A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES

F O R E N S I C A C C O U N T I N G

The Paramount Role of Valuation in Corporate Restructurings

by Jonathan Friedland, Attorney; Mike Xu, Attorney; and Jim Dykstra
aluation plays a critical role in all stages of a Chapter 11 bankruptcy proceeding. At the beginning of the bankruptcy, valuation helps determine whether a creditor can lift the automatic stay and whether the debtor can use cash collateral or obtain DIP nancing. At the con rmation stage, valuation helps determine the allocations among the tiers of the debtors capital structure and whether the debtor can cram down on a class of creditors. Even after con rmation, valuation can be critical in seeking recovery of alleged avoidable transfers. To be effective in a bankruptcy valuation engagement, the valuation analyst should understand the bankruptcy process and the situations where valuation becomes important in bankruptcy. In this rst part of a two-part series,

we discuss the role valuation and valuation analysts can play in corporate restructurings, and provide a basic, nuts and bolts overview of Chapter 11 of the Bankruptcy Code. Part 2 will comment about some of the more recent, signicant cases where valuation played a critical role in Chapter 11 bankruptcy proceedings. There seem to be relatively few valuators who specialize in bankruptcy. We think there are two principal reasons for this. First, acquiring a sound understanding of bankruptcy law may be perceived by valuators as a barrier to entry. Second, valuation reports must be supported by expert testimony in court, which may seem intimidating to some accountants who do valuation work. The skills necessary to analytically determine value are simply different than the skills necessary to defend a valuation in open court.

A valuation experts primary role in bankruptcy court is to help the court determine the facts. A valuator must provide a valuation produced in accordance with applicable bankruptcy law and procedure, using accepted methodologies and approaches, and most importantly, always remain impartial.

Chapter 11 in a Nutshell
Bankruptcy law and courts exist at the federal level, because Article I of the Constitution provides that Congress has the power to make bankruptcy law. Congress exercised the power through the Bankruptcy Reform Act of 1978, including the Bankruptcy Code, which is codified in Title 11 of the U.S. Code. The Bankruptcy Code was most recently amended by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, applicable to all cases led after October 17, 2005.

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When a business is unable to service its debt or pay its creditors, it (or its creditors) may le for protection under either Chapter 7 or Chapter 11 of the Bankruptcy Code. In Chapter 7, the business ceases operation and a trustee liquidates the assets to pay creditors. In Chapter 11, the business attempts to continue operating while the court supervises its reorganization. The court protects the business by issuing an automatic stay, prohibiting the continuance of any action by any creditor against the debtor or the debtors property.1 Following are the three major players in the Chapter 11 bankruptcy game: The bankruptcy judge. He or she presides over the bankruptcy court. There are about 340 bankruptcy judges around the country. As a matter of law, the court is always open, which is why you sometimes see major bankruptcy cases filed on Sundays and holidays the clerk will meet you there and accept the filing if necessary. The debtor in possession. When a company les Chapter 11, the company (that is, the debtor) typically remains in control of its business and assets as debtor-inpossession. To simplify matters, we use DIP to refer to the company in bankruptcy. The committee. In many Chapter 11 cases, there will be an ofcial committee of unsecured creditors, appointed by the United States Trustee, which is a division of the U.S. Department of Justice. The committee typically consists of the ve or seven largest unsecured creditors (which are typically rep-

resented by their creditor managers who would serve on the committee) that are willing to serve. The committee hires counsel, and sometimes nancial advisors and/ or other professionals, who are paid for by the debtors estate. The committee of unsecured creditors has standing to be heard on any issue in a Chapter 11 case, and its views tend to be taken seriously by the bankruptcy judge. An active and well represented committee can play a major role in the outcome of the case. In some cases, other ofcial committees will also be appointed, such as equity-holder committees consisting of representative equity holders of the debtor, bondholder committees consisting of representative bondholders of the debtor, etc. Unofcial committees, neither appointed by the U.S. Trustee nor necessarily paid for by the estate, may also form, with standing to be heard on most matters that arise in the Chapter 11 case. Other important players include secured parties, especially banks, which may have liens on substantially all of a debtors assets; and non-debtor parties to contracts under which the debtor has obligations to perform.

matters as the ling of new cases; employment of professionals; the automatic stay; the use, sale, and lease of estate assets; post-petition nancing; executory contracts; the dismissal and closing of cases; and some other matters. Chapter 5 covers a wide variety of matters relating to the rights of debtors and creditors, including claims and priorities, matters relating to exemptions and discharge of debts, and the avoidance provisions, which permit a DIP to claw back certain transfers to creditors made prior to the petition date.

