Restructuring

Contributed by Alexander Woolverton
In Whyte v. C/R Energy Coinvestment II, L.P. (In re SemCrude, L.P.), the United States Bankruptcy Court for the District of Delaware dealt with the familiar scenario of a litigation trustee aggressively pursuing fraudulent transfer claims.  Faced with as dramatic a fight about valuation theories as there could possibly be, the court held that using a balance sheet-based test was inappropriate for valuing a debtor as a going concern, where a third-party had prepared a then-current valuation utilizing the discounted cash flow method, notwithstanding the fact that such valuation failed to take into account certain facts that adversely affected the value of the debtors.
Background: The 2008 Distribution
In February 2008, prior to the commencement of its bankruptcy case, SemGroup L.P. (whose primary business was to provide various oil and gas-related serves) made an equity distribution totaling approximately $29 million to Ritchie SG Holdings, LLP, SGLP Holdings, Ltd., SGLP US Holding, LLC and Cottonwood Partnership, LLP (who were the owners of the equity interests in SemGroup, L.P.) and SemGroup L.P.’s general partner, SemGroup G.P., LLC.
Just a few months later, on July 22, 2008, SemGroup L.P. and its affiliates filed voluntary petitions under chapter 11 of the Bankruptcy Code.  Aside from their oil and gas business, the debtors also traded in derivatives, which trading activities ultimately gave rise to a severe liquidity crisis and triggered the debtors’ bankruptcy.
In March 2010, the litigation trustee appointed in the debtors’ cases filed a complaint against Ritchie, Cottonwood and the SGLP entities asserting, inter alia, a constructive fraudulent transfer claim pursuant to section 548 of the Bankruptcy Code.  The trustee alleged that, during the several months immediately preceding the bankruptcy, Thomas Kivisto, SemGroup’s CEO, was involved in derivatives trading that was prohibited by SemGroup’s various loan agreements and that the debtors were siphoning millions of dollars to a company owned by Kivisto so that he could trade commodities in his own name.  These speculative trading activities, the trustee alleged, rendered SemGroup insolvent at the time of the distribution.
The Court’s Decision
Section 548(a)(1) of the Bankruptcy Code allows a trustee to avoid a transfer made within two years of the filing date if the debtor “received less than reasonably equivalent value in exchange,” and if the debtor was either insolvent on the date of the transfer or was rendered insolvent as a result of the transfer.
The court was able to decide the first two elements “in summary fashion.”  First, there was neither dispute nor question that the distribution occurred within two years of the petition date.  Second, because the distribution was made on account of equity interests, it was not for reasonably equivalent value.  Section 548(d)(2)(A) of the Bankruptcy Code defines “value” as “property, or satisfaction or securing of a present or antecedent debt of the debtor,” and the court held that “equity distributions on account of partnership interests do not confer ‘value’ upon the transferor.”  Accordingly, the court honed in on the remaining point of contention:  whether the debtors were insolvent at the time of the distribution.
The Parties’ Insolvency Analyses: The Income, Market, and Asset Based Approaches
At the outset, the parties agreed that determining “fair value” required using one (or more) of three standard approaches: the Income Approach, the Market Approach or the Asset Based Approach.  The Income Approach begins by using the discounted cash flow method to estimate the value of a business.  Then, “adjustments are made to account for the company being valued on a going concern,” and liabilities are subtracted to produce either a net solvency or net insolvency.  Under the Market Approach, “net revenues and earnings are multiplied by an appropriate range of risk-adjusted multiples to determine the company’s total enterprise value.”  Typically, this approach involves comparison of valuation metrics, such as EBITDA from similar companies or precedent transactions from comparable companies.  Last, the Asset Based Approach “revalues at a fair value each of the individual balance sheet line items on a company’s balance sheet.”
The defendants relied on a 2008 valuation of the debtors by Goldman Sachs prepared in the context of a securities offering, which used a combination of the Income Approach and the Market Approach as a starting point and made a number of adjustments to them. Through the valuation made by Goldman, the defendants concluded that the debtors had a solvency cushion of at least $670 million during the relevant period.
While the trustee recognized that the Income Approach is generally the “preferred method,” the trustee’s nevertheless advocated in favor the Asset Based Approach, concluding that the debtors were insolvent at the time of the distribution by at least $428 million.  The trustee contended that the Asset Approach was “the only approach that [could] adequately take into account the impact of Kivisto’s speculative trading.”  Further, the trustee argued that the Income Approach was inappropriate because the valuation by Goldman Sachs did not set forth the assumptions it used and because it assumed that the debtors were not involved in “speculative trading,” which the trustee disputed.  For this reason, the trustee contended that the approach advanced by the debtors should not be relied upon by the court.  Additionally, the trustee argued against using the Market Approach because the debtors had a negative EBITDA throughout the relevant period, and using an adjusted EBITDA “would be inappropriate to use given significant unrealized derivative losses and the incorrect assumption that the debtors’ trading was fully backed by physical inventory.”
The Court’s Decision
The court was not persuaded by the trustee’s arguments.  As an initial matter, the court found that the parties agreed that the Income Approach is generally preferable.  The court additionally found unrealistic a number of the values attributed by the trustee to specific assets of the debtors.  Because the valuation of those assets ultimately contributed significantly to the trustee’s conclusion that the debtors were insolvent at the time of the distribution, the court rejected the trustee’s valuation.
By contrast, the court found the valuation by Goldman (which formed the basis of the defendants’ valuation) to be a “sufficiently reliable” starting point.  The court found that the Goldman valuation (and by extension, the defendants’ valuation) was reliable because it was prepared contemporaneously with the date of the distribution, and because it was not prepared in anticipation of litigation.  In support of the court’s acceptance of the reliability and validity of Goldman’s valuation, the court cited to the “significant due diligence” performed in connection with Goldman’s valuation.  Last, the court rejected the trustee’s contention that the defendants’ valuation insufficiently accounted for the debtors’ alleged speculative trading practices.  The court found that the defendants had adequately taken these practices into account by calculating the cost of replacing their trade book – which the debtors had, in fact, accomplished approximately six months after the distribution.
Conclusion
The trustee’s burden to show that the debtors were insolvent at the time of the distribution was made all the more difficult by the existence of an independent and contemporaneous valuation that favored the defendants and by her use of a valuation method the parties agreed was not a preferred valuation method when valuing a company as a going concern is appropriate.  These hurdles ultimately proved too steep to clear, and the court held that the trustee was unable to show that the debtors were insolvent at the date of the distribution.  Accordingly, the trustee was unsuccessful in her attempt to recover the money paid in connection with the distribution, and the court entered judgment in favor of the defendants on all counts.  Whether the SemCrude court’s analysis would be adopted by another court is difficult to tell particularly in this case, where the parties had agreed on an acceptable method of valuation, but the trustee elected to use another.
Disclosure: Weil represented the Debtors in their underlying bankruptcy proceedings.