Restructuring

Contributed by Andrea Saavedra
In previous posts in our Slice of the Pie series, we examined the statutory definition of insolvency as applicable to corporate and municipal debtors, exploring the differences between balance sheet insolvency versus that of equitable, or cash flow, insolvency.  We also observed that, in the context of fraudulent transfer litigation involving corporate debtors, financial distress can also be established pursuant to the capital adequacy standard set forth in section 548(a)(1)(B)(ii)(II) of the Bankruptcy Code.  We now turn our attention to an analysis of this provision, which is often referred to as the “unreasonably small capital” test of financial distress.
What Constitutes Unreasonably Small Capital?
Section 548(a)(1)(B)(ii)(II) provides that a transfer may be avoided if the debtor received less than reasonably equivalent value in exchange for such transfer and “was 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.”  The Bankruptcy Code does not provide further guidance as to what constitutes “unreasonably small capital.”  Courts, however, have said that inadequate capitalization applies where, post-transfer, the corporate debtor is left technically solvent, but doomed to fail.  The issue of inadequate capitalization is often litigated in the bankruptcy cases of corporate debtors that seek reorganization after a failed leveraged buyout, as demonstrated by the classic decision of the Third Circuit Court of Appeals.
How Is Unreasonably Small Capital Different from Balance Sheet or Equitable Insolvency?
Interestingly, some courts apply a “balance sheet-like” test to determine capital adequacy.  Others at times equate capital inadequacy with equitable insolvency (i.e., an inability to pay debts as they become due).  The majority of courts, though, have concluded that capital adequacy is different from either of the foregoing standards.  Indeed, courts frequently describe unreasonably small capital as a financial condition short of equitable insolvency, focusing on the existence — or lack thereof — of an adequate capital cushion post-transfer that enables the debtor to weather reasonably foreseeable business risks (including downturns).  In other words, unreasonably small capitalization encompasses difficulties that are “short of insolvency in any sense, but are likely to lead to insolvency at some time in the future.”
How Do Courts Measure Unreasonably Small Capital?
Determining capital adequacy is a question of fact, and the burden of proof is on the debtor in possession or trustee to prove by a preponderance of the evidence that the corporate debtor had unreasonably small capital during the period in which the transfer(s) occurred.
In undertaking an analysis of unreasonably small capital, courts will look to such factors as the company’s debt to equity ratio, its historical capital cushion, and the need for working capital in the specific industry at issue.  In addition, courts will compare a company’s projected cash inflows (also referred to as working capital or operating funds) with the company’s capital needs through a reasonable period of time after the transfer.  Courts evaluate the reasonableness of a company’s cash flow projections objectively so as to balance what might be considered management’s optimism with the company’s actual performance.  Only those cash inflows that are reasonable for a company to have expected to receive — whether through new equity, cash from operations, or available credit (whether secured or unsecured) — are considered in this analysis.  Although a company does not need resources sufficient to withstand any and all setbacks, projections are not reasonable unless they include a sufficient working capital cushion.  Mere survival post-transfer is not enough.
In determining whether a company has a sufficient working capital cushion, courts look not only at the company’s capital needs on the date of the transfer, but also at the company’s capital needs through a reasonable period of time thereafter.  The rationale behind this extended review period is to avoid the risk of ascribing “undue weight to the state of a company’s balance sheet on a particular day” and to allow “the court to make a realistic assessment of the impact of a transfer on a company’s ability to conduct its affairs.”  What constitutes a reasonable period of time after the transfer is a business-specific inquiry, and courts have used periods of approximately one year to as long as seven years.  This aspect is different from balance sheet analysis, which is focused on the specific time at which a transfer occurred.  Accordingly, in a capital adequacy analysis, it is not unusual for the court to look at post-transfer events to determine the reasonability of pre-transfer projections.
Why Does It Matter?
It is important for both legal and financial practitioners to understand the differences and similarities between the two separate, objective tests of financial distress that can be at issue in federal fraudulent transfer analysis.  Depending upon the facts and circumstances of any particular case, one standard may be more applicable than the other, and one may be more readily established than another.  Accordingly, in developing (or defending) a fraudulent transfer case, understanding the nuances of each test is essential to create a cogent story of financial distress (or financial stability), whether at the time of the contested transfer or thereafter.