Contingent Liabilities Determine Insolvency?

Official Comm. of Unsecured Creditors of LB Steel, LLC v. Steelcast Ltd. (In re LB Steel, LLC)

In the LB Steel, LLC bankruptcy case,1 a trial was held to resolve the issue of whether the trustee was able to avoid payments made to the parent company during the preference period.2 The issue turns on the sole issue of whether the debtor3 was insolvent during that preference period. Drilling down, the court4 determined that the insolvency boiled down to the inclusion of a value for a contingent liability. In this case, that liability was a pending litigation matter between the debtor and a construction company. The evidence presented at trial clearly indicated that it was almost a certainty that the debtor would incur some liability as a result of this litigation. The court noted that case law is on the side of including both contingent assets and contingent liabilities in determining the solvency or insolvency during the preference period. 

The court also noted that contingent liabilities are by their very nature an estimate of value and that the estimate should be of the present value of that liability at the appropriate date. The court sided with the debtor’s expert’s decision to include a value for the contingent liability. Although the court did not necessarily agree with the amount of the contingent liability the expert gave, the court applied a test based on the likely lowest amount of probable liability that was sufficient to create an insolvency for the business.

Having been engaged on a number of bankruptcy cases, I inevitably ran across this problem. In a particular case, the debtor’s trustee engaged me to determine the solvency of the debtor during various dates when alleged fraudulent transfers were made. In that case, the debtor made furnaces that were used primarily in warm climate locations. Unfortunately, the furnaces had a bad habit of catching on fire. So we had to construct a “reserve” for the probable payments to be made to claimants for damages related to these furnaces catching on fire. We did a lot of ground work in determining the “value” of that reserve, but the court accepted our value, and, without that value included as a liability of the debtor, the debtor would not have been insolvent at the various payment dates that were under question.

In both the LB Steel, LLC case and in my case, the court clearly understood that a liability (or an asset for that matter) does not have to be on the debtor’s balance sheet to be included in the computation of solvency. Valuation does not rely on financial statements. Instead it relies on an accumulation of all of the assets and operations of a business minus all of the liabilities, whether on the financial statements or not, in determining solvency. So don’t forget about those pesky contingent liabilities.

1 Full citation, Official Comm. of Unsecured Creditors of LB Steel, LLC v. Steelcast Ltd. (In re LB Steel, LLC), 2022 Bankr. LEXIS 2894; 2022 WL 6659945 (Oct. 11, 2022).

2 The 90 days prior to the filing of the bankruptcy.

3 LB Steel, LLC.

4 United States Bankruptcy Court for the Northern District of Illinois, Eastern Division.