Fraudulent Transfer Claims Fall Short in Second and Third Circuits: Appellate Courts Affirm Findings that Debtors Were Not Left with Unreasonably Small Capital

At one time the “fifth-largest privately held company in the United States,” SemGroup, L.P. provided transportation, storage and distribution services to oil and gas producers and refiners. It also traded options on oil-based commodities.[2]

SemGroup funded operations through credit facilities, including a significant line of credit lent by a “syndicate of over 100 different” banks (the “bank group”) and secured by a credit agreement. One term of the credit agreement prohibited SemGroup from trading “naked options” — i.e., “trades where the security is neither offset by other trades nor backed by physical inventory.”[3]

SemGroup depended on stable oil prices. From July 2007 through February 2008, however, the price of oil was “erratic.”[4] SemGroup incurred substantial trading losses that, in turn, caused the company to transfer its trading book in July 2008. Shortly thereafter, the bank group declared SemGroup to be in default under the credit agreement, precipitating the company’s bankruptcy filing.[5]

The bank group cited SemGroup’s trading losses as grounds for the default but apparently did not cite SemGroup’s naked-option trading, even though SemGroup evidently made no effort to conceal it.[6]

SemGroup’s plan of reorganization created a litigation trust. The trustee filed two adversary proceedings to recover equity distributions that SemGroup’s management approved in August 2007 and February 2008, which the trustee alleged were constructively fraudulent transfers under the Oklahoma Uniform Fraudulent Transfer Act. The bankruptcy court found that the trustee failed to meet her burden of proof and entered judgment for the transferees.[7] The district court affirmed.[8]

The trustee’s appeal to the Third Circuit presented two related questions: Did the equity distributions leave SemGroup with unreasonably small capital, and was SemGroup insolvent at the time of the 2008 equity distribution?

The parties did not dispute that SemGroup would have been adequately capitalized if it could have drawn from its line of credit. Analysis of the first question therefore focused on whether it was reasonably foreseeable that SemGroup’s trading of naked options — in violation of the credit agreement — would have foreclosed its access to its line of credit. But the trustee did not present at trial any evidence that SemGroup disguised or concealed its naked-option trading, and the bank group did not cite that practice as a ground for default. Further, SemGroup believed it was “acting transparently.”[9] Finally, circumstances in 2007 and 2008 did not indicate that SemGroup’s trading was destined to fail or that SemGroup would necessarily lose access to the line of credit as a result. The lenders had numerous options available, from pulling the credit line entirely to “restructuring it, to requiring a sale of assets to pay down a portion of the line, to imposing restrictions on the Debtor’s trading activity, to simply doing nothing.”[10] Thus, the Third Circuit held, it was not reasonably foreseeable that SemGroup had unreasonably small capital at the time of the equity distributions.[11]

The Third Circuit also rejected the trustee’s appeal from the ruling that she failed to prove that SemGroup was insolvent when it made the 2008 equity distribution. The sole issue on appeal on this point was the bankruptcy court’s admission of the testimony of the transferees’ expert witness, who relied on a prior Goldman Sachs solvency report to form his opinions. The Third Circuit found nothing wrong with that reliance. First, the report was prepared contemporaneously with the 2008 equity distribution. Second, the report was prepared for a contemplated securities offering for which Goldman Sachs engaged in significant due diligence. Finally, the transferees’ expert was a Goldman Sachs alumnus who was familiar with the firm’s methodology. Moreover, the expert adjusted his opinion to account for “SemGroup’s speculative derivative trading.” Given these factors, the Third Circuit held that the bankruptcy court did not err by admitting the expert testimony and affirmed its judgment for the transferees.[12]

In re Adelphia Communications Corp.[13]

Adelphia Communications Corp. was one of the largest cable companies in the U.S. So too was its 2002 bankruptcy proceeding. One component of Adelphia’s reorganization created a recovery trust that succeeded to Adelphia’s rights and brought suit on its and its creditors’ behalf.[14]

Before its bankruptcy, Adelphia paid roughly $150 million to FPL Group Inc. and West Boca Security Inc. in a stock-repurchase transaction. Believing these payments to be fraudulent transfers, the recovery trust sued FPL Group and West Boca Security to avoid them under the Pennsylvania Uniform Fraudulent Transfer Act. Following a four-day bench trial, the district court adopted the bankruptcy court’s recommendation to enter judgment for FPL Group and West Boca Security. On appeal, the recovery trust asked the Second Circuit to determine whether the district court erred by finding that the stock repurchase did not leave Adelphia with unreasonably small capital. The Second Circuit held that it did not, and affirmed.[15]

The Pennsylvania Uniform Fraudulent Transfer Act does not define what constitutes “unreasonably small” capital.[16] Courts interpreting the statute usually find that a transaction leaves a debtor with unreasonably small assets where the company is “technically solvent but doomed to fail.”[17] In other words, assets are unreasonably small where the debtor “had such minimal assets that insolvency was inevitable in the reasonably foreseeable future.”[18]

This inquiry considers an array of factors, including a company’s debt-to-equity ratio, historical capital cushion, need for working capital in the specific industry at issue, reasonably anticipated sources of operating funds (including credit), present and prospective debts and the ability to pay them as they come due, the ability to refinance its debts, and financial health as compared to its peers.[19]

In Adelphia, the recovery trust argued that the company was left with unreasonably small assets after its stock repurchase because it exceeded its maximum leverage under certain debt instruments, had negative cash flow, was beset by claims of fraud, and had defaulted on certain bond indentures.

The Second Circuit rejected these claims. It credited the findings below that Adelphia could have liquidated assets or obtained credit to continue operations and that its woes were not unique: Peer companies were “able to access capital markets despite having negative cash flows and/or having high leverage ratios, and . . . numerous other companies obtained access to capital markets after disclosing fraud.”[20] Ultimately, though, the case was a battle of the experts, and the Second Circuit found no reversible error in the district court’s reliance on the transferees’ expert testimony.[21]

Conclusion

SemCrude and Adelphia emphasize the demanding showing that must be made to avoid an allegedly fraudulent transfer on the ground that it left the debtor with “unreasonably small capital.” As demonstrated by the Second and Third Circuits, the effect of a transfer on the debtor’s capital is a fact- and expert-intensive inquiry. Analysis of the debtor’s capitalization as of the time of the allegedly fraudulent transfer is key. If a company can show that it had means to secure capitalization at that point, courts resist invitations to engage in hindsight bias.