'Triggering Event Test'

In the preference avoidance context, the insolvency of the debtor is an element of the prima facie case that is not commonly litigated. When it is litigated, however, the scope of a debtor's liabilities can make or break the case. This is because under established case law, if a liability is determined to be “contingent,” then courts are required to discount the face value of that liability by the estimated probability of the contingency occurring and the contingent liability becoming an actual liability. If the liability is deemed to be “non-contingent,” then the entire amount of the judgment can be added to the liability side of the balance sheet to usually make the debtor insolvent, thereby satisfying the insolvency element.

In August 2014, the Bankruptcy Appellate Panel for the Ninth Circuit (the Panel) issued a decision upholding a published decision by Judge Julia W. Brand in the Central District of California that left no doubt that the so-called “triggering event test” was the appropriate test to determine whether a liability is contingent or not for the purpose of showing insolvency under 11 U.S.C ' 547. The decisions are notable because prior to the bankruptcy court's decision, no court in the Ninth Circuit had provided clear guidance as to what constitutes a contingent liability in the specific context of an insolvency analysis under 11 U.S.C. ' 547. Applying the “triggering event test” to the facts at hand, the Panel held that a state court judgment is a non-contingent liability in its full amount for purposes of determining the insolvency of the debtor, even though on the date in question the judgment was not final under state law and the debtor had expressed optimism that the judgment would likely be overturned on appeal.

Factual Background

The debtor, Imagine Fulfillment Services, Inc. (IFS), is a full-service fulfillment company providing assembly, warehouse, and shipping services. Prior to the filing of its bankruptcy petition, a multimillion-dollar judgment was entered against IFS in California Superior Court. With judgment in hand, the judgment creditor then perfected a judgment lien on all of IFS's assets and, shortly thereafter, began to exercise its state law rights as a secured creditor by, among other things, levying on IFS's bank accounts.

IFS filed a timely appeal of the state court judgment and was optimistic about its chances on appeal. However, it nevertheless decided to seek bankruptcy protection and filed its voluntary petition under Chapter 11 within 90 days of the perfection of the judgment lien. After filing for Chapter 11 protection, IFS immediately commenced an adversary proceeding in bankruptcy court against the judgment creditor seeking to avoid the judgment lien pursuant to 11 U.S.C. ' 547, as a preferential transfer.

After substantial discovery and significant litigation in the adversary case, IFS and the judgment creditor eventually agreed that all the elements of a preferential transfer had been established, except the requirement under 11 U.S.C. ' 547 that the transfer in question be made “while the debtor was insolvent.” More specifically, the judgment creditor argued that at the time it perfected its lien over the assets of IFS, the latter's balance sheet as well as the other evidence presented to the court showed IFS to be solvent, so long as the multimillion dollar state court judgment was not included as a liability of the debtor in its full amount. Both parties agreed, however, that that if the state court judgment against IFS was added into the equation as a liability in its full face amount, IFS would have been hopelessly insolvent at the time of the contested transfer.

In the course of cross motions for summary judgment, the judgment creditor argued that because the state court judgment had been appealed and was not final under California state law, the bankruptcy court should consider it a contingent liability, which under established case law may be reduced for purposes of determining insolvency by a factor related to the likelihood that the judgment would actually have to be paid. See, e.g., Covey v. Commercial Nat'l Bank of Peoria , 960 F.2d 657, 659-61 (7th Cir. 1992). IFS, however, argued that the judgment shoud not be considered contingent because, on the date of the alleged preferential transfer, the judgment was enforceable and therefore should be construed as a liability in its full face amount, with no reductions.

The Bankruptcy Court's Decision and the 'Triggering Event Test'

After the matter was fully briefed, the bankruptcy court took the matter under submission and eventually issued a published opinion holding that the perfection of the judgment lien in favor of the judgment creditor constituted a preferential transfer and the lien could therefore be avoided. Crucial to the bankruptcy court's ruling was its finding that the state court judgment should be included as a liability in its full face amount. See Imagine Fulfillment Services, LLC vs. DC Media Capital, LLC, 489 B.R. 136 (Bankr. C.D. Cal. 2013). Besides being a major win for IFS, which allowed it to later confirm its plan of reorganization and to successfully emerge as a reorganized debtor, the bankruptcy court's published opinion is notable for its holding that a judgment on appeal was not a contingent liability for purposes of an insolvency analysis under 11 U.S.C. ' 547, even though: 1) the judgment was not final under California state law; and 2) the judgment debtor was optimistic that it would prevail on appeal and pay nothing on the judgment.

