Source: https://www.dailydac.com/valuation-the-pillar-of-corporate-restructuring/
Timestamp: 2019-04-24 20:30:41+00:00

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Valuation can be critical at the beginning of a bankruptcy case in determining whether the debtor can use cash collateral or obtain debtor-in-possession financing. At the confirmation stage, valuation plays a critical role in determining whether a chapter 11 plan can be confirmed and, if so, how much each class of creditors will receive on its claim. Even after confirmation, valuation is an essential issue in litigation seeking recovery of alleged avoidable transfers. Creditors may seek to lift the automatic stay at any time during a case based, in part, on the value of the debtor’s assets. This article examines how valuation impacts the outcome of each of these aspects of a commercial chapter 11.
The importance of valuation, of course, is not limited to bankruptcy proceedings but extends to out-of-court restructurings (and to many situations in which a debtor seeks to pay a creditor less than in full or otherwise outside of contract terms) because parties frequently seek to negotiate fully consensual restructurings outside of court to avoid the substantial costs and uncertainties of chapter 11.
A party’s negotiating position, in turn, is based in substantial part on what that party believes a litigated outcome would yield absent settlement (whereas the strength of a party’s position depends in large measure on what the actual result of litigation would be). Yet it is impossible to know with certainty how any court will rule on any matter, let alone one in which value is in dispute. Absent an actual sale, a determination of value is inherently subjective. Moreover, bankruptcy judges are not valuation experts. Rather, they hear evidence from dueling experts, each generally with excellent credentials, hired by opposing parties for the very purpose of persuading the judge to accept its view of valuation. This is the proverbial battle of the experts.
But before we proceed to address specific examples of how valuation impacts a commercial chapter 11 case and what experts are called on to opine about, let’s begin with a very brief overview of bankruptcy to provide the reader with appropriate context.
The bankruptcy process in the United States is governed by federal law. Article I of the U.S. Constitution grants Congress the power to make bankruptcy law and to create bankruptcy courts. Congress exercised this power through the Bankruptcy Reform Act of 1978, which formally enacted the current Bankruptcy Code, codified at Title 11 of the U.S. Code. The Bankruptcy Code was most recently significantly amended by Congress under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCA”).
Chapter 1 defines terms, delineates who can be a debtor, and describes the court’s powers, among other general rules.
Chapter 3 governs “case administration.” It addresses matters such as filing new cases; employing professionals; the automatic stay; the use, sale, and lease of estate assets; post-petition financing; executory contracts; dismissing and closing cases; as well as others.
Chapter 5 covers a wide variety of matters relating to the rights of debtors and creditors, including claims and priorities; matters relating to exemptions and discharge of debts; and the “avoidance” provisions, which permit a debtor or trustee to claw back certain prepetition transfers made by the debtor to its creditors. “Clawback” is the term used to describe when a trustee or debtor attempts to recover assets that should have been part of the debtor’s bankruptcy estate but were removed by means of preferential or fraudulent transfers.
Bankruptcy Rules. The Federal Rules of Bankruptcy Procedure (the “Bankruptcy Rules”) and local bankruptcy rules enacted by specific bankruptcy courts are more procedural in nature than the “rules” provided for in the Code and must be read alongside the Code. Examples of matters the Bankruptcy Rules and local rules address include how to provide proper notice of various actions to parties in interest and deadlines.
Other federal statutes and rules. There are many federal statutes that apply to every person (defined to include corporate entities) and those statutes generally continue to apply to debtors in bankruptcy. Examples include labor, tax, environmental statutes and regulations.
State laws. Federal law trumps state law where the two conflict and bankruptcy law is federal law. There are many areas, however, where there is no conflict between the two and, in fact, where bankruptcy law specifically makes clear that state law is to control over certain matters.
Case law. Bankruptcy law, like all other law in the United States, is not derived solely from statutes and rules. Ours, rather, is a system in which courts decide cases and those decisions are then used as precedent for future cases.
A classic reorganization is a chapter 11 case in which the equity owners of the debtor before the chapter 11 are still equity owners after confirmation of the chapter 11 plan. It may involve some creditors agreeing to forgive some debt and/or to stretch out the time in which the debtor may pay their debt. It may involve some creditors agreeing to trade some of their debt for some of the debtor’s equity, thus diluting the original equity holders. It may involve the sale of some of the debtor’s assets. But it does not involve the sale of substantially all the debtor’s assets (i.e. a liquidation).
