Best Practices for Bankruptcy-Related Property Appraisals

Part I of IV

This is the first article of a four-part series. This initial article summarizes the generally accepted property appraisal approaches and methods that appraisers typically consider in a bankruptcy-related assignment. This discussion also describes the property appraisal synthesis and conclusion process. Due to the litigious nature of a bankruptcy proceeding, bankruptcy-related property appraisals are often subject to a rigorous contrarian review. Therefore, this discussion summarizes what the parties-in-interest (and their legal counsel) and the appraiser should know about an effective (i.e., persuasive) bankruptcy-related property appraisal report.

Introduction

After adjusting to the initial pandemic-related disequilibrium, many industry segments have fared very well throughout the COVID-19 pandemic. Recently, several unfavorable economic influences have converged to create new uncertainty to many industrial and commercial companies. The following economic conditions are creating financial disruption for many companies: recent debt financing interest rate increases, prolonged supply chain disruptions, continuing labor shortages and the “great resignation,” and current high inflation rates affecting the cost of both materials and labor.

Some industrial and commercial company managements are considering the reorganization opportunity provided by a Chapter 11 bankruptcy filing. These company managements often consider that the debtor company will emerge from bankruptcy with (1) a reorganized capital structure and (2) a lower-cost operating expense structure. Accordingly, this discussion focuses on bankruptcy-related valuation issues.

Valuation analysts in all appraisal disciplines are often retained to provide consulting expert and testifying expert services related to the Chapter 11 bankruptcy proceeding. For purposes of this discussion, and solely intended for simplicity, valuation analysts practicing in all appraisal specialties are referred to as “appraisers.”

Since property appraisals influence many elements within the commercial bankruptcy process, this discussion summarizes what appraisers in all appraisal disciplines need to know about property appraisal within a bankruptcy context. For purposes of this discussion, the types of property considered in a bankruptcy may include: real estate and real property, tangible personal property, and intangible personal property.

There are many reasons why an industrial or commercial company debtor (or its legal counsel) may need to retain an appraiser to value the company’s property within a bankruptcy environment. While the focus of this discussion is on property appraisal, there are also many reasons why a company debtor (or its legal counsel) may need to retain an appraiser to develop a property damages analysis or property transfer price analysis within a bankruptcy environment.

Before the appraiser is retained, the party-in-interest to the bankruptcy (whether the debtor company itself or the various company creditors)—and that party’s counsel—should carefully define the property appraisal assignment. Based on that assignment definition, the appraiser, the client, and the counsel can all agree on the objectives and the scope of the bankruptcy-related property appraisal.

This discussion summarizes the generally accepted property appraisal approaches and methods that appraisers typically consider in a bankruptcy-related assignment. This discussion also describes the property appraisal synthesis and conclusion process.

Due to the litigious nature of a bankruptcy proceeding, bankruptcy-related property appraisals are often subject to a rigorous contrarian review. Therefore, this discussion summarizes what the parties-in-interest (and their legal counsel) and the appraiser should know about an effective (i.e., persuasive) bankruptcy-related property appraisal report.

This discussion is part one of a four-part series. Part one of this discussion summarizes what company managements (and their legal counsel) and the appraiser need to know about the reasons to develop a bankruptcy-related property appraisal. Part two of this series will summarize what the parties should know about (1) defining the property appraisal assignment and (2) performing and documenting the property appraiser’s due diligence procedures. Part three of this series will summarize what company managements (and their counsel) need to know about the bankruptcy-related property appraisal approaches and methods. And part four of this series will summarize (1) the property valuation synthesis and conclusion process and (2) the development of an effective bankruptcy-related property appraisal report.

A Property Appraisal

First, let’s define the term “property” within the context of this discussion. Second, let’s define the term “appraisal” within the context of this discussion.

For purposes of this discussion, let’s define the term “property” within a bankruptcy context. Unfortunately, the U.S. Bankruptcy Code does not define either the term “property” or the term “asset.”

