Recovering Transfers That Create Insolvency

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.

Once the balance sheet has been adjusted to reflect the date of the transaction, the analyst must then make adjustments to turn a GAAP-compliant document into a workable solvency analysis. These adjustments generally fall into three categories:

1. Adding certain non-GAAP items to the balance sheet. A GAAP-compliant balance sheet generally does not reflect certain ongoing commitments that are on the books, such as leases. Except for capitalized leases, these are generally disclosed in financial statements as commitments, but are not listed as either assets or liabilities on the balance sheet. When analyzing solvency, however, the balance sheet must be adjusted to reflect those obligations. For example, if the company is paying below market rate for space, a long-term lease would be recognized as an asset, based on the difference between contract rate and market rate for the duration of the contract. On the other hand, if the company is paying more than market rate, the lease would be a liability for purposes of the solvency analysis.

2. Removing certain GAAP-compliant items from the balance sheet. This category includes assets that have no value if the business is liquidated, such as certain prepaid expenses. Key man term life insurance, for example, would normally be counted as an asset on a GAAP balance sheet, but would not have value if the business closes. Therefore, such assets are taken out of the balance sheet for purposes of solvency analysis.

3. Adjusting the balance sheet to reflect variations between the book value and the market value of assets. Intellectual property is a good example of a variance between book value and market value. Patents, copyrights, and other types of intellectual property are commonly listed on the balance sheet as assets with value equivalent to the cost of producing or developing them. The actual market value of such property, however, may be much higher or much lower, because of variables such as the expiration dates of patents.

There can also be sizable differences between book and market value of assets such as real estate, vehicles, and equipment. For example, the book value of highly specialized equipment might be high, but its market value would be much lower because of the nature of the equipment. This is true especially if the company were being liquidated.

Determining Inadequate Cash Flow

Another indicator of a potentially fraudulent transfer under Section 548 is if the transaction caused the debtor to incur “debts that would be beyond the debtor's ability to pay as such debts matured” ' a condition we might call “cash flow insolvency.” As with the other types of financial nonviability, determining this condition requires specialized analysis because existing financial statements will typically not provide a sufficiently detailed exploration of cash flow.

The goal is to produce an integrated cash flow statement that reflects all projected income and expenses. The first step involves taking existing balance sheet balances, along with income and expense statements, and then overlaying various operating and production budgets, along with reasonable sales and income projections.

The next ' and critical ' step is to apply various stress tests to determine the business's ability to survive various potential setbacks. For example, what would happen if the company had to reduce its sales price by 10%? What would be the effect of a critical supplier failure or a 10% increase in material costs? What if fuel costs rise? What would happen if there was a labor shortage?

Determining which stress tests to apply can be a contentious process ' a reasonable stress in one industry might be completely inappropriate in another. In some cases, the debtor may have performed its own various stress tests prior to the transaction, but the parties seeking to challenge and unwind a contested transaction will want to build their own. The credibility and experience of the expert become critical, especially if the transfer or obligation is the subject of litigation in which expert witness credentials are essential.

Determining Unreasonably Small Capital

The final insolvency indicator under Section 548 is if the debtor “was engaged in business or a transaction, or was about to engage in business or a transaction, for which any property remaining with the debtor was an unreasonably small capital.”

In other words, was the debtor inadequately capitalized? If so, and if the questioned transaction did not yield the debtor reasonably equivalent value, there could be grounds for avoiding the transaction. An example would be an equity distribution to existing shareholders that left the company with inadequate funds for continuing operations.

What constitutes “unreasonably small capital” is, of course, a matter of opinion. The concept is derived from most states' corporations codes, although there is no fixed number or ratio that applies. The expert generally will look first at industry norms or the capital base of comparably sized companies. Here again, in the event of litigation, the expert's credibility and ability to justify his or her analysis with authority are essential to success.

Making Informed Decisions Early

Although discussions about fraudulent transfers and obligations under Section 548 often focus on the steps to unwinding such transactions in the wake of a bankruptcy, it is equally important to remember those steps before engaging in such transactions. An important lesson from recent high-profile bankruptcy cases is that secured creditors can no longer make loan decisions based solely on the value of pledged collateral. Rather, secured creditors must perform additional due diligence to determine if the entity pledging the collateral can survive if the loan is completed.

The detailed equivalent value and functional solvency analyses in such cases require a commitment of dedicated resources as well as potential expert witness capabilities. But the size of the issue and the funds involved often make such specialized professional analysis essential. TOUSA involved a series of loans totaling approximately $500 million, which were being contested by creditors holding more than $1 billion in unsecured bonds. But much smaller transactions may also merit a review, given that the cost of such a review is likely to be well under $50,000.

It is important to understand the basic financial analysis involved in determining financial health and to obtain reliable, credible advice as early as possible. With help from an experienced analyst, lenders can make more informed tactical decisions about how to proceed with a contested transaction, and they can document their reasonable basis for their decisions as a hedge against future litigation.

David Gottlieb, CPA, FAS, is a partner with Crowe Horwath LLP in the Los Angeles office. He can be reached at 818-325-8415 or [email protected].
Michael Schwarzmann, FAS, is with Crowe in the Los Angeles office. He can be reached at 818-325-8461 or [email protected].

