Chapter 7 liquidation. There are exceptions -- like those in the ordinary course of business. The trustee can ask the creditor to return the payment so it can be shared with other creditors. The second: Fraudulent transfers within the past two years can be undone.

The Supreme Court (Weintraub, 1985) held that a corporation’s attorney-client privilege passes to the trustee when it files, even for talks with the company’s lawyer before filing. The trustee can waive it. He, not you, decides whether the privilege stays intact. For a corporation or partnership in Chapter 7, the trustee must also file the company’s income tax returns (Form 1120, 1120-S or 1065), since no separate taxable estate is created.

Will the business keep running? Not by default. The court may let the trustee run it for a limited time if it helps the estate and fits an orderly liquidation. But most trustees don’t want to. They have three choices: Sell your interest, liquidate the company, or abandon it back to you.

The next question is whether the trustee will pursue your business. Some things weigh heavily against him going after it, notably the effort and time it takes to sell the operation. Businesses built on your own work usually have less value for the estate, since nothing stops you from opening a competing business. But real estate and restaurants, businesses with big inventories can draw more interest.

For the most part, your share of the business goes to the estate and then comes right back to you when the trustee closes the case. If it is worth something, the trustee may sell it, so it’s worth knowing its value before you file. How much is the business worth? In a one-owner business, the trustee usually starts with the balance sheet. The profit and loss picture may be less reliable, since you aren’t required to keep working for the company while the trustee looks for a buyer, and you can always start a competing business. With co-owners, the trustee looks to the profits from the tax returns and usually tries to find offers -- maybe from you or the other members.

What to do? You could keep your eye peeled for a chance to bid to buy back your interest in the business. Or you could consider Chapter 13 instead. Remember, though: A corporation or LLC gets no discharge in Chapter 7.

Talk through all the options with an experienced bankruptcy lawyer.