Is Community Property Included in Determining Solvency?

Samson v. Western Capital Partners LLC (In re Blixseth), 2013 Bankr. LEXIS 1001 (March 28, 2013)

Despite Edra Blixseth being one of the Forbes’ 400 wealthiest Americans in 2007, the Bankruptcy Court in Montana found her, in fact, insolvent.

In June 2007, Edra and her estranged husband were in the midst of a “long, costly, and acrimonious” California divorce. The divorce court appointed the husband as manager of the community property; he, in turn, curtailed Edra’s access to all family businesses and cash flow. During that time, Edra also entered into legal disputes related to her $18 million investment in two technology companies. In July 2007, she described her financial condition as “trying to pay $100 worth of stuff with 10 cents.” She was approximately $2 million in arrears to creditors, she stated in an affidavit, even after using all her money from the sale of real estate.

Also at that time, the husband ended his financial involvement with the businesses of the Edra’s son. Searching for funds to develop various projects, the son approached the defendant – Western Capital – for money. Western Capital considered this “the opportunity to do a large loan, anywhere between $5 million and $15 million for a billionaire and her son.” Regardless of the family’s cachet, it adhered to its standard practice and required personal guarantees from the Edra and her son. Recognizing that the son’s assets were all “illiquid,” the lender admitted the inducement to make the loan was Edra’s guarantee. When the defendant was unable to obtain Edra’s financial statements for due diligence, it accepted a written statement from her attorney regarding her financial and legal condition. Based on a preliminary review of the assets, the letter stated, it appeared the assets of the couple’s estate were community property, totaling “in excess of $1 billion.” It further noted that, under California law, the wife was expected to receive assets in excess of $500 million.

The two-year loan to Edra’s son closed on June 15, 2007, for a total amount of over $13 million. Edra’s personal guarantee included an after-acquired property clause. Between May 30, 2007, and Sept. 9, 2008, directly or indirectly, she made payments of over $4.5 million to the defendant. Edra’s divorce only became final in October 2008; along the way, the couple had reached two “minisettlements” and a 42-page final agreement that awarded her several businesses that declared Chapter 11 bankruptcy in November 2008.

In January 2009, the defendant obtained a default judgment against Edra and her son for nearly $13.3 million, after the son had failed to make payments on the loan. In March 2009, Edra filed for voluntary Chapter 11 bankruptcy, showing secured debt of nearly $103 million and unsecured debt of nearly $57 million.

After conversion to Chapter 7 bankruptcy, the trustee in charge of administering the bankruptcy estate filed an adversary proceeding against the defendant, claiming in essence that the guarantee was avoidable because it was a fraudulent transfer, because on the signing date, June 15, 2007, the debtor, Edra, was insolvent. The defendant claimed that Edra received reasonably equivalent value and was solvent. Both sides presented expert testimony.

To avoid the guarantee, under federal bankruptcy law, the trustee needed to show: (1) that the debtor was insolvent at the time she incurred the obligation or rendered insolvent by it; and (2) that she received less than reasonably equivalent value.

1. Solvency. Both sides’ experts—both CPAs—agreed that the debtor would be insolvent if she failed one of three tests: the cash flow test, balance sheet test, or adequate capital test. Not surprisingly, the trustee’s expert stated the debtor was insolvent under all three, whereas the defendant’s expert found her solvent under all of them.
The disparate conclusions stemmed in part from a disagreement over whether to include community property in the solvency analysis. The trustee’s expert considered only the debtor’s personal liabilities and the personal assets over which she had control on June 15. While he recognized that “control” of an asset was not a factor under the general balance sheet test, he nevertheless contended it was a critical element for any solvency analysis because all tests “come back to what an asset can generate in terms of cash on a forward looking basis.” He considered cash flow, and specifically future cash flows, “the most important determinant as to one’s ability to repay debts and meet scheduled obligations.”

For his analysis, he relied on information the trustee provided, reviewing about 1,000 pages of documents. Four or five of them, he said, had particular relevance, including the debtor’s bankruptcy schedules. These showed that in March 2009 she had zero operating cash flow, and, based on her own reports, her liabilities then exceeded her assets by roughly $60 million. Accountants routinely perform a “subsequent event review,” that is, “looking at events through the date of the report” when completing audits, he stated. He carefully reviewed a 2009 expert report from the bankruptcy proceedings related to one of the major assets the debtor obtained at divorce. It showed that by 2007 this business was highly leveraged, with insufficient capital to fund its financial plans and projections. He further reviewed affidavits and declarations the debtor had signed in the course of divorce and analyzed her general ledger activity to corroborate her statements. All this information confirmed her claim that in June 2007 her expenses amounted to $2 million and that she was borrowing to pay her daily expenses, he said. He had, the expert continued, looked hard to find assets that would generate cash from day-to-day activities. “The only form of cash generation that could occur would be through the sale of that asset, and that would essentially reduce her committed obligations.” He went on to conclude that, on June 15, 2005, her debts were roughly $21.5 million; this amount increased to $160 million by March 2009. Her assets on the signing day were only about $16.4 million. Her ability to borrow throughout did not substitute for operating cash flows, he said. The debtor was “the very definition of insolvency,” the expert concluded.

