Contents

There are a number of sources of fraudulent transfers law. These sources include: (i) the Bankruptcy Code (11 U.S.C. §548); (ii) the Uniform Fraudulent Transfer Act ("UFTA") (enacted into law in Pennsylvania at 12 Pa. C.S.A. §§5101 - 5119, effective February, 1994); (iii) the Uniform Fraudulent Conveyance Act ("UFCA") (previously located in Pennsylvania at 39 P.S. §§ 351 - 363, repealed by the enactment in Pennsylvania of the UFTA); (iv) the Statute of 13 Elizabeth Ch. 5 (1570) (replaced by the enactment in Pennsylvania of the UFTA); and (v) the common law of fraudulent transfers as derived from the principles underlying 13 Eliz. ch.5 (replaced by the enactment in Pennsylvania of the UFTA except to the extent the case involves the disposition of property that does not constitute an asset as defined in the UFTA).

The pre-UFTA law in Pennsylvania remains applicable for transactions occurring prior to the effective date of the UFTA. Furthermore, the UFTA does not purport to cover the whole law of voidable transfers. Various provisions in the Uniform Commercial Code and the Business Corporation Law, among other bodies of law, that refer to voidable transfers remain in effect.

Notwithstanding the many different sources of fraudulent transfers law, they all "boil down" into essentially four different ways a transaction may be attacked. The four lines of attack are as follows:

(A) that the transfer was intentionally fraudulent;
(B) that the transfer was in "reckless disregard" of the effect it would have on the debtor's ability to service its debt;
(C) that the transfer left the debtor with unreasonably small assets for the continuation of its business; and
(D) that the transfer was made while the debtor was insolvent or which caused the debtor to become insolvent.

(A) Intentional Fraud

An intentionally fraudulent transfer is defined as a: "transfer" made, or obligation incurred with the actual intent to hinder, delay or defraud any creditor of the debtor. The statutory authority for the avoidability of an intentionally fraudulent transfer includes: 11 U.S.C. §548(a)(1) (Bankruptcy Code); 12 Pa.C.S.A. §5104(a)(1) (Pennsylvania UFTA); and §7 of the UFCA.

There is seldom extrinsic evidence of intent. Courts use what are referred to as "badges of fraud" as circumstantial evidence of fraudulent intent. The badges of fraud, as set forth at 12 Pa.C.S.A. §5104(b), are as follows:

(1) the transfer was to an insider;

(2) the debtor retained possession or control of the property transferred after the transfer;

(3) the transfer or obligation was not disclosed and/or otherwise concealed;

(4) the debtor had been sued or threatened with a suit before the transfer was made or the obligation incurred;

(5) the transfer was of substantially all the debtor's assets;

(6) the debtor absconded;

(7) the debtor removed or concealed assets;

(8) the value of the consideration received by the debtor was not reasonably equivalent to the value of the asset transferred or the amount of the obligation incurred;

(9) the debtor was insolvent or became insolvent shortly after the transfer was made or the obligation was incurred;

(10) the transfer occurred shortly before or after a substantial debt was incurred; and

(11) the debtor transferred the essential assets of the business to a lienor who transferred the assets to an insider of the debtor.

(B) "Reckless" Fraud

Note that "reckless" fraud is not a term that appears in the cases or literature. It does appear to be descriptive of this particular line of attack.

A "recklessly" fraudulent transfer is defined as a transfer where: (1) the debtor received less than a reasonably equivalent value in exchange for such transfer or obligation; and (2) the debtor intended to incur, or believed or reasonably should have believed that it would incur, debts beyond its ability to pay as the debts became due. The statutory authority for the avoidability of a recklessly fraudulent transfer includes: 11 U.S.C. §548(a)(2)(B)(iii) (Bankruptcy Code); 12 Pa.C.S.A. §5104(a)(2)(ii) (Pennsylvania UFTA); and §6 of the UFCA.

This method of attack can be referred to as reckless since it requires, as an element, some showing of either intent or recklessness (i.e., proceeding with the transfer in reckless disregard of the consequences). Note, however, it is not necessary to establish a specific intent to hinder or delay creditors.

As pointed out in the Comment to § 5104, the tests of §§5104(a)(2)(i) (pertaining to unreasonably small assets) and (ii) (pertaining to intention or reasonable belief), should be viewed as addressing slightly different aspects of the same fundamental inquiry, i.e., whether the debtor is, and on a continuing basis will be, able to pay its debts as they become due. Committee Comment 4 (1993) to §5104. The determination of whether a debtor knew, or should have known, it would be unable to pay its debts will ordinarily turn on the reasonableness of the projections of future cash flow on which the debtor relied in proceeding with the transaction.

