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					Page 14                                                                  The Metropolitan Corporate Counsel                                                                     July 2004

The Zone Of Insolvency – Uncharted Territory
        Jeffrey W. Levitan                                                                      Delaware, have given opposite answers          ties to bear the burden of an incorrect lia-
                                                                                                to the question.                               bility estimate.
       PROSKAUER ROSE LLP                                                                                                                          In contrast, corporate decision makers
                                                                                                                                               may be able to take comfort in the deci-
    Whether a company is insolvent or                                                                                                          sion of a New York District Court which
not can have significant implications, and                                                          “. . . courts are sharply split             recently affirmed the Second Circuit
raises a host of issues for a board of                                                          as to the time at which the                    Court of Appeals interpreting the New
directors, management and their advisors                                                        estimate of potential liability is             York fraudulent conveyance statutes
to consider. For example, if a company is                                                                                                      which held that solvency must be gauged
insolvent, or is in the “zone of insol-                                                         made. Should a court making                    at the time of the transfer, and not with
vency,” it is generally accepted that the                                                       an insolvency determination                    the benefit of hindsight. Lippe v. Bairnco
fiduciary duty a board of directors ordi-                                                        use the valuation of liabilities               Corp., 249 F. Supp. 2d 357 (S.D.N.Y.
narily owes to shareholders and the cor-                                                                                                       2003) aff’d 2004 U.S. App. Lexis 7027
poration itself can expand to take into                                                         based on the facts as they                     (2d Cir. Apr. 9, 2004). In the Lippe case,
account the interest of creditors. (In a                                                        appeared at the time the                       trustees of a creditor trust established in
solvent corporation, creditors are left to                                                      transaction occurred? Or,                      connection with the bankruptcy proceed-
rely on contractual rights.) Also, in an                                                                                                       ings of Keene Corporation commenced
insolvency situation, some courts have
                                                                                                should the court evaluate the                  litigation against affiliated corporations,
held that the protection of the business                                                        likelihood of liability at the time            and former Keene officers and directors
judgment rule does not apply to the                       Jeffrey W. Levitan                    it considers the transaction                   alleging fraudulent conveyance, breach
extent it would to a financially healthy                                                                                                        of fiduciary duties, and conspiracy to
enterprise, utilizing a theory that the
                                                                                                . . . with the benefit of                      defraud with respect to, among other
                                               insolvency commonly used are easy to
assets of an insolvent corporation are         state, i.e. the fair value of liabilities        hindsight?”                                    things, a transaction involving the dispo-
impressed with a trust for the benefit of       exceeds the fair value of assets, or the                                                        sition of a division. In that case, in con-
creditors and shareholders, and therefore      company is not satisfying its obligations                                                       nection with its approval of the
the appropriate standard a court will use      as they become due, their application can                                                       transaction the Keene board went
                                                                                                    A dramatic decision strongly endors-       through great lengths to evaluate its
in reviewing a corporate action is one of      be quite difficult – especially in situations     ing the hindsight approach, is In re W.R.      asbestos exposure, retaining experts who
“entire fairness.” This change in fidu-         where there are unknown, disputed liabil-        Grace & Co., et al, 281 B.R. 852 (D. Del.      performed extensive analysis and
ciary duties and standards of review can       ities. For example, a company facing a           2002). In W.R. Grace, the parties applied      reported to the board. The court exam-
have significant practical implications, as     large amount of product liability claims         for an in limine ruling on the legal stan-     ined Section 271 of the New York Debtor
a strategy for a financially distressed         that it considers unjustified can believe         dards to be utilized in determining sol-       and Creditor law which defines insol-
enterprise that has the potential to create    that its liabilities do not exceed its assets,   vency in an adversary proceeding               vency as when the fair saleable value of
value for shareholders, but could cause        but the true measure of liabilities will
creditors to suffer a diminished recovery                                                       brought by asbestos claimants on behalf        assets is less than “probable” liability on
                                               only be definitively known after the liti-        of the bankruptcy estate attacking a spin-
if unsuccessful, could form the basis for      gation is resolved. Moreover, a board’s                                                         existing debts as they mature. In contrast
a creditor’s claim for breach of fiduciary                                                       off of a former division of the debtor.        to W.R. Grace, the court cited the Bab-
                                               good faith analysis of solvency at the           Because the transaction was the spinoff
duty. See In re Ben Franklin Retail            time a decision is made may not be dis-                                                         cock case with approval and stated “ . . .
Stores, 225 B.R. 646 (Bankr. N.D. Ill.                                                          to shareholders without payment, if the        solvency must be gauged at the time of
                                               positive when a court later reviews its          debtor was insolvent, a fraudulent con-
1998) (Directors of an insolvent corpora-      decisions. Certain courts have utilized                                                         the transfers, not analyses performed
tion can breach fiduciary duty to creditors                                                      veyance finding was a significant likeli-        now with the benefit of hindsight.” The
                                               hindsight in considering whether a cor-          hood. The parties disagreed whether in
if assets are put at undue risk for the ben-   poration was insolvent when considering                                                         court held that in light of the facts known
efit of shareholders); In re Healthco Int’l                                                      determining solvency the court should          at the time of the transaction, a reason-
                                               a transaction implemented many years             only consider those liabilities that were
Inc., 208 B.R. 288 (Bankr. D. Mass 1997)       before. Discussed below are the different                                                       able jury could only find that Keene had,