The defendant’s expert rebutted the opposing testimony and made her own solvency determination. She agreed with the trustee’s expert’s valuation of assets and liabilities. But she assumed, “as a matter of law,” that on the signing date Edra owned half of the marital assets. Therefore, she added assets that the debtor owned pursuant to the first mini settlement and subsequently further adjusted the debtor’s balance sheet to include what she called the debtor’s “vested 50 percent interest in the community property.” She based the second analysis on a June schedule of assets the husband had submitted to the divorce court (the opinion here states two conflicting dates, June 2007 and June 2008).

From a balance-sheet perspective, the debtor had assets in the amount of $377 million in June 2007; their value was roughly $173 million more than her liabilities. At the same time, the debtor had about $47 million in personal assets, excluding community property, and approximately $8.5 million in liabilities, the defendant’s expert concluded.

The cash flow test, she stated, centered on a debtor’s intent: Did she intend to incur or believe that she would incur debts beyond her ability to repay? The debtor’s statements that she planned to repay debt as it matured were “pretty good proof” that she was solvent under this test, the expert concluded.

The defendant’s expert also found the debtor was solvent under the adequate capital test, which considers “whether or not the transaction left the debtor with insufficient capital to continue normal business operations.” Avenues to obtain capital included operations, borrowing, or equity financing, the expert stated. In June 2007, the debtor was able to borrow money to fund her day-to-day operations.

The trustee’s expert failed to use “professional skepticism” in his analysis of documents that came into existence after June 2007, the defendant’s expert noted. These did not record “historical circumstances” but were “filed with the Court for the purposes of eliciting a result.” Moreover, she faulted him for considering the full amount of the debtor’s guarantee as a liability. He did not account for the value of the primary security, that is, “the probability that the other guarantor, [the son], would not satisfy the remainder of the loan.”

The trustee’s expert gave his own rebuttal. The competing expert failed to perform a proper analysis under any of the tests. Without questioning, she accepted the values the husband had assigned to assets in determining one-half of the community property and then subtracted certain liabilities.

The court credited the testimony of the trustee’s expert for numerous reasons:

• His choice to exclude community property that was under the control of the debtor’s husband aligned with case law that stated “[a]sset valuation … should be reduced by the value of those assets not readily susceptible to liquidation and the payment of debt.”
• In her solvency analysis, the defendant’s expert failed to consider whether any of the community assets generated income. She ignored the fact that “the marital asset which supposedly had the most value” was in financial straits and lacked the ability to generate any cash flow.
• While the defendant’s expert criticized the trustee’s expert for being insufficiently skeptical, she was the one who “applied no professional skepticism to values assigned to marital assets by [the husband].” By contrast, the trustee’s expert “tested the veracity of the documents and declarations he examined.”
• As to his ignoring that there were other primary borrowers (the companies the son set up for purposes of the loan) and two primary guarantors, the court pointed out that, before the promissory note matured, the defendant “was looking to Debtor for payment on the obligation,” as court documents against the son and debtor showed.
• The trustee’s expert “persuasively testified” that a solvency analysis should begin with an entity’s operating or future cash flows to determine “the supportable level of debt.” In 2007, none of the assets the debtor ultimately received had positive cash flows.
• Regardless of whether one considered only the assets over which the debtor had control or one-half of the community assets, the debtor was insolvent on the day of signing the guarantee.

2. Reasonably equivalent value. The defendant tried to argue that the debtor did not need to receive reasonably equivalent value for the full amount of the $13 million loan because there were other assets that secured the loan. The court dismissed this claim, noting the defendant itself admitted that it considered the son’s assets “illiquid and high-risk” and relied “almost exclusively” on the divorce settlement to ensure repayment.
The court also disposed of the claim that the debtor received “value” upon signing. “The sole value of the guarantee to Debtor was a mother’s satisfaction in helping her child,” the court said. There was no other value, “particularly from the standpoint of [her] creditors.”

Regardless of how Forbes magazine portrayed her, at the relevant time, the debtor did not have sufficient assets to support her lifestyle or carry on any business. In the defendant’s opinion, she was “too big to fail”; however, that opinion was based on “unreliable and untested information,” the court concluded.

As a remedy, it set aside the guarantee and ordered the defendant to return property it had received from the debtor and her son and still held as well as pay the trustee $4 million for property it had received but no longer held.

The determination of solvency is a matter of opinion, and, therefore, subjective. At Rosenfarb LLC we produce well supported, well-reasoned and well communicated solvency opinions that withstand the rigors of litigation. We are a firm of forensic accounting and valuation experts. We understand business, have keen insights and always connect the dots. We understand the litigation process. We frame the issues simply and in alignment with the litigation strategy. We use logic to support our opinions, while creating compelling stories. We are sincere, professional and credible. We are accounting experts with legal acumen.