In a recent opinion issued by the Honorable Kevin Gross of the United States Bankruptcy Court, District of Delaware, the Court addressed the issue of whether a debtor was solvent when it made allegedly preferential transfers to the Defendant. The Court’s decision provides a helpful analysis of the less frequent "solvency" defense to a preference action. Further, the decision provides guidance regarding the evidentiary issues that arise when a party raises this defense.
The Court issued its decision in Miller v. Barenberg, et al. (In re Bernard Technologies, Inc.), Adv. No. 06-51017(KG), slip op. (Bankr.D.Del. Dec. 5, 2008). In Bernard Technologies, George Miller, the chapter 7 Trustee and plaintiff, sought to recover pre-petition transfers paid to Bernard’s former CEO, Dr. Sumner Barenberg (the "Defendant"). As an alleged "insider," the Trustee sought to recover transfers made to the Defendant during the one year prior to Bernard Technologies (the "Debtor") filing for bankruptcy. One of the defenses raised by the Defendant was that the Debtor was solvent during both the 90 day preference period, as well as the one year preference period applied to insiders.
The Court began its analysis by recognizing that under 11 U.S.C. § 547(f), the Debtor is presumed insolvent during the 90 days prior to the filing for bankruptcy. The Defendant, however, challenged whether the Debtor was insolvent during the 91st to 365th day prior to filing for bankruptcy (the "Insider Preference Period"). The issue for Court, therefore, was whether the Trustee could prove that the Debtor was insolvent during the Insider Preference Period.
The Court noted that the Trustee did not offer an insolvency report or expert testimony to prove insolvency. Instead, the Trustee relied upon a partner in his firm who testified after reviewing the Debtor’s books and records. At trial, the Trustee’s witness testified that the Debtor was insolvent during the year prior to bankruptcy. The witness based her testimony, in part, on the Debtor’s financial records and a "Balance Sheet Summary" the witness prepared prior to trial.
After considering the evidence, the Court found that the Debtor was insolvent during the one year preference period. In reaching this conclusion, the Court first looked to § 101(32)(A)’s definition of "insolvent" under the Bankruptcy Code. The Code defines insolvent as "the financial condition such that the sum of such entity’s debts is greater than all of such entity’s property, at fair valuation." The Trustee’s solvency analysis failed to consider the fair market value of Debtor’s assets, instead relying on a balance sheet analysis. The Trustee’s lack of proof regarding the Debtor’s assets was "problematic" to the Court.
The Court noted that the issue of proving insolvency was previously addressed in Lids Corp. v. Marathon Investment Partners, L.P., (In re Lids Corp.), 281 B.R. 535 (Bankr.D.Del. 2002). In Lids, the Court held that the "balance sheet test" is typically applied, however, such a test is based on "fair valuation and not based on Generally Accepted Accounting Principles ("GAAP") which are used to prepare a typical balance sheet." Id. Applying Lids, the Court in Bernard Technologies held that a "solvency analysis requires asset valuation [of the Debtor]."
Despite the Trustee’s reliance on "balance sheet" analysis instead of "valuation," the Court in Bernard Technologies found that the Debtor was insolvent. It did so for two reasons. First, the Trustee had the presumption of insolvency during the 90 day preference period and the presumption was not rebutted by the Defendant. The Trustee also established that the Debtor was unable to "meet its obligations as they came due." The Defendant, however, did not establish that the Debtor was solvent, nor did it introduce evidence regarding the value of the Debtor’s assets. Based on such evidence, the Court found that the Debtor was insolvent at the time of the transfers. The clear message from this decision is that when a party is seeking to prove or disprove the solvency of a debtor, they should present qualified evidence regarding the fair market value of the Debtor’s assets.