Chapter 8 Valuing the Distressed or Bankrupt Fraud-Plagued Company

• Jurisdiction: United States

Chapter 8: Valuing the Distressed or Bankrupt Fraud-Plagued Company

A. Had the Information Been Known: Lessons from the Enron Insolvency⁶²

The concept of solvency is important for the analysis of a company in bankruptcy. A debtor company is generally considered solvent if the fair value of its assets exceeds the amount of its liabilities, and a debtor company is generally considered insolvent if the amount of its liabilities exceeds the fair value of its assets. The standards of fair value and fair market value are often used in the determination of solvency. Fair market value is generally defined as the price at which property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, with both parties having reasonable knowledge of relevant facts.

The estimation of fair value and the solvency of a debtor company are often affected by which facts should be considered in the derivation of solvency. The consideration of relevant facts typically includes information that was known or knowable as of the valuation date, whether disclosed to the marketplace or not. It may be helpful to distinguish between facts that were in existence but not publicly known until after the solvency assessment date, and information that was unknowable as of that date. Such unknowable "hindsight information" is generally excluded from a solvency analysis.

Any assessment of solvency typically values the debtor company's assets and liabilities as they existed as of the date of the solvency analysis. The solvency analysis typically does not include an increase in asset value or decrease in liabilities that could be obtained through a hypothetical recapitalization or restructuring.

Enron Corp.

To illustrate these solvency concepts, it is useful to examine the case of Enron Corporation ("Enron"),⁶³ one of the largest and most complex corporate bankruptcies in U.S. history.

Consider the task of valuing the Enron assets. For many years prior to its bankruptcy, Enron had migrated away from its traditional natural gas pipeline business to become a major merchant energy trader. Enron also purchased and developed a portfolio of energy assets and businesses, ranging from Dabhol, a power plant in India, to Elektro, an electric utility in Brazil. However, by as early as 1997, the largest portion of the company's reported operating profits came from its gas and power trading. For the fiscal year ended December 31, 2000, $2.3 billion of Enron's reported $2.5 billion in earnings before interest and taxes (EBIT) came from Enron Wholesale Services, the energy trading arm of Enron Corp.

Even on an as-reported basis (which inflated the Enron profits from trading and concealed large losses in the company's unprofitable Broadband and Retail Energy Services divisions), the Enron value as a business clearly depended on its ability to trade. In turn, this ability to trade rested on the company's maintenance of an investment grade credit rating. Without credit, counterparties worried about default risk would require high levels of collateral to do business with Enron, thereby destroying the company's trading volumes and margins. In addition, Enron's trading contracts commonly included a clause allowing for cancellation should either party suffer a "material adverse change" such as the loss of its investment-grade credit rating.

Documents produced in the Enron bankruptcy show that company management was well aware of the importance of the company's investment grade credit rating. Documents also indicated that many of its special-purpose entities and transactions were designed to lower its reported liabilities and improve its cash flow in order to maintain its investment grade credit rating. When Enron lost its investment grade credit rating in late November 2001, the company's trading operations ground to a halt and were never restarted.

Enron Bankruptcy

In the wake of the Enron bankruptcy, the credit ratings agencies made it clear that had they known the truth about Enron's liabilities, financial mismanagement and accounting fraud, they would have assigned to the company a noninvestment grade credit rating at least as far back as 1999. Moreover, Ronald Barone, a managing director at Standard & Poor's, testified that the company would not have been rated at all. Any valuation of the Enron trading assets for the purposes of solvency should consider this testimony. For periods significantly earlier than 2001, it may be appropriate to value the Enron trading operation as though its credit rating had been lost, its trading operation was no longer a going concern, and its in-the-money trading contracts were subject to revocation.

Similarly, a solvency analysis generally considers the amount of a company's liabilities had all relevant facts about those liabilities been known. For example, in Enron's third-quarter 2001 Form 10-Q filed with the SEC, the company reported debt totaling $14.3 billion as of November 16, 2001. In a private presentation given to its bankers just three days later, the company reported debt totaling more than $38 billion. The difference between these two figures was made up by a variety of financing vehicles that either hid liabilities in off-balance sheet special purpose entities, or misclassified liabilities on the Enron balance sheet.

Enron Solvency

A solvency analysis of Enron, or any other company for that matter, typically includes all the liabilities for which that company is responsible. Furthermore, the determination of liabilities for the purposes of solvency typically requires that substance prevails over form. Even if one were to hypothetically assume that Enron's methods of accounting for its liabilities were in accordance with GAAP (and work by forensic accountants such as the Enron examiner makes it clear that they were not), solvency usually requires that all debt obligations be accounted for regardless of where they appear, whether on a company's balance sheet or as off-balance sheet liabilities.

A solvency analysis typically includes the assets and liabilities of a company as they existed at a particular date. It is not a generally accepted procedure to estimate the value that may have been developed had a recapitalization or restructuring taken place. For example, following the company's bankruptcy, an Enron employee claimed that he could restart and profitably operate Enron's trading operation with the infusion of $6 billion in additional capital.

While it is always possible that a business may have a different value in different hands or under different circumstances, such additional capital was never actually at Enron's disposal. Therefore, such a reorganization cannot be considered in valuing Enron's trading assets for the purpose of solvency.

Following the bankruptcy, the Enron bankruptcy estate developed plans to distribute the company's assets to its creditors. The bankruptcy estate also filed claims against its bankers, accountants and trade counterparties. When determining solvency, an analyst typically could not reduce Enron's liabilities by hypothetical settlements of its liabilities for less than their stated value. Generally, the determination of a company's assets and liabilities for the purposes of solvency includes its assets and liabilities as they existed at the date of the solvency analysis.

Conclusion

Solvency analysis is typically performed with full consideration of all knowable relevant facts and circumstances, but without allowing the analysis to be influenced by hindsight. A solvency analysis typically includes all assets and liabilities of a debtor company. While a debtor company such as Enron may place certain of its liabilities and assets off balance sheets, substance generally prevails over form when determining the debtor company solvency.

B. Quantifying the Impact of Fraud⁶⁴

Fraud has played a role in many of the largest and most highly profiled bankruptcies in the 21st century. Companies such as Enron, WorldCom, Adelphia and Refco failed due in large part to fraud. Increased enforcement by the U.S. Securities and Exchange Commission (SEC) and the implementation of the Sarbanes-Oxley Act of 2002 may have reduced the number of fraud-related bankruptcies, but they still dominate the news on a regular basis.

When valuing a fraudulent company, the analyst will somehow factor the fraud into the valuation. It is common sense that if you have two identical companies and one is fraud-plagued, that company will be worth less than the nonfraudulent company, all other things being equal. This section discusses the application of a fraud penalty to one of the generally accepted market-approach valuation methods, the guideline publicly traded company (GPTC) method. This valuation method is also sometimes referred to as the comparable company multiple (or CompCo) method.

Fair Market Value Standard of Value

Fair market value is defined in Internal Revenue Service (IRS) Revenue Ruling 59-60 as the price at which the subject property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell and both parties have reasonable knowledge of the relevant facts. It follows that in order to perform a fair market valuation, the analyst should assume that both parties have reasonable knowledge of all of the relevant facts.

As discussed in an article published in the December/January 2007 issue of the ABI Journal,⁶⁵ the consideration of relevant facts typically includes information that was known or knowable as of the date of the valuation, whether disclosed to the marketplace or not. It is neither reasonable nor realistic to assume that fraudulent companies can be restructured, financials can be restated, management can be replaced and funds can instantly be raised. A valuation of a company with fraudulent...