Valuation of Assets in Business Bankruptcies
The valuation of assets plays a central role in most business bankruptcies. Among other things, a proponent of a chapter 11 plan must establish an accurate value of the debtor’s business, as such valuation is often tied to distributions to creditors, who are voting to approve the plan.
Valuation is also important in determining the amount of a secured claim, which may entitle a secured claimant to collect post-petition interest and other charges; collect adequate protection payments; relief from the automatic stay (enjoining litigation against the debtor); and credit bid the value of its secured claim in an auction for the sale of the debtor’s assets.
In avoidance litigation, valuation is important in determining whether the debtor was insolvent prior to bankruptcy, as insolvency is a critical element in establishing whether the debtor’s prepetition payments or transfers are avoidable. See 11.U..S.C. s. 547.
Generally, methods for fixing value fall into two categories: liquidation or going concern values. The purpose of the appraisal or valuation determines which approach should be followed. For example, the value of a single asset or liquidating business may be accurately established by liquidation value, while a reorganizing business or revenue producing asset generally entails a going concern value, which can include a premium for the goodwill of the company.
Unfortunately, in most instances, the Bankruptcy Code does not prescribe a particular method of valuation of assets. As a result, bankruptcy judges are often left to determine, on a case-by-case basis, the appropriate method of valuation based on the “proposed disposition or use of such assets.” See, e.g., 11 U.S.C. s. 506(a).
In recent history, the most significant development in the area of valuation was the Supreme Court’s 2004 decision in Till v. SCS Credit Corp., 124 S.Ct. 1951 (2004). There, the Supreme Court determined that in a chapter 13 cramdown context (where creditors do not approve the plan), the interest rate on payments to a secured claim under a plan must take into consideration the risk associated with the repayment. The Court evaluated four approaches in determining the appropriate interest rate: the formula rate, the coerced loan rate, the presumptive contract rate, and the cost of funds rate.
Under the formula rate, the national prime rate is adjusted to reflect the risk associated with a loan to the particular debtor. See Till, 124 S.Ct. 1957. Under the coerced rate, the appropriate rate of interest would be the rate charged by a lender who anticipates foreclosing on the loan based on the creditworthiness of the borrower at the outset. See id. Under the presumptive contract rate, the presumed rate is the contract rate, which can still be adjusted based on the risk and term of the loan. See id. at 1957-58. Under the cost of funds rate, the rate it would the cost the borrower to obtain the same financing, using the same collateral. See id. at 1958.
The Supreme Court ultimately adopted the formula rate because it “entails a straightforward, familiar, and objective inquiry, and minimizes the need for potentially costly additional evidentiary proceedings [and] the resulting ‘prime-plus’ rate of interest depends only on the state of the financial markets, the circumstances of the bankruptcy estate, and the characteristic of the loan; not the creditor’s circumstances or its prior interaction with the debtor.” Id. at 1961.
While Till was an opinion in a chapter 13 case (applicable to consumers), its holding has been used to analyze the appropriate rate of interest in chapter 11 cases. In a footnote, the Till opinion itself provides that “when picking a cram down interest rate in a Chapter 11 case, it might make sense to ask what an efficient market would produce.” Id. at note 14.
In the aftermath of Till, courts and commentators have been struggling to apply the Till holding in chapter 11 cases. The Sixth Circuit found that, after Till, “the market rate should be applied in chapter 11 cases where there exists an efficient market.” See In re Am. HomePatient, Inc., 420 F.3d 5559, 568 (6th Cir. 2005). According to the Sixth Circuit, where no efficient market exists, then the bankruptcy court should employ the formula approach used in Till. See id.
Going Concern Valuation
Several cases in Delaware and Texas demonstrate the unique valuation challenges when valuing a going concern company during the plan confirmation process. The Code simply does not provide court’s with a uniform standard to use in this context.
In In re Exide Technologies, 303 B.R. 48 (D. Del. 2003), the valuation of the debtor’s assets was central to the court’s determination whether the chapter 11 plan was confirmable. The court rejected the debtor’s valuation expert because his subjective adjustments to components of his evaluation, including discount rate, varied too much from the generally accepted method. The debtor’s plan divided unsecured claims into 2 classes. The first class consisted of prepetition lenders, which could elect to receive either cash or equity. The second class was divided into 2 subclasses, general unsecured claims and prepetition note claims. Under the plan, relying on the debtor’s calculations, general unsecureds and noteholders would receive a 1.4% recovery, including $4.1 million in equity in the reorganized debtor. The prepetition lenders would receive the balance of ownership in the reorganized debtor. The prepetition lender class was the only class that voted in favor of the plan.
