Chapter 7 Valuation

• Jurisdiction: United States

Chapter 7 Valuation

Valuation in dispute, as a discipline, is not now what it was at its start. No discipline exists without human beings to practice it, and human beings bring with them all the strengths and frailties of that status. Valuation is cumulative; each new theory incorporates successful earlier theories as approximations. Valuation, in the bankruptcy context, requires an interlacing of finance and law. Common valuation questions, such as insolvency, reasonably equivalent value and reorganizational value of the debtor, carry with them a specific legal context with specific legal requirements. This chapter provides a summary overview of valuation techniques applicable in bankruptcy disputes to aid in understanding the discussion of Daubert requirements in the context of financial distress. Our discussion is not intended to present all of the important issues that a valuation poses in and out of distressed settings.

Where finance ends and the law begins is unclear. An example should prove the point. The appropriate premise and standard of value depend on the facts and circumstances of each valuation, the need or purpose for the valuation, and any applicable legal directives.²³⁷ If an expert is asked to render an opinion on the insolvency of a debtor, an initial question the expert must explore is: What is the appropriate standard of value? Insolvency, to paraphrase Justice Cardozo, is not simply a thing in the air. It needs a mooring, a context. The question of insolvency may be different if the question presents in an avoidable preference action under § 547(b) of the Bankruptcy Code, a fraudulent-transfer action under § 548 of the Bankruptcy Code, a fraudulent-transfer action under § 544(b) of the Bankruptcy Code, or grounds for involuntary relief under § 303(h) of the Bankruptcy Code. An expert who simply states, "I have valued the assets of the debtor and determined the liabilities of the debtor and subtracted one from the other" is not aiding the trier of fact. What does she mean by "assets," "liabilities" and "valuation"? Is she applying the Generally Accepted Accounting Principles (GAAP) definition to the terms "asset" and "liability"? Is she using GAAP's book value standard for most asset values in her model without an explanation of why that may be appropriate? What should she use in, say, a determination of insolvency in an avoidable-preference action under § 547(b) of the Bankruptcy Code?

Among other elements that must be met, a transfer is an avoidable preference if it is made while the debtor was insolvent.²³⁸ "Insolvency" is a defined term under the Bankruptcy Code; a financial, accounting or historical definition of the term is informative but rather beside the point. Simply, insolvency is not a financial, accounting or historical test; it is a legal test. Thus, when an expert renders her opinion on the question of insolvency in a preference action, she is answering a financial/valuation question framed by a series of legal questions. She is providing her opinion from an economic or financial perspective, but she is also aiding the trier of fact in answering, linguistically, the same question of fact and law — that is, whether the debtor was insolvent as defined by applicable law at the relevant time.

Section 101(32) of the Bankruptcy Code defines "insolvency" as that state of a financial condition where the debts of a debtor exceed the property of the debtor at a fair valuation. "Debt" is a defined term as well; it means "liability on a claim."²³⁹ A "claim" is further defined to include "any right to payment" and is intended to be all-encompassing.²⁴⁰ "Property" is not defined at all, but the U.S. Supreme Court in Chicago Bd. of Trade v. Johnson²⁴¹ interpreted the term to be a very broad and federal question, even though state law is generally consulted in the initial evaluation and assessment. Noticeably absent from the definition of "insolvency" is any reference to assets, liabilities or GAAP. Moreover, the standard of value to be employed to respond to the insolvency question is a "fair valuation" — a standard that does not generally exist outside of bankruptcy. However, some commentators have suggested some link between a "fair valuation" standard with the "fair value" standard often used in merger- or appraisal-rights litigation, which may pose problems in certain contexts. Most others have suggested a link between a "fair valuation" standard with a "fair market value" standard, although the Bankruptcy Code explicitly adopts a "fair market value" standard in other sections of the Bankruptcy Code.²⁴²

