A Bankrupt “Kodak Moment”

This is an issue that frequently arises, but is not commonly reported.  The holders of common stock issued by the debtor in possession submitted motions shortly after the case was filed pursuant to § 1102(a)(2) of the Bankruptcy Code seeking an appointment.  That motion was denied.  A year later, the shareholders formally moved the court for the appointment of an equity committee on the basis that the shareholders were not being adequately represented by the unsecured creditors committee.

The timing of this motion, in this writer’s opinion, was suboptimal.  The arguments, submitted at the   eleventh hour, were light and based more on emotion rather than an in-depth analysis.  The court’s denial was correct.  Counsel for the shareholders should have retained consulting experts far earlier in the case.   This is something that occurs far too often.

After a review of the record, including the evidence and testimony submitted by the parties at an August 5, 2013 hearing, the court found that an equity committee was not necessary and that the costs of such a committee would be unreasonable in light of any possible benefits.  Accordingly, it denied the motion for a committee and sustained the decision of the United States trustee not to appoint such a committee.  While the cost consideration was a factor, it is not the only consideration.

The legal standard of review merits further consideration.  The U.S. trustee made the initial decision regarding what committees to form.  The record showed that a number of requests to form various committees were made and denied.  The key question in deciding this issue was whether the U.S. trustee abused its discretion.  We must consider case precedent to answer this question.  The U.S. trustee’s decision is entitled to due consideration.  See In re Texaco Inc., 79 B.R. 560, 566 (Bankr. S.D.N.Y. 1987); In re Enron Corp., 279 B.R. 671, 684 (Bankr. S.D.N.Y. 2002); 7 Collier on Bankruptcy 1102.07[1] (“While the court is empowered to overrule the decision of the United States trustee not to appoint an additional committee, the court should afford some deference to that decision.”).

More on point, section 1102(a)(1) of the Bankruptcy Code provides that the U.S. trustee may appoint an official committee of equity security holders.  If the U.S. trustee does not deem the appointment of such a committee “appropriate,” the court, on request of any party in interest, may order the appointment “if necessary to assure adequate representation of . . . equity security holders.” 11 U.S.C. § 1102(a)(2). 

As the court held in denying the shareholders’ 2012 motion for the appointment of a committee, the case law recognizes that the appointment of an equity committee constitutes extraordinary relief and is the exception rather than the rule in chapter 11 cases.  In re Williams Commc’ns Grp., Inc., 281 B.R. 216, 223 (Bankr. S.D.N.Y. 2002); In re Dana Corp., 344 B.R. 35, 38 (Bankr. S.D.N.Y. 2006); 7 Collier on Bankruptcy 1102.03[2] (16th ed. rev. 2013).  

The Bankruptcy Code specifically requires a court to find that appointment of an official committee is “necessary” for equity holders’ interests to be “adequately represented.” The term “necessary” sets a high standard that is more difficult to satisfy than if the statute merely provided that a committee would be useful or appropriate.  In re Oneida Ltd., No.06-10489, 2006 WL 1288576, (Bankr. S.D.N.Y. May 4, 2006). 

With respect to the term “adequate representation,” which is not defined by the Bankruptcy Code, courts have looked to a number of factors, including the number of shareholders; the complexity of the case; the likely cost of an additional committee to the estate; whether the equity holder is adequately represented by other stakeholders the timing of the motion relative to the status of the Chapter 11 case; and whether there appears to be a substantial likelihood that equity holders will receive a meaningful distribution in the case. See, e.g., Williams, 281 B.R. at 220-21; In re Leap Wireless Int’l, Inc., 295 B.R. 135, 137 (Bankr. S.D. Cal. 2003). 

In its decision denying the prior motion for a shareholders’ committee, the court found that the likely cost of an additional committee, the adequacy of existing representatives at the table and the small probability that shareholders would be entitled to a meaningful distribution all militated against the appointment of a shareholders’ committee. It also found that the number of shareholders and complexity of the case did not outweigh these factors.  In the intervening 13 months, none of these factors had changed in favor of appointment of a committee.  

Kodak’s first amended joint plan of reorganization was scheduled for a confirmation hearing on August 20, 2013, and the formation of an equity committee would likely result in a substantial delay.  The shareholders and their witnesses made it clear that if a committee were appointed, the committee would require weeks, if not months, just to investigate the issues they have purported to raise.  This would have delayed the possibility of any distribution and possibly result in the loss of the debtors’ exit and reorganization financing, to the detriment of Kodak’s thousands of creditors, who had a statutory priority over the shareholders. 

