Establishing Corporate Insolvency: The Balance Sheet Insolvency Test

By Dr. Kubi Udofia

Cash flow and balance sheet insolvency tests are the two predominant means of determining insolvency. A company is cash flow or commercially insolvent if it is unable to pay its debts as they fall due. Balance sheet or technical insolvency occurs where the value of a company’s assets is less than the amount of its liabilities, taking into account both contingent and prospective liabilities. The term liabilities is broader than debts as it encompasses liquidated and unliquidated liabilities arising from contracts, tort, restitution etc. This article compares the two insolvency tests and introduces the English approach to the balance sheet insolvency test.

Commercial insolvency is the more prominent of the tests. It is also comparatively easier to establish. In restructuring, a creditor’s immediate concern is often the debtor’s ability to make payments as they mature as opposed to whether its assets are sufficient to meet its present and future liabilities. Despite its seeming obscurity, balance sheet insolvency test is commonly employed in commercial transactions as an event of default. This provides counterparties with early warning signs in long-term contracts where there are no avenues of making demands capable of triggering commercial insolvency.

In BNY Corporate Trustees Services Ltd v Eurosail-UK 2007-3BL Plc [2013] UKSC 28, the English Supreme Court stated that balance sheet insolvency test required a court to be satisfied that, on the balance of probabilities, a company has insufficient assets to meet its liabilities, taking into account prospective and contingent liabilities. This is easier said than done. It has been rightly observed that valuation of assets and liabilities is not an exact science but a matter of judgment as to the amount a willing buyer would pay in the market when dealing with a willing seller. The valuation process may understandably be laborious, detailed and complex. Courts may not be capable of effectively dealing with such intricacies.

The full article is available here.

Simple Insolvency Detection for Publicly Traded Firms

By J.B. Heaton (J.B. Heaton, P.C.)

Solvency plays important substantial roles in both bankruptcy and corporate law. In practice, however, balance-sheet solvency testing is fraught with difficulties. Mechanically, the balance-sheet solvency test asks if the market value of assets exceeds the face value of debt.  As for assets, direct market values of assets are rarely if ever available (closed-end funds may be an exception, but these are hardly run-of-the-mill businesses). Analytical valuation tools—including discounted cash flow analysis, comparable company multiples, and comparable transaction analysis—require considerable subjective judgment and can lead to large valuation errors. As for debt, much debt that is on the balance sheet does not trade in the market, and it is often impossible even to identify all the contingent liabilities like pensions, guarantees, insurance liabilities, and obligations to involuntary creditors like tort claimants, all of which should be valued appropriately and included in determining the total face value of debt.

In a new paper forthcoming in Business Lawyer, I develop a simple balance-sheet solvency test for publicly traded firms. I derive the test from an elementary algebraic relation among the inputs to the balance-sheet solvency calculation: The solvency test requires only the assumption that the market value of assets equals the sum of the market value of the firm’s debt plus the market value of the firm’s equity. The test requires that at least one class of the firm’s debt is traded, and that the equity is traded as well. The result is a generated upper bound on the total amount of debt the firm can have and still be solvent.

The virtue of the method—apart from its ease of implementation—is that it makes possible the detection of balance-sheet insolvent firms notwithstanding the possibility that not all of the firm’s liabilities—including hard-to-quantify contingent liabilities—can be identified. As a result, the method allows for the detection of balance-sheet insolvent firms that otherwise might escape detection. This may assist in a wide variety of situations where it is necessary to analyze solvency.

The full article is available here.

Disagreement and Capital Structure Complexity

By Kenneth Ayotte (University of California, Berkeley School of Law)

Complex capital structures are prevalent in many recent high-profile Chapter 11 bankruptcy cases.  One recent example is Toys ‘R’ Us, whose debt structure included dozens of subsidiary entities, with separate debt facilities against entities owning the intellectual property, the real estate, and international operations, among other asset groups.  Why do capital structures become fragmented and complex in this way, and what are the implications for bankruptcy law?

In my working paper, I suggest one reason why a firm’s owners may have the incentive to engineer fragmented capital structures, using the idea that investors may disagree about the values of the various assets that make up the firm.  Fragmenting the capital structure horizontally—that is, pledging different assets and asset groups to different creditor classes—allows the firm to sell asset-based claims that are targeted to the investors who value those assets most highly. This targeting is good for the firm’s owners, because it minimizes the firm’s overall cost of capital.

