Memorandum To Our Clients and Friends

To Our Clients and Friends
District of Delaware Attributes Value to Debtor’s
Credit Facility in Denying a Fraudulent Transfer
Claim Based on Unreasonably Small Capital
Despite Existing Basis for Lenders to Terminate
and Subsequent Termination of the Facility
On September 30, 2014, in In re SemCrude, L.P., the United States District Court for the District of
Delaware, affirming the Bankruptcy Court’s decision, held that direct partnership distributions by debtor
SemGroup, L.P. (the “Debtor”) and indirect partnership distributions by its general partner, SemGroup
G.P., L.L.C., to certain limited and general partners could not be avoided as constructive fraudulent
transfers. The District Court rejected the argument of the trustee of the SemGroup Litigation Trust (the
“Trustee”) that the Debtor’s line of credit should not be allocated significant value because the Debtor’s
risky options trading activity violated the terms of its credit agreement and, therefore, the Debtor was left
with unreasonably small capital after the distributions were made.
The Debtor was a “midstream” energy company that provided transportation, storage, and distribution of
oil and gas products to oil producers and refiners. More than one hundred lenders formed a syndicate
(the “Bank Group”) that provided the Debtor with a line of credit from 2005 through July 2008 under a
credit agreement dated as of October 18, 2005 (the “Credit Agreement”).
The Debtor traded options on oil-based commodities in connection with its business, using a risky trading
strategy that was inconsistent with the terms of the Credit Agreement. There were no allegations that the
Debtor concealed its activities or engaged in fraud. Between July 2007 and February 2008, the Debtor
had to post large margin deposits on the options it sold, which forced the Debtor to increase its borrowing
under the Credit Agreement from approximately $800 million to over $1.7 billion. In July 2008, the Bank
Group declared the Debtor in default of the Credit Agreement, leading the Debtor to file a voluntary
petition for relief under chapter 11 of the Bankruptcy Code on July 22, 2008. There was no evidence of
record that the Bank Group declared a default due to the Debtor’s risky options trading activity in
contravention of the terms of the Credit Agreement.
In re SemCrude, L.P., 2014 U.S. Dist. LEXIS 137831 (Del. Sept. 30, 2014).
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Prior to the bankruptcy filing, the Debtor made two equity distributions totaling more than $55 million to
Ritchie SG Holdings, L.L.C., SGLP Holding, Ltd., and SGLP US Holding, L.L.C. (collectively, “Ritchie”) in
August 2007 (the “2007 Distribution”) and in February 2008 (the “2008 Distribution”).
The Trustee sought to avoid the 2007 Distribution and 2008 Distribution as constructive fraudulent
transfers under section 548(a)(1)(B) of the Bankruptcy Code, as well as Oklahoma state law, based on two
theories: (1) the Debtor was left with unreasonably small capital after both distributions and (2) the Debtor
was insolvent on the date of the 2008 Distribution. The Bankruptcy Court granted summary judgment
denying the claim based on unreasonably small capital and denied the claim based on insolvency after
trial. The Trustee appealed to the District Court.
District Court Analysis
Unreasonably Small Capital Claim
Pursuant to section 548(a)(1)(B) of the Bankruptcy Code, a trustee may seek to avoid any transfer of an
interest of the debtor in property if the debtor received less than reasonably equivalent value in exchange
for such transfer and, among other grounds, (a) was insolvent on the date of such transfer or became
insolvent as a result of such transfer or (b) was engaged, or was about to engage, in business or a
transaction for which any property remaining with the debtor was an unreasonably small amount of
capital. The District Court turned first to whether the Debtor was left with unreasonably small capital after
the 2007 Distribution and 2008 Distribution. Following the leading Third Circuit decision in Moody v.
Security Pacific Business Credit, Inc., the District Court noted that “unreasonably small capital” denotes a
financial condition short of equitable insolvency and refers to the inability to generate sufficient profits to
sustain operations. In addition, “the test for unreasonably small capital is reasonable foreseeability.” In
Moody, the Third Circuit ruled that it was proper for the district court in that case to consider the
availability of credit in determining whether the debtor was left with unreasonably small capital, but that
“[t]he critical question is whether the parties’ projections were reasonable.” The Third Circuit also
commented that to “strike a proper balance” under the “reasonable foreseeability” test, courts are to take
into account that there are many reasons why businesses fail and that fraudulent conveyance laws “are
not a panacea for all such failures.” The District Court further noted that “there must be a causal
relationship between the [fraudulent transfers] and the likelihood that the Debtor’s business will fail. . . . A
debtor’s later failure, alone, is not dispositive on this issue.”
