Valuation Outside the Box: Southern District of Texas Affirms the Bankruptcy Court’s Discretion to Select Appropriate Valuation Methodologies

In a recent decision, the United States District Court for the Southern District of Texas affirmed the bankruptcy court’s rejection of the cost methodology to value the right to use common amenities in a condominium development and, in the process, bolstered the notion that bankruptcy courts have discretion in determining what valuation methodologies are appropriate under the facts and circumstances of a particular case.  
Diamond Beach
Diamond Beach is a luxury condominium project in Galveston, Texas.  The International Bank of Commerce financed the land and construction costs for the project.  Randall J. Davis, the project’s principal owner, guaranteed a portion of the bank’s debt.  As originally conceived, the project would be built in two phases, which would share a “lavish array” of recreational facilities (for example, the largest resort pool in Texas) referred to as the “common amenities.”  Importantly, the common amenities were not commonly owned:  Phase I owned the common amenities, while Phase II merely possessed a right to use them.
In September 2008, Hurricane Ike caused significant damage in Galveston, and the real estate and mortgage markets in Galveston suffered as a result.  Diamond Beach found it difficult in that environment to sell units in the newly-constructed Phase I.  Eventually, Diamond Beach was unable to repay the bank, and ultimately it filed for bankruptcy in 2012.  Construction of Phase II never began.
Bankruptcy Court Settlement & Valuation
During the chapter 11 case, Diamond Beach negotiated a settlement with the bank, under which the bank’s prepetition claim was allowed in the amount of $28,193,759.32.  The settlement further provided that the bankruptcy court would determine the value of the property and that the bank’s deficiency claim (i.e., the difference between the value fixed by the bankruptcy court and the agreed-to prepetition claim) would be an allowed unsecured claim for which Mr. Davis would be liable under his personal guarantees.  As a result, the higher the value established for Diamond Beach, the less Mr. Davis would owe and vice versa.
To determine the value of the property, the bankruptcy court had to value (i) the Phase I units that had not yet sold at the time of valuation and (ii) the undeveloped Phase II, including the value of the land on which Phase II would have been built and the value of the right to use the common amenities which the owner of the Phase II land would possess.  Mr. Davis and the bank agreed on the value established by the bankruptcy court with respect to the unsold Phase I condominium units.  They also agreed on the value established by the bankruptcy court with respect to the land on which Phase II would have been built.  The parties were at odds, however, over the value of the Phase II owners’ right to use the common amenities.
In reaching its conclusions on the value of Phase II, the bankruptcy court rejected the replacement cost approach that had been used by the parties’ valuation experts because it determined that approach was inappropriate under the circumstances.  Rather, the bankruptcy court applied what it called a “modified income approach,” in which it valued the land and the amenities of the not-yet-built Phase II by (i) determining the likely sales price of the to-be-constructed units in Phase II, (ii) determining the expected cost of building, financing, and marketing Phase II without the amenities package, and (iii) subtracting the cost in (ii) from the sales price in (i), resulting in the combined value of the land and amenities.
Mr. Davis appealed the bankruptcy court’s valuation of Phase II, arguing, among other things, that the Bankruptcy Court had violated Texas law insofar as Texas law (i) permits only three methodologies to value property (the cost method, the comparable sales method, and the income method) and required the use of the cost method under the present circumstances, and (ii) bars the use of the subdivision development method.  Mr. Davis also argued that the bankruptcy court wrongly rejected the cost approach because that was the valuation methodology employed by the experts at trial.
Neither Texas nor Federal Law Required Use of the Cost Approach
The district court found that the bankruptcy court’s choice of valuation methodology was correct under either Texas or federal law and, therefore, passed on the question of which law should control the question.  With respect to Texas law, the district court found that an expert’s appraisal is not restricted to the three approaches cited by Mr. Davis because the Supreme Court of Texas, in the controlling case on this subject, left the door open for valuation methods other than the “three traditional approaches.”  Moreover, the district court rejected Mr. Davis’ argument that precedent required use of the cost approach in this case because, under the circumstances, it would not produce the amount a willing buyer would actually pay a willing seller.  In addition, the district court found that Texas law did not categorically proscribe the “subdivision development method” (described in the controlling Texas case as “estimat[ing] the land’s gross value as if it were subdivided for residential development, then discount[ing] this value for the estimated costs of development”) and, perhaps more importantly, that the bankruptcy court did not even use this method to value Phase II.
Further, the district court rejected arguments in Mr. Davis’ reply papers that federal law contains the same requirements as Texas law, stating that “[a]s it does with [Texas law], Appellant both misreads the three federal cases it cites and misapplies them to the case at bar.”
Bankruptcy Courts Have Discretion to Select Appropriate Valuation Methodologies
The district court affirmed the bankruptcy court’s decision to reject the use of the cost method, even though the four experts testifying at trial as to the value of Phase II all used a form of the cost approach.  The district court noted that, in the Fifth Circuit, bankruptcy courts have “broad leeway” in selecting a valuation methodology and made clear that a bankruptcy court is not bound by an expert’s choice of method but, instead, should choose the appropriate methodology based on the purpose of the valuation.  In this case, the bankruptcy court was justified in rejecting the cost approach “to determine how much a buyer would pay for Phase II’s land and the right to use, but not own, an elaborate set of entertainment facilities” because (i) the cost approach is an inappropriate methodology to value interests in less than complete ownership of property, (ii) “it would be absurd for a Phase II buyer to pay the cost to reproduce amenities that . . . are already there and . . . it would not even own,” and (iii) the asset was in a non-competitive market and “[i]n the absence of production, cost does not equate with value.”
In any context, valuation is part art, part science.  Corporate idiosyncrasies and legal nuances associated with valuing a company that is in distress or restructuring only heightens the need to provide bankruptcy professionals and courts with flexibility in evaluating and selecting appropriate methodologies.  The decision in Diamond Beach furthers this goal.
Gabriel A. Morgan is an Associate at Weil Gotshal & Manges, LLP in New York.