Bankruptcy Litigation Committee

ABI Committee News

What Is a “Fair Valuation”?

In order for a trustee or debtor-in-possession (DIP) to recover a fraudulent transfer pursuant to §548 of the Bankruptcy Code (absent an actual intent to hinder, delay or defraud creditors), one key element that must be established is that the debtor was either insolvent on the date that such transfer was made or the obligation was incurred, or became insolvent as a result of such transfer or obligation. This article will examine what is involved in proving that the debtor was insolvent.

The term “insolvent” is defined in 11 U.S.C. §101(32). Although the definition of the term varies depending on whether the debtor is a partnership, municipality or other entity, in the case of any entity other than a municipality, the methodology by which a DIP’s property is to be valued in order to conduct an insolvency analysis is at a fair valuation. See 11 U.S.C. §101(32).1 This test is referred to as the “traditional bankruptcy balance sheet test of insolvency”. H.R. No. 100-11, 100th Cong. 2d Sess. 5-6 (1988).

The Two-Step Insolvency Analysis under the Balance-Sheet Test

Courts conduct a two-step analysis to determine whether a debtor is insolvent under the balance-sheet test.2 First, the court determines whether it is proper to value the DIP’s assets on a going-concern basis or a liquidation basis.3 Second, the court conducts its own fair valuation and assigns a value to the debtor’s assets and liabilities to see if the debts exceed the assets.4

In a liquidation analysis, the assets are valued based on what they would generate in a quick or distressed sale. A liquidation analysis is generally used by courts to determine the fair valuation of assets where the debtor is financially dead or mortally wounded as of the date of the transfer.5 A valuation on this basis is appropriate when liquidation was imminent when the debtor’s petition was filed.6 However, if the bankruptcy filing was not imminent on the date of the challenged transfer, the court must achieve a fair valuation of the debtor’s assets on a going-concern basis.7 Liquidation value will almost certainly be less than going-concern value. Therefore, the determination of whether or not a court uses a going-concern valuation can make or break a fraudulent-transfer case.

The most common formulation of the fair valuation standard for a going concern says that a fair valuation of an entity’s property refers to the amount of cash that could be realized from a sale of the property within a reasonable period of time.8 A reasonable period of time has been defined as the time that “a typical creditor would find optimal: not so short a period that the value of goods as substantially impaired via a forced sale, but not so long a time that a typical creditor would receive less satisfaction of its claim, as a result of the time value of money and typical business needs, by waiting for the possibility of a higher price.”9 The three approaches to determining the fair value of assets, liabilities and enterprises are the cost, market and income approaches.10 The cost approach values an asset by determining replacement cost, the market approaches bases fair value on the value ascribed by the relevant market, and the income approach bases value on projected incomes or cash flows discounted to present value.11

Under the going-concern approach, the total value of the assets should be reduced by the debts due and owing and the value of assets that are not readily susceptible to orderly sale.12 Additionally, contingent assets or liabilities should be included as part of the balance-sheet insolvency test.13 Further, going-concern value necessarily includes intangibles such as relationships with customers and suppliers, and the name, profile and reputation of the business.14 After determining whether the liquidation or going-concern value should be used, the court must consider the evidence and assign a final value to the debtor’s assets and liabilities and then subtract the debtor’s liabilities from its assets to determine whether the debtor was insolvent under the balance-sheet test.15

What Evidence Is Needed to Prove Insolvency?

The determination of the fair valuation of the debtor’s assets at a specific time is at best an inexact science, and may often be impossible.16 Courts often utilize the bankruptcy principles of retrojection and projection, which provide for the use of evidence of insolvency on a date before and after the transfer date as competent evidence of the debtor’s insolvency on the transfer date.17

The trustee or DIP has the burden of proof to establish that the debtor was insolvent at the time of the transfer.18 There is no generally accepted accounting principle for analyzing the insolvency of a company.19 Therefore, the trustee or DIP may meet its burden by expert testimony, financial statements, public documents, appraisals or a combination of these.20 Insolvency is a finding of fact that will only be reversed if there clear error.21

Courts have explained that in determining a debtor’s insolvency, a court must examine the actual values of the assets at the time of the transfer and not arbitrary values assigned by the debtor.22 Therefore, the debtor’s balance sheet will be of limited use in the analysis because financial statements only reflect the book value of assets.23

The majority view is that book value is an improper measure of a fair valuation of the debtor’s assets because an asset’s fair value may not be equivalent to its book value.24 However, the Second Circuit has explained that “while book values alone may be inappropriate as a direct measure of the fair value of property, such figures are, in some circumstances, competent evidence from which inferences about a debtor’s insolvency may be drawn.”25 Similarly, the First Circuit has held that unaudited financial statements may be admissible as the best available evidence and that it is for the trier of fact to assess the accuracy of such statements.26 The Fifth Circuit has similarly explained that “while the balance sheets alone may not be sufficient evidence to support an insolvency finding, they can provide, in some circumstances, competent evidence from which inferences about a debtor’s insolvency may be drawn.”27

