Young & New Members Committee

ABI Committee News

Selected Cases on Valuation Methodology and Confirmation of Plans of Reorganization

Robert J. Keach; Bernstein, Shur, Sawyer & Nelson

Valuation of particular assets, or the entire enterprise, may be critical in a chapter 11 case. Valuation issues may determine whether a secured party is adequately protected or entitled to relief from stay and whether interest can or cannot accrue on secured claims. In contested proceedings with respect to the confirmation of plans of reorganization, valuation of the enterprise is critical. The valuation chosen by the court will often determine whether or not a plan unfairly discriminates among classes and/or is fair and equitable, including the absolute priority rule has been complied with or whether a class of senior debt has received more than 100 percent of the value of its claims to the detriment of a junior class of equity interests.1

Despite the importance of valuation to critical judicial decisions in a chapter 11 case, the Bankruptcy Code (the “Code”) is silent on what valuation methodology is appropriate in what circumstances, leaving it to the courts to determine how assets or the enterprise should be valued given the circumstances before the court. Case law has established some basic principles. If the debtor is retaining the assets in connection with the reorganization, or selling the assets as a “going concern,” the assets must be valued at “fair market” or “going concern” value.2 In a contested confirmation, for purposes of the cram down provisions of the Code, the debtor must demonstrate its present value “as a reorganized entity.”3

The Supreme Court long ago expressed that this “reorganization value” focuses on the income-producing or earning capacity of the reorganized entity and is forward looking.4 As the Court noted:

Such criterion is the appropriate one here, since we are dealing with the issue of solvency arising in connection with reorganization plans involving productive properties. It is plain that valuations for other purposes are not relevant or helpful in a determination of that issue, except as they may indirectly bear on earning capacity. The criterion of earning capacity is the essential one if the enterprise is to be freed from the heavy hand of past errors, miscalculations or disaster, and if the allocation of securities among the various claimants is to be fair and equitable.5

Thus, the appropriate valuation of the reorganizing debtor is “to be grounded upon its earning capacity as a reorganizing debtor.”6

Thus, the appropriate valuation methodologies are those that measure the earning capacity of the debtor and its assets. In simpler cases, such as cases of income-producing real properties, the preferred methodologies are discounted cash flow, capitalized earnings or “direct capitalization” and market comparables, usually in some combination.7

In the valuation of more complex enterprises, the courts have come to recognize certain valuation methodologies as “standard” in the measurement of future earning capacity and the value attributable to such capacity. Three methodologies that are designed to calculate enterprise value from expectations of future income, as recognized by the courts, are (1) comparable company analysis; (2) comparable transaction analysis; and (3) discounted cash flow.8 These methods are often used in combination. One court has described each of those methodologies as follows:

“Under the comparable companies analysis, the appraiser calculates value by examining the trading ranges of comparable publicly traded companies. These trading ranges are viewed as a multiple of an earnings standard, such as EBIT (that is, earnings before interest and taxes) or EBITDA (that is, earnings before interest, taxes, depreciation and amortization). These multiples are then applied to the same earnings standard of the company being valued, in order to determine its enterprise value.

The comparable transaction analysis determines value by examining the consideration paid to acquire an entity through a public merger or acquisition. Much like a comparable companies analysis, the disclosed purchase price is viewed as a multiple of an appropriate earnings standard. To calculate enterprise value, the resulting multiple is again applied to the same earnings standard of the subject company.

Under a discounted cash flow analysis, enterprise value is calculated as the sum of two parts. The first is the present value of the subject’s projected unlevered free cash flow. Unlevered free cash flow represents the cash flow that a company is projected to generate during a specific period of time if it were to have no debt in its capital structure. To calculate the present value of this cash flow, the appraiser discounts the unlevered free cash flow by the weighted average cost of capital. In a discounted cash flow analysis, the second part of enterprise value consists of the company’s terminal value. Terminal value represents the remaining value of an entity after the period during which the unlevered free cash flow was projected. An appraiser may calculate terminal value either by assuming a perpetual growth rate of terminal unlevered free cash flow, or as a multiple of the company’s terminal EBITDA.”9

While the methodologies may be “standardized” to a degree, the courts recognize that differences in the assumptions used by particular experts, or differences in the “inputs” used in the valuation formulas, may produce vastly different valuation results despite a general agreement among the competing experts as to which methodologies are used and in what combination.10 At the same time, the courts have recognized that different parties in the case have a stake in valuation outcomes and that choice of assumptions is influenced by many factors, including the desired outcome:

Before we proceed with our analysis of the competing valuations, we recognize each side’s incentives to either overvalue or undervalue the Debtors….We also understand that preparing valuations of companies is not an exact science. Experts and industry analysts often disagree on the appropriate value, even when employing the same analytical tools. Simply put, when it comes to valuation issues, reasonable minds can and often do disagree. This is because the output of financial valuation models are driven by their inputs, many of which are subjective in nature…. Although valuations are subjective, there are proper and improper methods of performing a valuation.11

