Covey v. Commercial National Bank of Peoria (960 F.2d 657, 1992)

EASTERBROOK, Circuit Judge.

A preference-recovery action requires us to revisit one aspect of In re Xonics Photochemical, Inc., 841 F.2d 198 (7th Cir.1988): how to value contingent liabilities. In 1982 a construction enterprise reorganized. Jobst Corporation was created as a holding company, with stock in four subsidiaries its only assets. With the consent of the lenders, the holding company assumed all of the debt that the enterprise owed to Commercial National Bank of Peoria and Continental Illinois National Bank. The subsidiaries are V. Jobst & Sons, a commercial and industrial construction contractor with headquarters in Peoria, Illinois; New Order, a commercial contractor with headquarters in Tulsa, Oklahoma; Homeway of Illinois, a manufacturer and marketer of single-family homes (and its subsidiary, Homeway of Texas); and Strehlow Corporation, a real estate venture. For clarity we call Jobst Corporation “the parent” and V. Jobst & Sons “Jobst.”

Early in 1984 the family’s senior managers discovered large cost overruns at the Homeways. A partnership (JDJ) between Jobst and Jarvis & DeLoach, Inc., which served as general contractor for residential construction projects (and the principal customer of the Homeways’ products), also was in financial trouble. The partnership abandoned work on several projects, turning them over to the bonding company. Jobst’s managers, and the two principal lenders, believed that New Order and the operations of Jobst outside the JDJ partnership would continue to be profitable if they were refinanced. On May 3 the banks loaned $250,000 to Jobst, $250,000 to New Order, and issued letters of credit from which the beneficiaries eventually drew $775,000. In exchange Jobst guaranteed the parent’s debt to the banks. To back up the guarantee, Jobst gave the banks a security interest in all of its assets — equipment, receivables, everything.

Ten months later Jobst was being liquidated under Chapter 7 of the Bankruptcy Code of 1978. The Homeways, the parent corporation, and the group’s principal manager and equity investor also were bankrupt. See In re Strehlow, 84 B.R. 241 (Bankr.S.D.Fla.1988). The banks sold Jobst’s assets and collected its receivables, obtaining a total of $1,472,937.40. The trustee filed this adversary proceeding, seeking to recover this sum as a preference under 11 U.S.C. § 548. Before the transaction of May 3, Jobst owed nothing to the banks. Because the transaction took place within the year before the bankruptcy, the Code authorizes recapture if the transaction was designed to hinder or delay other creditors (§ 548(a)(1)) or if the debtor received “less than a reasonably equivalent value” and the transaction occurred while the debtor was insolvent or rendered it insolvent (§ 548(a)(2)). The trustee contended that the guarantee and security interest not only were designed to defeat other creditors’ interests (§ 548(a)(1)) but also rendered Jobst insolvent yet did not supply “reasonably equivalent value” (§ 548(a)(2)). Recovery of the $1.47 million the banks obtained from their security interest would inure to the benefit of Jobst’s other creditors, of which there are two groups: suppliers, who had about $2 million in unsecured credit outstanding, and the bonding company, which eventually expended more than $24 million to complete JDJ’s contractual commitments. The trustee renews in this court its argument based on § 548(a)(1), but we need not consider that subject in light of § 548(a)(2).

The bankruptcy judge concluded that the size of Jobst’s contingent liability to the bonding company was unknowable on May 3, 1984. The contingent liability to the banks on the guarantee could be estimated with greater confidence: the judge concluded that there was approximately a 40% chance that the group would pull through its financial distress, and correspondingly a 60% chance that the banks would collect from Jobst under the guarantee. Holding that the value of a contingent liability is the amount the firm must pay if the contingency comes to pass (the parent’s $7.4 million debt), times the probability that this will occur, the judge concluded that Jobst’s guarantee had a value exceeding $4 million. ($7,400,000 x 0.6 = $4,440,000.) Its principal manager put the value of the firm immediately before May 3 at $3.5 million. A contingent liability exceeding $3.5 million then made the firm insolvent, allowing recovery under § 548(a)(2). The district judge affirmed.

Xonics shows that to find the value of a contingent liability a court must determine the likelihood that the contingency will occur. Accord, In re Chase & Sanborn Corp., 904 F.2d 588, 594 (11th Cir.1990); Douglas G. Baird, The Elements of Bankruptcy 150 (1992). To disregard the probability that the firm will not be called on to pay is to regard all firms as insolvent all of the time, for all firms face some (remote) contingencies exceeding the value of their assets. A firm’s product might prove dangerous, maiming hundreds of customers; all of an air carrier’s planes might fall out of the sky, or one of an electric utility’s nuclear stations melt down, creating stupendous liabilities; all of an insurer’s policyholders might die in the same year, generating obligations that exceed its assets. The probability of such occurrences is low, however, and it therefore makes sense to treat the firms as solvent.

