United States: In Search Of The Meaning Of "Unreasonably Small Capital" In Constructively Fraudulent Transfer Avoidance Litigation

Last Updated: December 4 2014
Article by Mark G. Douglas and Jane Rue Wittstein

The meaning of "unreasonably small capital" in the context of constructively fraudulent transfer avoidance litigation is not spelled out in the Bankruptcy Code. As a result, bankruptcy courts have been called upon to fashion their own definitions of the term. Nonetheless, the courts that have considered the issue have mostly settled on some general concepts in fashioning such a definition. In Whyte ex rel. SemGroup Litig. Trust v. Ritchie SG Holdings, LLC (In re SemCrude, LP), 2014 BL 272343 (D. Del. Sept. 30, 2014), a Delaware district court recently reaffirmed two such guiding principles: (i) a debtor can have unreasonably small capital even if it is solvent; and (ii) a "reasonable foreseeability" standard should be applied in assessing whether capitalization is adequate.

Avoidance of Fraudulent Transfers in Bankruptcy

Section 548(a)(1) of the Bankruptcy Code authorizes a trustee or chapter 11 debtor-in-possession ("DIP") to avoid any transfer of an interest of the debtor in property or any obligation incurred by the debtor within the two years preceding a bankruptcy filing if: (i) the transfer was made, or the obligation was incurred, "with actual intent to hinder, delay, or defraud" any creditor; or (ii) the transaction was constructively fraudulent because the debtor received "less than a reasonably equivalent value in exchange for such transfer or obligation" and was, among other things, insolvent, left with "unreasonably small capital," or unable to pay its debts as such debts matured, when or after the transfer was made or the obligation was incurred.

For one of these categories of constructive fraud, section 548(a)(1)(B)(ii)(II) provides that a transfer or obligation, if made or incurred by the debtor without an exchange of reasonably equivalent value, may be avoided if, among other things, the debtor "was engaged in business or a transaction, or was about to engage in business or a transaction, for which any property remaining with the debtor was an unreasonably small capital."

Transfers or obligations may also be avoided under analogous state laws by operation of section 544(b) of the Bankruptcy Code, which empowers a DIP or trustee to "avoid any transfer of an interest of the debtor in property or any obligation incurred by the debtor that is voidable under applicable law by a creditor holding an unsecured claim" against the debtor. Examples of such laws are the versions of the Uniform Fraudulent Transfer Act ("UFTA") and the Uniform Fraudulent Conveyance Act ("UFCA") adopted by most states.

The UFTA (which has been adopted by 44 states, the District of Columbia, and the U.S. Virgin Islands) includes the phrase "the remaining assets of the debtor were unreasonably small in relation to the business or transaction" in place of the corresponding language regarding "unreasonably small capital" in section 548(a)(1)(B)(ii)(II). See UFTA § 4(a)(2)(1). The (older but largely repealed) UFCA, which is still in effect in New York and Maryland, tracks the "unreasonably small capital" language in section 548(a)(1)(B)(ii)(II). See N.Y. Debt. & Cred. L. § 274.

The Bankruptcy Code and the UFCA do not define "unreasonably small capital" (nor does the UFTA define "unreasonably small" assets). This has largely been left to the courts.

The leading case on this issue is Moody v. Security Pacific Business Credit, Inc., 971 F.2d 1056 (3d Cir. 1992). In Moody, the Third Circuit expressed the concept as follows:


[A]n "unreasonably small capital" would refer to the inability to generate sufficient profits to sustain operations. Because an inability to generate enough cash flow to sustain operations must precede an inability to pay obligations as they become due, unreasonably small capital would seem to encompass financial difficulties short of equitable solvency.
Id.

at 1070. The Third Circuit further explained that, because a debtor's cash flow projections tend to be optimistic, the reasonableness of projections "must be tested by an objective standard anchored in the company's actual performance." According to the court, relevant data include cash flow, net sales, gross profit margins, and net profits or losses, but "reliance on historical data alone is not enough." Id. at 1073. The Third Circuit wrote that "parties must also account for difficulties that are likely to arise, including interest rate fluctuations and general economic downturns, and otherwise incorporate some margin for error." Id. 

As explained by the court in Autobacs Strauss, Inc. v. Autobacs Seven Co. (In re Autobacs Strauss, Inc.), 473 B.R. 525, 552 (Bankr. D. Del. 2012), in accordance with Moody, "Reasonable foreseeability is the standard." Because the term is "fuzzy, and in danger of being interpreted under the influence of hindsight bias," courts should resist the temptation to "suppose that because a firm failed it must have been inadequately capitalized." Boyer v. Crown Stock Distributions, Inc., 587 F.3d 787, 794 (7th Cir. 2009) (citing Moody). 

Many other courts have also endorsed Moody's articulation of the meaning of "unreasonably small capital." See, e.g., Global Outreach, S.A. v. YA Global Invs., LP (In re Global Outreach, S.A.), 2014 BL 275891, *15 (Bankr. D.N.J. Oct. 2, 2014); Gilbert v. Goble (In re N. Am. Clearing, Inc.), 2014 BL 271090, *8 (Bankr. M.D. Fla. Sept. 29, 2014); Tronox Inc. v. Kerr-McGee Corp. (In re Tronox Inc.), 503 B.R. 239, 320 (Bankr. S.D.N.Y. 2013).

