Restructuring

Contributed by Joshua Nemser
If a debtor incurs an obligation while insolvent, and if the debtor does not receive reasonably equivalent value in exchange, such obligation may be voidable as a fraudulent transfer.  But could such an obligation still be a fraudulent transfer if the debtor is only kind of insolvent?  Judge Isgur of the United States Bankruptcy Court for the Southern District of Texas recently held, in In re HDD Rotary Sales, Inc., that when a debtor is estimated to be insolvent by a mere half percent of its total asset base, and when that estimate is based on “inherently reliable and incomplete information,” the debtor will not be considered insolvent for the purpose of a fraudulent transfer analysis.  In reaching its conclusion, the court drew the distinction between a transfer and an obligation — both of which are avoidable under fraudulent transfer law — and also discussed when retrojection (projecting insolvency between two known insolvency dates) is an appropriate tool for proving insolvency.
Facts
HDD provided directional drilling equipment and services for on-shore drilling companies.  In August, 2008, a former HDD employee, Mr. Miller, lent $100,000 to HDD.  At some point (the date is uncertain), the $100,000 loan was converted to equity, but on June 30, 2009, the equity was “redeemed” for a $100,000 promissory note.  As of December 31, 2009, HDD recorded a liability to Miller for an increased amount of $293,167.  Miller alleged that the increased amount reflected the initial $100,000 owed to him as well as an additional $193,167 in sales commissions and bonuses, which Miller said arose from an oral agreement with HDD.  Although the sales commissions and bonuses ordinarily would have been treated as ordinary income, the parties agreed to characterize Miller’s bonus liability as a stock repurchase.  In sum, two distinct obligations arose from HDD to Miller:  one for the equity redemption (on June 30, 2009) and the second for the additional sales commissions and bonuses (on December 31, 2009).  Between May and December of 2010, HDD transferred certain inventory and equipment to Miller in satisfaction of the entire amount he was owed.
The plan agent argued that the obligations themselves (as opposed to the subsequent transfers) constituted fraudulent transfers.
Obligations vs. Transfers
The court began its analysis by noting the distinction between obligations and transfers.  Section 548 of the Bankruptcy Code provides that a bankruptcy trustee may avoid any transfer or any obligation.  If an obligation itself is avoided, any transfers on account of that obligation are necessarily fraudulent transfers.
The court noted that, although the term “obligation” is not defined in the Bankruptcy Code, “most courts hold that an obligation is incurred when it becomes legally binding under applicable non-bankruptcy law.”  So if, for example, an oral agreement (such as the one between HDD and Miller for the bonus amounts) is binding, the obligation is incurred upon entry into the agreement.
Unlike “obligation,” the term “transfer” is defined in section 101(54) of the Bankruptcy Code and includes “disposing of or parting with property or an interest in property.”
In conducting its fraudulent transfer analysis, the court first determined that HDD’s obligations to Miller under the promissory note arose on June 30, 2009 (when the note was issued).  HDD’s obligations under the oral agreement related to sales and bonus commissions arose on December 31, 2009, the first day by which Miller and HDD could have entered into the oral agreement.  It then focused its analysis on HDD’s solvency as of the date each obligation arose.
Retrojection
With respect to the promissory note obligation that arose on June 30, 2009, the court undertook an extensive, fact-based inquiry as to whether HDD was insolvent on that date.  The plan agent established that the debtor was insolvent as of January 1, 2009 and December 31, 2009 (established by audited financial statements).  But the agent was unable to establish that HDD was insolvent in between those dates.  The only way to infer that the HDD was insolvent on June 30, 2009 is by applying “retrojection.”
Retrojection is projecting insolvency between two known insolvency dates.  The court noted, “Where a debtor is shown to be insolvent at a date later than the date of the questioned transfer, and it is shown that the debtor’s financial condition did not change during the interim period, insolvency at the prior time may be inferred from the actual insolvency at the later date.”  What makes retrojection novel is that it permits the “court to conclude that a debtor is insolvent even when there is a deficiency of evidence as to financial status during some of the time period at issue.”
In discussing retrojection, the court cited a 1993 decision of the United States Bankruptcy Court for the Northern District of Texas, In re Sullivan, where retrojection was found to be appropriate.  In Sullivan, the debtor was nowhere near solvent in the six months prior to (insolvent by $68.9 million) or after (insolvent by $127.2 million) the relevant date.  The trustee was able to demonstrate the absence of any substantial or radical changes in the assets or liabilities of the debtor between the retrojection dates, and therefore, the Sullivan court found that the debtor was also insolvent on the relevant date.
The HDD court, however, determined that Sullivan was distinguishable.  First, HDD was insolvent by a much smaller margin than the debtor in Sullivan on the two known insolvency dates.  Second, the plan agent was unable to demonstrate the absence of any substantial or radical changes in the assets or liabilities of HDD between the two known insolvency dates.  In fact, Miller established that HDD was profitable during the six month period between January 1, 2009 (the first known insolvency date) and June 30, 2009 (the date HDD issued the promissory note).  Further, Miller provided evidence of a “spike in income during the intervening months between the two known insolvency dates.”  Thus, it was very possible that, although HDD was insolvent on January 1, 2009, it became solvent several months later.  It could have then become insolvent again by December 31, 2009.  Accordingly, the court declined to infer insolvency on June 30, 2009 by way of retrojection.
Holding
The court went on to provide its own estimate of HDD’s balance sheet and determined that the company’s liabilities exceeded its assets by $19,238 on June 30, 2009 (i.e. the company was insolvent as of that date).  Insolvency!  Not so fast.  The court noted that its “estimate is based on inherently unreliable and incomplete information” and went on to hold that because the company had approximately $4 million in assets and liabilities, and because the court’s estimate produced insolvency by only .5% of the total asset base, the plan administrator could not satisfy its burden of proof as to insolvency.  The court concluded that the equity redemption obligation, therefore, was not avoidable.
As to the sales commissions and bonus obligation that arose on or after December 31, 2009, the parties stipulated that HDD was insolvent by $3,205,393 as of that date.  As such, the court ordered a trial to determine whether the sales commission and bonus obligation was avoidable.  The issue to be determined at trial was whether that obligation was incurred for reasonably equivalent value.
What makes the holding in HDD remarkable is that the court concluded the debtor was insolvent on the date an obligation arose, just not insolvent enough.  Proving that an entity was already insolvent or became insolvent as a result of an obligation/transfer is not necessarily an easy task.