For purposes of this discussion, “property” is a legal term and “asset” is an accounting term. In general conversation, and even in appraisal-related conversation, these two terms are often treated as synonyms. However, they do not mean exactly the same thing. Not all types of property are considered to be assets. And not all types of assets are considered to be property.

Black’s Law Dictionary defines property as follows:

1. Collectively, the rights in a valued resource such as land, chattel, or an intangible. It is common to describe property as a “bundle of rights.” These rights include the rights to possess and use, the right to exclude, and the right to transfer.
2. Any external thing over which the rights of possession, use, and enjoyment are exercised.[1]

Typically, in order for something to be considered property, there should be an identified bundle of legal rights (including the legal right to transfer) associated with it.

While the term “property” has a legal definition, the term “assets” has an accounting definition. The term “assets” is generally defined by reference to the Financial Accounting Standards Board Statement of Concepts No. 8, Conceptual Concepts for Financial Reporting (CON8).

According to CON8, “Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.” CON8 also states, “An asset is a present right of an entity to an economic benefit.” In addition, CON8 continues as follows:

An asset has the following two essential characteristics:

(a) It is a present right.

(b) The right is to an economic benefit.

Both the legal definition of property and the accounting definition of assets focus on the concept of a bundle of rights. The result of something being considered to be property is that the property rights can be legally protected. The result of something being considered to be an asset is that it is recognized on an entity’s balance sheet prepared in accordance with U.S. generally accepted accounting principles (GAAP).

However, not all legally protected property is recognized on a GAAP balance sheet. And not all assets recorded on a GAAP balance sheet are legally protected property.

This discussion focuses on the concept of property within a commercial bankruptcy context (particularly within a Chapter 11 reorganization). However, this discussion recognizes that (rightly or wrongly) the term “assets” is frequently used within the commercial bankruptcy context.

This discussion will adopt the definition of appraisal provided in the Uniform Standards of Professional Appraisal Practice (USPAP). USPAP defines the term “appraisal” as, “(noun) the act or process of developing an opinion of value; an opinion of value; (adjective) of or pertaining to appraising and related functions such as appraisal practice or appraisal services.”[2]

This USPAP definition of the term “appraisal” is applicable to most bankruptcy-related issues. Unfortunately, the U.S. Bankruptcy Code does not provide a definition of value—or of any particular standard of value. In other words, the Bankruptcy Code does not define fair value, fair market value, market value, or any other standard (or definition) of value. And the Bankruptcy Code does not inform us as to which standard of value is relevant to which type of bankruptcy question.

Types of Property

This discussion is generally applicable to most categories of industrial or commercial property that may become an issue in a bankruptcy proceeding. Specifically, this discussion encompasses the following categories of debtor company property:

1. Real estate and real property
2. Tangible personal property
3. Intangible personal property

For purposes of this discussion, the real estate property category includes the tangible elements of land and the structures affixed to land, including, for example, the following:

1. Land
2. Land improvements
3. Buildings and building components

For purposes of this discussion, the real property category includes the intangible elements of real estate, including, for example, the following:

1. Lessor and lessee interests
2. Easements and rights of way
3. Air, water, and subsurface rights

For purposes of this discussion, tangible personal property includes, for example, the following property categories:

1. Office furniture and fixtures
2. Manufacturing machinery and equipment
3. Processing machinery and equipment
4. Trucks, automobiles, and transportation equipment
5. Computers and information technology equipment

For purposes of this discussion, intangible personal property includes, for example, the following property categories:

1. Identifiable intangible assets
2. Intellectual property
3. Personal and institutional (business) goodwill

We note that the U.S. Bankruptcy Code does not include trademarks or trade names within its definition of intellectual property. However, for purposes of this discussion, the term “intellectual property” is intended to include all of the following categories: trademarks and trade names, patents, copyrights, and trade secrets.

Unless specifically noted, most of the following discussion applies to each of the above-listed categories of debtor company property.

