Best Practices for Bankruptcy-Related Property Appraisals

Part II of IV

This article is part two (read Part I here) of a four-part series related to the bankruptcy-related appraisal of industrial and commercial company real estate and real property, tangible personal property, and intangible personal property. Part one of the series considered all of the reasons why a valuation specialist in any appraisal discipline (herein called an “appraiser”) may be retained to value the debtor company property within a bankruptcy context. This article considers what the appraiser, the client, and the client’s legal counsel need to know about the bankruptcy appraisal assignment and process.

Introduction

This article is part two of a four-part series related to the bankruptcy-related appraisal of industrial and commercial company real estate and real property, tangible personal property, and intangible personal property. Part one of the series considered all of the reasons why a valuation specialist in any appraisal discipline (herein called an “appraiser”) may be retained to value the debtor company property within a bankruptcy context. This article considers what the appraiser, the client, and the client’s legal counsel need to know about the bankruptcy appraisal assignment and process.

The Bankruptcy Appraisal Objective

The first element of the appraisal objective is a definition of the debtor company property. That definition should specify exactly what property is the subject of the appraisal. This definition should describe all of the tangible property and intangible property that are included as the subject of the appraisal.

In a bankruptcy-related environment, there may be uncertainty—or controversy—as to exactly what bundle of property—and what property rights—should be included with (or excluded from) the assemblage of property that is the objective of the appraisal. For example, in the property appraisal, there may also be controversy as to whether to include future access to the assets that are not in place as of the valuation date.

The second element of the appraisal objective is a description of the ownership characteristics of the property rights, including any lease, license, or contract in effect.

When a debtor company operates within the so-called zone of insolvency, that condition may undermine the incentives for the debtor to (1) lease or license any property and (2) make investments to exploit any lease or license agreements that have already been entered into.

When a bankruptcy petition is filed and the bankruptcy stay has been entered, the debtor (as property licensor/lessor or licensee/lessee) cannot pursue a breach of contract action without authorization from the bankruptcy court.

If there is a lease, license, or other agreement associated with the debtor company’s property, then the appraiser should be made aware of all relevant contract terms, such as the following:

1. Licensor/licensee responsibility contract terms

• • Legal protection requirements
  • Maintenance expenditures
  • Development expenditures
  • Licenses, permits, or other regulatory approvals

2. Other contract terms
   1. Minimum use, production, or sales
   2. Minimum marketing or commercialization expense
   3. Property development payments//completion payments
   4. Party responsible to obtain the required approvals
   5. Milestone lease or license payments

The third element of the appraisal objective is a description of the bundle of legal rights to be considered in the analysis. The assignment should specify which of the following (or which other) bundles of rights should be included in the appraisal:

1. Fee simple interest
2. Term/reversion interest
3. Licensor/licensee interest
4. Lessor/lessee interest
5. Territory (domestic/international) interest
6. Product line/industry interest
7. Sublease or sublicense rights
8. Development rights
9. Commercialization/exploitation rights

The fourth element of the appraisal objective is the appropriate standard (or the definition) of value. The standard of value typically relates to the question: Value to whom? Different standards of value often correspond to different reasons to conduct the appraisal.

The standard of value may be determined by a statutory, judicial, regulatory, or administrative requirement. Therefore, the client (or the client’s counsel) should instruct the appraiser as to the appropriate standard of value.

Some of the alternative standards of value that may be concluded in a debtor company property appraisal include the following:

1. Fair value
2. Fair market value
3. Market value
4. Use value
5. User value
6. Owner value
7. Investment value
8. Acquisition value

The fifth element of the appraisal objective is the premise of value. The premise of value considers the assumed set of transactional circumstances under which the property transfer (i.e., sale or license) will take place.

Some of the alternative premises of value that may be applied in a debtor company property appraisal include the following:

6. Value in continued use
7. Value in place (but not in use)
8. Value in exchange—orderly disposition basis
9. Value in exchange—voluntary liquidation basis
10. Value in exchange—involuntary liquidation basis

The selected premise of value is typically an assignment instruction from the client (or the client’s counsel) to the appraiser. If the client (or the counsel) does not instruct the appraiser as to the appropriate premise of value, then the appraiser may select the premise of value that concludes the highest and best use (HABU) for the debtor company’s property.

The tests for HABU are based on an analysis of what is physically possible, legally permissible, financially feasible, and maximally productive with regard to the subject property.

In selecting the appropriate HABU of the subject property, the appraiser may consider the following alternatives:

1. Current owner/operator HABU
2. New owner/operator (i.e., market participant) HABU
3. Licensor/lessor and licensee/lessee HABU

The sixth element of the appraisal objective is the valuation date. The client (or the client’s counsel) will instruct the appraiser as to the appropriate “as of” date on which to conclude the defined value.