As noted earlier, the court found in its prior decision that the record at that time did not indicate that shareholders would be entitled to a meaningful distribution, and that this factor also argued against the appointment of an equity committee.  Since then, among other things, the debtors had filed their First Amended Disclosure Statement, which the court approved by order entered June 26, 2013 as containing “adequate information” within the meaning of § 1125 of the Bankruptcy Code.  The disclosure statement, which was consistent with all of the other information received by the court throughout the case, demonstrated that the shareholders would have even less likelihood of a distribution than they did 13 months prior.

The disclosure statement contained projections and cash flow forecasts that represented that Kodak’s enterprise value as of the plan effective date was approximately $498 million.  This value was expected to be distributed to parties in interest under the plan of reorganization. Adjusting for payment of administrative, priority and secured claims, the disclosure statement estimates the recovery to unsecured creditors at 4-5 percent, or approximately $70 million, plus other modest considerations.  This was at least $2.4 billion less than the midpoint of aggregated estimated general unsecured claims and retiree settlement unsecured claims against the debtors. In order to demonstrate that there was even a remote possibility of a potential distribution to equity holders, the shareholders had to provide some evidence that the debtors had understated their expected value upon reorganization by over $2 billion.

Did the Bankruptcy Court err in denying the request for the appointment of the equity committee?  No, not in this writer’s opinion.  While the shareholders’ expectations were not met, those expectations were immaterial and were based on speculation and suboptimal analysis by their expert witnesses.  Significantly, they were unable to pinpoint any facts or evidence –such as fraud or a misrepresentation as to the quality of the patents and the strengths of the underlying claims to overcome the presumption that the “market” spoke or paid the fair market value of the portfolio.  From a practical standpoint, it was surprising that shareholders’ counsel even argued this point.  Assuming there were “red flags,’ counsel should have initiated an investigation well before the sale and retained consulting witnesses to advise on whether to raise the issue. 

In cases involving high financial and/or emotional stakes, competent counsel will retain both consulting and, if appropriate, expert witnesses.  In this case, shareholders’ counsel should have retained consulting witnesses early in the case.  Counsel waited too long.  The reason for that tactic is not known.  As for the expert witnesses selected at the eleventh hour, a number of questions can and should be raised.  One important question is why did these expert witnesses agree to this engagement?  Wherein one instance, legal counsel capped their time to under ten hours!  This is an engagement that required any expert witness to spend thousands of hours.  This is the type of engagement expert witnesses should avoid and also the type of situation—in this writer’s opinion—that trial counsel needs to avoid to effectively represent a client.

Kodak filed Daubert motions to exclude a significant portion of the documentary evidence as well as all of the expert witness testimony offered by the Shareholders.  See Daubert v. Merrell Dow Pharm., 509 U.S. 579 (1993).  The court scheduled the motions in limine to be heard at the evidentiary hearing.  In anticipation of the motion, the experts were deposed.  In opposition to the motion, Kodak also submitted declarations from  David S. Kurtz, vice chairman and global head of the Restructuring Group at Lazard Frères & Co. LLC, the debtors’ investment bankers, and  James A. Mesterharm, managing director of Alix Partners, LLP, and the debtor’s chief restructuring officer. 

The creditors’ committee submitted declarations from David Berten, a partner at Global IP Law Group, LLC, and  Robert J. White, a managing director at Jefferies LLC, both of whom are professionals retained by the creditors’ committee to advise it on economic issues in connection with the case. The court held a hearing on the motion on August 5, 2013, with the shareholders represented by counsel.

During this hearing, the court heard live testimony from Maulin V. Shah and Elise Neils, live testimony on cross and redirect from David S. Kurtz, received declarations from David S. Kurtz, James A. Mesterharm, David Berten and Robert J. White in lieu of testimony, and admitted numerous documents into evidence. The hearing produced no evidence of a value higher than the debtors had projected or of any likelihood that such value exists.