Chapter 11 Reorganization
If you ask a Chapter 11 lawyer what it means to reorganize, he or she will likely say something like this: Chapter 11 allows the debtor to preserve the business as a going concern, and thereby to maximize value for creditors, shareholders, employees, and other stakeholders. Preserving the business and rebuilding its protability will provide creditors with more of the money they are owed than if the business were liquidated and/or its assets distributed to the creditors in a Chapter 7 bankruptcy. The true picture is not always as simple and clear-cut as that. In fact, it is usually more complex. First, of course, not all businesses in bankruptcy are worth more to the creditors as a going concern than they are in liquidation. Second, complexity is introduced because Chapter 11 specically provides that a reorganization plan may include the liquidation of some or all of the debtors assets. So Chapter 11 is not exclusively about reorganization, and the Code implicitly recognizes that in some cases, value is maximized

Structure of the Bankruptcy Code

The Bankruptcy Code is divided into several chapters in addition to 7 and 11. Chapters 1, 3, and 5 are general chapters, applicable in all cases. Chapter 1 denes terms, delineates who can be a debtor, and describes the courts powers, among other general rules. Chapter 3 governs case administration, including such

Under limited circumstances, a secured creditor may be able to obtain an order from the court granting relief from the automatic stay.

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A O ONA D V LO M NT JOURNAL o he CONSULT NG D SC PL NES A PPRRO FFEESSSSI IO N A LL D EEV EEL O PPM EEN T J O U R N A L ffo rr tth e C O N S U L T IIN G D IIS C IIP L IIN E S through some combination of reorganization and liquidation. Third, the distinction between liquidation and going concern may be less clear in practice than in theory. One can very well liquidate a business by selling it as a going concern, in which case the distinction does not mean anything at all. Indeed, the going concern sale is an increasingly popular trend these days. Finally, complexity is introduced because bankruptcy law involves a tension between two concepts that are overlapping but fundamentally quite different. One is the notion of maximizing the value of the assets. The other is the notion of saving the residual stake of the pre-bankruptcy owners. This confusion is apparent in the classic Chapter 11 case. The old residual owners (equity holders), still in control of the enterprise, file the petition. They remain in control as DIP and propose a plan to save the going concern. If all goes well, the effect will be to maximize the payout to creditors and to leave something on the table for the owners (while preserving jobs, generating future tax revenues, and serving other social ends that are often touted as benefits of reorganization). Such a scenario appears to be a self-evident win-win situation. But it is rarely that simple. Saving the going concern means continuing the business, which means continuing to bear risk. Where the business is insolvent, equity always gains from taking risks: Liquidate today, and equity holders get nothing; keep the business going, and they may have a chance. Creditors tend to be correspondingly risk-averse: Liquidate today, and they get paid. Take a gamble, and the potential rewards go to equity, while the creditors bear the risk of loss. The point is not that creditors always favor liquidationclearly, thats not truebut the risk-reward calculation is different for creditors than for equity holders; and it is similarly different for junior creditors (unsecured creditors, for example) than it is for senior creditors (secured creditors, for example). There can be no doubt that Chapter 11 encourages, rather than resolves, this tensionas if deliberately to allow the court to choose, from case to case and even from time to time within a case, whether assets or equity will dominate. can be deemed adequate depends on, among other things, how great the risk is to the secured lender, what the cash collateral is being used for, and what types of protection the debtor is able to offer. For example, where the primary collateral is accounts receivable, it is common for the lender to be granted a replacement lien on receivables generated post-petition. Such protection is significant because 552 of the Code operates to cut off any receivables lien as of the bankruptcy filing date. Under this arrangement, the debtor spends the proceeds of the receivables that are subject to the lenders original lien in exchange for a lien on new replacement receivables. If the debtor continues to generate new receivables at the same rate or a higher rate as it spends the proceeds of old (pre-petition) receivables, then the lender would be adequately protected. What if the debtor is using the proceeds of a lenders hard collateral to preserve that hard collateral (e.g., rents generated by an apartment building are used to preserve and maintain the building)? Often such an arrangement is considered adequate protection because the maintenance and upkeep of the building benets the lender as mortgagee. In a similar fashion, if the secured lender has an equity cushionthe value of the hard collateral substantially exceeds the amount of the secured debtthat lender is likely to be deemed to have adequate protection. The theory for this outcome is that if the value of the secured creditors collateral substantially exceeds the debt owed to it, the use of cash collateral is unlikely to present an unfair risk to the secured lender.

