Conducting a thorough investigation of a debtor’s pre-petition activity can yield potential preference and fraudulent-transfer claims that can be valuable assets in a bankruptcy estate. Identifying potentially avoidable transfers goes hand in hand with evaluating the debtor’s financial condition to determine whether the debtor was insolvent when the transfer was made. Financial advisors can assist bankruptcy trustees and their counsel by conducting such an investigation, as well as aiding counsel in identifying financial documents necessary to complete the analysis, and identifying transactions that are the subject of additional investigation. They may also serve as expert witnesses at trial or other evidentiary hearings to prove insolvency.
Preferences
A preference is an avoidable payment to a creditor for a debt made while the debtor was insolvent within 90 days of the filing of the bankruptcy petition, unless the payment was made to an “insider,” in which case the look-back period to avoid the payment is within one year of the bankruptcy filing. Therefore, a determination of insolvency at the time the payment was made is required; however, there is a rebuttable presumption that the debtor was insolvent within the 90 days of filing bankruptcy.[1]
Fraudulent Transfers
There are two types of fraudulent transfers that are avoidable under the Bankruptcy Code. The first type is a transfer made with the actual intent to hinder, delay or defraud creditors, known as “actual fraud.”[2] Intent may be proven through badges of fraud. The second type of fraudulent transfer is known as a “constructive fraud.” An estate may avoid a constructive fraudulent transfer if the debtor received less than reasonably equivalent value in exchange for the transfer AND the debtor was insolvent or became insolvent as a result of the transfer, or if the property remaining was unreasonably small or beyond the debtor’s ability to repay, or the transfer was to an insider.[3]
The key to success in avoiding a constructive fraudulent transfer is to demonstrate that the debtor was insolvent at the time of the transfer. Title 11 U.S.C. § 101(32) defines the term “insolvent” as:
with reference to an entity other than a partnership and a municipality, financial condition such that the sum of such entity’s debts is greater than all of such entity’s property, at a fair valuation, exclusive of — (i) property transferred, concealed, or removed with intent to hinder, delay, or defraud such entity’s creditors; and (ii) property that may be exempted from property of the estate under section 522 of this title.
(A) with reference to a partnership, financial condition such that the sum of such partnership’s debts is greater than the aggregate of, at a fair valuation — (i) all of such partnership’s property, exclusive of property of the kind specified in subparagraph (A)(i) of this paragraph; and (ii) the sum of the excess of the value of each general partner’s non-partnership property, exclusive of property of the kind specified in subparagraph (A) of this paragraph, over such partner’s nonpartnership debts.
There are generally three tests to demonstrate insolvency. They are known as the (1) balance-sheet test, (2) the capital-adequacy test and (3) the cash-flow test.
Balance-Sheet Test
The balance-sheet test demonstrates that the value of a debtor’s liabilities exceeds assets at fair value. It is performed on the date of the transfer in question and excludes property that was transferred, concealed or removed with intent to hinder, delay or defraud creditors. The balance-sheet test begins with an analysis of the debtor’s balance sheet as of the date of the transfer. In some instances, locating a balance sheet as of the specific date can be challenging because often a debtor’s records might not be complete.
Balance-sheet data may be obtained from general ledgers or other underlying accounting records. In come cases, it may be necessary to apply retrojection to build a balance sheet from subsequent records or project a balance sheet based on transactional data, including bank records. Tax returns may provide balance sheets as of the end of a debtor’s tax year, but caution should be used if such tax returns are presented on a cash basis rather than an accrual basis, because key balance-sheet data, including accounts payable and accounts receivable, would be excluded.
In the instance of proving insolvency for an individual debtor, it may be necessary to create a balance sheet from scratch. In quantifying the liabilities of an entity or individual, claims filed in the bankruptcy case are often a good starting point. Rule 2004 exams or testimony from a debtor interview often yield useful information as well.
A determination of fair value is the subject of interpretation. The Bankruptcy Code does not define “fair value.” The AICPA’s International Glossary of Business Valuation Terms defines “fair-market value” as “the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.”
When adjusting to fair value, hindsight must be ignored, and a determination must be made to value the assets on a going-concern or liquidation basis. Consideration must also be given to contingent and off-balance-sheet liabilities, which, generally, would not be included on a GAAP-based balance sheet.
Capital-Adequacy Test
The capital-adequacy test will demonstrate that the property remaining with the debtor after the transfer in question was made was “unreasonably small.” An evaluation of capital adequacy will ultimately determine whether the debtor had enough capital to support its operations if its financial performance falls short of expectations.
The test determines whether a debtor can survive future business fluctuations with the capital that remains, and whether the debtor could reasonably have foreseen or predicted this when the transfer in question was made. Hindsight bias should also be disregarded. Retrojection may also be applied here by using a debtor’s subsequent accounting records to work backwards from the transfer date to prove inadequate capital on the date of the transfer.
Cash-Flow Test
The cash-flow test demonstrates whether a debtor intended or expected to incur debts beyond its ability to pay. The test is performed on the date of the transfer in question. If the analysis demonstrates that the debtor is able to continue conducting its business operations as a going concern and can pay its ongoing obligations, the debtor is considered cash-flow solvent. On the other hand, if the debtor demonstrates an inability to pay its debts and obligations as they mature, it is considered cash-flow insolvent.
When analyzing cash flow, the debtor’s internally prepared projections are a key starting point. An evaluation should be made to determine whether the projections are reasonable and feasible and whether they contain all data and factors that were known or knowable at the time of the transfer.
Conclusion
A determination of insolvency is necessary to evaluate the potential of recovering a constructive fraudulent transfer in a bankruptcy case. Conducting the balance-sheet, capital-adequacy and cash-flow tests can be document- and fact-intensive. The tests require a thorough analysis of the financial condition of the debtor at the time of the transfer. Consideration is also given to what the debtor knew or should have known when the transfer was made, and hindsight should be avoided.