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.

Once the balance sheet has been adjusted to reflect the date of the transaction, the analyst must then make adjustments to turn a GAAP-compliant document into a workable solvency analysis. These adjustments generally fall into three categories:

1. Adding certain non-GAAP items to the balance sheet. A GAAP-compliant balance sheet generally does not reflect certain ongoing commitments that are on the books, such as leases. Except for capitalized leases, these are generally disclosed in financial statements as commitments, but are not listed as either assets or liabilities on the balance sheet. When analyzing solvency, however, the balance sheet must be adjusted to reflect those obligations. For example, if the company is paying below market rate for space, a long-term lease would be recognized as an asset, based on the difference between contract rate and market rate for the duration of the contract. On the other hand, if the company is paying more than market rate, the lease would be a liability for purposes of the solvency analysis.

2. Removing certain GAAP-compliant items from the balance sheet. This category includes assets that have no value if the business is liquidated, such as certain prepaid expenses. Key man term life insurance, for example, would normally be counted as an asset on a GAAP balance sheet, but would not have value if the business closes. Therefore, such assets are taken out of the balance sheet for purposes of solvency analysis.

3. Adjusting the balance sheet to reflect variations between the book value and the market value of assets. Intellectual property is a good example of a variance between book value and market value. Patents, copyrights, and other types of intellectual property are commonly listed on the balance sheet as assets with value equivalent to the cost of producing or developing them. The actual market value of such property, however, may be much higher or much lower, because of variables such as the expiration dates of patents.

There can also be sizable differences between book and market value of assets such as real estate, vehicles, and equipment. For example, the book value of highly specialized equipment might be high, but its market value would be much lower because of the nature of the equipment. This is true especially if the company were being liquidated.

Determining Inadequate Cash Flow

Another indicator of a potentially fraudulent transfer under Section 548 is if the transaction caused the debtor to incur “debts that would be beyond the debtor's ability to pay as such debts matured” ' a condition we might call “cash flow insolvency.” As with the other types of financial nonviability, determining this condition requires specialized analysis because existing financial statements will typically not provide a sufficiently detailed exploration of cash flow.

The goal is to produce an integrated cash flow statement that reflects all projected income and expenses. The first step involves taking existing balance sheet balances, along with income and expense statements, and then overlaying various operating and production budgets, along with reasonable sales and income projections.

The next ' and critical ' step is to apply various stress tests to determine the business's ability to survive various potential setbacks. For example, what would happen if the company had to reduce its sales price by 10%? What would be the effect of a critical supplier failure or a 10% increase in material costs? What if fuel costs rise? What would happen if there was a labor shortage?

Determining which stress tests to apply can be a contentious process ' a reasonable stress in one industry might be completely inappropriate in another. In some cases, the debtor may have performed its own various stress tests prior to the transaction, but the parties seeking to challenge and unwind a contested transaction will want to build their own. The credibility and experience of the expert become critical, especially if the transfer or obligation is the subject of litigation in which expert witness credentials are essential.

Determining Unreasonably Small Capital

The final insolvency indicator under Section 548 is if the debtor “was engaged in business or a transaction, or was about to engage in business or a transaction, for which any property remaining with the debtor was an unreasonably small capital.”

In other words, was the debtor inadequately capitalized? If so, and if the questioned transaction did not yield the debtor reasonably equivalent value, there could be grounds for avoiding the transaction. An example would be an equity distribution to existing shareholders that left the company with inadequate funds for continuing operations.

What constitutes “unreasonably small capital” is, of course, a matter of opinion. The concept is derived from most states' corporations codes, although there is no fixed number or ratio that applies. The expert generally will look first at industry norms or the capital base of comparably sized companies. Here again, in the event of litigation, the expert's credibility and ability to justify his or her analysis with authority are essential to success.

Making Informed Decisions Early

Although discussions about fraudulent transfers and obligations under Section 548 often focus on the steps to unwinding such transactions in the wake of a bankruptcy, it is equally important to remember those steps before engaging in such transactions. An important lesson from recent high-profile bankruptcy cases is that secured creditors can no longer make loan decisions based solely on the value of pledged collateral. Rather, secured creditors must perform additional due diligence to determine if the entity pledging the collateral can survive if the loan is completed.

The detailed equivalent value and functional solvency analyses in such cases require a commitment of dedicated resources as well as potential expert witness capabilities. But the size of the issue and the funds involved often make such specialized professional analysis essential. TOUSA involved a series of loans totaling approximately $500 million, which were being contested by creditors holding more than $1 billion in unsecured bonds. But much smaller transactions may also merit a review, given that the cost of such a review is likely to be well under $50,000.

It is important to understand the basic financial analysis involved in determining financial health and to obtain reliable, credible advice as early as possible. With help from an experienced analyst, lenders can make more informed tactical decisions about how to proceed with a contested transaction, and they can document their reasonable basis for their decisions as a hedge against future litigation.

David Gottlieb, CPA, FAS, is a partner with Crowe Horwath LLP in the Los Angeles office. He can be reached at 818-325-8415 or [email protected].
Michael Schwarzmann, FAS, is with Crowe in the Los Angeles office. He can be reached at 818-325-8461 or [email protected].