February 15, 2012 Articles

Measuring Reasonably Equivalent Value

This article is the first in a four-part series addressing the complex issues bankruptcy professionals encounter when dealing with fraudulent conveyance claims and other issues related to analyzing solvency.

By Jeffrey L. Baliban

This article is the first in a four-part series addressing the complex issues bankruptcy professionals encounter when dealing with fraudulent conveyance claims and other issues related to analyzing solvency.

In analyzing whether transfers of property by a debtor may be fraudulent under 11 U.S.C. section 548 and subject to claw back by the trustee, most practitioners focus on the solvency of the debtor at the time of the transfer. To be sure, whether the debtor was insolvent at the time of the transfer in question or rendered insolvent as a result thereof is crucial, but an equally important issue in fraudulent transfer analysis is whether or not the debtor received reasonably equivalent value in exchange for the property transferred. “The cardinal feature of a constructively fraudulent transfer is that the debtor/transferor makes a transfer but receives ‘less than reasonably equivalent value in exchange for such transfer.’ 11 U.S.C. § 548(a)(1)(B)(i).” (Michael D. Fielding, Tri-Party Transactions & the Avoidance Powers [KC-1561411-1].) Where assets are transferred prebankruptcy and reasonably equivalent value is received in exchange, creditors are not perceived to have been harmed and there is no constructive fraud. While there is much information on general valuation, very little is written on what exactly constitutes reasonably equivalent value.

The present law of fraudulent conveyances has ancient roots. Section 548 is derived from the Statute of 13 Elizabeth passed by parliament in 1571. The statute was aimed at a practice by which overburdened debtors placed their assets in friendly hands thereby frustrating creditors’ attempts to satisfy their claims against the debtor. After the creditors had abandoned the effort to recover on their claims, the debtor would obtain a reconveyance of the property that had been transferred. Such transactions operated as a fraud against the debtor’s creditors because the debtor’s estate was depleted without exchanging property of similar value from which the creditors’ claims could be satisfied. (Mellon Bank N.A. v. Metro Communc’ns, Inc., 945 F.2d 635, 644–45 (3d Cir. 1991)).

Obviously, transfers made by a debtor with actual intent to hinder, delay, or defraud a creditor can be avoided under section 548. However, so can transfers made—voluntarily or involuntarily—by a debtor that was insolvent or rendered insolvent when the transfer was made where less than reasonably equivalent value was received in exchange for the transfer. While value is defined in section 548(d)(2)(A) as “property or satisfaction or securing of a present or antecedent debt of the debtor,” there is no definition in the code for reasonably equivalent value. Of course, “one does not need to review years of often conflicting jurisprudence to immediately realize that the term ‘reasonably equivalent value’ is a murky concept subject to a variety of interpretations.” (Irina Fox, “Reasonably Equivalent Value” in section 548 Avoidance Actions: An Analytical Framework Post In re TOUSA, Inc.).

This issue was one of the big takeaways from the Bankruptcy Court’s order in In re TOUSA, which required lenders to disgorge $480 million as a fraudulent transfer, and in the District Court’s subsequent reversal of that order. In June 2005, TOUSA, Inc., a Florida homebuilder, entered into a joint venture known as the Transeastern JV to acquire certain homebuilding assets. The JV was funded by $675 million from various lenders (the Transeastern Lenders), and TOUSA and its affiliate Tousa Homes LP were guarantors on the financing. By September 2006, TOUSA was in default of the Transeastern credit agreements, with potential liability under various completion guarantees estimated to be in excess of $2 billion.