A "recklessly"fraudulent transfer can be avoided by both present creditors (i.e., those in existence when the fraudulent transfer occurred), and future creditors (i.e., those that extend credit to the debtor after the transfer).

(C) Constructive Fraud - Unreasonably Small Assets

A constructively fraudulent transfer leaving the debtor with unreasonably small assets is defined as a transfer where: (1) the debtor received less than a reasonably equivalent value in exchange for such transfer or obligation; and (2) the debtor was engaged or was about to engage in a business or a transaction for which its remaining assets were unreasonably small in relation to the business or transaction. The statutory authority for the avoidability of a constructively fraudulent transfer leaving a debtor with unreasonably small assets includes: 11 U.S.C. §548(a)(2)(B)(ii) (Bankruptcy Code); 12 Pa.C.S.A. §5104(a)(2)(i) (Pennsylvania UFTA); and §5 of the UFCA.

A constructively fraudulent transfer leaving a debtor with unreasonably small assets can be avoided by both present creditors (i.e., those in existence when the fraudulent transfer occurred), and future creditors (i.e., those that extend credit to the debtor after the transfer).

There are 3 key issues that arise under this aspect of fraudulent conveyance law:

(1) is the transfer within the applicable statute of limitations;

(2) did the debtor receive reasonably equivalent value in exchange; and

(3) was the debtor left with unreasonably small assets capital in light of the business or transaction in which it was to engage.

(D) Constructive Fraud - Insolvency

A constructively fraudulent transfer leaving the debtor insolvent is defined as a transfer where: (1) the debtor received less than a reasonably equivalent value in exchange for such transfer or obligation; and (2) the debtor was insolvent on the date that such transfer was made or such obligation was incurred, or became insolvent as a result of such transfer or obligation. The statutory authority for the avoidability of a constructively fraudulent transfer leaving a debtor insolvent includes: 11 U.S.C. §548(a)(2)(B)(i) (Bankruptcy Code); 12 Pa.C.S.A. §5105 (Pennsylvania UFTA); and §4 of the UFCA.

A constructively fraudulent transfer leaving a debtor insolvent can be avoided only by present creditors under the Pennsylvania UFTA (i.e., those in existence when the fraudulent transfer occurred).

There are 4 key issues that arise under this aspect of fraudulent conveyance law:

(1) is the transfer within the applicable statute of limitations;

(2) is there currently a creditor whose debt has remained outstanding since the date of the transfer;

(3) did the debtor receive reasonably equivalent value in exchange; and

(4) was the debtor insolvent at the time of the transfer, or rendered insolvent as a result of the transaction.

The statute of limitations is often an issue in a fraudulent transfer case. Creditor awareness of the transfer (or in the case of reckless or constructive fraud the effect of the transfer) generally occurs some time after the transfer. Accordingly, one of the first questions that must be asked in evaluating a potential cause of action is whether it would be barred by some statute of limitations.

It seems that more often than not, particularly in the case of LBOs, the event which puts creditors on notice of the transfer (or the effect of the transfer) is a bankruptcy filling. There are two ways of attacking a potentially fraudulent transfer under the Bankruptcy Code: §548 and §544.

11 U.S.C. §548 is the bankruptcy avoidance statute. As indicated above, its language essentially mirrors the UFTA. Under §548, the transfer, in order to be avoidable, must have occurred within one year of the bankruptcy filing.

As long as the transfer occurred within one year of the bankruptcy filing, the complaint can be filed anywhere within two (2), and perhaps as long as three (3), years after the bankruptcy is filed. This additional period to initiate the action under the Bankruptcy Code arises out of the language of 11 U.S.C. §546.

For bankruptcy cases initiated after October 22, 1994, §546 provides that avoidance actions may not be commenced after the earlier of:

(a) two (2) years after the entry of the order for relief, plus up to one (1) extra year after the appointment of a trustee provided the trustee was appointed before the end of the initial two (2) year period; or

(b) the time the case is closed or dismissed.

See 11 U.S.C. §546(a), amended October 22, 1994. Accordingly, under the amended §546, the longest the trustee would have to initiate a preference action is 3 years after the filing provided that the trustee was appointed before the initial two year period ended. A debtor would, at most, only have two years.

