Restructuring

Co-Authored by Andrea Saavedra and Christopher Hopkins
In our Slice of the Pie series, we’ll explore those sections of the Bankruptcy Code that implicate valuation.  The series will also report on current cases where these provisions are at issue, and include contributions from others in the restructuring field that have experience with, and thoughts on, bankruptcy valuation disputes.
So as to set up a proper foundation for discussion around valuation, we begin the series with an overview of the Bankruptcy Code’s various definitions of “insolvent” and, specifically, examine their application in the context of constructively fraudulent transfer litigation for corporate debtors.
What constitutes insolvency under the Bankruptcy Code?
The Bankruptcy Code contains three definitions of “insolvent” and which definition applies in any particular case turns on the form of the debtor being examined.
Section 101(32)(A) defines “insolvent” for entities such as corporations and individuals as the “financial condition such that the sum of such entity’s debts is greater than all of such entity’s property, at fair valuation.”  When making this calculation, section 101(32) requires the exclusion of any fraudulently transferred property or property otherwise exempt under section 522.
For partnerships, section 101(32)(B) defines “insolvent” as the financial condition such that the sum of the partnership’s debts exceeds the aggregate fair value of (i) all partnership property and (ii) the sum of the excess of any general partner’s nonpartnership assets over nonpartnership debts.  Again, property fraudulently transferred or exempted is excluded from the calculation.
These definitions of “insolvent” are referred to as “balance sheet tests” because they require a comparison of the debtor’s assets to its liabilities.  Notably, the Bankruptcy Code never defines the qualifiers “fair valuation” or “fair value,” leaving it to the bankruptcy courts to determine on a case by case basis the proper methodology or market benchmark by which a debtor should be valued.
In contrast to these “balance sheet tests,” a municipality is “insolvent” under section 101(32)(C) if it is either (i) generally not paying its undisputed bona fide debts, or (ii) unable to pay its debts as they become due.  This approach is sometimes referred to as equitable, or cash flow, insolvency.  (Importantly, this concept is also reflected in the capital adequacy and ability-to-service-debt standards set forth in sections 548(a)(1)(B)(ii)(II) and 548(a)(1)(B)(ii)(III), each of which will be addressed in a separate post in this series.)
Because the Bankruptcy Code’s insolvency definitions create different tests for municipal and non-municipal debtors, this post will focus exclusively on the balance sheet test applied to non-municipal debtors.  A separate post discussing the solvency standards applicable to municipal debtors will follow.
How does the balance sheet test work?
The balance sheet test is best understood in its application.  Solvency disputes that implicate the definition of insolvency and, specifically, require interpretation of the phrases “fair valuation” and “fair value,” frequently arise when the trustee or debtor in possession (DIP) attempts to use its avoidance powers.  For example, constructive fraud transfer actions under section 548(a)(1)(B)(ii)(I) require the DIP or trustee to prove, among other things, that the debtor was “insolvent” on the date of the challenged transaction.  The party opposing the action will often argue in defense that the debtor was in fact solvent.  When these disputes arise, litigants may hire experts to present opinions as evidence of solvency (or insolvency).
In its simplest terms, the balance sheet test requires that experts engage in a three-step process.
First, an expert must determine whether, as of the date of the challenged transaction, the debtor was operating as a going concern or otherwise poised to liquidate, as the former typically would indicate higher value and the latter lower value.  Generally, in the context of a going concern, the “fair value” of a debtor’s assets is the fair market price that could be obtained if the assets were sold in a prudent manner in a reasonable period of time.  See, e.g., Lawson v. Ford Motor Co. (In re Roblin Indus., Inc.).  The reasonableness of the time period is determined in the context of what is optimal for the debtor’s creditors: not so short a time that value is impaired by a forced sale, but not so long that the time value of money and regular business needs would reduce a typical creditor’s recovery. See, e.g., Travellers Int’l. v. Trans World Airlines, Inc. (In re Trans World Airlines, Inc.).  In other words, as long as the amount the debtor could realize from converting its assets to cash in the ordinary course of business exceeds the expenses of continuing to conduct business, an expert’s determination that the debtor’s assets should be valued as a going concern may be deemed reasonable by a reviewing court. Heilig-Meyers Co. v. Wachovia Bank (In re Heilig-Meyers Co.). 
Second, the expert values the debtor’s assets using a generally accepted valuation methodology that he or she deems appropriate based on the facts and circumstances of the case.  The three most frequently encountered business valuation methodologies are discounted cash flow, comparable company, and comparable transaction analysis, and these methods have been accepted by many courts.  After calculating the value of the debtor’s assets under the appropriate standard, the expert compares the calculated asset values to the debtor’s liabilities to arrive at a solvency conclusion.
