Bankruptcy Litigation Update: Determining Adequate Capital

Transactions involving distressed companies, or healthy companies that become distressed, are often attacked as fraudulent transfers. These transactions include leveraged buy-outs, dividend recaps, spin-offs, substantial asset sales and other garden-variety transfers. To determine whether a transfer (or obligation) can be avoided as fraudulent, courts generally examine the effect of the transfer on the transferor's assets —€ i.e., whether the transfer infringes on creditors' rights to realize upon available assets of the transferor. The focus is from the creditor's perspective as to what the transferor surrendered (or obligation it incurred) and what the transferor received.

A transfer (or obligation) can be challenged as an actual fraudulent transfer, which requires evidence that the transferor intended to “hinder, delay or defraud” its creditors. Alternatively, a plaintiff can challenge the transfer (or obligation) as a constructive fraudulent transfer, which requires evidence that: 1) the debtor made a transfer or incurred an obligation in exchange for less than reasonably equivalent value; and 2) was either: (a) insolvent on the date of the transfer or became insolvent thereby; (b) “engaged in business or a transaction, or was about to engage in a business or transaction, for which any property remaining with the debtor was an unreasonably small capital;” or (c) “intended to incur, or believed that it would incur, debts that would be beyond the transferee's ability to pay as they matured.” See 11 U.S.C. § 548(a)(1)(B).

This article focuses on the concept of “unreasonably small capital,” which is not defined in the Bankruptcy Code or applicable state statutes. Consequently, the determination of adequate capital is fact-intensive and fertile grounds for litigation. We have divided into two parts: first, a summary of the general standards used by courts for determining adequate capital, and second, a summary of two recent circuit court decisions addressing adequate capital.

What Is Unreasonably Small Capital?

The leading case on adequate capital is the U.S. Court of Appeals for the Third Circuit's decision in Moody v. Security Pacific Business Credit, Inc., 971 F.2d 1056 (3d Cir. 1992), which defines the concept of unreasonably small capital as the “financial condition short of equitable insolvency” marked by the inability to generate sufficient profits to sustain operations. Stated differently, the question is whether the transfer left the “transferor technically solvent but doomed to fail.” MFS/Sun Life Trust-High Yield Series v. Van Dusen Airport Servs., Co., 910 F. Supp. 913, 844 (S.D.N.Y. 1995); see also Brandt v. Hicks, Muse & Co. (In re Healthco Int'l, Inc.), 208 B.R. 288, 302 (Bankr. D. Mass. 1997) (“[A] transaction leaves a company with unreasonably small capital when it creates an unreasonable risk of insolvency, not necessarily a likelihood of insolvency.”). An “inadequately capitalized company may be able to stagger along for quite some time, concealing its parlous state or persuading creditors to avoid forcing it into a bankruptcy proceeding … ” Boyer v. Crown Stock Distribution, Inc., 587 F.3d 787, 795 (7th Cir. 2009).

The test for adequate capital is predicated on “reasonable foreseeability.” Moody, 971 F.2d at 1073 (3d Cir. 1992). The inquiry determines whether it was “reasonably foreseeable” that the company would not be able to sustain operations, given its capitalization level before or after the transfer. Id.

To determine whether a company has adequate capital, courts expect the parties to present expert testimony focusing on the “long-term ability of an enterprise to sustain its liabilities.” In re Tronox Inc. v. Kerr McGee Corp. (In re Tronox Inc.), 503 B.R. 239, 322 (Bankr. S.D.N.Y. 2013). The analysis compares the company's projected cash inflows with its capital needs throughout a reasonable period of time after the questioned transfer. See In re Iridium Operating LLC, 373 B.R. 283, 345 (Bankr. S.D.N.Y. 2007). Generally, the capital adequacy test is “passed” if the debtor is reasonably expected to have the financial wherewithal to pay its reasonably anticipated operating expenses, capital expenditures, debt repayment obligations and other liabilities in connection with the operation of the business.

The starting place for determining adequacy of capital is the financial projections prepared at the time of the transaction. See Moody v. Security Pacific Business Credit, Inc., 971 F.2d 1056 (3d Cir. 1992); In re Plassein Int'l Corp., 2008 WL 1990315 (Bankr. D. Del. May 5, 2008). Because “projections tend to be optimistic, their reasonableness must be tested by an objective standard anchored in the company's actual performance.” Moody, 971 F.2d at 1073. “To a degree, parties must also account for difficulties that are likely to arise, including interest rate fluctuations and general economic downturns and otherwise incorporate some margin for error.” Id. Additionally, projections should be consistent with historical performance. Id. at 1074; In re Tronox Inc., 503 B.R. at 321.