First Valuation Opportunity: Adequate Protection

At the beginning of a Chapter 11 case, to continue its business operation as a going concern, the DIP will have to seek permission to use the lenders cash collateral and/or to borrow money to fund its operation. Moreover, although the automatic stay under the Bankruptcy Code can prevent any creditor from foreclosing on the DIPs operating assets, the DIP must fend off the creditors motion to lift the automatic stay. When parties cannot reach agreements regarding use of cash collateral, DIP nancing, or automatic stay relief, then contention ensues and valuation becomes important. The valuations in all these matters revolve around the concept of adequate protection. Adequate protection of collateral, described in Bankruptcy Code 361, can take on many forms, including periodic cash payments to the secured lender, payment of post-petition interest, or the granting of additional liens to the creditor on previously unencumbered assets. The form of protection that

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A third-party valuation will be necessary to determine whether the standard for adequate protection has been met. The process of liquidating hard collateral requires signicant expertise, as many pitfalls can arise. For example, what is the best sales process? Is breakup value greater than a goingconcern value? Hard assets like machinery and equipment can require substantial de-commissioning, transportation, and associated EPA costs before being sold. What are the current market conditions? Is there a limited market with few buyers, or a broad, liquid market?

provide adequate protection to the creditor in order to obtain permission to use the cash collateral.

DIP Financing
Sometimes, use of cash collateral is not sufcient to fund operations. In these instances, a DIP may need to borrow new money. Bankruptcy Code 364 authorizes the DIP to obtain credit. More to the point, it outlines these four paths whereby a lender may achieve priority for money advanced to a debtor after the petition date: If the DIP borrows in the ordinary course of business, then the lenders claim is a rst-priority administrative expense under 364(a). This priority is perhaps best understood as a protection for post-petition trade vendors. Even outside the ordinary course of business, the creditor may get an administrative priority if the post-petition advance, and the administrative priority, are approved by a court order under 364(b). But as a practical matter it happens very rarely, because most creditors who provide postpetition lending insist on the greater protections afforded by subsections (c) and (d). If the DIP cant get unsecured credit, the court may authorize the lender to get a super-priority administrative claim, or to take a security interest in unencumbered property (or a subordinate security interest in encumbered property). This is 364(c). Finally, if the DIP cannot get credit otherwise, the court may authorize a security interest that is senior or equal to an existing security interest, under 364(d). A DIP loan with a lien that is senior in priority to existing,

pre-petition liens is sometimes referred to as a priming lien. It is the most extraordinary protection for a post-petition lender, and it requires showing that the lender whose lien is primed is adequately protected. To obtain approval of one of these escalating priorities, the DIP must show the court that financing was not available with one of the lower priorities. 364(c)(d). At the hearing, the DIP should be prepared to discuss its efforts to obtain financing on less onerous terms.

The Use of Cash Collateral

If a lender has a security interest in cash collateral, which includes both cash and cash equivalentsincluding the cash proceeds of hard collateral (e.g., cash in a bank account, the proceeds of accounts receivable, rents from an office building or hotel, etc.)a debtor must have the secured creditors consent or a court order before it can use that cash collateral. Typically, a debtor will need immediate access to cash collateral when it files for bankruptcy, and will file an emergency motion for authority to use cash collateral as one of its first-day motions. In some cases, the secured creditor will use this opportunity to negotiate with the debtor to obtain certain rights or concessions in exchange for the creditors consent to the use of its cash collateral. In other cases, however, the parties are unable to reach an agreement, and a contested hearing will be held to determine the debtors right to use cash collateral. During a contested hearing, the debtor must then prove that it can

Second Valuation Opportunity: Motions to Lift the Stay

Valuation next presents itself in connection with a motion by a secured creditor to lift the automatic stay. Some familiarity with Chapter 3, Section 362 of the Bankruptcy Code is helpful: Section 362(a) lists the actions that are stayed by the bankruptcy ling. Section 362(b) sets forth exceptions to the automatic stay. Section 362(c) describes the duration of the automatic stay. Section 362(d) sets forth the grounds for seeking relief from the automatic stay. Section 362(e) provides the time framework under which the courts must operate in response to a motion for relief from the automatic stay. Section 362(f) provides a limited mechanism for emergency relief from the stay where it is necessary to prevent irreparable harm. Section 362(g) allocates the burdens of proof in a motion for relief from stay. Section 362(k) provides for damages in the event that a party willfully violates the automatic stay.