This complexity can become costly, however, when firms encounter financial distress.  The same disagreement-driven fragmentation that allows the company to borrow more cheaply up front can lead to costly valuation disputes in and around bankruptcy, since creditors place a higher valuation on their own collateral than do the other creditors.  This can lead to valuation disputes that are socially costly in terms of professional fees, delays, and lost opportunities.  An example of this is the Energy Future Holdings case.  Following it’s 2007 leveraged buyout, the capital structure was divided into two silos, with one silo of entities (called the “E” side) holding regulated power assets, and a separate silo of entities holding the non-regulated power assets (the “T” side), with separate creditor groups on each side.  The initial plan to avoid bankruptcy by converting E- and T-side debt into parent-level equity failed after more than a year of negotiations, as the two sides could not come to agreement about the relative value of the two sides.  The resulting bankruptcy took over four years to reach plan confirmation and generated over $500 million in professional fees, to the detriment of creditor recoveries.

The theory has several implications.  One is that disagreement about valuation can lead to inefficient liquidation of viable firms, as creditors may prefer to walk away with the collateral they value highly, rather than fight for that value in a reorganization where the other creditors (from their perspective) are clinging to inflated valuations of their own collateral.  These kinds of forces may have been at play in the Toys ‘R’ Us case.  The B-4 term lenders, including the hedge fund Solus Alternative Asset Management, believed they were better off monetizing their intellectual property collateral in a liquidation of Toys ‘R’ Us than backing a deal to keep existing stores open.  The recent cancellation of the auction of this collateral suggests that these lenders may have held optimistic beliefs than the marketplace about the value of these assets.

From an academic standpoint, the theory provides a new answer to a long-standing question in the literature: why do we need a corporate reorganization mechanism in the first place? Traditional answers to this question revolve around the need to solve illiquidity problems.  In the presence of disagreement, I suggest an alternative benefit.  A traditional Chapter 11 reorganization allows parties to walk away with securities backed by the assets they financed before bankruptcy, about which the creditors are likely to be more optimistic.  Thus, the creditors can continue “agreeing to disagree” about the values of their respective pieces, thus promoting settlement and avoiding socially costly valuation disputes.  This is not possible when the firm is sold as a going concern for cash, since cash has a commonly known value.

Finally, my model emphasizes that when capital structures are fragmented, bankruptcy costs can be driven by haggling and litigation over the value of the parties’ entitlements, even when the parties agree about what to do with the bankrupt firm.  This suggests that the time may be ripe for rethinking and improving the resolution of valuation disputes in bankruptcy.  In a related paper, published in University of Pennsylvania Law Review, Edward Morrison and I review valuation opinions in bankruptcy cases.

The full article is available here.

Consumer Response to Chapter 11 Bankruptcy: Negative Demand Spillover to Competitors

By O. Cem Ozturk (Georgia Institute of Technology – Scheller College of Business), Pradeep K. Chintagunta (University of Chicago), & Sriram Venkataraman (University of North Carolina at Chapel Hill – Kenan-Flagler Business School)

We empirically study the effect of Chrysler’s Chapter 11 bankruptcy filing on the quantity sold by its competitors in the U.S. auto industry. The demand for competitors could increase as they may benefit from the distress of the bankrupt firm (competitive effect). On the other hand, competitors could experience lower sales if the bankruptcy increases consumer uncertainty about their own viability (contagion effect). A challenge to measuring the impact of bankruptcies is the coincident decline in economic conditions stemming from the Great Recession and the potential effect of the “cash for clunkers” program. To identify the effect of the bankruptcy filing, we employ a regression-discontinuity-in-time design based on a temporal discontinuity in treatment (i.e., bankruptcy filing), along with an extensive set of control variables. Such a design is facilitated by a unique data set at the dealer-model-day level which allows us to compare changes in unit sales in close temporal vicinity of the filing. We find that unit sales for an average competitor reduce by 28% following Chrysler’s bankruptcy filing.

Our results suggest that this negative demand spillover effect is driven by a heightened consumer uncertainty about the viability of the bankrupt firm’s rivals. For example, we show that the sales of competitors’ vehicles that compete within the same segments as the bankrupt firm’s vehicles or that provide lower value for money are affected more negatively in response to the Chrysler filing. We also observe more web search activity for Chrysler’s competitors after the filing.

The full article can be found here.

How Much Value Was Destroyed by the Lehman Bankruptcy?

The Federal Reserve Bank of New York’s Liberty Street Economics Blog has run a series of five posts seeking to estimate the total value destroyed by the Lehman Brothers Holdings Inc.’s Chapter 11 and Lehman’s investment bank affiliate’s liquidation through separate Securities Investor Protection Act (SIPA) proceedings.

