The following is a case update prepared by Dan Schechter, Professor Emeritus, Loyola Law School, Los Angeles, analyzing a recent decision of interest:
A bankruptcy court in Florida has held that a trustee asserting an “unreasonably small assets” fraudulent transfer claim must show that the transfer in question was the event that caused the debtor to have unreasonably small assets; if the debtor was already in distress, then the transfer was not the cause of the debtor’s financial demise. [In re Palm Beach Finance Partners, LP, 2019 Westlaw 1301899 (Bankr. S.D. Fla.).]
Facts: Following the collapse of a large Ponzi scheme, a liquidating trustee brought a fraudulent transfer action against an entity that had received funds from the Ponzi scheme operator. The trustee’s fraudulent transfer action was specifically grounded in the Georgia version of section 5 of the Uniform Fraudulent Transfer Act, which states in part that a subsequent creditor (i.e., a creditor whose claim against the debtor arose after the transfer) may avoid a transfer if the debtor did not receive reasonably equivalent value for the transfer and “[w]as engaged or was about to engage in a business or a transaction for which the remaining assets of the debtor were unreasonably small in relation to the business or transaction . . . .”
The defendant moved for summary judgment on the ground that since the Ponzi scheme was already deeply distressed at the time of the transfers in question, the transfers did not cause the debtor’s assets to become unreasonably small. They were already too small.
Reasoning: The court granted summary judgment in favor of the defendant. In reaching its result, the court carefully examined three centuries of precedent on the issue of “unreasonably small assets” or “unreasonably small capital” (in the parallel verbiage of the Bankruptcy Code). The court distinguished between fraudulent transfer causes of action brought under the “insolvency” prong (in which only antecedent creditors have standing) and claims brought under the “unreasonably small assets” prong (in which either antecedent or subsequent creditors have standing):
A transaction or obligation leaves a debtor with unreasonably small assets when it creates an unreasonable risk of the debtor becoming insolvent, but not necessarily a likelihood that the debtor will become insolvent . . . . The state of unreasonably small assets differs from balance sheet insolvency. It is possible that a debtor will have assets at fair value which exceed its debts, but the assets are not sufficiently liquid to meet the debtor’s payment obligations and its business is not otherwise adequate to generate cash flow, borrow, or acquire capital investment to meet obligations as they come due. Such a debtor would be solvent but would suffer from unreasonably small assets. The opposite may also be true. A debtor may have regular cash flow or other access to funds sufficient to support timely payment of its obligations, but the actual sum of its assets at fair value may be less than the aggregate of its debts. Such a debtor would not suffer from unreasonably small assets but would be insolvent. Too frequently, insolvency and unreasonably small assets are equated in the case law, or at least no distinction is drawn. In many cases this is because insolvency and unreasonably small assets have occurred in tandem or have arisen so close in time as to support claims under either theory. In some cases, however, courts place an inappropriate gloss on these standards, failing to distinguish them. But, it is clear that insolvency is not the same as unreasonably small assets.
The court reviewed the conflicting precedent on point, noting that some courts had held that causation is not a key element of an “unreasonably small asset” claim. However, the court concluded that unless the challenged transfer actually caused the debtor to have “unreasonably small assets,” the transfer would not be avoidable:
A transfer that deepens a debtor’s already existing financial instability cannot form the basis of a claim based on unreasonably small assets. The transfer subject to the avoidance action must be the transfer that brought about the condition of unreasonably small assets, thus creating an unreasonable risk of insolvency and payment default. Perhaps it seems initially strange that where a debtor makes a series of transfers some of which are before its assets are so depleted as to put it into the requisite financial uncertainty, and some of which fall after that point, only one of the transfers may be subject to avoidance as only that one transfer will be the straw that broke the camel’s back, being the cause of the debtor having unreasonably small assets. But it must be kept in mind that the claim in question is one that may be brought by a creditor that did not exist at the time of the transfer. For such a creditor, the right obtained is a retrospective one unique to this provision of the law. It is reasonable to require that such a subsequent creditor, at a minimum, be able to point to the transfer sought to be avoided as the reason that the debtor was placed in a position leaving that future creditor at risk. If the debtor was already in financial distress before the transfer in question such that it was foreseeably doomed to insolvency, the recipient of the transfer should not be placed under the burden of a risk it did not create.
Applying its analysis of the statute to the facts of the case, the court held that the trustee had failed to show that the transfer in question left the debtor with “unreasonably small assets:”
[T]o prevail under [the statute], the plaintiff must show that a payment made by [the debtor] to the defendant left [the debtor] with unreasonably small assets. If [the debtor] already had unreasonably small assets at the time of any challenged payment, then the payment did not leave [the debtor] with unreasonably small assets. It is proper that a future creditor, such as the plaintiff in this case, should not have a claim in that instance as a transfer that has no potential causal connection to [the debtor’s] inability to pay the plaintiff’s claim should not be actionable.