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A O ONA D V LO M NT JOURNAL o he CONSULT NG D SC PL NES A PPRRO FFEESSSSI IO N A LL D EEV EEL O PPM EEN T J O U R N A L ffo rr tth e C O N S U L T IIN G D IIS C IIP L IIN E S A secured creditor that wants to foreclose may be unlikely to nd an applicable exception. After all, one of the main purposes behind Chapter 11 is to give the debtor breathing room to formulate a plan so it can try to preserve going-concern value. If secured creditors could generally foreclose on their collateral, there wouldnt be much breathing room and there probably wouldnt be much chance for a company to emerge from bankruptcy as a going concern. Bankruptcy Code 362(d) provides a few avenues for relief from the automatic stay. To obtain this relief, a creditor must le a motion for relief from the automatic stay. The first ground for relief from the stay is cause, including lack of adequate protection. So if the court finds that the creditor is entitled to adequate protection, but the debtor cant (or wont) provide it, then the creditor is entitled to stay relief. This provision suggests that lack of adequate protection is not the only cause justifying relief from the stay, but fails to enumerate any additional basis for demonstrating cause. This ambiguity gives the judge a lot of discretion. The second ground for relief from the stay is satised if (1) there is no equity in the property and (2) the property is not necessary to an effective reorganization. The rst prong (no equity) means that the debt secured by liens on the property exceeds the value of the property. The second prong (not necessary) means either that the debtor can reorganize without this particular piece of property or that the debtor is unlikely to be able to reorganize at all. (If the debtor cannot reorganize at all, then no property is necessary for its reorganization.) The secured creditor has the burden of proof on the no equity in the property issue, but the debtor has the burden of proof on the necessary for an effective reorganization issue. As noted previously, the necessity for a qualied appraiser to determine the forced or orderly liquidation value of the property will be the basis for the determination by the court of whether there is no equity. The court needs to be certain that the appraiser has considered current market conditions, all relevant costs, and can therefore share the best estimate of value (the facts) with the court. tor, a debtor must demonstrate that the creditor will receive a lien on property retained by the debtor or cash totaling the value of the secured portion of the claim. Suppose the DIP owes $1 million to the creditor under a contract providing for payment in annual installments over 10 years, with interest at 10 percent (the payment pencils out at about $162,000 a year). The debt is secured by Blackacre, which, luckily, is worth $1 millionexactly the same amount as the debt. The creditor has made it clear that he favors no resolution except payment in full immediately. The DIP certainly cant do that; indeed, it cant even meet the installments. But it could pay a lower installment. The DIP fires up the spreadsheet and determines that if the creditor increases the loan period from 10 to 20 years at the same rate of interest, then the payment would fall to around $127,000. The DIP figures it could pay $127,000. Can the DIP impose this deal under the cram-down rule? Lets say its a close call. The rule provides that we can impose the plan if the creditor gets a payment stream with a present value equal to the amount of its secured claim. Indeed, we are proposing to give him a payment stream with a value equal to his claimif 10 percent is the right interest rate. The creditor will say that a 20-year loan is riskier than a 10year loan and so he has a right to a higher interest rate. But if the interest rate is higher than 10 percent, a stream of 20 payments of $127,000 has a present value that is less than $1 million. So we may be heading for a fight over the question of what the right interest rate is.

Third Valuation Opportunity: Confirmation and Allocation

Valuation is often the crux of the financial restructuring transactionthe basis upon which a restructuring plan is negotiated. Thus, parties in the upper tiers of a capital structure favor low value situations so as to grab more equity. Creditors receiving equity would assign a low value so that they may be entitled to more equity. In the plan conrmation phase of a Chapter 11, a battle of experts over valuation may determine the ultimate plan allocation. The responsibility to provide unbiased clarity of value (the facts) requires a clear understanding of the limitations within the bankruptcy process, a consistent approach to valuing all assets, and the ability to defend the nal valuation to disparate parties and the court.

Cram-down over objection of impaired classes

Valuation is also central in a plan cram down context. The Bankruptcy Code allows a debtor to force conrmation of a plan over the objection of a class of creditors. To cram down on a secured credi-

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Fourth Valuation Opportunity: After Confirmation

Conrmation is not the end of a Chapter 11 case, though many people labor under that misconception. Distributions to creditors, pursuant to the conrmed plan, typically happen only after conrmation. Moreover, for a number of reasons, avoidance actions are often pursued after conrmation. Fraudulent Transfers. Under non-bankruptcy fraudulent transfer law, a creditor may avoid a transaction between the debtor and a third party if the transaction is, by appropriate standards, adverse to the creditor. Bankruptcy Code 548 is a fraudulent transfer provision. It gives the DIP the authority to avoid fraudulent transfers. Under 548(a)(1)(A), the DIP may avoid a transfer that was made with the actual intent to hinder, delay or defraud a creditorcall it an actual fraud fraudulent transfer. Under 548(a)(1)(B), the DIP may avoid a transfer made for less than a reasonably equivalent value, sometimes referred to as constructive fraud. If the DIP relies on this constructive fraud premise, then it must also show that the debtor was one of the following (these are simplied): Insolvent at the time of the transfer, or rendered insolvent thereby Engaged in a business or transaction for which his remaining property was unreasonably small capital Intending to incur debts beyond his capacity to repay Making the transfer not for reasonably equivalent value, or made the transfer or incurred the obligation for the benet of an insider under an employment contract and out of the ordinary course of business.

