Bankruptcy

The following issues in a bankruptcy proceeding summarize where the assistance of a valuation expert is needed.

Adequate Protection
Claims Determination
Asset Recovery (including preferences, fraudulent transfers, and reclamation)
Plan Confirmation
Liquidation Values
Intangible Assets
Fair Value

Adequate Protection

In situations where a creditor’s security interest is in property that is endangered, depreciating, or being dissipated by the debtor’s actions, the creditor may move the court for adequate protection. When a creditor seeks adequate protection, he or she is asking the court to ensure that the status quo will be maintained throughout the duration of the automatic stay (the “stay”). The court has broad discretion in the method it chooses to remedy adequate protection problems.

The legislative history indicates the process in which Congress intended to resolve adequate protection problems. First, the trustee or debtor-in-possession should propose a method for providing adequate protection. Then the creditor can accept, object, or negotiate an alternative solution. If the parties cannot reach an agreement, the court will step in to resolve the dispute.

Although a creditor may enter an adequate protection motion with the desire to continue a foreclosure action or stop the debtor from granting an additional lien on property in which the creditor holds a security interest, other remedies may be used. The court may require the debtor-in-possession to make cash payments to a creditor in situations where the value of the collateral is decreasing or where the amount of any security cushion is eroding as interest accrues. The court may also choose to grant relief from the stay in order to allow the creditor to seize assets in which the creditor holds a security interest. The court must balance the danger to the interests of the creditor against the necessity of the property to the debtor in the reorganization.

Claims Determination

Valuation issues need to be addressed in the determination of several types of claims. Among them are secured, recourse, and election to have all of the claims considered secured.

Secured Claims

Under section 506 of the Bankruptcy Code, the bankruptcy court may hold a hearing to determine the amount of the claim that is secured and the amount that is unsecured for under-secured claims. A secured claim is allowed for the value of the collateral, and an unsecured claim for the amount of the claim in excess of the value of the collateral. The unsecured part of the claim may be included in the same class as other unsecured claims or in certain situations placed in a separate class. Often, the creditor and the debtor will agree on how the claim is divided between the part that is secured and the part that is unsecured without a hearing. Notice of the agreement will be filed with the court, and unless there are objections by parties in interest, the court will normally allow the claim as filed.

Nonrecourse Considered Recourse

Section 1111(b) allows a secured claim to be treated as a claim with recourse against the debtor in chapter 11 proceedings (that is, where the debtor is liable for any deficiency between the value of the collateral and the balance due on the debt) whether or not the claim is nonrecourse by agreement or applicable law. This preferred status terminates if the property securing the loan is sold under Section 363, is to be sold under the terms of the plan, or if the class of which the secured claim is a part elects application of Section 1111(b)(2).

Asset Recovery

Action may be taken by the trustee or debtor-in-possession to recover assets. Among the sources of asset recovery are preferences, fraudulent transfers, and requests for reclamation.

Preferences (Section 547)

The provisions of section 547 of the Bankruptcy Code grant the debtor-in-possession broad powers to recover transfers made immediately prior to the filing of the petition. There are five elements that must be met for a transfer to be characterized as a voidable preference:

The transfer must be made for the benefit of a creditor.
The transfer must be made for, or on account of, an antecedent debt owed by the debtor.
The transfer must be made while the debtor is insolvent. Insolvency is presumed if the transfer is made within 90 days prior to bankruptcy.
The transfer must have been made within 90 days prior to the filing of the petition. In the case of insiders, the time period is extended to one year.
The transfer enables the creditor to receive more than it would receive in a liquidation or in a transfer made pursuant to an exception.

The time period to recover a preference from an insider is from 91 days to one year. Effective for bankruptcy petitions filed after October 22, 1994, the Bankruptcy Reform Act of 1994 amended Section 547 of the Bankruptcy Code to overrule In re Deprizio, 874 F.2d 1186 (7th Cir. 1989). Under Deprizio, the trustee or debtor-in-possession was able to recover, as preferences, payments made to non-insiders if such payment benefited an insider during the period between 90 days and one year prior to bankruptcy. Thus, if the debtor made a payment to a bank on a loan personally guaranteed within 90 days and one year prior to bankruptcy, the payment could be recovered by the trustee or debtor-in-possession. The Bankruptcy Reform Act of 1994 provides that payments made to non-insiders between 91 days and one year prior to bankruptcy are not subject to recovery action under Section 547 of the Bankruptcy Code.