According to the banks, the district and bankruptcy judges went awry in choosing the multiplicand. Instead of using the value of the debt guaranteed ($7.4 million), the courts should have used the value of Jobst’s assets ($3.5 million). A guarantee cannot be worth more than the assets standing behind it. Thus the right calculation, the banks submit, is $3,500,000 x 0.6 = $2,100,000, which leaves Jobst solvent after the transaction of May 3. They quote this language from Xonics, 841 F.2d at 200:

Suppose that on the date the obligations were assumed there was a 1 percent chance that Xonics Photochemical would ever be called on to yield up its assets [on its guarantees].... Then the true measure of the liability created by these obligations on the date they were assumed would not be [their face amount of] $28 million; it would be a paltry $17,000. For at worst Xonics Photochemical would have to yield up all of its assets (net of other liabilities), that is, $1.7 million, and the probability of this outcome is by assumption only 1 percent.... Discounted, the obligations would not make Xonics insolvent....

The method used by the bankruptcy court here—multiplying the total debt guaranteed by the probability that the guarantor must make good—would have called for a different example in Xonics: $28,000,000 X 0.01 = $280,000. The banks ask, us to adhere to the method illustrated in Xonics.

Discounting a contingent liability by the probability of its occurrence is good economics and therefore good law, for solvency, the key to § 548(a)(2), is an economic term. That Xonics departs from accounting conventions, see Note, Estimating Contingent Liabilities to Determine Insolvency in Bankruptcy Proceedings, 1989 B.Y.U.L.Rev. 1315, 1328-30, is true but not pertinent. Accountants may value assets at cost (“book value”), but if the market value of a firm’s assets exceeds its liabilities, it is solvent notwithstanding red ink in the balance sheet. The reverse is true as well: a firm whose assets are worth less than book value may be insolvent despite a financial statement showing positive net worth. Market value of both assets and liabilities determines solvency. The formula used in Xonics to find the value of contingent liabilities also is good economics—but only from the perspective of the creditor. The beneficiary of a guarantee never values that obligation at more than the issuer’s gross assets, and if other claims (say, secured debts) stand ahead of this one, the beneficiary does not value the guarantee at more than the issuer’s net assets. Valuing the guarantee for its own purposes, the creditor would proceed just as we did in Xonics. We did not hold, however, that this is the calculation the Code requires. Xonics used an illustration to demonstrate discounting; the parties did not debate, the case did not depend on, and we therefore did not decide, whether the creditor’s perspective is the right one. The subject is open to initial decision.

The Bankruptcy Code requires us to assess things from the debtor’s perspective. Consider a simple case. Debtor issues its note for $10 million. It has assets of $5 million, secured debt of $2 million, and no other debt. From the creditor’s perspective this note is worth somewhat less than $3 million. (Collection is costly and uncertain.) Together, Debtor’s creditors place a value of less than $5 million on its commitments. Nonetheless, Debtor is insolvent. Against assets of $5 million, there are claims of $12 million. Now turn the $10 million note into a guarantee of a parent corporation’s $50 million debt, coupled with a probability of 20% that Debtor will be called on to pay. The two commitments are economically equivalent: $10,000,000 = $50,000,000 X 0.2. The creditor will treat each instrument as worth a little less than $3 million. There is no reason not to treat the promises identically from Debtor’s perspective too. Each commitment renders the firm insolvent by creating aggregate claims exceeding its assets. If we use net assets as the maximum value of a contingent liability, it follows that no contingent liability ever renders any firm insolvent. A $5 million note issued by a firm with $4 million in assets propels the firm into insolvency, but a $5 billion guarantee by the same firm, on which the beneficiary is 99% certain to draw, would not: instead of multiplying $5 billion by 0.99, the court would multiply $4 million by 0.99. Yet all would concede that, from the debtor’s perspective, the guarantee is more costly than the unconditional note. (Consider: What happens if the firm unexpectedly receives an enormously valuable patent shortly after issuing the note or the guarantee? Which of these instruments will the equity owners more regret signing?)

To decide whether a firm is insolvent within the meaning of § 548(a)(2)(B)(i), a court should ask: What would a buyer be willing to pay for the debtor’s entire package of assets and liabilities? If the price is positive, the firm is solvent; if negative, insolvent. To illustrate, suppose Exxon Corporation were considering the acquisition of our hypothetical debtor with outstanding notes of $2 million and $10 million. It would acquire assets worth $5 million and debts of $12 million. Exxon would value this package at a negative $7 million. Now substitute the guarantee of $50 million in debt (with a 20% chance that the principal debtor will not pay). Again Exxon would treat this package as having a negative value of $7 million. That the guarantee exceeds the guarantor’s net assets would be of no moment to Exxon or an equivalently flush buyer. (The assumption of a buyer having assets exceeding the liabilities to be acquired is important. A stumblebum would pay l