The Bankruptcy Valuation Assignment

A statement of the purpose and the objective of the appraisal is a best practice at the outset of any bankruptcy-related valuation assignment.

Such a statement requires the appraiser, the client, and the legal counsel to carefully consider all of the so-called elements of the valuation assignment. Such a statement also mitigates the possibility of any misunderstandings about the bankruptcy-related valuation assignment.

Whether tangible property or intangible property is the subject of the appraisal, it is a best practice to consider all of the elements of the assignment. When the parties-in-interest need to know the value of property that is either owned by or operated by a debtor company, the party-in-interest to the bankruptcy should carefully define the elements of the valuation.

Bankruptcy law seeks to preserve the on-going value of—and to maximize the economic stake of—the creditors to the debtor company. Typically, in the bankruptcy environment, contracts, leases, and licenses can be assumed, rejected, or assigned. This fact may complicate the appraisal when the debtor in possession (DIP) is either a property lessor/licensor or a property lessee/licensee.

For example, let’s assume that the debtor industrial or commercial company is an intellectual property licensor and that the license may be assignable by the bankruptcy estate to the licensor’s competitor. In that case, the appraiser may have to consider whether the intangible property appraisal should be based on the expectation that the licensor is required to continue to support (e.g., make improvements to) the intellectual property (even if it is in the hands of a competitor).

Defining the assignment is a first best practice in the property appraisal process. This definition may influence many of the appraiser’s considerations and procedures. The assignment definition may influence many of the decisions to be made in the appraisal. The time spent by the appraiser, the client party-in-interest, and the legal counsel to define the purpose and the objective of the valuation assignment is time well spent.

There are many possible clients for a bankruptcy-related property appraisal assignment. This is because there are typically many parties-in-interest to a commercial bankruptcy. These various parties may include the debtor company, the debtor company directors, the court-appointed bankruptcy trustee, the individual secured creditors, a secured creditors committee, an unsecured creditors committee, the individual contract counterparties (e.g., a labor union), and the debtor company equity holders.

Each of these parties may have an interest in some valuation (or damages or transfer price) aspect of the bankruptcy proceeding.

Regardless of who the client is, the valuation assignment is typically provided by the client to the appraiser. The valuation assignment should describe the objective of the property appraisal by considering these elements of the appraisal:

1. Definition of the subject property
2. Description of the ownership characteristics subject to appraisal
3. Decision of the appropriate bundle of legal rights
4. Decision of the appropriate standard of value
5. Decision of the appropriate premise of value
6. Specification of the “as of” valuation date

Before these elements are defined, the purpose of the valuation assignment should be agreed to. That is, the elements of the valuation assignment may also be influenced by the stated purpose of the appraisal. The purpose of the valuation assignment should describe:

1. Why the property appraisal is being prepared, and
2. Who may (and may not) rely on the property value conclusions.

The Bankruptcy Valuation Purpose

There are many reasons why an appraiser may be retained to value the debtor company’s property within a bankruptcy context. For this purpose, the subject property can include both:

1. The property owned by the debtor company and
2. The property operated by the debtor company (including inbound and outbound leases and licenses).

The property could serve as collateral for either the debtor company’s pre-bankruptcy financing or the DIP financing. A debtor property sale or license could serve to generate needed cash flow for the financially troubled DIP.

The appraiser may be asked to opine on the fairness of the consideration or terms of a property sale, lease, or license. The appraiser may be asked to opine on the impact of an assignment or a rejection of a lease or a license. The appraiser may assess this transactional fairness to the creditors or to other parties-in-interest.

The property value often affects the debtor company solvency (or insolvency) at various dates prior to the bankruptcy filing.

These debtor company solvency issues become relevant with regard to allegations of fraudulent conveyance or preference payments. Such solvency issues also may be relevant when the pre-filing debtor company is operating within the so-called zone of insolvency.

The debtor company property commercialization potential (or the associated spin-off opportunities) could affect the reasonableness of a proposed plan of reorganization. And the fair value of the property may be recognized in the fresh start accounting when the debtor company emerges from bankruptcy.

