Sole Proprietors At Risk In Chap. 7: The Trustee Shuts The Door

Why would a Chapter 7 trustee shut down a sole proprietorship business with no value?

That question comes up again and again from newish bankruptcy lawyers who can’t imagine that a trustee would demand the closing of the debtor’s business.

After all, goes the argument, the debtor needs to make a living and the business has no non-exempt value.

The trustee’s insistance on closing the business is more understandable when you hear this nightmare.

The postman, the pit bull and the priority claim

This Chapter 11 debtor had a rental property leased to a tenant with a pair of large dogs. During the pendency of the case, the dogs bit the postman.

The postman sued the debtor in possession along with the tenant on the grounds that the owner was liable for injury incurred on rental property.

Assuming a verdict in favor of the postman, not only is the bankruptcy estate liable, but the claim is a cost of administration, payable ahead of the prepetition creditors.

Not a good state of affairs for the debtor in possession who is supposed to be operating as a fiduciary for his creditors.

Granted, I don’t know if the estate was adequately insured nor how liability was allocated among the defendants in the dog bite case.

I do know, from representing a creditor in the case upon conversion to Chapter 7, that there was far too little money in the estate to make a dent in the claims of prepetition creditors, even before an administrative tort claim.

Sole proprietorships in Chapter 7

Apply the lessons of that premises liability case to your typical, self employed debtor.

Let’s assume the debtor is a hairdresser whose only business assets is a market rate lease on a beauty shop, and her tools of the trade.

Consider the liability of the estate should the trustee permit continued operation of the shop. A customer trips over the debtor’s pet Chihuahua, who accompanies the debtor to work each day, and cracks her head in the fall.

Or, the customer suffers an adverse reaction to hair products.

One can well imagine that the bankruptcy trustee, the nominal owner of the business and its assets upon filing of the Chapter 7, will be named as a defendant in the resulting suit.

And if the suit is successful, the judgment becomes an expense of administration, with priority equal to the trustee’s commission, and ahead of the prepetition creditors.

No Chapter 7 trustee wants to have to explain that state of affairs to his boss or to the creditors.

Incorporate or file Chapter 13

My rule in situations where the prospective debtor has a proprietorship that she wants to continue to operate is simple:

Either incorporate the business in advance of filing Chapter 7 or file Chapter 13.

In Chapter 13, the continued operation of the debtor’s business is expressly authorized. The debtor can continue to make a living and get a discharge of debts at plan completion.