CFL Bankruptcy & Insolvency Litigation 2 — Questions and Answers
Question 1: What test do courts apply to determine whether a debtor was insolvent at the time of a challenged transfer in a bankruptcy avoidance action?
- The balance sheet test: whether liabilities exceeded the fair value of assets at the time of the transfer (Correct answer)
- The cash flow test only: whether the debtor could pay debts as they came due
- Either the balance sheet or the going concern value test, at the debtor's election
- Insolvency is presumed for any transfer made within 12 months of filing
Correct answer: The balance sheet test: whether liabilities exceeded the fair value of assets at the time of the transfer
The Bankruptcy Code's insolvency definition is the balance sheet test: a debtor is insolvent when the sum of debts exceeds the fair value of all property at a fair valuation.
Question 2: What is a 'cram-down' in Chapter 11 plan confirmation?
- Confirmation of a plan over the objection of a dissenting class if the plan is fair and equitable and does not discriminate unfairly (Correct answer)
- Forcing all unsecured creditors to accept equity in the reorganized entity
- A provision that eliminates all pre-petition claims upon confirmation
- A plan provision that requires management to resign upon emergence
Correct answer: Confirmation of a plan over the objection of a dissenting class if the plan is fair and equitable and does not discriminate unfairly
Under 11 U.S.C. § 1129(b), a plan may be confirmed over a dissenting class's objection if it satisfies the 'fair and equitable' standard, which includes the absolute priority rule for that class.
Question 3: What is the 'new value exception' to the absolute priority rule in Chapter 11?
- Existing equity holders may retain an interest if they contribute new money or money's worth to the reorganized entity equal to the value of the interest received (Correct answer)
- Junior creditors may receive new securities instead of cash to satisfy the priority rule
- The exception allows management to receive equity compensation regardless of senior creditor recovery
- New value contributions by directors automatically satisfy all creditor claims
Correct answer: Existing equity holders may retain an interest if they contribute new money or money's worth to the reorganized entity equal to the value of the interest received
The new value exception permits existing equity to survive a cram-down if shareholders contribute new capital at least equal in value to the equity interest they retain in the reorganized entity.
Question 4: Under the 'business judgment rule' as applied in bankruptcy, what standard governs a Chapter 11 trustee's or DIP's decision to sell assets outside the ordinary course of business?
- The trustee must show a sound business purpose for the sale and that it is in the best interest of the estate and its creditors (Correct answer)
- Any asset sale outside ordinary course automatically requires court approval and a competitive auction
- The trustee has absolute discretion to sell any assets without court review
- Asset sales are governed by state law, not the Bankruptcy Code
Correct answer: The trustee must show a sound business purpose for the sale and that it is in the best interest of the estate and its creditors
Section 363(b) requires court approval and a showing of sound business purpose for sales outside the ordinary course, and courts apply a business judgment standard to the debtor's decision.
Question 5: What is 'substantive consolidation' in bankruptcy, and when do courts order it?
- The pooling of assets and liabilities of multiple affiliated entities into a single bankruptcy estate, ordered when the entities are so intertwined that separate treatment would harm creditors (Correct answer)
- The consolidation of multiple bankruptcy cases into one court for administrative efficiency only
- The merger of a subsidiary's estate into the parent's estate upon plan confirmation
- A provision allowing joint filing by multiple entities under a single petition number
Correct answer: The pooling of assets and liabilities of multiple affiliated entities into a single bankruptcy estate, ordered when the entities are so intertwined that separate treatment would harm creditors
Substantive consolidation merges the legal estates of related entities, eliminating inter-company claims and pooling assets for creditor distribution — courts require a showing that benefits outweigh harm to creditors who dealt with entities separately.
Question 6: What is the 'strong arm clause' under 11 U.S.C. § 544, and what power does it grant the bankruptcy trustee?
- The power to avoid any transfer that could be avoided by a hypothetical lien creditor or bona fide purchaser of real property as of the filing date (Correct answer)
- The power to reject any executory contracts the debtor entered into within one year of filing
- The authority to cancel all pre-petition security interests that were not perfected before filing
- The power to subordinate insider claims without proving inequitable conduct
Correct answer: The power to avoid any transfer that could be avoided by a hypothetical lien creditor or bona fide purchaser of real property as of the filing date
Section 544's strong arm powers give the trustee the status of a hypothetical lien creditor or bona fide purchaser, allowing avoidance of unperfected security interests and other defective pre-petition transfers.
CFL Bankruptcy & Insolvency Litigation 2
What test do courts apply to determine whether a debtor was insolvent at the time of a challenged transfer in a bankruptcy avoidance action?