In June 2007, TOUSA and the Transeastern JV subsidiaries entered into a settlement, and Transeastern Lenders were to be paid $420 million. The settlement was funded by new loans from what came to be called the first and second lien term lenders. To obtain these new loans, TOUSA caused its subsidiaries, some of which had not been involved in the Transeastern JV at all (the conveying subsidiaries), to pledge assets as security. As a result, liens were placed on assets pledge by both TOUSA as well as the conveying subsidiaries, in exchange for what the first and second lien term lenders loaned $500 million to TOUSA, who then paid $426 million to the Transeastern Lenders. Within about six months, TOUSA and most of its subsidiaries filed for bankruptcy. The Official Committee of Unsecured Creditors brought an adversary proceeding on behalf of the conveying subsidiaries seeking to recover the Transeastern settlement funds. The committee argued that, because the conveying subsidiaries were not defendants in the Transeastern litigation, they did not receive reasonably equivalent value for funds paid to settle the Transeastern litigation.

The Bankruptcy Court agreed and held that amounts paid to the Transeastern Lenders were a fraudulent conveyance, in part because “the Conveying Subsidiaries did not receive reasonably equivalent value in exchange for the transfer [and] . . . did not receive either ‘property’ or the ‘satisfaction or securing of a present or antecedent debt of the debtor.’” (Opinion and Order on Appeals by Transeastern Lenders, Case No. 10-60017-CIV/Gold, p. 56 (citing 11 U.S.C. § 548(d)(2)(A)).) The Bankruptcy Court also found that defendants produced no evidence of indirect benefits that were tangible and concrete, or any quantification of value of such benefits with any reasonable precision.

Identifying Value
In its initial order, the Bankruptcy Court held that, under the language of section 548(a)(1)(B)(1), an indirect benefit is cognizable only if three requirements are satisfied. First, the benefit must be received, even if indirectly, by “the debtor,” [in this case] by an individual conveying subsidiary. Second, the “value” received must only encompass “property,” which is limited to some kind of enforceable entitlement to some tangible or intangible article. Third, property must have been received “in exchange for” the transfer or obligation, such that any “property that a Conveying Subsidiary would have enjoyed regardless of the [Settlement Transaction] cannot be regarded as property ‘in exchange for’ the transfer obligation.” (Opinion and Order on Appeals by Transeastern Lenders, Case No. 10-60017-CIV/Gold, p. 62–63 (citing 11 U.S.C. § 548(d)(2)(A))).

In his 113-page opinion overturning the Bankruptcy Court’s findings, the Hon. Alan S. Gold, U.S. District Court Judge, took issue with, among other things, the Bankruptcy Court’s finding, stating that “the record establishes beyond dispute that the Conveying Subsidiaries themselves, as compared to the TOUSA Parent, received indirect economic benefits, constituting reasonably equivalent ‘value’ in exchange for their lien transfers.” He further concluded that “the Bankruptcy Court committed legal error in holding that the ‘avoidance of default and bankruptcy by the Conveying Subsidiaries’ is as a matter of law ‘not property and not cognizable as value’ under Section 548 of the Bankruptcy Code.”

While it is certainly appropriate that valuation experts should leave matters of law to the court, they can help with matters of fact where quantifying value is concerned. Determining reasonably equivalent value where property is directly exchanged is usually straightforward, e.g., for each dollar transferred by the debtor a debt owed by the debtor is reduced. However, where benefits are received indirectly, determining their reasonable equivalence will not be so clear. “There is no bright line rule used to determine when reasonably equivalent value is given.” In re Lindell, 334 B.R. 249, 255 (Bankr. D. Minn. 2005); see also Creditors’ Comm of Jumer’s Castle Lodge, Inc. v. Jumer (In re Jumer’s Castle Lodge, Inc.), 338 B.R. 344, 354 (C.D. Ill. 2006). (Michael D. Fielding, Tri-Party Transactions & the Avoidance Powers [KC-1561411-1].)

First, the task is to determine whether value was received by the transferor; that is, any value at all. While section 548(d)(2)(A) refers to property in its definition of value, Judge Gold cautions that this must be construed “in its broadest sense, including cash, all interests in property, such as liens, and every kind of consideration including promises to act or forbear to act.” (Opinion and Order on Appeals by Transeastern Lenders, Case No. 10-60017-CIV/Gold, p. 67 (citing 11 U.S.C. § 548(d)(2)(A))). He points out that property is broadly defined to include all legal or equitable interests of the debtor.

