Evolution of Valuation in Bankruptcy - 2017 NCBJ … symp Simkovic...[The] weighted average method of valuation . . . shall no longer exclusively control such proceedings. We believe
National Conference of Bankruptcy Judges San Francisco October 27, 2016 Michael Simkovic Associate Professor of Law Seton Hall University School of Law Email: [email protected] or [email protected] Phone: (516) 423-9187
Valuation, solvency, and adequate capitalization analysis are central to corporate reorganization and bankruptcy
Allowance of claims Claim relative to value of collateral determines secured vs. unsecured Some property tax claims disallowed if greater than value of property
Adequate protection
Debtor has no equity or value of collateral likely to decline
Avoidance actions Fraudulent transfer “insolvent” or inadequately capitalized Preference “insolvent”
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Presenter
Presentation Notes
Note that valuation opinions are sought prospectively in anticipation of leveraging transactions.
Valuation, solvency, and adequate capitalization analysis are central to corporate reorganization and bankruptcy
Rejection of collective bargaining agreements Rejection must be necessary for successful reorganization Financial status of debtor relevant
Plan confirmation
Because of priority, valuation helps determine allocation among claimants and extent of discharge
Plan must be feasible
363 sales Sales price considered relative to expected recovery under alternate
sale or reorganization plan
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Judicial valuation methods evolved gradually, generally trailing the financial community
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Frequency of valuation terms in books 1900-2006
Cap rates (1940s to present)
DCF (1980s)
Mkt (1990)
Source: Google Books Ngram viewer; Consolidated Rock; Blum, .
Presenter
Presentation Notes
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. R. H. Parker, Discounted Cash Flow in Historical Perspective, 6 J. Acct. Res. 58, 59–60 (1968). Susie Brackenborough, Tom McLean & David Oldroyd, The Emergence of Discounted Cash Flow Analysis in the Tyneside Coal Industry C.1700–1820, 33 Brit. Acct. Rev. 137–155 (2001); Parker, supra note 11. Consolidated Rock Products Co. V. Du Bois, 312 U.S. 510, 526-527 (1941). Group of Investors v. Milwaukee R. Co., 318 U.S. 523 (1943); Walter J. Blum & Stanley A. Kaplan, The Absolute Priority Doctrine in Corporate Reorganizations, 41 U. Chi. L. Rev. 651, 656 (1974); Fortgang and Mayer, supra note 1 at 1128–29.
Market-based solvency analysis has many advantages over the traditional accounting-based approach
Improved accuracy & consistency
Market prices are a historical record of professional investor opinion at a specific point in time and prices therefore cannot exhibit hindsight bias
Precedent is more valuable if it is based on a unitary, consistent metric
Market-based measures of solvency historically have been more accurate than rating agency, analyst, and accounting based measures
Faster, cheaper, and more nuanced
Market-based analysis is faster and cheaper—the financial markets have already done most of the work
Courts can shift from a binary view focused on a single point in time to a probabilistic point of view that acknowledges changes over time
Risk management and prevention
Clear ex-ante liability empowers risk managers at investment banks to block imprudent transactions before they are completed
Commitments explicitly contingent on solvency / adequate capitalization?
Easier to prevent a bad transaction than to make stakeholders whole after the fact
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Caesars risk-neutral market-implied probability of default: Comparison of CDS and bond spreads
LBO 5% Equity Sale
Four Properties
CERP Growth
2009 WSOP 2011 WSOP Trademark
Transfer 0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
CDS Bonds
Market participants' view of probability of Caesars Entertainment Operating Company default within 5 years, assuming 30% recovery Percent, Nov. 2006 – Jan. 2015*
* Caesars Entertainment Operating Company filed bankruptcy in January of 2015. CDS probabilities of default based on 5-year CDS spread from Bloomberg CBIN and 5-year swap rate. Bond probabilities based on spread between yield of CEOC 6 ½ percent 6/1/2016 Senior Unsecured Bullet Bond and U.S. Treasury with similar maturity date. 5
Note the cost difference– a few days, a few thousand dollars versus $17 million for the examiners report and months of time in the Ceasar’s bankruptcy, with more on the way. The results are generally very similar, but in 2012 to 2013, the CDS market was more skeptical than the bond market. https://www.dropbox.com/s/6pyh6rdplk6tu3q/Caesar%20Michael%20CDS%20data%202.xlsx?dl=0 Note—on days when 5-year swap spread was missing, filled in using average of previous and subsequent day.
Key cases in the history of valuation
Consolidated Rock Products Co. V. Du Bois, 312 U.S. 510, 526-527 (1941)
Group of Investors v. Milwaukee R. Co., 318 U.S. 523 (1943)
Weinberger v. UOP, Inc., 457 A. 2d 701, 712–713 (1982)
Basic v. Levinson, 485 U.S. 224, 244 (1988)
Bank of Am. Nat’l Trust & Sav. Ass’n v. 203 N. LaSalle St. P’ship, 526 U.S. 434, 456–57 (1999)
VFB LLC v. Campbell Soup Co., 482 F.3d 624, 629–30 (3d Cir. 2007) aff’g VFB LLC v. Campbell Soup Co., 2005 WL 2234606 (D. Del. 2005)
In re Iridium Operating LLC, 373 B.R. 283, 352 (Bankr. S.D.N.Y. 2007)
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SCOTUS seemed to embrace DCF in Consolidated Rock . . .
“From this record it is apparent that little, if any, effort was made to value the whole enterprise by a capitalization of prospective earnings. . . .
The criterion of earning capacity is the essential one if the enterprise is to be freed from the heavy hand of past errors, miscalculations or disaster, and if the allocation of securities among the various claimants is to be fair and equitable. . . .
Since its application requires a prediction as to what will occur in the future, an estimate, as distinguished from mathematical certitude, is all that can be made. But that estimate must be based on an informed judgment which embraces all facts relevant to future earning capacity and hence to present worth…”
Consolidated Rock Products Co. V. Du Bois, 312 U.S. 510, 526-527 (1941).
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But in practice multiples analysis was routinely used for decades
The usual valuation process involves making a projection of earnings . . . and then capitalizing earnings at an appropriate rate. Capitalization establishes the relationship between projected earnings and total present value. . . . For example, if the annual earnings of the business are deemed to constitute 20 percent of its worth, the earnings would be said to be capitalized at a 20 percent rate or on a five times earnings basis. . . . Some guidance may be found in comparisons with rules of thumb frequently used in the valuation of businesses and in the price-earnings ratios of securities traded in the public market.
Walter J. Blum & Stanley A. Kaplan, The Absolute Priority Doctrine in Corporate Reorganizations, 41 U. CHI. L. REV. 651, 656 (1974)
In . . . Jade Oil and Gas Co. under Chapter X of the Bankruptcy Act, the Securities and Exchange Commission for the first time in over a decade discussed and applied a projected cash flow method of arriving at value for reorganization purposes.
Walter J. Blum, Corporate Reorganizations Based on Cash Flow Valuations, 38 U. CHI. L. REV. 173, 173 (1970).
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Shortly after Delaware courts embraced DCF for corporate appraisals, bankruptcy courts started to use it more regularly
“The so-called "Delaware block" or weighted average method . . . has been in use for decades. . .
However, to the extent it excludes other generally accepted techniques used in the financial community and the courts, it is now clearly outmoded. [The] weighted average method of valuation . . . shall no longer exclusively control such proceedings.
We believe that a more liberal approach must include proof of value by any techniques or methods which are generally considered acceptable in the financial community and otherwise admissible in court . . .
Weinberger v. UOP, Inc., 457 A. 2d 701, 712–713 (1983)
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Presenter
Presentation Notes
“The so-called "Delaware block" or weighted average method was employed wherein the elements of value, i.e., assets, market price, earnings, etc., were assigned a particular weight and the resulting amounts added to determine the value per share. This procedure has been in use for decades. . . However, to the extent it excludes other generally accepted techniques used in the financial community and the courts, it is now clearly outmoded. It is time we recognize this in appraisal and other stock valuation proceedings and bring our law current on the subject.. . . the standard "Delaware block" or weighted average method of valuation, formerly employed in appraisal and other stock valuation cases, shall no longer exclusively control such proceedings. We believe that a more liberal approach must include proof of value by any techniques or methods which are generally considered acceptable in the financial community and otherwise admissible in court . . .
