Three Common Roles for Financial Experts
In Chapter 11 Bankruptcies, Part 2
Financial experts may be called on to provide a number of services in Chapter 11 bankruptcy cases. Common among these services is the analysis of the interest rate to be paid on secured claims, the valuing of the bankrupt business or a portion of the bankrupt estate, and the creation or analysis of cash flow projections to assist in determining the feasibility of the reorganization plan. None of these functions are exclusive to the bankruptcy courts. However, in applying commonly used techniques, an expert must be aware of the methodologies that have been accepted by bankruptcy courts and how they have been applied. In this two-part series, Dr. Allyn Needham provides an overview for those seeking to become financial experts in Chapter 11 bankruptcy and explains the four methods accepted by the courts for analyzing interest rates, commonly used methods for performing business valuations in bankruptcy situations, and the factors important to a feasibility study.
In this second part of this two-part series, Dr. Needham discusses valuation approaches and the feasibility of the plan of reorganization. To view Part 1, click here.
At heart, Chapter 11 is a simple exercise. In bankruptcy parlance, it is to gather the property of the estate, determine the amount and nature of the claim and confirm a plan of reorganization that distributes the property of the estate to the creditors in accordance with the requirements of the Bankruptcy Code. Inherent in the process is determining the value of the property of the estate and the claim. (Sontchi, 1)
Two forms of valuation may be sought in a Chapter 11 matter: the liquidation value of the business‚Äôs assets or the going enterprise value of the business or specific assets. Liquidation is normally associated with Chapter 7 of the Bankruptcy Code. Chapter 7 specifically addresses the liquidation of a bankrupt estate. But even under Chapter 11, a liquidation value is needed. This is because the debtor must establish that each claimant in an impaired class has either voted for the reorganization plan or ‚Äúwill receive or retain under the plan on account of such a claim or interest in property of the value, as of the effective date of the plan, that is not less than the amount that such holder would so receive or retain if the debtor were liquidated under chapter 7 of this title on such date.‚ÄĚ (11 U.S.C. 1129 (a)(7)(A)(ii))
The liquidation value would determine the value of the assets of the business less any expenses for liquidating those assets. The total is the amount of funds available for distribution relative to the allowed claims: first the secured, then the unsecured.
Often, the valuation question is, ‚ÄėWhat is the value now?‚Äô When answering that question, the expert delivers his or her opinion of current value (the valuation date) at a court hearing (the opinion date), and the court decides the current value of the business or asset. In this situation, the valuation date and opinion date are the same. (Ratner, Stein, Weitnauer, 5)
Valuations may also be related to issues called ‚Äúavoidance actions.‚ÄĚ These actions normally take one of two forms: (1) preferences and (2) fraudulent transfers. In preference matters, one creditor is paid prior to the bankruptcy to the detriment of the bankrupt estate and therefore the remaining creditors. In these matters, the valuation is to determine if the debtor was solvent when the payment(s) were made. Fraudulent transfers occur when assets are transferred by the estate prior to bankruptcy that were either made by the estate to delay or defraud its creditors or were made by the debtor without receiving the reasonable equivalent in exchange. In these matters, the valuation is based on the value of the transferred assets or the debtor‚Äôs estate at the time of the transfer. (U.S. Bank, N.A. v Verizon Communications, Inc.)
More often, an expert will be asked to determine the fair market value of the going concern. When a company has been publicly traded, its previous stock transactions provide a starting place. However, the majority of Chapter 11 cases involves smaller, non-publicly traded companies or closely held corporations.
