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.
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
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