DCF became popular with bankruptcy courts starting in the late 1980s
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Debtors' and Creditors' use of DCF valuation models, 1982-1998 Percent of Bankruptcy cases
Note: Missing data for 1983 and 1996 interpolated by averaging previous and following years' data. Source: Trujillo (2005), figures 13 and 14.
0%
10%
20%
30%
40%
50%
60%
70%
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100% Creditors
Debtors
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Presentation Notes
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. R. H. Parker, Discounted Cash Flow in Historical Perspective, 6 J. Acct. Res. 58, 59–60 (1968). Susie Brackenborough, Tom McLean & David Oldroyd, The Emergence of Discounted Cash Flow Analysis in the Tyneside Coal Industry C.1700–1820, 33 Brit. Acct. Rev. 137–155 (2001); Parker, supra note 11. Consolidated Rock Products Co. V. Du Bois, 312 U.S. 510, 526-527 (1941). Group of Investors v. Milwaukee R. Co., 318 U.S. 523 (1943); Walter J. Blum & Stanley A. Kaplan, The Absolute Priority Doctrine in Corporate Reorganizations, 41 U. Chi. L. Rev. 651, 656 (1974); Fortgang and Mayer, supra note 1 at 1128–29.
Comparables continue to be used for decades, and only faded gradually with the rise of DCF
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Debtors' and Creditors' use of Comparables valuation models, 1982-1998 Percent of Bankruptcy cases
Note: Missing data for 1983 and 1996 interpolated by averaging previous and following years' data. Source: Trujillo (2005), figures 15 and 16.
0%
10%
20%
30%
40%
50%
60%
70%
80%
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100%
Creditors Debtors
Presenter
Presentation Notes
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. R. H. Parker, Discounted Cash Flow in Historical Perspective, 6 J. Acct. Res. 58, 59–60 (1968). Susie Brackenborough, Tom McLean & David Oldroyd, The Emergence of Discounted Cash Flow Analysis in the Tyneside Coal Industry C.1700–1820, 33 Brit. Acct. Rev. 137–155 (2001); Parker, supra note 11. Consolidated Rock Products Co. V. Du Bois, 312 U.S. 510, 526-527 (1941). Group of Investors v. Milwaukee R. Co., 318 U.S. 523 (1943); Walter J. Blum & Stanley A. Kaplan, The Absolute Priority Doctrine in Corporate Reorganizations, 41 U. Chi. L. Rev. 651, 656 (1974); Fortgang and Mayer, supra note 1 at 1128–29.
DCF and multiples are subjective and easily manipulated
How used by experts and courts Subjectivity and manipulability Projected cash flows
•Used in both Discounted Cash Flow analysis and liquidity analysis
•Experts can construct their own projections post-hoc or selectively emphasize some historic projections
Discount rates •Used to convert future cash flows into present value
•Depend on financial arcana such as equity risk premiums and systemic risk •Manipulation hard to detect
Terminal values •Used to limit explicit projection •Depends on discount rate, last year’s projections, and perpetual growth rate
•Manipulate projections and discount rate (as above) •Choose either industry, company, or economy-wide historic growth rate
Comparables / Multiples
•Used as a market check on DCF •Compare ratio of accounting metrics to market value of “comparable” firms or acquisition price of “comparable” transactions
•No two firms are ever perfectly comparable •Manipulate the selection of comparables and metrics to produce the desired multiples
Sensitivity analysis
•Used to show a range of outcomes by varying assumptions within the model
•Manipulate endpoints to produce the desired middle-of-the-road outcome
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Presenter
Presentation Notes
Battle of experts; very expensive; complicated and subjective; Exide In re Exide Techs., 303 B.R. 48, 59 (Bankr. D. Del. 2003). The expert financial adviser to the debtor submitted a valuation range of $950 million to $1.05 billion, while the expert financial adviser to the creditors’ committee submitted a valuation range of $1.478 billion to $1.711 billion. Exide involved valuation for plan confirmation, not for fraudulent transfer. Id. at 66. Judge Carey determined the debtor’s valuation to be in the range of $1.4 billion to $1.6 billion. When Exide emerged from bankruptcy in May 2004, the market set an enterprise value of $1.03 billion. By November 16, 2005, Exide’s enterprise value had declined to $788 million. See Miller & Waisman, supra note 65. . Cash Flow Projections Are Inherently Subjective and Prone to Hindsight Bias Projected cash flows are probably the single most important component of solvency analysis because they are relevant to both a dynamic, cash-flow concept of solvency (can the company pay its debts as they become due?) and to a static, balance sheet approach to solvency (is the company currently worth more than it owes?). Projections are used both in liquidity analysis and in discounted cash-flow (“DCF”) analysis. Projecting future cash flows involves making a subjective judgment about the future based on imperfect and limited information about the past and the present. Although projections are generally based on a financial model, the complexity of sophisticated financial models may make it more difficult for bankruptcy judges to detect unreasonable subjective assumptions. DCF is a method of valuation that has three components: (1) projections of future cash flows of the debtor; (2) a discount rate that is used to convert future cash flows into their present value; and (3) a terminal value used to limit the necessary projection period. Experts can manipulate the outcome of a DCF analysis, either by constructing their own post hoc cash-flow projections or by selectively emphasizing certain projections that were created at the time of the allegedly fraudulent transaction. Terminal value can similarly be manipulated because it depends on the last year of cash-flow projections and on a perpetual growth rate for the company. Experts can manipulate terminal value by choosing a growth rate that is similar to the historical growth rate of either the company, the industry, or the broader economy (U.S. or global)—whichever leads to the outcome they prefer. In the fraudulent transfer context, where experts retroactively select cash-flow “projections” for the period between the challenged transaction and the bankruptcy, the credibility of cash-flow projections and growth rates depends on the apparent foreseeability of the business setbacks that derailed the debtor. Foreseeability is determined on a case-by-case basis, but such an ad hoc approach to justice provides little guidance to counterparties structuring transactions. In many cases, courts have reached seemingly inconsistent determinations about whether a particular type of business setback is foreseeable. Low-cost competition is apparently foreseeable in the automotive industry, but not in the mobile communications industry. Loss of revenue is apparently foreseeable if it is due to the loss of a key customer, but not if it is due to the loss of a key employee. Financial crises are apparently not foreseeable if they are due to defaults by poor, formerly communist countries, but they are foreseeable if they are due to defaults by poor subprime mortgage borrowers. In addition to contending with manipulations by expert witnesses and inconsistent precedent, judges must also contend with innate and universal psychological biases that affect all decision makers. An overwhelming amount of psychological research suggests that a judge will tend to believe that projections that closely match what actually happened are more reasonable than would a decision maker who did not have the benefit of hindsight. In other words, the court will generally tend to believe that more negative projections are more reasonable because the debtor did in fact file for bankruptcy. Instructions to the contrary, and legal prohibitions against hindsight, are an ineffective prophylactic against such hindsight bias. 2. Discount Rates Can Be Manipulated Because They Depend on Complicated Math Masking Subjective Assumptions Discount rates are important for static balance sheet solvency analysis. Experts can manipulate the discount rate by choosing from several methods of calculation. In addition, within each method, experts can manipulate assumptions about financial arcana such as equity risk premiums and systemic risk (beta). All else being equal, higher projections should be accompanied by a higher discount rate because more extreme projections are less likely to materialize. In practice, however, plaintiffs’ experts will typically use a high discount rate and low projections, while defense experts will typically use a low discount rate and high projections. 3. Multiples Methods Can Easily Be Manipulated Unless the Judge Is an Expert on Several Industries 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. Some are more cost-efficient, some have better growth prospects, some have stronger brands, and some enjoy better relationships with the government. They may have a different mix of business lines or operate in different markets. The selection of comparable companies is an art, not a science, with considerable room for manipulation by experts. Defense experts tend to select guideline companies or transactions that will yield a high multiple, and therefore a high valuation of the debtor, while plaintiffs’ experts tend to select guideline companies or transactions that will yield a low multiple. Without extensive knowledge of many companies (and industries, given that large debtors often have multiple business lines), courts cannot easily evaluate which comparables are more appropriate than others. 