Restructuring

Contributed by Doron P. Kenter.
As we’ve noted on several occasions, parties in interest in a bankruptcy case generally hope for “big money – no whammies” (“Think of Thanksgiving. Everyone wants the biggest turkey possible (except, perhaps, the chef) but all bets are off when it’s time to wrestle over who gets a leg.”). Putting aside those with short positions and those who would like to exercise control at the fulcrum position, certain other parties want to show that they have but a small turkey – plaintiffs asserting actions to recover constructively fraudulent transfers. In such a situation, the plaintiff must prove, among other things, that the transfers (i) were made while the debtor was insolvent or rendered the debtor insolvent; (ii) left the debtor with unreasonably small capital; or (iii) were made with the belief that the debtor would incur debts beyond its ability to satisfy those debts as they matured.
Such was the case in a recent dispute between the Adelphia Recovery Trust and FPL Group. In attempting to collect any available assets for the Adelphia estate’s remaining beneficiaries, the recovery trust commenced an action seeking to recover $150 million that Adelphia paid FPL Group and one of its affiliates in connection with Adelphia’s repurchase in January 1999 of its own stock from FPL. One of the central issues before the bankruptcy court was whether Adelphia was insolvent at the time of the challenged transfer. Even though the district court had ruled that the bankruptcy court lacked final adjudicatory authority over the matter, the bankruptcy court’s proposed decision is a prime example of an exercise in complex valuation, especially in the context of major corporate fraud and inaccurate or unreliable contemporaneous information.
The facts of the underlying transaction are interesting in their own right, but time and space constraints prevent them from being fully repeated here. For purposes of our analysis of this particular aspect of the bankruptcy court’s decision, suffice it to say that if Adelphia was solvent in January 1999, the recovery trust’s action to recover the $150 million paid to FPL would fail. Among other topics, Judge Gerber touched on the following aspects of the parties’ arguments in support of their respective valuations:
Discounted Cash Flow Analysis Is Not Persuasive in the Absence of Accurate Projections or in the Presence of Fraud
Perhaps the most important aspect of the valuation dispute and the court’s decision is the treatment of the Discounted Cash Flow (“DCF”) method of valuing Adelphia as of January 1999. The DCF method is a common one in bankruptcy valuations and estimates an enterprise’s net present value by adding together (i) the projected unlevered cash flows for a certain number of upcoming years, discounted to present value based on the company’s weighted average cost of capital (“WACC”) and (ii) the company’s projected cash flows for the period thereafter in perpetuity (the “terminal” or “exit” value). Using this methodology, the recovery trust’s expert reached a total enterprise value of $2.538 billion before any adjustments – far less than the company’s liabilities, which the experts had valued between $3 billion and $3.9 billion.
The problem with DCF, however, is that it almost always relies upon management projections. In Adelphia’s case, however, management projections were unavailable. In any event, Judge Gerber found that any such projections would have been unreliable because they would have been generated by unreliable management, many of whom were subsequently convicted on multiple counts of fraud in connection with their management of the company. Accordingly, the recovery trust’s expert generated his own cash flow projections for the company, based on contemporaneous reports from two third-party analysts.
Because of these deficiencies in management’s own projections, FPL’s expert declined to use a DCF analysis. The bankruptcy court agreed with that decision, observing that “[a]s a matter of common sense, DCF works best (and, arguably, only) [i] when a company has accurate projections of future cash flows, [ii] when projections are not tainted by fraud, and [iii] when at least some of the cash flows are positive.” Arguably, there is some overlap between the first two of these premises (i.e., where projections are tainted by fraud, they will likely be inaccurate – or at least unreliable). But in any event, because the fraud at Adelphia made historical financials and forward projections unreliable, the court concluded that the dispute before it was a “poster child” for a situation in which “the propriety of any use of DCF (and the weight DCF conclusions should be given)” becomes “debatable at best.”
In light of that conclusion, the bankruptcy court was “surprised” by the recovery trust’s expert’s use of DCF alone, based only roughly on third-party projections for a “typical cable company.” Moreover, the court questioned the recovery trust’s expert’s decisions to use certain assumptions from one third-party analyst selectively, while using different assumptions from another. And even though the recovery trust’s expert made these choices out of necessity (rather than data manipulation), those choices “underscore[d] the excessively arbitrary, and ultimately speculative, nature” of the analysis. Consequently, the court concluded that, because of the fraud at Adelphia, “use of alternative established metrics would be superior to reliance on DCF – and especially to sole reliance on DCF.”
Comparable Companies and Precedent Transactions
Having dismissed DCF as a reasonable form of valuation methodology in the context of the fraud at Adelphia, Judge Gerber looked to the two methodologies employed by FPL’s expert – namely, “Comparable Companies” and “Precedent Transactions.” The first methodology examines the value of comparable firms and then uses those firms’ metrics to project a value for the subject company. In this case, FPL’s expert looked to the “Value per Subscriber” – a common valuation metric in the cable industry – of six comparable companies. In light of the data for those peer companies, FPL’s expert selected a Value Per Subscriber for Adelphia at $3,024 per subscriber – which reflected a valuation in the lowest quartile of the comparable companies’ multiples – resulting in a valuation of Adelphia’s cable assets at $4.472 billion. That value, plus a control premium of $376.4 million and cash of $156.1 million, amounted to a total unadjusted enterprise value of $5.004 billion.
The Precedent Transactions methodology similarly derives an enterprise’s value from comparable companies, but derives its data from the purchase prices for comparable companies in connection with their mergers and acquisitions. Those comparable transactions led FPL’s expert to assign a Value per Subscriber to Adelphia of $3,277, plus $156.1 million in cash, yielding a total unadjusted enterprise value of $5.001 billion.
Market Cap
Notably, the bankruptcy court did not simply accept either of these valuations. Instead, it observed that all methodologies introduced in the dispute were “speculative” (though perhaps there was no alternative to some degree of speculation) and that both experts’ valuations were questionable, at least in certain respects. Indeed, the court noted that Adelphia’s market capitalization in January 1999, based on the market value of the company’s equity, was approximately $3.14 billion, before Adelphia’s fraud was disclosed (which, in all likelihood, would mean that Adelphia’s “true” market price would be materially lower than that amount). In any event, the court reasoned that this $3.14 billion market cap demonstrated problems with both experts’ analyses. In the first instance, the court observed that the recovery trust’s expert had not demonstrated how the undisclosed fraud would have eliminated the entire $3.14 billion market cap, plus another $1 billion in asserted negative equity. On the other hand, the court was perhaps more troubled by the valuation of FPL’s expert, which yielded a 19% premium over Adelphia’s market cap. The court therefore had “some difficulty” understanding how Adelphia’s value could ever exceed its market cap – particularly given that the as-yet-undisclosed fraud likely artificially increased Adelphia’s market cap beyond its true value at the time of the stock buyback.
Based on this observation regarding Adelphia’s Market Cap, the court reached its own independent conclusions regarding Adelphia’s enterprise value and concluded that Adelphia’s enterprise value exceeded its liabilities a(even with other important adjustments described in detail in the court’s decision). Accordingly, the court concluded that Adelphia was still solvent at the time of the challenged transaction.
The Court’s Data
Lastly (at least for now), we note that the court provided a chart (copied here) as a guide to understanding its valuation as of the time of the challenged transfer. Though it is not the first time a court has provided a similar demonstrative aid, it is a useful example of the calculations that are taken into account in a comprehensive valuation and may help parties in interest to understand certain courts’ decision-making processes in connection with resolving valuation disputes.