Debtor Fails Insolvency Tests for Fraudulent Transfers

A recent bankruptcy case provides a helpful primer on the insolvency tests required to determine whether a debtor’s pre-filing transfer can be rejected as fraudulent. In re International Supply Co. clarifies that a debtor may be solvent under one test but ultimately be found insolvent.

Case facts

According to the U.S. Bankruptcy Court for the Northern District of Illinois, the debtor company appeared to be profitable and showed potential for significant growth. But over time, the company became the “personal piggy bank” of its controlling shareholder, who caused an asset liquidation to fund millions of dollars in distributions to him or on his behalf. When the assets were depleted, the company took on substantial debt to funnel him cash.

After the company filed for bankruptcy in September 2015, the trustee filed a lawsuit to avoid $1.72 million in transfers to a credit union. The money was transferred in August 2013 under a settlement agreement involving a defaulted loan on which the controlling shareholder had a personal guarantee. The loan was made to a different company managed by the controlling shareholder’s wife.

Under federal bankruptcy law, a trustee generally can avoid transfers made within two years before a bankruptcy filing if the debtor:

• Didn’t receive a reasonably equivalent value for the transfer, and
• Was insolvent on the date of the transfer or became insolvent as a result of the transfer.

Here, the court considered the “materially identical” state law counterpart that has a four-year statute of limitations.

3 tests

To determine insolvency, the trustee and credit union hired financial experts who applied the following three tests:

1.  Balance sheet. This test considers whether assets exceed liabilities. Both experts agreed that the company was solvent at the time of the transfers under the balance sheet test, but they diverged on the other two tests.
2. Cash flow. This evaluates whether the debtor has cash to pay its debts as they come due. In this case, cash flows were evaluated over the 12-month period within which most of the company’s debt was due. The trustee’s expert opined that the company was insolvent during the relevant years due to negative cash flow.

The credit union’s expert reached a different conclusion after making two adjustments to the sources of cash that differed significantly from the opposing expert’s calculations. First, he added in a new contract as a source of cash, deducting only the associated start-up costs. This resulted in an earnings figure higher than the company had ever achieved — a figure the court found “too high to pass a sanity check.”

Second, the court deemed the addition of $3.6 million in refinanced debt by the credit union’s expert “problematic.” The expert assumed that the company would refinance the debt again when it came due. As the court described it, he effectively reduced current debt by the amount the company couldn’t pay. However, refinancing this current debt, which was always due within 12 months, didn’t make it long-term debt. The fact that the company needed to refinance the debt supported a finding of insolvency.

3. Adequacy of capital. This test assesses whether a debtor has sufficient available capital to pay its debts, operating expenses and capital expenditures within a specific period. The credit union’s expert determined that the company failed the cash flow test, so the company essentially was doomed to fail the adequacy of capital test. If the company didn’t have sufficient cash to pay its current debts as they came due, it also couldn’t pay other expenses for the period.

Avoidance secured

Because the transfers benefited the controlling shareholder and not the company, the bankruptcy court easily found that the company didn’t receive equivalent value for them. Therefore, the transfers were avoided.

The three tests used to determine insolvency are applied based on the case-specific facts. Subtle differences in debtors’ situations may lead to markedly different outcomes. That’s why it’s critical for the parties to hire experts with experience in federal bankruptcy cases to support or defend against fraudulent transfer claims.