In Segal v. Rochelle, 382 U.S. 375 (1966), the Supreme Court held that inchoate claims for [federal income tax] loss carryback refunds constituted property as that term is used in section 70a(5) of the Bankruptcy Act (pre-Bankruptcy Reform Act of 1978). The Court further stated that, in section 70a(5), the term property has been generously construed and does not exclude interests that are novel or contingent or where enjoyment must be postponed. One court cited the increased ability to borrow working capital, the general relationship between affiliates or ‘synergy’ within a corporate group as a whole, and a corporation’s ability to retain an important source of supply or an important customer as indirect benefits that may constitute value within the meaning of section 548. (Jumer’s Castle Lodge, Inc. v. Jumer (In re Jumer’s Castle Lodge, Inc.), 338 B.R. 344, 481 (C.D. Ill. 2006)). This can be widened to include any benefit that has economic value to the debtor because economic value connotes monetary value, even if it is not immediately actualized. (See Thomas J. Hall and Keith Levenberg, The Banking Journal, Volume 128, Number 8, September 2011.)

Measuring Reasonable Equivalence
Given that the overriding purpose of section 548 is the preservation of value for unsecured creditors, valuation of property/benefits received in a transfer should be analyzed from the creditors’ point of view. One way to assess the value of an economic benefit received is to estimate its fair market value. The fair market value is generally considered to be the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. United States v. Cartwright, 411 U. S. 546, 551(1973) (quoting from U.S. Treasury regulations relating to Federal estate taxes, at 26 C.F.R. sec. 20.2031-1(b)).

Because fair market value of an income-producing property is the present value of expected future cash flows––forecasted either through direct or relative methodologies––and because no two assets are identical, establishing fair market value in the absence of an actual transaction usually requires extensive analysis. Even in the case of there being an actual transaction where a buyer and seller agreed on a price, determining that such price was the result purely of a negotiated market auction process between a hypothetical buyer and seller (i.e., absent specific strategic or other non-economic motivations as in related-party transactions) is a fact-specific analysis. This is exacerbated where information is limited, as can often be in the case where property received in return for the transfer is stock in a new or privately held company.

In Cooper v. Ashley Commc’ns, Inc. (In re Morris Communications, Inc.), 914 F.2d 458 (4th Cir. 1990), the trustee filed an action to void a transfer of corporate stock by the debtor to defendant Ashley. At the time of the transfer, Ashley and Morris agreed on a value of $5,000 for the stock, which represented a 26 percent interest in C-PACT, a North Carolina corporation with no assets but organized for the purpose of filing an application for a cellular telephone license in the Charleston area with the FCC. The sale of the stock (i.e., the transfer date) took place in May 1984. At the time, C-PACT was one of 22 applicants for the FCC cellular license, which would have been awarded on a lottery basis. In September 1984, apprehensive of the chancy lottery award system, all 22 applicants agreed upon a partnership to merge all of their applications, creating a single applicant assured of being awarded the contract. Share prices of the individual applicants immediately rose.

The date of the transfer is the critical time at which value should be measured. The bankruptcy judge did find that the transfer was made in good faith between a willing purchaser and a willing seller at a price ($5,000) upon which the parties agreed at arm’s length. However, at the hearing, one expert persuaded the court that the stock would have been worth $50,000 at the transfer date between a knowledgeable buyer and a knowledgeable seller. Finding that the parties to the transfer were neither well-informed nor knowledgeable, the judge declared in his opinion that there had not been reasonable equivalence in this transfer. In reaching his dispositive conclusion, the bankruptcy judge stated that “[t]he word ‘value,’ in the [statutory] phrase ‘reasonably equivalent value’ means ‘fair market value,’ that is, what a willing purchaser with full knowledge would pay and what a willing seller would accept,” determinable as of the date of the transfer (i.e., May 17, 1984). He then went on to describe why he believed this would be $50,000 and not $5,000.