Under Section 547(g), the debtor has the burden of proof to show that a transfer should be avoided as a preference. The effect of finding that a transfer is an avoidable preference is to void the entire transaction, not just the excess over what would be received in a liquidation. In general, any payment made to an unsecured creditor who would not receive 100 percent on liquidation would be considered a preference. Payments to fully secured creditors cannot be preferences, since by definition, the secured creditor would receive full payment on liquidation.

Section 547(f) provides that the debtor is presumed to be insolvent within the 90 days prior to the date the petition is filed. This presumption does not apply in the case of transfers to insiders between 91 days and one year prior to the filing of the petition. This presumption requires the adverse party to come forth with some evidence to prove the presumption. The burden of proof, however, remains with the party in whose favor the presumption exists. Once the presumption is rebutted, the insolvency at the time of payment must be proved.

Fraudulent Transfers (Sections 548 and 544)

Fraudulent conveyances may be attacked under the Bankruptcy Code or under state law according to Section 544(b) of the Bankruptcy Code. Section 548 of the Bankruptcy Code allows transfers within one year prior to filing of a petition to be avoided.

Action under Sections 548 and 544 must be brought within two years after the order for relief, or if a trustee is appointed in the second year, within one year after the trustee is appointed.

Bankruptcy Code

There are two separate grounds for finding a fraudulent transfer under Section 548. The provisions found in Section 548 act to restrain the debtor from entering into transactions which defraud the creditors. For a transfer to come under this section, it must have occurred within one year prior to the date the petition was filed.

First, if the debtor entered into the transaction with the actual intent to hinder, delay, or defraud a creditor, the transfer may be avoided. Those who became creditors before the fraudulent transfer and those who became creditors after the fraudulent transfer may utilize this section. All that is relevant is the intent of the debtor; thus, it is unnecessary to determine the solvency or insolvency of the debtor.

The second section where valuation is important applies to transfers where the debtor conveys property or an interest in property for less than equivalent value and transfers where the debtor incurred an obligation for less than equivalent value. There is no need to show that the debtor intended to defraud the creditors. The transaction must have occurred when the debtor:

Was insolvent, or completion of the transfer must have caused the debtor to become insolvent,
Was engaged in a business or transaction, or was about to be engaged in a business or transaction, and was left with an unreasonably small capital, or
Intended to incur debts beyond its ability to pay as they matured.

Reclamation (Section 546)

Under Uniform Commercial Code (UCC) 3-503(2)(a) and Bankruptcy Code Section 546©, a seller can require return of goods only if requested within 10 days of a transfer if the seller discovers the buyer is insolvent. A seller who transferred goods to the debtor in the ordinary course of business may reclaim the goods, if the seller demands reclamation, within 20 days after the debtor received the goods, provided the goods were delivered within 10 days before the petition was filed. The court may only deny the seller’s reclamation rights if it grants the seller either administrative priority or a lien. Courts generally construe the 10-day requirement literally and do not allow extensions or exceptions.

Plan Confirmation

Valuation services are often needed in several parts of the process of developing a plan of reorganization. Often it is necessary to determine the value of the surviving business before a plan of reorganization can be developed. While this valuation is not required by the Bankruptcy Code, it is necessary for effective negotiations of a plan. Generally, it is much easier to negotiate a plan if all of the interested parties agree on the value of the business. Additionally, confirmation standards provided in Section 1129 of the Bankruptcy Code may require a valuation of the business as described below.

Feasibility

Feasibility establishes the standard that confirmation of the plan is not likely to be followed by liquidation or the need for further financial reorganization, unless such liquidation or reorganization is provided for in the plan. This requirement means that the court must ascertain that the debtor has a reasonable chance of surviving once the plan is confirmed and the debtor is out from under the protection of the court. A well prepared forecast of future operations based on reasonable assumptions, taking into consideration the changes expected as a result of the confirmation of the plan, is an example of the kind of information that can be very helpful to the court in reaching a decision on this requirement.