Closely held corporations are those corporations the shares of which are owned by a relatively limited number of shareholders. Often, the entire stock issue is held by one family. The result of this situation is that little, if any, trading in the shares takes place. There is, therefore, no established market for the stock and such sales as occur at irregular intervals seldom reflect all of the elements of a representative transaction as defined by the term ‚Äėfair market value.‚Äô (Rev. Rul. 59-60 Sec. 2.03)
The guidance found in Internal Revenue Service Revenue Ruling 59-60 is useful in determining the fair market value of a small or closely held business. Revenue Ruling 59-60 defines fair market value as ‚Äúthe price at which the property would change hands between a willing buyer and willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.‚ÄĚ (Rev. Rul. 59-60 Sec. 2.02)
This definition of fair market value has been adopted by most courts and is the commonly used definition for fair market value in business appraisal literature. ‚ÄúCourt decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.‚ÄĚ (Rev. Rul. 59-60 Sec. 2.02)
Any fair market value analysis should begin with examining the business in three ways: the Asset Approach, the Income Approach, and the Market Approach. The Asset Approach does not simply apply book value, it determines the market value of the business‚Äôs assets less liabilities. The Income Approach examines the entity‚Äôs earnings through a discounted cash flow analysis. Through this approach, a value is determined for the firm‚Äôs equity based on its ability to generate revenue and net income. The Market Approach provides a comparative analysis of the value of publicly traded companies that provide the same type of products or services to the company being appraised or data from transactions for the purchase/sale of comparable companies. Either or both of these sets of data may be used to determine the value of the company being appraised.
In general, the appraiser will accord primary consideration to earnings when valuing stocks of companies which sell products and services to the public; conversely, in the investment or holding type company, the appraiser may accord the greatest weight to the assets underlying the security to be valued. (IRS Rev. Rul. 59-60, Sec. 5(a))
The Asset Approach provides an estimate of the value of the business‚Äôs equity based on an examination of its assets and liabilities. Starting with the most recent balance sheet, the amounts are restated at market or replacement value. Many businesses seeking protection under Chapter 11 have debt levels that exceed the value of their assets. Therefore, under this approach, it would not be unusual to determine a negative value for the debtor‚Äôs equity.
Some firms may be in an industry that is vulnerable to weak profits. Martin Stopford‚Äôs Maritime Economics (2009) notes such a circumstance. ‚ÄúNew entrants bring new capacity and seek market share, pushing down margins, whilst powerful buyers or suppliers bargain away the profits for themselves.‚ÄĚ (Stopford, 338) This may make the net asset value of a business its greatest value. (In re: Genco Shipping & Trade, Ltd.)
With the Income Approach, the fair market value is based on the debtor‚Äôs projected future cash flows. Through this process, the value of the business or a particular asset is determined by estimating the present value of its future income stream.
‚ÄúThe underlying premise of the income approach is that the value of a company or business interest is equal to the present value of all future cash flows generated by its assets, discounted at a company‚Äôs weighted average cost of capital (WACC).‚ÄĚ (Ratner, Stein, Weitnauer, 58-59) The Discounted Cash Flow Method is commonly used in bankruptcy valuations. Through it, a business‚Äôs net present value is estimated by adding together the projected unlevered cash flows for a certain number of upcoming years, discounted to present value based on the company‚Äôs weighted average cost of capital and the company‚Äôs projected cash flows for the period thereafter in perpetuity. (Kenter)
As Justice Holmes said [cite omitted], ‚Äėthe commercial value of property consists in the expectation of income from it.‚Äô Such criterion is the appropriate one here, since we are dealing with the issue of solvency arising in connection with reorganization plans involving productive properties‚Ä¶The criterion of earning capacity is the essential one if the enterprise is to be freed from the heavy hand of past errors, miscalculations or disaster, and if the allocation of securities among the various claimants is to be fair and equitable.
