Editor’s Note: References herein are to the Uniform Voidable Transactions Act (final version) (“UVTA”) promulgated by the Uniform Law Committee, which is based on the predecessor Uniform Fraudulent Transfer Act (“UFTA”).
Section 4 of the UVTA, based on its corresponding predecessor Section 4 of the UFTA, is the most frequently-cited rule for defining voidable transactions (aka, fraudulent transfers). Paragraph (a) presents the “actual intent” test for a voidable transaction, and paragraph (b) informs us when “constructive intent” may be imputed if the debtor does not receive a reasonably equivalent value in exchange for a transfer or obligation.
The constructive intent test of Section 4(b) offers two alternative means of application where reasonably equivalent value has not been received in the exchange. The first is if 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 relation to the business or transaction.” The second is if the debtor “intended to incur, or believed or reasonably should have believed that the debtor would incur, debts beyond the debtor’s ability to pay as they became due.”
In In re Adelphia Communications Corp., 2016 WL3315847, *2 (2d Cir. June 15, 2016), the Second Circuit was tasked with defining the phrase “unreasonably small” under the first alternative to the constructive intent test. The debtor, a cable company, had repurchased its own stock for $150 million from shareholders. Three years later, the company filed for bankruptcy, and the repurchase was challenged as a fraudulent transfer under Pennsylvania’s version of the UFTA. Experts testified that Adelphia had an equity cushion of $2.5 billion at the time of the repurchase, meaning that the transfer could not be set aside on account of insolvency but only as a potential “constructive intent” fraudulent transfer if Adelphia’s capital cushion was “unreasonably small.”
The Second Circuit observed that the issue of adequate capitalization is a mixed question of law and fact that generally devolves into a battle of experts. Citing MFS/Sun Life Tr. High-Yield Series v. Van Dusen Airport Srvs. Co., 910 F. Supp. 913, 944 (S.D.N.Y. 1995), the Second Circuit found that most courts interpret the phrase “unreasonably small” to describe “a situation where a transaction leaves a debtor ‘technically solvent but doomed to fail.’” The inquiry seeks to determine whether, at the time of the transaction, there was a “reasonable foreseeability * * * the debtor had such minimal assets that insolvency was inevitable in the reasonably foreseeable future.” Citing both MFS/Sun Life and Moody v. Sec. Pac. Bus. Credit, Inc., 971 F.2d 1056, 1063 (3d Cir. 1992), the Second Circuit highlighted the following factors relied on in court decisions to answer this inquiry:
- The debtor’s debt to equity ratio
- The debtor’s historical capital cushion
- The need for working capital in the specific industry
- “All reasonably anticipated relevant sources” of operating funds, including (i) new equity infusions, (ii) cash from operations, and (iii) cash from secured or unsecured loans over the relevant time period
Applying these factors to the facts of the case, the Second Circuit found that Adelphia only needed capital of $600 million to cover its operating expenses for the three-year period between the time of the stock repurchase and its bankruptcy filing. This meant that its equity cushion of $2.5 billion was more than sufficient. In other words, Adelphia’s capitalization was not “unreasonably small” within the meaning of Section 4(b)(i) of the UFTA.
Notwithstanding the equity cushion, the receiver highlighted several bad facts: At the time of the repurchase, Adelphia had a negative cash flow and was in default on some of its bonds. There was also an active fraud investigation of the company’s management. Nevertheless, the Second Circuit concluded that Adelphia “could have sold off enough of its assets or alternatively obtained sufficient credit to continue its business for the foreseeable future.” Helping to convince the Second Circuit on this point was expert testimony demonstrating that similarly-situated cable companies were able to access capital markets with the same problems that plagued Adelphia.
Analysis
Readers may recall that the company in this case was run into the ground by the Rigas family, who were later charged by the SEC with fraud. Both John Rigas, the Chairman and CEO of Adelphia, and his son, a Vice President with the company, were ultimately convicted of fraud.
Lost among the Second Circuit’s opinion was the fact that the $150 million stock repurchase discussed in its ruling was done at the behest of the Rigas family and Adelphia’s management shortly before the company assumed a $3 billion debt that proved to be the company’s undoing. Criticism of the lower court proceedings has centered on the fact that the experts testifying in support of a fraudulent transfer used only one valuation methodology to assess Adelphia’s capitalization levels and net worth, relying significantly on financial statements generated by Adelphia at the time of its fraudulent activity. Other valuation methodologies would have discounted those financial statements significantly.
Voidable transactions (aka fraudulent transfers) are determined based on a fact-intensive analysis. While the UVTA sets the standard by which to determine the existence of a voidable transaction, ultimately expert witnesses at trial define the success or failure of the transaction. In re Adelphia demonstrates that even the worst among debtors – behind on its bills and orchestrating a massive fraud – can still engage in gratuitous transfers so long as the debtor has sufficient equity to cover expenses for the “reasonably foreseeable future.” If the debtor’s balance sheet shows a positive net worth that can be monetized, Adelphia demonstrates just how difficult it can be for the debtor to run afoul of the “unreasonably small” test of UVTA Section 4(b)(i).