In a “presentation,” filed on July 23, 2013 by the shareholders who joined in the instant motion, but before they retained counsel, they moved to divide their argument as to the existence of undisclosed value into “three sections.” The shareholders  asserted that the debtors were giving up close to $2.6 billion in U.S. net operating losses in connection with their current plan, and that preservation of those losses would “provide substantial ‘new value’” to the benefit of all parties in interest. The shareholders also asserted that $498 million as set forth in the Disclosure Statement “grossly underestimates the fair market value.” Finally, the shareholders asserted that the current “reorganization plan is not fair and equitable” and referred to “potential violations of laws.”

As for the argument that the debtors grossly underestimated their reorganization , the shareholders called two witnesses to testify to Kodak’s alleged underestimation of fair market value, Maulin V. Shah and Elise Neils.  Shah testified as to alleged undisclosed value in Kodak’s patent portfolio, and Neils testified as to value in the Kodak brand. Both of these witnesses purported to be experts, and the debtors filed Daubert motions to exclude their testimony on multiple grounds. The court reserved decision on the motions, heard the testimony and received the reports of the two expert witnesses.  Subsequently, it excluded as wholly unreliable the two expert witness’ opinions under applicable law.

One expert, Maulin V. Shah, was a law graduate who had practiced for a year when, in 2009, he founded his firm called Envision IP, LLC.  This firm is in the business of intellectual property advisory and research services.  He testified that he valued the intellectual property of numerous companies, but had never previously testified in court.  Whatever the strength of his background, he spent only five hours, and his firm spent a total of ten hours on an effort to value the Kodak patents; the firm reported on the results of his work to the shareholders in a three-page letter dated June 10, 2013 in which it stated, “Based on a discounted cash flow analysis, Envision IP estimates the intrinsic value of Kodak’s US patent portfolio to be $1.6 billion to $2.5 billion.” The record of the hearing established that this opinion was based on assumptions that had no validity whatsoever. Shah admitted as much during cross-examination. 

As for his analysis, Shah started with the premise that Kodak had 8,532 U.S. patents in force as of June 2013, and that the average remaining term was 8.177 years.  Those figures appeared to be rooted in reality.  A number of analysts covering Kodak had undertaken time to analyze the patent portfolio and arrived at the aforementioned forecast.   Despite that consensus or estimate, Shah went on to presume the amounts that these patents could earn over the next eight years.  Shah used a range of $250 to $350 million in annual patent revenue. While he admitted that this revenue was derived from the amount set forth in the debtor’s “Public Lender Presentation dated January 23, 2012, as well as publicly reported licensing figures published by Kodak in recent years,” this information was dated.  In fact, it included annual patent revenue from Kodak’s most valuable digital imaging patents.  These were sold months earlier to a consortium of buyers for more than $500 million and this strained his credibility.

Despite the analytical flaw, Shah did not change his prediction of future revenues based on the 2013 sale and other recent developments, of which he was aware.  This cast him as an advocate for the shareholders’ rather as an advocate for his opinion and stripped him of his role as a neutral.  Even so, he tried to redeem himself by admitting shortcomings in his analysis, by acknowledging that he did not consider either whether the debtor had granted licenses to virtually all their retained patents to the consortium involved in the purchase of their digital imaging patent assets or assess whether the remaining unlicensed patents could be essential to a reorganized Kodak’s core businesses. Shah did not know what remained to be sold or licensed. Shah’s expert report was deeply flawed.  His willingness to state an opinion, especially based on incomplete and dated information, was (in this writer’s opinion) suboptimal.  This is the type of engagement that practitioners should avoid and can use to underscore—when visiting with legal counsel—the value of retaining a consulting expert early on in the case to assess the financial claims.  This is an ideal case to use to explain why one may not want to go on record as an expert. The expert has a brand, and it too needs to be protected.  The timing of Shah’s employment and time spent valuing the patent was suboptimal.  As for his lack of prior court testimony, that was not fatal.  The court on this point added: 

[An] expert opinion on the value of patent income streams must be based on facts and data specific to the patents at issue.  Uniloc USA, Inc. v. Microsoft Corp., 632 F.3d 1292, 1316-17 (Fed. Cir. 2011).  An expert cannot base his analysis on “licenses with no relationship to the claimed invention to drive the royalty rate up to unjustified double-digit levels.” Resqnet.com, Inc. v. Lansa, Inc., 594 F.3d 860, 869 (Fed. Cir. 2010). Since Shah’s valuation testimony rests on revenue assumptions that have no support in the facts of record, his testimony must be stricken.  See Johnson Elec. N. Am. Inc. v. Mabuchi Motor Am. Corp., 103 F. Supp. 2d 268, 283 (S.D.N.Y. 2000) (excluding testimony because “the expert must have some reliable basis for extrapolating from the available data”); Chartwell Litig. Trust v. Addus Healthcare, Inc. (In re Med Diversified, Inc.), 346 B.R. 621, 633-34 (Bankr. E.D.N.Y. 2006) (striking testimony on similar grounds). 

