Fraudulent conveyance laws may end up back in the spotlight as the economy slows following a period of sharply increased leveraged buyout activity and aggressive lending tactics. Since participants in leveraged transactions are more sophisticated than in the past, plaintiffs may focus on unreasonably small capital, rather than insolvency, to show that a debtor engaged in a constructively fraudulent conveyance or transfer. Unfortunately, unreasonably small capital is an underdeveloped legal concept, particularly with regard to standards by which courts can determine whether a transaction left a debtor with unreasonably small capital.
The leading case on the subject, Moody v. Security Pacific Business Credit, decided during the aftermath of the I98os LBO boom, defines unreasonably small capital as a "financial condition short of equitable [cash flow] insolvency." Moody held that the test for unreasonably small capital is "reasonable foreseeability" and the critical issue is whether the financial projections prepared by the parties to a transaction were reasonable. The general approach now used by most courts is a fact-based test of whether a debtor's cash flow forecasts are reasonable and leave enough margin for error to account for reasonably foreseeable difficulties, which could be described as a "cash flow cushion" test.
This Note proposes a broader test for unreasonably small capital, based on views advocated by other courts and commentators around the time of Moody, whereby unreasonably small capital is defined as a financial condition that poses an unreasonable risk of loss to creditors. It proposes a broad-based test of all facts and circumstances including the amount of cash flow cushion (the Moody test), equity cushion, and all other factors that impact creditworthiness, including criteria used by ratings agencies, to determine when the risk of loss becomes unreasonable. That point may be when a reasonable creditor would no longer be willing to extend additional credit. This approach is more consistent with the purpose of fraudulent conveyance laws (protecting creditors) and longstanding case law.
Lee B. Shepard,
Beyond Moody: A Re-Examination of Unreasonably Small Capital,
57 Hastings L.J. 891
Available at: https://repository.uchastings.edu/hastings_law_journal/vol57/iss4/5