In ruling that a judgment on appeal is not “contingent,” Judge Brand relied on the “triggering event” test from the All Media case published over 30 years ago. In All Media, a dispute regarding the meaning of “contingent” arose in the context of an involuntary petition. At the time of the All Media decision, 11 U.S.C. ' 303 allowed creditors to file an involuntary petition against an alleged debtor so long as each creditor held a “claim ' that is not contingent as to liability.” To determine the appropriate definition of “contingent,” the court in All Media first looked to the very broad definition of “claim” under the 11 U.S.C. ' 101(4)(A). Then the court noted that the Code's definition of “claim” combined with the plain language of 11 U.S.C. ' 303(b) made it clear that “there is a difference between a disputed claim, an unmatured claim, an unliquidated claim and a contingent claim. Otherwise, there would be no necessity to include the word 'contingent.'” In re All Media Properties, Inc., 5 B.R. 126, 133 (Bankr. SD Texas 1980). Thus, the court concluded that:

[C]laims are contingent as to liability if the debt is one which the debtor will be called upon to pay only upon the occurrence or happening of an extrinsic event which will trigger the liability of the debtor to the alleged creditor and if such triggering event or occurrence was one reasonably contemplated by the debtor and creditor at the time the event giving rise to the claim occurred. ' On the other hand, if a legal obligation to pay arose at the time of the original relationship, but that obligation is subject to being avoided by some future event or occurrence, the claims is not contingent as to liability, although it may be disputed as to liability for various reasons.

In re All Media Properties, Inc., supra at 133.

Recognizing that courts in the Ninth Circuit had not specifically discussed the definition of a “contingent liability” in connection with a solvency analysis, Judge Brand concluded that because the 'triggering event test' has been widely applied to determine whether a debt it contingent in other contexts since All Media, the “triggering event test” should also control in an insolvency analysis under 11 U.S.C. ' 547. Applying the “triggering event test” to the facts of IFS's avoidance action, the court concluded that because the breach of contract giving rise to the state court judgment in favor of the creditor (and entry of the judgment itself) occurred prior to the allegedly preferential transfer at issue with nothing else left to be decided by the state trial court, the judgment was not a contingent liability and IFS was therefore entitled to include the full face value of the judgment as a liability when determining whether or not IFS was insolvent at the time of the transfer.

With the full amount of the judgment on IFS's balance sheet in the liability column, the bankruptcy court found that IFS easily satisfied the required element of insolvency and, because all other elements of a preferential transfer had also been established, IFS was entitled to avoided the creditor's pre-petition judgment lien pursuant to 11 U.S.C. ' 547.

The Bankruptcy Appellate Panel's Opinion

Not happy with the bankruptcy court's decision and recognizing that no other court in the Ninth Circuit had specifically applied the “triggering event test” to determine whether or not a judgment on appeal could be discounted for purposes of an insolvency analysis under Section 547, the judgment creditor appealed the bankruptcy court's decision to the Ninth Circuit Bankruptcy Appellate Panel. In a decision dated Aug. 6, 2014, the Panel affirmed the bankruptcy court's “well-reasoned ' Memorandum Decision.” In re Imagine Fulfillment Services, LLC, 2014 WL 3867531 *4 at fn. 8 (9th Cir. BAP Aug. 6, 2014).

In its decision, the Panel specifically held that because the events giving rise to the state court judgment occurred before the date of the allegedly preferential transfer, the liability was not contingent as a matter of law at the time of the transfer and therefore should be considered as a liability of the debtor in the full amount of the judgment for purposes of an insolvency analysis under 11 U.S.C. ' 547. Id . at *6 (citing In re Fostvedt, 823 F.2d 305, 306 (9th Cir. 1987)) (“We see no reasoned or statutorily supported purpose to deviate, for insolvency determination purposes, from the definition of 'contingent debt' as one which the debtor will be called upon to pay only upon the occurrence or happening of an extrinsic event which will trigger the liability of the debtor to the alleged creditor.”).

