OCTOBER 2010

Tax-Affecting & Discounts May Not Apply

to Insolvency Opinions
Paloian v. LaSalle Bank, 2010 WL 3363596 (C.A.7 (Ill.))(Aug. 27, 2010)

In a major new opinion by Judge Frank Easterbrook, a former University of Chicago law professor who is “widely respected for his
creative applications of economic theory to legal issues,”1 the U.S. Court of Appeals for the Seventh Circuit adjudged two “first
impression” issues for the federal circuits—one concerning the use of a discounted cash flow (DCF) analysis in forming insolvency
opinions, and the second considering whether to permit fraudulent conveyance claims against banks that merely hold securitized
assets.

Court records are encyclopedic. Doctors Hospital of Hyde Park first filed for Chapter 11 relief in 2000. Several years
and multiple adversary proceedings later, the bankruptcy court concluded the hospital was insolvent no later than August 1997 (see
In re Doctors Hospital of Hyde Park, Inc., 2007 Bankr. App. LEXIS 605). Based on this finding, the court avoided two loans to the
hospital and its owner-controlled affiliates: a $25 million line of credit, in which the lender took a security interest in the hospital’s
current and future accounts receivable; and a $50 million loan, collateralized in part by an interest in the hospital’s rent payments.
Shortly after funding, this second loan was securitized (along with billions of dollars of commercial credit) and transferred to a trust
overseen by LaSalle National Bank. (The first named party in these proceedings, Gus Paloian, is trustee for the debtor.)

The parties appealed, and in LaSalle Nat’l Bank. v. Paloian, 2009 WL 721510 (N. D. Ill.) the federal district court upheld the insol-
vency findings based in large part on three valuations by the trustee’s experts. In particular, the court confirmed the bankruptcy
judge’s adoption of a “fair market balance sheet” test (essentially a DCF analysis) that viewed the hospital as a going concern
by capitalizing its normalized cash flows. The court also found that the trustee’s experts had appropriately reduced the hospital’s
earnings by its fraudulent Medicaid and Medicare overpayments (the hospital was under federal investigation in 1997, at the time
of the loans, but the government didn’t charge it—for $18.5 million—until 1999-2000). Even the bank’s experts believed “some”
reduction in cash flow was warranted based on known future liability for the hospital’s fraud, and thus the DCF value was not driven
by improper hindsight bias, the district court ruled.

The court also approved a combined 40% tax-affecting discount applied by the trustee’s experts, based on their opinions (substanti-
ated by valuation literature) that it was “standard” practice to do so when valuing a controlling interest in an S corporation. Although
it criticized the bankruptcy court for its broad finding that the “object of an insolvency analysis is to determine the value of [the
hospital] to a theoretical buyer,” the district court nevertheless found the dispositive factor in tax-affecting the hospital, an S corpo-
ration, was the 100% ownership interest at stake. It also confirmed the 10% company-specific risk premium applied in the experts’
DCF as “reasonable” and even “conservative” under the circumstances that plagued the hospital prior to bankruptcy.

The appeal to the 7th Circuit presented more than 20 issues; the appellate briefs approached 300 pages and the bankruptcy and
district court opinions were “thick enough to outweigh a dictionary,” Judge Easterbrook noted. Fortunately, the parties resolved most
of the issues, he said, making it “unnecessary to traipse through them again.” That left two valuation questions for his consider-
ation.

Having first dispatched an issue of whether the trustee for the securitized pool of assets was “merely a conduit” (which may have
broad implications for a securities pool trustee with a depleted or non-existent corpus, forced to rely on its own funds or sue inves-
 OCTOBER 2010
tors for reimbursement), the court turned to the valuation issue. Until it filed bankruptcy in 2000, the hospital had stayed current in
payments to creditors and had consistently posted positive EBITDA. “Yet the bankruptcy judge concluded that it had been insolvent
for almost three years,” Judge Easterbrook observed. “How was that possible?” Even subtracting $18.5 million, the amount that
federal audits later charged the hospital for fraudulent overpayments, was not enough to turn the hospital’s “bottom line red,” he
added:

What did the trick was lopping off the portion of the Hospital’s assets that represented the present value of future
income. The rationale for this adjustment was that the Hospital was a Subchapter S corporation that did not pay
taxes, and a taxable buyer would reduce the purchase price in recognition...that its profits must be shared with state
and federal treasuries.

In this appeal, the bank didn’t resurrect its hindsight arguments so much as claim that the bankruptcy court erred by applying the
actual value of federal overpayments ($18.5 million) in 2000 rather than their expected value of as of 1997. The trustee claimed
the bank forfeited this argument on appeal, because it had neglected to raise it at trial. But Judge Easterbrook saw “an even more
glaring error,” obviating the need to consider “the right way” to value contingent liabilities. “Contingent liabilities must be matched
against contingent assets,” he said.

In fact, the missing, matching asset was the wealth of the doctor who bought the hospital back in 1992 (and who was also held ac-
countable for its fraud). As it happened, the doctor paid the entire $18.5 million of the hospital’s federal liability in or around 2000.
The trustee claimed this was not foreseeable, resurrecting the hindsight argument, but the Judge disagreed. The doctor’s substan-
tial personal wealth was not “pie in the sky.” If the doctor had executed a note in the hospital’s favor, a court would not ignore it
as an asset, but would simply discount the note to reflect the probability that it might not be paid. Yet in this case, the bankruptcy
court essentially valued the contingent assets at 0 cents on the dollar but valued contingent liabilities at 100 cents on the dollar.

“The treatment must be symmetrical,” Judge Easterbrook reasoned. “So too with hindsight: If a court uses hindsight to value the
liability at $18.5 million, it must. . . .[also] value [the doctor’s contribution] at $18.5 million, for a net zero effect on the Hospital’s
balance sheet.”

“The 40% reduction was likewise a mistake,” the Judge held. The discount is based in part on the illiquidity of the hospital’s shares
and its status as a non-taxable S corporation compared to that of a potential buyer. “Neither of these had anything to do with a cor-
poration’s solvency,” the Judge declared. “They concern the market value of its securities, not the state of its balance sheet,” he
added (citing Gross v. Comm’r, 272 F.3d 333 (6th Cir. 2001)).

“Take tax effects,” the Judge continued. An S corporation does not pay taxes; some potential buyers do. “But how much a buyer
will pay for a revenue stream does not tell us whether a firm is insolvent, except indirectly: If a buyer will pay a positive price for the
firm’s stock, then it is very likely to be solvent.” However, even bankrupt firms will sell for a small price, the Judge noted, reflect-
ing a buyer’s belief in the firm’s turnaround potential. Moreover, income tax questions arise only when a firm is profitable; i.e., has
reportable net income. “So whether an outsider would have paid $50 million or $40 million (a 40% discount) for all stock in the
Hospital, either price implies that the Hospital’s assets are worth more than its liabilities,” Judge Easterbrook emphasized. Finally,
most prospective buyers for a hospital would be non-profit (and non-taxable) organizations, which would not reduce their bids to
account for taxes.

The Judge had much the same to say about discounts. When shares of a closely held company (or other restricted asset) are ap-
praised for purposes of estate and gift tax assessments, for example, the ultimate value is typically discounted from fair market
value. But when the Judge asked counsel for both parties to cite one decision, from any court, that applied either a liquidity
discount or a tax-effect discount to the asset side of a corporation’s balance sheet for the purpose of determining solvency, neither
side could find one. “Our own research did not turn one up,” the Judge said. Accordingly, he found the hospital solvent as of 1997
and reversed the bankruptcy court’s avoidance of the loan transfers as fraudulent conveyances.
 OCTOBER 2010

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