Shah admitted at the hearing that it would take his firm 5,000 hours to perform a full analysis but he did not take the position that he could not provide any opinion testimony until such an analysis had been performed.  In his “Declaration of Maulin Shah Responding to the Debtor’s Objection to his Testimony,” which was submitted by counsel in response to the Daubert motions, he continued to rely on the following fallacious logic: “Envision IP has shown that Kodak has a sizable patent portfolio remaining, and Kodak has stated in the past that it has received over $3 billion in licensing revenue.  Kodak has not accounted for $2 billion of that licensing revenue.  Kodak clearly understood the nature of patent licensing and enforcement, given its track record in the past of obtaining over $3 billion in revenue.”

Shah’s speculation as to Kodak’s past revenues from patent licensing could have encouraged some shareholders to conclude that Kodak could not conceivably have fallen as far and as fast as it did, but it did not constitute useful or admissible testimony as to the current value of Kodak’s estate.  Shah admitted at the hearing that he did not review Kodak’s most recent public financial statements, which include a projection of 2013 IP revenue of $35 million, not $350 million.

In their response to the shareholders’ motion, Kodak and the creditors’ committee described Kodak’s anticipated revenue, including its patent revenue.  On the patent revenue portion, the creditors’ committee in particular submitted the declaration of its patent expert, David Berten, co-founder and partner of Global IP Group, LLC.  Berten demonstrated—according to the Bankruptcy Court “convincingly”—-that Shah’s conclusions were technically faulty and based on unreliable assumptions, and that the creditors’ committee did not ignore intellectual property as one element of value in Kodak’s asset base.  Berten  agreed that the creditors’ committee supported Kodak’s projections of future patent revenues and enterprise value. Other than the unsupported hypothesis that Kodak, Kodak’s professional advisors, the creditors’ committee, and the committee’s professional advisors were all not to be trusted, the shareholders provided no reason whatsoever for disregarding Kodak’s publicly filed financial statements and projections.

The expert testimony of Elise Neils, a managing director of Brand Finance, was also excluded under Daubert.  Neils had substantial experience in determining the value of brands and has frequently testified.  However, she or her colleagues spent a total of six hours before producing  the shareholders a “Kodak^® Preliminary Brand Valuation.”  That document was produced at 3:00 a.m. on July 26, 2013. This document concluded that “under conservative assumptions, it is the opinion of Brand Finance that the value of the Kodak brand under the Relief from Royalty method as of July 25, 2013 is in the range of $400 million to $1 billion. 

A time constraint of this nature is problematic, as even the smallest of matters takes far more time.  Neils’ willingness to take the case is also problematic since she should have known or anticipated the Daubert motion and recognized that her ability to assist the trier of fact was compromised.  As for the testimony regarding the Relief of Royalty Method, that, too, presented a similar set of issues. The Relief from Royalty Method is an accepted methodology of attempting to estimate the “proportion of future cash flows that are attributable to the brand—the present value of the post-tax royalties that are held to represent the value of the brand today.” Neils admitted that she did not have the time or information to perform the analysis thoroughly and had little or no information of the type she would ordinarily access in performing a brand valuation.  She did not interview Kodak’s management or determine the impact of the settlement with the U.K. Kodak Pension Plan, pursuant to which Kodak apparently will grant a perpetual license for its products.  Her admitted inability to perform an analysis with the same information she would ordinarily use made her “preliminary brand valuation” unreliable and excludable.  Amorgianos v. Nat’l R.R. Passenger Corp., 303 F.3d 256, 265-66 (2d Cir. 2002) (“[T]he district court must ‘make certain that an expert . . . employs in the courtroom the same level of intellectual rigor the characterizes the practice of an expert in the relevant field.’”), quoting Kumho Tire Co., Ltd. v. Carmichael, 526 U.S. 137, 152 (1999).