The District Court wrote that while no cases were found that addressed the factual scenario at present,
consistent with Moody, it is proper to consider the availability of credit in determining whether a company
has been left with unreasonably small capital after a distribution, and that there was no dispute that at the
time of the 2007 Distribution and 2008 Distribution, the Debtor had a substantial line of credit under the
Credit Agreement.
971 F.2d 1056 (3d Cir. 1992).
Id. at 1070.
Id. at 1073.
Quoting In re Kane & Kane, 2013 WL 1197609, at *10 (Bankr. S.D. Fla. Mar. 25, 2013).
Fried Frank Client Memorandum
The District Court next turned to the Trustee’s argument that the Debtor was left with unreasonably small
capital after the distributions because “it was reasonably foreseeable that [the Debtor] would be unable to
sustain its operations due to its massive breach of the Credit Agreement” and the likely termination of the
credit facility provided thereunder. The District Court found that it was not clear from the record whether
the Bank Group was aware of the Debtor’s risky options trading activity that could have been deemed to
be inconsistent with the Debtor’s obligations under the Credit Agreement. In rejecting the Trustee’s
argument, the District Court found that it would be required to engage in multiple levels of forecasting to
accept the Trustee’s position. Specifically, the court would be required to forecast “(1) the lenders’
reaction to discovering the conduct, and then (2) the consequences of that reaction, i.e., that the only
option chosen by all of the lenders would have been to foreclose access to all credit, which (3) had the
reasonably foreseeable consequence of the bankruptcy.”
The District Court noted that such a
speculative exercise is not rooted in existing case law and affirmed summary judgment against the
Trustee on the fraudulent conveyance claims based on the allegation of unreasonably small capital.
Insolvency Claim
The District Court then turned to the issue of whether the 2008 Distribution was a fraudulent transfer
based on the theory that the Debtor was insolvent at the time of the 2008 Distribution. The District Court
began by noting that although the Trustee had the burden to prove insolvency, on appeal the Trustee
offered very little insight into the Trustee’s expert’s approach to valuation and, instead, focused only on
alleged errors committed by Ritchie’s expert. The District Court also noted that Ritchie’s expert used an
income approach to valuation because the Debtor was a going concern at the time of the 2008
Distribution, which was preferable to the asset approach used by the Trustee’s experts. Ritchie’s expert
valued the equity cushion at between $670 million and $2.7 billion at the time of the distribution.
The District Court further commented that judging the credibility and reliability of witnesses at trial is within
the exclusive purview of the trial judge. Since Ritchie’s expert used the preferred valuation method and
presented cogent rationales for its conclusions, the District Court found no error in the Bankruptcy Court’s
entry of judgment after trial in favor of Ritchie in connection with the fraudulent transfer claim based on
alleged insolvency.
The District Court’s decision is an important reminder that in determining whether a debtor had
unreasonably small capital to support a fraudulent transfer claim, a court’s analysis must be based on
reasonable foreseeability at the time of the transaction in question regarding whether the debtor would be
able to continue to generate sufficient cash flow to sustain its operations and carry on its business after
the transaction. As part of that analysis, the court should take into account the debtor’s foreseeable line
of credit projected as of that time. As the District Court cautions, courts should not base an unreasonably
small capital determination on subsequent facts not reasonably anticipated at the time of the transaction,
such as the speculative possibility that lenders will terminate lines of credit due to the debtor’s conduct.
Although it may be tempting for a judge to consider the fact that a line of credit was actually terminated at
a later time, the District Court warns that courts must resist such hindsight bias when determining whether
the debtor had unreasonably small capital at an earlier time.
2014 U.S. Dist. LEXIS 137831, at *10.
Fried Frank Client Memorandum
This memorandum is not intended to provide legal advice, and no legal or business decision should be
based on its contents. If you have any questions about the contents of this memorandum, please call your
regular Fried Frank contact or an attorney listed below:
Authors and Contacts:
New York
Brad Eric Scheler
[email protected]
Alan N. Resnick
[email protected]
Gary L. Kaplan
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Jennifer L. Rodburg
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Kalman Ochs
[email protected]
New York
Washington, DC
Hong Kong