The Structure of Your Small Business Matters

When you’re setting up a business, keep a close eye on the structure. You may think you can go into business with your best friend without worrying about it. Unfortunately, the best intentions may not lead to financial success. Set up your business separately from your personal interests. Otherwise, bankruptcy for one might mean disaster for the whole business. Assets in your name will be considered yours for the purposes of bankruptcy, no matter what you and your business partners agree on. Below, we've highlighted a case from New Jersey which demonstrates the point.

In re Day, 443 B.R. 338 (D.N.J. 2011)

Here are the facts: Ralph and Louis embarked on a real estate venture together; they called their company Durie. They planned to buy pieces of property and flip them for profit. With the new company’s lack of credit, they chose to structure their first purchase such that Ralph would hold the legal title for the benefit of Durie and then transfer it to the company at a later date. Interest rates dropped, and when an opportunity arose to refinance, Ralph and Louis jumped on it. Ralph’s credit wasn’t good enough for that loan, so Louis’s wife took it. She gave her bank, HSBC, a mortgage for the property and paid off the original mortgage. Ralph had poor credit for a reason, and shortly thereafter declared bankruptcy. His original chapter 11 bankruptcy failed, and the court converted his case to chapter 7. The trustee claimed the Durie property along with the rest of Ralph’s assets as part of the bankruptcy estate. Both Louis and HSBC objected, claiming that they had an interest in the property that took priority over the trustee’s.

11 U.S.C.A. § 544(a)(3)

Under 11 U.S.C.A. § 544(a)(3), a bankruptcy trustee has the rights and powers of “a bona fide purchaser of real property” as of the commencement of the case. In other words, the bankruptcy trustee has all the rights of someone who purchased the property in good faith and took title before the filing of the bankruptcy petition. As a hypothetical bona fide purchaser, the trustee’s rights generally trump the rights of others who may claim an interest in the property. The only people whose rights have priority over the trustee are those who have purchased and taken possession of the legal title of the property in good faith before the debtor files for bankruptcy. Put simply, unless you sell the property before declaring bankruptcy, it belongs to your estate.

The Bank's Argument

HSBC argued that it gained an interest before Ralph filed for bankruptcy. Unfortunately for HSBC, Louis's wife didn't grant the original mortgage on the property. Because HSBC gave the loan (which paid off the mortgage) to someone other than the original title-holder, it couldn’t record the mortgage. So, it didn’t appear officially in the chain of title. That made HSBC an “unrecorded equitable interest holder.” In re Day, 443 B.R. 338, 343 (D.N.J. 2011) According to the court, HSBC obviously meant to create a mortgage-backed loan. The fact that it failed to verify ownership and record the mortgage did not give it precedence over the bankruptcy trustee as bona fide purchaser. The court had no sympathy for HSBC's sloppy lending practices. Without the legal title, HSBC could not trump the trustee’s rights. Ralph still held the legal title when he filed for bankruptcy, so the property was part of his bankruptcy estate. Id. at 342. HSBC also argued that even if the trustee had priority for the bare legal title, HSBC still retained equitable interest in the property because of the creation of a “constructive trust” between Ralph and Louis for Durie. A constructive trust is created when one party is deprived of its rights or property by the actions of another. The court may impose a constructive trust to protect the wronged party’s interest in that property; assets held in a constructive trust are protected from creditors.

Constructive Trust Argument

If the property had been placed in a constructive trust, the legal title would still have passed to the bankruptcy estate. However, the property would not have been liquidated because there would have been equitable interest in it outside the bankruptcy estate. In other words, your bankruptcy estate can’t include things you don’t actually own and the trust would own an interest in the property. 11 U.S.C.A. § 541(d). HSBC wanted the property placed in a constructive trust so that it could be used to pay back the loan the bank had made to Louis’s wife. Otherwise, HSBC would be left with a large unsecured loan and Louis's wife would be left without the means to repay it. A constructive trust is a serious remedy and HSBC’s argument wasn’t strong enough for the court. Any agreement that Ralph and Louis had was purely verbal; no one wrote anything down or kept any records. Under the Statute of Frauds, oral (or “parol”) evidence is not admissible because it is impossible to verify. As far as the court was concerned, no such agreement existed. So, Louis and Durie did not have an enforceable legal interest in the property and no constructive trust was merited. On this point, too, the court ruled against HSBC. The property legally belonged to Ralph, regardless of any agreement he and Louis made. As it turned out, the property remained in the bankruptcy estate and the trustee presumably liquidated it to pay Ralph’s debts. HSBC was left with an unsecured loan of almost $700,000 to Louis’s wife; she was left with a $700,000 loan without the income property she was planning to use to pay it off.  Whoever holds legal title is the owner for purposes of bankruptcy. Image credit