4. Experts Can Exploit Judges’ Natural Tendency to Avoid Extremes Experts often provide a “sensitivity analysis” displayed as a table containing a range of possible assumptions and projections. Such an analysis enhances the apparent sophistication of the projections and the credibility of the expert. However, because judges, like most decision makers, tend to prefer to avoid extremes, courts will be inclined to believe that the most likely outcome is one that is in the middle. By manipulating the endpoints of the range, and thereby moving the middle, the expert can guide the court toward a decision that is favorable to his client. Judges may also want to split the difference between experts, which encourages experts to take extreme positions. 5. Traditional Methods Assume That Capital Markets Are Efficient For all of their subjectivity and complexity, the traditional methods of solvency analysis still depend on the assumption that capital markets are efficient. The discount rate used in DCF analysis is almost always calculated using mathematical methods that require an assumption that capital markets are efficient. Multiples methods rely on the capital markets to value comparable firms comparably. If financial markets can be trusted to discount cash flows or value comparable firms, then one wonders why they cannot be trusted to value the debtor, thereby eliminating the need to determine which projections are appropriate or which firms are comparable. As discussed below, a number of recent decisions have suggested that not only can financial markets frequently be trusted, but they are in fact usually more trustworthy than litigation experts. Douglas Baird & Robert Rasmussen, Anti-Bankruptcy, 119 Yale L. J. 648, 655 (2010); Koller, Goedhart & Wessels, supra note 27, at 159. Prescott Group Small Cap v. Coleman Co., No. 17802, 2004 WL 2059515, at *31 (Del. Ch. Sept. 8, 2004); Cede & Co. v. Technicolor, Inc., No. Civ. A. 7129, 2003 WL 23700218, at *2 (Del. Ch. Dec. 31, 2003). Richard A. Brealey, Stewart C. Myers & Franklin Allen, Principles of Corporate Finance 65 (8th ed. 2006); Doft & Co. v. Travelocity.com, Inc., No. 19734, 2004 WL 1152338, at *5 (Del. Ch. May 20, 2004). See To-Am Equip. Co. v. Mitsubishi Caterpillar Forklift Am., Inc., 953 F. Supp. 987, 996–997 (N.D. Ill. 1997), aff’d, 152 F.3d 658 (7th Cir. 1998); Iridium Capital Corp. v. Motorola, Inc. (In re Iridium Operating), 373 B.R. 283, 351 (Bankr. S.D.N.Y. 2007). To-Am Equip., 953 F. Supp. at 996 (“[A] skilled practitioner can come up with just about any [projected future cash-flow] value he wants . . . .”); see also Bernstein, Seabury & Williams, supra note 25, at 187–88 Management, lending banks, investors, and Wall Street research analysts will typically all have prepared projections for large companies, often under several different scenarios and at several different points in time. Baird & Bernstein, supra note 22, at 1942–43. See CNB Int’l, Inc. v. Kelleher (In re CNB Int’l, Inc.), 393 B.R. 306, 321 (Bankr. W.D.N.Y. 2008). See In re Iridium Operating, 373 B.R. at 298 . See In re CNB Int’l., 393 B.R. at 321 . See MFS/Sun Life Trust-High Yield Series v. Van Dusen Airport Servs. Co., 910 F. Supp. 913, 944 (S.D.N.Y. 1995). See Peltz v. Hatten, 279 B.R. 710, 734–47 (D. Del. 2002) (finding that collapse of the high-yield bond market following the Russian debt default in the late 1990s was not foreseeable). See Official Comm. of Unsecured Creditors of Tousa, Inc. v. Citicorp N. Am., Inc. (In re TOUSA, Inc.), 422 B.R. 783, 813–14 (Bankr. S.D. Fla. 2009) (finding that the sharp decline in the housing market in August 2007 was foreseeable at least several months prior), rev’d on other grounds, In re TOUSA, Inc., Nos. 10-60017-CIV/GOLD, 10-61478, 10-62032, 10-62035, 10-62037, 2011 WL 522008 (S.D. Fla. Feb. 11, 2011). See Brealey, Myers & Allen, supra note 37, at 16, 37, 222–24; Koller, Goedhart & Wessels, supra note 27, at 292–94; Bernstein, Seabury & Williams, supra note 25, at 190. Brealey, Myers & Allen, supra note 37, at 66–67, 222–26; Bernstein, Seabury & Williams, supra note 25, at 191 n.102. See Del. Open MRI Radiology Assocs. v. Kessler, 898 A.2d 290, 338 (Del. Ch. 2006) (noting that “[t]estimonial feuds about discount rates often have the quality of a debate about the relative merits of competing alchemists” and that “[o]nce the experts’ techniques for coming up with their discount rates are closely analyzed, the court finds itself in an intellectual position more religious than empirical in nature, insofar as the court’s decision to prefer one position over the other is more a matter of faith than reason.”). See Brealey, Myers & Allen, supra note 37, at 217 (noting that “[m]easuring differences in risk is difficult to do objectively”); Koller, Goedhart & Wessels, supra note 27,, at 297–98 (“Sizing the market risk premium . . . is arguably the most debated issue in finance.”); Bernstein, Seabury & Williams, supra note 25, at 190–93. See Brealey, Myers & Allen, supra note 37, at 219–21; Koller, Goedhart & Wessels, supra note 27, at 307–08; Bernstein, Seabury & Williams, supra note 25, at 190–93. See CNB Int’l, Inc. v. Kelleher (In re CNB Int’l, Inc.), 393 B.R. 306, 320 (Bankr. W.D.N.Y. 2008). Koller, Goedhart & Wessels, supra note 27,, at 361. Id. Id. at 366–68, 380; Brealey, Myers & Allen, supra note 37, at 511; Bernstein, Seabury & Williams, supra note 25, at 196; Prescott Group Small Cap, L.P. v. Coleman Co., No. 17802, 2004 WL 2059515, at *22 (Del. Ch. Sept. 8, 2004); In re Radiology Assocs., Inc., 611 A.2d 485, 490 (Del. Ch. 1991). Koller, Goedhart & Wessels, supra note 27, at 362–63, 366–67. Peltz, 279 B.R. at 737–38; Lippe v. Bairnco Corp., 99 F. App’x 274, 279 (2d Cir. 2004); In re Oneida Ltd., 351 B.R. 79, 91 n.18 (Bankr. S.D.N.Y. 2006); see also Bernstein, Seabury & Williams, supra note 25, at 198–99. See, e.g., Global GT LP v. Golden Telecom, Inc., 993 A.2d 497, 510 (Del. Ch. 2010). Brealey, Myers & Allen, supra note 37, at 248 (“Sensitivity analysis boils down to expressing cash flows in terms of key . . . variables and then calculating the consequences of misestimating the variables. . . . One drawback to sensitivity analysis is that it always gives somewhat ambiguous results.”). See, e.g., Lippe, 288 B.R at 686–87, 689–90. Cass R. Sunstein, Social Norms and Social Roles, 96 Colum. L. Rev. 903, 933 (1996) (citing Itamar Simonson & Amos Tversky, Choice in Context: Tradeoff Contrast and Extremeness Aversion, 29 J. Marketing Res. 281, 289–92 (1992)); Bernstein, Seabury & Williams, supra note 25, at 198–99. Bernstein, Seabury & Williams, supra note 25, at 198–99. Koller, Goedhart & Wessels, supra note 27,, at 294–318; Del. Open MRI Radiology Assocs. v. Kessler, 898 A.2d 290, 338 (Del. Ch. 2006) (“[T]here is much dispute about how to calculate the discount rate to use in valuing their future cash flows, even when one tries to stick as closely as possible to the principles undergirding the capital asset pricing model and the semi-strong form of the efficient capital markets hypothesis.”); Bernstein, Seabury & Williams, supra note 25, at 190–92.
Delaware and New York Courts have started to use market prices to limit reliance on experts and avoid hindsight bias
Basic v. Levinson
(1988)
• U.S. Supreme Court embraces the efficient market hypothesis and the ability of well informed, well regulated securities markets to value securities
VFB (2005-2007)
• Delaware District Court and Third Circuit use security market prices to value an entire firm for fraudulent transfer analysis
• Court considers stock prices, bond prices (par), and access to credit • Misinformation cured by checking market price after truth was disclosed • Expert opinion a distant second to market valuation
Iridium (2007)
• S.D.N.Y. Bankruptcy Court approvingly cites VFB • Stock market prices and access to credit as signs of valuation • Notes in dicta that a sharp stock price decline may suggest a slide into the zone of
insolvency
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Presentation Notes
Strategy good, Implementation bad Note that courts essentially ignored experts, just checked to make sure the market had good data
SCOTUS has embraced market-based valuation:
“[T]he best way to determine value is exposure to a market,” not through a “determination . . . made by a judge in bankruptcy court.” --Bank of Am. Nat’l Trust & Sav. Ass’n v. 203 N. LaSalle St. P’ship, 526 U.S. 434, 456–57 (1999) “[T]he market . . . ideally transmits information to the investor in the processed form of a market price. Thus the market is performing a substantial part of the valuation process performed by the investor in a face-to-face transaction. The market is acting as the unpaid agent of the investor, informing him that given all the information available to it, the value of the stock is worth the market price.” “In an open and developed market . . . purchasers generally rely on the price of the stock as a reflection of its value.” --Basic v. Levinson, 485 U.S. 224, 244 (1988) (quoting, In re LVT Securities Litigation, 88 F.R.D. 134, 143 (N.D. Tex. 1980).