Under GAAP, the fresh start accounting fair value measurement guidance is provided in the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 852.

Legal counsel is often involved in the bankruptcy-related property appraisal. This is because legal counsel is involved in assisting the party-in-interest client in structuring transactions, complying with taxation and accounting requirements, negotiating and arranging financings, litigating claims, and defending and commercializing the debtor company property.

Within a bankruptcy context, legal counsel may become involved in the process of:

1. Identifying the debtor company property;
2. Performing certain due diligence procedures;
3. Interviewing and selecting the appropriate appraiser;
4. Defining the appraiser’s assignment;
5. Helping to assemble valuation-related data and documents;
6. Providing legal instructions to the appraiser;
7. Reviewing and challenging the property appraisal work product;
8. Interpreting and relying on the property appraisal report; and
9. Defending the appraiser—and the value conclusions—during any administrative, regulatory, or judicial proceeding.

The appraiser may value the debtor company’s property in a bankruptcy proceeding without legal advice from, or assistance by, counsel. However, due to the special nature of the bankruptcy-related engagement, the appraiser and the counsel will often work closely in several phases of the bankruptcy-related appraisal.

The following list summarizes some of the many reasons why an appraiser may be retained to value company property in a bankruptcy environment. Such assignments may come directly from a party-in-interest to the bankruptcy. However, such assignments may also come from the legal counsel of one of the parties.

1.Transaction pricing and structuring

• Pricing the sale of a DIP’s individual property or of a portfolio of two or more property assets
• Pricing the license of the DIP’s individual property or of a portfolio of two or more properties
• Valuing the equity allocations in a DIP joint venture when one or more parties contributes property
• Valuing the property distributions in a debtor company liquidation when one or more parties receives distributed properties
• Transferring a property between a parent company’s subsidiaries (when one subsidiary has filed for bankruptcy protection and another subsidiary has not filed for bankruptcy protection)

2. Financings collateralization and securitization

• Use of the property as collateral for cash-flow-based or asset-based pre-bankruptcy debt financings
• Sale/leaseback financing of the (pre-bankruptcy) debtor company property

3. Taxation planning and compliance

• Effect of the property value on the Internal Revenue Code Section 382 limitation on the debtor company’s use of a net operating loss
• Effect of the property value on the Section 108 discharge of indebtedness income exclusion related to the debtor company amount of insolvency

4. Adequate consideration for DIP transactions

• Use of debtor company property as collateral for a secured creditor’s position
• Use of debtor company property as collateral for a new secured financing for the DIP
• Fairness of the sale or lease of property as a DIP cash generation spin-off opportunity
• Use of the property in the assessment of the debtor company’s solvency or insolvency with respect to alleged fraudulent transfers and preference actions
• Impact of the debtor company property on the reasonableness of a proposed plan the reorganization

5. Financial accounting and fair value measurement

• Fair value measurement impairment testing for the debtor company’s tangible property, intangible property, and goodwill
• Post-bankruptcy fresh start accounting for the tangible assets and intangible assets of the reorganized debtor company emerging from bankruptcy

6. Debtor entity strategic planning and management information

• Formation of a DIP property joint venture, joint development agreement, or joint commercialization agreement
• Negotiation of a DIP inbound or outbound property use, development, commercialization, or exploitation agreement, lease, or license
• Identification and negotiation of a DIP property license, spin-off, joint venture, and other commercialization opportunity

7. Other bankruptcy considerations

• Prosecution or defense of secured creditor claims that the debtor company property collateral had “inconsequential value”
• Assessment of the impact on the DIP’s decision to reject property inbound/outbound lease or license agreements
• Assessment of the impact on a counterparty of the DIP’s decision to reject property inbound/outbound lease or license agreements

Defining the purpose of the assignment may influence the form or the format of the property appraisal work product. The appraisal report can be oral, written, or a combination of the two. The appraisal report should be prepared for a specified purpose and for a specified audience.