For transfers occurring more than one year prior to the bankruptcy, 11 U.S.C. §544 might be available. Section §544 gives the trustee (or debtor-in- possession in a Chapter 11 or debtor in a Chapter 12 or 13) the right to avoid any transfer of an interest of the debtor in property that is voidable under applicable law (i.e., state law) by an unsecured creditor. This creates another statute of limitations issue, that being which controls, the state statute of limitations or 11 U.S.C. §546. It appears that most courts that have analyzed the conflict have concluded that as long as the state statute of limitations for bringing the avoidance action has not expired prior to the bankruptcy filing, the trustee (or debtor) has the time provided under §546 to bring the action. See, e.g., Glosser v. S & T Bank (In re Ambulatory Medical & Surgical Health Care, Inc.), 187 B.R. 888, 900-01 (Bankr. W.D. Pa. 1995); Tabas v. Maloney (In re Florida West Gateway, Inc.), 182 B.R. 595 (Bankr. S.D. Fla. 1995); In re Mahoney, Trocki and Associates, Inc., 111 B.R. 914 (Bankr. S.D. Cal. 1990); and Owen W. Katz, Statutes of Limitation in Bankruptcy, Pittsburgh Legal Journal, August 9, 1994. The rationale for this conclusion is that a §544 action is not a prepetition cause of action belonging to the debtor which would be controlled by §108(a), but rather is an action belonging the the bankruptcy estate which is created by bankruptcy law and therefore controlled by §546.

Finally, there is the matter of the applicable state statute of limitations. For cases subject to pre-UFTA law, the statute of limitations (absent any equitable tolling) is two years from the transfer (except in cases involving transfers to insiders in which case the limitation period is arguably six years). Under the Pennsylvania version of the UFTA, at 12 Pa.C.S.A. §5109, the statute of limitations is as follows:

(1) with respect to intentionally fraudulent transfers, it is four (4) years after the transfer was made or the obligation incurred or, if later, within one year after the transfer or obligation was or could reasonably have been discovered; or

(2) with respect to quasi-constructive fraud or constructive fraud, it is four (4) years after the transfer was made or the obligation was incurred.

(A) Generally

The determination of this element is normally straight forward. Usually it is simply a matter of comparing the value of what was transferred with what was received. See, e.g., Shape, Inc. v. Midwest Engineering (In re Shape, Inc.), 176 B.R. 1 (Bankr. D. Me. 1994) (payment of $70,000 for stock worth more than $1.5 million lacks reasonably equivalent value).

The UFTA does not provide a clear definition of reasonably equivalent value in exchange. To the extent that the statute is modeled after §548 of the Bankruptcy Code, the definition of that phrase in the Code would seem to be relevant.

The courts evaluating reasonable equivalence under §548 of the Bankruptcy Code utilize a totality of the circumstances test under which the good faith of the purchaser, whether the parties were dealing at arms length, and the relationship of price paid to the fair market value, are all considered. In re Morris Communications N.C., Inc., 914 F.2d 458 (4^th Cir. 1990). While the cases do not discuss the relative weight of the factors, common sense dictates that the relationship of price to fair market value will be accorded the greatest weight. See, e.g., BFP v. Resolution Trust Corporation, 511 U.S. 531, 114 S.Ct. 1757, 128 L.Ed.2d 556 (1994) (observing that in most cases, the traditional common law notion of fair market value is the benchmark for determining reasonably equivalent value).

(B) In the Context of LBOs

LBOs create particular "equivalency" problems. The target in an LBO generally receives no direct benefit from the payment to the selling shareholders. Parties defending LBOs will therefore typically rely on the argument that the target (i.e., debtor) received indirect consideration as a result of the transaction. Arguments of indirect benefit include better management (management led LBO), tax benefits from paying debt rather than dividends (LBO involving public company), and synergies (if LBO involves a combination of companies). See James F. Queenan, Jr., The Collapsed Leveraged Buyout and the Trustee in Bankruptcy, 11 Cardoza L. Rev. 1, 8-13 (1989).

In evaluating whether reasonably equivalent value has been given the debtor courts should consider indirect benefits. Mellon Bank, N.A. v. Metro Communications, Inc., 945 F.2d 635, 646 (3d Cir. 1991). In Metro Communications the Third Circuit reversed a Bankruptcy Court's finding that reasonably equivalent value was not given by a debtor which had been subject to an LBO because the Bankruptcy Court had failed to consider the debtor's alleged increased ability to borrow money after the LBO (as result of the guarantees of its new shareholders), and/or the alleged synergy created by the joinder of the debtor with its new parent. Cf., Rubin v. Manufacturers Hanover Trust Co., 661 F.2d 979 (2d Cir. 1981), and Gannett v. Falkner (In re Royal Crown Bottler, Inc.), 23 B.R. 28 (Bankr. N.D. Ala. 1982) (both discussed in the Queenan article, both holding that the identity of business interests between target (i.e., debtor) and the purchaser (or other recipient of the value) does not constitute an indirect benefit; instead there must be some quantifiable economic benefit which can be compared to the amount of assets transferred (or debt incurred)).

