On September 30, 2014, in In re SemCrude, L.P.,1 the United States District Court for the District of Delaware, affirming the Bankruptcy Court’s decision, held that direct partnership distributions by debtor SemGroup, L.P. (the “Debtor”) and indirect partnership distributions by its general partner, SemGroup G.P., L.L.C., to certain limited and general partners could not be avoided as constructive fraudulent transfers. The District Court rejected the argument of the trustee of the SemGroup Litigation Trust (the “Trustee”) that the Debtor’s line of credit should not be allocated significant value because the Debtor’s risky options trading activity violated the terms of its credit agreement and, therefore, the Debtor was left with unreasonably small capital after the distributions were made.
The Debtor was a “midstream” energy company that provided transportation, storage, and distribution of oil and gas products to oil producers and refiners. More than one hundred lenders formed a syndicate (the “Bank Group”) that provided the Debtor with a line of credit from 2005 through July 2008 under a credit agreement dated as of October 18, 2005 (the “Credit Agreement”).
The Debtor traded options on oil-based commodities in connection with its business, using a risky trading strategy that was inconsistent with the terms of the Credit Agreement. There were no allegations that the Debtor concealed its activities or engaged in fraud. Between July 2007 and February 2008, the Debtor had to post large margin deposits on the options it sold, which forced the Debtor to increase its borrowing under the Credit Agreement from approximately $800 million to over $1.7 billion. In July 2008, the Bank Group declared the Debtor in default of the Credit Agreement, leading the Debtor to file a voluntary petition for relief under chapter 11 of the Bankruptcy Code on July 22, 2008. There was no evidence of record that the Bank Group declared a default due to the Debtor’s risky options trading activity in contravention of the terms of the Credit Agreement.
Prior to the bankruptcy filing, the Debtor made two equity distributions totaling more than $55 million to Ritchie SG Holdings, L.L.C., SGLP Holding, Ltd., and SGLP US Holding, L.L.C. (collectively, “Ritchie”) in August 2007 (the “2007 Distribution”) and in February 2008 (the “2008 Distribution”).
The Trustee sought to avoid the 2007 Distribution and 2008 Distribution as constructive fraudulent transfers under section 548(a)(1)(B) of the Bankruptcy Code, as well as Oklahoma state law, based on two theories: (1) the Debtor was left with unreasonably small capital after both distributions and (2) the Debtor was insolvent on the date of the 2008 Distribution. The Bankruptcy Court granted summary judgment denying the claim based on unreasonably small capital and denied the claim based on insolvency after trial. The Trustee appealed to the District Court.
District Court Analysis
Unreasonably Small Capital Claim
Pursuant to section 548(a)(1)(B) of the Bankruptcy Code, a trustee may seek to avoid any transfer of an interest of the debtor in property if the debtor received less than reasonably equivalent value in exchange for such transfer and, among other grounds, (a) was insolvent on the date of such transfer or became insolvent as a result of such transfer or (b) was engaged, or was about to engage, in business or a transaction for which any property remaining with the debtor was an unreasonably small amount of capital. The District Court turned first to whether the Debtor was left with unreasonably small capital after the 2007 Distribution and 2008 Distribution. Following the leading Third Circuit decision in Moody v. Security Pacific Business Credit, Inc.,2 the District Court noted that “unreasonably small capital” denotes a financial condition short of equitable insolvency and refers to the inability to generate sufficient profits to sustain operations. In addition, “the test for unreasonably small capital is reasonable foreseeability.”3 In Moody, the Third Circuit ruled that it was proper for the district court in that case to consider the availability of credit in determining whether the debtor was left with unreasonably small capital, but that “[t]he critical question is whether the parties’ projections were reasonable.”4 The Third Circuit also commented that to “strike a proper balance” under the “reasonable foreseeability” test, courts are to take into account that there are many reasons why businesses fail and that fraudulent conveyance laws “are not a panacea for all such failures.”5 The District Court further noted that “there must be a causal relationship between the [fraudulent transfers] and the likelihood that the Debtor’s business will fail. . . . A debtor’s later failure, alone, is not dispositive on this issue.”6
The District Court wrote that while no cases were found that addressed the factual scenario at present, consistent with Moody, it is proper to consider the availability of credit in determining whether a company has been left with unreasonably small capital after a distribution, and that there was no dispute that at the time of the 2007 Distribution and 2008 Distribution, the Debtor had a substantial line of credit under the Credit Agreement.
The District Court next turned to the Trustee’s argument that the Debtor was left with unreasonably small capital after the distributions because “it was reasonably foreseeable that [the Debtor] would be unable to sustain its operations due to its massive breach of the Credit Agreement” and the likely termination of the credit facility provided thereunder. The District Court found that it was not clear from the record whether the Bank Group was aware of the Debtor’s risky options trading activity that could have been deemed to be inconsistent with the Debtor’s obligations under the Credit Agreement. In rejecting the Trustee’s argument, the District Court found that it would be required to engage in multiple levels of forecasting to accept the Trustee’s position. Specifically, the court would be required to 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 the bankruptcy.”7 The District Court noted that such a speculative exercise is not rooted in existing case law and affirmed summary judgment against the Trustee on the fraudulent conveyance claims based on the allegation of unreasonably small capital.
The District Court then turned to the issue of whether the 2008 Distribution was a fraudulent transfer based on the theory that the Debtor was insolvent at the time of the 2008 Distribution. The District Court began by noting that although the Trustee had the burden to prove insolvency, on appeal the Trustee offered very little insight into the Trustee’s expert’s approach to valuation and, instead, focused only on alleged errors committed by Ritchie’s expert. The District Court also noted that Ritchie’s expert used an income approach to valuation because the Debtor was a going concern at the time of the 2008 Distribution, which was preferable to the asset approach used by the Trustee’s experts. Ritchie’s expert valued the equity cushion at between $670 million and $2.7 billion at the time of the distribution.
The District Court further commented that judging the credibility and reliability of witnesses at trial is within the exclusive purview of the trial judge. Since Ritchie’s expert used the preferred valuation method and presented cogent rationales for its conclusions, the District Court found no error in the Bankruptcy Court’s entry of judgment after trial in favor of Ritchie in connection with the fraudulent transfer claim based on alleged insolvency.
The District Court’s decision is an important reminder that in determining whether a debtor had unreasonably small capital to support a fraudulent transfer claim, a court’s analysis must be based on reasonable foreseeability at the time of the transaction in question regarding whether the debtor would be able to continue to generate sufficient cash flow to sustain its operations and carry on its business after the transaction. As part of that analysis, the court should take into account the debtor’s foreseeable line of credit projected as of that time. As the District Court cautions, courts should not base an unreasonably small capital determination on subsequent facts not reasonably anticipated at the time of the transaction, such as the speculative possibility that lenders will terminate lines of credit due to the debtor’s conduct. Although it may be tempting for a judge to consider the fact that a line of credit was actually terminated at a later time, the District Court warns that courts must resist such hindsight bias when determining whether the debtor had unreasonably small capital at an earlier time.