A critical distinction here is the matter of intent. If the DIP can show the relevant intent, then it doesnt have to worry about issues of solvency or value. If it has the right evidence on value and solvency, it doesnt have to worry about intent. If the insolvency or the reasonably equivalent value becomes the contested area during the avoidance litigation, then valuation experts have to come in and help the court to determine such factual elements of the avoidance actions. Preferences. To understand preferences, it is easier to understand what they are not. Consider the case of Delbert, who owes $100 each to Butcher, Baker, and Candlestick Maker, all unsecured. Delbert pays $100 in cash to Butcher and then les for bankruptcy, holding no other assets. Baker and Candlestick Maker have claims against the estate of Delbert, but the claims are worthless. Butcher has no claim because he was paid in full. The first thing to note about this case is that Delberts conduct is not wrong in any global sense, because it is not wrong to pay a debt. The trouble is that a first principle of bankruptcy law is that similarly situated creditors share pro rata. If you allow the debtor to pick and choose which creditors it pays on the eve of bankruptcy, then you undercut this first principle. So it is not surprising to find in the Bankruptcy Code a rule that allows the trustee to undo certain pre-bankruptcy transactions, which may be otherwise unobjectionable, that would have the effect of undercutting the principle of pro rata distribution. The core of preference law is in 547. The prima facie case is in 547(b). It provides (slightly simplied) here that the DIP may avoid a transfer to a creditor for an anteced-

ent debt (a debt that existed before the transfer), if the transfer was made while the debtor was insolvent and within 90 days before bankruptcy (or 1 year if the recipient is an insider)assuming that would permit the creditor to get more than it would get in Chapter 7. In our example, Delbert is clearly insolvent: He has $100 and owes $300. If the transfer had not occurred, then creditors would have taken one-third of $100 or $33.33 each (ignoring costs), so Butcher clearly got more via the transaction than he would have under Chapter 7. The only open question is timing: If the transaction was made within 90 days before bankruptcy, then it would appear to be avoidable. If it was made earliersay, 91 days before bankruptcythen it would seem to be bulletproof. Most preferences involve payment of money to satisfy a debt, but there is one other case that is important but perhaps not so obvious. Suppose that Delbert, rather than paying Butcher, merely gave him a security interest in all his property to secure his antecedent debt, and Butcher perfected that security interest within 90 days of bankruptcy. Assuming the other conditions are met, then this giving of security may also be a preference and avoidable under 547. Similar to avoiding the fraudulent transfers, two elements of the prima facie elements involve valuation: insolvency and more than it would get in Chapter 7. Although these two elements are not often contested in preference litigations, lawyers have to hire valuation experts if they become contested. The prima facie elements of a preference are not, however, the end of the story. There are many cases where the debtor made a payment that

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A O ONA D V LO M NT JOURNAL o he CONSULT NG D SC PL NES A PPRRO FFEESSSSI IO N A LL D EEV EEL O PPM EEN T J O U R N A L ffo rr tth e C O N S U L T IIN G D IIS C IIP L IIN E S meets the elements of a preference, but will not be avoidable because it falls within one of the defenses set forth in 547(c). In Part II, we will build on the foundation we laid here and take you through a few of the more signicant valuation battles that have been fought in some recent Chapter 11 cases. VE
James C. Dykstra is president of Gemini Valuation Services in Los Angeles (www. geminipartners.net). GVS provides valuation services to public and private companies, financial institutions, private equity groups, and service providers. Jonathan Friedland, Attorney at Law, is a partner with Schiff Hardin LLP, a Chicago-based law firm. He practices in the area of bankruptcy law, with particular emphasis on restructurings, the representation of debtors in out-of-court workouts, and Chapter 11 proceedings. He is coauthor of Chapter 11 101: The Essentials of Chapter 11 Practice (American Bankruptcy Institute, Alexandria, VA, 2007). Portions of this article were adapted from that book. Contact jfriedland@ schiffhardin.com.

Mike Xu, Attorney at Law, is an associate with Schiff Hardin LLP in Chicago. Contact mxu@schiffhardin.com.

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