It appears that increased efficiencies, synergies, greater access to additional funds, etc., which increase the value of the debtor (by increasing the free cash flow which can be generated in the future or increasing the valuation multiple (or decreasing the discount rate)), can make up for the lack of direct benefit provided by the former shareholders. In a manner of speaking, in determining indirect benefit, the entire transaction is collapsed so that any increase in value of the debtor as the result of its association with its new owner(s) is considered.

In another case, Official Committee of Unsecured Creditors of Phar-Mor, Inc. v. Action Industries, Inc. (In re Phar-Mor, Inc., Securities Litigation), 185 B.R. 497 (W.D. Pa. 1995), it was held that $75 million paid to shareholders pursuant to a tender offer made part of a $200 million equity infusion was not avoidable because the net effect of the entire transaction was not to deprive the debtor of $75 million, but rather to provide it with the $125 million remaining from the $200 million after the tender offer was effected. The court held that the $75 million paid to the shareholders, without which the other $125 million would not have been invested in the company, was reasonably equivalent.

The indirect benefits must be somehow measured and then compared to the obligations that the debtor incurred. Metro Communications, 945 F.2d at 647. Here, as well as in determining insolvency under §548(a)(2)(B)(i), it is appropriate to take into account intangible assets not carried on the debtor's balance sheet, including, among other things, goodwill in determining the value of the debtor. Id. Realizable commercial value is, however, different from accounting goodwill. Thus, goodwill (as defined by GAAP as the amount paid for assets in excess of their fair market value) will not necessarily constitute something that constitutes realizable commercial value. Bay Plastics, Inc. v. BT Commercial Corp. (In re Bay Plastics, Inc.), 187 B.R. 315 (Bankr. C.D. Cal. 1995).

Note that new management, alone, no matter how capable, seems to outside of the range of benefits which can be considered sufficient. See, e.g., Moody v. Security Pacific Business Credit, Inc., 127 B.R. 958, 993 (W.D. Pa. 1991), and cases cited therein. This seems consistent with the concept that the indirect benefit must have some realizable commercial value. New management does not, alone, ordinarily bring anything new to the debtor other than management technique. While a superior management can, over time, create value, it is not something which can, alone, ordinarily be borrowed against or otherwise be valued. It seems that in order to constitute sufficient consideration, the benefit must be something which could not otherwise have been accomplished without the buyout (or other transfer), and is capable of being reduced to some dollar value by an impact on free cash flow, valuation multiple, or assets. Accordingly, financial LBOs (i.e., LBOs done solely to cash out shareholders or to provide an investment for the new shareholders) may be more at risk than strategic LBOs (i.e., LBOs involving some strategic rationale on the part of the purchaser). See also Leonard v. Norman Vinitsky Residuary Trust (In re Jolly's, Inc.), 188 B.R. 832, 842-45 (Bankr. D. Minn. 1995) (holding that there was no benefit to corporate debtor in granting blanket liens to a creditor who had claims against the shareholders of a closely held company and had been secured by the stock of the closely held company even though, the creditor would have become the new owner of the company through execution on the stock).

IV. DEFINING INSOLVENCY FOR PURPOSES OF CONSTRUCTIVE FRAUD

(A) Insolvency as defined by the Pennsylvania UFTA and Bankruptcy Code

Under Pennsylvania's version of the UFTA (12 Pa.C.S.A. §5102), the general rule is that a debtor is insolvent if at fair valuations, the sum of the debtor's debts is greater than all of the debtor's assets. This is derived from the definition of insolvency in the Bankruptcy Code. See Committee Comment 1 (1993) to §5102.

The definition is different from that which had been used in the UFCA. Under the UFCA, insolvency was based on the "fair salable value of assets." The UFTA Comment indicates that the definitions in the UFTA and UFCA may be interpreted differently and, therefore, decisions under the UFCA are not necessarily persuasive. Unlike the UFCA which may have confused balance sheet insolvency with equitable insolvency, the UFTA makes clear that the test is "balance sheet." Furthermore, under the UFTA, the assets are not necessarily valued at their present salable values (i.e., at a present liquidation which was, arguably the standard under the UFCA), but rather at "fair value" which requires the method of valuation to be driven by the circumstances at the time of the transaction.

