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The future of a company reorganizing in Chapter 11, and the recoveries to creditors and equity holders, hinge on the company’s value. With the proliferation of junior secured credit and private equity investments in financially or operationally challenged companies, Chapter 11 valuation litigation has been brought to center stage, as the parties in the increasingly crowded capital structure jockey over whether, if not to what extent, their investments are in or out of the money. In the Nellson Nutraceutical Inc. Chapter 11 case, the Delaware bankruptcy court held a 23-day valuation trial from September through December 2006. On Jan. 18, 10 days shy of the one-year anniversary of the debtors’ Chapter 11 filings, the bankruptcy court issued a 125-page decision in which it concluded that the debtors had an enterprise value of $320 million. That enterprise value is significant since, as of Dec. 31, 2006, the first- and second-lien lenders were owed, in total, approximately $355 million, including fees, charges and default interest. The second-lien lenders’ outstanding principal as of the commencement of the bankruptcy cases was approximately $75 million. This valuation trial was unusual in that it was commenced by the debtors-makers of nutritional bars and powders for weight loss, sports training and other wellness-related purposes-just three months into their Chapter 11 cases. As described below, the debtors and their equity sponsor were rebuked for what the court viewed as their attempt to dictate the course of the debtors’ reorganization for the benefit of the equity holder. In re Nellson Nutraceutical Inc., 2007 Bankr. Lexis 99, at *8 (Bankr. D. Del. Jan. 18, 2007). A year earlier than the Nellson Nutraceutical valuation trial, the bankruptcy court in the Mirant Corp. Chapter 11 case convened a similarly complex and time-intensive 27-day valuation hearing lasting 11 weeks, from April to June 2005, encompassing reports and testimony from nine different experts. In re Mirant Corp., 334 B.R. 800 (Bankr. N.D. Texas 2005). The debtors-producers and marketers of electrical energy-agreed to proceed with a valuation trial upon the filing of their initial joint plan, to resolve the dispute among the major creditor and equity constituencies as to whether value existed for the equity security holders. Ultimately, as described below, the bankruptcy court declined to determine the debtors’ total enterprise value. Instead, the court established a methodology for recalculating the debtors’ total enterprise value, and charged the debtors, as honest brokers in the case, with the recalculation task in accordance with the court’s directives. These two cases highlight the defining impact valuation litigation can have on a debtor’s reorganization at any point in a bankruptcy case. Valuation litigation requires considerable time and effort, and is expensive. Once brought before the court, a valuation trial becomes the focus of the case. As total senior and junior debt starts reaching levels that threaten to encroach on the debtor’s equity value, the impact of valuation litigation looms larger in the bankruptcy landscape. This article summarizes the fundamental principles of bankruptcy valuation used by these courts, reviews the specific methodologies employed by the experts, and examines the courts’ respective views on valuation-views that might surprise practitioners-to gain insight on how future valuation disputes likely will be litigated and determined. Bankruptcy valuation principles The U.S. Supreme Court’s decision in Consolidated Rock Products Co. v. Du Bois, 312 U.S. 510, 526 (1941), instructed that a company’s reorganization enterprise value should be based on its future earnings capacity, to ensure that bankruptcy and past difficulties did not devalue the company. Consideration of its past earnings and performance, as well as relevant risk factors, is appropriate, however, to assess the validity and reasonableness of the company’s projections. Id.; Protective Comm. v. Anderson, 390 U.S. 414 (1968); Nellson Nutraceutical, 2007 Bankr. Lexis 99, at *84. By 1999, the Supreme Court appeared to have a dimmer view of the bankruptcy valuation process, at least in the context of single-asset real estate cases. Bank of America National Trust and Savings Ass’n v. 203 North LaSalle Street Partnership, 526 U.S. 434 (1999). While the issue of value was not directly considered by the court, it commented that, when possible in the Chapter 11 process, courts would be well served by resolving valuation disputes through a market-tested auction process. Id. at 457. Nevertheless, the Mirant court concluded that the market is not a proper measurement for value in the context of a plan, because the advantages of the Chapter 11 process-disclosure, court supervision and the court’s ultimate determination of plan feasibility-are not given sufficient recognition by the market. The Mirant court believed that the Supreme Court’s decision in Till v. SCS Credit Corp., 541 U.S. 465 (2004) (determining the rate of interest necessary to make a secured creditor whole in a Chapter 13 consumer reorganization) indicated that a secured creditor would be made whole under a Chapter 11 plan when it received consideration based on a market interest rate adjusted to reflect the specific risks associated with the debtor. Mirant, 334 B.R. at 821. Over time, valuation methodologies have been developed to determine future earning capacity in a manner that reflects the various risks faced by a company reorganizing under Chapter 11. The experts who were deemed credible by the Mirant and Nellson Nutraceutical courts focused on three customary analyses: discounted cash flow (DCF), comparable companies and comparable transactions. Commonly, an expert will use the DCF method and