Courts look to expert opinions to confirm the reasonableness of the assumptions underlying the company's business plan. Iridium, 373 B.R. at 348. Without a “firm basis to replace management's cost projections with those developed in preparation of litigation,” management's projections should be the starting point of any solvency analysis. Id. at 347. Courts examining the question of adequate capital also place great weight on the debtor's ability to obtain financing. See, e.g., Moody, 971 F.2d at 1071-73; In re Plassein Int'l Corp., 2008 WL 1990315 (Bankr. D. Del. May 5, 2008); Peltz v. Hatten, 279 B.R. 710, 746-48 (D. Del. 2002).

Courts also will examine other factors, including the company's leverage ratios, its historical capital cushion and the need for working capital in the specific industry at issue and the length of time between the transaction and bankruptcy filing. MFS/Sun Life Tr.–High Yield Series v. Van Dusen, 910 F. Supp. at 944; In re Fid. Bond & Mortg. Co., 340 B.R. at 299 (citing Daley v. Chang (In re Joy Recovery Tech. Corp.), 286 B.R. 54, 76 (Bankr. N.D. Ill. 2002)).

Recent Circuit Court Decisions

Adelphia Recovery Trust

In Adelphia Recovery Trust v. FPL Group, Inc. (In re Adelphia), 652 Fed. Appx. 19 (2d Cir. 2016) (“Adelphia“), a plan litigation trust challenged a stock repurchase as a constructive fraudulent transfer. Having found that Adelphia was solvent with an equity cushion of approximately $2.5 billion, the bankruptcy court then analyzed during the course of a four-day bench trial whether Adelphia was adequately capitalized. The plaintiff's expert opined that Adelphia had unreasonably small capital and “would have been unable to maintain operations over a three year period due to its negative cash flow and lack of access to new capital.” Dist. Ct. Opin., 2015 WL 1208588, at *3 (S.D.N.Y. Mar. 17, 2015).

Although it was undisputed that Adelphia “required substantial capital expenditures to stay afloat over three years” in excess of $500 million, the plaintiff's expert opined that Adelphia could not access the capital markets or generate capital from asset sales because of a confluence of three factors. Id.

First, the plaintiff's expert opined that Adelphia's debt covenants limited its ability to raise capital by selling assets. Id. at *4. The defendants' expert disagreed and explained that Adelphia in fact had flexibility under its existing covenants to sell certain assets. Id. The bankruptcy court agreed with the defendants' expert, concluding that Adelphia could have sold assets to provide sufficient capital if necessary. Id.

Second, the plaintiff's expert opined that Adelphia's high leverage ratio put it in breach of debt covenants contained in its bond indentures, thereby restricting Adelphia's ability to borrow under its existing facility, and further limiting its access to the capital markets. Id. The defendants' expert presented a different picture and showed that at the time of the challenged transaction, Adelphia's debt-to-EBITDA ratio was 8.7%, which was below the 8.75% cap imposed by its debt covenants. Id. The defendants also pointed to industry comparisons, noting that certain of Adelphia's peers were able to access capital markets despite operating with negative cash flow and worse leverage ratios. Id. The bankruptcy court sided with the defendant's expert that Adelphia's high leverage ratio would not have caused Adelphia to lose access to the capital markets. Id.

Finally, the plaintiffs argued that Adelphia's access to the capital markets would have been “closed or severely limited” once Adelphia disclosed that it had fraudulently overstated its earnings by more than $400 million. Id. at *5. In opposition, the defendant's expert presented data from a study of 19 companies, and “argued that while it was 'theoretically possible' that Adelphia would have lost access to the capital markets if the fraud had been disclosed, the empirical evidence showed that, under similar circumstances, companies were typically able to raise capital after the disclosure of a fraud.” Id.

Ultimately, the bankruptcy court concluded that the plaintiff had failed to satisfy its burden to establish that Adelphia would have lost access to the capital markets if its fraud had been disclosed. Because the dispute was non-core, the bankruptcy court's findings and conclusions of law were submitted to the district court's de-novo review under 28 U.S.C. § 157(c)(1). The district court, after considering those findings and conclusions, entered judgment against the plaintiff.