Under the UFTA and Bankruptcy Code, different bases of valuation may be appropriate depending upon the circumstances, and different methods of determining value on any particular basis may be appropriate depending upon the business engaged in by the debtor and other factors. See Committee Comment 1 (1993) §5102. For a debtor which is a business enterprise, valuation on the basis of continuation of the business by the debtor as a going concern ordinarily would be the appropriate basis of valuation if, at the time as of which the valuation is made, it reasonably would be expected that the enterprise will continue as a going concern. Id. In such a case, appropriate values may be ascribed to goodwill and to nonassignable licenses, franchises, contracts and rights. Id. Often it would be appropriate not to attempt to determine the value of separate assets and debts, but rather to determine only the "enterprise value" representing the aggregate difference between the debtor's assets and debts. Id. Enterprise value should be determined by methods appropriate under the circumstances which can include the capitalization or discounted cash flow ("DCF") methodology. Id. Even if it is appropriate to value on a liquidation basis, this may mean carving up the company into smaller going concern units (where the company can be so carved up) rather than a piecemeal forced liquidation. In any event, the GAAP balance sheet, while a starting point for the analysis, is not dispositive of value.

Vadnais Lumber Supply, Inc. v. Byrne (In re Vadnais Lumber Supply, Inc.), 100 B.R. 127, 131-32 (Bankr. D. Mass. 1989), discussing the proper standard of valuation to be applied in the determination of solvency under the Bankruptcy Code, appears to be an example of what is intended by the UFTA. As set forth in Vadnais Lumber, the proper standard of valuation is the value of the business as a going concern, not the liquidation value of its assets less its liabilities, provided that the business was a going concern at the time of the transfer. On the other hand, liquidation value is appropriate if, at the time of the transfer, the business is so close to shutting its doors that a going concern standard is unrealistic. In Vadnais Lumber the court found that although the business was weak after the transfer, the debtor was still able to continue its business operations without a bankruptcy for some period of time. Therefore, going concern was appropriate. See also, Moody v. Security Pacific Business Credit, Inc., 971 F.2d 1056, 1076-69 (3d Cir. 1992); In re Taxman Clothing Co., 905 F.2d 166, 169-70 (7th Cir. 1990)(under Bankruptcy Code avoidance action going concern value is proper method for determining solvency unless business is on its deathbed).

Valuation of debts should also take into account all relevant factors. Debt due in the future should be valued at its present value (which may be more or less than par depending on the coupon interest rate.) Contingent liabilities (including guarantees) should be discounted by the probability that such contingency will occur as well as the time value of money (if the contingency is to occur sometime in the future). It therefore appears that the most efficient valuation procedure would involve the determination of value of the enterprise on a debt free present value basis (using capitalization or DCF method), and then to subtract out the (expected present) value of debt to get a net (equity) value. If the net equity value is positive, the company is solvent.

(B) The creation of a rebuttable presumption of insolvency under the UFTA where debtor is not generally paying its debts

The UFTA, while utilizing a balance sheet test for insolvency as the general rule, uses equitable insolvency as a presumption of insolvency. As set forth in the UFTA (12 Pa.C.S.A. §5102(b)), a debtor who is generally not paying its debts as they become due is presumed to be insolvent. This presumption shall impose on the party against whom the presumption is directed the burden of proving that the nonexistence of insolvency is more probable than its existence.

The "general nonpayment" standard is fashioned on that utilized in the Bankruptcy Code for determining whether an order for relief should be entered in an involuntary bankruptcy (11 U.S.C. §303(h)(1)). See Committee Comment 2 (1993) to §5102 . As further set forth in the Comment, the presumption is established in recognition of the difficulties typically imposed on a creditor in proving insolvency in the "balance sheet" sense under §5102(a). In determining whether a debtor is paying its debts as they become due, the court should look at the number of creditors, the proportion of those debts not being paid, the duration of nonpayment, the existence of bona fide disputes, the debtor's payment history, etc. The Comment cited Hill v. Cargill (In re Hill), 8 B.R. 779 (Bankr. D. Minn. 1981) (nonpayment of three largest debts held to constitute general nonpayment although small debts were being paid); and In re All Media Properties, Inc., 5 B.R. 126 (Bankr. S.D. Tex. 1980) (missing significant number of payments or regularly missing payments significant in amount said to constitute general nonpayment, nonpayment for more than 30 days after billing held to establish nonpayment of debt when it is due). General nonpayment does not require a showing that a majority in number and amount of debts is not being paid, rather it is fact specific depending on circumstances.

