Covering Business Credit Logo Home   About Us   Services   Credit Articles   Q&A   Contact  

  Business Credit Articles  

Defending a Preference Claim Under the Solvency Defense
What the Vendor Must Prove
By Scott E. Blakeley

Your customer files Chapter 11. Two years later, you receive a demand letter from the litigation trustee demanding return of payments within the 90 days of the customer's filing. You consider the common preference defenses, contemporaneous exchange, ordinary course of business and new value. You review the debtor's most recent audited financial statements which covered a portion of the preference period. The public financial statements show the debtor was apparently solvent during this period. You consider the preference defense of solvency, which provides that if the debtor was solvent at the time of preferential transfer the vendor may have an absolute defense. How may a court consider this defense? How are the debtor's assets and liabilities valued during the preference period? What evidence must the vendor introduce to prevail on this defense?

In the bankruptcy case of Payless Cashways, the bankruptcy court recently ruled that the debtor, who had filed a second chapter 11, was solvent during the preference period and thus payments to vendors during the preference period could not be recaptured. In In re Lids Corporation, 281 B.R. 535 (Bankr. D. Del. 2002) the bankruptcy court considering the solvency defense ruled otherwise. The In re Lids decision is considered.

Insolvency Dispute

In Lids, a retailer of licensed logo sports caps, filed chapter 11. The debtor lost money the three years prior to bankruptcy. Prepetition, the debtor executed a secured credit agreement with a lender. The debtor also granted a junior security interest in its assets to a creditor when it defaulted on its financing with its lender. The creditor perfected its security interest during the preference period.

The debtor filed a preference complaint to avoid the security interest against the creditor, thereby attempting to lower the creditor's payment standing to unsecured. The creditor's defense to the preference was that the debtor was solvent at the time it took a security interest in the debtor's assets.

The Avoidance Powers

Upon a bankruptcy filing, a number of rights and powers are created for the benefit of unsecured creditors. Those powers include the ability of a trustee, debtor in possession, or creditors' committee in appropriate circumstances, to avoid the fixing of a lien on a debtor's property. The avoidance powers may allow for unseating a lien not properly perfected prior to the commencement of the bankruptcy filing, as well as a lien that was properly perfected but recorded during the preference period.

As a general rule, outside of bankruptcy, an unperfected security interest is binding between a debtor and vendors. Thus, a secured creditor has priority over unsecured vendors even if the creditor has not strictly complied with the state (Article 9 of the Uniform Commercial Code, of example) or federal statutory scheme to perfect its claim. The lack of perfection creates a problem for the alleged secured creditor only when an intervening third party obtains a perfected security interest that trumps the unperfected interest. This means that upon the bankruptcy filing, a debtor, or a creditors' committee (in Chapter 11), may act as a hypothetical judgment lien creditor with the ability to unseat prior, unperfected liens. With the assignment of the avoidance powers by the debtor or trustee, a creditors' committee may use the "strong arm" powers to unseat the creditor's alleged lien.

A creditor's lien may also be avoided even if properly perfected but recorded during the preference period, in certain circumstances. The Bankruptcy Code's preference law, which is part of the avoidance powers, provides for the recapture of payments made to creditors within the 90 days prior to a debtor's bankruptcy filing. The preference law also provides for unseating a creditor's lien recorded during the preference period, if the recordation of the lien -- for example, filing of a UCC-1 with the appropriate filing office when the collateral is the debtor's personal property -- is untimely.

Presumption of Insolvency During Preference Period

While a business that is filing Chapter 11 usually does so because its liabilities exceed assets, the Bankruptcy Code does not condition the Chapter 11 filing on the business' insolvency. Generally, insolvency is a financial condition in which the sum of the entity's debts is greater than the fair value of its assets. A debtor is presumed insolvent 90 days before filing bankruptcy. If a vendor challenges the presumption, the burden is on the vendor to produce financial evidence to rebut the presumption of insolvency. There is no presumption of the debtor's insolvency more than 90 days prior to the bankruptcy filing.

Court Finds Debtor Insolvent

In In re Lids, the parties agreed to all of the elements necessary to avoid the transfer of the security interest as a preference, except whether the debtor was insolvent when the creditor perfected its security interest by filing its UCC-1.

As a starting point in establishing the solvency defense, the court noted that the creditor must present sufficient evidence that the debtor was solvent on the transfer date to rebut the presumption of insolvency. That evidence of solvency usually requires expert testimony. Complicating the question of solvency valuation, however, is that there is no GAAP method for measuring the insolvency of a company.

The parties agreed that the Balance Sheet Test (assets over liabilities) was to be used to determine solvency. The court found that in valuing the debtor's assets it would consider the sale price a willing seller would accept from a willing buyer if the assets were offered in a fair market for a reasonable period of time.

The creditor employed a financial consultant that prepared a report regarding the value of the debtor's assets as of the transfer date. In its report, the financial consultant relied on three valuation methods - adjusted balance sheet, market multiple, and comparable transaction - to establish the value of the debtor's assets.

The debtor objected to the creditor's balance sheet valuation as the debtor claimed it did not ascribe fair market value to its assets. The debtor employed its own financial consultant that valued the debtor's assets at far less. The debtor's analysis started with the book values and the estimated recoverable percent of each asset's value to determine the total fair market value of the debtor's assets. The court did not accept the creditor's balance sheet valuation.

The creditor's financial consultant also applied a Market Multiple Methodology to also value the debtor's assets. Under this methodology, net revenues and earning are multiplied by an appropriate range of risk-adjusted multiples to determine the debtor's total enterprise value. In its analysis, the creditor selected multiples by bench marking certain publicly traded companies, using quantitative and qualitative factors. The bankruptcy court did not accept the creditor's consultant's choice of multiples as they did not accurately reflect the comparable companies' values because the debtor had not been profitable while the other companies were.

The creditor's consultant also applied the valuation method of Comparable Transaction Methodology which is designed to yield the price the company would carry in the marketplace based on similar transactions. The court also found this analysis unconvincing as it ignored that the debtor had not been profitable so it cannot be compared to profitable companies.

After the court determined the value of the debtor, it considered the liabilities of the debtor during the preference period. When conducting a balance sheet analysis, the court found that the fair market value of the assets is compared to the face value of the liabilities, including contingent liabilities.

Based on the values the creditor's consultant assigned to the debtor's assets and debts, the creditor's consultant concluded that the debtor's assets exceeded debts by several million dollars, and therefore was solvent. The debtor's consultant reached a far different conclusion, finding that the debtor's consultant estimated that the debtor's liabilities exceeded assets by a range of $8 million to $107 million.

The bankruptcy court concluded that the creditor's consultant's solvency report did not rebut the presumption of insolvency imposed under the preference provision of the Bankruptcy Code. As the debtor was found insolvent during the preference period, the creditor's lien was ordered unseated.


A vendor has a number of standard preference defenses to attempt to shield payments received during the preference period, from contemporaneous exchange, to ordinary course of business to new value. The vendor should also consider the possibility of raising the solvency defense. In re Lids shows that the solvency defense can involve complicated valuation issues that may require an expert, which may make such a defense quite expensive. To mount a solvency defense, a group of vendors may join together to share expenses to prove this defense that otherwise each would have to attempt to establish.

Corporate Credit Executive
Reprinted by permission from
Trade Vendor Quarterly
Blakeley & Blakeley LLP Spring 03

Share |

Business Credit Articles
Send to a Friend
Ask A Credit Question
Questions & Answers
Business Credit News
Your Privacy
Site Map