The Future of Solvency and Adequate Capitalization Analysis

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By Michael Simkovic, Seton Hall University School of Law

Valuation, solvency, and adequate capitalization analyses play a crucial role in corporate reorganization. Courts and bankruptcy professionals have often complained about the expense, delay, subjectivity, and unpredictability inherent in traditional approaches to valuation.

However, newer methods based on market prices for equity, debt, or options and derivatives are supplementing, and in some cases supplanting more established approaches. One proposal is that instead of looking to bond or equity prices, courts should look to credit spreads between corporate and treasury bonds. Because investors could eliminate almost all credit risk by selling a corporate bond and purchasing a treasury bond, the difference in yield between a corporate bond and a treasury bond must compensate investors for the additional risks of non-payment of corporate bonds.

Credit spreads offer a clear indicator of market actors’ expectations about the likelihood of default and the likely losses given default. With a single assumption about recovery rates—which can be grounded in historic data or sometimes backed out from contemporaneous market data—one can reconstruct a daily market estimate of a debtors’ probability of default.

Credit-spread based approaches are faster, less expensive, and more objective than current approaches. An example is provided below using data for Caesar’s Entertainment Operating Company:

 

Figure 1. Caesars risk-neutral market-implied probability of default from CDS and bond spreads (preliminary analysis).

 

The traditional financial analysis performed by the Examiner in Caesars required months of work and only looked at a few specific dates. The preliminary market-based analysis above was completed by a law professor in a few days, and indicates capital adequacy on a daily basis.

If market-based approaches to solvency analysis could be used with confidence in many large corporate bankruptcy cases, the collective savings to debtors’ estates over a decade could easily be in the tens of millions of dollars.

 

Earnings Management and Firm Value in Chapter 11

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Timothy C.G. Fisher, University of Sydney

Ilanit Gavious, Ben-Gurion University of the Negev

Jocelyn Martel, ESSEC Business School & THEMA

 

Earnings management occurs when managers deliberately manipulate the company’s earnings either to mislead stakeholders about the underlying economic performance of the company or to influence contractual outcomes. We study the impact of earnings management prior to bankruptcy filing on the passage of firms through Chapter 11.

Using the UCLA-LoPucki Bankruptcy Research Database, we merge a sample of 261 U.S. public firms that filed for Chapter 11 between 1995 and 2009 with firm-level financial information. We construct three measures of earnings management, two of which are accounting (accrual) manipulation measures (discretionary accruals and abnormal working capital accruals) and one a real activities manipulation measure (abnormal operating cash flows).

We find that upward earnings management (more positive or less negative abnormal accruals/operating cash flows) prior to filing significantly reduces the likelihood of confirmation, while downward earnings management significantly increases the likelihood of confirmation. We also find that the likelihood of emerging from Chapter 11 is significantly lower with upward earnings management. The impacts on confirmation and emergence are primarily due to the influence of earnings management values that are one- and two-standard deviations above or below the mean. Thus, our findings are consistent with creditors rewarding unduly conservative earnings reports while punishing overly optimistic earnings reports. We also find that auditor choice (Big 4 vs. non-Big 4) directly affects the probability of confirmation and of emergence from bankruptcy.

Overall, we find that upward management of earnings destroys economic value by making the survival of the firm less likely, an effect that has not previously been uncovered in the literature.

To access the full article, please click here.

Genco: Dry Bulk Shipping Valuations No Longer Anchored to Discounted Cash Flow Method

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By Gabriel A. Morgan, Weil Gotshal LLP

PITCH_Morgan_Gabriel_22091Discounted cash flow analysis is a mainstay among the valuation methodologies used by restructuring professionals and bankruptcy courts to determine the enterprise value of a distressed business. Despite its prevalence, the United States Bankruptcy Court for the Southern District of New York recently concluded that the DCF method was inappropriate for the valuation of dry bulk shipping companies. In In re Genco Shipping & Trading Limited, Case No. 14-11108 (Bankr. S.D.N.Y. July  2, 2014), the bankruptcy court explained that the DCF method is of limited use when projections of future cash flows are unreliable or difficult to ascertain.  The bankruptcy court then found that accurate cash flow projections did not exist for Genco because dry bulk shipping rates are difficult to forecast due to the volatile nature of the dry bulk shipping market.  Interestingly, the bankruptcy court concluded not just that accurate projections were unobtainable in the case of Genco, specifically, but also for dry bulk shippers, generally.  The bankruptcy court observed that the DCF method is inappropriate for the dry bulk shipping market because it is volatile and highly fragmented, has low barriers to entry, and little differentiation exists among competitors, causing charter rates to fluctuate with supply and demand and making revenues unpredictable.  Although the bankruptcy court merely applied existing law to the facts of the case, the decision in Genco could serve as precedent for the valuation of companies in other segments of the shipping industry, and other industries, that experience significant volatility in rates.

The full discussion can be found here.

Valuation Methodologies: A Judge’s View

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Author: the Hon. Christopher S. Sontchi

There are a variety of methodologies to determine the value of assets that are routinely presented to bankruptcy courts: (i) asset-based valuation, (ii) discounted cash flow or “DCF” valuation, and (iii) relative valuation approaches, which include the “comparable company analysis” and the “comparable transaction analysis.”

This article explains in layman’s terms each of the methodologies and how they are used to reach a conclusion as to value.  An asset based valuation generally calculates the liquidation value of individual assets and aggregates them to arrive at a firm value.  DCF valuation calculates the value of any asset from the present value of expected future cash flows from it, which, in turn, rests on the proposition that a dollar today is worth more than a dollar tomorrow.  Relative valuation involves the pricing of comparable assets, standardized using a common variable such as earnings, cash flows, book value, or revenues.  The conclusion rests on the selection of the valuation metric, e.g., EBITDA, and the similarity of the companies or transactions used.  The conclusions from each of the methodologies are generally blended to arrive at a conclusion of value.

The article closes by noting that bankruptcy judges have become familiar and comfortable with the DCF, comparable companies and comparable transactions methodologies, which are often referred to as the “standard” methodologies.  Departures from the standard methodologies or how they are calculated must be explained to the judge.

This article was published in the American Bankruptcy Institute Law Review (20 Am. Bankr. Inst. L. Rev. 1 (2012)) and is available online here.

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