When seeking to prove or disprove insolvency, counsel should obtain a qualified expert witness and be sure to make a complete record, including all available financial data that reflects the financial condition of the debtor, as close to the transfer date as possible.28

1 The Uniform Fraudulent Transfer Act, adopted by many states, contains the same fair valuation standard.

2 See Diamond v. Osborne, 102 Fed. Appx. 544, 548 (9th Cir. 2004); see also Union Bank of Switzerland v. Deutsche Financial Servs. Corp., 2000 WL 178278 at *9 (S.D.N.Y. Feb. 16, 2000).

3 See In re WRT Energy Corp., 282 B.R. 343, 369 (Bankr. W.D. La. 2001).

4 See id.

5 See Diamond v. Osborne, 102 Fed. Appx. 544, 548 (9th Cir. 2004); see also Langham, Langston & Burnett v. Blanchard, 246 F.2d 529, 532-33 (5th Cir. 1957); Mitchell v. Investment Secs. Corp., 67 F.2d 669, 671 (5th Cir. 1933) (stating that use of scrap or junk values is proper if the debtor, though nominally alive, is really dead on its feet on the date of the transfer).

6 See In re Helig-Meyers Co., 328 B.R. 471, 477 (E.D. Va. 2005).

7 See In re Trans World Airlines Inc., 134 F.3d 188 (3d Cir. 1998); see also WCC Holding Corp. v. Texas Commerce Bank-Houston, 171 B.R. 972, 984 (Bankr. N.D. Tex. 1994) (citing Moody v. Security Pac. Business Credit Inc., 971 F.2d 1056, 1067 (3d Cir. 1992)).

8 See, e.g., Travellers International AG v. Trans World Airlines Inc. (In re Trans World Airlines Inc.), 134 F.3d 188, 194 (3d Cir.), cert denied, 523 U.S. 1138 (1998); Lawson v. Ford Motor Co., 78 F.3d 30, 35 (2d Cir. 1996); In re Merry-Go-Round Enterprises Inc., 229 B.R. 337 (Bankr. D. Md. 1999) (“a fair valuation of an entity’s property refers to the amount of cash that could be realized from a sale of the property”).

9 Travellers International AG, 134 F.3d at 195; In re Roblin Indus. Inc., 78 F.3d 30, 35 (2d Cir. 1996) (“Fair value, in the context of a going concern, is determined by the fair market price of the debtor's assets that could be obtained if sold in a prudent manner within a reasonable period of time to pay the debtor's debts.”) (internal citations omitted); Lamar Haddox, 40 F.3d at 121 (stating that “fair value of property is … determined [not by arbitrary book values of assets but rather] by … ‘estimating what the debtor's assets would realize if sold in a prudent manner in current market conditions’”; equating fair value with fair market value at the time of the transfer); see, also, Langham, Langston & Burnett, 246 F.2d at 532 (quoting Mitchell v. Investment Securities Corp., 67 F.2d 669, 671 (5th Cir. 1933) (“One is insolvent under the statute when his assets, if converted into cash, at a fair not forced sale will not pay [his debts].”).

10 See Auditing Fair Value Measurement and Disclosures, app. At 28 (American Inst. of Certified Pub. Accountants 2003).

11 See, e.g., In re Am. Homepatient Inc., 298 B.R. 152, 174-75 (Bankr. M.D. Tenn. 2003); In re Exide Techs, 303 B.R. 48, *3 (Bankr. D. Del. 2003).

12 See Trans World Airlines, Inc., 134 F.3d at 194 (1st Cir. 1985) (quoting Briden v. Foley, 776 F.2d 379, 382 (1985)); Constructora Maza, Inc. v. Banco De Ponce, 616 F.2d 573, 577 (1st Cir. 1980) (“Reduction in the fair value of assets may be appropriate if those assets are not susceptible to liquidation, and thus cannot be made available for payment of debts, within a reasonable period of time"; discussing discounting of accounts receivable); Louisiana Nat. Life Assur. Society v. Segen, 196 F. 903, 905 (E.D. La. 1912) (same).

13 See, e.g., In re Worcester Quality Foods Inc., 152 B.R. 394 (Bankr. D. Mass. 1993) (stating that §101(32) requires the full amount of contingent liabilities to be included in solvency analysis and thus the full amount of debtor’s contingent lease commitments should be reflected on the liability side of the balance sheet); Covey v. Comm. Nat’l Bank of Peoria, 960 F.2d 657, 659-61 (7th Cir. 1992) (holding that contingent liabilities should be discounted for the probability that the contingency will occur and that the valuation after such discounting is made from the debtor’s perspective); Syracuse Engineering Co. v. Haight, 97 F.2d 573, 576 (2d Cir. 1938) (contingent subrogation and contribution rights must be valued as assets in determining solvency).

