United States: Are A Debtor’s Trading Prices Reliable Evidence Of Its Enterprise Value?

First published by ABI Journal, September 2011

Valuation disputes can be among the most critical issues addressed during the course of a bankruptcy case, at least in terms of economic impact to various bankruptcy participants. They arise in several contexts, including plan confirmation, adequateprotection requests, avoidance actions and the appointment of equity committees. Courts have generally recognized three accepted methodologies for valuing a debtor company: (1) the "discounted cash flow" (DCF) approach, which values a company based on the present value of projected future cash flows; (2) the "comparable company" approach, which values a company by reference to the trading prices of similar public companies; and (3) the "comparable transactions" approach, which values a company by reference to recent mergers and acquisitions involving similar companies.²

Problems with Valuation Methodologies

Courts may be reluctant to embrace any methodology outside this "trinity," and a number have looked askance at any sort of "novel" deviation from it.³ At the same time, courts and commentators have long acknowledged the many shortcomings of the accepted methodologies, even referring to the valuation exercise in its current form as "a guess compounded by an estimate."⁴ The DCF method, generally regarded as "the most commonly used and accepted method of valuing an enterprise,"⁵ presents an alluring façade of exactitude but can sometimes rest on a shifting foundation of assumptions and subjectivity. The slightest tweak in a debtor's assumed cost of debt, cost of equity or revenue growth rate can alter a calculated enterprise value by billions of dollars, particularly because so much of the debtor's value often comes from a "terminal value" up to 10 years in the future.⁶ Comparable companies and recent comparable transactions can be difficult to find. Each of these problems is magnified by the systemic biases the parties and their experts may have, in order to arrive at a particular value that could serve their economic interests.⁷ Judges are often placed in the difficult position of having to choose between two extreme polar valuations.

Traded Claims and Interests

All the while, in major cases, another rather obvious source of information about a debtor's enterprise value has largely been ignored: the trading prices of various claims against or equity interests in the debtor, including traded securities (e.g., stocks and bonds), bank debt and trade claims. Perhaps, seeing clearly insolvent chapter 11 debtors maintain positive stock prices, courts struggled with concerns that the trading prices of a debtor's securities are inherently unreliable.⁸ It is no longer the case that a debtor's stock comprises the only commonly traded interest. In large chapter 11 cases, bank loans,⁹ second-lien financings ,bonds and even trade claims¹⁰ may be freely traded in fairly liquid secondary markets. Unlike equity markets, which are more acce ssible to unsophisticated and potentially inattentive investors, distressed-debt markets tend to be dominated by professional investors. To take just one run-of-the-mill example of how liquid such markets are, consider the case of Blockbuster Inc. From its petition date of Sept. 23, 2010, to April 2011, its senior subordinated bonds traded 1,524 times for an aggregate volume of approximately $323 million.11 The range of values expressed by such trades can inform the court's view of whether value is likely to be available to unsecured debtholders. Actively traded instruments could be an efficient mechanism for price (value) discovery; while not dispositive, they can provide dozens of daily datapoints from sophisticated investors with "skin in the game."

Campbell Soup

Courts have recognized the valuediscovery benefits of markets in certain bankruptcy contexts. For example, in VFB LLC v. Campbell Soup Co., the Third Circuit resoundingly approved of market capitalization (number of shares multiplied by share price) as a measure of reasonably equivalent value for purposes of fraudulent-transfer analysis.¹² Creditors of debtor Vlasic Foods International Inc. (VFI) brought a fraudulent-transfer action against VFI's former parent Campbell Soup, arising from a "leveraged spin-off" of VFI. The creditors argued that the value of the businesses VFI received in the spin-off was not reasonably equivalent to the $500 million it transferred to Campbell Soup. Campbell Soup countered that the businesses were worth at least that much, and noted that the public-equity markets placed a value of more than $1 billion on VFI after the spin-off. The court agreed with Campbell Soup, holding that "[a] bsent some reason to distrust it, the market price is a more reliable measure of the stock's value than the subjective estimates of one or two expert witnesses."¹³ Courts also frequently endorse market-checking or "shopping" in § 363 asset sales as a means of verifying that the debtor is getting a fair price.¹⁴

Delaware Court's Response to Market-Trading Evidence

Nevertheless, in the context of determining total enterprise value,¹⁵ courts have had varied reactions to evidence of the debtor's own market-trading prices. Some courts have left open the possibility that they might be willing to accept evidence of debt-trading prices upon a proper showing of the depth and reliability of the market. In the Spansion case, in response to certain plan objectors' arguments that claims-trading prices should be taken as evidence of value, Hon. Kevin J. Carey of the U.S. Bankruptcy Court for the District of Delaware noted that "there is no evidence beyond the mere statement of certain trading prices. There is no record on the number of trades, over what period of time such trades occurred, how open the market is to participants or other factors that may be relevant."¹⁶ By negative inference, one could conclude that Judge Carey may have accorded some deference to trading prices if facts about the market had been shown.

