Valuation Experts, Beware the Gatekeeper!

The courts recognize that valuation experts generally employ the same or similar financial valuation models, but frequently reach substantially different conclusions. For example, in In re Coram Healthcare Corp., the court described that both the Chapter 11 trustee's valuation expert and the equity committee's valuation expert had determined the going concern value of the debtors by applying the three standard valuation methodologies: 1) comparable public company analysis; 2) comparable transaction analysis; and 3) discounted cash flow analysis (DCF), and 'the end results were far from similar.' In re Coram Healthcare Corp., 315 B.R. 321, 337-38 (Bankr. D. Del. 2004). In that case, leading to different conclusions, the experts 'included different assets in reaching their valuation conclusions, attached different weights to the three valuation methodologies, and took different positions regarding management's projections.' Id. Making the same point that valuation experts using the same methodologies frequently reach different conclusions, the court in Peltz v. Hatten stated:

[I]t is clear that experts and industry analysts often disagree on the appropriate valuation of corporate properties, even when employing the same analytical tools such as DCF analysis or a comparable sales method. Sim-ply put, when it comes to valuation issues, reasonable minds can and often do disagree. This is because the output of financial valuation models are driven by their inputs, many of which are subjective in nature ' The DCF method involves projections of future cash flows (which are largely dependent on judgments and assumptions about a company's growth rate) and judgments about liquidity and the cost of capital. Similarly, the comparable sales method involves making subjective judgments as to what transactions are 'comparable' to the property being valued.

Peltz v. Hatten, 279 B.R. 710, 737-38 (D. Del. 2002) (footnote and citation omitted).

The vast differences in the conclusions reached by valuation experts addressing enterprise value in the Chapter 11 plan of reorganization context can be astounding. For example, in In re Oneida Ltd., 2006 Bankr. LEXIS 1985, 18-21 (Bankr. S.D.N.Y. 2002), the midpoint value range of the experts diverged by as much as $90 million. In In re Mirant Corp., 334 B.R. 800, 824 (Bankr. N.D. Tex. 2005), the enterprise values opined to in the expert reports submitted in the case ranged from $7.2 billion to $13.6 billion.

Enterprise/Going Concern Value

Valuation disputes are frequently at the core of contested Chapter 11 reorganization plans. Under a Chapter 11 plan, senior creditors are entitled to be paid in full before any creditor or equity holder with rights that are junior in priority receives anything (See 11 U.S.C. ' 1129(b)). The flip side of this rule of 'absolute priority' is that junior creditors or equity holders are entitled to participate under a plan of reorganization upon the senior claims or interests being satisfied in full and the senior parties are not entitled to receive more than full recovery at the expense of the junior parties. See In re Exide Technologies, 303 B.R. 48, 61 (Bankr. D. Del. 2003).

The Supreme Court has held that a reorganized debtor's value should be based upon earning capacity. [See Consolidated Rock Products, Co. v. Du Bois, 61 S. Ct. 675, 685 (1941) ('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.')]. Courts recognize that determining enterprise or going concern value is not an exact science. In the context of a contested plan confirmation hearing, the Oneida court described the goal of a valuation as follows:

The goal of any valuation is to make an estimate based on an informed judgment which em-braces all facts relevant to future earning capacity and hence to present worth, including, of course, the nature and conditions of the properties, the past earnings record, and all circumstances which indicate whether or not the record is reliable criterion of future performance.

In re Oneida Ltd., 2006 Bankr. LEXIS 1985, 27-28 (quotations and citations omitted).

In the Chapter 11 case of In re Mirant Corporation, the court addressed the issue of how to determine the total enterprise value of the entities that made up the Mirant Group. The valuation hearing in the Mirant case was conducted for 27 days over a span of 11 weeks. Separate valuation experts testified for the debtors, several creditor constituencies, and equity holders (In re Mirant Corp., 334 B.R. at 809). The valuation conclusions of the experts diverged dramatically, with a low enterprise value presented of $ 7.2 billion and a high value presented of $ 13.6 billion (Id. at 824).

In addressing competing Chapter 11 plans and valuations, the court in In re Coram Healthcare Corp., perhaps cynically (or just realistically), recognized 'each side's incentives to either overvalue or undervalue the Debtors.' In re Coram Healthcare Corp., 315 B.R. at 339. Further, the Coram court emphasized what it viewed as the key point that [a]lthough valuations are subjective, there are proper and improper methods of performing a valuation.' Id.