(C) Insolvency as defined by the UFCA.

Insolvency, under the UFCA, as it had developed under Pennsylvania law, had two components: insolvency in the bankruptcy or balance sheet sense (negative net worth); and insolvency in the equity sense (inability to pay debts as they mature.) Moody v. Security Pacific Business Credit, Inc., 971 F.2d 1056, 1064 (3d Cir. 1992). Under the Pennsylvania case relied upon by the Third Circuit in Moody:

A reasonable construction of the [UFCA §4] indicates that it not only encompasses

insolvency in the bankruptcy sense, i.e., a deficit net worth, but also includes a condition wherein a debtor has insufficient presently salable assets to pay existing debts as they mature [i.e., insolvency in the equity sense]. If a debtor has a deficit net worth, then the present salable value of his assets must be less than the amount required to pay the liability on his debts as they mature. A debtor may have substantial paper net worth including assets which have a small salable value, but which if held to a subsequent date could have a much higher salable value. Nevertheless, if the present salable value of assets are less than the amount required to pay existing debts as they mature the debtor is insolvent.

Under the balance sheet part of the test, the Third Circuit held that the standard was the "going concern" value of the enterprise unless liquidation was imminent, thus following Vadnais Lumber, Taxman Clothing, etc. Satisfaction of the balance sheet test would not, however, end the inquiry under the UFCA §4 since, as pointed out by Larrimer, a company may have a positive net worth but, because of the nature of that net worth, be insolvent in an equitable sense.

The analysis of the "equitable insolvency" aspect of the test created an additional complexity. As observed by the Third Circuit in Moody, the relationship between equitable insolvency for purposes of §4 of the UFCA, and unreasonably small capital for purposes of §5 of the UFCA, was unclear. The Third Circuit concluded that the better view was that unreasonable small capital denotes a financial condition short of equitable insolvency, citing Murphy v. Meritor Sav. Bank (In re O'Day Corp.), 126 B.R. 370, 407 (Bankr. D. Mass. 1991) (unreasonably small capitalization need not be so extreme a condition of financial debility as to constitute equitable insolvency), Vadnais Lumber, 100 B.R. at 137 (unreasonably small capitalization ... encompasses difficulties which are short of insolvency in any sense but are likely to lead to insolvency at some point in the future).

As will be discussed below, under the "small capital" provision of the UFTA (12 Pa.C.S.A. §5104(a)(2)(i)), the court considers what the recipient of the value from the debtor should reasonably have known (based on projections) about the future. By comparison, equitable insolvency in §5102(b) (where it creates a presumption), looks into the extent to which the debtor was actually paying debts presently due at or about the time of questioned transfer. See Committee Comment 4 (1993) to §5104 (regarding distinction between equitable insolvency as presumption under §5102(b) for purposes of establishing §5105, and the incurring of debts beyond an ability to pay as used §§5104(a)(2)(i) and (ii)). Accordingly, whether the Third Circuit correctly defined the relationship between the two concepts under the UFCA, under the UFTA the distinction is the time during which the cash flow problems must manifest itself. Of course, this can still be reconciled with the Third Circuit view. A company with cash flow problems at or immediately after a transfer is likely also left with unreasonably small capital to continue the business. On the other hand, a company may be left with adequate assets to meet current obligations, but have insufficient resources to survive forseeable events in the future.

The Third Circuit in Moody went on to consider the equitable insolvency and unreasonably small capital questions together. Since the Third Circuit had decided that unreasonably small capital denotes a financial condition short of equitable insolvency, it becomes unnecessary to consider whether the debtor was rendered equitably insolvent if the court determines that the capital with which the debtor was left was adequate.

V. DEFINING UNREASONABLY SMALL ASSETS (CAPITAL) FOR PURPOSES OF CONSTRUCTIVE FRAUD

(A) Unreasonably small assets under the UFTA.

UFTA §5104(a)(2)(i) is an adoption of UFCA §5, except for the substitution of "unreasonably "small assets]" in relation to the business or transaction for "unreasonably small capital." Committee Comment 4 (1993) to § 5104. The drafters thought the reference to "capital" in the UFCA was ambiguous in that it has certain meanings in a corporate sense that is different from the term "asset." Id. Assets are defined in the UFTA as property of the debtor other than: (1) property to the extent it is encumbered by a valid lien; (2) property to the extent it is generally exempt under nonbankruptcy law; or (3) an interest in property held in tenancy by the entireties to the extent it is not subject to process by a creditor holding a claim against only one tenant. 12 Pa.C.S.A. §5101(b).