one, if not both, of the other “comparables” methods to formulate a valuation opinion by assigning weights to reflect the expert’s judgment on a particular method’s applicability to the case at hand. The DCF analysis calculates enterprise value in two parts. The first determines the present value of the company’s unlevered projected free cash flow, i.e., cash flow assuming no debt in the capital structure. The second calculates the company’s so-called terminal value, which represents the remaining value of the company after the period covered by the company’s cash flow projections. The present value of this cash flow is then discounted by the weighted average cost of capital, determined by the expert using generally accepted techniques, and by other factors appropriate to the case. Under the comparable-companies analysis, value is derived from the expert’s examination of trading ranges for publicly traded companies viewed as comparable to the debtor, with the method having more weight the more similar the guideline companies are to the debtor. Trading ranges are viewed as a multiple of a performance standard, such as revenue, EBIT (earnings before interest and taxes) or EBITDA (earnings before interest, taxes, depreciation and amortization). The comparable-transactions method looks at the consideration paid in acquisitions or mergers of comparable companies, with the purchase price viewed as a multiple of an appropriate performance standard. The expert then applies the resulting multiple to the same performance standard of the debtor to arrive at an enterprise value. The Mirant and Nellson Nutraceutical decisions highlight that, among the different methodologies commonly accepted among valuation experts, myriad variables based on the each expert’s specific assumptions and judgments usually result in different and often widely disparate opinions on value, even when using common data on the subject company. Also notable is that the courts looked favorably upon long-standing valuation techniques, and eschewed valuation theories that were unprecedented or not suitable to the debtor in question. The many differences among the accepted expert opinions prompted the courts to fashion their own assumptions and judgments, often based on their perception of the specific expert’s bias and credibility. The ‘Mirant’ court’s approach At the outset of the Mirant trial, the court was presented with nine different expert reports expressing enterprise values ranging from $7.2 billion to $13.6 billion. It found all of the experts to be qualified. Nonetheless, it determined that one report, which was relied on by three of the experts, contained significant errors that rendered these experts’ reports unreliable. In considering the various reports, the court recognized that each expert had different motivations and viewed each report with some degree of skepticism, noting that each expert is necessarily influenced by the needs of the party he or she represents. The court did not view this influence as improper, but, rather, noted its own caution in examining the expert evidence. The court also discussed other issues that would influence its determination, such as business decisions factored into the estimates of future cash flow, the experts’ choice of comparable companies, the experts’ value judgments as to discount rates and risk premiums, and the experts’ use of data based on a particular date that may not be applicable at a later date. Next, the court adopted the debtors’ business plan as the baseline for its valuation analysis, rejecting alternative projections of future operations presented by the official equity committee. The court found that substantial evidence supported the debtors’ business plan as a fair and reasonable projection. Notably, it found that the debtors and their management were not influenced in the valuation process by any particular creditor or equity constituency. Although settling on the debtors’ plan, the court still required that some of the data contained in that plan be recalculated using certain revised assumptions, and that other changes be implemented as instructed by the court in areas such as contractual obligations of the debtors, tax attributes, commodity pricing and certain projected revenues. The court also required changes to the debtors’ valuation approach, finding that the market formula used by their expert was too pessimistic about the effects of bankruptcy and not sufficiently appreciative of the benefits the debtors had received from the Chapter 11 process, such as the resolution of a multitude of operational and litigation issues. The court, disagreeing with the debtors’ expert, believed a valuation approach based on the projected price of the new equity immediately upon the debtors’ emergence from bankruptcy would improperly substitute the market’s view on plan feasibility for its own. Ultimately, the variables intrinsic to the experts’ respective reports and testimony were so complex that the court required a recalculation of the total enterprise value based on the court’s instructions as to the appropriate data points and assumptions. The court commented that “[a]t best, the valuation of an enterprise like Mirant Group is an exercise in educated guesswork. At worst it is not much more than crystal ball gazing . . . .It may be that there are better ways to determine value than through courtroom dialectic. That said, the court must work within the system created by Congress-and, in valuing a company in Chapter 11, that system contemplates an adversary contest among parties before a neutral judge.” 