Breaking Deadlock: The Advantages of Using a Chapter 7 Bankruptcy Trustee as an Alternative to Seeking the Appointment of a State Court Receiver

9 Min Read By: Eric R. Perkins, Justin S. Baumgartner

In the event of a management deadlock among owners of a closely held entity with a limited number of shareholders, partners, or members, the non-operating owners often pursue a resolution of the parties’ management disputes through state court litigation. The simplest example of corporate deadlock involves a company with two co-owners who are equal (50–50) shareholders or members and can no longer agree on how to run or capitalize their business leading to major animosity and a lack of goodwill between the parties. In cases such as this, when the breakdown of the interest holders’ relationship is irreparable, an aggrieved shareholder or member who wants themself or their business partner(s) to exit the company, or to even wind up the company as a whole, may seek to accomplish his goals through the appointment of a state court receiver.[1]

In state court, receivers are generally appointed by filing an order to show cause along with a verified complaint.[2] Because an action to appoint a receiver is an equitable remedy, and the receiver’s duties and powers are determined based on the specific facts of each case, such actions are generally heard by a chancery court sitting in equity.[3] Notwithstanding the equitable nature of a receivership action, courts view the appointment of a receiver as an extraordinary remedy that requires imposing and persuasive proof.[4] As such, it can take months or even years before a receiver is appointed and given a directive by the appointing court to run, liquidate certain assets, or even dissolve a deadlocked company. Accordingly, breaking a corporate deadlock by using a state court appointed receiver can be a time consuming, expensive, and arduous process, which, in the interim, can lead to the further deterioration of a company’s finances and ability to conduct business as a going concern.

In contrast to the drawn out nature of a receivership action, a non-operating owner can break a company’s management deadlock in a relatively short amount of time by electing to put his or her company in a Chapter 7 bankruptcy proceeding.[5] Indeed, once a Chapter 7 proceeding is filed the day to day control and operations of the business immediately pass to a Chapter 7 trustee, an independent and objective third party, pursuant to § 541(a) of the Bankruptcy Code. The non-operating owner can then negotiate with the Chapter 7 trustee to sell the business entity as a going concern through a § 363 asset sale or even request that the company be liquidated outright. Both of these actions would result in the non-operating owner (and perhaps the operating owner if he or she does not elect to purchase the assets alone or through another entity) essentially selling his or her interest in the now-bankrupt company and cashing out, thereby breaking the management deadlock. This is the case because the funds derived from the sale of the business or its assets after paying the administrative expenses associated with the sale(s) and all outstanding pre-petition creditors will be distributed to the entity’s members or shareholders under Bankruptcy Code § 726(a)(6).[6]

In regard to selling a business as a going concern, a non-operating owner can also request that a Chapter 7 trustee request authorization from the bankruptcy court to temporarily operate the business under Bankruptcy Code § 721 to preserve the debtor entity’s business relationships and by extension its going concern value while working toward completing the sale. Unlike the drawn out process of a party seeking a state court receiver, a bankruptcy court can grant a trustee the authority to run a debtor’s business temporarily within a week of the bankruptcy filing if the trustee deems it necessary to file an expedited motion during the first days of the case. What’s more, with the expressed interest of a motivated buyer, a going concern sale or full asset liquidation can be accomplished within weeks of a bankruptcy petition being filed if the trustee is aware of the potential purchaser of the company or its underlying assets. Such a purchaser may be one of the company’s owners who now seeks to operate the business or a successor entity without the constraints of his or her former business partner.

This was exactly the case in the recent Chapter 7 bankruptcy case of In re Key Metal Refining, LLC filed in the United States Bankruptcy Court for the District of New Jersey.[7] In that case, the 51 percent majority owner of Key Metal Refining, LLC (the Debtor) was a separate entity that filed the Debtor’s Chapter 7 petition. The minority owner of the Debtor was also an entity that together with its sole principal owned the remaining 49 percent of the Debtor. The principal of the minority owner also owned a separate real estate holding entity that, in turn, owned the property on which the Debtor operated. Prior to the management deadlock, the real estate holding entity had leased the property to the Debtor with such lease remaining in effect as of the date of the Debtor’s bankruptcy filing.

Once appointed, the Chapter 7 trustee[8] in this case expeditiously filed first day motions with the bankruptcy court for the authority to operate the Debtor’s business on an interim basis and to obtain post-petition financing directly from the majority owner to fund the projected shortfall in the Debtor’s business operations and the costs of administering the Chapter 7 case. The goal of both of these motions was to allow the trustee to continue to operate the Debtor’s business pending the negotiation and consummation of a sale of the business’s assets in an effort to maximize the value of the Debtor’s assets, which otherwise would have significantly deteriorated in value. The bankruptcy court granted both the trustee’s motions on an interim basis just three days after the Debtor’s bankruptcy filing.

