Page 101 - Bankruptcy and Reorganization Services
P. 101
Although parties to an avoidance action may have differing opinions regarding the inputs to, and under-
lying assumptions of, the balance sheet test, it is nevertheless a bright line test in the sense that the
amount (or fair value) of liabilities either does, or does not, exceed the fair value of assets. This is not
the case with the unreasonably small capital test. It is a more subjective test to assess when a debtor’s
assets (and the associated cash flow generated from those assets), in relation to its liabilities (and the
cash requirements associated with those liabilities), are sufficiently small that it no longer possesses a
reasonable amount of capital. In essence, the question to be answered is whether the debtor has a suffi-
cient cushion of cash flows, working capital, equity capital, and access to capital to have a reasonable
prospect of avoiding bankruptcy through the normal ebbs and flows of economic cycles.
An Assessment Based on Facts and Circumstances
Whether the amount of capital remaining in the hands of the debtor is an unreasonably small amount for
running a business must be decided by the bankruptcy court based on the facts and circumstances of
each case.
A Condition That Precedes Insolvency (in either the bankruptcy or equity sense)
Neither the Bankruptcy Code nor the UFTA defines the concept of unreasonably small capital or assets.
However, courts have ruled that, generally, unreasonably small capital encompasses the financial situa-
tion where the debtor is left solvent (in either the bankruptcy or equity sense) after the subject transac-
tion, but only to a limited degree; in such cases, bankruptcy or liquidation of the debtor may be substan-
tially likely or there is at least an unreasonable risk thereof. fn 50
Conditions Surrounding the Transfer Date Should Be Evaluated
A court may go beyond a simple review of the debtor’s financial condition on the specific date of the
subject transfer or transaction and examine the debtor’s capital structure within a reasonable timeframe
(although often a relatively brief timeframe) surrounding the date of the scrutinized transaction. fn 51
fn 50 See, for example, Moody v. Security Pacific Business Credit, Inc., 971 F.2d 1056, 1070 (3d Cir. 1992); Official Committee of
Unsecured Creditors of Toy King Distributors, Inc., v. Liberty Savings Bank (In re Toy King Distributors, Inc.), 256 B.R. 1, 142
(Bankr. M.D. Fla. 2000); In re Vadnais Lumber Supply, Inc., 100 B.R. 127, 137 (Bankr. D. Mass. 1984); In re Norstan Apparel
Shops, Inc., 367 B.R. 68, 79 (Bankr. E.D.N.Y. 2007); In re Healthco Int’l, Inc., 208 B.R. 288, 302 (Bankr. D. Mass. 1997) ("[Inade-
quate capitalization] connotes a condition of financial debility short of insolvency (in either the bankruptcy or equity sense) but which
makes insolvency reasonably foreseeable [footnote omitted]. In other words, a transaction leaves a company with unreasonably small
capital when it creates an unreasonable risk of insolvency, not necessarily a likelihood of insolvency."); In re Crown Unlimited Ma-
chine, Inc., 2006 Bankr. LEXIS 4651, *28 (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) ("Another way to conceptualize the issue is to ask whether the transaction in question put the debtor ‘on the road
to ruin.’"); In re Doctors Hospital of Hyde Park, Inc., 360 B.R. 787 (Bankr. N.D. Ill. 2007), vacated and remanded on other grounds,
619 F.3d 688 (7th Cir. 2010) (Unreasonably small capital "encompasses difficulties which are short of insolvency in any sense but are
likely to lead to insolvency at some time in the future.").
fn 51 See Barrett v. Continental Ill. Nat’l Bank and Trust Co., 882 F.2d 1, 4 (1st Cir. 1989), cert. denied, 494 U.S. 1028 (1990) (no
fraudulent conveyance although company may have been technically insolvent for brief period after transfer, where per prior plan, the
company shortly thereafter sold certain assets to shore up capital position; analysis requires a court to examine debtor’s capital
throughout a reasonable period of time surrounding the precise date of a challenged transfer, in order to avoid risk of giving too much
weight to the state of debtor’s balance sheet on a particular date and to make a realistic assessment of the impact of the transfer on
debtor’s ability to conduct its affairs); In re Iridium Operating, LLC, 373 B.R. 283, 345 (Bankr. S.D.N.Y. 2007) ("courts compare a
company’s projected cash inflows...with the company’s capital needs throughout a reasonable period of time after the questioned
© 2020 Association of International Certified Professional Accountants 99