A leading bankruptcy treatise supplements Moody's formulation of the definition of "unreasonably small capital" with the following commentary:


Adequate capitalization is also a variable concept according to which specific industry of business is involved. The nature of the enterprise, normal turnover of inventory rate, method of payment by customers, etc[.], from the standpoint of what is normal and customary for other similar businesses in the industry, are all relevant factors in determining whether the amount of capital was unreasonably small at the time of, or immediately after, the transfer.

Collier on Bankruptcy ¶ 548.05[3][b] (16th ed. 2014). A Delaware district court examined the meaning of "unreasonably small capital" in SemCrude.

SemCrude

SemGroup, L.P. ("SemGroup"), at one time the fifth-largest privately held U.S. company, was a "midstream" energy company that provided transportation, storage, and distribution of oil and gas products to oil producers and refiners. SemGroup's general partner was SemGroup G.P., L.L.C. ("SGP"). Approximately 25 percent of SemGroup's limited partnership interests were held by Ritchie SG Holdings, L.L.C., and two affiliates (collectively, "Ritchie").

More than 100 lenders formed a syndicate (the "bank group") that provided SemGroup with a line of credit from 2005 through July 2008.

SemGroup also traded options on oil-based commodities, using a trading strategy that was inconsistent with both its risk management policy and the agreement governing its line of credit (the "credit agreement"). In addition, SemGroup made advances on an unsecured basis to fund trading losses incurred by Westback Purchasing Company, L.L.C. ("Westback"), a company owned by SemGroup's CEO and his wife, without any loan documentation calling for payment of principal or interest.

In August 2007 and February 2008, SemGroup and SGP paid Ritchie more than $55 million in distributions with respect to Ritchie's limited partnership interests. Because oil prices between July 2007 and February 2008 were volatile, SemGroup was obligated to post large margin deposits on the options it sold, which forced the company to increase its borrowing under the credit agreement from $800 million to more than $1.7 billion.

In July 2008, the bank group declared SemGroup in default of the credit agreement. SemGroup filed for chapter 11 protection on July 22, 2008, in the District of Delaware.

SemGroup's confirmed chapter 11 plan became effective in November 2009. Among other things, the plan provided for the creation of a litigation trust to prosecute avoidance claims belonging to the bankruptcy estate. In 2010, the litigation trustee sued Ritchie, seeking to avoid the $55 million in distributions as constructively fraudulent transfers under section 548(a) of the Bankruptcy Code and Oklahoma's version of the UFTA. Among other things, the trustee alleged in the complaint that SemGroup was left with unreasonably small capital after both distributions.

Bankruptcy judge Brendan L. Shannon granted summary judgment in favor of Ritchie on the "unreasonably small capital" issue. He concluded that, because all available sources of capital, including bank lines, should be considered when determining whether a company is adequately capitalized, there was no serious dispute that SemGroup had adequate capital and liquidity to operate after the distributions to Ritchie. Judge Shannon also found that there was no evidence that SemGroup had engaged in fraud or that the bank group had declared SemGroup in default due to the company's options trading or the Westback payments.

The litigation trustee appealed to the district court.

The District Court's Ruling

The district court affirmed on appeal. After examining the standard articulated in Moody, Judge Sue L. Robinson emphasized that " 'there must be a causal relationship between the [fraudulent transfer] and the likelihood that the Debtor's business will fail . . . [and that a] debtor's later failure, alone, is not dispositive on the issue' " (quoting In re Kane & Kane, 2013 BL 79573 (Bankr. S.D. Fla. Mar. 25, 2013)). According to the SemCrude court, "unreasonably small capital" refers to problems that " 'are short of insolvency in any sense but are likely to lead to insolvency at some time in the future' " (quoting In re Tronox, 503 B.R. 239, 320 (Bankr. S.D.N.Y. 2013)).

Judge Robinson found no error in the bankruptcy court's conclusion that SemGroup's substantial line of credit should be considered in assessing whether the company was adequately capitalized. She rejected the litigation trustee's argument that the complaint raised a material disputed fact concerning whether it was reasonably foreseeable that SemGroup would be unable to sustain its operations due to its "massive breach" of the credit agreement:


It is not clear from the record whether or not the Bank Group was aware of the business activities identified by appellant as being inconsistent with SemGroup's obligations under the Credit Agreement. . . . As recognized by the bankruptcy court, however, it makes no difference. If the Bank Group was aware of such, appellant's position collapses on itself, for there is no forecast to make—SemGroup's access to credit had not been withdrawn at the time of either of the distributions despite the "massive" breach of the Credit Agreement. If the Bank Group was not aware of such activities, one has to engage in multiple levels of forecasting in order to embrace appellant's position. . . . [A]ppellant would have the court, in effect, forecast (1) the lenders' reaction to discovering the conduct, and then (2) the consequences of that reaction, i.e., that the only option chosen by all of the lenders would have been to foreclose access to all credit, which (3) had the reasonably foreseeable consequence of bankruptcy.

Judge Robinson agreed with the bankruptcy court that "what appellant proposes is a 'speculative exercise' not rooted in the case law."

Outlook

Determining whether a debtor has unreasonably small capital as a consequence of a transfer or obligation that is later challenged as being constructively fraudulent is a fact-intensive inquiry. Guided by Moody, the district court in SemCrude reinforced the widely held recognition in the courts that: (i) "unreasonably small capital" is something less than insolvency but is likely to lead to insolvency at some time in the future; and (ii) it is not enough for a company to have small capital—there must also be a "reasonable foreseeability" that a corporation does not have sufficient capital to sustain its business.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Mark G. Douglas
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Emails

From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

*** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.