Determining Insolvency in Preference and Fraudulent Conveyance Actions

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Nov 2001

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Was the debtor insolvent at the time of the transfer? This is often the threshold
issue in preference and fraudulent conveyance actions. It is therefore necessary in
many cases to determine insolvency at a specific point in time, prior to the
bankruptcy filing.

For corporations, §101 (32) of the Bankruptcy Code adopts a traditional
balance-sheet definition of insolvency, a "...financial condition such that the
sum of such entity's debts is greater than all of such entity's property, at fair
valuation..." (emphasis added). "Fair valuation" is not defined in the Bankruptcy
Code, but case law defines it as the amount that can be realized from the conduct
of an orderly sale of the debtor's assets in an open market within a reasonable time
frame, not liquidation value.<a href="#1" name="1a">1</a> To determine insolvency, the debtor's assets and
liabilities should be valued at fair value, "unless a business is on its death
bed."<a href="#2" name="2a">2</a> The bankruptcy court may consider subsequent events, but the debtor's assets
and liabilities must be valued as of the time of the transfer, not at what they
ultimately were worth in the bankruptcy.<a href="#3" name="3a">3</a> In addition, §101(32)(A)(1)
requires that the company's assets be valued exclusive of any "property transferred,
concealed or removed with the intent to hinder, delay or defraud" creditors.

<h3>The Presumption of Insolvency</h3>

In preference actions, §547(f) gives the trustee (or the debtor-in-possession
(DIP)) a presumption of insolvency for the 90 days immediately preceding the
bankruptcy filing. This presumption of insolvency is rebutable.<a href="#4" name="4a">4</a> Section 547(f)
does not change the burden of proof, which remains with the trustee; it just shifts
the burden of going forward with the evidence.<a href="#5" name="5a">5</a> In a preference action against an
insider in which the transfer occurred more than 90 days before the date of filing,
there is no presumption of insolvency, and the trustee must establish insolvency on
the date of the transaction. There is also no presumption of insolvency in avoidance
actions for constructive fraud brought under §548(a)(1)(B).

<h3>The Burden of Proof</h3>

Insolvency is a question of fact that the trustee must prove by the preponderance
of the evidence.<a href="#6" name="6a">6</a> The preponderance standard means that the trustee must persuade the
bankruptcy court that the proposition sought to be proven—that the debtor was insolvent
on the date of the transfer—"is more likely true than not."<a href="#7" name="7a">7</a> If a creditor meets the
presumption of insolvency with credible evidence, then the burden of introducing evidence
of insolvency shifts to the trustee.<a href="#8" name="8a">8</a> The trustee will typically rely on testimony of
an accountant, appraiser or business valuation expert to establish the fair value of the
debtor's assets and liabilities at the time of the transfer in question.<a href="#9" name="9a">9</a> If the
transfer occurred in the middle of an accounting period and there is no record of the
value of the debtor's assets and liabilities on that date, the determination of
insolvency is difficult at best.

<blockquote><blockquote>
<hr>
<big><center>
Insolvency is a question of fact that the
trustee must prove by the preponderance of
the evidence.
</center></big>
<hr>
</blockquote></blockquote>

The debtor's financial statements for the reporting period closest to the transfer
date provide a good place to start, but they are historical statements of value,
i.e., book value, and must be converted to fair value. The book value of assets
such as property and equipment are recorded at cost, less accumulated depreciation. The
fair value of such assets does not depend on how fast they have been depreciated on
the company's books, but on what they are worth in the current market. Assets such
as inventory should be adjusted based on age, liquidity and market conditions, and
accounts receivable should be discounted for collectibility. Likewise, liabilities should
be reduced to their expected or present value before a determination can be made
regarding whether a company's assets exceed its liabilities.<a href="#10" name="10a">10</a>

Table 1 illustrates a typical balance sheet for a closely held corporation. The
first column represents historical value and indicates, based on these values, that the
company is solvent by $1,219,000.