In denying confirmation, the Exide court found that the plan was not fair and equitable with respect to the dissenting unsecured creditor subclasses. The experts for both the debtor and committee used the comparable company method, comparable transaction analysis, and the discounted cash flow analysis, in valuing the company. However, the debtor’s expert valued the company at $950 million to $1,050 billion, while the creditors committee’s expert valued it between $1.478 billion and $1.711 billion.
The debtor’s expert subjectively adjusted downward certain variables in calculating the debtor’s value, including the multiples applied to the debtor’s EBITDA in the comparable company analysis and the comparable transaction analysis, used to calculate the debtor’s terminal value in its DCF analysis. The goal of the debtor’s expert was to bring value calculations in line with the current market value. The creditors committee’s expert argued, however, that no adjustment was necessary.
Siding with the creditors committee, the Exide court held that a straightforward valuation was more appropriate because the “taint” of bankruptcy will generally cause the market to undervalue ownership interests and the debtor’s future earning capacity. Thus, the market-based adjustments made by the debtor’s expert were not proper to consider the debtor’s going-concern value. The court ultimately adopted the value of $1.4 and $1.6 billion, which was within the creditors committee’s range. In doing so, the Exide court agreed with the committee’s expert that projected earnings values were appropriate for calculating the value of entities emerging from bankruptcy because such values take into account the benefit of restructuring.
In In re Coram Healthcare Corp., 312 B.R. 321 (Bankr. D. Del. 2004), the court found that, for plan confirmation purposes, it was proper to adjust going concern value based on the value given to unsecured creditors under the plan. But, the Coram court rejected subjective adjustments of the debtor’s EBITDA or growth rate, finding the purpose of valuation drives the method used.
Among other things, the court examined whether a value from an income method could be adjusted to reflect items of value not considered in the income method. The court ultimately found that, because the chapter 11 plan transferred equity to noteholders and did not involve a sale, a proper valuation should have included all items of value given to the noteholders, not just items that affected the debtor’s sale price. For example, net operating loss carryovers, unavailable to a purchaser of more than 50% of equity, should have been added to the debtor’s value because the Tax Code effectively permitted a transfer of NOLs under a chapter 11 plan.
Te Coram court did not go as far as to say that other items of value, like avoidance actions or goodwill, could be considered. The court nonetheless refused to apply market consideration to value the restructured debtor’s going concern value, without an upward adjustment for the intended purpose, i.e., transfer of ownership without a sale.
In In re Mirant, 334 B.R. 800 (Bankr. N.D. Tex. 2005), a Texas bankruptcy court echoed the Exide court’s concerns that the market undervalues debtors emerging from bankruptcy. In the words of the Court, the “market’s formula for valuing Mirant Group is too pessimistic about the effects of bankruptcy and not sufficiently appreciative of chapter 11’s benefits,” which include a cleaner balance sheet, resolution of unknown factors, like litigation, that could have effected cash flow, and rejection of contracts.
The Mirant court used as a starting point the valuation made by a financial advisor under the discounted cash flow method based on how the market would value Mirant for purposes of equity investment in or loans to Mirant. In determining that a higher valuation was necessary, the court observed that it did not “accept that what the market would demand for investment is equivalent to what the Code commands creditors are entitled.
Many times, in the context of litigation, like fraudulent transfer litigation or preference actions, experts are asked to value companies in hindsight.
For example, in VFB LLC v. Campbell Soup Co., 482 F.3d 624 (3d Cir. 2007), the court, in a fraudulent transfer suit, was required to determine whether a subsidiary of Campbell Soup was insolvent when it spunoff from its parent. Prior to the subsidiary’s bankruptcy, Campbell Soup had engaged in a leverage spin transaction in 1998, whereby it incorporated a wholly-owned subsidiary, Vlaska Foods International, Inc., and sold to Vlaska several food companies. Vlaska took on bank debt to finance the transaction. Campbell then distributed the stock in Vlaska to Campbell’s shareholders in an in-kind dividend. Prior to the spin, Campbell had artificially improved the operating results of these food companies, using techniques like “product loading” to encourage retailers to increase inventory–and thus increase sales of Vlaska in the short term.