Cram Down

Subsection (b) of Section 1129 allows the court under certain conditions to confirm a plan even though an impaired class has not accepted the plan. The plan must not discriminate unfairly, and must be fair and equitable, with respect to each class of claims or interest impaired under the plan that has not accepted it. The Code states conditions for secured claims, unsecured claims, and stockholder interests that would be included in the “fair and equitable” requirement. It should be noted that since the word “includes” is used, the meaning of fair and equitable is not restricted to these conditions.

Secured Creditors’ Test

According to Section 11296 of the Bankruptcy Code, the plan must provide for at least one of the following to be fair and equitable:

The holders of such claims must retain the lien securing such claims, whether the property subject to such lien is retained by the debtor or transferred to another entity, to the extent of the allowed amount of such claims (see Section 1124). In addition, each holder of a claim of such class must receive on account of such claim, deferred cash payments totaling at least the allowed amount of such claim, of a value, as of the effective date of the plan, of at least the value of such holder’s interest in the estate’s interest in such property,
For the sale, subject to Section 363(k), of any property that is subject to the lien securing such claims, free and clear of such lien, with such lien to attach to the proceeds of such sale, and the treatment of such lien on proceeds under clause (1) or (3) of this subparagraph, or
For the realization by such holders of the indubitable equivalent of such claims.

Unsecured Creditors’ Test

For holders of unsecured claims, the Bankruptcy Code provides that one of the two following requirements must be satisfied for each class that is impaired and does not accept the plan:

The plan provides that each holder of a claim of such class receive or retain on account of such claim property of a value, as of the effective date of the plan, equal to the allowed amount of such claim, or
The holder of any claim or interest that is junior to the claims of such class will not receive a retain on account of such junior claim or interest to any property according to Section 1129(b)(2)©.

Members of the class must, if they have not accepted the plan, receive or retain property that has a present value equal to the allowed amount of the claim. Alternatively, the plan can contain any provision for a distribution of less than full present value as long as no junior claim or interest will participate in the plan. Implicit in the concept of fairness is that senior classes will not receive more than 100 percent of their claims and any equal class will not receive preferential treatment.

Stockholders’ Interest Test

The test for equity interests is very similar to the test for unsecured claims. Again, one of two standards must be satisfied for each class that is impaired and does not accept the plan:

The plan provides that each holder of an interest of such class receive, or retain on account of such interest, property of a value, as of the effective date of the plan, equal to the greatest of the allowed amount of any fixed liquidation preference to which such holder is entitled, any fixed redemption price to which such holder is entitled, or the value of such interest, or
The holder of any interest that is junior to the interests of such class will not receive or retain under the plan on account of such junior interest any property according to Section 1129(b)(2)©.

One major provision in the first standard is that the equity interest must receive the greater of liquidation preference, fixed redemption price, or the value of its equity. Thus, a corporation could not file a chapter 11 petition just for the purpose of taking advantage of the low liquidation value of preferred stock.

New Value

An issue that may arise under the cram down rules deals with the extent to which cram down might apply if the shareholders retain an interest due to the contribution of new capital and retain no interest due to their prior ownership interest in the corporation. The Supreme Court in 203 North LaSalle, 526 U.S. 434 (1999), held that for such a condition to exist, the bankruptcy court should consider if one of the following conditions existed:

The exclusivity period must be ended before confirmation providing an opportunity for other plans to be filed, or
The bankruptcy court must provide an opportunity for other bids for the equity to be made for the equity interest.

Based on the decision by the Supreme Court, it appears that if one of the above conditions is satisfied, then, for example, a class of unsecured creditors that voted against confirmation of the plan would be crammed down.

Liquidation Values

It is necessary for the creditors or stockholders who do not vote for the plan to receive as much as they would if the business were liquidated under chapter 7. The requirement as set forth in Section 1129(a)(7) of the Bankruptcy Code is referred to as “best interest of creditors test.” The first part of this requirement is that each holder of a claim or interest in each class must accept the plan or will receive, as of the effective date of the plan, a value that is not less than the amount the holder would receive in a Chapter 7 liquidation. Note that the first alternative is that each holder must accept the plan. Thus, if any holder does not vote or votes against acceptance, it is necessary for the liquidation values to be ascertained. This requirement, in fact, makes it necessary for the court to have some understanding of the liquidation value of the business in practically all Chapter 11 cases, since there will almost always be some creditors who do not vote. The extent to which the liquidation values will have to be applied to individual classes other than those of a large number of unsecured claims will depend on the manner in which the claims are divided into classes and whether there are any secured classes with a large number of claims.