Thereafter, the trustee negotiated with the two deadlocked members of the Debtor and ultimately came to a consensual settlement and asset purchase agreement, which provided, among other things, that the trustee would sell substantially all of the Debtor’s assets to the Debtor’s majority owner. The proceeds of the sale would be placed in a settlement fund and then go toward the claims of the Debtor’s non-insider general unsecured creditors. The minority owner of the Debtor benefited from the sale and settlement agreement because the trustee rejected the Debtor’s property lease with the real estate holding company controlled by the debtor’s minority owner under Bankruptcy Code § 365. As such, the principal of the minority owner and his real estate holding company were now free to use the property for their own independent business operations. Moreover, the parties stipulated that the minority owner was entitled to a substantial claim for damages stemming from the trustee’s rejection of the lease agreement. This rejection claim was paid pro rata with other non-insider unsecured creditors from the settlement fund. The entire sale and settlement agreement between the parties was negotiated, agreed, and consummated within approximately six months of the Debtor’s bankruptcy filing.

The Key Metal Refining, LLC case goes to show that the time constraints associated with a Chapter 7 asset sale are likely to incentivize the deadlocked owners of a company to come to some form of an agreement regarding their business’s or a successor entity’s future management structure within a relatively short amount of time. This is the case as the value of the debtor company and its associated good will continue to deteriorate the longer it remains in a Chapter 7 bankruptcy proceeding without the ability to conduct its normal business operations.

In sum, while putting a company in a Chapter 7 proceeding is not a panacea, it is certainly worth considering in the right situations. Indeed, such an approach can be an economical and expedient way to break a management deadlock and solve what could otherwise be a prolonged and complicated litigation battle in state court for the appointment of a receiver.

[1] Generally, a receiver appointed in state court has the power to acquire legal title of the debtor’s assets and to liquidate and dissolve the debtor entity. See e.g., N.J.S.A. § 14A:14-4. Depending on state law and the retention order, receivers can also have the authority to continue to operate the debtor’s business, assume or reject unexpired leases, sell assets, collect rents, and have the power to close the business.

[2] In New Jersey, the procedures governing receiverships are provided in Court Rule 4:53-1, et seq.

[3] See e.g., Roach v. Margulies, 42 N.J. Super. 243, 245 (App. Div. 1956) (holding that it is well recognized that a court of equity has inherent power to appoint a receiver for a corporation).

[4] See Ravin, Sarasohn, Cook, Baumgarten, Fisch & Rosen, P.C. v. Lowenstein Sandler, P.C., 365 N.J. Super. 241 (App. Div. 2003).

[5] A significant limitation to this strategy is that the non-managing owner must have the authority to place the business in a bankruptcy proceeding or else he or she risks the case being thrown out upon a motion to dismiss being filed by one or more of the remaining owners of the company. State laws differ regarding whether a consensus among an entity’s owners is a prerequisite for a bankruptcy filing. For instance, in New Jersey, unless the members otherwise agree in writing, the law governing LLCs requires the unanimous vote of the members of an LLC to undertake actions outside the ordinary course. N.J.S.A. § 42-2C-37(c)(1)-(4); see also In re Crest By The Sea, LLC, 522 B.R. 540, 545 (Bankr. D.N.J. 2014) (concluding New Jersey LLC statute applies when LLC operating agreements are silent as to the vote required to authorize a debtor’s bankruptcy filing). In contrast, New York law does not specify what type of consent is required by the members of an LLC prior to filing a petition for bankruptcy; consequently courts look to the entity’s operating agreement for guidance. See In re E. End Dev., LLC, 491 B.R. 633, 639 (Bankr. E.D.N.Y. 2013) (holding that LLC operating agreement that conferred on the managing member broad authority to take any action necessary to preserve the value of its assets and to further its business operations, authorized managing member to file for bankruptcy on behalf of the LLC).

[6] Section 726(a) governs the order of distribution of property of the estate in a Chapter 7 case. A debtor, or the equity owners thereof, can receive nothing from the estate until after all administrative expenses and claims held by creditors are paid in full with interest. In re Deer Valley Trucking, Inc., 569 B.R. 341, 347 (Bankr. D. Idaho 2017).

[7] In re Key Metal Refining LLC, Case No. 19-24581-VFP, filed on July 28, 2019.

[8] The co-author of this article, Eric R. Perkins, served as the Chapter 7 trustee in this case.

By: Eric R. Perkins, Justin S. Baumgartner

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