After the spin, Vlaska’s sales and earnings figures corrected themselves and these declines led to a covenant breach in Vlaska’s loan agreements, which ultimately required renegotiation. While Vlaska did not immediately collapse after the spin, it nonetheless filed bankruptcy in 2001. Vlaska eventually assigned all its claims to a liquidating trust, which was controlled by creditors. The liquidating trust later brought claims against Campbell, asserting that the spinoff constituted constructive fraud on creditors.
The district court found that there was no constructive fraud because the food companies acquired by Vlaska were worth more than the price Vlaska paid for them. The court based this conclusion on the price of Vlaska’s stock following the spinoff, which price remained high even after the market recognized the “product loading” short term strategy employed by Campbell.
The Third Circuit Court of Appeals found that the district court did not err in choosing to rely on objective evidence from the public equity and debt markets. According to the Third Circuit, in this instance, absent some reason to distrust it, the market price is a more reliable measure of the stock’s value than the subjective estimation of expert witnesses. VFB LLC, 482 F.3d at 633.
The VFB opinion was followed by a similar opinion in the Southern District of New York. In In re Iridium Operating LLC, 373 B.R. 283 (Bankr. S.D.N.Y. 2007), the creditors committee brought a fraudulent transfer against Motorola, the former parent of the debtor. Following the Third Circuit’s reasoning, the court held that “VFB validates the use of market data for purposes of valuing a public company for fraudulent conveyance purposes and makes clear that the public markets constitute a better guide to fair value than the opinions of hired legal experts whose valuation work is performed after the fact and from an advocate’s point of view.” Id.at 291.
The Iridiumcourt ultimately rejected attempt by expert witnesses to use hindsight and other valuation techniques that the market mis-valued Iridium prior to its bankruptcy. According to the court, “[e]ven though Iridium’s failure demonstrates that the public markets turned out in this instance to be a very poor predictor of Iridium’s future value, the Court has no doubt that the markets, especially after the commercial launch, were reasonably well-informed as to Iridium’s operating characteristics and constraints, yet still managed to be terribly wrong about the company’s actual prospects.” Id.at 293.
The Iridium court also noted that the experts opining on value had some credibility problems because they did not deal with extensive anecdotal evidence that contradicted their opinions. Id.. According to the court, the experts’ analyses were dubious because they failed to explain, rebut or analyze contemporaneous market valuations that indicated that Iridium had a positive enterprise value at the relevant time. Id.at 350. Accordingly, the court ruled that the creditors committee failed to prove insolvency by the preponderance of evidence.
Valuation of Collateral
There are other instances where valuation becomes important to determine the rights of secured parties in bankruptcy. For example, pursuant to section 506(c) of the Bankruptcy Code, a secured creditor may be entitled to interest and reasonable legal fees and charges post-bankruptcy. But to determine whether the secured creditor is entitled to such items, the court must first value the collateral of the secured creditor. If the secured creditor is undersecured, he is not entitled to interest and fees under section 506(b).
In 1997, the Supreme Court adopted th fair market asset valuation technique known as the replacement value test. See Associates Commercial Corp. v. Rash, 520 U.S. 953 (1997). In the Rash case, the debtor attempted to retain a truck under his chapter 13 plan. The Court held that replacement value, defined as the “price a willing buyer in the debtor’s trade, business, or situation would pay to obtain like property from a willing seller,” was the proper measure to value the truck in the chapter 13 plan for the purpose of determining how much distribution to provide to the secured lender.
While the Rashopinion is the Supreme’s Court’s most recent opinion of the topic of valuing collateral, the Rashopinion involved a chapter 13 case. This opinion seen little use in corporate chapter 11 cases. In fact, it is more commonly applied in single asset valuations. See, e.g., In re Donato, 253 B.R. 151, 155 (M.D. Pa. 2000); In re Trible, 290 B.R. 838 (Bankr. D. Kan. 2003).
There are numerous occasions where valuation plays a critical role in business reorganizations. The issues discussed above simply demonstrate how important this issue becomes to a debtor and creditors at various points in a business bankruptcy case.
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