Solvency Analysis in Preference Litigation

13 Sep Solvency Analysis in Preference Litigation

Last week’s post discussed public-market data as the benchmark for solvency in assessing fraudulent transfers.  This week’s post covers solvency the “old fashioned” way – in addressing preference litigation.

Ray Clark, who runs Valcor Consulting – an Irvine-based restructuring, valuation, and litigation consultancy – and who contributes regularly to this blog, recently offered an overview of the solvency analysis and valuation techniques that apply when a company faces claims for payments made within 90 days of a debtor’s bankruptcy:

The question of solvency in a voidable preference action depends upon the fair valuation of the debtor’s assets at the time of the transfer, along with other solvency analyses.  The question of whether to use a “going concern” valuation analysis versus a “liquidation” analysis depends upon whether the debtor was “on its death bed” at the testing date, e.g. the transfer date.  If the going concern premise is applied, then the BK court typically relies on an appraisal of the business, i.e., the value of the assets used in an ongoing enterprise, as the basis for the solvency analysis.  By contrast, if it is determined that the business was not a going concern at the transfer date, and then an asset-by-asset analysis under a liquidation scenario will be used.  Lastly, solvency can also be judged by whether the debtor is able to pay his debts as they come due.  So, there is essentially a two-pronged definition of insolvency:    

1. A debtor is insolvent if the sum of the debtor’s debts is greater than all the debtor’s assets, at a fair valuation, or
2. A debtor who is generally not paying his debts as they become due is presumed to be insolvent.

Ultimately, stakeholders may rely on a so-called “Solvency Opinion,” which is designed to assess a company’s overall financial condition at a designated time and using a variety of tests determine whether the entity was solvent or insolvent.  The three tests that are typically applied include:

1. The Balance Sheet Test (with case law references),
2. The Capital Adequacy Test and
3. The Cash Flow Test

Ray’s article disucssing each of these tests is available here.  For further questions, contact mgood@southbaylawfirm.com or rclark@valcoronline.com.