In keeping with a recent ruling by the U.S. Court of Appeals for the Third Circuit, a federal bankruptcy court in Delaware has held that market capitalization should be used to assess whether a company is solvent for purposes of analyzing a fraudulent conveyance claim.
In EBC I, Inc., f/k/a eToys, Inc. v. America Online, Inc., (In re EBCI, Inc. f/k/a eToys, Inc.) No. 01-00706 (MFW) (Bankr. D. Del., Jan. 10, 2008), reorganized debtor EBI Inc., which had done business as eToys, filed a complaint in the U.S. Bankruptcy Court for the District of Delaware seeking the recovery of alleged fraudulent conveyances.
eToys and AOL had entered into an Interactive Marketing Services Agreement under which AOL committed to provide online advertisements and other services to eToys for three years for $18 million, payable in installments. eToys paid $7.5 million through July 2000, but when AOL did not deliver the promised ads, the parties renegotiated, and the agreement was modified by an Amendment Nov. 15, 2000. At that time, eToys paid another $750,000.
After what the court characterized as a "disastrous" holiday season, eToys realized it would not be able to meet its projected sales figures. The company failed in its efforts to sell itself as a going concern, and terminated its agreement with AOL in February 2001. The company dissolved its business and filed for bankruptcy in March 2001.
In the current action, eToys claimed that both the payment made to AOL in November 2000, and the termination agreement struck in February 2001, were avoidable as constructively fraudulent conveyances under section 548 of the Bankruptcy Code, because the company was insolvent by Nov. 15, 2000.
AOL moved for partial summary judgment on the fraudulent conveyance claim, which the court granted in part, and held an evidentiary hearing on the issue of whether eToys was insolvent Nov. 15, 2000. At the hearing, AOL presented expert testimony that eToys was solvent. In analyzing solvency, AOL's expert employed the going concern premise of value as opposed to the liquidation premise of value.
eToys disputed AOL's approach but not present rebuttal expert testimony.
The Delaware bankruptcy court concluded that AOL's expert used the appropriate methodology to value eToys' assets on its balance sheet, as a going concern was appropriate to use the going concern premise of value in analyzing eToys' solvency.
Third Circuit Holding
The decision in eToys was consistent with a recent holding by the U.S. Court of Appeals for the Third Circuit. The court in eToys agreed with the expert's decision to make adjustments to the book value of eToy's assets to reflect its market value, citing the Third Circuit's recent ruling in VFB LLC. v. Campbell Soup Co., 482 F.3d 624 (3d Cir. 2007).
"[T]he Third Circuit has stated that the Court should consider the market capitalization of a company in valuing its intangible assets," the Delaware court stated.
"Indeed, the Third Circuit has expressed that there is no error in 'choosing to rely on the objective evidence from the public equity and debt markets,'" the Delaware court stated, quoting from Campbell Soup. See also "Market Price Used To Reject Fraudulent Conveyance Challenge To Leveraged Spin," Commercial Restructuring & Bankruptcy Alert, January 2008, Vol. III, No. 2, p. 1 (discussing Campbell Soup in more detail).
The Delaware court concluded that eToys was solvent at the time of its final payment to AOL in November. The court further found that although the company was insolvent in February when it terminated its agreement with AOL, eToys lost nothing of value from termination of the agreement, and therefore was not entitled to recovery.
New York Ruling
The eToys holding is in line with a similar conclusion by a federal bankruptcy court in New York last year.
In August, the U.S. Bankruptcy Court for the Southern District of New York concluded that the market price of a company's stock is the most reliable valuation to determine whether disputed transfers were avoidable. See Statutory Committee of Unsecured Creditors of Iridium v. Motorola, Inc. (In re Iridium Operating LLC) 373 B.R. 283 (Bankr. S.D.N.Y. Aug. 31, 2007). See also, "New York Court Follows Third Circuit on Valuation," Commercial Restructuring & Bankruptcy Alert, January 2008, Vol. IV, No. 1, p. 11 (discussing Iridium in more detail).
This article is presented for informational purposes only and is not intended to constitute legal advice.