Author’s Comment: I am not sure that this opinion reaches the right result, but it is well-researched, well-written, and thought-provoking. The court holds, in essence, that a plaintiff asserting an “unreasonably small assets” claim has to show that the transfer in question was the very straw that broke the camel’s back. If the camel’s back was already broken, the transfer is not avoidable.
My problem with this opinion is that the language of the statute does not clearly require a showing of “broken camel” causation. Let us look again at section 5 of the Uniform Fraudulent Transfer Act: it provides that the transfer is avoidable if the debtor “[w]as engaged or was about to engage in a business or a transaction for which the remaining assets of the debtor were unreasonably small in relation to the business or transaction . . . .”
Let us narrow the statutory focus even more: “was engaged or was about to engage.” That makes it sound as though if the debtor was already engaged in business with unreasonably small assets prior to the time of the challenged transfer, the transfer is avoidable. By contrast, the “about to engage” language seems to say that if the challenged transfer causes the debtor to enter the status of having “unreasonably small assets,” the transfer is also avoidable, even though the debtor had sufficient assets prior to the transfer. The court’s “causation” theory of liability is tied to the “about to engage” sub-prong of the statute, but it seems to elide the “was engaged” sub-prong.
Despite the statutory language, the problem with my bifurcated reading of the statute is that it seems to blur the line between insolvency (a claim assertable only by antecedent creditors) and “unreasonably small assets,” a claim assertable by either antecedent or subsequent creditors: after all, if the debtor “was engaged” in business with unreasonably small assets, doesn’t that necessarily mean that the debtor was already insolvent? The court addressed that issue by quoting Bruce A. Markell, Toward True and Plain Dealing: A Theory of Fraudulent Transfers Involving Unreasonably Small Capital, 21 Ind. L. Rev. 469, 494 (1988):
“[T]he application of a per se rule subsuming unreasonably small capital within insolvency would appear unwarranted. Its blind application produces an antinomy; the automatic extension of standing to future creditors upon proof of insolvency—which is a result consciously not included in the statute.”
But is my bifurcated reading of the statute really an antinomy? (Full disclosure: I had to look up the precise meaning of antinomy, which means “a paradoxical contradiction of two or more logical propositions.” The accent is on the second syllable.). I think that the paradox is not inevitable. Even if the debtor were not insolvent on a balance sheet basis (thus depriving subsequent creditors of the ability to assert an insolvency-based fraudulent transfer claim), the debtor could still be operating with “unreasonably small assets” if, for example, it did not have enough liquidity to deal with the normal vicissitudes of business. The same is true if the debtor, while technically solvent, were unable to procure normal financing, due to a precarious ratio of debt to equity.
Perhaps the court’s analysis of “unreasonably small assets” indicates a need for an amendment to the Uniform Voidable Transactions Act (as the UFTA is now called in most states). Perhaps the “was engaged” sub-prong should be eliminated as illogical. But that is not what the statute now says.
Finally, in the interests of thoroughness, I must note that although the court’s opinion in this case quotes at length from Judge Markell’s seminal article, the court’s conclusion differs from his. The court holds that the transfer in question must cause the debtor to be left with unreasonably small assets. By contrast, Judge Markell shifts the issue of causation to focus on whether the transfer in question is the event that caused the plaintiff’s debt to remain unpaid:
An action will lie under the unreasonably small capital section if a transfer is made for less than reasonably equivalent value, and if: the transferor is engaged in business or a business transaction; non-payment of the plaintiff’s claim was reasonably foreseeable at the time of the transfer due to the inadequacy of the transferor’s reasonably foreseeable present and future resources; and but for the transfer and the inadequacy of the transferor’s resources, the plaintiff’s claim would have been paid. [Id., 21 Ind. L. Rev. at 508.]
I think that Judge Markell’s nuanced version of “causation” is well-supported by the case law and is consistent with the wording of the statute, unlike the court’s version. I hope that we will soon see how this decision fares on review. For discussions of other cases dealing with related issues, see:
- 2009 Comm. Fin. News. 98, Asset Purchase Is Recharacterized as LBO and Is Avoided as Fraudulent Transfer, When Acquired Entity Is Left with Unreasonably Small Assets.
- 2008 Comm. Fin. News. 88, Where Post-LBO Entity Is Forced to Stretch Its Trade Payables, Company Is Undercapitalized and Upstream Payments Made by Company May Be Attacked as Fraudulent Transfers.
These materials were written by Dan Schechter, Professor Emeritus, Loyola Law School, Los Angeles, for his Commercial Finance Newsletter, published weekly on Westlaw. Westlaw holds the copyright on these materials and has permitted the Insolvency Law Committee to reprint them.