(B) Relationship between use of projections to value a business for purposes of "insolvency" and to determine whether the debtor was left with "unreasonably small assets"

As observed in Alemante G. Selassie, Valuation issues in Applying Fraudulent Transfer Law to Leveraged Buyouts, 32 Boston College L. Rev. 377, 426-28 (1991), while "insolvency" and "unreasonably small assets" are separate tests of constructive fraud, the manner in which they are applied in the LBO context suggests a synthesis. This synthesis arises out of the court's willingness to determine solvency under a going-concern value standard by a capitalization of earnings (or DCF) unless the company is on its deathbed at the time of the transaction and then to essentially use the same projections of earnings (or cash flow) to determine the adequacy of capital/assets. Generally, it would seem, if the projections reflect solvency, they would also reflect adequate capitalization.

To the extent a distinction can (or perhaps should) be drawn, it may arise out of focus of the analysis. The solvency question may turn not only on the reasonableness of the earnings and/or cash flow projections, but also the appropriate capitalization multiple and/or discount rate used to determine value. The adequacy of the capital (or assets) question on the other hand, turns on the actual period to period projected cash flow. Of course, when you get right down to it, if a company cannot service its debt as that debt becomes due it is likely to have no (or negative) present value. Alternatively, if the company can service its debt for the foreseeable future and have some amount of free cash flow left over, it will likely have some positive net equity value regardles of what capitalization multiple, discount rate, or other valuation methodology is used.

(C) Determining the reasonableness of projections

To evaluate whether a debtor will be able to pay its debts as they become due it may be necessary to prepare financial projections for the debtor. If such financial projections show that the debtor will be able to pay its debts as they become due on a continuing basis, the debtor should be deemed to satisfy §5104(a)(2)(i) (as well as the "reasonably should have believed" test under §5104(a)(2)(ii)), provided such financial projections were reasonable. Reasonableness of the projections is, in turn, a function, of, among other things, the reasonableness of the assumptions on which the projections were based. Id. As further set forth in the Comment to the Pennsylvania UFTA:

The debtor should not be responsible as a matter of hindsight for developments that could not reasonably have been foreseen at the time of the transfer. "[T]he question the court must decide is not whether [the] projection was correct, for clearly it was not, but whether it was reasonable and prudent at the time it was made." Credit Managers Association of Southern California v. Federal Co., 629 F.Supp. 175, 184 (C.D. Cal. 1985). Among other matters, appropriate weight should be given to the likelihood that maturing debts will be refinanced where, on the basis of the debtor's financial condition and future prospects and the general availability of credit to debtors similarly situated, it is reasonable to assume that such refinancing may be accomplished; appropriate weight should be given to the debtor's ability to pay debts by disposing of fixed assets or other transactions outside the ordinary course of business; and appropriate allowance should be made for reasonably foreseeable contingent obligations as they become absolute.

In the case of a proposed LBO, the preparation of projections is critical. Richard Lieb and Robert Feinstein in LBO Litigation, Financial Projections, and the Chapter 11 Plan Process, 21 Seton Hall L. Rev. 598, 603-623 (1991). Lieb and Feinstein observed that the generation of the projections was essential in both structuring the LBO transaction and selling the "deal" to lenders. They further observed that the quality of the projections were only as good as the assumptions on which they were based. In determining the adequacy of projections and their underlying assumptions, Lieb and Feinstein suggest a bipartite inquiry:

(i) were the assumptions underlying the projections fairly made, and grounded on the prior and current experience of both the company and other companies in the same field of business in which the company engaged; and

(ii) was there a failure to factor into the projections all of the risks or other circumstances that had a foreseeable impact on the future revenue and income of the enterprise.

Also within the concept of the importance of prior and current experience is the debtor's success in meeting prior projections. In re Allegheny International, Inc., 118 B.R. 282 (Bankr. W.D. Pa. 1990), illustrates this point. The issue in Allegheny International was the proper discount from the market earnings multiple to be used to value the stock of the reorganized company. The testimony relied upon by the court called for a 25% to 30% discount. In accepting this discount, the court observed that any lower discount did not fully consider the fact that the debtor consistently failed to meet its projections prior to and since the filing of the bankruptcy. See also In re Embers 86th Street, Inc., 184 B.R. 892, 900-01 (Bankr. S.D.N.Y. 1995) (finding that a restaurant debtor's projections failed to provide adequate assurance of ability to cure lease arrearages where its current results were worse than that projected, and the improvement in operating results were to be based on a strategy of increasing prices while at the same time reducing the quality of its services and the size of its servings).