The U.S Court of Appeals for the Second Circuit's decision, which is three pages as compared with the bankruptcy court's 48-page decision, begins by setting forth the standard of review: Factual findings are reviewed for clear error and legal conclusions are reviewed de novo. Cir. Ct. Opin., 652 Fed. Appx. 19, 20 (2d Cir. 2016). Here, the court noted that adequate capital arguments are “mostly or entirely fact based.” Id. After summarily describing the plaintiff's contentions on adequate capital, the Second Circuit found that the lower courts' findings —€ that “Adelphia could have sold off enough of its assets or alternatively obtained sufficient credit to continue its business for the foreseeable future” —€ were “amply supported by the declarations and trial testimony of defendants' experts, which showed, inter alia, that similarly-situated companies in the cable industry were able to access capital markets despite having negative cash flows and/or having high leverage ratios and that numerous other companies obtained access to capital markets after disclosing a fraud.” Id. at 22-23.

The Second Circuit affirmed the lower courts, and concluded that the “record demonstrates that the issue of adequate capitalization came down to a battle of experts. We cannot say that the district court clearly erred in accepting as more persuasive the evidence presented by defendants' experts.” Id. The Second Circuit's decision was a “summary order” with no “precedential effect.” Id. at 19.

SemGroup Litigation Trust

In Whyte v. SemGroup Litigation Trust (In re SemCrude LP), 648 Fed. Appx. 205 (3d Cir. 2016) (“SemGroup“), a plan litigation trust sought to avoid and recover dividends as constructive fraudulent transfers. The adequate capital dispute hinged upon the reasonableness of SemGroup's reliance on its continuing ability to draw upon its existing bank facility. Id. at 210. The plaintiff argued that the company's reliance on continued access to its line of credit was unreasonable because SemGroup was engaged in a trading strategy that it knew was prohibited under the credit agreement. The parties disputed, and the evidence was unclear, whether the lenders were aware that SemGroup was engaged in this prohibited trading strategy. Id. at 210-11.

The bankruptcy court granted the defendants' motion for summary judgment and found that the plaintiff's argument “rested upon conjecture biased by hindsight such that it was not reasonably foreseeable that SemGroup would lose access to credit when it made the challenge equity distribution.” Id. The district court affirmed. The trust appealed to the Third Circuit, arguing, “there are at least questions of material fact to the issue of whether it was reasonably foreseeable that the Bank Group would have pulled their line of credit as a result of SemGroup's derivatives trading.” Id. The Third Circuit reviewed the grant of summary judgment under a de novo standard. Id. at 208.

The Third Circuit affirmed and held that “it simply cannot be said that SemGroup was likely to be denied access to a credit facility that had been in place while it was engaging in the allegedly improper trading strategy.” Id. at 211. The court refused to accept the trust's argument because doing so would have required the court to “forecast: 1) the lenders' reaction to discovering the conduct; and then 2) the consequences of that reaction, i.e., that the only option chosen by all of the lenders would have been to foreclose access to all credit; which 3) had the reasonably foreseeable consequence of bankruptcy.” Id. (citing the district court). The court also noted that the trust “presented no evidence that SemGroup tried to disguise its trading strategy from the [lenders] or acted deceptively.” Id. at 212.

Thus, the court held, it was proper to find as a matter of summary judgment that SemGroup could not “reasonably foresee” that the lenders would declare a default upon learning of their trading strategy, nor could they foresee that their trading strategy would fail in the first place. Id. The Third Circuit stated that the decision was “not an opinion of the full Court” and “does not constitute binding precedent.” Id. at 207.

Conclusion

Proving inadequate capital is a fact-intensive exercise, and litigated success will often hinge on the relative credibility and persuasiveness of each party's expert witnesses. Moreover, as Adelphia proves, it is difficult to reverse the trial court's finding of facts under the “clear error” standard of appellate review. Finally, as SemGroup confirms, the “reasonably foreseeable” standard requires proof beyond conjecture or speculation regarding the debtor's future access to capital. Absent such proof, summary judgment dismissal of the claim may be warranted.

***** David M. Hillman is a partner and Parker J. Milender is an associate in the Business Reorganization Group at Schulte Roth & Zabel LLP.