Intangible Assets

There is little doubt that much of the value found in today’s companies is derived from intangible assets. According to valuation authors Gordon Smith and Russell Parr, “The most important assets possessed by successful companies are intangible, primarily represented by intellectual property. It is intellectual property that establishes markets, dominates industries, assures national security, captures the loyalty of customers, and allows the generation of superior profits.” With increasing frequency, business valuation practitioners are encountering intangible asset issues, and the bankruptcy arena is no exception. This section provides a brief overview of some of the basics associated with the valuation of intangible assets and is intended to provide a point of reference for the case study examples appearing in this Practice Aid. A more detailed analysis regarding the valuation of intangible assets can be found in the AICPA Consulting Services Practice Aid 99-2, Valuing Intellectual Property and Calculating Infringement Damages.

Definition

For valuation purposes, assets basically fall into three general categories: monetary, tangible, and intangible. Examples of monetary assets include working capital items, such as cash and equivalents, accounts receivable, and inventory. Tangible assets are generally comprised of fixed capital assets. Therefore, intangible assets are those assets that are not considered monetary or tangible.

Like tangible assets, intangible assets can be real (derive their value from land) or personal (not related to land). Real estate differs from real property. Real estate is associated with the tangible assets, such as land, improvements, and buildings; whereas real property represents the legal rights associated with ownership of the tangible real estate. Because all legal rights are intangible, real property is intangible. Examples of real property ownership rights include the rights to use, sell, lease, or give away the real estate. Examples of intangible real property include leases, air rights, water rights, development rights, and easements.

When most people use the term intangible assets, they mean intangible personal property. Intangible personal property assets do not possess physical substance; therefore, their value isn’t dependent on physical attributes. Intangible assets and intellectual property can be further differentiated by those that are created by the business from those that exist under protection of law. Intangible assets are often created by a business in the course of conducting its basic operations. However, a customer list or assembled workforce is commonly found in most businesses. Because of their special status, intellectual properties enjoy special legal protection and are usually registered under specific federal and state statutes. Common examples of intellectual property include patents, copyrights, trademarks, and trade secrets.

Intangible Assets Are Frequently Overlooked

Although important, intangible assets are frequently overlooked, usually because they do not appear on a company’s balance sheet. Further, when they do appear, they are carried at an amortized cost that is usually very different from their fair market value. Therefore, before the valuation process can begin, it is necessary to identify all of a company’s assets. In order to do this properly, it is usually necessary to look beyond GAAP financial statements and obtain a thorough understanding of the business’ operations. Essentially, this process is similar to the initial analysis conducted in business valuation. For example, determining what competitive advantages the company enjoys may lead to the realization that a company’s trade secrets or supplier contracts provide significant cost savings in comparison to the competition, which in turn may lead to intangible assets to be valued.

It may also help to speak with nonfinancial managers, such as engineers, marketers, customer service representatives, and human resources personnel. Often, this process brings to light intangible assets that the Company itself did not realize existed. It can also be helpful to think about intangible assets in terms of income generation ability. For example, because customer lists are routinely rented or licensed, the customer list of a company in liquidation may have more value to a licensee than to the company that originated it.

Valuation of Intangible Assets Is Complex

The valuation of intangible assets and intellectual property is a complex topic that is beyond the scope of this Practice Aid. This is further complicated by the fact that some intangible assets cannot function, except as part of a going-concern business enterprise, while others can be bought, sold, and licensed as independent properties. Practitioners lacking experience in this difficult area are encouraged to consider using the work of a specialist with specialized knowledge, training, and experience in intangible asset valuation. Readers may also consult the reference materials cited throughout this section for more information and guidance.

Intangible Asset Valuations in Bankruptcy

The following are examples of the valuation of intangible assets in bankruptcy situations:

Allocation of reorganization value to a company’s net assets.
The purchase or sale of individual intangible assets (such as customer lists and patents).
The quantification of a secured creditor’s collateral position.
Valuation of intangible assets under Internal Revenue Code (IRC) Section 108(b) - cancellation of indebtedness income (income exclusion related to insolvent companies).
The need to enter into a licensing arrangement involving intellectual property.
The need to value certain intangible assets in order to calculate the value of other intangible assets under a residual allocation method.

