Print   Email   RSS

Insolvency

April 13, 2006

	Visited: 199
	Not rated
	Rate: Select 1 - Terrible 2 - Poor 3 - Average 4 - Good 5 - Outstanding

When battling creditor's challenges to asset transfers, insolvency is a key factor in establishing fraudulent intent in many actual fraud cases, and one of two determining factors in constructive fraud cases.

Because insolvency can be an important factor in asset transfers, you should be familiar with the two different ways to gauge insolvency. Specifically, the Uniform Fraudulent Transfers Act (UFTA) provides that you are insolvent if:

• your liabilities exceed your assets (i.e., a balance sheet analysis shows a negative owner's equity, or net worth), or
• you cannot pay your debts as they come due (i.e., a cash flow statement shows the debtor has a negative cash flow)

Although either version can be important, the cash flow analysis will usually carry more weight.

Work Smart Don't confuse insolvency in a constructive fraud case with insolvency in an actual fraud case. Insolvency is defined in the same way in both situations. However, the effect of a finding of insolvency is very different in each case. In the constructive fraud theory, insolvency, when coupled with a lack of adequate consideration in return for the transfer, automatically renders the transfer fraudulent, regardless of motive or intent. In contrast, under the actual fraud theory, insolvency is weighed by the courts as just one of the factors. Here, it is not absolute proof when it comes to the issue of fraud. Because transfer strategies advocated in this section generally will be for adequate return consideration (thus making constructive fraud a non-issue), insolvency will usually be more important in an actual fraud case, where it is just one factor (albeit usually an important factor) that will be weighed by the court. Nevertheless, because a finding of insolvency will control the outcome of a constructive fraud case, whenever there is an absence of adequate return consideration, the business owner who is, or anticipates becoming, insolvent, must ensure that transfers are either supported by adequate return consideration or that they do not qualify as "transfers" covered under the UFTA.

When making transfers, you should prepare a balance sheet that indicates your financial position (assets minus liabilities) and cash flow statement that shows your liquidity as of the date of that transfer.

However, it must be understood that the UFTA applies to existing and future creditors. Accordingly, any analysis of insolvency also must project your financial position and cash flow (for you and your business) for at least the next three months after a transfer, and preferably for the next year as well. Thus, a second balance sheet and a second cash flow statement should be prepared based on these projections. A finding of insolvency based on either the financial situation on the date of the transaction or under the projections can be significant.

Separate statements for the owner and the business entity. Determinations of insolvency (or, hopefully, the lack of it) will have to be made for you as an individual, based on your individual financial situation when you make a transfer, as in the case of asset exemption planning. They also may have to be made for the business entity, as in the case of liens placed on the entity's assets in favor of the owner or payments from the entity to the owner.

Great care must be taken to separate the owner's personal finances from those of the business entity. If the small business follows our advice, this separation will already exist in the recordkeeping system for the business. This separation is essential if you are to preserve your limited liability for the business's debts (see our discussion of piercing the veil of limited liability).

Balance sheet analysis. This analysis involves subtracting liabilities from assets. Assets should be valued at fair market value, and not original cost, for purposes of this projection. Note that, in a conventional accounting system, most assets will remain in the accounting records at historical cost. For our purposes here, these assets must be adjusted to fair market value. Thus, an adjustment may be necessary for an asset such as an office building, which has appreciated significantly in value. The fair market value of depreciated assets should be used and not the book value, as an estimate of fair market value already includes adjustments for depreciation.

Liabilities should normally be subtracted at face value. This includes any liens established on the assets by the owner, which should always be recorded on the entity's books as liabilities in any event.

Exempt assets must be excluded from the balance sheet equation. In the business entity, this will not affect the calculation because asset exemptions are available only to natural persons.

For an individual, exempt assets are excluded because they are not available to the creditors. However, exempt assets are available to the holders of consensual and statutory liens on exempt assets. Thus, when exempt assets are excluded, the corresponding consensual and statutory liens on the exempt assets also should be excluded.

This will make a significant difference in an individual's balance sheet calculation. Among the assets that must be excluded are the homestead to the extent of its exemption, ERISA-qualified retirement plan assets and, in many states, IRAs.

When the face value of a liability insurance policy would be available to a particular creditor, this amount should be included as an asset in the balance sheet calculation. This would be appropriate when, for example, a claim was made by an injured party in the form of a negligence lawsuit, and the plaintiff, after securing a judgment, alleged that a transfer from the defendant was fraudulent. This can make a dramatic difference in the calculation results, turning the results into a finding of solvency.

It would be inappropriate to include the face value of the policy in the calculation when the policy could not be paid to the creditor in question (e.g., a breach of contract claim). Thus, the calculation should initially be made without inclusion of the face value. A second determination, made by plugging this amount into the equation, should also be made. This determination will be relevant only with respect to those creditors who could make claims covered by the policy (i.e., usually claims based on the commission of a tort, such as negligence).

Ultimately, the effect of the exclusion of exempt assets will mean that, in many cases, individuals will be deemed insolvent. Similarly, financing the business entity with leases and loans and encumbering the entity's assets with liens in favor of the owner, all of which are extremely effective asset protection strategies, will also mean that in many cases the business entity will be insolvent, according to the calculation.

In these situations, it is essential to exchange adequate consideration when making transfers, to avoid application of the constructive fraud theory. Then, actual fraud can be avoided through proof that the debtor is not insolvent from a cash flow perspective, plus proof that the transfer was motivated by a legitimate reason, as explained above. In addition, the absence of findings on the other factors can help to disprove an allegation of actual fraud.