In another example, in connection with the plan-confirmation hearings of packaging company Smurfit-Stone, Hon. Brendan L. Shannon entertained an official committee of equityholders' arguments that the bonds had traded up during the course of the case from 12 cents on the dollar into the range of 90 cents on the dollar, and it was therefore likely that equity was in the money. Judge Shannon did not reject such evidence outright, but asked on the record, "the question is how much weight and significance I can accord to it and the extent to which I need to actually drill down on that question and find out what actually is—what does that market consist of? Is it an open and robust market with multiple players?... I'm trying to figure out how to deal with that."¹⁷ Judge Shannon's comments reflect at least some willingness to entertain bond prices as evidence of value for purposes of confirmation.

Mirant

On the other hand, at least one court has rejected the contention that preconfirmation trading prices are reliable evidence of a debtor's total enterprise value. In Mirant, the U.S. Bankruptcy Court for the Northern District of Texas was faced with statements from the equity committee that Mirant's bonds traded as high as 101.25 percent of face amount, suggesting that there may be slight residual value left over for equity.¹⁸ The court held that "the market is not the proper measure of value for Mirant Group for the purpose of satisfying claims," and explained this holding on three principal grounds: (1) the trading price of a single share or bond may not reflect the price the company "might command if sold as a going-concern, with control, synergies and other attributes that might affect a buyer's judgment of fair value"; (2) the market price at the time of a preconfirmation valuation hearing is less relevant, and reflects the uncertainties associated with plan confirmation; (3) the relevant time for valuation is the time of confirmation; and (4) the market "is too pessimistic about the effects of bankruptcy and not sufficiently appreciative of [c] hapter 11's benefits."¹⁹

Courts in the future may inquire as to whether these concerns are unique to debt-trading prices or whether they apply equally to the accepted valuation methodologies. With respect to the court's first concern, for example, comparable companies' trading prices are often used to value the debtor, but such trading prices may exclude specific regard for the value of "control, synergies and other attributes that might affect a buyer's judgment of fair value." Nor does a typical DCF analysis (outside of a sale context) reflect synergies, which are unique to each particular buyer. In response to the court's second concern, other courts may simply schedule enterprise valuation hearings closer to confirmation. Further, a court need not limit itself to wholesale adoption or rejection of trading prices on one particular day, but may instead utilize claims-trading prices to determine a reasonable range of value, which may be blended with the other methods to arrive at an assumed value. Finally, the currently accepted valuation methodologies are also susceptible to the criticism that they fix value at the wrong point in time: Comparable transactions are frequently years old, and DCFs reflect assumptions made with only the information available at the time of the valuation hearing.

With respect to the court's third concern that the market is too pessimistic about bankrupt companies, future courts may consider whether the current realities of the distressed investing market support such a view. During the recession of 2008-09, billions of dollars flowed into the distressed investing strategy, and it is dominated by sophisticated investors who specialize in putting large sums of capital at risk in bankrupt companies. While there is room for debate about the desirability of such participants' impact on the bankruptcy dynamic, it may be increasingly difficult to support the contention that investors are ill-informed or frightened about chapter 11.

Additional Concerns

Two further criticisms may be raised against using a debtor's trading prices as a measure of enterprise value. First, certain thin markets may be manipulable. An investor might intentionally and artificially drive up prices in one security in order to impact the distribution in connection with another. A natural curb on such conduct is the fact that such a party would probably sustain losses because it would have to intentionally overpay for one security. Markets in bankrupt companies' debt and bonds are often sufficiently deep and diverse that tens of millions of dollars must be invested to substantially impact price. Further, courts could address this concern by taking evidence of market depth and likely manipulation. Bankruptcy courts have demonstrated their ability to police investments made in bad faith.²⁰ Revisions to Bankruptcy Rule 2019, taking effect on Dec. 1, 2011, could also aid courts in this regard: The revised Rule will require certain parties to disclose every "disclosable economic interest," including short and derivative positions, whenever they take a position before the court or solicit votes on a plan.

A second possible concern is that securities prices may be volatile or seemingly irrational. In thin, illiquid markets dominated by a few traders, it may be that trading prices are irredeemably unreliable, but in larger, more liquid markets for claims against "mega-case" debtors, the dynamic should be less pervasive. Some respected commentators have suggested that seemingly economically irrational claims-bargaining behavior may be attributable to valuation uncertainty existing under the prevailing methods.²¹

Conclusion

Some courts have signaled a willingness to attribute significance to a debtor's own market-trading prices for purposes of arriving at an enterprise value. Whether the market-friendly rationale underlying Campbell Soup is extended to the area of enterprise valuation remains to be seen. Parties requesting that a court accord significance to a debtor's trading prices should be prepared, at a minimum, to present evidence of market liquidity and reliable pricing.

