Donald Rumsfeld might sum up a recent decision by Judge Isgur out of the United States Bankruptcy Court for the Southern District of Texas as follows: “We also know there are known unknowns; that it to say we know there are some things we do not know. But there are also unknown unknowns – the ones we don’t know we don’t know.” Little did we know that this sentiment could be applied to evaluating a company’s solvency in the context of a fraudulent transfer analysis.
In TTC Plaza, the chapter 7 trustee commenced an adversary proceeding alleging that certain prepetition transfers made by the debtor in March 2011 were fraudulent under section 24.006(a) of the Texas Business and Commerce Code. Judge Isgur held a trial on the threshold issue of whether the debtor was insolvent at the time of the March 2011 transfers. The definition of insolvency under Texas law is that “[a] debtor is insolvent if the sum of the debtor’s debts is greater than all of the debtor’s assets at a fair valuation.” This definition closely mirrors the Bankruptcy Code’s definition in section 101(32) of the Bankruptcy Code, which defines insolvency as a “financial condition such that the sum of [the] entity’s debts is greater than all of [its] property, at a fair valuation.”
Judge Isgur summarized the Fifth Circuit standard for assessing fair value as being determined “by estimating what the debtor’s assets would realize if [the assets] were sold in a prudent manner” under the “market conditions” present on “the date of the challenged transfer.” Although the debtor’s March 2011 balance sheet showed the debtor’s assets exceeded its liabilities, the chapter 7 trustee argued, and Judge Isgur ultimately agreed, that the assets listed on the March 2011 balance sheet were overvalued and that the debtor was actually insolvent at the time of the transfers. In addition to a number of receivables on the March 2011 balance sheet that the chapter 7 trustee was able to demonstrate the debtor had no real prospect of collecting, the chapter 7 trustee pointed to the eventual postpetition April 2012 sales price for the debtor’s primary asset, a piece of real property, to argue that the value of the property as listed on the debtor’s March 2011 balance sheet should be reduced for purposes of the solvency determination. Although the eventual buyer of the property was originally willing to purchase the property at an amount near the value listed on the debtor’s March 2011 balance sheet, the sales price ended up being reduced after a neighbor refused to grant the buyer ingress/egress rights over its land to permit access to the property from a second road. Lack of access from a second road required the buyer to reduce the scope of its planned project for the property and forced the chapter 7 trustee to lower the sales price.
In determining the proper valuation to give to the property for purposes of the insolvency question, Judge Isgur held that “[t]he best evidence of the fair market value of the property as of March 2011 [was] . . . the purchase price obtained for the property in 2012.” Even though the ingress/egress problem was not discovered until the property was sold, Judge Isgur found it appropriate to use the 2012 sales price (which factored in the ingress/egress problem) to determine the March 2011 value of the property, because the ingress/egress problem nonetheless existed at the time of the transfers. Judge Isgur went on to note that the defendant did not present any evidence to demonstrate that the chapter 7 trustee obtained less than fair market value from the sale of the property or that any changes to the real estate market occurred between March 2011 and April 2012 “that would have affected the fair market value of the property.”
At first glance (but as we shall see, only at first glance), Judge Isgur’s willingness to use hindsight to consider facts unknown to the debtor and the transferees at the time of the allegedly fraudulent transfers appears to be a departure from the standard in certain other districts. For instance, in Iridium Operating, Judge Peck rejected the use of hindsight in “valuing a company’s pre-bankruptcy assets.” In Iridium, Judge Peck held that the market value of a startup company (that had yet to commence commercial operation) as determined by the value of its publicly traded securities at the time of certain allegedly fraudulent transfers was the best indicator of value. Judge Peck refused to use hindsight to factor into the valuation the fact that once the startup company commenced operations, it was an immediate commercial failure that never turned a profit and quickly fell into chapter 11. Judge Peck held that the market value as determined contemporaneously with the allegedly fraudulent transfers was the best indicator of value even if it turned out to “be an unreliable indicator of future fair market value” in hindsight.
Although one judge seemingly was willing to use hindsight and the other was not, Judge Peck and Judge Isgur’s decisions, upon closer examination, are actually complementary. The following passage from Judge Peck’s Iridium opinion demonstrates how the two decisions may be reconciled:
When determining the value of a company’s assets prepetition, it is not improper hindsight for a court to attribute “current circumstances” which may be more correctly defined as “current awareness” or “current discovery” of the existence of a previous set of circumstances. Such value, however, must be determined as of the time of the alleged transfer and not at what assets turned out to be worth at some time after the bankruptcy intervened.
The key distinction is between facts used to make a valuation that turned out to be wrong and facts that were present at the time of the transfers but were left out of an earlier valuation because they were unknown. In Iridium, Judge Peck relied upon a contemporaneous market valuation that reflected the value of the company as determined by the market with full knowledge of the factors that ultimately led to Iridium’s demise. Market participants were aware of the factors when determining the value of Iridium, but didn’t fully appreciate how fatal those factors were to the future business prospects of Iridium. In TTC Plaza, on the other hand, the valuation on the March 2011 balance sheet did not account for the ingress/egress problem at all even though the problem existed (albeit unknown to the parties to the transfers) at the time of the transfers.
Thus, when reading the two cases together, a hindsight rule begins to take shape. It is inappropriate to use hindsight to second guess a valuation made with full information even if such valuation turns out to be overly optimistic about future prospects (we might consider these the known unknowns). It is appropriate to use hindsight, however, when a fact that results in a lower valuation of the property and existed at the time of the transfer, but was not factored into the valuation because it was unknown to the debtor, is later uncovered (these are the unknown unknowns). Put simply, courts are unwilling to second guess valuations made with full information, but are willing to factor in newly introduced information that was left out of a valuation even if it was unknown to the parties at the time of the transfer.
Thus, when conducting a solvency analysis in connection with evaluating fraudulent transfer risk, as Rumsfeld famously cautioned, it’s not necessarily the “known unknowns” that you need to worry about, but the “unknown unknowns.”