If you were to go back and study the history of bankruptcy, including the legislative history surrounding the enactment of the Code, you would readily see that business bankruptcy exists to serve two primary, but ostensibly conflicting, goals.
A fundamental problem with leaving equity in control is that when a business is insolvent (or nearly so), equity (and junior creditors) nearly always gains from taking risk. Liquidate today and equity holders get nothing. Keep the business going and they may have a chance to recover.
Creditors tend to be correspondingly risk-averse. Liquidate today and they (at least the most senior creditors) are more likely to get paid. Take a gamble by keeping the business going equity has the highest upside, while the creditors bear the greatest risk of loss.
The point is not that creditors always favor liquidation—clearly, that’s not true—but the risk-reward calculation is different for creditors than for equity holders. It is similarly different for junior creditors (unsecured creditors, for example) than it is for senior creditors (secured creditors, for example). There can be no doubt that chapter 11 encourages, rather than resolves, this tension—as if deliberately to allow the court to choose, from case to case and even from time to time within a case, whether “assets” or “equity” will dominate.
At this point we reach back again to the concept of valuation, which bears a central role in determining who gets to decide the direction in which a chapter 11 case will go.
In bankruptcy valuation is a critical issue in disputes regarding the “adequate protection” of a secured creditor’s collateral. Whether a creditor is adequately protected, in turn, is the key question that a court must answer when faced with whether to permit a debtor to (i) use cash collateral, (ii) enter into DIP financing, and (iii) overcome a lender’s request to lift the automatic stay and take its collateral. And as we explore valuation in each of these disputes, take note that while the context for each is different, the evidence at issue and, the issue itself is largely the same.
Adequate protection, and thus valuation, also plays a pivotal role in most lift stay motions. The automatic stay prevents creditors from foreclosing on the debtor’s assets but the automatic stay can be overcome by a creditor’s motion seeking to lift the automatic stay. To successfully lift the automatic stay, a secured creditor must show that its collateral will not be “adequately protected” if left in the possession of the debtor.
If a lender has a security interest in a debtor’s cash, which includes both cash and cash equivalents (e.g., cash in a bank account, the proceeds of accounts receivable, rents from an office building or hotel), the debtor must have the lender’s consent or a court order before it can use that cash collateral. Bankruptcy Code § 363(c) provides that a debtor may use “cash collateral” only with (1) creditor consent or (2) court order.
A debtor will typically need immediate access to cash collateral in order to continue operating when it files for bankruptcy and will therefore commonly file a motion for authority to use cash collateral as one of its “first-day motions.”³ If the parties do not reach an agreement regarding the use of cash collateral, a contested hearing will be held to determine the debtor’s right to use the cash collateral. In a hearing on the matter, the prepetition creditor must prove the “validity, interest, extent” in the cash collateral; and the debtor must prove that the cash collateral is adequately protected. The issue of valuation is commonly the sine qua non of determining whether a lender’s interest is in fact adequately protected.
When the use of cash collateral is not sufficient to fund ongoing operations, a debtor must look to other sources of funds. In these instances, a debtor may need to borrow “new money.” In doing so, a potential lender will often be willing to loan only if it is granted a security interest that is superior to that of existing secured creditors. And for a debtor to grant such priming lien, it must show that the creditor whose lien is to be primed will be adequately protected, which again is often decided by the determination of a valuation of the lender’s interest in its collateral.
If the debtor borrows on an unsecured basis “in the ordinary course of business,” then the lender’s claim is a first-priority administrative expense under § 364(a).
Even outside the ordinary course of business, a lender who lends on an unsecured basis can have its claims approved by the court as first priority administrative expenses under § 364(b). But as a practical matter, this happens very rarely because most creditors who provide post-petition lending insist on the greater protections afforded by subsections (c) and (d).
If the debtor cannot find unsecured credit, the court may allow the lender to hold a “super-priority” administrative claim, or to take a security interest in unencumbered property (or a subordinate security interest in encumbered property). This is § 364(c).