Footnotes

1 The views expressed herein are the authors' own and not necessarily those of the firm's clients.

2 Familiarity with these methodologies is assumed. For a more detailed review, see Bernstein, et. al., "Squaring Bankruptcy Valuation Practice with Daubert Demands," 16 Am. Bankr. Inst. L. Rev. 161, 187-97 (2008). Because this article addresses going-concern enterprise value rather than liquidation value, the "asset value" approach is not addressed.

3 See, e.g., In re Young Broadcasting Inc., 430 B.R. 99, 128 (Bankr. S.D.N.Y. 2010) ("levered" DCF analysis inadmissible as unreliable); In re Med Diversified Inc., 334 B.R. 89, 102-3 (Bankr. E.D.N.Y. 2005) (rejecting use of Black-Scholes method to value option to purchase 100 percent of equity).

4 U.S. Bank Nat'l Assoc. v. Wilmington Trust Co. (In re Spansion Inc.), 426 B.R. 114, 130 (Bankr. D. Del. 2010) (quoting Peter Coogan, "Confirmation of a Plan under the Bankruptcy Code," 32 Case Western L. Rev. 313, n. 62 (1982)).

5 In re Young Broadcasting Inc., 430 B.R. at 126.

6 See, e.g., In re Nellson Nutraceutical Inc., 356 B.R. 364, 374 (Bankr. D. Del. 2006) (terminal value comprised 68 percent of total enterprise value).

7 See In re Med Diversified Inc., 346 B.R. 621, 642 (Bankr. E.D.N.Y. 2006) (striking expert testimony because of "deliberate, manifest, pervasive systemic bias").

8 The tendency of a debtor's stock price to remain positive may not be irrational if such value is viewed as "option value," or the value of an unlikely but potentially large reversal in the debtor's fortunes.

9 See Loan Syndications and Trading Association 2010 Loan Market Update, http://apps.americanbar.org/buslaw/blt/content/2011/02/r0003a.shtml , on April 27, 2011 (noting that 2010 distressed bank loan trading reached new high of $35 billion per quarter on average).

10 Internet-based markets have begun to establish viable secondary markets for such claims. See, e.g., www.secondmarket.com. See also "Trading in Lehman Bankruptcy Claims Sets Record in April," ABI Daily Bankruptcy Headlines, May 23, 2011 ("April saw 380 claims traded for a combined face value of $1.8 billion... Nearly $42 billion of Lehman claims have traded since the firm filed for [bankruptcy] protection.").

11 Source: Bloomberg.

12 482 F.3d 624 (3d Cir. 2007).

13 Id. at 633. The court also suggested that bond prices can be evidence of insolvency. See id. at 633; see also Statutory Comm. of Unsecured Creditors ex rel. Iridium Operating LLC v. Motorola Inc. (In re Iridium Operating LLC), 373 B.R. 283 (Bankr. S.D.N.Y. 2007) ("The public trading market constitutes an impartial gauge of investor confidence and remains the best and most unbiased measure of fair-market value and, when available to the Court, is the preferred standard of valuation.").

14 Bank of America Nat. Trust and Sav. Ass'n v. 203 North La Salle Partnership, 526 U.S. 434, 457 (1999) ("[T] he best way to determine value is exposure to a market."); In re Boston Generating LLC, 440 B.R. 302, 325-26 (Bankr. S.D.N.Y. 2010).

15 Valuation often arises in connection with plan confirmation when the debtor attempts to "cram down" a plan over the objection of a nonconsenting class, and the debtor must show that the plan is "fair and equitable" pursuant to § 1129(b)(2)(B) of the Bankruptcy Code.

16 In re Spansion, 426 B.R. at 130.

17 See Transcript at 39-40, In re Smurfit-Stone Container Corp., Case No. 09-10235 (Bankr. D. Del. April 20, 2010). The author worked as a judicial clerk for Judge Shannon at the time of the case. The discussion here reflects only publicly available information and is used with permission of the judge.

18 See In re Mirant, 334 B.R. 800, 832 n. 112 (Bankr. N.D. Tex. 2005).

19 Id. at 832-35. The court also suggested that valuation of a debtor may be affected by the Supreme Court's holding in Till v. SCS Credit Corp., 541 U.S. 465 (2004). The application of Till in chapter 11 cases and to enterprise valuation is beyond the scope of this article.

20 See In re DBSD N. Am., 421 B.R. 133 (Bankr. S.D.N.Y. 2009) (designating and disqualifying vote of creditor who purchased debt on eve of confirmation to block confirmation).

21 See Douglas C. Baird and Donald S. Bernstein, "Absolute Priority, Valuation Uncertainty and the Reorganization Bargain," 115 Yale L. J. 1930 (2006).

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