By affirming the bankruptcy court's use and application of the “triggering event test” in the context of the insolvency element of a preferential transfer, the Panel's recent ruling validated IFS's efforts to avoid the judgment lien and provides more clarity going forward with respect to when a bankruptcy court can estimate the probability of future liability and when a bankruptcy court must accept the entire amount the liability without any reduction.

Open Questions and Practice Pointers

The Imagine Fulfillment Services decisions leave little doubt as to the definition of a “contingent liability.” However, some questions still remain when applying the definition to different facts and it seems that courts will in the future still look closely at the underlying facts specific to each particular case to determine whether or not a liability satisfies the definition of contingent.

For example, what if instead of having a judgment at the time of the transfer in question the creditor in the IFS case only had a pending lawsuit against the debtor for breach of contract. According to the “triggering event test,” the liability in that scenario would still be a non-contingent liability because the breach of contract was alleged to have occurred years prior to the petition date. However, in a case where the liability is non-contingent under the “triggering events test,” will courts still permit a debtor to claim as a liability the full amount of the claim made by the defendants in their breach of contract complaint before any judgment has been entered? Indeed, in that scenario, the judgment is not contingent, but it would certainly seem to be disputed.

Furthermore, what if a judgment had been entered, but enforcement of the judgment was stayed pending the state court appeal and the judgment creditor was not allowed to enforce its rights? In that scenario, again, the liability would certainly not be contingent under the 'triggering events test' since the events giving rise to liability all happened prior to entry of the judgment. However, if enforcement of the judgment was stayed would a court be more inclined to find the judgment to be disputed even though the trial court had already ruled?

Without discounting the uncertainties discussed above, knowing that the “triggering event test” is applicable to the insolvency analysis under 11 U.S.C ' 547 should not be overlooked in future avoidance actions and will give lawyers representing debtors and trustees additional ammunition to potentially increase the liability side of a balance sheet in those cases where the insolvency of the debtor is disputed.

Aram Ordubegian is a Bankruptcy & Financial Restructuring partner and M. Douglas Flahaut is an associate at Arent Fox LLP in Los Angeles. The authors represented Imagine Fulfillment Services in the Chapter 11 case, and on appeal before the Bankruptcy Appellate Panel for the Ninth Circuit.

In the preference avoidance context, the insolvency of the debtor is an element of the prima facie case that is not commonly litigated. When it is litigated, however, the scope of a debtor's liabilities can make or break the case. This is because under established case law, if a liability is determined to be “contingent,” then courts are required to discount the face value of that liability by the estimated probability of the contingency occurring and the contingent liability becoming an actual liability. If the liability is deemed to be “non-contingent,” then the entire amount of the judgment can be added to the liability side of the balance sheet to usually make the debtor insolvent, thereby satisfying the insolvency element.

In August 2014, the Bankruptcy Appellate Panel for the Ninth Circuit (the Panel) issued a decision upholding a published decision by Judge Julia W. Brand in the Central District of California that left no doubt that the so-called “triggering event test” was the appropriate test to determine whether a liability is contingent or not for the purpose of showing insolvency under 11 U.S.C ' 547. The decisions are notable because prior to the bankruptcy court's decision, no court in the Ninth Circuit had provided clear guidance as to what constitutes a contingent liability in the specific context of an insolvency analysis under 11 U.S.C. ' 547. Applying the “triggering event test” to the facts at hand, the Panel held that a state court judgment is a non-contingent liability in its full amount for purposes of determining the insolvency of the debtor, even though on the date in question the judgment was not final under state law and the debtor had expressed optimism that the judgment would likely be overturned on appeal.

Factual Background

The debtor, Imagine Fulfillment Services, Inc. (IFS), is a full-service fulfillment company providing assembly, warehouse, and shipping services. Prior to the filing of its bankruptcy petition, a multimillion-dollar judgment was entered against IFS in California Superior Court. With judgment in hand, the judgment creditor then perfected a judgment lien on all of IFS's assets and, shortly thereafter, began to exercise its state law rights as a secured creditor by, among other things, levying on IFS's bank accounts.

IFS filed a timely appeal of the state court judgment and was optimistic about its chances on appeal. However, it nevertheless decided to seek bankruptcy protection and filed its voluntary petition under Chapter 11 within 90 days of the perfection of the judgment lien. After filing for Chapter 11 protection, IFS immediately commenced an adversary proceeding in bankruptcy court against the judgment creditor seeking to avoid the judgment lien pursuant to 11 U.S.C. ' 547, as a preferential transfer.

