The Evolution Of Valuation In Bankruptcy
Seton Hall Law School; Harvard Law School – John M. Olin Center for Law and Economics
July 16, 2016
will be presented at 2016 National Conference of Bankruptcy Judges; Am. Bankr. L. J. (Forthcoming)
Financial analyses such as valuation, solvency and capital adequacy play a crucial role in bankruptcy. Over the course of the 20th century, methods of financial analysis in bankruptcy have shifted from earnings multiples to discounted cash flow (DCF) and recently to market-based approaches such as auctions, market pricing of equity and unsecured debt, and credit spreads. Each shift in bankruptcy court practice followed shifts in financial services industry practice and developments in academic finance. Bankruptcy courts shifted gradually, often several decades after the financial community. Newer methods encountered resistance and skepticism, and older methods continued to be used by courts in conjunction with newer methods for many years. The overall pattern reflects a movement toward greater financial and quantitative sophistication by bankruptcy courts and practitioners and seems to be driven by a desire for greater accuracy and objectivity.
The Evolution Of Valuation In Bankruptcy – Introduction
Financial analyses such as valuation, solvency and capital adequacy play a crucial role in bankruptcy. They are central to allowance of claims, adequate protection, avoidance actions such as fraudulent transfer and preference, rejection of collective bargaining agreements, plan confirmation, and 363 sales. Today, established methods of analysis accepted by most bankruptcy courts include discounted cash flow (DCF), comparable companies and comparable transactions. However, newer methods based on market prices for equity, debt, or options and derivatives are supplementing, and in some cases supplanting more established approaches.
In this time of transition between methods of financial analysis, it may be helpful to look back, tracing the evolution of methods of valuation in bankruptcy. Today’s “established” methods–DCF and comparables–were also once new, less than fully understood, and met with suspicion by the courts. Understanding how these methods went from novel and controversial to established and accepted can help shed light on what we might expect to see during the anticipated transition from DCF and comparables toward more fully market-based approaches. If history is any guide, lags between industry use, academic acceptance, and adoption with in the legal system could be substantial.
The mathematics underlying net present value were published in the late 1500s. Early versions of DCF were used in coal mining and railroads as early as the 1800s, but DCF was not widely discussed in the finance literature until the mid 20th century. The Supreme Court discussed and embraced an approach to valuation resembling DCF as early as the 1940s. But lower courts interpreted Consolidated Rock by using earnings multiples or “capitalization rates”–an approach similar to comparable companies analysis.
Figure 1 below shows growing awareness of discounted cash flow analysis from the 1960s through the 1980s and then levelling off. Awareness of capitalization rates, an earlier approach to valuation similar to comparables or multiples, spread from the early 1900s until around 1980, and started to drop off in the 1990s. More recently, from the 1980s through the mid 2000s, awareness of credit spreads and related credit derivatives(starting in the 1990s) has increased.
DCF was rarely used for bankruptcy valuation until the mid 1980s and did not become the leading method of valuation analysis until the 1990s. Growth in the use of DCF in bankruptcy is shown in Figure 2 below. Even with the rise of DCF, litigants continued to present and courts continued to consider other methods in conjunction with DCF. Other methods declined gradually as DCF ascended, as shown in Figure 3 below.
Established methods of financial analysis such as DCF, though quantitative and grounded in assumptions of efficient markets, largely depend on subjective judgments. Multiples analysis embraces market value as a reality check on DCF analysis. However, rather than using market prices of the debtor, this approach uses market prices of similar firms. The problem with the multiples approach is that no two companies are ever perfectly comparable. There is ample room for differences of opinion about the appropriate group of comparable companies.
New market-based methods can be more objective, less susceptible to hindsight bias, harder to manipulate, and less expensive to implement. However, courts may not fully understand how market information should be interpreted. In addition, such information could be of limited value if critical contemporaneously known information was not available to investors. In the context of plan confirmation and alternatives to chapter 11 reorganization, the rise of 363 sales is driven in part by preferences for market valuation through a judicially supervised auction process rather than purely judicial valuations. The Supreme Court has also favored the use of an auction process within a plan of reorganization to help price equity of the reorganized firm and avoid absolute priority rule violations.
In other contexts, where judicial valuations are necessary–such as adjudication of avoidance actions–Bankruptcy courts have considered equity prices, unsecured bond prices relative to par, and the ability to raise equity or debt (especially unsecured debt) as evidence that is relevant to valuation and solvency and adequate capitalization analysis. When important information was not known to investors, courts have effectively back-dated market valuations to the date when such information was publicly disclosed.
The first judicial use of market prices as a substitute for, rather than as a supplement to, expert opinion in fraudulent transfer cases was by the Delaware District Court in VFB LLC v. Campbell Soup Co. in 2005, affirmed by the Third Circuit in 2007. The propriety of using financial market prices for fraudulent transfer analysis was further reinforced by Judge Peck of the U.S. Bankruptcy Court for the Southern District of New York in In re Iridium Operating LLC, 373 B.R. 283 (Bankr. S.D.N.Y. 2007). Recently, the court in Tronox Inc. v. Kerr McGee Corp. (In re Tronox Inc.), 503 B.R. 239 (Bankr. S.D.N.Y. 2013), took a nuanced and skeptical approach to certain market-based defenses, but distinguished VFB.
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