The date, or dates, as of which the property is valued may be important to the value conclusion. This is because circumstances can cause values to vary materially from one date to another, and the valuation date directly influences data available for the appraisal.

Many internal and external factors can influence property value. A sudden change in the debtor company earnings, especially if unanticipated, can have a material effect on value. Also, the property value can vary with the debtor company’s cost of capital, a factor that can vary over time. Major events, such as the signing or the termination of a license agreement, can also impact the property value.

In order to serve the information needs of the client, the appraiser should have a clear understanding of the assignment. In a bankruptcy-related assignment, counsel is typically responsible for ensuring that the appraiser develops that understanding.

Appraisal Data Gathering and Due Diligence Procedures

Before selecting and applying any of the generally accepted property appraisal approaches, methods, and procedures, the appraiser performs due diligence with respect to the debtor company property. Counsel may participate in this due diligence process. That counsel participation may particularly occur if the appraisal relates to a property transaction, financing, or litigation.

These due diligence procedures relate to identifying and obtaining information to be considered in the development of the property appraisal. The appraiser’s due diligence process is a supplement to—and not a substitute for—counsel’s legal due diligence process.

First, the appraiser typically gathers and analyzes information related to the current owner/operator (i.e., the debtor company). The information typically relates to the property’s historical development and current use.

Such information may include the following:

1. Owner/operator historical and prospective financial statements
2. Owner/operator historical and prospective development/maintenance costs
3. Current and expected owner/operator resource/capacity constraints
4. Description and estimate of the property’s economic benefits to the current owner/operator

• • Associated revenue increase (e.g., related service unit price/volume, market size/position)
  • Associated expense decrease (e.g., expense related to service defects; cost of services performed; selling, general, and administrative; R&D)
  • Associated investment decrease (e.g., inventory, capital expenditures)
  • Associated risk decrease (e.g., the existence of a property lease, license, or other contract, decrease in the cost of capital components)

The appraiser may consider the property’s market potential outside of the debtor company. For example, the appraiser may consider the following factors from the perspective of an alternative (e.g., hypothetical willing buyer/willing lessee or licensee) owner/operator:

1. Change in the market definition or in the market size for an alternative owner/user
2. Change in alternative/competitive uses for an alternative owner/user
3. The property’s ability to create inbound/outbound lease or license opportunities to an alternative owner/user
4. Whether the debtor company can operate the property and also outbound lease or license the property (in different products, different markets, different territories, etc.)

The appraiser may also review and challenge any debtor-prepared financial projections and any debtor-prepared measurements of the property’s economic benefits. The appraiser may test such financial projections and economic benefit measurements against industry, guideline company, and other benchmark comparisons.

For example, the appraiser may develop the following comparative benchmark analyses:

1. Compare prior debtor management projections to prior debtor company actual results of operations
2. Compare current debtor management projections to the debtor’s current capacity constraints
3. Compare current debtor management projections to the current total market size
4. Consider published industry average comparable profit margin data
5. Consider selected guideline publicly traded company profit margin data
6. Consider the quality and the quantity of available guideline or comparable property lease or license data
7. Perform a debtor property UEL analysis, with consideration to the following:
   • Physical life
   • Legal/statutory life
   • Contract/license life
   • Technology obsolescence life
   • Economic obsolescence life
   • Lives (i.e., ages) of any prior generations of the subject property
   • Position of the subject property in its life cycle

In addition to comparing the debtor company’s historical and projected results of operations to those of selected guideline public companies (described below), the appraiser may compare the debtor company’s results of operations to published industry data sources.

Summary and Conclusion

Due to current high interest rates and related debt service obligations, the impact of recent high inflation on material and labor prices, ongoing supply chain disruption, continuing labor supply shortages, and other economic factors, some industrial and commercial company managements may consider the implications of a bankruptcy filing. Managements that consider a Chapter 11 bankruptcy filing typically expect that the debtor company will reorganize and emerge from bankruptcy with a lower-cost capital structure and a lower-cost operating expense structure. Debtor company property appraisals are a common element to most commercial bankruptcy proceedings.

This discussion summarizes what valuation specialists (herein called “appraisers”), company managements, and their legal counsel need to know about property appraisals conducted within a bankruptcy environment. This part two of a four-part series focused on (1) structuring the elements of the property appraisal assignment and (2) conducting the appraiser’s due diligence procedures.

Part three will focus on the generally accepted property appraisal approaches and methods applied within a bankruptcy context.

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.

---

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.