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Delaware and Third Circuit Courts have embraced market-based solutions:
“[T]he district court regarded the hired expert valuations as a side-show to the disinterested evidence of VFI’s capitalization in ‘one of the most efficient capital markets in the world’:
‘ . . . There is simply no credible evidence to justify setting aside VFI’s stock price and the other contemporaneous market evidence of VFI’s worth. Even if, as VFB implies, the market was suffering from some “irrational exuberance” in establishing VFI’s stock price, that gives me no basis for second-guessing the value that was fairly established in open and informed trading.’”
-VFB LLC v. Campbell Soup Co., 482 F.3d 624, 629-30 (3d Cir. 2007) affirming VFB LLC v. Campbell Soup Co., 2005 WL 2234606 (D. Del. 2005).
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Presenter
Presentation Notes
Delaware District Court and Third Circuit use security market prices to value an entire firm for fraudulent transfer analysis Court considers stock prices, bond prices (par), and access to credit Misinformation cured by checking market price after truth was disclosed Expert opinion a distant second to market valuation
New York Courts have embraced market-based solutions:
“The fact that Iridium failed in such a spectacular fashion stands out as a disturbing counterpoint to the market’s optimistic predictions of present and future value for Iridium, but in the end, the market evidence could not be denied. The capital markets synthesized and distilled what all the smart people of the era knew or believed to be true about Iridium. Given the overwhelming weight of that market evidence, it may be that the burden of proving insolvency and unreasonably small capital simply could not be met under any circumstances, regardless of the evidence adduced, in the wake of the Third Circuit’s VFB decision . . . ”
S.D.N.Y. Bankruptcy Court approvingly cites VFB Stock market prices and access to credit as signs of valuation Notes in dicta that a sharp stock price decline may suggest a slide into the zone of insolvency
Caesars risk-neutral market-implied probability of default: Comparison of CDS and bond spreads
LBO 5% Equity Sale
Four Properties
CERP Growth
2009 WSOP 2011 WSOP Trademark
Transfer 0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
CDS Bonds
Market participants' view of probability of Caesars Entertainment Operating Company default within 5 years, assuming 30% recovery Percent, Nov. 2006 – Jan. 2015*
* Caesars Entertainment Operating Company filed bankruptcy in January of 2015. CDS probabilities of default based on 5-year CDS spread from Bloomberg CBIN and 5-year swap rate. Bond probabilities based on spread between yield of CEOC 6 ½ percent 6/1/2016 Senior Unsecured Bullet Bond and U.S. Treasury with similar maturity date. 17
Note the cost difference– a few days, a few thousand dollars versus $17 million for the examiners report and months of time in the Ceasar’s bankruptcy, with more on the way. The results are generally very similar, but in 2012 to 2013, the CDS market was more skeptical than the bond market. https://www.dropbox.com/s/6pyh6rdplk6tu3q/Caesar%20Michael%20CDS%20data%202.xlsx?dl=0 Note—on days when 5-year swap spread was missing, filled in using average of previous and subsequent day.
Market-based methods seem to be gradually gaining greater acceptance, with more nuanced understanding of limitations
American Classic
Voyages (2008)
• Delaware District Court • Market-based methods are not mandatory under VFB
• DCF and expert testimony remain acceptable methods of solvency analysis • Court nevertheless sides with defense experts whose analysis was more consistent with market-
based measures • Debtor able to refinance debt and had access to revolving credit in spite of drop in equity value
Tronox (2013)
• S.D.N.Y. Bankruptcy Court • When debtor did not disclose material liabilities to market, market assessment of debtor’s
prospects unreliable • Ability to raise secured debt provides less evidence of solvency than unsecured debt or equity
• high recovery rate for secured debt not sensitive to default risk
Halliburton (2014)
• SCOTUS hears challenge to Basic v. Levinson • Fraud-on-the-market theory of Basic v. Levinson is valid—market price presumed to be accurate
and efficient • Party wishing to reject market valuation must prove that the markets are inefficient as a result of
manipulation
18
Presenter
Presentation Notes
American Classic Voyages 384 B.R. 62 District of Delaware, March 25, 2008 Adelphia Recovery Trust 2015 U.S. Dist. LEXIS 33229, March 17, 2015 SDNY
Market-based solvency analysis has many advantages over the traditional accounting-based approach
Improved accuracy & consistency
Market prices are a historical record of professional investor opinion at a specific point in time and prices therefore cannot exhibit hindsight bias
Precedent is more valuable if it is based on a unitary, consistent metric
Market-based measures of solvency historically have been more accurate than rating agency, analyst, and accounting based measures
Faster, cheaper, and more nuanced
Market-based analysis is faster and cheaper—the financial markets have already done most of the work
Courts can shift from a binary view focused on a single point in time to a probabilistic point of view that acknowledges changes over time
Risk management and prevention
Clear ex-ante liability empowers risk managers at investment banks to block imprudent transactions before they are completed
Commitments explicitly contingent on solvency / adequate capitalization?
Easier to prevent a bad transaction than to make stakeholders whole after the fact
19
Some predictions
Traditional methods will continue to be used alongside market-based methods for the foreseeable future
Courts will become more sophisticated in their understanding of market-based methods and eventually more reliant on these methods
20
Presenter
Presentation Notes
S.D.N.Y. Bankruptcy Court approvingly cites VFB Stock market prices and access to credit as signs of valuation Notes in dicta that a sharp stock price decline may suggest a slide into the zone of insolvency
Backup
Backup slides
21
Using Credit Spreads for Adequate Capitalization and Solvency Analysis
Legal background
Problems with traditional methods of solvency analysis
Courts in search of a market-based solution
A better approach—credit spreads
22
Corporate debtor’s credit risk is legally relevant and often hotly contested
Retrospective litigation Constructive fraudulent transfer / voidable transactions litigation Duty to creditors in the “zone of insolvency” Preference litigation (maybe)
Prospective transactional advice Solvency opinions in anticipation of leveraging transactions
Leveraged buyouts Dividend recapitalizations Corporate spin-offs Upstream or affiliate guarantees
23
Presenter
Presentation Notes
Note—under American Classic Voyages, court seemed open to solvency analysis for preference using market based measures like access to credit.
Fraudulent transfer law limits transfers of risk from equity holders to creditors
Liens and obligations incurred within 2 to 6 years of bankruptcy can be avoided if:
24
Fraudulent transfer law limits transfers of risk from equity holders to creditors
Liens and obligations incurred within 2 to 6 years of bankruptcy can be avoided if:
1. Transaction destroyed value for the debtor For less than reasonably equivalent value; OR Without fair consideration;
25
Presenter
Presentation Notes
6 years in New York under New York Civil Practice Law and Rules § 213(1), or 2 years from discovery, 213(8).
Fraudulent transfer law calls for prospective credit analysis at time of transfer
Liens and obligations incurred within 2 to 6 years of bankruptcy can be avoided if:
1. Transaction destroyed value for the debtor For less than reasonably equivalent value; OR Without fair consideration;
AND
2. Debtor was insolvent or inadequately capitalized at the time of the transaction
Already insolvent or became insolvent as a result; OR
Engaged in business with unreasonably small capital (assets); OR
Intended or believed it was incurring debts that it could not repay as they matured
26
Presenter
Presentation Notes
Because the test for the financial condition of the debtor is disjunctive, constructive fraudulent transfer is less tolerant of risk to creditors than a simple standard of balance sheet solvency. For example, even though a debtor currently has assets that exceed the value of its liabilities, it could still be inadequately capitalized or unlikely to pay its debts as they mature. 6 years in New York under New York Civil Practice Law and Rules § 213(1), or 2 years from discovery, 213(8).