Premise

Before the intangible assets in question can be valued, the valuator must make sure the adopted premise is appropriate under the circumstances. It is important to understand that the appropriate premise for valuing individual assets may differ from the one used to value the overall company. For example, under an orderly liquidation premise, an assembled workforce or goodwill is not usually valued. However, if the company’s patents, customer list, and other intellectual property have value (for example, if they can be sold separately), they should be valued. The going-concern premise may be appropriate for valuing these assets, especially if the company’s orderly liquidation period allows them to be exposed to their primary or secondary marketplace for a period of time sufficient to find a buyer willing to pay for the going concern income producing ability of these assets.

Valuation Approaches

Usually, all three general approaches to value - market, income, and asset-cost (see previous discussion in Section 7, “Valuation Approaches and Methods”) should be considered in valuing a company’s intangible assets. Of course, for each intangible asset, one or more of these approaches and their underlying methods will be more relevant than the others. However, all three approaches should be considered because each may result in a preliminary indication of the asset’s value. It is later in the valuation synthesis and conclusion process, that the valuator reconciles the different approaches and methods used, which result in the final conclusion of value about the subject asset.

Income Approach

This approach is based on the present value of the anticipated future economic benefit stream related to the ownership, use, or forbearance of the intangible asset. The income approach is generally adaptable to most categories or types of intangible assets and it is arguably the most frequently used approach in the valuation of intangible assets, and related analyses.

Incremental Revenue and Cost Reduction

Economic income attributable to intangible assets generally occurs in two ways: incremental revenue and cost reduction. Either is equally acceptable as a basis for valuing intangible assets. A description of each follows:

Incremental revenue. This often occurs when the existence of intangible assets allows the asset owner to sell products for a higher selling price or to sell more units than would otherwise be possible. The presence of these assets may also allow the owner to introduce new products or develop new markets not previously possible.
Cost reductions. These may occur when certain intangible assets allow the asset owner (or renter or licensor) to incur lower costs than would otherwise be possible. Examples include: lower materials or scrap costs, avoided start-up or development costs, and lower data processing costs.

Income Caveats

The following caveats should be kept in mind when using the income approach to value intangible assets.

The remaining economic life of the intangible asset must be carefully considered in analyzing the future income generating benefits associated with a particular intangible asset.
One of the most difficult elements in the valuation of intangible assets under the income approach involves clearly assigning the economic income stream (whether incremental revenue or cost reductions) to that particular intangible asset. For example, in apportioning excess earnings (economic income) between a company’s individual intellectual property assets, great care should be taken so that an asset with little incremental economic value is not attributed to income pertaining to a different asset.

Examples of Intangibles Commonly Valued by the Income Approach

These include customer-related intangibles such as customer lists and contract-related intangibles such as favorable supply contacts and favorable leases. Technology-related examples include patents, trademarks, and copyrights.

Asset-Cost Approach

The cost approach attempts to measure the future benefits of ownership by quantifying the dollar amount that would be required to replace the future service capability of the subject intangible asset. The underlying assumption is that the cost to purchase or develop a new asset will approximate the economic value that the asset can provide during its life.

In the valuation of intangible assets, cost can be either a historical amount or a current estimate. Historical cost relates to the actual cost to create or develop an intangible asset. Current estimates relate to cost to reproduce the intangible asset as of a certain date. In addition, the estimated cost may also be based on the costs avoided due to the existence of the intangible asset. There are two fundamental cost approach valuation methods: reproduction cost and replacement cost. Therefore, at the start of each cost valuation analysis, the valuator must first decide which type of cost will be estimated and which cost method will be used.

Reproduction Cost

This is the estimated cost to construct, at current prices, an exact duplicate intangible asset. Such a duplicate would be created using the same standards, design, layout, and so on as the original asset. And therefore, it would suffer from the same defects/inadequacies and obsolescence as the original.

Replacement Cost

This represents the estimated cost to construct, at current prices, an intangible asset with equal functionality. Since the asset would be created using current standards and state-of-the-art design and layout, it would exclude any functional or technological obsolescence that might be included in the subject asset.

