April 2010

Business Valuation in a Volatile Economy: Three Bankruptcy Cases

From America's fiscal crisis have emerged a number of test cases for bankruptcy courts, attorneys and business valuation experts. The three cases discussed below - one an outgrowth of the S&L scandal - illustrate common qualities of bankrupt and distressed companies and the peculiar challenges that valuation professionals must confront in producing reliable valuation reports amid chaotic financial conditions.

Refinancing of TOUSA

After expanding rapidly during the 2003-2007 housing boom, homebuilding giant TOUSA, Inc., made a last, disastrous acquisition in 2005, funded with over $675 million in secured financing provided by Citigroup. When the bubble burst, TOUSA defaulted, and Citigroup insisted that the company cause its subsidiaries to borrow $500 million secured by liens on substantially all their assets. According to court records:

• The company's restructuring advisor (Lehman Bros.) called the $500 million deal the "best alternative" for TOUSA shareholders but declined to provide a fairness opinion.

• TOUSA's CEO warned that the company was "dangerously overleveraged" and in "desperate need" of equity. Even if de-leveraging was successful, he said, the company could probably not service its debts and would "crash and burn."

• Even Citicorp harbored significant doubts about TOUSA's solvency but pressed forward, motivated by the prospect of substantial fees.

• A multi-million-dollar incentive bonus for TOUSA's CEO was contingent on completing the refinancing, as was $2.9 million in Lehman Bros. fees.

• A hastily prepared fairness opinion, provided by a third-party firm, relied heavily on management projections and the promise of a $2 million fee for finding solvency.

The deal closed in 2007, but, within a year, the company lost over 98% of its market value and filed for Chapter 11 protection. In In re: TOUSA, Inc., 2009 WL 3519403 (Bankr. S.D. Fla.) the unsecured creditors claimed that the transactions involving TOUSA's subsidiaries were fraudulent because the subsidiaries were insolvent at the time of refinancing.

In a 186-page opinion, the Bankruptcy Court examined the testimony from the parties' insolvency experts in great detail, including their assumptions, methodologies and possible motives. The Court found "serious problems" with the lenders' first expert, including his "cherry-picking" of data. Even more problematic, the lenders' second expert claimed that "no court" had ever rejected his opinion as unreliable, but the Court found this was "simply not true." Worse, the expert contradicted his deposition testimony in court, which "served only to erode [his] overall credibility further." Finally, the fairness opinion was incredible, undermined by haste and conflicts of interest.

By contrast, each of the analyses provided by the plaintiffs' experts was reliable. In combination, "the analyses derive even greater force" and persuaded the Court to find that TOUSA and its subsidiaries were "grossly insolvent" as a result of the July 2007 transaction.

DBSD Cram-Down

In In re: DBSD North America, Inc., 2009 WL 3491060 (Bankr. S.D.N.Y.), the debtors were a next-generation mobile satellite service provider. Despite obtaining over $51 million in secured first-tier financing and a $752 million secured, second-tier facility, the debtors were unable to rent their broadcast spectrum and sought Chapter 11 relief. They filed a deleveraging pan that would exchange 95% of their stock for the $752 million in second-lien notes. The first-tier lenders objected, contending that the cram-down failed to provide them the "indubitable equivalent" of their secured claims.

To determine the debtors' total enterprise value (or TEV), the parties' experts applied three methods: a guideline comparables analysis, comparable transactions, and discounted cash flow (DCF). With varying assumptions and weightings, however, their opinions created a wide, multi-billion-dollar spectrum of value, radically ranging from $70 million to $3.1.billion.

The Court found "serious problems" with both experts' DCF approach. In particular, the lenders' expert assumed a continuous stream of "unrelenting" negative cash flows, which the Court found unrealistic, serving only to skew his opinion to the low extreme. Only the comparable company analysis was reliable, the Court concluded, in part because both experts used the same guideline companies and produced mean values that were "only" $45 million apart. Because the debtors' expert gave more weight to this approach than did the lenders' expert, the Court found his was the "best assessment" of TEV, in the range of $492 million to $692 million, sufficient to keep the secured lenders' investment "safe" during the proposed restructuring.

The Impact of FIRREA

In First Annapolis Bancorp., Inc. v. U.S., 2009 WL 349020 (Fed. Cl.) the plaintiff/bank agreed to purchase a failing federal thrift for $13.7 million. In exchange, the government agreed to relax its capital and supervisory goodwill requirements. Within a year, however, Congress passed the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA), effectively eliminating those forbearances, breaching the agreement between the government and the bank, and, the Court held, causing the plaintiff to fail.

The government presented two experts to obviate damages. The first claimed that the bank was in such dire financial condition at the time of the acquisition that it would have failed regardless of the government's breach. Its second expert said the government's forbearances were "essentially worthless" and, even without them, the bank would have failed.

The Court rejected the government's position. Neither expert specifically analyzed when the bank became non-viable, and both admitted that FIRREA negatively impacted the bank. They tried to cite myriad causes for the bank's demise but failed to establish that any had the same dramatic impact as FIRREA, which "destroyed [the bank's] ability to operate," the Court held. The Court cited credible evidence from the plaintiff's expert showing the bank was viable at the time of the purchase and was meeting its capital benchmarks until the government's breach "put it on an unavoidable course to insolvency." Based on these findings, the Court awarded full restitution of the bank's $13.7 million investment. ■