Since its application requires a prediction as to what will occur in the future, an estimate, as distinguished from mathematical certitude, is all that can be made. But that estimate must be based on an informed judgment which embraces all facts relevant to future earning capacity and hence to present worth, including, of course, the nature and condition of the properties, the past earnings record, and all circumstances which indicate whether or not that record is a reliable criterion of future performance. A sum of values based on physical factors assigned to separate units of the property without regard to the earning capacity of the whole enterprise is plainly inadequate. (Consolidated Rock Products Co. v Du Bois)
The Market Approach is a relative valuation approach. ‚ÄúIn relative valuation, the value of an asset is derived from the pricing of comparable assets, standardized using a common variable such as earnings, cash flows, book value, or revenues. Unlike discounted cash flow valuation, which is a search for intrinsic value, relative valuation relies more on the market. In other words, one assumes that the market is correct in the way it prices assets and firms on average, but that it makes errors on the pricing of individual assets and firms.‚ÄĚ (Sontchi, 10)
The market approach includes the guideline and the comparable transaction method. These methods are similar in that multiples are derived from public trading values or publicly disclosed sales prices, and are applied to the corresponding financial metrics of the subject company to determine the value. (Ratner, Stein, Weitnauer, 81)
Multiples for publicly trading companies are readily available through various on line sources (e.g., Yahoo Finance). For experts valuing small or closely held businesses, Shannon Pratt‚Äôs Pratt‚Äôs Stats and the Institute of Business Appraiser‚Äôs IBA Market Data provide useful information on the multiples regarding the sale of closely held businesses.
Some federal court decisions have held that market evidence should be given greater weight than the income approach. ‚ÄúIt has now been five years [written in 2012] since two important federal court rulings embraced the view that contemporaneous market evidence, rather than expert testimony based on discounted cash flow or other after-the-fact analyses created for purposes of litigation, should control corporate determination.‚ÄĚ (Schwartz, Bryan, 939)
The judges in these cases pointed to an expert‚Äôs ability to manipulate the discounted cash flow data as a source of concern. Part of this was because the experts were performing their analyses after the events occurred. The courts felt that subsequent facts had clouded the Income Approach results causing them to be tilted toward whichever party had hired them. Values from relative valuations (particularly those performed at the time of the event (i.e. the bankruptcy date or transfer date) were found to be more reliable and/or easy to understand.
In some situations, the discounted cash flow data that would have been used for assessing value with the Income Approach were unreliable or unavailable. In these situations, the use of comparable companies and precedent transactions was the only approaches available to an expert.
In re: Adelphia Communications Corp, the judge agreed with an expert not using the Income Approach. ‚ÄúAs a matter of common sense, DCF works best (and, arguably, only) [i] when a company has accurate projections of future cash flow, [ii] when projections are not tainted by fraud, and [iii] when at least some of the cash flows are positive.‚ÄĚ (In re: Adelphia Communications et. al.; Adelphia Recovery Trust v FLP Group, Inc. et. al)
When discussing the Market Approach (comparative analyses), Judge Sontchi notes,
Multiples are simple and easy to relate to. The can be used in a relative valuation to obtain estimates of value quickly for firms or assets, and are particularly useful when a large number of comparable firms are being traded on financial markets and the market is, on average, pricing these firms correctly. They tend to be more difficult to use to value unique firms with no obvious comparables, with little or no revenues, or with negative earnings.‚ÄĚ (Sontchi, 10)
When a business in Chapter 11 files a reorganization plan, the court reviews it to ensure it meets certain statutory requirements. Among those requirements is whether the plan has a reasonable chance of survival once the plan is confirmed and the debtor has moved out from under the protection of the bankruptcy code. In other words, the plan must be feasible. It must demonstrate that the business will be a viable entity, one that is able to meet its repayment schedule as it moves forward.
The feasibility of a reorganization plan is critical to the court‚Äôs decision to confirm or deny such a plan. (In re: Northwest Timberline Enterprises, Inc.) ‚ÄúIn their service to the debtor or its creditors, accountants (and other financial experts) have an opportunity to provide value by assisting in the evaluation of the quality and feasibility of the plan of reorganization.‚ÄĚ (Baldiga)
Courts do not need to determine a plan‚Äôs success will be a ‚Äėsure thing‚Äô in order to make a feasibility finding, but courts also do not want to confirm a speculative plan just to find the company back in bankruptcy a second time. If the expert cannot provide a ‚Äėfeasible‚Äô financial plan to the court, its reorganization plan may not be approved and this failure can result in liquidation of the company. (Suker)
In general terms, a feasibility study is defined as an analysis of the ability to complete a project successfully, taking into account legal, economic, technological, scheduling and other factors. ‚ÄúRather than just diving into a project and hoping for the best, a feasibility study allows project managers to investigate the possible negative and positive outcomes of a project before investing time and money.‚ÄĚ (Investopedia)
The first part of a feasibility study in a Chapter 11 matter is similar to one performed on a non-bankrupt company. The analysis should consider the adequacy of the debtor‚Äôs capital structure, its earnings power, ability and commitment of management, economic conditions, the current credit markets, and the retention of its clients. In the end, the analysis will determine whether the debtor will be able to have sufficient cash on hand to pay its debts over the proposed repayment period.
