Anglo-American fraudulent transfer law originated in 1571 with the Statute of Elizabeth, which nullified any transfer that was consummated with the intent “to delay, hinder or defraud creditors and others of their just and lawful actions, suits, debts. . . .” As Borowitz and Hahn describe in The Troubled Leveraged Buyout: Risks (and Opportunities) Under Fraudulent Conveyance and Other Creditors’ Rights Laws (PLI Course Handbook Ser. No. 649, 1989), the quintessential Elizabethan fraudulent conveyance would involve the fast action of a sheep farmer, who, having been warned that the sheriff was about to descend on his flock to enforce a creditor’s writ, would hastily ship his sheep over to his brother’s pasture. Further, the shepherd could not “sell” his flock to his brother for a single shilling, and then claim to have no assets with which to satisfy his debts. Similarly, it would be unfair for the same shepherd to sell his flock for a fair price and then, having received less than the sum total of his debts, proceed to allocate such funds to the benefit of certain creditors and to the detriment of other creditors. In Max Sugarman Funeral Home, Inc. v. A.D.B. Investors, 926 F.2d 1254, 1254 (1st Cir. 1991), the court said that “[t]he policy underlying [U.S. Bankruptcy Code] §548 [on fraudulent conveyance] is to protect creditors against the depletion of a bankruptcy estate through transfers of the debtor’s interests in property taking place within one year before the bankruptcy petition was filed.” After the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) was signed into law in April 2005, the change to a two-year look-back period became effective on, and is applicable to cases commenced on or after, April 20, 2006.
When a company becomes insolvent, it can seek protection against creditors’ attempts to commence, enforce, or appeal actions and judgments, judicial or administrative, for the collection of a claim that arose prior to the filing of the bankruptcy petition. The U.S. Bankruptcy Code exists to provide for a fair allocation of the debtor’s assets among its creditors, and to protect those creditors from a debtor that may wish to allocate its assets in an unfair or preferential manner. In seeking such fairness, the court-appointed trustee is authorized to avoid any payments made by the debtor during the 90 days prior to filing as preferential to certain outside creditors or other interested parties (and to the detriment of the remaining creditors), and to bring that value back into the estate. This places the onus on the creditor receiving such a payment to show it was not preferential.
Beyond the 90-day preferential period, the trustee can look as far as two years back (and possibly even longer) for transfers of assets from the debtor estate that can be deemed fraudulent (either actually or constructively) and recoverable by the estate. Under section 548, a conveyance of assets from the debtor’s estate may be fraudulent (and, therefore, subject to avoidance) if the debtor knowingly or unknowingly
made the transfer to hinder, delay, or defraud a creditor; or
received less than a reasonably equivalent value in exchange for such transfer or obligation;
1. was insolvent on the date that such transfer was made or became insolvent as a result of the transfer;
2. was left with an unreasonably small capital;
3. intended or believed it would incur debts that would be beyond the debtor’s ability to pay as such debts matured; or
4. made such transfer to or for the benefit of an insider, or incurred such obligation to or for the benefit of an insider, under an employment contract, and not in the ordinary course of business.
Each of the conditions 1, 2, and 3 above suggests one of the three generally applied tests for solvency: the balance sheet test, the test for adequate capitalization, and the test of the transferor’s ability to pay its debts. These three tests for insolvency are generally allied. However, they are not identical and often give different answers as to whether and when the debtor became insolvent. For instance, even though the company passes the balance sheet test (i.e., the fair market value of assets exceeds liabilities), cash generated from operations may not be sufficient to meet current obligations (say, for the next year or so), and the company may already be too leveraged to access capital markets. As such, it may not have the ability to maintain sufficient liquidity to pay its debts as they come due. Further, companies need to be adequately capitalized so that they can withstand a reasonable range of business and economic fluctuations.
Economically, the solvency tests play an important role in credit and other capital markets.
Limitations on a firm’s activities based on solvency tests—embedded in laws such as fraudulent transfer law, preference law, and the law of fiduciary duties—allow a borrower to increase its debt capacity ex ante by protecting creditors ex post from actions that make it less likely that the firm will pay its debts. Creditors who know that such limits are in place are willing to lend more money to the firm in the first place. Firms would have little or no debt capacity if there were no controls on their power to intentionally reduce their ability to pay debts after they have borrowed money.
J.B. Heaton, Solvency Tests (Sept. 2006 draft).
