In Search Of The Meaning Of 'Unreasonably Small Capital' In Constructively Fraudulent Transfer Avoidance Litigation

The meaning of "unreasonably small capital" in the context of constructively fraudulent transfer avoidance litigation is not spelled out in the Bankruptcy Code. As a result, bankruptcy courts have been called upon to fashion their own definitions of the term. Nonetheless, the courts that have considered the issue have mostly settled on some general concepts in fashioning such a definition. In Whyte ex rel. SemGroup Litig. Trust v. Ritchie SG Holdings, LLC (In re SemCrude, LP), 2014 BL 272343 (D. Del. Sept. 30, 2014), a Delaware district court recently reaffirmed two such guiding principles: (i) a debtor can have unreasonably small capital even if it is solvent; and (ii) a "reasonable foreseeability" standard should be applied in assessing whether capitalization is adequate.

AVOIDANCE OF FRAUDULENT TRANSFERS IN BANKRUPTCY

Section 548(a)(1) of the Bankruptcy Code authorizes a trustee or chapter 11 debtor-in-possession ("DIP") to avoid any transfer of an interest of the debtor in property or any obligation incurred by the debtor within the two years preceding a bankruptcy filing if: (i) the transfer was made, or the obligation was incurred, "with actual intent to hinder, delay, or defraud" any creditor; or (ii) the transaction was constructively fraudulent because the debtor received "less than a reasonably equivalent value in exchange for such transfer or obligation" and was, among other things, insolvent, left with "unreasonably small capital," or unable to pay its debts as such debts matured, when or after the transfer was made or the obligation was incurred.

For one of these categories of constructive fraud, section 548(a)(1)(B)(ii)(II) provides that a transfer or obligation, if made or incurred by the debtor without an exchange of reasonably equivalent value, may be avoided if, among other things, the debtor "was engaged in business or a transaction, or was about to engage in business or a transaction, for which any property remaining with the debtor was an unreasonably small capital."

Transfers or obligations may also be avoided under analogous state laws by operation of section 544(b) of the Bankruptcy Code, which empowers a DIP or trustee to "avoid any transfer of an interest of the debtor in property or any obligation incurred by the debtor that is voidable under applicable law by a creditor holding an unsecured claim" against the debtor. Examples of such laws are the versions of the Uniform Fraudulent Transfer Act ("UFTA") and the Uniform Fraudulent Conveyance Act ("UFCA") adopted by most states.

The UFTA (which has been adopted by 44 states, the District of Columbia, and the U.S. Virgin Islands) includes the phrase "the remaining assets of the debtor were unreasonably...