January 2011

Business Valuation Issues in Bankruptcy

With the increased volume of bankruptcy filings and corporate distress that have accompanied the recent economic downturn,
valuation specialists have been engaged to provide opinions of value that are a critical component of any meaningful assessment
of value at different points in the bankruptcy process.

Bankruptcy courts determine the applicable definition of value on a case-by-case basis and in light of each valuation’s purpose and the underlying circumstances. Therefore, different definitions of value may be required for different purposes, and the definition of value applicable to a certain purpose may not be binding with respect to other purposes.

This article discusses two important valuation issues in the bankruptcy setting: (a) solvency tests and (b) standards of value and alternative premises of value (below).

Solvency Tests

A 2010 case, In re Premier Entertainment Biloxi LLC, illustrates how the application of different solvency tests could result in a material difference in the final outcome.

Just two weeks after its grand opening, the Hard Rock Hotel and Casino in Biloxi, Mississippi, was nearly destroyed by Hurricane Katrina. The owners eventually recovered $181 million from their insurers, but the casino’s first lien note holders disputed the owners’ rights to the funds. The casino ultimately filed for Chapter 11 bankruptcy because the owners could not access the funds to finish the reconstruction.

Almost immediately after filing, the debtors proposed to pay the notes at par value plus interest, thereby extinguishing the note holders’ liens and releasing the insurance proceeds. The bankruptcy court confirmed the plan and released the funds, despite objections from the note holders, who claimed they were still owed $10.75 million in prepayment penalties pursuant to the original security agreement and the Bankruptcy Code.

In particular, the note holders argued, Sec. 502(b) of the Bankruptcy Code permits unsecured creditors to recoup damages from a solvent debtor, and the debtors were solvent at all times because, simply put, “their debts never exceeded their assets.” The debtors had access to more than $40 million in financing from a secondary source, which had already invested over $150 million in rebuilding the resort.

By contrast, the debtors insisted they were “equitably” insolvent as of the bankruptcy petition, because without access to the insurance proceeds they had only $200,000 in cash and over $230 million in outstanding liabilities. More important, they were in danger of losing their Hard Rock license and any opportunity to successfully rebuild.

After reviewing a “wealth of evidence" from both parties, the court ultimately said the issue turned on which solvency test applied: (a) the adjusted balance sheet test, as proposed by the note holders, or (b) the debtors’ “equitable insolvency” test, derived largely from statutory case law concerning fraudulent transfers.

To support the former, the note holders’ solvency expert testified that the debtors had nearly $253 million in assets and only $230 million in liabilities per their bankruptcy schedules. He made two adjustments:

• increased the Hard Rock license from its $472,000 book value on the schedules to over $11.8 million, the value on the debtors’ application for secondary financing and SEC filing; and

• included $17.5 million for construction in progress, which the debtors also reported to their lenders but omitted from their cost-basis bankruptcy balance sheets.

After these adjustments, the debtors’ assets exceeded liabilities by roughly $50 million at the time of filing. Even on a cost-basis approach, assets exceeded liabilities by over $28 million.

The debtors did not present their own expert but maintained they had limited usable cash at the time of filing and owed hundreds of millions, including $160 million to the note holders. Several trade vendors had filed lawsuits and liens, and the owners contended that three or more could have filed an involuntary bankruptcy petition, thereby meeting the equitable insolvency test.

Unfortunately for the debtor, the court ruled that their test applied to limited factual circumstances. In this case, the adjusted balance sheet was “the traditional bankruptcy test of insolvency.” The adjustments by the note holders’ expert were appropriate — in particular, his use of the market value of the Hard Rock license, as corroborated by its assigned value in the debtors public filings and loan documentation. Accordingly, the court found the debtors were solvent at all relevant times and awarded the note holders their unsecured claims for $10.5 million liquidated damages.

Standards of Value, Premises of Value

In a bankruptcy proceeding, valuation specialists may be utilized prior to the bankruptcy filing, during the pendency of the bankruptcy proceeding and when the entity emerges from bankruptcy.

The standard-of-value terminology applicable to valuations in bankruptcy may differ from the terminology in traditional valuation circumstances, and it is often the case that value is not clearly defined in the Bankruptcy Code or applicable state statutes. Moreover, the premise-of-value decision in certain bankruptcy matters is not straightforward and may require consideration of court precedent, characteristics specific to the subject company, and the circumstances related to and the intended use of the valuation.

In these cases, the choice of the applicable premise of value may have the single largest impact on valuation results and, therefore, the outcome of the matter. Addressed in further detail below are the different standards and premises of value that merit consideration in bankruptcy matters.

Traditional business enterprise and asset valuations are typically performed under one of three basic standards of value: (a) fair market value, (b) investment value, or (c) fair value.

However, the valuation terminology that applies in bankruptcy matters may differ from traditional valuation and, as stated above, is most often not clearly defined in the Bankruptcy Code or applicable state statutes.

The selected premise of value should reflect the facts and circumstances underlying each valuation engagement. In the bankruptcy context, all valuations are performed under a "going concern" premise of value or a liquidation premise of value. Assets are typically valued under the going-concern premise of value, unless a debtor was on its deathbed at the time or liquidation in bankruptcy was clearly imminent, in which case a liquidation premise of value may be applicable. Under the liquidation premise of value, either an orderly disposition or forced liquidation premise is utilized.