The forward-looking (sometimes called projected, or pro forma) balance sheet should include any assets and liabilities (subject to the rules discussed above) that the individual or business, as the case may be, can reasonably expect to materialize. As discussed above, this projected statement should be in addition to a balance sheet based on the individual's or business entity's existing financial position.

The forward-looking balance sheet is important because an anticipated change in circumstances can be used to prove or disprove insolvency. A debtor who is solvent at the time a debt was incurred can be ruled insolvent at a future date, when he or she fails to pay the debt. If it can be shown that the debtor could have reasonably anticipated this result, this can be important evidence of fraudulent intent.

Conversely, a debtor who is insolvent at the time a debt is incurred can disprove intent of fraud by proving that he or she reasonably anticipated being able to pay the debt through future earnings. This strategy is discussed in more detail above.

Cash flow statement analysis. Measuring cash flow for an individual amounts to adding up the individual's monthly sources of income, and then subtracting the monthly expenses. A home finance program such as Intuit's "Quicken" or Microsoft's "Managing Your Money" will be helpful here. A cash flow statement is a standard feature in every business accounting software program. Thus, for the business entity, you can generally rely on the business entity's accounting software to make such calculations.

Ratios can be used to quickly gauge an entity's current and future solvency from a cash flow perspective. The current ratio is calculated by dividing the entity's current assets by its current liabilities. Current assets are those that will be converted to cash or used up within one year. Current assets include cash, receivables, marketable securities, inventory and prepaid expenses. Similarly, current liabilities are those that will be paid within the next year. This should include the next 12 monthly payments for any installment loans (such as mortgages, or car loans). A result of 2:1, or better, is desirable. A ratio of 1:1 means the entity is solvent, but on the border of being insolvent in the sense of being unable to pay its debts as they come due. A different version of the ratio, called the quick ratio or acid test ratio, excludes inventory and prepaid expenses from the definition of current assets, on the grounds that inventory can be difficult to quickly convert to cash. This ratio should normally be 1:1 or better.

Take into account any source of income that can reasonably be expected to materialize. As was suggested above, courts generally hold that, if such sources do not materialize, there is no fraud, as long as the original projections had some basis in fact. Here, again, offering a reasonable explanation, with supporting proof, can be an effective strategy.

Let's say Linda Jones had a reasonable expectation, based on past experience, that she would receive a sizable bonus in the last quarter of the year. Accordingly, in anticipation of this bonus, she makes substantial charges on her credit card, even though at the time of the purchases she is insolvent. Here, the future projection of solvency, if reasonable, would negate any finding of fraudulent intent. Similar conclusions are warranted when a business incurs debt or makes transfers at a time when it is insolvent. If such transactions are based on reasonable projections that the entity would be solvent in the future (e.g., from increased sales, decreased operating expenses, etc.), these projections can negate a finding of fraudulent intent even if the projections do not materialize. Conversely, debts incurred on a date when the individual or business was solvent can be shown to be the result of fraudulent conduct, when reasonable projections would have indicated future insolvency.

Proof that the debtor was not insolvent from a cash flow analysis can negate a finding of insolvency from a balance sheet analysis, as illustrated in the examples below.

John Smith, a Florida resident, owns a home worth $180,000, which is subject to a mortgage in the amount of $100,000. He also has an ERISA-qualified retirement plan with assets worth $140,000. His only nonexempt asset is cash in a savings account of $19,000. His only other liability is for several credit cards that total $20,000. Smith makes mortgage payments with his credit card, totaling $4,000. This leaves Smith with a balance on his credit cards of $24,000. Smith is insolvent under the balance sheet analysis ($19,000 less $24,000). The home and the retirement plan must be excluded from the calculation because both are completely exempt. The corresponding mortgage loan on the exempt home must also be excluded. If Smith is paying his monthly bills as they come due, he will not be insolvent from a cash flow perspective. For example, Smith earns $4,000 per month, has monthly expenses of $2,000 and he has been paying his bills each month. Smith is not insolvent, despite the results from the balance sheet analysis. The cash flow analysis makes more sense in this case, and it should, accordingly, bear more weight in any court proceeding. Now let's say Smith has a limited liability company (LLC). The LLC has $210,000 of assets it owns, including cash in a checking account of $20,000. Smith has liens on these assets from various extensions of credit he made to the entity. The LLC also has $100,000 of assets in its possession that it leases from Smith. The LLC also has $80,000 of other liabilities, from open accounts it has with suppliers. Also, the LLC pays Smith's monthly salary of $10,000. The LLC is insolvent, from a balance sheet analysis: $200,000 of assets less $280,000 of debt. The lease of assets must be excluded because the LLC does not own these assets and they are, thus, unavailable to its creditors. The $200,000 of liens created by Smith ($210,000 - $10,000 monthly salary) will be for liabilities the LLC owes Smith, for extensions of credit Smith made to the LLC (loans, unpaid wages, etc.). Thus, these liabilities must be included in the total liabilities. Nevertheless, the LLC can escape any allegation of insolvency based on the same rationale as in the first example. If the LLC is paying its bills as they come due, it will not be deemed insolvent, despite the results under the balance sheet analysis.

Regardless of whether you're planning to make a transfer in the near future, you should periodically make separate determinations of solvency for yourself personally and for your business, being careful to separate your resources from those of the business entity.

Your personal analysis will be relevant for asset exemption planning and personal borrowing, while the business entity's analysis will be relevant when the entity makes payments to, and creates liens in favor of, you, and otherwise engages in borrowing.

 Feedback   Mail To A Friend   Submit Article   Add To Favorites