Chapter 8 Expert Witnesses in Recurring Substantive Disputes in Bankruptcy Litigation

• Jurisdiction: United States

Chapter 8 Expert Witnesses in Recurring Substantive Disputes in Bankruptcy Litigation

In this chapter, we share our analysis of a sampling of bankruptcy cases that have wrestled with the application of Daubert principles to expert valuation testimony in recurring areas. Although we could have considered countless cases focusing on valuation testimony in collateral disputes, adequate protection, cash collateral, stay relief, feasibility or many other contests that regularly occur in bankruptcy cases, we offer up our thoughts in three common and often challenging areas of dispute: (1) the determination of insolvency for avoidance purposes; (2) the determination of reasonably equivalent value in constructive fraudulent transfer adversary proceedings; and (3) the determination of the reorganizational value of the debtor in contested plan-confirmation disputes.

To advance to the punchline, it is common to see parties move to exclude financial expert testimony in these substantive areas in hearings and trials before bankruptcy judges; however, it is rare that these motions are granted, largely because the most common grounds to seek to exclude expert testimony rest on explicit or implicit challenges to the credibility and persuasiveness of the inputs, assumptions, approaches, methods and conclusions. These grounds are precisely what are left to the trier of fact — that is, the bankruptcy judge — in virtually all bankruptcy contests over valuation.

A. Insolvency

Insolvency is defined by § 101(32) of the Bankruptcy Code to be a condition pursuant to which the sum of the debtor's debts exceeds the debtor's property at a fair valuation. Courts have permitted the use of all three valuation approaches, and multiple methods under those approaches, to assess whether a debtor is insolvent as of a transfer date. Under § 547(f) of the Bankruptcy Code, the debtor is presumed to be insolvent for the 90 days preceding the filing of the bankruptcy petition for preference purposes. However, the insolvency presumption is rebuttable.⁴³⁰

Courts have interpreted the fair-valuation standard in the business context to suggest the use of the fair market value standard as a going concern, unless the business is on its deathbed. The fair market value standard is commonly defined as

the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm's length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.⁴³¹

Further, a variant of the same idea is "the price that a seller is willing to accept and a buyer is willing to pay on the open market and in an arm's-length transaction; the point at which supply and demand intersect."⁴³²

In valuation theory, the fair market value standard presumes a number of assumptions that may or may not reflect the actual circumstances of a transaction under evaluation:

Determining fair market value requires the establishment of the premise of value to understand exactly how the business should be valued. The general premise driving the theoretical underpinnings of fair market value is that fair market value is a value in exchange. The value in exchange is estimated whether the property is actually up for sale or not; it is presumed to be for sale in a hypothetical transaction at a point where there is a meeting of the minds between a willing buyer and willing seller. As such, fair market value is premised on the value of the property in exchange for cash in a hypothetical sale consummated between a willing buyer and willing seller.⁴³³

Thus, when performing a valuation using a fair market value standard, experts outside of this context tend to avoid facts peculiar to the transaction and the parties in question, because in theory, fair market value obeys the "rule of one price" and does not consider factors unique to any specific buyer or any specific transaction:

In most interpretations of fair market value, the willing buyer and willing seller are hypothetical persons dealing at arm's length, rather than any particular buyer or seller. In other words, a price would not be considered representative of fair market value if influenced by special motivations not characteristic of a typical buyer or seller.⁴³⁴
On the surface, in a strict fair market value interpretation, a marketplace of hypothetical buyers and sellers will bid and eventually reach an agreeable price. The marketplace, however, may be made up of a variety of different types of buyers. There might be entrepreneurs looking to continue the business on their own. There might be financial buyers who see the business as a good investment. There may also be synergistic buyers who see a conjunctive value with other acquisitions or owned assets.⁴³⁵

The following two subsections focus on recurring valuation issues in the context of assessing insolvency in preference and fraudulent transfer actions. Keep in mind, though, that although the actual test for insolvency is the same for both forms of action,⁴³⁶ a transfer is avoidable as a preference if the debtor was insolvent at the time of the transfer (assuming the other elements are met and no applicable defenses are present), whereas a transfer is avoidable as a constructive fraudulent transfer if the debtor was insolvent or rendered insolvent by the transfer. This nuance can present some challenging timing issues and may require, in certain circumstances, an expert to assess insolvency both before and after a transfer in dispute.

