AuthorAyotte, Kenneth
PositionSymposium on the Fortieth Anniversary of the 1978 Bankruptcy Code

INTRODUCTION 1820 I. VALUATIONIN LAW AND PRACTICE 1824 A. The Law of Valuation 1824 B. Valuation in Practice 1825 1. Discounted Cash Flow (DCF) 1826 2. Comparable Company Multiples (CCM) and Comparable Transaction Multiples (TM) 1830 II. DATA 1831 III. FINDINGS: PATTERNS IN VALUATION DISPUTES 1832 IV. DISCUSSION 1834 A. Experts and courts routinely incorporate firm-specific risk premia in discount rates. They appear to do this in order to adjust for biases in cash flow projections 1834 B. Courts disagree on the reliability of DCF, but are reluctant to consider techniques that they have not seen before 1836 C. Courts are often aware that many experts are designing their testimony strategically to provide maximal support for their client. Some, but not all, courts catch these attempts 1838 D. Overall, courts seem more adept at applying multiples, based on CC or TM, than DCF 1839 E. Judges are also increasingly looking to market measures instead of expert valuations 1840 V IMPLICATIONS: RULES OF THUMB FOR JUDGES 1841 A. Reject arbitrary add-ons to the discount rate. Use the peer-reviewed finance literature for credible approaches on discount rates 1841 B. Weighting schemes are sources of manipulation, both across methods and within methods 1842 C. Markets beat experts 1843 CONCLUSION 1845 FIGURES 1847 INTRODUCTION

Valuation disputes lie at the heart of the Chapter 11 reorganization process. (1) The premise of reorganization is that the firm may be worth more as a going-concern than liquidated. Markets may be sufficiently illiquid that this going-concern value cannot be realized through a sale of the entire firm. To avoid the illiquidity problem, the law allows a plan proponent to avoid a sale and instead distribute new claims (new debt and new equity) on the reorganized company to its old investors according to their entitlements.

Those entitlements hinge upon the value of the company. Junior creditors, for example, are entitled to new claims only if there is sufficient value to pay more senior creditors in full. Deciding what the company is worth is the job of the bankruptcy judge. In doing that job, the judge is placed in the difficult position of having to reach a valuation determination in the presence of competing arguments from expert witnesses. In theory, parties can settle their disputes in the shadow of a judicial valuation, but they often do not. The testimony required to resolve these disputes can delay resolution of a case by months, and costs imposed on the estate can be substantial. Experts typically base their valuation testimony on complicated techniques that require substantial discretion to implement. Evaluating the validity of the assumptions used in valuation modeling requires an understanding of finance theory, statistical methods, and industry-specific and company-specific conditions.

The academic literature on bankruptcy has long been aware of the judicial valuation problem generally, as early work by Blum illustrates. (2) More recently, Baird (3), Bebchuk (4), Adler (5) and other scholars (6) have proposed various mechanisms that avoid judicial valuations entirely. Whatever the merits of these proposals, they do not reflect existing law. Since judicial valuation is unlikely to disappear from bankruptcy any time soon, we should understand more about how parties explain their opposing valuation positions to a judge, and how judges decide these disputes.

To do this, we study reported cases involving a Chapter 11 valuation dispute. Our sample begins in 1990 and includes 143 cases. Each case was coded by two research assistants and read by one of us. The most common settings in which these disputes appear are plan confirmation hearings and fraudulent transfer litigation, but they also arise in adequate protection hearings, preference actions, motions to value secured claims, and other contexts.

Attempts at manipulating valuations to serve the self-interest of the litigants is common. In some cases, the judge catches it. But in many cases, experts on both sides use assumptions that have no reliable basis in finance theory or evidence. The most prominent of these is the use of "company-specific" or "unsystematic" premiums when calculating the discount rate for future cash flows. These are nothing more than arbitrary add-ons that drive the company's reported value downward. We find cases in which experts recommend, and judges approve, company-specific risk premia as large as 10%. Although prominent practitioner publications admit the absence of reliable evidence for these add-ons, they recommend them anyway. (7) Absent training in financial theory, it would be difficult for a judge to "smoke out" this kind of valuation manipulation. It is especially difficult when both sides employ similar manipulations, but in opposite directions.