The Balance Sheet Test
The “balance sheet” test gets its name from the first condition listed above, that the debtor was insolvent on the date that such transfer was made or became insolvent as a result of the transfer. The Bankruptcy Code’s own definition characterizes insolvency as a balance-sheet-related measure because “insolvent” is defined as the “financial condition” such that the sum of an entity’s debts “is greater than all of such entity’s property, at a fair valuation. . . .” 11 U.S.C. § 101(32)(A). The first thing to understand is that the balance sheet contemplated in this test will most likely bear little or no resemblance to the company’s balance sheet prepared in accordance with generally accepted accounting principles (GAAP). As a result, the fact that a company’s GAAP balance sheet indicates positive book or equity value is insufficient to support a finding of solvency. Analysis of financial statements as well as key financial ratios is necessary. This, however, often will not be sufficient to assess the company’s ability to generate cash flow from operations in the future, continue as a going concern, or access capital markets to fund operations and growth. Economic analysis of markets, opportunities available to the putative debtor, competition, availability of costly production inputs, access to capital, and a host of other factors that drive the debtor’s business will be necessary.
The Entity’s Debts
The sum of an entity’s debts becomes the benchmark against which the value of assets will be measured. Debts are measured at their face value for the balance sheet test. See, e.g., Hanna v. Crenshaw (In re ORBCOMM Global L.P.), 2003 Bankr. LEXIS 759, at *8 (Bankr. D. Del. June 12, 2003). This usually does not present a problem as most companies carry liabilities at their face value for reporting purposes. There are some important exceptions.
The Financial Accounting Standards Board (FASB) issued FAS 159 (The Fair Value Option for Financial Assets and Financial Liabilities) in February 2007. Currently incorporated in the new GAAP Codification ASC 825, this fair value option permits an entity to choose to measure at fair value many financial instruments, including certain liabilities. The fair value of a liability is defined as “the price that would be paid to transfer the liability in an ‘orderly’ transaction between market participants at the measurement date.” The original rule also states that the fair value of a liability should reflect the “non-performance risk” relating to that liability. Obviously, writing down the value of liabilities due to an entity’s inability to perform would ensure that liabilities could never be valued in excess of assets and no firm could fail the balance sheet test of insolvency. In the case where a company makes the FAS 159 election to carry liabilities at fair value, the balance sheet test would require their presentation at face value.
GAAP rules for contingent liabilities do not always require financial statements to reflect—or even disclose—the existence of a possible contingency. Only where contingent liabilities are probable or measurable, or both, are they recognized in financial statements, either through actually booking the liability or by disclosing its existence in footnotes to the financial statements. For solvency purposes, all contingent liabilities are included for the balance sheet test, discounted for their probability of occurrence.
Property at a Fair Valuation
In performing the balance sheet test, the entity’s property (i.e., its assets) must be presented at a fair valuation. Typically, fair market value methodologies are applied—including income, market, and asset approaches. (See Heaton, supra; Briden v. Foley, 776 F.2d 379, 382 (1st Cir. 1985) (bankruptcy code definition of insolvency applied in preference case is a “balance sheet test” that “focuses on the fair market value of the debtor’s assets and liabilities within a reasonable time of the transfers”). This is necessary because insolvency is an economic condition (contrasted with “bankruptcy,” which is a legal concept) that must be identified in the context of an individual entity’s access to capital and its ability to generate cash flow from operations in the future. Understanding this is essential to the application of the tests for insolvency. Experts must bring considerable economic, business valuation, finance, and accounting acumen and resources to thoroughly analyze many company-specific factors as well as market and industry factors. Their valuations must consider the following:
the nature of the business,
the markets in which it operates,
the availability of product substitutes,
potential for market entry by competitors,
relative bargaining power of suppliers and customers,
the general economic outlook for those markets and industries, and
other factors specific to the circumstances.
“While discounted cash flow valuation is only one of the three ways of approaching valuation, and most valuations done in the real world are relative valuations, it is the foundation on which all other valuation approaches are built.” Aswath Damodaran, Investment Valuation: Tools & Techniques for Determining the Value of Any Asset (2d ed. 2002). In other words, the value of business assets in a going concern is the present value of cash flows those assets can generate into the future. This stream of cash flows is what the acquirer of a business is buying. Accordingly, relative valuation approaches like the market approach and consideration of various multiples can be seen as just another way of estimating the present value of expected future cash flows.
As much as possible, cash flow forecasts must go beyond simple historical extrapolation techniques and incorporate quantitative examinations of how one variable (e.g.,revenues) can be statistically explained by other independent market variables (e.g.,cost and availability of production, labor, and capital inputs; market demand; competition; availability of substitutes). Also, cash flows differ from profits in many ways. Prominent among these is the fact that cash flow forecasts to equity holders incorporate non-income statement items like capital expenditures and the repayment of debt principal. Therefore, a negative present value of cash flows to equity holders indicates a condition where cash flows generated by business operations are insufficient to support operating expenses, capital expenditure needs, and long-term debt service. In other words, insolvency.