Erin Denison, Michael Fleming, and Asani Sarkar, of the Federal Reserve Bank of New York’s Research and Statistics Group, estimate the total value destruction for Lehman, its creditors, and stakeholders to be approximately between $46 billion to $63 billion (between 15 to 21 percent of Lehman’s pre-bankruptcy consolidated assets), excluding expenses from the SIPA proceedings (an additional $1.4 billion) and the costs of resolving Lehman’s foreign subsidiaries. These estimates also exclude boarder spillover effects on the economy caused by Lehman’s collapse.

Denison, Fleming, and Sarkar suggest the main drivers of value destruction include: professional fees and expenses ($5.9 billion for Chapter 11 proceedings with an additional $1.36 billion for SIPA proceedings); liquidity costs for creditors during the lengthy proceeding ($15 billion); and lost relationships between Lehman and its equity underwriting clients ($23 billion). They break down these estimates of the value destroyed through a series of four posts, analyzing the direct costs (expenses paid to third parties for services provided during bankruptcy) and the indirect costs (opportunity costs for the firm, its creditors, and its stakeholders).

The first post on Creditor Recovery in Lehman’s Bankruptcy can be found here. The second post on Lehman’s Bankruptcy Expenses can be found here.  The third post on Customer and Customer and Employee Losses in Lehman’s Bankruptcy can be found here.  The fourth post on Indirect Costs of Lehman’s Bankruptcy can be found here.  The final summary post can be found here.


 

For previous Roundtable posts on the valuation and resolution of Lehman, see Steven Lubben, “Lehman’s Derivative Portfolio”; Mark J. Roe, and Stephen D. Adams, “Restructuring Failed Financial Firms in Bankruptcy: Selling Lehman’s Derivatives Portfolio.”

(This post was authored by Ryan Rossner, J.D. ’19.)

Fifth Circuit Adopts Flexible Approach to Collateral Valuation in Cramdown Chapter 11 Cases

posted in: Cramdown and Priority, Valuation | 0

By Peter S. Saba (Jones Day).

In In re Houston Regional Sports Network, L.P., 886 F.3d 523 (5th Cir. 2018), the U.S. Court of Appeals for the Fifth Circuit held that bankruptcy courts have flexibility in selecting the date on which to value collateral, “so long as the bankruptcy court takes into account the purpose of the valuation and the proposed use or disposition of the collateral at issue.”  In so holding, the Fifth Circuit rejected the proposition that a bankruptcy court must value collateral as of either the bankruptcy petition date or the effective date of a cramdown chapter 11 plan.  However, because the bankruptcy court failed to consider the proposed use of the collateral in assigning it a value, the Fifth Circuit remanded the case below for additional findings.

In declining to establish a bright-line rule mandating the valuation date for a creditor’s collateral in cramdown chapter 11 cases, the Fifth Circuit’s ruling, informed by section 506(a), gives bankruptcy courts the flexibility to consider an appropriate valuation date based on the actual use or disposition of a creditor’s collateral and the purpose of the valuation.  The principal benefit of this approach is that it recognizes that any valuation in this context should consider developments in a chapter 11 case which may have an impact on value.  Even so, secured creditors should be aware that consideration of the proposed or actual use of collateral under a plan may in some cases mean that collateral may be assigned a lower value as of plan confirmation or effectiveness than as of the bankruptcy petition date.

The article is available here.

Junior Creditors Could Share In 363 Bankruptcy Sales

posted in: 363 Sale, Priority, Valuation | 0

By Charles Tabb and Tamar Dolcourt (Foley & Lardner LLP).

In July, the Seventh Circuit Court of Appeals issued a decision that appeared to upend the long-held understanding that an underwater secured creditor was entitled to all of the proceeds of a sale under Section 363 of the Bankruptcy Code. In our new article, we analyzed the decision in Illinois Department of Revenue v. Hanmi Bank in which the Seventh Circuit opened the door to a potential recovery for out-of-the-money junior creditors based on the theory that a free and clear sale under the Bankruptcy Code created a premium for the assets that the junior creditor may be entitled to share. Though Hanmi dealt explicitly with a state taxing authority and its particular rights under Illinois state law, there is nothing in the opinion which limits it to those facts or that type of creditor. Furthermore, even though the court ultimately valued the interest that the Illinois Department of Revenue was forced to give up through the free and clear sale at zero, that was simply a failure of proof in the particular case. We also consider the long-term ramifications of this opinion and its likely effect on future sales under Section 363, including the possibility of increased costs and delays of negotiating these sales with recalcitrant junior creditors.