Finally, if the debtor cannot otherwise obtain credit otherwise, the court may authorize a security interest that is “senior or equal” to an existing security interest, under § 364(d). A DIP loan with a lien that is senior in priority to existing, prepetition liens is sometimes referred to as a priming lien. It is the most extraordinary protection for a post-petition lender, and it requires a showing that the lender whose lien is to be primed will nonetheless be adequately protected.
Bankruptcy Code § 362(d) offers two principal paths by which a creditor can obtain relief from the automatic stay that goes into effect immediately upon a debtor’s entry into bankruptcy (which, in the absence of stay relief prevents a creditor from seeking to take its collateral from the debtor). The first is “cause, including lack of adequate protection.” If the court finds that the lender is entitled to adequate protection, but the debtor cannot or will not provide it, then the lender is entitled to stay relief. This provision suggests that a lack of adequate protection is not the only “cause” justifying relief from the stay, but it is the only one we will focus on here.
The second path to obtaining stay relief is satisfied if there is no equity in the property and the property is “not necessary to an effective reorganization.” The no-equity prong means the debt secured by liens on the property exceeds the value of the property. The secured creditor bears the burden of proving the no-equity prong. The import of value should be clear.
A debtor can combat a motion to lift the automatic stay by showing that it is able to adequately protect (per Bankruptcy Code § 361) the lender’s collateral via periodic cash payments to the lender, paying post-petition interest, or granting the lender additional liens on previously unencumbered assets.
For example, where the primary collateral encumbered by the lender’s lien is accounts receivable, it is common for the lender to be granted a “replacement lien” on the debtor’s receivables generated post-petition. Such protection is significant because Bankruptcy Code § 552 operates to cut off any receivables lien as of the bankruptcy filing date. A replacement lien enables the debtor to spend the proceeds of the receivables that are subject to the lender’s original lien in exchange for a lien on new “replacement” receivables. If the debtor continues to generate new receivables at the same rate or a higher rate as it spends the proceeds of old (prepetition) receivables, then the lender is adequately protected.
Alternatively, if the secured lender has an “equity cushion” in the collateral it is seeking stay relief to foreclose upon, then that lender will be deemed adequately protected because the use of cash collateral is unlikely to present an unfair risk to the secured lender.
Even in the absence of an equity cushion, adequate protection may be deemed to exist. If the debtor is using the proceeds of the secured lender’s hard collateral to preserve that hard collateral, for example, it may be deemed adequately protected. Rents generated by an apartment building if used to preserve and maintain the building, for example, can result in a court concluding that the secured lender’s interest will be adequately protected.
As can often be the case in politics, “where you stand depends on where you sit.” Valuation is the crucible in which a restructuring plan is negotiated, and parties take fairly predictable positions depending on where they stand in the capital structure.
This concept is best illustrated by a simple hypothetical: Senior “Class A” is owed $1 million by a debtor, and the reorganization plan calls for Class A to get 100% of the stock of the reorganized debtor as payment of its claims. “Class B” consists of the existing interests of equity holders of the debtor and is therefore junior to Class A. Under the absolute priority rule, Class A has priority over Class B and is entitled to receive payment in full of its claims before any payment is made to Class B.<sup?6 But since Class A is set to receive 100% of stock of the new equity, there will be nothing left to pay Class B. This plan can be confirmed (assuming all other requirements are met), as long as the value of the new equity does not exceed $1 million. As a result, junior Class B will have a strong incentive to argue that the enterprise value is higher than $1 million.
With that warm-up, let’s take a stab at a case study.
Exide Technologies manufactured and supplied lead acid batteries for transportation and industrial applications. It has operations across the world.8 Prior to its chapter 11 filing, Exide owed a group of bank lenders about $700 million and it had also issued many senior and convertible notes.
First, the senior lenders could elect to receive preferred stock in the reorganized debtor, or a combination of preferred stock and cash.
Second, general unsecured claims were divided into two subclasses—non-noteholder general unsecured claims, and senior claims.11 Non-noteholder unsecured claims would receive cash, valued under the plan at $322.5 million, resulting in a pro rata distribution of $4.4 million—a 1.4% payout on these claims. Senior claims would receive the common stock of the reorganized debtor (thus, the Senior Claims were the fulcrum security holder), which the debtor valued at $300 million, resulting in a pro rata distribution of $4.1 million (also a 1.4% payout).