In most cases, valuing an entity’s assets assumes the entity will continue as a going concern. A current definition of the going-concern assumption can be found in the AICPA Statement on Auditing Standards No.1, Codification of Auditing Standards and Procedures § 341 (The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern) (AU Section 341). The “going concern” concept assumes that the business will remain in existence long enough for all the assets of the business to be fully utilized. In other words, there is an assumption that the individual assets working together with a trained production and sales staff in situ will be worth more than liquidating assets individually. However, this is not always the case. There are times when the highest and best use of the entity’s assets is to liquidate them in an orderly fashion. In fact, various business valuation standards (e.g., the Uniform Standards of Professional Appraisal Practice, or USPAP) require valuation analysts to incorporate this highest-and-best-use concept into their valuations.
This brings up an interesting point. While, in most cases, going-concern value exceeds liquidation value, this is not always the case. However, consider a circumstance where a debtor can show that, even though on the date of the transfer the company was going-concern insolvent, the value of the group of individual assets—if liquidated in an orderly fashion—exceeded the value of liabilities. Would it be appropriate to allow a firm to make gratuitous transfers of assets to the detriment of creditors just because the entity may be liquidation solvent? Obviously not. Creditors’ decisions to advance funds in the first place would certainly be affected by the awareness that the company to which those funds were being advanced could not continue as a going concern and that creditors’ only remedy in the case of the borrower’s default would be limited to what might be available under a liquidation.
Return on Assets
Discounted cash flow analyses forecast all cash flows into the future. Among the more difficult issues is the timing and amount of capital expenditures needed in the future to support the levels of production and sales being forecast. A very common assumption in many discounted cash flow valuations is that capital expenditures offset depreciation in stable growth. When combined with the assumption of no working capital changes, this translates into zero reinvestment. While this may be a reasonable assumption for a year or two, it is not consistent with the assumption that operating income will grow in perpetuity. See Damodaran, supra, ch. 14. One way to test whether appropriate assumptions on capital expenditures are being made is to monitor return on assets (ROA) over the discounted cash flow model forecast period. ROA calculates the ratio of annual earnings divided by total assets. It provides a measure of how efficiently management is using total investment in assets. Without appropriate assumptions on capital spending into the future, ROA will grow (often unreasonably) as earnings into perpetuity continue to grow.
In a leveraged buy-out, the cost of acquiring the assets of another company is entails significant amounts of debt (loans, bonds, etc.), with the debt often collateralized by the assets themselves. This debt-heavy capital structure impacts the company’s cost of capital. (See the discussion in two articles published in the Spring and Summer 2012 issues of this newsletter, “A Primer on Discount Rates” (May 30, 2012), and “A Primer on Discount Rates Continued” (Aug. 21, 2012)). The cost of debt is often an amalgamation of interest on bank loan facilities, interest on bond issuances, effective interest rates on operating leases, and even returns on equity offerings that have the characteristics of debt (e.g., preferred shares on which dividends are participating and cumulative). The cost of equity, on the other hand, is the equity holder’s opportunity cost of capital for making this particular investment (i.e., forgoing the opportunities to make other investments). Debt instruments have the benefit of contractual terms and a priority on a business’s earnings for their return. In other words, interest expense must be paid to creditors before equity holders get any share of a business’s earnings. Because this can make debt investments less risky, the cost of debt is often less than the cost of equity. As a result, using the insolvent entity’s own cost of capital can be misleading. If the valuation exercise is to determine in part what a willing hypothetical buyer would pay for the entity’s assets, then the hypothetical acquirer’s capital structure must be assumed. Often, analyzing most likely acquirers’ capital structures reveals a bit more balance between debt and equity capital. This results in a higher discount rate and a correspondingly lower present value of future cash flows.
Because the U.S. Bankruptcy Code definition of “insolvent” prescribes a comparison of asset and liability values, the balance sheet test is usually performed first. As we discussed, there are some important differences in the way the balance sheet test is performed and the balance sheet of the entity as part of its financial statements under GAAP. Also, as we will discuss in subsequent articles, the ability-to-pay test and the capital adequacy test are just as important in determining whether a company was or was not solvent on the date of a transfer.
Keywords: bankruptcy and insolvency litigation, fraudulent transfer, insolvency, tests for insolvency, balance sheet test, 11 U.S.C. § 548, discounted cash flow, going concern, liquidation value, ability to pay, adequate capital, reasonably equivalent value, discount rate, cost of capital