The article may be found at Law 360:  the original publication.

Valuation Disputes in Corporate Bankruptcy

Kenneth Ayotte (U.C. Berkeley School of Law); Edward R. Morrison (Columbia Law School)

In bankruptcy, valuation drives disputes. Prior bankruptcy scholarship points to disagreements about valuation and judicial valuation error as key drivers of Chapter 11 outcomes. Avoiding valuation disputes and errors is also the underlying driver of most proposed reforms to Chapter 11.

This paper studies all reported bankruptcy court opinions filed between 1990 and mid-2017 that provide detail about a valuation dispute and methodologies employed. We have two goals. The first is to understand how parties and their expert witnesses justify opposing views, and how judges decide between them. The second is to provide practical guidance to judges.

We find sharper disagreement among experts regarding inputs to the discounted cash flow method (DCF) than regarding inputs to multiples-based methods. In nearly half of cases involving DCF, experts fight over the discount rate; in nearly three quarters, they fight over cash flow projections. By contrast, disagreement over inputs to multiples-based methods, such as the choice of comparable companies, occurs in less than a fifth of the cases. This pattern helps explain why many judges view DCF as far more complex and error-prone than multiples-based methods.

There are also surprisingly pervasive (and often self-serving) errors in expert testimony. This is particularly true when valuation experts apply DCF. The choice of discount rates is frequently unsupported by, and often at odds with, finance theory and evidence. We also find experts strategically weighting methods with values most favorable to their clients.

We propose simple strategies based in finance theory that judges can employ to reduce the scope for valuation disagreements in Chapter 11. For example, we argue that courts should reject the use of company-specific risk premia in discount rates and be highly skeptical whenever experts weight some valuation methods more than others in calculating “average” estimated values.

The full article is available here.

 

The Year in Bankruptcy: 2017

by Charles M. Oellermann and Mark G. Douglas (Jones Day).

In their annual chronicle of business bankruptcy, financial, economic, and related developments in the U.S., Charles M. Oellermann and Mark G. Douglas of Jones Day review the most significant events of 2017, including business bankruptcy filing statistics and industry trends; newsworthy developments regarding sovereign and commonwealth debt; the top 10 public-company bankruptcies of the year; notable private and cross-border bankruptcy cases; significant business bankruptcy and U.S. Supreme Court bankruptcy rulings; bankruptcy-related legislative and regulatory developments; noteworthy chapter 11 plan confirmations and exits from bankruptcy; and more.

The article is available here.

Selling Innovation in Bankruptcy

posted in: 363 Sale, Valuation | 0

By Song Ma (Yale School of Management), (Joy) Tianjiao Tong (Duke University, Fuqua School of Business), and Wei Wang (Queen’s School of Business).

The past decades have witnessed the emergence of patent sales in corporate bankruptcies. Yet we know little about the facts and rationales of these important economic transactions.

In this working paper, we assemble a comprehensive data set of US Chapter 11 filings, USPTO patent transaction documents, and court records on assets sales from the past three decades. We document three stylized facts on patent sales in bankruptcy. First, patent sales are pervasive — more than 40% of bankrupt firms sell at least one patent, and on average they sell 18% of their patent portfolios. Second, patent transactions occur immediately after bankruptcy filing — concentrating largely within the first two quarters after filing. Third, patents are frontloaded in general asset sales in bankruptcy — firms sell a disproportionately large quantity of patents in asset sales during the early period of reorganization.

Why do firms sell patents during bankruptcy? We design a set of empirical tests to study the economic decisions behind patent sales based on the two economic views on assets reallocation in bankruptcy, namely asset restructuring and financing through asset sales. Our results show that bankrupt firms reallocate patents that are more redeployable and trade in a more liquid market . We find no evidence that they sell underexploited or underperforming patents. This pattern of selling more liquid patents holds stronger in firms with financial distress, firms undergoing poor industry conditions, and firms lacking external financing. The combined evidence lends support to the view that firms sell innovation during bankruptcy for financing purposes rather than for asset restructuring. Additionally, we find that bankrupt firms try to retain the inventors of sold patents and continue to cite sold patents after their sale. The evidence overall suggests that a firm’s imminent financing needs interact with its intent to avoid bankruptcy costs in shaping a firm’s decision to sell patents in bankruptcy.

The full paper is available here.

 

The Roundtable will be off for the holidays. We’ll be back early after the New Year.

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