In addition, the study should consider benefits arising from confirmation of the plan. This may include improving profitability by increasing revenue or reducing expenses and/or eliminating unprofitable products or services. (Suker)
Finally, the expert needs to be aware of why the company is in bankruptcy. This could be due to external factors (e.g., increased competition or product obsolescence), internal factors (e.g., poor management or undercapitalization), or a combination of both. These factors play an important role in assessing the ability of the debtor to move out of bankruptcy, operate profitably and repay its debts as schedule in the repayment plan.
The Disclosure Statement will contain the debtor‚Äôs cash flow projections. For an expert preparing or reviewing the projected cash flow, the reliability of the debtor‚Äôs previous cash flow projections and the reasonableness of assumptions made in estimating future cash flow will need to be assessed. To paraphrase the court in Adelphia Communications, a confirmable reorganization plan only works when the debtor has accurate projections of its future cash flow. These projections should not be tainted by fraud and able to show positive cash flows. (In re: Adelphia Communications et. al.; Adelphia Recovery Trust v. FLP Group, Inc., et. al)
For these reasons, ‚Äúa feasibility opinion should be more than just a ‚Äėrubber stamp‚Äô prepared by the financial expert. The opinion should be credible and reliable, and should give a basis for tis calculations, conclusions and opinions.‚ÄĚ (Suker)
Financial experts can provide a number of services to the parties involved in a Chapter 11 bankruptcy matter. One of the most common is the analysis of the interest rate to be applied to secured claims as they are repaid. This type of engagement may include determining the interest rate, discussing the repayment terms and assessing the ability of the debtor to complete the repayment plan.
Other engagements may call for the valuation of a business or portion of a business (e.g. a particular asset) that has been transferred or may be sold. In addition, an expert may be asked to assist in preparing or reviewing the cash flow projections to determine if the debtor‚Äôs reorganization plan is financially feasible.
None of these functions are exclusive to the bankruptcy courts. Experts may already provide these or similar services to clients in litigious or non-litigious matters. However, in applying these commonly used techniques, an expert must become aware of how they are applied in bankruptcy court along with the rules governing the presentation of such analyses. For an expert to be successful, a good working relationship with the hiring attorney is necessary. Gaining knowledge of bankruptcy courts‚Äô opinions on cramdown interest rates, feasibility studies, and business valuation models will assist an expert in developing that good working relationship and the ability to provide a value added service to any bankruptcy engagement.
Readers interested in knowing more about bankruptcy and turnarounds are encouraged to visit NACVA/ CTI‚Äôs website and learn more about the Master Analyst in Financial Forensics (MAFF) designation offered in the area of insolvency, bankruptcy and reorganizations.
Allyn Needham, PhD, CEA, is a principal at Shipp, Needham & Durham, LLC (Fort Worth, Texas). For the past 17 years, he has worked in the area of litigation support. Prior to that, he worked for more than 20 years in the area of banking and risk management. Dr. Needham has also been an adjunct professor of economics at Texas Christian University and Weatherford College. As an expert, he has testified on various matters relating to commercial damages, personal damages, business bankruptcy, and business valuation. Dr. Needham has been retained by attorneys representing plaintiffs and defendants, debtors and creditors. He has given expert testimony in state and federal courts. Dr. Needham can be reached at firstname.lastname@example.org and (817) 348-0213.