Chapter 16 Bankruptcy Valuations for Special Purposes

• Jurisdiction: United States

Chapter 16: Bankruptcy Valuations for Special Purposes

A. Fraudulent Transfers and the Balance Sheet Test

Many parties may seek to recover a debtor entity's fraudulent transfer under the provisions of Bankruptcy Code § 548. These parties pursue fraudulent transfer remedies if they can prove that the debtor had actual intent to hinder, delay or defraud the creditors. In the more common claim, the party seeking recovery demonstrates that the debtor company was insolvent on the date that the objectionable transfer was made or that the objectionable obligation was incurred. Alternatively, the party seeking recovery demonstrates that the debtor company became insolvent as a result of that objectionable transfer or obligation.

According to § 547, a transfer may be voided if it was made while the debtor company is insolvent. The party seeking recovery will claim debtor company insolvency in order to include the transferred assets back into the bankruptcy estate or to exclude the assumed liabilities from the bankruptcy estate.

Section 548 provides three tests to determine whether a transfer or obligation may be avoided: (1) the balance sheet test (i.e., whether the liabilities exceed the fair value of the assets), (2) the cash flow test (i.e., whether the debtor company incurred debts that are beyond the debtor's ability to repay as those debts mature), and (3) the capital adequacy test (i.e., whether the debtor company engaged in a business or transaction for which any property remaining with the debtor was unreasonably small capital).

This discussion focuses on the balance sheet test to determine a potential fraudulent transfer.

Balance Sheet Test

The 11 U.S.C. § 101(32) definition of "insolvent" varies depending on whether the debtor is a corporation, partnership or other type of entity. The Bankruptcy Code indicates that the value of the company assets should be determined at fair valuation." However, the Bankruptcy Code does not specifically say that the appropriate standard of value is fair value. Many analysts, and many legal counsel, apply the fair market value (as opposed to the fair value) standard of value when performing the balance sheet test. Accordingly, there is not a universal consensus as to the appropriate standard of value to apply within the context of the balance sheet test and the fraudulent transfer analysis.

In the balance sheet test, first the analyst assesses the debtor company highest and best use (HABU). Based on the HABU conclusion, the analyst typically decides whether to value the debtor company assets based on (1) a value in continued use, going-concern premise of value or (2) a value in exchange, orderly disposition premise of value.

Second, the analyst estimates the fair market value of the debtor company assets (both tangible assets and intangible assets) based on the selected premise of value. Next, the analyst concludes the amount of the debtor company liabilities (both recorded and contingent liabilities). Third, the analyst considers any debtor asset reductions (e.g., cash payments to creditors, cash dividends/distributions to stockholders, sales or other transfers of tangible assets) related to the objectionable transaction and any debtor liability increases (e.g., leases, loans or other obligations) related to the objectionable transaction.

If the fair market value of the debtor company total assets exceeds the amount of the debtor company total liabilities, then the debtor "passes" the balance sheet test — and the entity is considered to be solvent. If the amount of the debtor company total liabilities exceeds the fair market value of the debtor company total assets, then the debtor "fails" the balance sheet test — and the entity is insolvent. A common definition of fair market value is the price (in terms of cash) that a willing buyer would pay and that a willing seller would accept in the arm's-length sale of the subject property, within a reasonable time period and with neither party being under compulsion to transact.

Of course, the above summarized balance sheet test is only one of the tests for a fraudulent transfer. If the debtor fails any one of the tests (including the balance sheet test), that failure is an indication of a fraudulent transfer.

The standard of value answers the question, "Value to whom?" The fair market value standard of value contemplates a sale between an unidentified, hypothetical willing seller and an unidentified, hypothetical (and unrelated) willing buyer. The premise of value answers the following questions: "How will the parties come together to structure the transaction?" and "Will the hypothetical buyer buy (and the hypothetical seller sell) the debtor company as a going-concern business, as an in-place assemblage of tangible and intangible assets, or as a collection of individual tangible assets and intangible assets sold on a piecemeal basis?"

The courts have generally defined the "reasonable time period" as the amount of time that "a typical creditor would find optimal: not so short a period that the value of goods are substantially impaired via a forced sale, but not so long a time that a typical creditor would receive less satisfaction of its claim, as a result of the time value of money and typical business needs, by waiting for the possibility of a higher price."¹¹⁴

Generally Accepted Valuation Approaches and Methods

There are three generally accepted business valuation approaches: income approach, market approach and asset-based approach. Each approach includes several generally accepted valuation methods. Individual valuation procedures are performed in the appreciation of each valuation method. The debtor company business valuation conclusion is generally based on a synthesis of the value indications from each applicable valuation approach and method.

There are also three generally accepted asset or property valuation approaches: income approach, market approach and cost approach. The names of these asset/property valuation approaches sound very similar to the names of the business valuation approaches. However, the individual valuation methods and procedures are different between the business valuation approaches and the asset (or property) valuation approaches.

As with the business valuation approaches, there are several generally accepted valuation methods under each asset/property valuation approach. Additionally, individual valuation procedures are performed in the appreciation of each valuation method. The debtor company asset/property value in conclusion is generally based on the synthesis of the value indications from each applicable asset valuation approach and method.

While there are certain conceptual similarities, it is important to note that there are important methodological differences between the asset-based business valuation approach and the cost approach to asset/property appraisal.

The cost approach values the debtor company tangible assets or intangible assets or properties by estimating a current cost measure (typically replacement cost new, but other current cost measures may also be used) less allowances for physical depreciation, functional obsolescence, and external obsolescence. A common cost-approach valuation method for valuing debtor assets is the replacement cost new less depreciation (RCNLD) method. Other cost-approach methods may also be used. It is noteworthy that the fair market value of a debtor company asset is not measured by its replacement cost new (RCN); rather, the fair market value of a debtor company asset is measured by its RCNLD.

The market approach values the debtor company tangible assets or intangible assets based on sales, licenses and other transfers of sufficiently comparative assets (typically operating in the same or similar industry). A common market-approach asset valuation method is the sales comparison method. The first procedure is to identify and confirm the sales (or other transfers) of comparable (or guideline) assets. The second (and perhaps more important) procedure is to compare the debtor company assets to the comparable (or guideline) assets. This comparison allows the analyst to select debtor-specific valuation pricing metrics from within (or sometimes outside of) the range of market-derived pricing metrics that is extracted from the comparative sale transactions.

The income approach typically values the debtor company tangible assets or intangible assets based on the projected income from the ownership/operation of the individual assets. The ownership/operation income relates to income derived only from the use of the subject assets. It is not the level of business operating income that comes from the sale of goods or services. That business operating income measure is used in the business valuation income-approach analysis. Two common income-approach asset valuation methods are the direct-capitalization method and the yield-capitalization method.

The direct-capitalization method involves a normalized one-year estimate of future income divided by a direct-capitalization rate. The yield-capitalization method involves an income projection for each year in a projection period. This projection is converted to an indication of fair value by using a yield-capitalization rate (also called a present value discount rate). Both the direct-capitalization rate and yield-capitalization rate consider the risk associated with achieving the income projection. Both of these valuation methods consider the expected remaining useful life (RUL) of the debtor company tangible assets or intangible assets.

As mentioned above, the three generally accepted valuation approaches to value the debtor company business are the asset-based approach, the market approach and the income approach. The debtor company business enterprise value (or BEV) is often defined as the total of (1) the debtor company long-term, interest-bearing debt and (2) the debtor company owners' equity. The term...