With respect to the second aspect of the suggested bipartite inquiry, the question is whether the causes of the financial difficulty experienced by the target could reasonable have been foreseen. A number of cases have directly, or indirectly, wrestled with that question.

(1) Credit Managers Association

Credit Managers Association of Southern California v. Federal Co., 629 F. Supp. 175 (C.D. Cal. 1986), involved a failed LBO. The lender had predicted that the debtor would have sufficient cash flow to fund operations. The projections turned out to be wrong and were attacked on the basis of reliance on faulty assumptions.

The court observed that the question was not whether the lender's projections were correct, for they clearly were not, but rather whether the projections were reasonable and prudent at the time they were made. The court found that the projections turned out to be wrong because of two unforseeable events - the shut down of one of the debtor's customers, leaving the debtor with substantial excess inventory; and a three month strike against the debtor beginning shortly after the LBO was consummated. The court therefore found that the projections were reasonable and prudent when made.

The rule of Credit Managers is that a finding of sufficient capital/assets may be supported by a cash flow projection that erroneously predicted there would be sufficient cash, so long as it is shown that the projection was prudently prepared at the time of the transaction and that it indicated that the business was left with sufficient resources to meet all future contingencies and eventualities to the extent they could reasonably have been foreseen.

(2) Moody v. Security Pacific

Moody v. Security Pacific Business Credit, 971 F.2d 1056 (3d Cir. 1992), affirming 127 B.R. 958 (W.D. Pa. 1991), began with the conclusion that the Credit Managers analysis appears to strike a proper balance between the interests of the participants to an LBO and their creditors. Businesses fail for reasons other than leveraged buyouts. Therefore, the test for unreasonably small capital/assets is reasonable foreseeability of problems which strain cash availability and whether the projections were reasonable. As stated by the Court:

Because projections tend to be optimistic, their reasonableness must be tested by an objective standard anchored in the company's actual performance. Among the relevant data are cash flow, net sales, gross profit margins, and net profits and losses. [Citation omitted.] However, reliance on historical data alone is not enough. To a degree, the 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. [Citation omitted.]

The Third Circuit concluded that the lower court had not erred in finding that the debtor's failure was caused by an unforeseeable dramatic decrease in sales due to increased foreign and domestic competition, rather than a lack of capital. Accordingly, the projections were not unreasonable.

(3) O'Day Corporation

Murphy v. Meritor Savings Bank (In re O'Day Corporation), 126 B.R. 370 (Bankr. D. Mass. 1991), involved a failed LBO where the court concluded that the projections relied upon by the lender had not been prudent.

The court in O'Day concluded that the projections generated by the lender were totally inconsistent with the historical operating results of the debtor. The projections assumed as a worst case scenario an EBIT which was well above the historical average (over the 5 year period preceding the year of the LBO). In other words, the projection was based on the assumption that in the worst case scenario the debtor would somehow match or exceed its best financial performance of the 5 years before the LBO.

The lender claimed that the ultimate causes of the bankruptcy were a variety of unpredictable, internal and external problems, such as poor management, bad marketing decisions, decline in the number of dealers and sales people, and the stock market crash of October 1987 (which the lender apparently alleged reduced the wealth of the debtor's customer base). The court found, however, that the labor problems, cost variances, and the cyclical nature of the industry which were the major contributors to the debtor's financial woes were manifest and readily predictable. Although not mentioned by name, the court essentially had found that the lender had failed both parts of the Lieb and Feinstein bipartite inquiry.

The lender had emphasized that the debtor had significant sums available to it under a revolver. The court responded that common sense dictates that an ability to borrow is not a substitute for operating profits. Implicit in that response is the conclusion that while an ability to borrow within an operating cycle is a factor in determining the adequacy of cash flow, there must also be an indication that there will be sufficient operating funds to repay the borrowings by the end of the cycle. The court further noted that the revolver would have been reduced to zero soon after the LBO had payments to the trade creditors not been stretched out.

VI. CONCLUSION

The surge in LBO transactions in the mid to late 1980s was followed by a surge in bankruptcy filings. The potential avoidability of LBOs as fraudulent transfers in a subsequent bankruptcy naturally became a hot topic. While the number of LBOs and bankruptcies have both decreased over the last couple of years, the significance of fraudulent transfer law has not. The case law generated as the result of the attempted avoidance of LBOs, as well as the adoption of the UFTA, remain important considerations in the structuring of any type of debt financed transaction, as well as the analysis of the legal rights of the creditors if the transaction is followed by a financial collapse.