Recent decisions have favored a “straight-forward” application of the three recognized methodologies.12 While the inputs into the methodologies may justifiably vary, such differences must be based in reasonable judgments, and adjustments to the conclusion reached from applying the inputs to the methods, such as bringing the conclusion in line to a perceived market, are frowned upon.13

At least one recent decision has recognized that when the debtor is retaining the assets in a reorganization case, all of the retained assets must be valued even if a purchaser would not buy them or place a value upon them, so long as they have value to the reorganized debtor.14 Thus, net operating losses that were to be preserved under a plan had to be valued, even though a purchaser could not have acquired them.15 Cash on hand, minus the amount of the operating capital on which the valuation of the debtor as a going concern was premised, had to be added to value. However, the same court found it inappropriate to place a value on goodwill amortization, because the determination of going concern value already includes the value of goodwill: “Consequently, we decline to add goodwill amortization to the Debtor’s going concern value, because doing so would double count that asset.”16

In the end however, it is not the opinions of the valuation experts that is determinative. Such opinions are themselves “inputs.” The court—not the experts—must use these opinions and other factors and determine reorganization value. As the judges are perhaps fond of saying, the court is free to reject such opinions and may arrive at its own opinion of value.17

Notes

  1. Equity interest holders and equity committees will often contend that a senior class of creditors that is receiving all of the debtor’s stock is receiving more than 100% because the plan proponents have undervalued the reorganization securities. See, e.g., In re Coram Healthcare Corp., 315 B.R. 321 (Bankr. D. Del. 2004); In re Bush Indus., Inc., 315 B.R. 292 (Bankr. W.D.N.Y. 2004); In re Exide Tech., 303 B.R. 48 (Bankr. D. Del. 2003). Return to article.
  2. E.g., In re Winthrop Old Farm Nurseries, Inc., 50 F.3d 3072 (1st Cir. 1995); In re River Valley Fitness One L.P., 2003 WL 252111 (Bankr. D.N.H.); In re Waterville Valley Town Square Assocs., 208 B.R. 90, 98 (Bankr. D.N.H. 1997)(“In the context of confirming a plan, the Court must determine the entity’s going concern value.”); In re Colfor, Inc., 1996 WL 628057 (Bankr. N.D. Ohio)(“Substantial case law also supports the use of a going concern valuation.”) Return to article.
  3. Bush Indus., 315 B.R. at 299. Return to article.
  4. Consolidated Rock Prods. Co. vs. Du Bois, 312 U.S. 510, 615. S.Ct. 675, 85 L.Ed 982 (1941). Return to article.
  5. 312 U.S. at 526, 61 S.Ct. 675 (citations deleted). Return to article.
  6. Bush Indus., 315 B.R. at 299. See also, Old Winthrop Farm, 50 F.3d at 75 (“In ordinary circumstances the present value of the income stream would be equal to the collateral’s fair market value”.); In re Jar Tran, Inc., 44 B.R. 331, 368 (Bankr. N.D. Ill. 1984) (“The value of a firm corporate reorganization purposes depends primarily upon its earning capacity….”). Return to article.
  7. E.g., River Valley Fitness, 2003 WL 252111 at *1 (direct capitalization); Bank of America, Illinois vs. 203 North LaSalle Street Partnership, 195 B.R. 692, 696 (N.D. Ill. 1996)(discounted cash flow); Dacon Boilingbrook Assoc. L.P. v. FNMA, 155 B.R. 467 (N.D. Ill. 1993)(combination of DCF and direct capitalization); In the matter of Savannah Gardens-Oaktree, 146 B.R. 306 (Bankr. S.D. Ga. 1992)(direct capitalization and comparables). Return to article.
  8. Bush Indus., 315 B.R. at 299; Coram Healthcare, 315 B.R. at 337; Exide Tech, 303 B.R. at 59. Return to article.
  9. Bush Indus., 315 B.R. at 299. Return to article.
  10. Bush Indus., 315 B.R. at 299–300 (“Although the four experts shared a common acceptance of appraisal theory and methodologies, they reached vastly different conclusions about the value of the reorganized debtor”; Court notes that disparity of result was attributable to differences of terminal value used in DCF analysis, derived from the use of significantly different exit multiples.); Coram Healthcare, 315 B.R. at 337–38 (“Despite using the same valuation methodologies, the end results were far from similar. [The competing experts] included different assets….attached different weights to the three valuation methodologies, and took different positions regarding management’s projections.”); Exide Tech., 303 B.R. at 58 (“Both experts used the same three methods to determine the Debtor’s value…. However, the end results of their valuations were far from similar”). Return to article.
  11. Coram Healthcare, 315 B.R. at 339. Return to article.
  12. Id. at 337–392. See also, Exide Tech, 303 B.R. at 62–66. Return to article.
  13. Coram Healthcare, 315 B.R. at 337–42; Exide Tech., 303 B.R. at 62–66. Return to article.
  14. Coram Healthcare, 315 B.R. at 341. Return to article.
  15. Id at 341–42. Return to article.
  16. Id. at 341. Return to article.
  17. River Valley Fitness, 2003 WL 252111 at *5 (“The Court is not bound by the opinion of any expert witness and may accept or reject expert testimony in the exercise at sound judgment.”). Return to article.