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sufficient capital, it needs to have a sufficient cushion in its cash flow estimates, working capital, equity
capital, and other financial metrics. An assessment of an entity’s ability to pay debts as they mature, on
the other hand, does not contemplate a cushion. In theory, if an entity has $1 remaining after paying ex-
penses, capital expenditures, and debt service, then it is able to pay its debts as they mature. As with the
ability to pay test, the balance sheet test does not require a cushion in order for the test to be triggered. In
theory, if the fair value of an entity’s assets exceeds its liabilities by at least $1, it is solvent. In this
sense, both the ability to pay test and the balance sheet test, as applied in the context of avoidance ac-
tions, represent a litmus test. Although the parties to the avoidance actions may disagree on issues such
as cash flow estimates or valuation methodologies, the point of demarcation is clear regarding whether a
company is solvent or insolvent, able to pay debts or unable to pay debts. Such a point of demarcation
does not exist for the sufficiency of capital test. As a result, an additional element of judgment is re-
quired in the application of this test.

Thin Capital or Unreasonably Small Capital Test

Section 548(a)(1)(B)(ii)(II) of the Bankruptcy Code allows a debtor in possession or trustee to avoid a
transaction if the debtor did not receive reasonably equivalent value and if, immediately after the trans-
action, the debtor was left with "unreasonably small capital." The UFTA, which serves as the model for
many states’ fraudulent transfer laws, similarly provides that a transfer by a debtor is fraudulent if the
debtor did not receive reasonably equivalent value and the debtor "was engaged or was about to engage
in a business or a transaction for which the remaining assets of the debtor were unreasonably small in re-
lation to the business or transaction." fn 49

ment of the reasonableness or sufficiency of a debtor’s assets only makes sense when assessing the debtor’s assets in relation to the
debtor’s debts.

When the sum of a debtor’s assets at a fair valuation is greater than all of the debtor’s debts, the debtor possesses capital (assets –
debts = capital). As a debtor’s assets decrease or a debtor’s debts increase, the amount of the debtor’s capital decreases. When a debt-
or’s assets decrease or a debtor’s debts increase to the point that a debtor’s debts are greater than all of the debtor’s property at a fair
valuation, the debtor is deemed insolvent.

Accordingly, the point at which the remaining assets of a debtor become unreasonably small, in relation to the business or trans-
action, is at some point when the debtor still possesses capital, therefore, before the debtor is deemed insolvent. This is because,
among other things, at the point of insolvency the impairment to a debtor’s ability to continue operations has become evident. It is
unreasonable to presume that the point at which the remaining assets of a debtor become unreasonably small in relation to the business
or transaction is at some deepened level of insolvency beyond the point when the debtor is initially deemed insolvent. This is further
supported by the fact that what appears to be the equivalent test under the Section 548(a)(1)(B)(ii)(II) of the Bankruptcy Code uses the
term capital. As stated previously, Section 548(a)(1)(B)(ii)(II) of the Bankruptcy Code states that the debtor "was engaged in business
or a transaction, or was about to engage in business or a transaction, for which any property remaining with the debtor was an unrea-
sonably small capital."

fn 49 See UFTA Section 4(a)(2)(i). Section 544(b) of the Bankruptcy Code allows for the avoidance of a transfer of an interest of the
debtor in property or an obligation incurred by the debtor that is "voidable under applicable law" (by an unsecured creditor), which
includes state fraudulent transfer laws. Although the UFTA refers to "unreasonably small assets" and Bankruptcy Code Section 548
refers to "unreasonably small capital," courts have usually applied the same or similar analysis when applying the UFTA constructive
fraudulent transfer statutes. See, for example, In re Jackson, 459 F.3d 117 (1st Cir. 2006); In re Crown Unlimited Machine, Inc., 2006
Bankr. LEXIS 4651, *27 (Bankr. N.D. Ind. Oct. 13, 2006), aff’d in part and rev’d in part on other grounds, 587 F.3d 787 (7th Cir.
2009) ("This change in phraseology does not appear to have been intended to be a change in meaning. Instead, it was designed to
eliminate a potential ambiguity and dispel the idea that the test depended upon the special meanings corporation law gave to the term
capital. The inquiry is supposed to be broader than narrow technical definitions of capital").

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