When a chapter 7 case is filed, or converted to chapter 7 from another chapter in bankruptcy, a trustee is typically appointed. [FN1] In the administration of the case, a chapter 7 trustee’s duties include the orderly liquidation of assets and collection of proceeds for distribution to creditors with allowed claims against the bankruptcy estate. [FN2]
One way that a chapter 7 trustee can liquidate assets is by their sale. [FN3] In a recent opinion from the Northern District of Illinois, the primary question before the Bankruptcy Court (“Court”) was the reasonableness of such a sale. The Court’s decision is helpful in illustrating the guiding principles in evaluating a trustee’s business judgment with regard to such a transaction.
In the Efoora case, a chapter 7 trustee (“Trustee”) sought permission to sell the bankruptcy estate’s rights under a 2008 Asset Purchase Agreement (“APA”) with Applied Biomedical, LLC (“Applied”). [FN4] One investor filed an objection to the proposed sale. [FN5]
Efoora was a company placed into receivership after its principals were convicted of various federal criminal offenses and investigated for securities fraud. Applied was an entity formed by a former Efoora investor and California physician for the purpose of acquiring Efoora’s assets. Applied’s goal was to manufacture and sell the HIV and blood glucose test kits that Efoora had only claimed it would. The receiver sought and received permission to sell substantially all of Efoora’s assets to Applied under the APA. [FN6]
Under the APA, Applied paid $1 million cash for the assets. The APA also included a provision for further payment to the receiver of a percentage of either net sales or net income, in the event they were earned. [FN7] The receiver subsequently sought and obtained permission to file a chapter 7 case on behalf of Efoora. [FN8] In the chapter 7 case, by her motion to sell, the Trustee sought permission to amend the APA to allow Applied to buy the estate’s rights to the earnout payments under the APA for $50,000. [FN9]
In support of her motion, the Trustee outlined the following factors as the basis for her decision to propose the sale:
- that since the closing of the sale, no payments were due to the estate from Applied, and hence Applied had not been and was not obligated to make any earnout payments;
- that she had learned that it was unlikely that Applied would be able to continue in business without additional financing, and the earnout provision was preventing Applied from obtaining it; and
- that financial information indicated that Applied was unlikely to make any earnout payments in the near future, and the company might go out of business if the APA was not amended. [FN10]
The objecting investor argued, among other things, that the Trustee had engaged in insufficient due diligence before agreeing to the sale, and the troubles of Applied were exaggerated. [FN11] Given the factual issues that the investor’s objection raised, the Court subsequently set the motion for an evidentiary hearing.
The Court ultimately found that the Trustee articulated a rational business justification for the sale and more than adequately supported her decision to sell the rights under the APA. [FN12]
Section 363(b)(1) of the Bankruptcy Code permits a trustee, after notice and a hearing, to “use, sell, or lease” property of the estate outside of the ordinary course of business. [FN13] A sale is permissible and will be authorized as long as the trustee has an “articulated business justification.” [FN14]
The business judgment test, as it is sometimes called, differs from the business judgment rule in corporate law. [FN15] In a bankruptcy case, a reviewing court will review a chapter 7 trustee’s decision to determine independently whether the judgment was reasonable. [FN16]
In so doing, however, the court is not to substitute its judgment for the chapter 7 trustee. [FN17] A chapter 7 trustee is given considerable discretion in his or her judgment as long as a sound business reason is given. [FN18]
The chapter 7 trustee bears the burden of demonstrating a sound business justification. [FN19] An objecting party must produce some evidence with respect to its objections. [FN20]
The Court found that the Trustee offered a sound business justification for selling the estate’s rights to the earnout payments for $50,000. The Trustee explained that her decision was based on the answer to two questions: first, whether any payments under the APA were due to the estate from Applied, and second, whether Applied was reasonably likely to owe the estate any such payments in the future. After her investigation, the answer to both questions was no. [FN21]
The Court did acknowledge that the investor was correct in that a chapter 7 trustee must conduct a sufficient investigation, but found that the Trustee’s investigation in this case was adequate under the circumstances. The Trustee repeatedly spoke to Applied’s counsel about the situation and obtained a package of financial documents that she concluded backed up what she had been told about Applied’s history and prospects. She then required Applied’s founder to make representations about the company under oath, which he did both at his deposition and again at the hearing on the motion to sell. No evidence was produced showing that anything he said was false. [FN22]
The Court noted that a more extensive investigation is always possible. But a chapter 7 trustee is charged with the duty to balance the need for investigation against the responsibility not to waste estate assets, and it did not find that the Trustee struck the balance incorrectly in this case. [FN23]
[FN1] 11 U.S.C. § 701.
[FN2] 11 U.S.C. § 704(a)(1).
[FN3] 11 U.S.C. 363(b).
[FN5] Also before the Court was the investor’s motion to dismiss the bankruptcy case for lack of jurisdiction based on the alleged dissolution of the corporation at the time the case was filed. Applying Delaware law, it found that a corporate dissolution was not the same as a forfeiture of a company’s certificate of incorporation for the failure to pay franchise taxes as in this case, and denied the motion. Id. at *5.
[FN6] Id. at *1.
[FN7] Id. at *2.
[FN8] The district court granted permission for the receiver to file a chapter 7 case on Efoora’s behalf, given the receiver’s suggestions as to the likely length of time that it would take for him to receive sufficient funds to make a meaningful distribution, and the potentially complex claims resolution process, making the bankruptcy court better suited than the district court to handle claims administration involving thousands of investors. Id.
[FN9] The Court noted that because the amendment’s effect would be to sell to Applied the estate’s remaining rights to receive payments under the APA, the Trustee’s motion was one for permission to sell estate property under 11 U.S.C. § 363(b). Id.at *2 n.2.
[FN10] Id. at *2, 6-9.
[FN11] Id.at *2, 9-10.
[FN12] Id. at *5, 11.
[FN13] 11 U.S.C. § 363(b)(1).
[FN14] Id. at *6 (citing Fulton State Bank v. Schipper (In re Schipper), 933 F.2d 513, 515 (7th Cir. 1991)).
[FN15] Id. at 6 (citing 3 Collier on Bankruptcy ¶ 363.02 at 363-18 (Alan N. Resnick & Henry J. Sommer eds., 16th ed. 2012)).
[FN18] Id. (citations omitted).
[FN19] Id. (citing In re Lionel Corp., 722 R.2d 1063, 1071 (2d Cir. 1983)).
[FN21] Id. at *6-7.
[FN22] Id. at *10.
[FN23] Id. (citing In re Commercial Loan Corp., 316 B.R. 390, 703–04 (Bankr.N.D.Ill.2004)).