The property appraisal should consider all of the generally accepted appraisal approaches and methods that are relevant for the intended audience. And the appraisal report should include all of the information appropriate to the intended audience.

The assignment should describe the purpose of the appraisal. And that assignment purpose should consider the following elements of the appraisal:

1. How will the property appraisal be used?
2. Who will rely on (or receive a copy of) the property appraisal report?
3. What form and format of appraisal report is appropriate?
4. Are there any legal instructions (e.g., specific statutory definitions, judicial precedent, or reporting requirements) that the appraiser should consider?

In addition to understanding the reason for developing the property appraisal, it is a best practice for the appraiser to understand exactly what the appraisal objective is. The client or the counsel should specifically define which of the following opinions the appraiser is being asked to render:

1. Estimate a value (as specifically defined) for the debtor company property
2. Measure lost profits or some other damages measurement related to a tort or breach of contract related to the debtor company property
3. Conclude an arm’s-length price for the intercompany transfer of the property
4. Estimate a fair lease or license agreement royalty rate between independent arm’s-length parties
5. Conclude the fairness of a property sale, lease, license, or other transfer transaction from a financial perspective
6. Estimate the debtor company property’s useful economic life (UEL)

Summary and Conclusion

Due to recent unfavorable economic influences, some industrial and commercial company managements are considering the implications of a bankruptcy filing—particularly a Chapter 11 reorganization filing. These company managements often expect that the debtor company will emerge from the reorganization with a lower-cost capital structure and a lower-cost operating expense structure. Property appraisals are a common element in many bankruptcy proceedings.

Part one of this four-part series introduced the many reasons why appraisers may be asked to value debtor company real estate, tangible personal property, and intangible personal property within a bankruptcy context. Part two of this series will introduce what appraisers, clients, and legal counsel need to know about the bankruptcy-related property appraisal process. Part two of this series will also discuss the appraiser’s typical due diligence procedures.

The opinions and materials contained herein do not necessarily reflect the opinions and beliefs of the author’s employer. In authoring this discussion, neither the author nor Willamette Management Associates, a Citizens Company, is undertaking to provide any legal, accounting or tax advice in connection with this discussion. Any party receiving this discussion must rely on its own legal counsel, accountants, and other similar expert advisors for legal, accounting, tax, and other similar advice relating to the subject matter of this discussion.

[1] Black’s Law Dictionary, 10th edition (Thomson Reuters, 2014).

[2] 2020–2022 Uniform Standards of Professional Appraisal Practice (The Appraisal Foundation, 2022).

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Robert Reilly, CPA, ASA, ABV, CVA, CFF, CMA, is a Managing Director in the Chicago office of Willamette Management Associates, a Citizens company. His practice includes valuation analysis, damages analysis, and transfer price analysis.

Mr. Reilly has performed the following types of valuation and economic analyses: economic event analyses, merger and acquisition valuations, divestiture and spin-off valuations, solvency and insolvency analyses, fairness and adequacy opinions, reasonably equivalent value analyses, ESOP formation and adequate consideration analyses, private inurement/excess benefit/intermediate sanctions opinions, acquisition purchase accounting allocations, reasonableness of compensation analyses, restructuring and reorganization analyses, tangible property/intangible property intercompany transfer price analyses, and lost profits/reasonable royalty/cost to cure economic damages analyses.

Mr. Reilly has prepared these valuation and economic analyses for the following purposes: transaction pricing and structuring (merger, acquisition, liquidation, and divestiture); taxation planning and compliance (federal income, gift, estate, and generation-skipping tax; state and local property tax; transfer tax); financing securitization and collateralization; employee corporate ownership (ESOP employer stock transaction and compliance valuations); forensic analysis and dispute resolution; strategic planning and management information; bankruptcy and reorganization (recapitalization, reorganization, restructuring); financial accounting and public reporting; and regulatory compliance and corporate governance.

Mr. Reilly can be contacted at (773) 399-4318 or by e-mail to RFReilly@Willamette.com.