(Directors that approve a transaction that                                                      known at the time of the transfer (or          or believed it had, more than sufficient
                                               approaches adopted by courts in deter-           those the debtor reasonably should have
renders corporation insolvent where pro-                                                                                                       assets to cover its probable liability. The
                                               mining whether a company facing unde-            known about) or whether the court
ceeds paid to shareholders and not credi-                                                                                                      Second Circuit affirmed because, among
                                               termined disputed liabilities was in fact        should make its determination based on
tors could be held liable for damages).                                                                                                        other reasons, the solvency definition in
                                               insolvent at the time of a particular trans-     actual liabilities, without regard to what
Additionally, when a corporation is insol-                                                                                                     the statute at issue refers to “existing”
                                               action.                                          the debtor knew or should have known
vent, transactions without adequate con-                                                                                                       debts, and therefore unaccrued claims
                                                   One of the earlier decisions to discuss      about the liabilities on the transfer date.
sideration can be attacked by creditors,                                                                                                       could not be included.
                                               the valuation of undetermined liabilities        This was a critical distinction, as the
and payments and other transfers to cred-                                                                                                          However, the willingness of some
                                               in determining solvency is In re Xonics          defendants argued that there was a spike
itors can be recovered if there is a bank-                                                                                                     courts to use hindsight could result in a
                                               Photochemical Inc., 841 F.2d 198 (7th            in asbestos claims after the spinoff trans-
ruptcy filed within ninety days.                                                                                                                company being held to be insolvent
                                               Cir. 1988). In that case, Judge Posner           action was effectuated, which asbestos         based on facts not capable of being ascer-
                                               wrote that in making a solvency determi-         claims eventually forced the company to        tained at the time a particular transaction
                                               nation, a contingent liability must be dis-      seek Chapter 11 protection. The court          is considered. Under existing case law, a
   “. . . in an insolvency                     counted by the probability that the              determined that the Uniform Fraudulent         serious potential consequence of a deter-
situation, some courts have                    contingency would occur and the liability        Transfer Act was applicable which              mination of insolvency could be the
held that the protection of the                become real. For example, if there was a         defined insolvency “by reference to strict      imposition of a fiduciary duty to creditor
                                               1% chance of a $1.7 million guarantee            balance sheet tests; a debtor is insolvent
business judgment rule does                    being called, the value assigned to the
                                                                                                                                               constituencies where decision makers
                                                                                                if its debts exceed its assets” and rejected   may not know that the corporation is
not apply . . ., utilizing a                   liability for the purposes of solvency           the defendants’ position that post-trans-      liable to such creditors. See Lipson,
theory that the assets of an                   analysis would be $17,000. However,              action claims were “contingent” and thus       Directors Duties to Creditors: Power
                                               because Xonics was in the context of a           subject to a discounting analysis because
insolvent corporation are                      “contingent” claim, i.e. a liability that is
                                                                                                                                               Imbalance and the Financially Dis-
                                                                                                the exposure to asbestos, and therefore        tressed Corporation, 50 U.C.L.A. L. Rev.
impressed with a trust for the                 triggered by an extrinsic event that may         the injuries, had occurred pre transaction.    1189, 1255 (2003) (Courts may have to
benefit of creditors and                       never occur (i.e. a guarantee which is           Thus, there was no extrinsic event             fashion protection for directors of a cor-
shareholders, and therefore                    contingent on a default by the primary           required to trigger liability. The court       poration that is discovered, after the fact,
                                               obligor), its application may be limited.        disagreed with the holding of the court in     to have had tort liabilities but directors of
the appropriate standard a                         In any event, courts are sharply split       In re Babcock v. Wilcox, 274 B.R. 230          a distressed corporation that have reason
court will use in reviewing a                  as to the time at which the estimate of          (Bankr. E.D. La. 2002) that a debtor           to know the corporation has engaged in
corporate action is one of                     potential liability is made. Should a            would be considered insolvent only if the      tortuous conduct should owe a duty of
                                               court making a solvency determination            debtor’s estimation of the tort liabilities    care to tort creditors.)
‘entire fairness.’ ”                           use the valuation of liabilities based on        at the time of the transfer were not rea-          Given the lack of clear guidance, cau-
                                               the facts as they appeared at the time the       sonable. Finally, in addressing policy         tion in structuring transactions involving
                                               transaction occurred? Or, should the             arguments, the W. R. Grace court stated        companies facing unknown liabilities
   However, it is often difficult to ascer-     court evaluate the likelihood of liability       that the interests of creditors are para-      may be well advised. Approaches should
tain whether a corporation is in the zone      at the time it considers the transaction         mount, and noted that there will be no         be considered, such as retaining a portion
of insolvency. While the definitions of         (which could be years after the consum-          liability if the transaction involved fair     of proceeds so they remain available to
                                               mation of the transaction) with the bene-        consideration. The court did not have          creditors, or utilizing a bankruptcy pro-
Jeffrey W. Levitan is a Partner in the         fit of hindsight? Unfortunately, there is         any sympathy for the “less-than-full-          ceeding to effectuate a transaction, giv-
Bankruptcy Practice Group of                   no clear answer, and courts in two key           value” transferee, and felt that such party    ing certainty and protection to all
Proskauer Rose LLP in New York City.           commercial jurisdictions, New York and           and the debtor were the appropriate par-       interested parties.

                             Please email the author at jlevitan@proskauer.com with questions about this article.

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