Valuation is, foundationally, a process for determining the value of assets, both tangible and intangible, including the value of a business.²⁴³ A valuation reflects worth at a particular point in time and may change based on the premise and standard of value employed.²⁴⁴ Valuation is both an objective and subjective process with many areas calling for the exercise of the discretion of an expert.²⁴⁵ By "subjective," we do not mean the word in the sense that we prefer chocolate ice cream to vanilla; rather, what we mean is that a valuation process requires that the valuation expert exercise judgment at a number of milestones in the valuation process, but that subjective judgment (is there really any other type) is exercised through the imposition of well-accepted techniques that impose discipline on thought and are based on a fair-minded and reasonably objective discussion of that process and the assumptions embedded in it. Valuation in dispute calls on the approaches and methods of valuation technique and theory in the context of answering a factual and legal issue in dispute.

Fundamentally, business valuation is based on growth, risk and cash flows.²⁴⁶ Although the fundamental concepts of business valuation hold true when valuing distressed businesses, particular facts and circumstances may require certain adjustments and additional considerations. For example, although traditional valuation tools and methodologies may be applicable, factors such as the impact of cancellation of indebtedness²⁴⁷ on net operating losses and carryforwards (as well as carrybacks),²⁴⁸ additional working capital and capital expenditure needs, volatility and vulnerability of economic earnings, extending credit terms in an effort to force suppliers into short-term lenders, a history of loan defaults and forbearance agreements, and the loss of key customers or suppliers, among others, might be considered so as to minimize the likelihood of an erroneous valuation.

In theory, an expert should be able to explain to the court the approach, method, methodology and factors necessary to perform a valuation in a bankruptcy context — an aspect necessary in any case where reasonably equivalent value²⁴⁹or insolvency are at issue,²⁵⁰ or where a total reorganizational value of the reorganized debtor is a relevant question²⁵¹ — for example, when assessing a proposed cramdown plan.²⁵²

A. Methodology

Valuation requires the implementation of a generally accepted methodology or protocol. Although methodologies are varied, those passing muster under Daubert tend to follow a fairly predictable path in the bankruptcy-dispute context. Further, while the techniques employed in valuing distressed businesses are generally understood, their actual applications are drawn from experience, reasoned judgment and discretion.²⁵³ These quantitative tools for valuation are steeped in a qualitative space and subject to an intellectual rigor that has been developed by experts over time. Thus, identifying and applying an explicitly defined methodology with identified assumptions permits the trier of fact to consider the reasonableness of assumptions and procedures in an expert's opinion on value and indirectly tests for reliability.

The Association of Insolvency and Restructuring Advisors (AIRA) has developed its Standards for Distressed Valuation (the "AIRA Standards"),²⁵⁴ which require an expert on business valuation generally to employ the following approach:

1. Define the legal interest being valued.²⁵⁵ Generally, in the distressed-business context, the legal interest being valued is the company, usually referred to as the total or business enterprise value. Often, the equity interest is "out of the money" and ascribed a zero value, although more cases are litigating that very point as a precondition to plan confirmation.
2. Identify the characteristics of the ownership interest. This step involves the identification of the ownership characteristics of marketability and control. Marketability is a characteristic that attempts to measure the speed at which an interest can be converted to cash at minimal cost — that is, an asset's liquidity. Generally, readily marketable assets are perceived to be worth more than less-marketable assets, all things being equal.²⁵⁶ Control is also perceived to affect value. Thus, a lack of control is generally perceived to reduce the value of an asset vis-a-vis its proportionate share, all things being equal.²⁵⁷
3. Select a date of valuation. The selection of a valuation date affects the universe of data and information available for determining the value of a business. The relevant facts and circumstances considered by an expert in distressed business valuations include that information that is known or reasonably foreseeable as of the valuation date.²⁵⁸ Obviously, the frame of facts and circumstances may change over time. Generally, the date of valuation will depend on the purpose of the valuation.
4. Identify the purpose of the valuation. No single valuation method is universally applicable to all valuation purposes. Context is critical, as noted repeatedly above. An expert should document the purpose of the valuation; it is that purpose that generally determines the standard and premise of valuation.²⁵⁹
5. Identify the standard of valuation. The appropriate standard of value depends on the facts and

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