After substantial discovery and significant litigation in the adversary case, IFS and the judgment creditor eventually agreed that all the elements of a preferential transfer had been established, except the requirement under 11 U.S.C. ' 547 that the transfer in question be made “while the debtor was insolvent.” More specifically, the judgment creditor argued that at the time it perfected its lien over the assets of IFS, the latter's balance sheet as well as the other evidence presented to the court showed IFS to be solvent, so long as the multimillion dollar state court judgment was not included as a liability of the debtor in its full amount. Both parties agreed, however, that that if the state court judgment against IFS was added into the equation as a liability in its full face amount, IFS would have been hopelessly insolvent at the time of the contested transfer.

In the course of cross motions for summary judgment, the judgment creditor argued that because the state court judgment had been appealed and was not final under California state law, the bankruptcy court should consider it a contingent liability, which under established case law may be reduced for purposes of determining insolvency by a factor related to the likelihood that the judgment would actually have to be paid. See, e.g., Covey v. Commercial Nat'l Bank of Peoria , 960 F.2d 657, 659-61 (7th Cir. 1992). IFS, however, argued that the judgment shoud not be considered contingent because, on the date of the alleged preferential transfer, the judgment was enforceable and therefore should be construed as a liability in its full face amount, with no reductions.

The Bankruptcy Court's Decision and the 'Triggering Event Test'

After the matter was fully briefed, the bankruptcy court took the matter under submission and eventually issued a published opinion holding that the perfection of the judgment lien in favor of the judgment creditor constituted a preferential transfer and the lien could therefore be avoided. Crucial to the bankruptcy court's ruling was its finding that the state court judgment should be included as a liability in its full face amount. See Imagine Fulfillment Services, LLC vs. DC Media Capital, LLC, 489 B.R. 136 (Bankr. C.D. Cal. 2013). Besides being a major win for IFS, which allowed it to later confirm its plan of reorganization and to successfully emerge as a reorganized debtor, the bankruptcy court's published opinion is notable for its holding that a judgment on appeal was not a contingent liability for purposes of an insolvency analysis under 11 U.S.C. ' 547, even though: 1) the judgment was not final under California state law; and 2) the judgment debtor was optimistic that it would prevail on appeal and pay nothing on the judgment.

In ruling that a judgment on appeal is not “contingent,” Judge Brand relied on the “triggering event” test from the All Media case published over 30 years ago. In All Media, a dispute regarding the meaning of “contingent” arose in the context of an involuntary petition. At the time of the All Media decision, 11 U.S.C. ' 303 allowed creditors to file an involuntary petition against an alleged debtor so long as each creditor held a “claim ' that is not contingent as to liability.” To determine the appropriate definition of “contingent,” the court in All Media first looked to the very broad definition of “claim” under the 11 U.S.C. ' 101(4)(A). Then the court noted that the Code's definition of “claim” combined with the plain language of 11 U.S.C. ' 303(b) made it clear that “there is a difference between a disputed claim, an unmatured claim, an unliquidated claim and a contingent claim. Otherwise, there would be no necessity to include the word 'contingent.'” In re All Media Properties, Inc., 5 B.R. 126, 133 (Bankr. SD Texas 1980). Thus, the court concluded that:

[C]laims are contingent as to liability if the debt is one which the debtor will be called upon to pay only upon the occurrence or happening of an extrinsic event which will trigger the liability of the debtor to the alleged creditor and if such triggering event or occurrence was one reasonably contemplated by the debtor and creditor at the time the event giving rise to the claim occurred. ' On the other hand, if a legal obligation to pay arose at the time of the original relationship, but that obligation is subject to being avoided by some future event or occurrence, the claims is not contingent as to liability, although it may be disputed as to liability for various reasons.

In re All Media Properties, Inc., supra at 133.

Recognizing that courts in the Ninth Circuit had not specifically discussed the definition of a “contingent liability” in connection with a solvency analysis, Judge Brand concluded that because the 'triggering event test' has been widely applied to determine whether a debt it contingent in other contexts since All Media, the “triggering event test” should also control in an insolvency analysis under 11 U.S.C. ' 547. Applying the “triggering event test” to the facts of IFS's avoidance action, the court concluded that because the breach of contract giving rise to the state court judgment in favor of the creditor (and entry of the judgment itself) occurred prior to the allegedly preferential transfer at issue with nothing else left to be decided by the state trial court, the judgment was not a contingent liability and IFS was therefore entitled to include the full face value of the judgment as a liability when determining whether or not IFS was insolvent at the time of the transfer.

