Bankruptcy Court: Expedited Settlements Produce
Unique Valuation Issues
Four bankruptcy cases illustrate the
complexity of challenges faced by the courts, the parties and their valuation
In the wake of the recent economic crisis, bankruptcy courts have taken on large, complex cases that are made even more complicated by continuing uncertainty in the credit and liquidity markets. Adding to the pressure, expedited settlements are creating unique valuation issues that are, as one court put it, "testing the limits of bankruptcy law."
Here are four bankruptcy cases that illustrate the complexity of challenges faced by the courts, the parties and their valuation professionals.
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Limits to Using Unencumbered Assets to Pay
Off Secured Lenders
In In re Capmark Financial Group, 2010 WL 4313046 (Bkrtcy. D. Del.)(Nov. 1, 2010), the debtor proposed to cash out a $1.5 billion secured loan in exchange for the lenders' release of the collateral, valued at $1.3 billion to $1.5 billion. The committee of unsecured creditors objected, arguing that the pre-confirmation cash payment of the secured claim violated the Bankruptcy Code's limits.
In a 93-page opinion, the Bankruptcy Court focused on whether the value of the collateral equaled or exceeded the proposed cash payment. Part of this determination required assessing the value of several insider guaranties given to secure the financing. The debtors' expert likened the guaranties to "put" options and used standard option pricing models to estimate their replacement value, which the expert calculated to be $878 million. The expert further testified that the remaining collateral, consisting primarily of a pledged pool of 127 distressed or nonperforming mortgage loans, would be expected to recover $1.48 billion to $1.6 billion over the next three years. Overall, the retained collateral exceeded the proposed cash settlement by $625 million.
By contrast, the creditors' expert claimed the retained collateral was not "worth anywhere near" the asserted $1.3 billion to $1.5 billion value. The court found this evidence to have limited utility, however, because the creditors' expert failed to apply risk profiles and discount rates that were appropriate to the debtor. At the same time, the court conceded that the proposed settlement "certainly tests the limits of the authority to pay prepetition secured claims outside a plan." Nonetheless, the court found that the proposed plan did not violate the Bankruptcy Code because the value of the debtors' retained collateral was "well in excess" of the cash payout to the secured lenders. The court also found that the unsecured creditors were not harmed in any way by the settlement and approved the plan as reasonable and fair.
Limits to Using Just One Valuation Method
In In re Chemtura Corp., 2010 WL 4272727 (Bkrtcy. S.D. NY.)(Oct. 29, 2010), the debtors - a specialty chemical maker and its affiliates - proposed a reorganization plan to which no creditors objected except the equity shareholders, who claimed it substantially undervalued the company.
At an independent valuation hearing, the debtors' expert concluded that the company's "total enterprise value" was just over $2 billion, while the shareholders' expert said it was worth $2.45 billion. Both experts applied a discounted cash flow approach, using similar discount rates and relying on the debtors' long-range forecasts. In their terminal value calculations, however, the experts selected very different earnings levels to which to apply their multiples. The debtors' experts used mid-cycle and normalized earnings, but the shareholders' experts used the final year of forecasted earnings.
In a 78-page opinion, the court found that, on balance, the debtors' discounted cash flow analysis was more persuasive. In any other economy, the use of final year cash flows might be "perfectly ordinary, if not preferred," the court held. In the current economy, however, such a reliance was too aggressive. The court was also troubled because the shareholders' expert, unlike the debtors' expert, did not conduct a comprehensive analysis of comparable companies to provide an independent value indicator; rather, the shareholders' expert merely used the market approach to test the reasonableness of his discounted cash flow.
"That's disappointing," the court said, especially as it found the comparable companies analysis to be more meaningful in this case than either the discounted cash flow approach, which is generally susceptible to uncertain projections, or the comparable transactions approach, which can be subject to control premiums, synergies, bidding wars and hostile deals. Moreover, the shareholders' expert relied too heavily on pre-crisis transactions.
Based on all the evidence, the court found that the debtors' value did not exceed the $2 billion underlying the plan and confirmed the same.
Limitations to Using Discounted Cash Flow to Trump Market Value
In In re Boston Generating, 2010 WL 4922578 (Bkrtcy. S.D.N.Y.)(Dec. 3, 2010), the owner of the third-largest group of power plants in New England signed an asset purchase agreement in August 2010 and, the next day, filed for bankruptcy. The debtor and its affiliates immediately sought authority to enforce the sale, which required court approval within 90 days. The $1.1 billion cash transaction would pay nearly 99% of the debtor's secured first lien debt but none of its second lien or unsecured debt.
Not surprisingly, the creditors (except for the first lien holder) objected to the sale, claiming that the debtor was not getting fair market value. Their expert's discounted cash flow indicated that the debtor's assets were worth $1.38 billion, over a quarter of a billion dollars more than the proposed sale price. However, the expert made several critical assumptions that required "substantial judgment," according to the court, including his estimates of the discount rate. He also used projections that surpassed both the debtor's and industry forecasts and were too heavily contingent on a wide range of factors, including regulatory reform, demand, capacity, energy and other costs.
"Simply put," the court said, the expert believed "he is right and the market is wrong." The court went on to note that, absent a clear showing of market failure, the market price is still the "best indicator of enterprise value." Accordingly, the court found that the sale transaction was the best indication of market value for the debtor's assets, and it authorized the sale.
Limits to Hope and Effort
In In re Fairvue Club Properties, 2010 WL 4501959 (Bkrtcy. M.D. Tenn.)(Nov. 2, 2010), the owner of two golf courses pledged to do "whatever it takes" to pull his properties out of bankruptcy. He proposed an optimistic reorganization plan that his lender rejected as not feasible.
In particular, the owner forecast annual cash flows at nearly twice the clubs' historic rates. Moreover, the owner's projections exceeded his appraiser's projections by between 14% and 23%. In an unusual turn, the lender called the owner's appraiser as a witness, and he testified that the owner's projections were unrealistic ("a default waiting to happen"). While the court acknowledged the owner's apparent commitment to reversing the fortunes of his golf courses, it rejected the owner's plan, noting that "hope and effort alone cannot make the debtor's projections attainable."
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