Recovering Transfers That Create Insolvency

Over the past few years, several companies have run out of money and been forced to declare bankruptcy within months of completing transactions that depleted their equity value and rendered them insolvent. Sometimes the value was dissipated through an equity distribution and other times through non-ordinary course expenses.

There are successful approaches to recovering funds for creditors in such cases. Creditors, however, are not the only parties with a stake in understanding how such transactions can be unwound. The recipients of the funds generated by such loans could be required to return the proceeds, leaving the recipients in significantly worse condition than they were before they received the funds.

By understanding the test for determining whether such a transaction can be unwound, lenders, recipients, and creditors all benefit. Lenders can recognize the inherent risk in such transactions in advance and make adjustments to protect themselves. Recipients can learn to forecast scenarios in which the funds would be expunged and thus make informed decisions about accepting such loan proceeds. Creditors can potentially unwind the questioned transactions and recover value.

Because the stakes are often high, lenders, creditors, and borrowers alike should understand the underlying principles and use credible, credentialed experts to assist in understanding, implementing, unwinding, and untangling these complex transactions.

Overview of the Issue

A simple example illustrates the issue: A parent company owns a subsidiary that manufactures products. The parent is liable for an obligation it cannot satisfy, so it borrows funds from a third party. In doing so, the parent pledges the subsidiary's assets as collateral and then uses the borrowed funds to satisfy the parent's obligation. Shortly thereafter, the subsidiary runs out of cash to operate.

Because the subsidiary no longer has unencumbered or under-encumbered assets it can pledge to acquire working capital, the parent's transaction has rendered it unable to pay its debts as they come due. At first glance, unsuspecting creditors of the subsidiary might appear to have few means of redress, but there are circumstances when such a transaction can be unwound.

Under the provisions of Section 548(a)(1)(B) of the U.S. Bankruptcy Code, “Fraudulent Transfers and Obligations,” a bankruptcy trustee may avoid a transfer of an interest or obligation that a debtor incurred within the two years prior to a bankruptcy petition if the debtor: 1) was insolvent or became insolvent as a result of the transaction; and 2) received less than “reasonably equivalent value” in exchange for the obligation ' a form of constructive fraud. This article focuses on the solvency analysis. Reasonably equivalent value is also central in such cases and often is the cause of additional contention.

In our example above, the parent company received the funds and the subsidiary pledged its assets. Because the subsidiary did not receive the proceeds of its collateral pledge, it did not receive reasonably equivalent value. The question then becomes whether the subsidiary became insolvent as a result of the transaction or remained solvent and merely upstreamed value to its parent.

TOUSA

One of the most prominent recent examples is the long-running bankruptcy litigation involving homebuilder TOUSA Inc. This case has seen five years of court actions, appeals, and reversals. Most recently, the U.S. Court of Appeals for the Eleventh Circuit upheld an original ruling of the U.S. Bankruptcy Court for the Southern District of Florida, which voided a series of loan transactions that the court ruled were fraudulent transfers.

In TOUSA, the parent pledged a subsidiary's assets to settle the parent's litigation obligation. This left the subsidiary with insufficient funds to complete its housing development. The court invalidated the liens (harming the lender by making the loans unsecured) and ordered the funds returned (harming the litigation plaintiff because TOUSA was now insolvent and completely unable to satisfy the judgment). The court found that the subsidiary did not receive reasonably equivalent value in exchange for the collateral it had pledged, and the transaction rendered the subsidiary insolvent.

There are three solvency tests: 1) traditional balance sheet insolvency; 2) cash flow insolvency; and 3) unreasonably small capitalization. Any one of these shortcomings, coupled with a demonstration that the transaction resulted in less than a reasonably equivalent value being received by the party, could be grounds for avoiding a transfer or obligation that occurred prior to bankruptcy.

Determining Balance Sheet Solvency

Section 548 does not offer a specific definition of insolvency for the purposes of examining a fraudulent transfer or obligation. Instead, we must rely on Section 101, in which the insolvency is generally defined as “financial condition such that the sum of [an] entity's debts is greater than all of such entity's property, at a fair valuation.” This is the classic, balance sheet definition of insolvency: liabilities are greater than assets.

From a practical standpoint, a balance sheet prepared according to U.S. generally accepted accounting principles (GAAP) must become a solvency analysis tool that reflects the business's actual ability to continue operating as a going concern. This transition involves two steps: 1) determining what the company's balance sheet reflected on the specific date in question; and 2) adjusting the balance sheet to reflect economic realities that create either additional assets or liabilities.

The first step, determining the balance sheet as of the specific transaction date, can be quite challenging. In general terms, the financial adviser expert must find reliable financial statements nearest the transaction date and then make adjustments. If audited financial statements are not available, internal statements or information from outside sources may be used to reconstruct the needed information. The experience and credibility of the expert are crucial when judgment calls must be made.