With the full amount of the judgment on IFS's balance sheet in the liability column, the bankruptcy court found that IFS easily satisfied the required element of insolvency and, because all other elements of a preferential transfer had also been established, IFS was entitled to avoided the creditor's pre-petition judgment lien pursuant to 11 U.S.C. ' 547.

The Bankruptcy Appellate Panel's Opinion

Not happy with the bankruptcy court's decision and recognizing that no other court in the Ninth Circuit had specifically applied the “triggering event test” to determine whether or not a judgment on appeal could be discounted for purposes of an insolvency analysis under Section 547, the judgment creditor appealed the bankruptcy court's decision to the Ninth Circuit Bankruptcy Appellate Panel. In a decision dated Aug. 6, 2014, the Panel affirmed the bankruptcy court's “well-reasoned ' Memorandum Decision.” In re Imagine Fulfillment Services, LLC, 2014 WL 3867531 *4 at fn. 8 (9th Cir. BAP Aug. 6, 2014).

In its decision, the Panel specifically held that because the events giving rise to the state court judgment occurred before the date of the allegedly preferential transfer, the liability was not contingent as a matter of law at the time of the transfer and therefore should be considered as a liability of the debtor in the full amount of the judgment for purposes of an insolvency analysis under 11 U.S.C. ' 547. Id . at *6 (citing In re Fostvedt, 823 F.2d 305, 306 (9th Cir. 1987)) (“We see no reasoned or statutorily supported purpose to deviate, for insolvency determination purposes, from the definition of 'contingent debt' as one which the debtor will be called upon to pay only upon the occurrence or happening of an extrinsic event which will trigger the liability of the debtor to the alleged creditor.”).

By affirming the bankruptcy court's use and application of the “triggering event test” in the context of the insolvency element of a preferential transfer, the Panel's recent ruling validated IFS's efforts to avoid the judgment lien and provides more clarity going forward with respect to when a bankruptcy court can estimate the probability of future liability and when a bankruptcy court must accept the entire amount the liability without any reduction.

Open Questions and Practice Pointers

The Imagine Fulfillment Services decisions leave little doubt as to the definition of a “contingent liability.” However, some questions still remain when applying the definition to different facts and it seems that courts will in the future still look closely at the underlying facts specific to each particular case to determine whether or not a liability satisfies the definition of contingent.

For example, what if instead of having a judgment at the time of the transfer in question the creditor in the IFS case only had a pending lawsuit against the debtor for breach of contract. According to the “triggering event test,” the liability in that scenario would still be a non-contingent liability because the breach of contract was alleged to have occurred years prior to the petition date. However, in a case where the liability is non-contingent under the “triggering events test,” will courts still permit a debtor to claim as a liability the full amount of the claim made by the defendants in their breach of contract complaint before any judgment has been entered? Indeed, in that scenario, the judgment is not contingent, but it would certainly seem to be disputed.

Furthermore, what if a judgment had been entered, but enforcement of the judgment was stayed pending the state court appeal and the judgment creditor was not allowed to enforce its rights? In that scenario, again, the liability would certainly not be contingent under the 'triggering events test' since the events giving rise to liability all happened prior to entry of the judgment. However, if enforcement of the judgment was stayed would a court be more inclined to find the judgment to be disputed even though the trial court had already ruled?

Without discounting the uncertainties discussed above, knowing that the “triggering event test” is applicable to the insolvency analysis under 11 U.S.C ' 547 should not be overlooked in future avoidance actions and will give lawyers representing debtors and trustees additional ammunition to potentially increase the liability side of a balance sheet in those cases where the insolvency of the debtor is disputed.

Aram Ordubegian is a Bankruptcy & Financial Restructuring partner and M. Douglas Flahaut is an associate at Arent Fox LLP in Los Angeles. The authors represented Imagine Fulfillment Services in the Chapter 11 case, and on appeal before the Bankruptcy Appellate Panel for the Ninth Circuit.