In any event, regardless of the insufficiency of Ms. Neils’ report, for purposes of establishing whether shareholders could reasonably expect a meaningful recovery in this case, the exercise was of no use. Even if  Neils had the opportunity in her six hours of work to learn the basic facts regarding Kodak’s present financial situation—and she admitted at the hearing that she did not—she did not dispute that brand value is not a separate item of value in excess of the total equity of an enterprise. Kodak publicly estimated its equity value upon reorganization as between $208 and $658 million—for an average of $433 million—or, if implied by the rights offering being conducted in connection with the debtors’ plan, as $498 million.  Lazard’s managing partner, David Kurtz, testified that his valuation was the result of hundreds of hours of work by recognized professionals.

Although some shareholders may not accept the outcome here, the disappointed shareholders—the party moving the court—– did not provide any reason to distrust Kodak’s valuation. They could not disprove it on the unsupported hypothesis that the Kodak brand might be worth $1 billion, or on the basis that the Kodak brand was worth $1 billion years ago when it was still a leader in the photography business.   Whatever value the Kodak brand may have after the sale of its camera business and its bankruptcy, it was embedded in total equity value, reasonably estimated at less than $500 million and resulting in a wholly insolvent debtor.

In the presentation referred to above, the shareholders speculated on numerous other possibilities that Kodak’s enterprise value might have been much higher than what Kodak had disclosed. They speculated that use of certain multiples resulted in a $3.7 billion reorganization value, that the value of Kodak should be increased by over $3 billion by comparing it to a company named Graphic Packaging Holding Company; and that insufficient attention had been paid to certain portions of its business going forward.  The shareholders, however, presented no testimony, much less expert testimony, to support their speculation. The Creditors’ Committee, in opposition to the shareholders’ motion, submitted the declaration of Robert J. White, a managing director of Jeffries LLC, the creditors’ committee’s investment bankers. The White declaration was admitted as his direct testimony, the shareholders declined to cross-examine him, and his declaration not only refuted the shareholders’ speculations, but also was evidence that the Creditors’ Committee had done its job of testing the debtors’ projections and attempting to obtain as much value as possible for Kodak’s stakeholders.

The shareholders also focused on two other areas, namely Kodak’s net operating losses (NOL) and the trading in its debt.  The subject and treatment of a debtor’s of NOL is one that has received considerable attention within the valuation community in the past two to three years, and it is worth reflecting on how, if at all, NOLs add value to the emerging company.  A liquidation analysis should address the value if any of the NOL to the emerging enterprise. This issue was not properly developed or presented by the shareholders.  This is surprising considering this is an issue that should and could have been addressed far earlier in the proceeding. 

The shareholders argued in their presentation that the current plan of reorganization “unnecessarily” gave up $2.6 billion in NOLs for U.S. tax purposes because the plan would constitute a change of ownership under § 382 of the Internal Revenue Code.  They asserted that “[p]reserving the tax attributes provides $760 [million] new value and increases the reorganization value to $1.258 [billion].” The shareholders did not explain how preserving the tax attributes would increase reorganization value to $1.258 billion (or that how they would get a distribution at that level).  In order to use NOLs, a reorganized debtor has to have income to offset. Kurtz testified without contradiction that Kodak would not pay taxes in the United States until 2019 under its projections of income, even after loss of the bulk of its NOLs.

Kurtz  testified that a change of ownership for tax purposes was inevitable and that the creditors, who could have benefited from the preservation of all NOLs, recognized this and negotiated for a plan that resulted in an ownership change and a loss of many of the NOLs.  The creditors were not willing to leave enough equity in the hands of the existing shareholders to avoid the loss of the NOLs. The benefit this would have conveyed to the shareholders explains why they have placed emphasis on the tax issue, but there is nothing in the Bankruptcy Code that requires the result that they desire.  The tax issue did not support their contention that Kodak was solvent, that they could have anticipated a distribution and that a committee should be formed. 

The shareholders’ presentation was entitled “Reorganization Plan is Not Fair and Equitable and Potential Violations of Laws.” The shareholders argued that creditors who allegedly own a substantial portion of Kodak’s debt bought the debt at a substantial discount and stood to make great profits “by potential insider trading and potential price manipulation of Kodak’s unsecured debt and claims. . . .” Although the shareholders attached some exhibits that purported to show trading in Kodak’s claims, these charges are unsupported.

The shareholders did not explain why claims that creditors might have had against other creditors for the latter’s trading activities would entitle shareholders to a greater recovery.  The shareholders provided no authority for the appointment of an equity committee for the purposes they cited.