In the November/December 2014 edition of the Business Restructuring Review, we discussed a decision handed down by the U.S. District Court for the District of Delaware addressing the meaning of “unreasonably small capital” in the context of constructively fraudulent transfer avoidance litigation. In Whyte ex rel. SemGroup Litig. Trust v. Ritchie SG Holdings, LLC (In re SemCrude, L.P.), 526 B.R. 556 (D. Del. 2014), the district court upheld a bankruptcy court’s reaffirmation of two guiding principles in this context: (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. A three-judge panel of the Third Circuit Court of Appeals affirmed the decision in In re SemCrude, L.P., 2016 BL 135006 (3d Cir. Apr. 29, 2016).

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 immediately 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 Voidable Transactions Act (the “UVTA”), until 2014 known as the Uniform Fraudulent Transfer Act (the “UFTA”), and the Uniform Fraudulent Conveyance Act (the “UFCA”) that have been adopted by most states.

The UFTA (which currently is in force in 35 states, the District of Columbia, and the U.S. Virgin Islands) and the UVTA, which has been adopted by nine states, include 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)(i); UVTA § 4(a)(2)(i). The older UFCA, which remains in effect only 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 do the UFTA and the UVTA define “unreasonably small” assets. This has been left largely 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 insolvency.

Id. at 1070 (footnote omitted). 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. 2016).

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. The plan provided for, among other things, 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. The trustee alleged in the complaint, among other things, 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 district 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.” Once more, the litigation trustee appealed.

The Third Circuit’s Ruling

A three-judge panel of the Third Circuit affirmed in a nonprecedential ruling for substantially the same reasons articulated by the lower courts. Writing for the panel, circuit judge Thomas I. Vanaskie wrote that “[a]bsent the bias of hindsight, it simply cannot be said that SemGroup was likely to be denied access to a credit facility that had been in place while it was engaging in the allegedly improper trading strategy.” Under the circumstances, the judge explained, it cannot be said that it was reasonably foreseeable that SemGroup’s capitalization was unreasonably small because the company would forfeit the ability to draw on its credit facility.

The Third Circuit panel also briefly considered Ritchie’s argument that the rulings below should be affirmed because the indenture trustee failed to show a causal link between the equity distributions and the adequacy of SemGroup’s capitalization—i.e., that the distributions were the cause of undercapitalization. Judge Vanaskie acknowledged that “[t]here may be some force to this argument.” However, he concluded that the court need not resolve the question “because it cannot be shown that it was reasonably foreseeable at the time of the equity distributions that SemGroup would lack adequate access to capital.”

Outlook

Even though the Third Circuit’s ruling is not precedential, SemCrude provides important guidance in avoidance litigation involving constructively fraudulent transfers. 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 Third Circuit as well as the lower courts 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 Second Circuit recently handed down a ruling reaffirming these basic concepts in Adelphia Recovery Tr. v. FPL Grp., Inc. (In re Adelphia Commc’ns Corp.), 2016 BL 190083 (2d Cir. June 15, 2016). In Adelphia, the Second Circuit affirmed lower court rulings that the assets of defunct cable services provider Adelphia Communications Corp. (“Adelphia”) were not “unreasonably small” within the meaning of Pennsylvania’s version of the UFTA when Adelphia repurchased its stock in 1999.

The Second Circuit rejected Adelphia’s argument that the lower courts “improperly conflated” their analysis of Adelphia’s solvency with their analysis of the adequacy of the company’s capital. Concluding that the “unreasonably small” test focuses on reasonable foreseeability and that the test is met if the debtor shows it had such minimal assets that insolvency was “inevitable in the foreseeable future,” the Second Circuit determined that Adelphia’s legal argument was without merit.

In particular, the court concluded that, although insolvency and unreasonably small capital are analytically distinct, the concepts overlap and “adequacy of capital is typically a major component of any solvency analysis.” According to the Second Circuit, the lower courts analyzed Adelphia’s solvency separately from the adequacy of its capital and properly relied on some of the same key facts to support their findings on both of these issues.