Valuation often requires a retrospective inquiry to determine solvency as of a specific point in the past.  Valuation experts therefore must be wary of hindsight bias.  Accordingly, courts often remind experts that, absent fraud or other exceptional circumstances, they should rely primarily upon contemporaneously known facts and information in developing their post-facto solvency assessments.
The importance of getting it right
Because solvency presents the court with questions of fact, a court generally will rely upon opposing experts’ valuation testimony in reaching a conclusion.  Given the adversarial nature of the process, opposing parties’ experts often arrive at conflicting conclusions, which then requires the court to determine the weight to be given to each expert’s conclusions on value.
While there are many published decisions discussing the statutory definition of insolvency as applied in constructive fraudulent transfer cases, the decisions reached in the chapter 11 cases of Heilig-Meyers Co. are particularly noteworthy because the bankruptcy court there, frustrated with the work presented to it by the dueling experts, ultimately chose to engage in its own valuation analysis, which was upheld by the reviewing district court on appeal.
In Heilig-Meyers, the corporate debtors sought to avoid, as either preferential or constructively fraudulent, certain transfers made to secured creditors in connection with a prepetition restructuring of their capital structure.  A prolonged solvency dispute ensued, with both sides presenting solvency analyses that, in the bankruptcy court’s words, were “absurdly disparate.”
The debtors’ expert ultimately concluded that, on the relevant date, the debtors were insolvent by more than $330 million. The creditors’ expert concluded, in contrast, that the debtors were solvent by approximately $218 million. The difference between the opposing parties’ asset valuations was over $500 million.
Despite this huge disparity, the bankruptcy court acknowledged that both experts employed valuation methodologies that were widely accepted in the financial community.  The debtors’ expert constructed a balance sheet based on the assumed sale proceeds of each marketable asset. He also conducted a market multiple analysis, but concluded that it could not be used to value the debtors because there was no reasonable prospect that they would have continued as a going concern.  The creditors’ expert primarily relied on a comparable company analysis, but also performed a discounted cash flow analysis that appraised the value of the debtors’ equity.  Because both experts used generally accepted valuation methodologies, the bankruptcy court concluded that it could not reject one report in favor of the other because of any difference in method.
Although it concluded the debtors used standard valuation methodologies, the bankruptcy court ultimately rejected the majority of the debtors’ solvency analysis, finding that the expert erred by failing to value the debtors as a going concern. Specifically, because the debtors’ expert relied on post-petition sales of the debtors’ assets and other events that occurred after the transfers in question, the court likened the report to a liquidation analysis and faulted the expert for engaging in hindsight bias.  In contrast, the court concluded that, because the creditors’ expert utilized the correct going concern analysis, it was the stronger of the two, although not without flaw.  Consequently, the bankruptcy court conducted its own balance sheet analysis, taking what it deemed best from each report, and rejecting all of the debtors’ valuations that contemplated liquidation or any other events that occurred subsequent to the transfer.  As a result, the bankruptcy court accepted most of the creditors’ valuations and was persuaded that the debtors were solvent on the date of the transfers.  Accordingly, the court held that the debtors failed to meet their burden of proof on the issue of insolvency and could not avoid the transfers.
The debtors then appealed the bankruptcy court’s decision, arguing that the bankruptcy court failed to use the correct values when valuing the debtors’ assets. Applying the clearly erroneous standard of review, the district court reviewed both parties’ solvency reports and the bankruptcy judge’s own balance sheet analysis, and ultimately agreed with the bankruptcy court’s decision to reject all of the debtors’ valuations that were based on liquidation values or otherwise tainted by hindsight bias.  Further, the court conducted a line-by-line review of the balance sheet the bankruptcy judge constructed, and concluded that it was not clearly erroneous because the judge’s analysis adhered to the framework of the balance sheet test.  Accordingly, the district court affirmed the bankruptcy court’s finding of solvency.
In many ways, the Heilig-Meyers decisions presents us with a microcosm of the universe of issues – both legal and factual – that are raised in context of a valuation dispute.  Further, they serve as a useful reference for those of us in the trenches – whether lawyer or expert – about how a proper understanding of the words “fair valuation” and “fair value” contained in section 101(32) of the Bankruptcy Code can frame an analysis of, and winning on, the solvency issue as a matter of fact.
We’ll be back to discuss more nuances of valuation as this series continues.