14 See 2 Heroy & Schaeffer, Valuation in Bankruptcy, PLI: 26th Annual Current Developments in Bankruptcy & Reorganization 155, 169 (2004).

15 See, e.g., Associated Painting Servs. Inc., 1993 WL 179423 (E.D. La. April 29, 1993) (reviewing trial court's fair valuation and insolvency calculations); see Pioneer, 147 B.R. at 892 (stating that ultimately, under the balance sheet test, “it is the actual, rather than the theoretical condition of the debtor which determines [insolvency]” at the time of the transfer).

16 See Hassan v. Middlesex County Nat’l Bank, 333 F.2d 838 (1st Cir.), cert denied, 379 U.S. 932 (1964).

17 See Gillman v. Scientific Research Products Inc. (In re Mama D’Angelo Inc.), 55 F.3d 552, 554 (10th Cir. 1995) (citing Porter v. Yukon Nat’l Bank, 866 F.2d 355, 357 (10th Cir. 1989), and In re Bellanca Aircraft Corp., 56 B.R. 339, 385 (Bankr. D. Minn. 1985), aff’d in relevant part, 850 F.2d 1275 (8th Cir. 1988).

18 11 U.S.C. §547(f) provides that “for the purposes of this section, the debtor is presumed to have been insolvent on and during the 90 days immediately preceding the date of the filing of the petition.” A presumption requires the party against whom the action is directed “to come forward with evidence to rebut or meet the presumption.” In re Emerald Oil Co., 695 F.2d 833, 838 (5th Cir. 1983) (quoting Fed. R. Evid. 301) (holding that creditor did not rebut presumption of insolvency during 90-day period prior to bankruptcy, where debtor rested on presumption and creditor presented a CPA who testified that it was possible debtor's assets exceeded its liabilities).

19 Arrow Electronics Inc. v. Justus (In re Kaypro), 218 F3d 1070 (9th Cir. 2000).

20 See, e.g., Mayer v. Blanchard, 1999 WL 777758 (E.D. La. Sept. 29, 1999) (it is proper to establish fair market value of an asset through compilation of expert testimony, balance sheets, financial statements, appraisals and other affirmative evidence); Pembroke Dev. Corp. v. Commonwealth Sav. & Loan Ass'n, 124 B.R. 398, 402 (Bankr. D. Fla. 1991) (holding that evidence such as appraisals or opinion testimony was required to establish actual fair market value vs. book value of real properties).

21 See In re Hechinger Investment Co. of Delaware, 147 Fed. Appx. 248, 250 (3d Cir. 2005); Orix Credit Alliance Inc., 40 F.3d at 120; In re Erstmark Capital Corp., 73 Fed. Appx. 79 (5th Cir. 2003) (unpublished opinion); In re DAK Indus. Inc., 170 F.3d 1197, 1199-1200 (9th Cir. 1999); see also In re Metro Communications Inc., 945 F.2d 635, 649 (3d Cir. 1991) (reversing bankruptcy court’s determination of insolvency); In re Taxman Clothing Co. Inc., 905 F.2d 166, 168 (7th Cir. 1990) (reversing bankruptcy court’s determination of insolvency where the court improperly used a liquidation value over a going-concern value).

22 See, e.g., Pioneer, 147 B.R. at 892.

23 See Lamar Haddox, 40 F.3d at 121.

24 See, e.g., In re WRT Energy Corp., 282 B.R. 343, 369 (Bankr. W.D. La. 2001) (“Book value may not be equivalent to fair market value.”); Lawson v. Ford Motor Co. (In re Roblin Indus. Inc.), 78 F.3d 30, 36 (2d Cir. 1996); Orix Credit Alliance Inc. v. Harvey (In re Lamar Haddox Contractor Inc.), 40 F.3d 118, 121 (5th Cir. 1994); Pembroke Dev. Corp. v. Commonwealth Sav & Loan Ass’n, 124 B.R. 398, 402 (Bankr. D. Fla. 1991) (holding that evidence such as appraisals or opinion testimony was required to establish actual fair market value vs. book value).

25 Lawson, 78 F.3d at 36.

26 See Consove v. Cohen (In re Roco Corp.), 701 F.2d 978 (1st Cir. 1983) (citing Braunstein v. Massachusetts Bank & Trust, 443 F.2d 1281, 1284 (1st Cir. 1971).

27 In re Erstmark Capital Corp., 73 Fed. Appx. 79 (5th Cir. 2003) (unpublished opinion) (citing Lawson, 78 F.3d at 36).

28 See Fed. R. Evid. 702; In re Nellson Nutraceutical Inc., 2006 Bankr. LEXIS 3186 (Bankr. D. Del. Nov. 29, 2006) (excluding valuation expert’s testimony as unreliable).