The court of appeals found that the bankruptcy judge was clearly erroneous in finding that the record supported by credible evidence a finding of $50,000 as the value of the debtor’s C-PACT stock on May 17, 1984; nor did the trustee sustain his burden of proof that the price paid by the defendant for the debtor’s C-PACT stock did not represent reasonable equivalence at the time of the transfer. In its opinion, the court of appeals makes some interesting statements about applying a fair market value standard to estimating reasonable equivalence:

Section 548 provides no definition to guide the Court in the application of the term “reasonably equivalent value.” Congress left to the courts the obligation of marking the scope and meaning of such term. In discharging this responsibility, the courts have considered a number of standards to be applied. All of the cases seem to agree that reasonable equivalence is not wholly synonymous with market value, even though market value is an extremely important factor to be used in the Court’s assessment of reasonable equivalence. This is obvious in the various formulations of the standards for reasonable equivalence as stated in the cases. Some courts, for instance, have suggested the application of a mathematical formula as a benchmark for such determination. One of the standards known generally as the mathematical formula originated in the setting of a foreclosure sale in Durrett v. Washington Nat'l Ins. Co., 621 F.2d 201 (5th Cir.1980), and was followed in Madrid v. Lawyers Title Ins. Co., 21 B.R. 424 (Bankr. 9th Cir.1982), affd. on other grounds, 725 F.2d 1197 (9th Cir.), cert. denied, 469 U.S. 833, 105 S.Ct. 125, 83 L.Ed.2d 66 (1984). Under this standard, a consideration less than 70% of the fair market value will normally not qualify as “reasonably equivalent value.” Durrett, supra, at 201. The rules to be applied in defining reasonable equivalence, as adopted by the later cases, however, take a less rigid approach and are most accurately summarized in Bundles v. Baker, 856 F.2d 815, 823-24 (7th Cir.1988). That decision rejects any fixed mathematical formula for determining reasonable equivalence and opts for the standard that “[r]easonable equivalence should depend on all the facts of each case,” an important element of which is market value. Such a rule “requires case-by-case adjudication [with fair market value of the property transferred] as a starting point.

914 F.2 at 466–467.

Another way to estimate economic value of indirect benefits to a transferor is to look at the impact such a transfer may have on its cost of capital. Fundamentally, cost of capital is the “expected rate of return that the market participants require in order to attract funds to a particular investment.” (Shannon Pratt and Roger Grabowski, Cost of Capital: Applications and Examples, Fourth Edition, 2010, p. 3.) It includes the interest rate a debt investor would require along with any other limits or constraints on amounts borrowed, often built into liquidity facilities as covenants. It also includes the rate of return an equity investor would require to invest. To the transferor, these various rates combine to form its cost of capital, i.e., the discount rate applied to forecasted future cash flows to state them at their present value. These required rates of return are inevitably tied to the anticipated level of risk of the investment. It, therefore, stands to reason that any transfer a debtor corporation may have made that improved its ability to generate cash flow, make its cash flows more consistent, or avoid the loss of cash flow could be viewed to have favorable impact on its cost of capital.

Examples of this favorable impact include Mellon Bank, N.A. v. Metro Commc’ns, Inc., supra, 945 F.2d 635. The debtor executed a guaranty and granted a security interest to the creditor that the court found put the debtor in the position to borrow needed working capital and continue as a going concern, avoiding an unviable increase in the debtor’s cost of capital. In Creditors’ Comm. of Jumer’s Castle Lodge, Inc. v. Jumer (In re Jumer’s Castle Lodge, Inc.), 338 B.R. 344 (C.D. Ill. 2006), the court found that the debtor received more in value than it transferred to its shareholder. According to the debtor, its new financial structure, as a result of the transactions, made it more attractive to investors and financiers, which also represents a favorable impact on cost of capital.

Jeffrey L. Baliban – February 15, 2012

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