Third Circuit values debtor's liabilities at face value for purposes of insolvency analysis under Bankruptcy Code

Secured Lender, The, Sep/Oct 1998 by Bernstein, H Bruce

Third Circuit values debtor's liabilities at face value for purposes of insolvency analysis under Bankruptcy Code In a clear departure from precedent in other circuits, the Third Circuit has ruled that a debtor is "insolvent" for the purposes of bankruptcy when the value of the debtor's propertymeasured at its fair market value, is exceeded by its liabilities - measured at face value. Travellers Int'l v. Trans World Airlines, 134 F.3d 188 (3d Cir. 1998) ("TWA").

In TWA, the debtor brought an action against an insurance company ("Travellers") alleging that a $13.7 million appeal bond that TWA had posted upon losing certain prebankruptcy litigation with Travellers was an avoidable preference under sec 547 of the Bankruptcy Code. Code sec 547(b) sets forth the prima facie elements of a preference action and requires, inter alia, a showing that the debtor was "insolvent" as of the time the alleged preferential transfer. The Bankruptcy Code, in turn, defines insolvency to mean a "financial condition such that the sum of the entity's debts is greater than all of such entity's property, at a fair valuation..." 11 U.S.C. sec 101(32)(A) (emphasis added). Under sec 547(f), there is a rebuttable presumption that the Debtor was insolvent if the transfer was made within 90 days of the filing of the bankruptcy petition (the appeal bond was posted on the 88th day). This case arises out of Traveller's attempt to rebut the presumption of TWA's insolvency.

Arguing that TWA was solvent at the time of the transfer, Travellers requested that the Court value the debtor's assets and liabilities at a "fair market value," which, according to Travellers, required: (i) valuing the debtor's assets as part of a hypothetical sale as a going concern in an open market, without any forced sale discounts; and (ii) reducing the debtor's publicly traded liabilities to the value at which they were trading as of the date of the transfer.

In rejecting Travellers' arguments on both counts, the Third Circuit affirmed the lower court's holding that a "fair valuation" of the debtor's assets contemplated a hypothetical conversion of assets into cash during a "reasonable" (but not unlimited) period of time. The Court defined a "reasonable time" as: the time that the typical creditor would find optimal; not so short a period that the value of the goods is substantially impaired via a forced sale, but not so long a time that a typical creditor would receive less satisfaction of its claim as a result of the time value of money and typical business needs, by waiting for the possibility of a higher price. Id. at 195.

The bankruptcy court had previously held that a hypothetical sale conducted over 12-18 months was a "reasonable time" for the purposes of valuing the debtor's property. The Third Circuit upheld that time period as not clearly erroneous.

The Court then addressed the valuation of TWA's liabilities, considering whether TWA's publicly traded debt should be measured at its face value (approximately $1.8 billion), or its market value at the time of the transfer (approximately $663 million). Travellers argued that the phrase "fair valuation" in the Code's definition of insolvency applied to both the debtor's assets and its liabilities and that, therefore, the lower market valuation should apply. In contrast, TWA asserted that the "fair valuation" qualifier applied only to the asset calculation and that the amount of its liabilities should be calculated at face value instead.

The Third Circuit concluded that its "going concern" valuation methodology mandated valuing the liabilities at face value:

We agree with TWA that we must consider the face value of TWA's publicly traded debt rather than the market value. This follows from our determination that we must treat TWA as a "going concern." [Citation omitted]. Because we treat TWA as a going concern, we cannot consider the market's devaluation of TWA's debt resulting from the possibility as of the date of the transfer that TWA would cease operations and be unable to satisfy its promises.

Thus even accepting . . . that we must fairly value liabilities. . . in this context we do interpret the term "fair valuation" to mean fair market valuation. Because our going concern methodology precludes us from devaluing TWA's debt based on creditors' perceptions of TWA's viability, a fair valuation of TWA's public debt is the face value of that debt. Id. at 196-97.

The Court went on to hold that although its approach permitted it to factor in certain contingent liabilities for "costs arising from foreseeable events that might arise while the debtor is a going concern" when calculating insolvency, the liabilities associated with closing the business (i.e., winding down expenses, severance payments, pension plan liabilities, etc.) were contrary to the "going concern" approach and could not be considered. Id. at 197. After applying this analysis, the Court concluded that the debtor's liabilities did, in fact, exceed its assets as of the time of the transfer and, accordingly, found that the Debtor was insolvent for the purposes of the preference action.