Each asset and liability on the historical balance sheet must be analyzed and
adjusted to fair value, if applicable. In this example, accounts receivable and
inventory have been reduced to their realizable values. Prepaid expenses and other
assets are assumed to have no net realizable value. Property and equipment have been
reduced to appraised market value. On the liability side, accrued expenses have been
reduced to reflect only those accruals that would actually require payment by the
company in an orderly liquidation. Taking these adjustments into consideration, the
company is insolvent by $164,000.

<h3>Inference of Insolvency by Retrojection</h3>

In a case where the debtor's financial position is unascertainable on the date of
a challenged transfer, a number of courts have permitted the trustee to infer
insolvency on a particular date by a method known as "retrojection." The "retrojection
rule" provides that "if a debtor was insolvent on the first known date and insolvent
on the last relevant date, and the trustee demonstrates the absence of any
substantial or radical changes in the assets or liabilities of the debtor between the
two retrojection dates, then the debtor is deemed to be insolvent at all intermediate
times."<a href="#11" name="11a">11</a> The retrojection method has also been described this way:

<blockquote>
A [debtor's] insolvency on a transfer date may be shown by using company books
and a later inventory and by working backwards though a ledger to reflect
sales, purchases [and] returns after the critical date...a trustee must be able
to show absence of substantial or radical changes in assets or liabilities of the
bankrupt between (retrojection dates).<a href="#12" name="12a">12</a>
</blockquote>

Some courts, however, have been reluctant to infer insolvency using this method going
back more than a few months before a proven date of insolvency.<a href="#13" name="13a">13</a>

<h3>Practice Pitfalls</h3>

In presenting the evidence of insolvency to the bankruptcy court, the trustee (or
DIP) should always bear in mind that he has the burden of proof; a tie on the
issue of insolvency goes to the transferee. For instance, judgment was entered for
the defendants in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Claiborne (In re Kaylor Equipment Rental Inc.), 56
B.R. 58, 63 (Bankr. E.D. Tenn. 1985)</a>. The trustee sought to avoid
the debtor's $15,000 in payments to two of its three owners as fraudulent
transfers under §548(a)(2) of the Bankruptcy Code.

At trial, the only disputed issue was the corporation's solvency on the date of
the transfers. The trustee offered some documentary evidence of insolvency at the time
of the transfers, but the debtor's records were inconclusive. The trustee failed to
introduce expert testimony to rebut the defendants' certified public accountant (CPA),
who testified that all of the debtor's debts could have been paid in full had the
debtor's assets been sold on the date of the transfers. The trustee lost his case,
despite introducing some evidence of insolvency, because he failed to carry his burden
of proof at trial. The bankruptcy court hinted that the outcome might have been
different if the trustee had offered expert testimony demonstrating a substantial change
in the financial condition of the company between the date of the transfers and the
date of filing, or if the trustee had used a valuation expert to establish that the
debtor's asset valuation on the date of the transfers exceeded fair market value14
and should have been adjusted downward.

On the other hand, the trustee should not rely on "conclusory" expert testimony
alone. In <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Credit Alliance Inc. v. Harvey (In re Lamar Haddox Contractor
Inc.), 40 F.3d 118, 122 (5th Cir. 1994)</a>, the Fifth Circuit
reversed the preference judgment entered in favor of the chapter 11 estate
representative because the "conclusory opinion testimony" of the estate's CPA was
insufficient to establish the debtor's insolvency on the dates of the transfers. The
accountant testified that he had no idea of the fair value of the debtor's heavy
equipment, its major asset. The estate representative introduced no other testimony,
nor financial records from which the court could determine the fair value of the
debtor's assets. Ironically, the accountant actually had in his possession the debtor's
financial statements and general ledger. These financial records could have been used
as a starting point for determining fair value, but counsel did not introduce them
into evidence, and the Fifth Circuit found that the estate representative failed to
carry his burden of proof.