Leveraged buyout transactions frequently satisfy the “not for reasonably equivalent value” prong of fraudulent transfer liability
Acquirer offers to buy equity at substantial premium to market price
Firm borrows money from the bank and
offers its assets as collateral
Acquirer uses the borrowed funds to pay
old shareholders
for their equity
New owner, less equity, less cash, more debt
27
Presenter
Presentation Notes
Notable cases, Lyondell, Tribue, Tousa
Using Credit Spreads for Adequate Capitalization and Solvency Analysis
Legal background
Problems with traditional methods of solvency analysis
Courts in search of a market-based solution
A better approach—credit spreads
28
Courts rely on the opinions of experts using methods of solvency analysis that are subjective and easily manipulated
How used by experts and courts Subjectivity and manipulability Projected cash flows
•Used in both Discounted Cash Flow analysis and liquidity analysis
•Experts can construct their own projections post-hoc or selectively emphasize some historic projections
Discount rates •Used to convert future cash flows into present value
•Depend on financial arcana such as equity risk premiums and systemic risk •Manipulation hard to detect
Terminal values •Used to limit explicit projection •Depends on discount rate, last year’s projections, and perpetual growth rate
•Manipulate projections and discount rate (as above) •Choose either industry, company, or economy-wide historic growth rate
Comparables / Multiples
•Used as a market check on DCF •Compare ratio of accounting metrics to market value of “comparable” firms or acquisition price of “comparable” transactions
•No two firms are ever perfectly comparable •Manipulate the selection of comparables and metrics to produce the desired multiples
Sensitivity analysis
•Used to show a range of outcomes by varying assumptions within the model
•Manipulate endpoints to produce the desired middle-of-the-road outcome
29
Presenter
Presentation Notes
Battle of experts; very expensive; complicated and subjective; Exide In re Exide Techs., 303 B.R. 48, 59 (Bankr. D. Del. 2003). The expert financial adviser to the debtor submitted a valuation range of $950 million to $1.05 billion, while the expert financial adviser to the creditors’ committee submitted a valuation range of $1.478 billion to $1.711 billion. Exide involved valuation for plan confirmation, not for fraudulent transfer. Id. at 66. Judge Carey determined the debtor’s valuation to be in the range of $1.4 billion to $1.6 billion. When Exide emerged from bankruptcy in May 2004, the market set an enterprise value of $1.03 billion. By November 16, 2005, Exide’s enterprise value had declined to $788 million. See Miller & Waisman, supra note 65. . Cash Flow Projections Are Inherently Subjective and Prone to Hindsight Bias Projected cash flows are probably the single most important component of solvency analysis because they are relevant to both a dynamic, cash-flow concept of solvency (can the company pay its debts as they become due?) and to a static, balance sheet approach to solvency (is the company currently worth more than it owes?). Projections are used both in liquidity analysis and in discounted cash-flow (“DCF”) analysis. Projecting future cash flows involves making a subjective judgment about the future based on imperfect and limited information about the past and the present. Although projections are generally based on a financial model, the complexity of sophisticated financial models may make it more difficult for bankruptcy judges to detect unreasonable subjective assumptions. DCF is a method of valuation that has three components: (1) projections of future cash flows of the debtor; (2) a discount rate that is used to convert future cash flows into their present value; and (3) a terminal value used to limit the necessary projection period. Experts can manipulate the outcome of a DCF analysis, either by constructing their own post hoc cash-flow projections or by selectively emphasizing certain projections that were created at the time of the allegedly fraudulent transaction. Terminal value can similarly be manipulated because it depends on the last year of cash-flow projections and on a perpetual growth rate for the company. Experts can manipulate terminal value by choosing a growth rate that is similar to the historical growth rate of either the company, the industry, or the broader economy (U.S. or global)—whichever leads to the outcome they prefer. In the fraudulent transfer context, where experts retroactively select cash-flow “projections” for the period between the challenged transaction and the bankruptcy, the credibility of cash-flow projections and growth rates depends on the apparent foreseeability of the business setbacks that derailed the debtor. Foreseeability is determined on a case-by-case basis, but such an ad hoc approach to justice provides little guidance to counterparties structuring transactions. In many cases, courts have reached seemingly inconsistent determinations about whether a particular type of business setback is foreseeable. Low-cost competition is apparently foreseeable in the automotive industry, but not in the mobile communications industry. Loss of revenue is apparently foreseeable if it is due to the loss of a key customer, but not if it is due to the loss of a key employee. Financial crises are apparently not foreseeable if they are due to defaults by poor, formerly communist countries, but they are foreseeable if they are due to defaults by poor subprime mortgage borrowers. In addition to contending with manipulations by expert witnesses and inconsistent precedent, judges must also contend with innate and universal psychological biases that affect all decision makers. An overwhelming amount of psychological research suggests that a judge will tend to believe that projections that closely match what actually happened are more reasonable than would a decision maker who did not have the benefit of hindsight. In other words, the court will generally tend to believe that more negative projections are more reasonable because the debtor did in fact file for bankruptcy. Instructions to the contrary, and legal prohibitions against hindsight, are an ineffective prophylactic against such hindsight bias. 2. Discount Rates Can Be Manipulated Because They Depend on Complicated Math Masking Subjective Assumptions Discount rates are important for static balance sheet solvency analysis. Experts can manipulate the discount rate by choosing from several methods of calculation. In addition, within each method, experts can manipulate assumptions about financial arcana such as equity risk premiums and systemic risk (beta). All else being equal, higher projections should be accompanied by a higher discount rate because more extreme projections are less likely to materialize. In practice, however, plaintiffs’ experts will typically use a high discount rate and low projections, while defense experts will typically use a low discount rate and high projections. 3. Multiples Methods Can Easily Be Manipulated Unless the Judge Is an Expert on Several Industries 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. Some are more cost-efficient, some have better growth prospects, some have stronger brands, and some enjoy better relationships with the government. They may have a different mix of business lines or operate in different markets. The selection of comparable companies is an art, not a science, with considerable room for manipulation by experts. Defense experts tend to select guideline companies or transactions that will yield a high multiple, and therefore a high valuation of the debtor, while plaintiffs’ experts tend to select guideline companies or transactions that will yield a low multiple. Without extensive knowledge of many companies (and industries, given that large debtors often have multiple business lines), courts cannot easily evaluate which comparables are more appropriate than others. 