Major Bankruptcy Rulings Rest on Common Interpretation, Credible Valuation Approaches

The numbers involved in recent bankruptcy cases can be staggering, as can the financial heights from which many of the big-name debtors have fallen. But as one federal bankruptcy court observed, even these big, complicated cases often come down to fairly common statutory construction plus credible valuation approaches, assumptions, and inputs.

Team of Experts Tries to Overturn Lehman Sale

In re Lehman Bros. Holdings Inc., 2011 WL 597970 (Bankrtcy. S.D.N.Y.)(Feb. 22, 2011) concerned “the largest, most expedited and probably the most dramatic asset sale that has ever occurred in bankruptcy history,” the court observed, namely, the “urgent” sale of Lehman Brothers’ North American assets to Barclays bank during the “war zone” that Wall Street became in September 2008.

See below: Third Circuit Confirms DCF to Value Mortgage Portfolios in Dysfunctional MarketsTransparency Aids Credibility

A year later, after the crisis had subsided, the debtor and its unsecured creditors asked the court to rescind the sale under Rule 60(b) of the Federal Rules of Civil Procedure. They claimed that Barclays reaped a windfall from the sale – up to $13 billion – by secretly negotiating (and then failing to disclose to the court) a discounted value for the Lehman assets. Six valuation experts testified for the movants, but none were market participants and all were litigation consultants who worked to achieve a “concerted” outcome, the court found. For instance, one expert prepared a summary spreadsheet in which he made “misleading” adjustments and “reverse-engineered” the outcomes.

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By contrast, Barclays’ expert, a finance professor, was able to “tie together all of the evidence relating to valuation in a most persuasive and comprehensive manner.” Specifically, the expert concluded that the sale did not understate the book value of the assets – certainly not by $13 billion. The collateral included many illiquid and difficult-to-value securitized assets. The expert also gave great deference to the “front line” Barclay’s personnel who were making those difficult valuations during a time of great turmoil, subject to independent audit. Finally, it was “almost inconceivable” that Lehman could have realized more from a liquidation sale or sale to another bidder, the expert said, “because there wasn’t another bidder.”

The Bankruptcy Court agreed. “Despite the insinuations of wrongdoing … , the marking down of asset values … appears to have been consistent with an attempt, apparently undertaken in good faith, by employees of both Lehman and Barclays to estimate market values for assets that were difficult to value at a time of extreme uncertainty in the financial markets,” the court found. Barclays may have taken advantage of Lehman’s vulnerable position, but it did not receive assets “that were collectively worth any more in the market than it paid for them,” the court said, and declined to reconsider the sale.

Third Circuit Confirms DCF to Value Mortgage Portfolios in Dysfunctional Markets

In In re American Home Mortgage Holdings, Inc., 2011 WL 522945 (C.A. 3 (Del))(Feb. 16, 2011), the debtors sold $1.2 billion worth of mortgages pursuant to a 2006 repurchase (“repo”) agreement. When the markets crumbled in 2007, the debtors went bankrupt and the repo participants accelerated their claims, asserting over $478 million in damages under Sec. 562 of the Bankruptcy Code. In particular, since there were no “commercially reasonable determinants of value” available on the 2007 acceleration date, as required by the statute, their damages should be measured as of August 2008 (the earliest date they could have sold the loans) for a mere 10 cents to 50 cents on the dollar.

In response, the debtors claimed that a commercially reasonable determinant of value – namely, the discounted cash flow (DCF) method – existed on the acceleration date. Under this method, the value of the loan portfolio exceeded the repurchase price and, therefore, no damages were due. The Bankruptcy Court (Delaware) agreed with the debtors, and the loan participant appealed to the U.S. Court of Appeals for the Third Circuit, which considered the issue of first impression.

Although the amounts at stake were “dazzling,” the court said, the issue simply came down to whether Sec. 562 permitted the use of any “commercially reasonable” valuation method to determine damages. The “primary purpose” of Sec. 562 was to preserve liquidity in the assets and to align the “risk and rewards” associated with their investment, the court found. Moreover, Sec. 562 seeks to avoid the “moral hazard” that would result if damages were measured at any other time than as of the acceleration date, such that the repo participant could hold the assets at little or no risk while the debtor became the insurer of the risk – despite having no management or control over the assets. Accordingly, “There is nothing in Sec. 562 that would imply a limitation on any methodology used to determine value, provided it was commercially reasonable,” the court held, accepting the DCF method as such a determinant and dismissing the loan participant’s deficiency claims.

Transparency Aids Credibility

In In re Spansion, 426 B.R. 114 (April 1, 2010), the third-largest maker of flash memory wireless devices filed for Chapter 11 relief in part to refocus on the more profitable markets for embedded applications. Trading of claims began almost immediately. Institutional investors purchased converted debt and then offered $112 million in equity financing, derived from a total enterprise valuation (TEV) of $1.5 billion. The debtors rejected the offer in favor of their own plan, supported by the senior noteholders. Not surprisingly, the equity investors objected, claiming that the debtors’ proposal understated TEV and gave away too much value to management-employees via equity compensation plans.

In deciding whether the debtors’ proposed plan was fair and equitable, the court heard that TEV ranged from $700 million to $944 million on the lower end (according to the debtors’ and secured noteholders’ experts) to a high of $1.054 billion to $1.419 billion (the equity investors’ expert). Each expert conducted a discounted cash flow (DCF) analysis and, not surprisingly, accused the other experts of manipulating certain inputs and assumptions to reach their ultimate values – including the discount rate, terminal values and management projections. In addition, each expert applied a comparable companies analysis as well as a comparable transactions (M&A) approach but reached their different values by applying different multiples, either revenue or earnings.

Overall, the court found that the valuation by the senior noteholders’ expert rested on “the most sound” assumptions for determining the debtors’ current value in its industry. It was also more transparent than the report by the debtors’ expert and “more in line with common valuation practices” than the report by the equity investors’ expert.

Based on these observations, the court found that the debtors’ TEV ranged from $872 million to $944 million and its plan treated all unsecured creditors fairly. At the same time, it declined to confirm the debtors’ proposal until it reduced the management incentive plan and amended certain releases.

Note: Within two weeks of this decision, the equity investors raised nearly $420 million and asked the court to delay the proceedings in order to consider their proposal. The debtors rushed to cut more than $14 million from their equity incentives and obtained court confirmation on April 15, 2010.

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