In a decision last month in Whyte v. SemGroup Litig. Trust (In re Semcrude L.P.), No. 14-4356, 2016 U.S. App. LEXIS 7690 (3d Cir. Apr. 28, 2016), the United States Court of Appeals for the Third Circuit held that proving that a debtor was left with unreasonably small capital will not turn on either hindsight or a “speculative exercise” based on what might have happened if certain things were known at the time. Even though the decision was “not-precedential” since it was not issued by the full court, because it affirmed decisions of the bankruptcy and district courts, it is likely to have far-reaching significance in fraudulent conveyance litigation.

Under Section 548(a)(1)(B) of the Bankruptcy Code (and similar state-law fraudulent conveyance statutes), a transaction by a debtor may be set aside as constructively fraudulent if it can be proven that the debtor (i) received less than reasonably equivalent value in exchange, and (ii) was left with “unreasonably small capital” following, or according to some courts, as a result of the transfer. But what does “unreasonably small capital” actually mean? After all, the term is “is fuzzy, and in danger of being interpreted under the influence of hindsight bias.” Boyer v. Crown Stock Distrib., Inc., 587 F.3d 787, 794 (7th Cir. 2009).

In SemGroup, the litigation trustee (the “Trustee”) for the estate of SemGroup L. P. (“SemGroup”) sought to claw-back as fraudulent conveyances more than $55 million in distributions made to certain of SemGroup’s equity holders. SemGroup, then a very large “midstream” energy company, was party to a Credit Agreement with a syndicate of lenders (the “Bank Group”) under which it was prohibited from engaging in certain trading activity and insiders transactions. SemGroup nevertheless engaged in the prohibited actions, and between July 2007 and February 2008, a period during which oil prices were erratic and the company incurred significant losses, SemGroup increased its borrowings under its credit line from $800 million to more than $1.7 billion.

The Bank Group ultimately declared SemGroup in default under the Credit Agreement, but not specifically based on the alleged improper activity. SemGroup thereafter filed for bankruptcy in 2008 and successfully confirmed a plan of reorganization which established a litigation trust in order to pursue certain claims held by the SemGroup estate. The Trustee then commenced two adversary proceedings against various SemGroup equity holders in order to avoid the approximately $55 million that was distributed to them by SemGroup’s management prior to the bankruptcy filing.

It was undisputed that “no reasonably equivalent value was provided” by the equity holders for the challenged distributions. Therefore, what needed to be determined was whether, following those distributions, SemGroup was left with “unreasonably small capital.” Based on applicable Third Circuit precedent, in determining the existence of “unreasonably small capital,” the Third Circuit found that the bankruptcy court had properly considered the continuing availability of credit to SemGroup under the Credit Agreement after the challenged distributions were made. Thus, the sole issue in dispute was whether SemGroup would have been able to draw on its line of credit if the Bank Group had known of its alleged violations of the Credit Agreement.

In an earlier case, Moody v. Sec. Pac. Bus. Credit, Inc., 971 F.2d 1056, 1071 (3d Cir. 1992), the Third Circuit had ruled that “the test for unreasonably small capital is reasonable foreseeability.” Based on Moody, the Trustee argued that it was reasonably foreseeable at the time of the equity distributions that SemGroup would not have access to its line of credit because it was engaging in activities that violated the terms of the Credit Agreement. However, both the bankruptcy and district courts rejected the Trustee’s argument concerning continuing access under the Credit Agreement, since it “rested upon conjecture biased by hindsight.” In affirming summary judgment in favor of the equity holders on that aspect of the Trustee’s constructive fraudulent conveyance claims, the Third Circuit held that arguments based upon what the Bank Group would have done were an insufficient basis for proving that SemGroup had unreasonably small capital:

Absent 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. Telling in this regard is the fact that SemGroup’s trading strategy was not cited by the Bank Group when they declared a default under the Credit Agreement. As we observed in Moody, the test for unreasonably small capital holds debtors responsible “when it is reasonably foreseeable that [a company] will fail, but at the same time takes into account that ‘businesses fail for all sorts of reasons, and that fraudulent [conveyance] laws are not a panacea for all such failures.’” . . . In this case, the Trustee cannot show that SemGroup could reasonably foresee either that its trading strategy would fail or that the Bank Group would declare a default based upon that trading strategy. The Trustee presented no evidence that SemGroup tried to disguise its trading strategy from the Bank Group or acted deceptively. From SemGroup’s perspective, it was acting transparently vis-à-vis the Bank Group in connection with its trading strategy. Under these circumstances, it cannot be said that it was reasonably foreseeable that its capitalization was unreasonably small because it would lose its ability to draw upon its credit facility.

What are the implications of the Third Circuit’s SemGroup decision? The main “take-away” is that the bar for proving that a debtor was left with “unreasonably small capital” is high and will not be met with speculative arguments based on 20/20 hindsight. In particular, having access to credit sufficient to keep the business running – even if the lender had the right to stop lending, but did not, and the company lands in bankruptcy shortly thereafter – will likely be sufficient to defeat any such claim. More definitive evidence will be required to prove unreasonably small capital; for example, that that the lender knew about, and objected to, the debtor’s activity and was taking steps to curtail access to credit, or that the debtor was trying to hide its activities from the lender. What is clear is that, at least in the Third Circuit, it is not enough that the lender had the right to stop lending.