4. Experts Can Exploit Judges’ Natural Tendency to Avoid Extremes Experts often provide a “sensitivity analysis” displayed as a table containing a range of possible assumptions and projections. Such an analysis enhances the apparent sophistication of the projections and the credibility of the expert. However, because judges, like most decision makers, tend to prefer to avoid extremes, courts will be inclined to believe that the most likely outcome is one that is in the middle. By manipulating the endpoints of the range, and thereby moving the middle, the expert can guide the court toward a decision that is favorable to his client. Judges may also want to split the difference between experts, which encourages experts to take extreme positions. 5. Traditional Methods Assume That Capital Markets Are Efficient For all of their subjectivity and complexity, the traditional methods of solvency analysis still depend on the assumption that capital markets are efficient. The discount rate used in DCF analysis is almost always calculated using mathematical methods that require an assumption that capital markets are efficient. Multiples methods rely on the capital markets to value comparable firms comparably. If financial markets can be trusted to discount cash flows or value comparable firms, then one wonders why they cannot be trusted to value the debtor, thereby eliminating the need to determine which projections are appropriate or which firms are comparable. As discussed below, a number of recent decisions have suggested that not only can financial markets frequently be trusted, but they are in fact usually more trustworthy than litigation experts. Douglas Baird & Robert Rasmussen, Anti-Bankruptcy, 119 Yale L. J. 648, 655 (2010); Koller, Goedhart & Wessels, supra note 27, at 159. Prescott Group Small Cap v. Coleman Co., No. 17802, 2004 WL 2059515, at *31 (Del. Ch. Sept. 8, 2004); Cede & Co. v. Technicolor, Inc., No. Civ. A. 7129, 2003 WL 23700218, at *2 (Del. Ch. Dec. 31, 2003). Richard A. Brealey, Stewart C. Myers & Franklin Allen, Principles of Corporate Finance 65 (8th ed. 2006); Doft & Co. v. Travelocity.com, Inc., No. 19734, 2004 WL 1152338, at *5 (Del. Ch. May 20, 2004). See To-Am Equip. Co. v. Mitsubishi Caterpillar Forklift Am., Inc., 953 F. Supp. 987, 996–997 (N.D. Ill. 1997), aff’d, 152 F.3d 658 (7th Cir. 1998); Iridium Capital Corp. v. Motorola, Inc. (In re Iridium Operating), 373 B.R. 283, 351 (Bankr. S.D.N.Y. 2007). To-Am Equip., 953 F. Supp. at 996 (“[A] skilled practitioner can come up with just about any [projected future cash-flow] value he wants . . . .”); see also Bernstein, Seabury & Williams, supra note 25, at 187–88 Management, lending banks, investors, and Wall Street research analysts will typically all have prepared projections for large companies, often under several different scenarios and at several different points in time. Baird & Bernstein, supra note 22, at 1942–43. See CNB Int’l, Inc. v. Kelleher (In re CNB Int’l, Inc.), 393 B.R. 306, 321 (Bankr. W.D.N.Y. 2008). See In re Iridium Operating, 373 B.R. at 298 . See In re CNB Int’l., 393 B.R. at 321 . See MFS/Sun Life Trust-High Yield Series v. Van Dusen Airport Servs. Co., 910 F. Supp. 913, 944 (S.D.N.Y. 1995). See Peltz v. Hatten, 279 B.R. 710, 734–47 (D. Del. 2002) (finding that collapse of the high-yield bond market following the Russian debt default in the late 1990s was not foreseeable). See Official Comm. of Unsecured Creditors of Tousa, Inc. v. Citicorp N. Am., Inc. (In re TOUSA, Inc.), 422 B.R. 783, 813–14 (Bankr. S.D. Fla. 2009) (finding that the sharp decline in the housing market in August 2007 was foreseeable at least several months prior), rev’d on other grounds, In re TOUSA, Inc., Nos. 10-60017-CIV/GOLD, 10-61478, 10-62032, 10-62035, 10-62037, 2011 WL 522008 (S.D. Fla. Feb. 11, 2011). See Brealey, Myers & Allen, supra note 37, at 16, 37, 222–24; Koller, Goedhart & Wessels, supra note 27, at 292–94; Bernstein, Seabury & Williams, supra note 25, at 190. Brealey, Myers & Allen, supra note 37, at 66–67, 222–26; Bernstein, Seabury & Williams, supra note 25, at 191 n.102. See Del. Open MRI Radiology Assocs. v. Kessler, 898 A.2d 290, 338 (Del. Ch. 2006) (noting that “[t]estimonial feuds about discount rates often have the quality of a debate about the relative merits of competing alchemists” and that “[o]nce the experts’ techniques for coming up with their discount rates are closely analyzed, the court finds itself in an intellectual position more religious than empirical in nature, insofar as the court’s decision to prefer one position over the other is more a matter of faith than reason.”). See Brealey, Myers & Allen, supra note 37, at 217 (noting that “[m]easuring differences in risk is difficult to do objectively”); Koller, Goedhart & Wessels, supra note 27,, at 297–98 (“Sizing the market risk premium . . . is arguably the most debated issue in finance.”); Bernstein, Seabury & Williams, supra note 25, at 190–93. See Brealey, Myers & Allen, supra note 37, at 219–21; Koller, Goedhart & Wessels, supra note 27, at 307–08; Bernstein, Seabury & Williams, supra note 25, at 190–93. See CNB Int’l, Inc. v. Kelleher (In re CNB Int’l, Inc.), 393 B.R. 306, 320 (Bankr. W.D.N.Y. 2008). Koller, Goedhart & Wessels, supra note 27,, at 361. Id. Id. at 366–68, 380; Brealey, Myers & Allen, supra note 37, at 511; Bernstein, Seabury & Williams, supra note 25, at 196; Prescott Group Small Cap, L.P. v. Coleman Co., No. 17802, 2004 WL 2059515, at *22 (Del. Ch. Sept. 8, 2004); In re Radiology Assocs., Inc., 611 A.2d 485, 490 (Del. Ch. 1991). Koller, Goedhart & Wessels, supra note 27, at 362–63, 366–67. Peltz, 279 B.R. at 737–38; Lippe v. Bairnco Corp., 99 F. App’x 274, 279 (2d Cir. 2004); In re Oneida Ltd., 351 B.R. 79, 91 n.18 (Bankr. S.D.N.Y. 2006); see also Bernstein, Seabury & Williams, supra note 25, at 198–99. See, e.g., Global GT LP v. Golden Telecom, Inc., 993 A.2d 497, 510 (Del. Ch. 2010). Brealey, Myers & Allen, supra note 37, at 248 (“Sensitivity analysis boils down to expressing cash flows in terms of key . . . variables and then calculating the consequences of misestimating the variables. . . . One drawback to sensitivity analysis is that it always gives somewhat ambiguous results.”). See, e.g., Lippe, 288 B.R at 686–87, 689–90. Cass R. Sunstein, Social Norms and Social Roles, 96 Colum. L. Rev. 903, 933 (1996) (citing Itamar Simonson & Amos Tversky, Choice in Context: Tradeoff Contrast and Extremeness Aversion, 29 J. Marketing Res. 281, 289–92 (1992)); Bernstein, Seabury & Williams, supra note 25, at 198–99. Bernstein, Seabury & Williams, supra note 25, at 198–99. Koller, Goedhart & Wessels, supra note 27,, at 294–318; Del. Open MRI Radiology Assocs. v. Kessler, 898 A.2d 290, 338 (Del. Ch. 2006) (“[T]here is much dispute about how to calculate the discount rate to use in valuing their future cash flows, even when one tries to stick as closely as possible to the principles undergirding the capital asset pricing model and the semi-strong form of the efficient capital markets hypothesis.”); Bernstein, Seabury & Williams, supra note 25, at 190–92.
Courts are supposed to make adequate capitalization determinations without hindsight
The court’s task is “not to examine what happened to the company but whether the projections employed prior the LBO were prudent. . . . [A] decision should not be made using hindsight.” -Murphy v. Meritor Sav. Bank (In re O’Day Corp.), 126 B.R. 370, 404 (Bankr. D. Mass. 1991).
“We know, with hindsight, that the forecasts were not realized. But ‘[t]he question the court must decide is not whether [the] projection was correct, for it clearly was not, but whether it was reasonable and prudent when made.’” -MFS/Sun Life Trust High-Yield Series v. Van Dusen Airport Servs. Co., 910 F. Supp. 913, 943–44 (S.D.N.Y. 1995); (quoting Credit Managers, 629 F. Supp. 175, 184 (C.D. Cal. 1985); Moody v. Sec. Pac. Bus. Credit, 971 F.2d 1056, 1073 (3d Cir. 1992)).
