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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.
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