It should be noted that even though these two terms have different meanings, as defined above, the ultimate value conclusions derived from these two methods should not be materially different. This occurs because of allowable differences in adjustments made for obsolescence factors, that is, each method starts from a different base and then adjusts, as needed, for relevant obsolescence factors.

Cost methods are most applicable to intangible valuation in the following situations:

The subject intangible asset can be recreated or replaced.
The intangible asset is relatively new, or suffers from very little obsolescence, and the cost to create it is well documented.
When valuing special purpose or internally generated intangibles.
When guideline sales or license transactions are not available and the asset isn’t income producing, thereby effectively leaving only the cost approach.

Cost Caveats

It is important to keep in mind that cost relates more to the production or creation of an asset as opposed to the reflection of a market-based exchange amount. For this reason, none of the cost concepts assumes a marketplace or a transaction involving the intangible asset per se. Rather, cost describes what the original asset owner spent in creating the asset, or what the owner would have to spend as a particular date to recreate the asset. Therefore, it is important to keep in mind that cost, by itself, does not tell how much a buyer would be willing to pay or a seller would require before agreeing to sell an asset.

Examples of intangibles commonly valued by the asset-cost approach are as follows:

Blueprints and Technical Drawings
Chemical Formulations and Processes
Computer Software
Technical Libraries
Training Manuals
Assembled Workforce

Market Approach

Most business valuation practitioners agree that whenever sufficient, reliable transactional data are available, the market approach is the most direct method to use in the valuation process. However, they would also agree that finding relevant market-derived data, especially concerning intangible assets, could often be very difficult. Essentially, this approach estimates a market value by analyzing recent sales or licenses of similar intangible assets (guideline transactions) and then compares those transactions to the subject asset to be valued.

This approach generally works best when the following factors are present:

An active market with sufficient data available.
Licensing agreements have been negotiated at arm’s length.
Royalty rates, as a percentage or revenues, have been established by licensing agreements or can be derived from the licensing agreements.

Search for Guideline Transactions

In determining acceptable guideline asset sale or license transactions to compare to the subject intangible asset, the following types of factors should be considered:

Expected remaining useful life of the guideline intangible asset.
Date of the sale or license transaction.
Terms and conditions of the sale or license (such as seller financing, earn-out agreement, and so on).
Bundle of legal rights transferred in the guideline transaction.
Expected return on investment to be earned by the guideline intangible asset.
Market conditions at the time of the guideline sale.
Presence of other unrelated assets in the guideline sale.

Adjustments to Guideline Transactions

The types of factors outlined above are analyzed for each guideline intangible asset transaction. Based on the differences in the factors between the subject intangible asset and the guideline transactions, adjustments may need to be made to the guideline data found to make it comparable to the subject intangible asset. For example, if a seller was going out of business and needed cash quickly, the resulting guideline transaction price might be below market.

Market Caveats

As previously mentioned, this approach works best when sufficient information is available. Therefore, if the subject intangible asset is truly unique or recent sales and exchanges are limited, this method may not prove useful. Other problems arise if the prospective comparable asset was part of a transaction involving other tangible or intangible assets. In this case, the valuation analyst must first establish that the transaction consideration regarding the subject asset represented arm’s length pricing, and then he or she must properly allocate the transaction consideration between the assets.

Examples of Intangibles Commonly Valued by the Market Approach

Licenses and permits often valued under this approach include liquor licenses, franchise agreements, and certificates of need. Real estate intangibles that lend themselves to this approach include leasehold interests, easements, and development rights. In financial institutions, the market approach may be used in valuing mortgage servicing rights, credit card portfolios, and loan portfolios.

Case Analysis

The following hypothetical example using information discussed in Section 10, “Case Study,” illustrates the valuation of a trademark using the market approach, capitalized royalty income method.