More broadly, based on our reading of the opinions in our sample, we believe that the discounted cash flow (DCF) method is particularly susceptible to the kinds of manipulation that are difficult for non-experts to evaluate. Because DCF leans heavily on subjective assumptions that are difficult to test, if not entirely untestable, we believe this method is not well-suited for adversarial litigation in a bankruptcy case. It may be best used as a last resort when more transparent approaches (surrounding market evidence, comparable transactions, or comparable company multiples) are unreliable, and only when discount rates can be calculated using well-grounded approaches that have a basis in finance theory and evidence. Thus, we find opinions such as Iridium (8) and Boston Generating, (9) which place greater weight on contemporaneous evidence of offers (or lack of offers) by market participants, more convincing than post-hoc valuation estimates by self-interested litigants.

When DCF is used, assumptions used to calculate the discount rate should be justified using theory and evidence from the peer-reviewed finance literature, rather than valuation industry journals and guides. Assessing appropriate risk factors, such as whether a risk premium is warranted for small firms, is a complicated judgment that requires finance theory and sophisticated statistical techniques. Because finance scholars have spent decades engaged in this debate, support from the peer-reviewed finance literature should be a necessary condition for admissibility of any method used to calculate a discount rate.

The judges in our sample of cases are adept in screening out manipulative assumptions when they evaluate multiples-based valuations. In those cases, disputes between experts take many forms: which income statement variable should be used to generate the multiple? Should the multiple be trailing or forward? Is the comparison group, which was chosen to generate the multiple, actually comparable? Expertise in finance theory is less essential to evaluate competing arguments about these inputs, so judges and adversarial litigants do a better job screening out assumptions that are intended to manipulate the valuation estimate.

Although we are critical of many practices in our sample, we believe expert witnesses can and should continue to serve an important role in valuation disputes. Experts are necessary for understanding the subject company's unique circumstances, making inherently difficult judgments about discount rates and comparable companies, and conveying technical information effectively to non-expert judges. We believe this process will be more informative to judges if experts are required to make decisions based on a more confined and standardized toolkit than the wide-open space that currently exists. Shrinking the space of available arguments also has the potential to reduce disagreement between the parties as to how a court will value the asset in question. (10) Reducing this disagreement should promote settlement, increase speed, and reduce litigation costs that deplete the bankruptcy estate.

Our paper proceeds as follows. In Part I, we give a brief overview of valuation techniques, our classification scheme, and our hypotheses. Part II introduces the data and our findings. Part III provides some practical takeaways that judges can use to spot manipulation and separate the good arguments from the bad.


    1. The Law of Valuation

      Key moments in a Chapter 11 reorganization hinge on valuation. The judge must value an asset or the entire firm when a creditor seeks compensation for depreciation in the value of collateral ("adequate protection"); when the judge determines the amount each creditor is owed, and whether the debt is secured or unsecured ("claims allowance"); when the debtor attempts to recover assets that were transferred improperly to creditors or others prior to the bankruptcy case ("preferential transfer" and "fraudulent conveyance" actions); and when the debtor proposes a plan of reorganization that is opposed by some stakeholders ("cramdown").

      Sometimes the valuation is straightforward. During claims allowance, for example, the judge determines whether debt owed to a secured creditor exceeds the value of the underlying collateral. The creditor has a secured claim up to the value of the collateral and an unsecured (deficiency) claim to the extent that the debt exceeds the collateral's value, which "shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property." (11) This means, according to the Supreme Court, that we use "foreclosure value" if the debtor plans to sell or abandon the property, but use "replacement value" if the debtor plans to keep it. (12) Replacement value is "the cost the debtor would incur to obtain a like asset for the same 'proposed... use.'" (13) Neither "foreclosure value" nor "replacement value" are typically difficult to measure in practice.

      Most of the time, however, the standards for valuation are vague and unhelpful. When a proposed plan of...

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