30
Experimental evidence suggests that traditional methods lead to legally impermissible hindsight bias
Real judges
• 2 studies, collectively including hundreds of judges
In a similar situation
• Evaluating auditors’ reports for company that subsequently did poorly
Show hindsight
bias
• Judges opinion of auditors depends on whether judges knew the ultimate outcome for the company
Hard to de-bias
• Instructions not to use hindsight don’t work
• Risk of higher level review does not work
• Deference to primary reviewer helps
31
Presenter
Presentation Notes
In the prototypical study of hindsight bias in the litigation context, evaluators are randomly divided into two groups, a foresight group and a hindsight group. Evaluators from both groups are asked to independently evaluate the prudence of a defendant’s decision.104 However, each group of evaluators has access to different information. Evaluators in the foresight group are presented with all of the information that was available to the defendant at the time of the decision, but do not know the outcome of the decision. Evaluators in the hindsight group are presented with all of the information shown to the foresight group, plus the ultimate outcome. In other words, evaluators in the hindsight group share the role of real world decision makers—such as bankruptcy judges—who attempt to judge without utilizing hindsight, but nevertheless have access to information that may lead them to inadvertently judge with hindsight. The studies consistently find that evaluators in the hindsight group view the actual outcome as far more likely, and the defendant as far more culpable, than do evaluators in the foresight group.105 Worse yet, the more severe the negative outcome, the stronger the hindsight bias.106 In the fraudulent transfer context, this suggests that the more severe the losses—and therefore the higher the stakes of fraudulent transfer litigation between secured lenders and unsecured creditors—the greater the danger of hindsight bias. 1. Studies Demonstrate That Hindsight Bias Affects Judges There are strong reasons to believe that the results of these controlled experiments are applicable to legal decision making in the real world. Several studies set in a context resembling the circumstances of bankruptcy judges in fraudulent transfer cases against LBO lenders have found evidence of hindsight bias. In one study, 193 actual judges were divided into foresight and hindsight groups.107 The judges in each group were not aware of the existence of the other group. The judges were presented with information relevant to a determination under accounting rules of whether or not a merger target should immediately book losses because its inventory could become obsolete.108 The judges also learned that an auditing firm retained by the target recommended that it not book the losses.109 The judges in the hindsight group received additional information: they learned that after the audit opinion, the merger target’s market share declined, the target was forced to book inventory losses, and he acquiring corporation sued the auditor based on its audit opinion.110 Both groups of judges read a disclaimer stating that they had all of the information that was available to the auditors at the time of the audit.111 Finally, both groups of judges were asked to evaluate the propriety of the auditing firm’s decision not to recommend immediate booking of losses.112 The study found significant hindsight bias among judges in the hindsight group: judges in the hindsight group were far more likely to rate the auditor’s decision as “inappropriate.”113 In a similar study involving 96 actual judges, judges in the foresight group read detailed information about the business and financials of a manufacturing company facing potential obsolescence of its major product.114 The judges learned that a retained auditor had opined that the company would continue as a going concern for at least one additional year.115 Judges in the hindsight group received the same information but learned that soon after the audit opinion the company was forced to take a significant inventory write- down and was driven into bankruptcy.116 Finally, both groups of judges were asked to evaluate the propriety of the auditing firm’s opinion.117 The study found significant hindsight bias among judges in the hindsight group.118 While this study did find evidence that more experienced judges were less likely to exhibit hindsight bias in the litigation context, there was no evidence that experience could entirely eliminate hindsight bias in judges.119 The researchers specifically noted that audit trails may be particularly conducive to hindsight bias, because “evidence can be reconstructed to reveal arguable deficiencies in audit procedures and decisions.”120 Similarly, in the fraudulent transfer context, historical cash-flow analyses can be picked apart years later, providing a convenient means to reconstruct the evidence with the benefit of hindsight.
Using Credit Spreads for Adequate Capitalization and Solvency Analysis
Legal background
Problems with traditional methods of solvency analysis
Courts in search of a market-based solution
A better approach—credit spreads
32
New York Courts have embraced market-based solutions:
“The fact that Iridium failed in such a spectacular fashion stands out as a disturbing counterpoint to the market’s optimistic predictions of present and future value for Iridium, but in the end, the market evidence could not be denied. The capital markets synthesized and distilled what all the smart people of the era knew or believed to be true about Iridium. Given the overwhelming weight of that market evidence, it may be that the burden of proving insolvency and unreasonably small capital simply could not be met under any circumstances, regardless of the evidence adduced, in the wake of the Third Circuit’s VFB decision . . . ”
S.D.N.Y. Bankruptcy Court approvingly cites VFB Stock market prices and access to credit as signs of valuation Notes in dicta that a sharp stock price decline may suggest a slide into the zone of insolvency
95
97
99
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103
105
107
109
7/1/
067/
3/06
7/5/
067/
7/06
7/9/
067/
11/0
67/
13/0
67/
15/0
67/
17/0
67/
19/0
67/
21/0
67/
23/0
67/
25/0
67/
27/0
67/
29/0
67/
31/0
68/
2/06
8/4/
068/
6/06
8/8/
068/
10/0
68/
12/0
68/
14/0
68/
16/0
6
40
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50
HCA Equity (USD)
HCA 8-3/4 11/01/10 Bond
HCA 8-3/4 09/01/10 Bond
Transaction announced
Equity prices and bond prices are bad measures of solvency: Equity prices can go up while bond prices go down
Note: HCA buyout was announced July 24, 2006 and completed November 20, 2006 Source: Bloomberg
HCA bonds closing price 100 = par
HCA equity closing price USD per share
34
Presenter
Presentation Notes
Explain why equity prices go up – option value, upside volatility Explain bond prices– move inverse to interest rates, inflation, liquidity, etc.
Bond prices are a bad measure of solvency: Many factors besides default risk affect bond prices
As prevailing market interest rates go up. . .
. . . Bond prices go down (especially for bonds with high duration)
Market Interest rates
Inflation
Risk free rate of return
Liquidity
Default risk
35
Using Credit Spreads for Adequate Capitalization and Solvency Analysis
Legal background
Problems with traditional methods of solvency analysis
Courts in search of a market-based solution
A better approach—credit spreads
36
Estimating risk-neutral market-implied probabilities of default
37
Presenter
Presentation Notes
The model assumes that investments in education are driven both by financial returns and by non-financial considerations, or consumption, Ce. The model assumes that the market will equalize the after-tax marginal rate of return on higher education plus the consumption value of higher education on the one hand, with the after-tax marginal rate of return to another market investment on the other. So the model captures most people’s intuition that decisions about education are driven both by financial and non-financial considerations. The financial considerations are influenced by tax rates. I’ve decomposed after-tax rates of return into a combination of pre-tax rates of return and tax rates. I then algebraically rearranged the equation to solve for the pre-tax rate of return to higher education. Then I plugged in some illustrative values.
Mathematical model: Estimating risk-neutral market-implied probabilities of default
Corporate bonds Credit default swaps
38
Presenter
Presentation Notes
The model assumes that investments in education are driven both by financial returns and by non-financial considerations, or consumption, Ce. The model assumes that the market will equalize the after-tax marginal rate of return on higher education plus the consumption value of higher education on the one hand, with the after-tax marginal rate of return to another market investment on the other. So the model captures most people’s intuition that decisions about education are driven both by financial and non-financial considerations. The financial considerations are influenced by tax rates. I’ve decomposed after-tax rates of return into a combination of pre-tax rates of return and tax rates. I then algebraically rearranged the equation to solve for the pre-tax rate of return to higher education. Then I plugged in some illustrative values.
As number of years in reach-back period increase, cumulative probability of default increases
Presenter
Presentation Notes
Holding all else equal, as the tax rate on higher education increases [trace from left to right on the x-axis]— the pre-tax rate of return to higher education increases [trace from bottom to top on the y-axis]. In other words, higher taxes on higher education help explain higher returns on higher education. What about the consumption value of education? The traditional view that education should not be taxed as an investment because it has positive consumption value makes high pre-tax returns to education even more mysterious. As the consumption value of higher education goes from negative to positive [trace down the curves], the pre-tax return to higher education falls. In other words, if on the margin prospective students dislike education or related work, then this can help explain high financial returns. People need a higher financial return to make up for their pain and suffering. Academics tend to have a hard time with this idea. A lot of people in this room have one or two or three advance degrees, and most of us probably enjoyed getting them. Professors are people who love school so much that we never wanted to leave. But our preferences are unusual. Most people seem to find learning stressful and difficult. This can help explain the high returns to education. If we think that higher education has positive consumption value, then under equal tax rates, the returns to education should be lower than other investments. [point to lower left corner] To explain the high returns to higher education, we need an even larger tax rate differential. So, if you believe this story about taxes driving down investment in higher education, then what should we do about it?
As expected loss rate increases, probability of default decreases
Presenter
Presentation Notes
Holding all else equal, as the tax rate on higher education increases [trace from left to right on the x-axis]— the pre-tax rate of return to higher education increases [trace from bottom to top on the y-axis]. In other words, higher taxes on higher education help explain higher returns on higher education. What about the consumption value of education? The traditional view that education should not be taxed as an investment because it has positive consumption value makes high pre-tax returns to education even more mysterious. As the consumption value of higher education goes from negative to positive [trace down the curves], the pre-tax return to higher education falls. In other words, if on the margin prospective students dislike education or related work, then this can help explain high financial returns. People need a higher financial return to make up for their pain and suffering. Academics tend to have a hard time with this idea. A lot of people in this room have one or two or three advance degrees, and most of us probably enjoyed getting them. Professors are people who love school so much that we never wanted to leave. But our preferences are unusual. Most people seem to find learning stressful and difficult. This can help explain the high returns to education. If we think that higher education has positive consumption value, then under equal tax rates, the returns to education should be lower than other investments. [point to lower left corner] To explain the high returns to higher education, we need an even larger tax rate differential. So, if you believe this story about taxes driving down investment in higher education, then what should we do about it?
