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Whether a company is insolvent can have significant implications, and raises a host of issues for a board of directors, management, and their advisers to consider. For example, if a company is insolvent, or in a “zone of insolvency,” it is generally accepted that the fiduciary duty a board of directors ordinarily owes to shareholders and the corporation itself can expand to take into account the interest of creditors. (In a solvent corporation, creditors are left to rely on contractual rights.) Also, in an insolvency situation, some courts have held that a company’s discretion to conduct its affairs free from litigation under the business judgment rule does not apply to the extent it would to a financially healthy enterprise. Rather, the assets of an insolvent corporation must be used for the benefit of creditors and shareholders, and therefore the appropriate standard a court will use in reviewing a corporate action is one of “entire fairness.” EXPANDED DUTIES This change in fiduciary duties and standards of review can have significant practical implications. For instance, a strategy for a financially distressed enterprise that has the potential to create value for shareholders but could cause creditors to suffer a diminished recovery if unsuccessful could form the basis for a creditor’s claim for breach of fiduciary duty. See In re Ben Franklin Retail Stores, (Bankr. N.D. Ill. 1998) (directors of an insolvent corporation can breach fiduciary duty to creditors if assets are put at undue risk for the benefit of shareholders); In re Healthco International Inc., (Bankr. D. Mass 1997) (directors that approve a transaction that renders corporation insolvent where proceeds paid to shareholders and not creditors could be held liable for damages). Additionally, when a corporation is insolvent, transactions without adequate consideration can be attacked by creditors, and payments and other transfers to creditors can be recovered if there is a bankruptcy filed within 90 days. However, it is often difficult to ascertain whether a corporation is in the zone of insolvency. The definitions of insolvency commonly used are easy to state: i.e., the fair value of liabilities exceeds the fair value of assets, or the company is not satisfying its obligations as they come due. But application of the definitions can be quite difficult — especially in situations where there are unknown, disputed liabilities. For example, a company facing a large number of product liability claims that it considers unjustified can believe that its liabilities do not exceed its assets, but the true measure of liabilities will be definitively known only after the litigation is resolved. Moreover, a board’s good faith analysis of solvency may not be dispositive when a court later reviews its decisions. Certain courts have utilized hindsight in considering whether a corporation was insolvent when considering a transaction implemented many years before. Discussed below are the different approaches adopted by courts in determining whether a company facing undetermined disputed liabilities was in fact insolvent at the time of a particular transaction. One of the earlier decisions to discuss the valuation of undetermined liabilities in determining solvency is In re Xonics Photochemical Inc. (7th Cir. 1988). There, Judge Richard Posner wrote that in making a solvency determination, a contingent liability must be discounted by the probability that the contingency would occur and the liability become real. For example, if there was a 1 percent chance of a $1.7 million guarantee being called, the value assigned to the liability for the purposes of solvency analysis would be $17,000. However, because Xonics was in the context of a “contingent” claim, i.e., a liability that is triggered by an extrinsic event that may never occur (i.e., a guarantee that is contingent on a default by the primary obligor), its application may be limited. DIFFERENCES OVER TIMING Courts are sharply split as to the time at which the estimate of potential liability is made. Should a court making a solvency determination use the valuation of liabilities based on the facts as they appeared at the time the transaction occurred? Or should the court evaluate the likelihood of liability at the time it considers the transaction (which could be years after the consummation of the transaction), with the benefit of hindsight? Unfortunately, there is no clear answer, and courts in two key commercial jurisdictions, New York and Delaware, have given opposite answers. A dramatic decision strongly endorsing the hindsight approach is In re W.R. Grace & Co. (D. Del. 2002). There, the parties applied for a ruling on the legal standards to be used in determining solvency in an adversary proceeding brought by asbestos claimants on behalf of the bankruptcy estate attacking a spinoff of a former division of the debtor. Because the transaction was the spinoff to shareholders without payment, then if the debtor was insolvent, a fraudulent conveyance finding was a significant likelihood. The parties disagreed on whether, in determining solvency, the court should consider only those liabilities that were known at the time of the transfer (or those the debtor reasonably should have known about) or whether the court should make its determination based on actual liabilities, without regard to what the debtor knew or should have known about the liabilities on the transfer date. This was a critical distinction, because as the defendants argued that there was a spike in asbestos claims after the spinoff transaction was completed, those claims eventually forced the company to seek Chapter 11 protection. The court decided to apply the Uniform Fraudulent Transfer Act, which defined insolvency “by reference to strict balance-sheet tests. Therefore, a debtor is insolvent if its debts exceed its assets,” and it rejected the defendants’ position that post-transaction claims were “contingent” and thus subject to a discounting analysis because the exposure to asbestos, and therefore the injuries, had occurred pre-transaction. Thus, there was no extrinsic event required to trigger liability. So the court disagreed with the holding in In re Babcock v. Wilcox, (Bankr. E.D. La. 2002) that a debtor would be considered insolvent only if the debtor’s estimation of the tort liabilities at the time of the transfer was not reasonable. Finally, in addressing policy arguments, the W.R. Grace court stated that the interests of creditors are paramount, and noted that there will be no liability if the transaction involved fair consideration. The court had no sympathy for the “less-than-full-value” transferee, and felt that such party and the debtor were the appropriate parties to bear the burden of an incorrect liability estimate. On the other hand, corporate decisionmakers may be able to take comfort in the decision of a New York federal district court recently affirmed by the U.S. Court of Appeals for the 2nd Circuit, interpreting the New York fraudulent conveyance statutes, which held that solvency must be gauged at the time of the transfer, not with the benefit of hindsight. Lippe v. Bairnco Corp. (S.D.N.Y. 2003), aff’d (2d Cir. 2004). In Lippe, trustees of a creditor trust established in connection with the bankruptcy proceedings of the Keene Corp. commenced litigation against affiliated corporations, and former Keene officers and directors, alleging fraudulent conveyance, breach of fiduciary duties, and conspiracy to defraud with respect to, among other things, a transaction involving the disposition of a division. In connection with its approval of the transaction, the Keene board went to great lengths to evaluate its asbestos exposure, retaining experts who performed extensive analysis and reported to the board. The court examined the relevant New York law, which defines insolvency as occurring when the fair saleable value of assets is less than “probable” liability on existing debts as they mature. In contrast to W.R. Grace, the Lippe court cited the Babcock case with approval and stated that “solvency must be gauged at the time of the transfers, not analyses performed now with the benefit of hindsight.” DANGERS OF HINDSIGHT The court held that in light of the facts known at the time of the transaction, a reasonable jury could only find that Keene had, or believed it had, more than sufficient assets to cover its probable liability. The 2nd Circuit affirmed because, among other reasons, the solvency definition in the statute at issue refers to “existing” debts, and therefore unaccrued claims could not be included. However, the willingness of some courts to use hindsight could result in a company being held to be insolvent based on facts not capable of being ascertained at the time a particular transaction is considered. Under existing case law, a serious potential consequence of a determination of insolvency could be the imposition of a fiduciary duty to creditor constituencies where decision-makers may not know that the corporation is liable to such creditors. Given the lack of clear guidance, caution in structuring transactions involving companies facing unknown liabilities may be well-advised. Approaches such as retaining a portion of proceeds so they remain available to creditors, or utilizing a bankruptcy proceeding to effectuate a transaction, can give certainty, and protection to all interested parties should be considered. Jeffrey W. Levitan is a partner in the bankruptcy and reorganization group at Proskauer Rose in New York. He can be reached at [email protected].

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