334 B.R. at 848. The ‘Nellson’ court’s approach The Nellson Nutraceutical court’s valuation decision proved to be a more problematic task. First, the valuation trial was brought by the debtors relatively early in their cases, before they were in a position to promulgate, let alone negotiate, a plan. Then, as a threshold matter, the court found that the debtors’ business plan, the basis for all of the expert reports, was not “management’s best and most honest thinking about the Debtors’ financial future but rather was manipulated at the direction of and in cooperation with the Debtors’ controlling shareholder to bolster the perceived value of the Debtors’ business solely for purposes of this litigation.” 2007 Bankr. Lexis 99, at *4. Indeed, the first 53 pages of the court’s decision amount to a scathing indictment of how the business plan was prepared, finding that the debtors’ equity sponsor unduly influenced the formulation of the business plan to support a high enterprise value that would enfranchise the debtors’ equity. Moreover, soon after the trial’s conclusion but before it rendered its valuation decision, the court threw out the report and testimony of the debtors’ expert, finding it to be unreliable and, therefore, inadmissible. Among other things, the court found that the debtors’ expert based its opinion on a methodology that was unproven, untested and not accepted by the valuation community. This discredited methodology used the debtors’ projected EBITDA minus capital expenditures as the value metric for determining the debtors’ terminal value in the DCF analysis. In addition, the debtors’ expert, which based its opinion entirely upon the DCF analysis and not on a weighted average of the various valuation methods, arrived at a value far in excess of the next highest opinion. In re Nellson Nutraceutical Inc., 2006 Bankr. Lexis 3186 (Bankr. D. Del. 2006) In contrast, the court did accept the opinions of the three remaining experts, representing the official unsecured creditors’ committee, the informal committee of first-lien lenders and the agent for all first- and second-lien lenders. Nonetheless, the court made adjustments to those opinions to correct for what it found to be errors or inconsistencies, weighed the credibility of the experts and adjusted the weighted average of the experts’ opinions to compensate for the debtors’ business plan and continuing poor performance since the date of that plan. In response to the creditors’ arguments that the expert reports should be taken as a whole, the court noted that the purpose of an expert opinion is to assist the court as trier of fact, not to substitute the expert’s opinion for that of the court. 2007 Bankr. Lexis 99, at *70-71. As in Mirant, the court then examined the different discount rates, emergence risk premiums and multiples used by each of the experts. The second half of the court’s decision is a detailed review of the three valuation opinions presented to it. The experts produced a range of values within 10% of each other, even after the corrections applied by the court to the calculations. The court then weighed the expert opinions. The valuation of the expert found to be the most credible was accorded a 40% weight by the court; the other two experts’ valuations were accorded a 30% weight. The court then adjusted the resultant value to take into account the debtors’ poor operating performance after the date of the business plan upon which the valuations were based, and also “to compensate for the deliberately inaccurate [business plan], which affected virtually every aspect of the experts’ analysis.” Id. at *124. The Nellson Nutraceutical and Mirant cases provide useful lessons to parties considering valuation litigation. Significantly, the courts in these cases were cognizant of the biases reflected in an expert’s valuation. Since litigants were expected to present values that supported their litigation positions, these courts viewed the expert reports as merely an aid to their own determination of value. In this respect, the courts both agreed that a company’s reorganization value may differ greatly from the company’s market value as determined by the price of the debtor’s debt or equity during the bankruptcy case. Even debt and equity trading values fixed after the filing of the debtor’s Chapter 11 plan will not be determinative of the reorganized debtors’ enterprise value. These cases are also instructive in demonstrating the extreme skepticism that courts take with respect to unproven valuation methodologies. In dismissing completely the valuation report and testimony of the debtors’ expert, the Nellson Nutraceutical court made clear that the valuation hearing is not the time for an expert to present a novel, untested approach to valuation. The cases also provide clear insight into how the courts will analyze the various assumptions and data points that are embedded within the competing valuation reports. Notwithstanding the metrics advanced by the experts, these courts applied case-appropriate methodologies to a common set of financial projections to develop what, in the courts’ view, were fair and reasonable projections of the debtors’ business prospects. The more these projections vary from the debtors’ historic and recent performance, the more likely a court will discount the projections, and impose alternatives and adjustments that, in the court’s view, paint a more fair and reasonable portrait of the reorganized company’s prospects and value. All of this dovetails into what is perhaps the most significant lesson learned from Mirant and Nellson Nutraceutical: A strategy of valuation litigation will only be as effective as the method, nature and quality of the data upon which the competing valuations are to be based. Michael E. Foreman and Scott K. Rutsky are partners in the bankruptcy and reorganization practice group at New York-based Proskauer Rose. They regularly advise senior and junior lien creditors, investors and debtors in bankruptcies and out-of-court restructurings.

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