Finally, junior noteholders receive nothing.
Several parties, including the creditors’ committee, filed objections to the plan arguing that the reorganized debtor’s enterprise value would be worth far more than the debtor estimated and that as a result, the secured lenders would be receiving more than payment in full of their claims.
The Court held a confirmation hearing and heard evidence relating to each party’s assertion as to what the reorganized debtor’s enterprise value would be, to determine whether the proposed plan was fair and equitable. The debtor presented evidence through its valuation expert that the reorganized debtor’s enterprise value would be between $950 million and $1.050 billion. The committee presented evidence through its valuation expert assessing the reorganized debtor’s enterprise value as being significantly higher—between $1.478 billion and $1.711 billion.
Exide’s expert attempted to argue that a chapter 11 “taints” the enterprise and thus impacts negatively its securities and future earning potential. The court disagreed, concluding that Exide’s expert subjectively and inappropriately altered the valuation methods, and holding that restructuring is a benefit to the enterprise value. The court found the reorganized enterprise’s value between $1.4 billion and $1.6 billion and thus found the proposed plan to not be fair and equitable, because it would have paid the senior lenders more than what they were owed, leaving nothing for junior classes of creditors.
Now take another look at footnote 10 above. Then look at the use of the phrase “fair and equitable” in the discussion of Exide above. Do you see that the fight in Exide was a “cramdown” fight? Let’s discuss this in a bit more detail.
Suppose a debtor owes $1 million to a creditor under a secured lending agreement providing for payment in annual installments over 10 years, with interest at 10% (your calculator will tell you this amounts to $162,000 per year). The debt is secured by Farm, which, luckily, is worth $1 million- as it just so conveniently happens for the sake of this example- the same amount as the debt.
The creditor has made it clear that it favors no resolution other than immediate payment in full. The debtor certainly can’t do that; indeed, it can’t even meet the installments. But the debtor could pay a lower installment.
The debtor analyzes its options and determines that if the creditor increases the loan period from 10 to 20 years at the same rate of interest, then the debtor’s annual payment would fall to around $127,000. The debtor concludes it can pay $127,000 each year.
Can the debtor impose this deal under the cramdown rule? It’s a close call. The rule provides that a debtor can impose the plan if the creditor gets a payment stream with a present value equal to the amount of its secured claim. In this case, the debtor is proposing a payment stream with a value equal to the creditor’s claim—if 10 percent is the right interest rate.
The creditor will argue that a 20-year loan is riskier than a 10-year loan, and so it has a right to a higher interest rate. But if the interest rate is higher than 10%, a stream of 20 payments of $127,000 has a present value less than $1 million.
The exact fight here would be one over what the interest rate should be. And who would be the participants in this fight? Dueling experts (the lawyers would be more like the boxer’s trainers- think Mickey to Rocky).
The debtor in Sunnyslope developed a low-income housing development, borrowing money to do so. The loans were provided under a condition that the debtor, indeed, develop low-income housing.16 The housing restrictions were ingrained in the deed and ran with the land unless foreclosed-on.
After defaulting on its loans, but before a $7.65 million foreclosure sale was finalized, Sunnyslope filed for chapter 11, where it sought to cramdown a reorganization plan over the objection of its first mortgagee, First Southern National Bank, which held a secured claim against Sunnyslope for approximately $5 million.
Thus, the pivotal issue in the case became how to appropriately value First Southern’s collateral.
The bankruptcy court concluded that the debtor’s proposed $2.6 million valuation was appropriate, based on the property continuing to be used as low-income housing. It confirmed the plan over First Southern’s objection on that basis. On appeal, the Ninth Circuit affirmed the bankruptcy court’s decision.
The Ninth Circuit held that, when determining valuation in the context of a cramdown, a court must consider the actual use of the property, and that replacement value was the value of the property assuming its continued use after reorganization.
In discussing its holding, the Ninth Circuit adopted the reasoning of the Supreme Court’s opinion in Associates Commercial Corp. v. Rash,20 the main case over which Sunnyslope and First Southern fought. In Rash, the Supreme Court adopted a replacement value standard for valuing collateral in a cramdown context and rejecting a foreclosure value standard since the foreclosure sale would not take place, and therefore the value of the collateral “hinged [on] the property’s ‘disposition or use.’”21 Thus, even though First Southern’s collateral could have a higher value at foreclosure, the Ninth Circuit adhered to the replacement value standard from Rash.