Fair Value

Case law generally interprets “fair valuation,” as referenced in Section 101(32) of the Bankruptcy Code, to mean fair market value. Generally, courts under the Bankruptcy Act held that “fair value” was the fair market value of the property between willing buyers and sellers or the value that can be made available to creditors within a reasonable period of time. While these cases were based on the Bankruptcy Act, courts looking at the issue of insolvency for purposes of Section 547 under the Bankruptcy Code have applied the same standard. For example, the Fifth Circuit in Lamar Haddox Contractors, noted that “the fair value of property is not determined by asking how fast or by how much it has been depreciating on the corporate books, but by ‘estimating what the debtor’s assets would realize if sold in a prudent manner in current market conditions.’ Pennbroke Dev. Corp. v. Commonwealth Sav. & Loans Ass’n, 124 B.R. 398, 402 (Bankr. S.D. Fl. 1991).”

In re Nextwave Personal Communications, Inc., 15 235 B.R. 277, 294 (Bankr. S.D.N.Y. 1999), the bankruptcy court noted that for purposes of determining insolvency under Section 548, the three general approaches used to determine value apply – (1) the replacement cost approach, (2) the market comparison approach, and (3) income stream or discounted cash flow analysis. The bankruptcy court concluded that the market comparable analysis, subject to appropriate adjustments, was the appropriate approach to use in this case. The court noted that discounted cash flow analysis “is widely, if not universally, used in the business and financial world as a tool to assist management in making decisions whether to invest in or dispose of businesses or major assets. It is generally not used as a tool for determining fair market value, particularly when that determination can be made using either replacement cost or market comparables.” (Id. P. 294) In reaching this conclusion, the bankruptcy court cited Keener v. Exxon Co., 32 F.3d 127, 132 (4th Cir. 1994), cert. Denied, 513 U.S. 1154 (1995) where the court noted that “fair market value is, by necessity, best set by the market itself. An actual price, agreed to by a willing buyer and willing seller, is the most accurate gauge of the value the market places on a good. Until such an exchange occurs, the market value for an item is necessarily speculative.”

Read Variations on a Theme

Fair Market Value and Reasonably Equivalent Value. Are They The Same?

Value of Liabilities

In determining the insolvency of the debtor for purposes of Sections 547 and 548 of the Bankruptcy Code, debt is not necessarily measured at its face value. In situations where the debt was originally issued at a discount, it would appear that the debt should be valued at the initially issued price, plus the amortization of the discount based on the effective interest method. For publicly traded debt, the Third Circuit held in re Trans World Airlines, Inc., 134 F. 3d. 188 (3d Cir. 1998), that the debt should be measured at its face value and not its market value.

Retrojection and Projection

Generally, a valuation of assets must be determined as of the date of the transfer at issue. Sometimes such a valuation may not be available. In certain instances, courts will provide for the use of evidence of insolvency on a date different from the date in question as competent evidence of the debtor’s insolvency on that date. Termed “retrojection” by the courts, it says that if “a debtor is shown to be insolvent at a date later than the date of the questioned transfer, and it is shown that the debtor’s financial condition did not change during the interim period, insolvency at the prior time may be inferred from the actual insolvency at the later date.”

Retrospective Appraisal

According to the Uniform Standards of Professional Appraisal Practice (USPAP), 1998 edition, Statement on Appraisal Standards No. 3 (SMT-3), Retrospective Value Estimates, retrospective appraisals (effective date of the appraisal prior to the date of the report) may be required for certain matters. In its Statement, the Appraisal Standards Board concluded, “Data subsequent to the effective date may be considered in estimating a retrospective value as a confirmation or trends (that would reasonably be considered by a buyer and seller as of that date).

Solvency Analysis

Accountants and financial advisers are often hired by one or both parties to assert or rebut a solvency or insolvency conclusion. Practitioners should begin with a thorough evaluation of the debtor’s operations on the date of the subject transfer(s). The valuation premise adopted by the financial adviser should be based on the operating characteristics of the debtor company in existence as of the date of the subject transfers. However, sometimes the adviser is given the premise by his or her client and in these instances, the adviser should make it clear in the report (statement of assumptions and limiting conditions) and in testimony that the client provided the valuation premise.

Solvency or Insolvency – Positive or Negative Stockholders’ Equity

Using the Bankruptcy Code definition of insolvency and the appropriate premise, the valuation analyst considers and applies the applicable approaches and methods to value the company. The goal of the analysis is to conclude as to the value of the company’s stockholders’ equity (adjusted assets less liabilities) as of a particular date. A positive number indicates solvency, a negative number means that the company is insolvent.