Example: Caesars Fraudulent Transfer Litigation
TPG and Apollo Global Management purchase Harrah’s / Caesars in LBO;
$30.7 billion (including assumption of $12.4 billion in debt)
Deal agreed December 2006 Deal closed January 28, 2008
Caesars Entertainment Operating Company files Chapter 11 in Northern District of Illinois, January 15, 2015
Examiner’s report
Analyzes solvency at a few points in time and uses “retrojection” to fill in the times in between
Suggests that the LBO itself is probably not a constructive fraudulent transfer because Caesars was solvent at the time
But a series of transactions from 2009 forward may be constructive fraudulent transfers
41
Caesars risk-neutral CDS market-implied probability of default and selected transactions
LBO 5% Equity Sale
Four Properties
CERP Growth
2009 WSOP 2011 WSOP Trademark
Transfer 0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Assuming 40% recovery
Assuming 20% recovery
CDS market participants' view of probability of Caesars Entertainment Operating Company default within 5 years Percent, Oct. 2007 – Nov. 2014*
* Caesars Entertainment Operating Company filed bankruptcy in January of 2015. Probabilities of default based on 5-year CDS spread from Bloomberg CBIN (Intra-day NY). Transactions closing date showed as vertical lines. 5-year swap rate used as risk-free rate (results would have been similar with 5-year constant maturity treasury). 42
https://www.dropbox.com/s/6pyh6rdplk6tu3q/Caesar%20Michael%20CDS%20data%202.xlsx?dl=0 Note—on days when 5-year swap spread was missing, filled in using average of previous and subsequent day.
Caesars risk-neutral market-implied probability of default: Comparison of CDS and bond spreads
LBO 5% Equity Sale
Four Properties
CERP Growth
2009 WSOP 2011 WSOP Trademark
Transfer 0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
CDS Bonds
Market participants' view of probability of Caesars Entertainment Operating Company default within 5 years, assuming 30% recovery Percent, Nov. 2006 – Jan. 2015*
* Caesars Entertainment Operating Company filed bankruptcy in January of 2015. CDS probabilities of default based on 5-year CDS spread from Bloomberg CBIN and 5-year swap rate. Bond probabilities based on spread between yield of CEOC 6 ½ percent 6/1/2016 Senior Unsecured Bullet Bond and U.S. Treasury with similar maturity date. 43
The results are generally very similar, but in 2012 to 2013, the CDS market was more skptical than the bond market. https://www.dropbox.com/s/6pyh6rdplk6tu3q/Caesar%20Michael%20CDS%20data%202.xlsx?dl=0 Note—on days when 5-year swap spread was missing, filled in using average of previous and subsequent day.
Caesars risk-neutral bond market-implied probability of default and selected transactions
LBO 5% Equity Sale
Four Properties
CERP Growth
2009 WSOP 2011 WSOP Trademark
Transfer 0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Assuming 40% recovery
Assuming 20% recovery
Bond market participants' view of probability of Caesars Entertainment Operating Company default within 5 years Percent, Nov. 2006 – Jan. 2015*
* Caesars Entertainment Operating Company filed bankruptcy in January of 2015. Probabilities of default based on spread between yield of Caesars Entertainment Operating Company 6 ½ percent 6/1/2016 Senior Unsecured Bullet Bond and U.S. Treasury with similar maturity date. Transactions closing date showed as vertical lines.
Caesars Bond CUSIP 413627AX8 Matched Treasury Bond CUSIP912810DW5
Caesars risk-neutral bond market-implied probability of default within 2, 4, and 6 years
LBO 5% Equity Sale
Four Properties
CERP Growth
2009 WSOP 2011 WSOP Trademark
Transfer 0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Within 4 years
Within 2 years
Within 6 years
Bond market participants' view of probability of Caesars Entertainment Operating Company default assuming 30 percent recovery Percent, Nov. 2006 – Jan. 2015*
* Caesars Entertainment Operating Company filed bankruptcy in January of 2015. Probabilities of default based on spread between yield of Caesars Entertainment Operating Company 6 ½ percent 6/1/2016 Senior Unsecured Bullet Bond and U.S. Treasury with similar maturity date. Transactions closing date showed as vertical lines.
Option 2: Derivatives Market Sell CDS Protection for 3% extra yield
Investor B Risky portfolio,
wants to reduce risk
Initial portfolio: Corporate bond yielding 8%
Option 1: Cash Market Sell corporate bond,
Buy risk free instrument
Option 2: Derivatives Market Buy CDS protection for a 3% fee
* In practice, will often not be precisely equal because of taxes, liquidity, regulation, market fragmentation, transaction fees, and counterparty risk at derivatives dealers.
Default risk
Counterparty risk
58
Basell was the riskiest LyondellBasell Industries entity, followed by Lyondell, Millennium, and Equistar
LBO Announced LBO Completed
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09
Basell
Lyondell
Millennium
Equistar
CDS market participants' view of Lyondell entities’ probability of defaulting assuming 30 percent recovery Percent, Jan. 2006 – Jan. 2009*
* Lyondell Chemical company filed bankruptcy in January of 2009. Probabilities of default based on 5 year CDS spreads.
59
Presenter
Presentation Notes
Used 5 year swap rate as risk free rate.
Lyondell was more likely to default than comparable refining companies
LBO Announced LBO Completed
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09
Lyondell
Tesoro
Sunoco
Valero
CDS market participants' view of refining companies’ probability of defaulting assuming 30 percent recovery Percent, Jan. 2006 – Jan. 2009*
* Lyondell Chemical company filed bankruptcy in January of 2009. Probabilities of default based on 5 year CDS spreads.
60
Presenter
Presentation Notes
Used 5 year swap rate as risk free rate.
New UVTA provision clarifies that plaintiffs bear the burden of persuasion of financial condition in constructive fraud
UVTA § 4(c) (c) A creditor making a claim for relief under subsection (a) has the burden of proving the elements of the claim for relief by a preponderance of the evidence. Comment 11
Subsection (c) [newly added in 2014] allocates to the party making a claim for relief under § 4 the burden of persuasion as to the elements of the claim. Courts should not apply nonstatutory presumptions that reverse that allocation, and should be wary of nonstatutory presumptions that would dilute it. . . . An example of a nonstatutory presumption that should be rejected . . . is a presumption that the transferee bears the burden of persuasion as to the debtor’s compliance with the financial condition tests in § 4(a)(2) and § 5, in an action under those provisions, if the transfer was for less than reasonably equivalent value (or, as another example, if the debtor was merely in debt at the time of the transfer). See Fidelity Bond & Mtg. Co. v. Brand, 371 B.R. 708, 716-22 (E.D. Pa. 2007) (rejecting such a presumption previously applied in Pennsylvania).
61
Presenter
Presentation Notes
Introduce goal
Although insolvency is narrowly defined under the bankruptcy code as balance sheet insolvency . . .
The term “insolvent” means . . . [a] financial condition such that the sum of such entity’s debts
is greater than all of such entity’s property,
at a fair valuation, exclusive of—
(i) property transferred, concealed, or removed with intent to hinder,
delay, or defraud such entity’s creditors; AND (ii) property that may be exempted from property of the estate . . .
62
Presenter
Presentation Notes
Introduce goal
Statutory text calls for a predictive analysis beyond the balance sheet
Transfer from the debtor is voidable if no reasonably equivalent value and debtor:
(I) was insolvent on the date
that such transfer was made or such obligation was incurred, OR became insolvent
as a result of such transfer or obligation; [OR]
(II) was engaged in business or a transaction, or was about to engage in business or a transaction, for which any property remaining with the debtor was an unreasonably small capital;
[OR]
(III) intended to incur, or believed that the debtor would incur, debts that would be beyond the debtor’s ability to pay as such debts matured . . .
63
Presenter
Presentation Notes
Introduce goal
Some notable fraudulent transfer cases
Liquidation Trust of Hechinger Inv. Co. of Del. v. Fleet Retail Fin. Grp. (In re Hechinger Inv. Co. of Del.), 327 B.R. 537, 546–47, 551 (D. Del. 2005), aff’d, 278 F. App’x 125 (3d Cir. 2008).
In re Tribune Co., 418 B.R. 116 (Bankr. D. Del. 2009).
In re TOUSA, 422 B.R. 783 (Bankr. S.D. Fla. 2009) 444 B.R. 613 (S.D. Fla 2011) 680 F. 3d 1298 (11th Cir. 2012)
Complaint of the Official Committee of Unsecured Creditors of Lyondell Chemical Co., In re Lyondell Chemical Co., No. 09-10023 (REG), 2009 WL 2350776 (Bankr. S.D.N.Y. July 22, 2009.
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