Most, but not all, corporate bankruptcy cases proceed in the same general order. The first part of a case is often occupied by activities necessary to assure continued operations, for example, and plan confirmation generally occurs toward the end of a case. In fact, many business people without prior experience with bankruptcy assume that plan confirmation marks the end of a case. And while that is in some ways accurate, it is in other ways not accurate at all.
Avoidance actions are commonly brought after confirmation, and the issue of valuation is pivotal in such actions.
Making the transfer for less than reasonably equivalent value or making the transfer or incurring the obligation for the benefit of an insider under an employment contract and out of the ordinary course of business.
In the context of an actual fraud claim, if the plaintiff can show that the debtor intended to defraud interested parties, then it doesn’t have to worry about issues of solvency or value. But showing actual intent is very difficult to do. Thus, most fraudulent transfer actions are brought under § 548(a)(1)(B), thus making a valuation expert very important to analyze and opine both on solvency, as well as reasonably equivalent value.
A sine qua non of bankruptcy is equality of distribution among similarly-situated creditors. To use a simple example, assume a debtor has 10 unsecured creditors, owes eight of them $10 each and owe the other two $100 each. The general rule is that each creditor will be paid pro rata.
How is this calculated? First, we divide what the creditor is owed (say, $10 in the case of any of the eight) by the total the debtor owes to all similarly situated creditors ($280 in this example). The math tells us that each of those creditors who is owed $10 is owed 3.57% of the total amount owed by the debtor to all is unsecured creditors. Since there is $100 to go around, each of the creditors who is wed $10 will be paid $3.57.
Maybe Peter just got lucky.
Regardless of the reason, Peter may be the recipient of a preference. And the debtor (or trustee, standing in the debtor’s shoes) can seek to avoid the preference so that the funds are returned to the estate and all creditors (including Peter) can be paid pro rata as if the preferential payment had not been made.
The core of preference law is in § 547 of the Bankruptcy Code. The elements of a preference claim are stated in § 547(b). It provides that a debtor may (subject to certain defenses) avoid a transfer to a creditor for a preexisting debt, if the transfer was made while the debtor was insolvent and was made in the 90 days24 before the debtor filed for bankruptcy—so long as the payment constituted more than would get as a distribution in a chapter 7 bankruptcy case.
Akin to avoiding the fraudulent transfers, two elements of the prima facie elements involve valuation: insolvency and the determination as to whether the creditor received more than it would have in a chapter 7 liquidation. And while these two elements are not often contested in preference litigation, parties must hire valuation experts if they are.
Valuation’s crucial role in a restructuring/insolvency situation is undeniable. Trying to guide a company through the maze that is corporate restructuring (regardless of the company’s size and regardless of whether it in bankruptcy) without at least a basic understanding of valuation is like trying to understand Better Call Saul without first having watched Breaking Bad—it can be done but it’s not a good idea.
This point is especially well illuminated by the example of the Sunnyslope case, illustrating the wide latitude courts may exercise in determining the proper method of valuation, swinging the pendulum in favor of debtors or lenders as they may see fit, and serving as a cautionary tale to those wading into the deep end of the distressed debt investing pool.
The comparable company analysis assesses a company’s going concern value. Exide argued that it was best to assess the reorganized enterprise’s value based on historical EBITDAR (earnings before interest, taxes, depreciation, amortization, and restructuring costs). It used the EBITDAR from a year ending in June 2003, the latest available at the confirmation hearing, resulting in $179 million. The Committee argued that projected EBITDAR would best reflect the valuation of the reorganized Exide because it would bestow on it the benefit of the restructuring. The court agreed with the Committee, reasoning that valuation should be forward-looking, and concluded it was appropriate to use the projected EBITDAR.
Each side chose a multiple by comparing the enterprise value of comparable publicly-traded companies to their trailing twelve months EBITDA, and both sides seemed to have arrived at a similar multiple, with Exide at 7.2x and the Committee at 7.7x. Exide’s expert, however, adjusted his multiple downward to 5.0x to 6.0x, based on his judgment that this comparable for a particular part of Exide’s business should be given less weight. The Court rejected the subjective adjustment and determined that the proper multiple was between 7.2x and 7.7x.