<h3>Conclusion</h3>

Proving insolvency can be difficult, especially if the transfer in question took
place between accounting periods. The use of credible experts such as accountants,
appraisers and business valuation professionals can be critical to the ultimate outcome
of a proceeding involving the determination of insolvency.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> See, e.g., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Briden (In re Arrowhead Gardens Inc.), 32 B.R. 296, 299 (Bankr. D. Mass.
1983)</a>, aff'd., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.2d 379 (5th Cir. 1985)</a>; see, also, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Sales Inc. v. First Eastern Bank N.A. (In
re Coated Sales Inc.), 144 B.R. 663, 667 (Bankr. S.D.NY. 1992)</a> ("[f]air value is not synonymous with a forced
sale"); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Von Christierson (In re CSI Enterprises Inc., 220 B.R. 687, 692 (Bankr. D. Colo. 1998)</a>. <a href="#1a">Return to article</a>

<a name="2">2</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Arrowhead Gardens Inc., 32 B.R. at 299</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Coated Sales Inc., 144 B.R. at 668</a>. <a href="#2a">Return to article</a>

<a name="3">3</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Coated Sales Inc., 144 B.R. at 668</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Scientific Research Products Inc. (In re Mama D'Angelo
Inc.), 55 F.3d 552, 856 (10th Cir. 1995)</a>. <a href="#3a">Return to article</a>

<a name="4">4</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Ford Motor Co. (In re Roblin Industries Inc.), 78 F.3d 30, 34 (2nd Cir. 1996)</a>. <a href="#4a">Return to article</a>

<a name="5">5</a> See, e.g., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Technical Services Inc. v. Whitworth (In re Total Technical Services Inc.), 150 B.R. 893, 899
(Bankr. D. Del. 1993)</a>. <a href="#5a">Return to article</a>

<a name="6">6</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Strickland (In re Strickland), 230 B.R. 276, 282 (Bankr. E.D. Va. 1999)</a>. See, also, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
v. Nunes (In re Terrific Seafoods Inc.), 197 B.R. 724, 731 (Bankr. D. Mass. 1996)</a>. <a href="#6a">Return to article</a>

<a name="7">7</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Electronics Inc. v. Justus (In re Kaypro), 230 B.R. 400, 412 (BAP 9th Cir. 1999)</a>, aff'd. in
part, rev'd., in part, and remanded (on other grounds) <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.3d 1070 (9th Cir. 2000)</a>. <a href="#7a">Return to article</a>

<a name="8">8</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Roblin Industries Inc., 78 F.3d at 34-35</a>. <a href="#8a">Return to article</a>

<a name="9">9</a> Tax returns and actual sales of assets may also be used. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Strickland, 230 B.R. at 283</a>. Securities and Exchange
Commission (SEC), filings are also a starting point for valuation. See, e.g., In re Total Technical Services Inc., at <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… B.R.
at 900</a>. <a href="#9a">Return to article</a>

<a name="10">10</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Xonics Photochemicals Inc., 841 F.2d 198, 200-201 (7th Cir. 1988)</a>. <a href="#10a">Return to article</a>

<a name="11">11</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Strickland Inc., 230 B.R. at 284</a>. See, also, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Terrific Seafoods Inc., 197 B.R. at 731</a>. <a href="#11a">Return to article</a>

<a name="12">12</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re S&W Exports Inc., 16 B.R. 941, 947 n.2 (Bankr. S.D.N.Y. 1982)</a>, quoting <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… & Hubbard
Inc. v. Stewart, 387 F.2d 907 n.1 (5th Cir. 1967)</a>; see, also, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Mama D'Angelo, 55 F.3d at 554-555</a>. <a href="#12a">Return to article</a>

<a name="13">13</a> See, e.g., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Bancorporation v. Hodges (In re Washington Bancorporation), 180 B.R. 330, 333-335
(Bankr. D. D.C. 1995)</a>. <a href="#13a">Return to article</a>

<a name="14">14</a> See, also, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Dev. Corp. v. Commonwealth Sav. & Loan Ass'n. (In re Pembroke Dev. Corp.), 124 B.R.
398, 402</a> (Bankr. S.D. Fla.), which held that a loan-modification agreement was not a preference because the debtor failed to
introduce any evidence, such as appraisals or opinion testimony, that the actual value of the debtor's real property was worth substantially
less at the time of the transfer. <a href="#14a">Return to article</a>

Journal Authors

Richard P. Finkel

Sharyn Beth Zuch

Journal Date

Thursday, November 1, 2001 - 12:00

Bankruptcy Rule

2001