Chapter 4 Implications for Corporate Bankruptcy Litigation

• Jurisdiction: United States

Chapter 4 Implications for Corporate Bankruptcy Litigation

This chapter provides an overview of corporate bankruptcy-related case law interpretations and the considerations necessary to place reliance upon management's prospective financial information in a bankruptcy context. The examples in this chapter highlight common issues that may affect the interpretation and use of prospective financial information. Application of these items depends on the facts and circumstances of each situation.

Valuation issues arise in many contexts within corporate bankruptcy. For example, the pursuit of a constructive fraudulent transfer claim requires the testing of insolvency⁶⁴ or a related measure of financial distress,⁶⁵ and whether the transfer was made for less than reasonably equivalent value.⁶⁶ Actions to recover preferential payments could also raise questions of valuation and require an assessment of forward-looking financial statements, particularly if there is a dispute about whether the recipient of a payment actually received more than it would have in a hypothetical liquidation of the debtor. Issues involving adequate protection,⁶⁷ collective bargaining agreements,⁶⁸ claims allowance,⁶⁹ determination of secured status⁷⁰ and § 363 sales⁷¹ all may require valuation analysis.

Chapter 11 plan confirmation often requires the court to determine reorganization/enterprise value in order to determine whether the plan satisfies various confirmation criteria, including the best-interests-of-creditors test,⁷² plan feasibility,⁷³ and whether the plan is fair and equitable to dissenting creditors.⁷⁴ Indeed, recent years have seen a number of high-profile valuation disputes with respect to restructuring businesses, as increasingly savvy investors in distressed assets have fought to maximize their recoveries.

Yet, valuations performed in the world of distressed businesses and in corporate bankruptcy settings are particularly challenging. One author concludes:⁷⁵

• Historical performance is less useful in developing cash flow forecasts;
• Useful market prices for a firm's claims are often unavailable;
• Firms in the same industry often have recently restructured or are in distress themselves;
• Acceptance of potentially useful valuation methods that may have been shown to be useful in academic studies has been slow; and
• Valuations can be strategically influenced by the bargaining power of parties to the negotiations and/or judicial discretion in bankruptcy.

A study published in 2018 concluded that disagreements over projected cash flows occurred in 74 percent of the 143 disputed chapter 11 valuations that were reviewed. The overall percentage difference between the highs and lows in the resulting valuation conclusions had a mean difference of 47 percent. Errors made by advisors were considered often self-serving, producing valuations more favorable to their clients. Other factors included disagreement over the choice of comparable companies (72 percent of cases), or disagreement over the discount rate (46 percent) that may have included significant use of "firm-specific risk premiums" to arbitrarily increase discount rates.⁷⁶ Debates over financial projections clearly dominate.

Regardless of the particular context in which the valuation dispute arises, the valuation expert and counsel should carefully lay a foundation for the selection and use of the appropriate financial documents. As explored in Chapter 3, regardless of the title assigned to any particular documentation of prospective financial information, the document should not be taken at face value. Instead, the purpose of the budget, projection, forecast or pro forma documents should be understood. Only then can the expert accurately evaluate and interpret management's views and intentions at the time period that is at the center of the dispute.

Understanding Professional Roles

It is customary in large and complex corporate bankruptcy matters for the debtor, secured creditors, and representatives of the unsecured creditors or other creditor constituencies and/or classes of creditors (e.g., retirees, tort claimants, etc.) to each retain financial and other non-legal advisors. Financial advisors skilled in corporate finance, business valuation, capital markets, accounting and other subjects may provide analyses and assistance in formulating strategy and in preparing information used in the legal proceedings. Counsel is responsible for providing legal strategy, legal interpretation and legal pleadings, as well as courtroom representation. Counsel and financial professionals may collaborate by sharing information, and they may work together toward laying a foundation for analysis and discussion as the financial professional shares ideas and suggestions with counsel for counsel to draft subpoenas, motions and pleadings, and as counsel relies on the financial advisor to help analyze business documents. Counsel may instruct the valuation analyst regarding statutory authority and judicial precedent, but valuation analysts work independently from counsel, perform independent analyses and reach independent opinions. Both counsel and the valuation expert should be cautious about the extent to which collaboration and information exchanged between counsel and the financial analyst may later be discoverable under the federal or other rules of civil procedure or other relevant authority.⁷⁷

Within this publication, counsel, litigation consultants and experts may be described as working together to develop foundational information (i.e., locate documents, share information, etc.), but their roles and work are understood to be separate functions with separate responsibilities.

Understanding the Documents

Valuation disputes often turn on the discounted cash flow analysis, which is dependent on financial forecasts and projections.⁷⁸ The quality of the output depends on the quality of the inputs.⁷⁹ Developing an understanding of management's views requires the use of contemporaneously prepared prospective financial information, which may include budgets, projections, forecasts or pro forma financial statements and other supporting documents and analyses. But an expert cannot simply treat these documents as interchangeable. Counsel, litigation consultants and valuation experts may have to work together to properly evaluate and determine whether a projection or forecast best reflects management's current understanding of the condition of the business and most likely future outcome at the time in question. They should assess which document best reflects the facts and circumstances that deal with the issues in the case.

Similarly, counsel and the valuation expert may have to collaborate and share information and ideas to determine whether the opposing valuation expert has properly selected a forecast or projection for his or her analysis. Interviews, depositions, affidavits and interrogatories may be important to capture management's intended purpose for the materials in question, as well as the historical use of each document.

Business valuations are often performed using management's forecasts, regardless of how the preparer labels them, because they generally represent management's best guess at the expected outcome. They are typically intended to represent the best estimate of the future based on the most recently available information and would therefore best represent the expected outcome of future events. However, projections may be more appropriate depending on the facts and circumstances of the litigation. Projections may better represent a view of the future under defined circumstances or fact patterns because they better present certain financial or accounting adjustments and the impact of events. Those projections may also present "with" and "without" results under various underlying assumptions for the business's circumstances and any conceived future events.

Verification and Use of Financial Evidence

Regardless of whether they are using a forecast or projection for the litigation analysis, the valuation expert and counsel should verify the supporting documents and their underlying assumptions and calculations. Counsel and the valuation expert should then determine whether those underlying assumptions and calculations are appropriate given the particular context of the litigation. Assumptions about future revenues, customers, cost of goods sold, overhead expenses, secured and unsecured debt, equity capital, cash flows and other items should be examined line by line.

One book suggests starting with 10 important questions:⁸⁰

• Are any documents missing from within a series of documents?
• Are any of the documents incomplete?
• Are any documents contradictory?
• Do the documents produced appear to be draft, final or reviewed versions of the purported documents?
• Were multiple documents produced in response to the same discovery request?
• Are the documents produced responsive to the discovery request?
• What are the effective dates of the documents and data produced?
• Were the documents that were produced prepared contemporaneously (i.e., pre-litigation) or prepared in response to the discovery request?
• Were the documents ever relied on by parties independent of the litigation, or were they prepared solely for the litigation?
• Were the documents ever reviewed by parties independent of the litigation, or were they prepared solely for the litigation?

Trend analysis can establish a context for past events. The search for historical patterns can provide a perspective on the business's trajectory and the presence or lack of continuity. Comparisons of actual results for the business to important business and industry metrics and to financial ratios can help illustrate the reasonableness of management's assumptions. Analytical comparisons of historic data from the business to its own prospective financial information, and to competitors, industry analysts, industry studies and...