The debtor’s valuation expert used two merger and acquisition transactions from 2002, which placed the values of the companies at EBITDA multiples of 6.0x and 7.2x. The Committee argued that valuation should be assessed based off multiple acquisitions that occurred since 1992, but the court disagreed arguing the market has changed. As a result, the court applied a straightforward method and adopted the 6.4x factor, that was later applied to Exide’s $188 million EBITDA figure.
The objective of the DCF analysis is to provide enterprise value by discounting the projected cash flow based on the weighted average of cost of capital, which is the weighted average costs of equity and debt. Exide argued that because it was emerging from a reorganization, it may face a substantial risk in meeting its five-year plan. The court found Exide’s valuation expert’s subjective DCF approach strayed from generally accepted approaches in the field.
1 The author thanks his colleagues Jack O’Connor and Hajar Jouglaf for their valuable assistance in preparing this article and his partner Elizabeth Vandesteeg for her very thoughtful comments.
² The difference between a classic reorganization and a sale is not as profound as it may seem at first glance and, indeed, we believe the ultimate goal of chapter 11 (or any out-of-court restructuring for that matter) should be to maximize creditor recoveries because serving that goal necessarily maximizes the likelihood of achieving the other goal. See Chapter 11: Not Perfect, But Better Than The Alternatives James H.M. Sprayregen, P.C., Jonathan Friedland and Roger J. Higgins, 14 Journal of Bankruptcy Law and Practice 6 Art. 1 (December 2005). As stated in that article, “with the rise of the distressed debt markets, a financial restructuring of the historic entity through a confirmed plan of reorganization is functionally equivalent to the purchase of assets in a section 363 sale.” Id. at note 72.
³ First-day motions are a series of motions filed simultaneously with a bankruptcy petition seeking case-dispositive relief.
5 The class which receives payment and below which no class receives any consideration is commonly referred to as the fulcrum security. See Corporate Restructuring 2017: Why Some Attorneys See Rising Rates, but Most Don’t.
6 Under Bankruptcy Code § 1129 (b)(1), a Chapter 11 plan will be confirmed so long as (1) it does not discriminate unfairly and (2) it is “fair and equitable” with respect to each non-accepting class that will be impaired under the plan. Simply put, a class would be “impaired” if the plan alters the pre-bankruptcy contractual rights between the debtor and the class. For a plan to be “fair and equitable,” it must pay off the senior creditors in full before junior creditors are paid anything. On the other hand, a senior class may not be paid more than it is owed by the debtor.
7 303 B.R. 48 (D. Del. 2003).
9 For a general primer on this topic, read about the chapter 11 plan confirmation process.
10 303 B.R. at 55.
12 See App. A for a brief discussion of each of these valuation methodologies.
14 859 F.3d 637 (9th Cir. 2017).
19 Id. at 642. First Southern’s expert also asserted that, even if the low-income housing restrictions remained in place, the property would be worth nearly $4.89 million. Id.
20 520 U.S. 953 (1997).
21 See id. at 963 (quoting In re Winthrop Old Farm Nurseries, Inc., 50 F.3d 72, 75 (1st Cir. 1995)).
22 When considering the breadth of discretion, a bankruptcy judge may exercise over the value of collateral, one may ask whether such broad discretion is actually a good thing. At first glance, one might conclude that broad discretion is bad in that it can lead to inconsistent results and rulings. But after further contemplation one can easily conclude the opposite—introducing uncertainty and risk for parties in dispute incentivizes them to settle and resolve their differences more efficiently.
23 Similarly, § 544 of the Bankruptcy Code authorizes the debtor to pursue avoidance actions arising under state law. 11 U.S.C. § 544.
24 Or one year, if the transfer was to an “insider” of the debtor. 11 U.S.C. § 547(b)(4)(B).
25 See infra at pp. 10-11.

References: § 363
 § 364
 § 364
 § 364
 § 364
 § 362
 § 361
 § 552
 v. 
 § 548
 § 547
 § 547
 Art. 1
 § 1129
 § 544
 § 544
 § 547