Teaching Bankruptcy Valuations to Law Students and Other Unnatural Acts

• Publication year: 2023

Teaching Bankruptcy Valuations to Law Students and Other Unnatural Acts

Jack F. Williams

TEACHING BANKRUPTCY VALUATIONS TO LAW STUDENTS AND OTHER UNNATURAL ACTS^* Jack F. Williams^** ABSTRACT

We often measure that which we can as opposed to that in which we are most interested, and fail to appreciate the difference between the two. Experts may aid a trier of fact in measuring fair market value, fair value, investment value, or some other measure of value; however, courts make determinations with regard to a legal standard, not a financial standard. For example, "fair valuation" may be used for determinations of insolvency or the "fair and equitable" rule may be used for determinations of chapter 11 cramdown plan confirmation disputes. Other measures of value may be used in determining the amount of a claim or to satisfy other financial tests in bankruptcy. There is a difference between employing common valuation standards using traditional and well-accepted techniques and fashioning equitable relief demanded by bankruptcy law. Through the lenses of the "insolvency" and "fair and equitable" tests in the bankruptcy process, I suggest that principles of equity offer a competing vision in approaching valuation issues where an expert

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provides significant input in an overall assessment of the totality of circumstances, the bedrock principle of exercises of equitable remedies. In building the case, I challenge the body of criticisms directed at experts and courts in their construction of valuation models, susceptibility to hindsight bias, and manipulations of assumptions and inputs. I also modestly reject the notion that a market approach is less speculative than an income approach. Both approaches require considerable judgment—one more transparent and the other more opaque. Both approaches must be considered in the robust context of unique disputes, and their use may be driven by the application of specific statutory language. Throughout this Article, I identify various assumptions and inputs to classic valuation approaches and methods that have been rightly contested or unnecessarily confused. The process often requires an expert and a court to make tradeoffs between degrees of (i) relevance and reliability and (ii) opaqueness and transparency. In the end, valuations in bankruptcy disputes look less like lessons in finance, and more like classic fashionings of equitable relief in a court of equity, a needed reminder that finance is the handmaiden of the court and not its jailer.

TABLE OF CONTENTS

I. CONTEXT MATTERS..........................................................................54

A. Different Approaches for Different Questions............................ 54
B. Building on a Strong Foundation .............................................. 60
C. A Good Roadmap Helps............................................................ 63

II. BANKRUPTCY VALUATION IN DISPUTE.............................................65

A. Bankruptcy Law's Frame.......................................................... 65
B. Choices Made ........................................................................... 74

III. METHODOLOGY................................................................................ 80

A. Premise of Value and Standard of Value ................................... 83
B. Approaches and Methods .......................................................... 85

IV. INCOME APPROACH..........................................................................86

A. Projections ............................................................................... 88
B. Terminal Value ......................................................................... 92
C. Discount Rate ........................................................................... 96

1. Required Rate of Return on Equity or Cost of Equity...........97

a. Capital Asset Pricing Model ......................................... 98
b. Risk-Free Rate of Return ..............................................98
c. Equity Risk Premium .................................................... 99
d. Beta (ß) ...................................................................... 101
e. Size Premium ............................................................. 107
f. Company Specific Risk Adjustment ............................. 108

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2. Required Rate of Return on Debt or Cost of Debt .............. 111
3. Capital Structure .............................................................. 113

V. MARKET APPROACH....................................................................... 114

A. Guideline Public Company Method ......................................... 115
B. Guideline Merged and A cquired Method................................. 116
C. Selection of Comparable Company Sets Under the Guideline Methods.................................................................. 117
D. Selection of Valuation Multiples Under the Guideline Methods.................................................................. 119
E. Observable Market Value Method and Associated Challenges .............................................................................. 121
F. Additional Challenges to the Market and Income Approaches ............................................................................. 123

VI. ASSET APPROACH........................................................................... 125

VII. RECONCILING MULTIPLE APPROACHES AND METHODS................... 128

VIII. OBSERVATIONS.............................................................................. 130

A. Cluster C₁: Choosing Between Relevance and Reliability........ 131

1. Risk-Free Rate (Income Approach) ................................... 131
2. Historical Beta Lookback and Interval (Income Approach) ........................................................... 131
3. Cost of Debt (Income Approach) ....................................... 132
4. Debt to Total Capital Structure (Income Approach) .......... 133
5. Earnings Base Metric Selection (Market Approach) .......... 133

B. Cluster C₂: Addition of the Opaque v. Transparent Choice ...... 134

1. Future Economic Benefits or Projections (Income Approach and Market Approach)......................... 134
2. Beta (Income Approach) ................................................... 135
3. Equity Risk Premium (Income Approach) .......................... 137

C. Cluster C₃: Hotly Contested Risk Determinations .................... 138

1. Terminal Value (Income Approach) .................................. 139
2. Small Size and Company Specific Risk Premiums (Income Approach) ........................................................... 139
3. Comparable Company or Comparable Transaction Set (Market Approach) ........................................................... 142
4. Reconciliation of Value Indications (All Approaches)........ 143

D. Conclusion ............................................................................. 145

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I. CONTEXT MATTERS

A. Different Approaches for Different Questions

The role of valuation in bankruptcy law is fascinating and presents layers of complexity and nuance, as one seeks to understand and master it and the process that bears its relevance. So much in the practice of law is predicated on the concept and determination of questions of value across many substantive and remedial areas of the law in general, and of remedies and applications under bankruptcy law specifically.¹ Valuation practice as performed in disputes, as a discipline, continues to evolve, and it has changed over time. No discipline exists outside human nature, and human nature brings with it all varietals of insights, creativity, experience, wisdom, bias, prejudice, competence, vagueness, ambiguity, hindsight, and the like.² Valuation practice is a cumulative endeavor; each new theory and practice incorporates successful earlier theories and practices, some practices fall away or are discarded, and some rise and fall in their frequency of use over time (driven in part by their theoretical or popular acceptance over time). Some practices may also rise and fall based on their ease of use, such as those that may now be quickly performed as mechanical exercises or those that depend on easy access to widespread data that is more readily available in today's computer-driven world. Valuation, performed in the bankruptcy context, requires an interlacing of one's cumulative understanding of valuation theory, finance, and bankruptcy law. Valuation is essential and ubiquitous in chapter 11 cases,³ with valuation disputes being, at times, a long and hotly contested process.⁴ Valuation experts play an important role in this

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process,⁵ and they are not alone. "[L]itigation over enterprise value can be quite technical; as a result, the relative sophistication and experience of counsel, as well as the bankruptcy court itself, can have a tremendous impact on the quality of the ruling."⁶ Common valuation-related questions confronted in bankruptcy, such as collateral valuations, adequate protection, insolvency, reasonably equivalent value, and reorganizational value of the assets of a debtor, carry with them a specific legal context with specific legal requirements.

Where finance ends and the law begins is unclear. An example helps illustrate 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 standards or directives.⁷ If an expert is asked to render an opinion on the insolvency of a debtor, one of the initial questions the expert must explore is the appropriate standard of value. Insolvency, to paraphrase Justice Cardozo, is not simply a thing in the air;⁸ it needs a mooring, a context. An expert who simply states, "I have valued the assets of the debtor, determined the liabilities of the debtor, and subtracted one from the other" is...