1. Avoidance of Preferential Transfers

An avoidable preference is (1) any transfer of an interest of the debtor in property; (2) to or for the benefit of a creditor; (3) for or on account of an antecedent debt owed by the debtor before the transfer was made; (4) made while the debtor was insolvent; (5) made on or within 90 days before the date of the filing of the petition (or within one year if the creditor is an insider); and (6) that enables the creditor to receive more than it would have received under a chapter 7 liquida-tion.⁴³⁷ The trustee, or the debtor in possession in a chapter 11 case,⁴³⁸ shoulders the burden of proof on all the elements of an avoidable preference action. However, there is a statutory presumption that the debtor is insolvent on or within 90 days of the filing of the petition in bankruptcy.⁴³⁹ Furthermore, if the creditor who received the alleged avoidable preference was an insider of the debtor,⁴⁴⁰ then the operative period is extended from 90 days to one year before the filing of the petition in bankruptcy.⁴⁴¹ The following cases address the issue of insolvency.

a. In re Lids Corp.

In In re Lids Corp.,⁴⁴² the court conducted a two-day hearing on the admissibility of the testimony of the defendant's valuation expert, who was affiliated with an investment banking firm. The defendant's expert first opined that the debtor was solvent at the time of the relevant transfer under the "adjusted balance sheet" method, a method under the asset-based approach. After careful consideration, the court rejected this aspect of the valuation opinion for several reasons.

First, the court rejected the expert's "adjusted balance sheet" valuation method because it strictly adopted "values" contained in the debtor's financial statements prepared according to GAAP without any explanation of why those account balances reflect a "fair valuation," the standard required by applicable law.⁴⁴³ The court found that unless the entries to a balance-sheet account have been "marked to market" or otherwise reflect an adjustment to fair valuation, which can be done in only a few well-defined asset categories under GAAP, reliance on book values as proxies was inherently unreliable and irrelevant to the question of whether the debtor was insolvent at a fair valuation at the time of the transfer in question.⁴⁴⁴ Moreover, reliance on a GAAP balance sheet tends to ignore certain intangible assets or unrecorded liabilities, thus potentially amplifying the unreliability of the inputs and results. The defendant's expert did not adjust for the fair valuation of the tangible assets, which was primarily the debtor's inventory of hats with sports team logos, and made only an unexplained minor adjustment in the debtor's accounting entry for the intangible of "goodwill."⁴⁴⁵

The defendant's expert also opined that the debtor was solvent at the time of the transfer on an enterprise basis. To arrive at an enterprise valuation, the defendant's expert employed the two above-described market or relative valuation approaches: the guideline public company and the guideline merged and acquired methods. The court rejected the expert's guideline public company method for three reasons.

First, the court found that none of the selected companies were truly comparable because (notwithstanding that they too were specialty retailers) none of them shared key attributes with the debtor: These companies were profitable, although the debtor was not; these companies had proven business plans, although the debtor did not; and these companies met their projections, although the debtor did not.⁴⁴⁶ In other words, the court found that the relevant financial characteristics of the comparable companies were too distant from the financial characteristics of the subject company to make unreliable any extrapolation to an estimate of value.

Second, the court found troubling that the expert did not consider multiple ranges for the comparable companies selected and failed to explain adequately why those ranges were not considered.⁴⁴⁷ Thus, according to the court, multiples selected by the expert were "inaccurate because the EBITDA multiples used were greater than the mean and median multiples used for the other, more profitable and stable, companies."⁴⁴⁸ The point here is that an expert may consider a number of...