Credibility

In light of conflicting enterprise valuations frequently presented by the parties in connection with contested and/or competing plans of reorganization, it is essential that valuation experts maintain credibility with the court. Some courts have found the adversarial process and the temptation or pressure on expert valuation witnesses to serve as advocates, strategists, consultants and/or advisors, rather than disinterested experts, create an environment where credibility is almost automatically in question. In the Med Diversified case, a bankruptcy court, disillusioned with what it perceived to be the bias and lack of objectivity of the valuation reports presented in connection with litigation involving an alleged constructive fraudulent transfer, stated:

If a court of record cannot rely on its 'officers' to ensure it that their retained experts prepare valuation reports in as objective and unbiased manner as can reasonably be achieved under the current state of the appraisal art, then those officers will suffer the adverse consequences from an excess of vigorous advocacy that impairs the truth-seeking duties of the court. The whole point of experts is to assist the court in determining the relevant facts, not in adding to the court's burden in having to redeem unreliable testimony by its own likes.

Chartwell Litigation Trust v. Addus Health Care, Inc. (In re Med Diversified, Inc.), 2006 Bankr. LEXIS 1677, 27 (Bankr. E.D.N.Y. 2006).

In In re Oneida Ltd., 2006 Bankr. LEXIS 1985, 31 (Bankr. S.D.N.Y. 2006), the court found that a contingent fee arrangement entered by a valuation expert's firm with the official equity committee (a monthly advisory fee, plus a 'success fee' of 1% of any recovery by equity holders) seriously undermined the expert's credibility. In Coram Healthcare Corp., 2006 U.S. Dist. LEXIS 14935, 2-6 (D. Del. 2006), the unsecured creditors' committee retained a valuation expert under terms, approved by the court, providing for payment of $700,000 on the effective date of the plan of reorganization proposed by the debtors. However, the debtors were unable to successfully confirm a plan of reorganization, a Chapter 11 trustee was appointed and, ultimately, the bankruptcy court confirmed a plan of reorganization proposed by the trustee. Query whether this arrangement created a conflict of interest unduly predisposing the expert to reaching a valuation conclusion in support of confirmation of a plan of reorganization presented by the debtors. In any event, presumably just as bad from the expert's point of view, the court determined that the expert was not entitled to any compensation since its engagement agreement (as approved by the court) required payment only upon the effective date of a plan proposed by the debtors and the confirmed reorganization plan in the case was proposed by the trustee (Id. at 4-5).

The court in In re Mirant Corp. faced an equity committee valuation expert who negotiated an incentive based fee arrangement to receive an additional $1 million plus 0.4% of any recovery by shareholders in excess of $400 million. The court recognized that the presentation materials submitted by the valuation expert to the equity committee could be read as identifying the valuation expert as not simply a disinterested neutral, but as an advocate for the equity committee. Nonetheless, in contrast to the approach of the Oneida court, the court found it neither startling nor enough reason to disregard their testimony that experts may be anxious to serve the interests of the parties retaining them, may receive additional compensation depending on the results of the case and, in some circumstances, would even have some commitment to a strategy (and its factual underpinnings) that they may have helped devise. In re Mirant Corp., 334 B.R. at 815.

Next month, we discuss admissibility of expert evidence, and disqualification of experts.

David S. Kupetz is a partner with SulmeyerKupetz in Los Angeles. He is an expert in business reorganization, debt restructuring, bankruptcy, and other insolvency alternatives. He can be reached at [email protected].

Valuation issues come into play throughout Chapter 11 business reorganization cases. These issues are frequently at the heart of the reorganization process and involve a wide variety of different matters. Bankruptcy courts determine value on a case-by-case basis and in light of the purpose and circumstances of the valuation. Near the inception of the case, the court may be asked to determine whether equity security holders of the debtor are in the money and, therefore, may be entitled to the appointment of an official equity security holders' committee to be funded from the bankruptcy estate. As the pivotal, central issue in connection with the confirmation of a contested plan of reorganization, the court may be required to determine the enterprise value of the reorganized debtor. This determination dictates how interests in the reorganized debtor must be allocated to satisfy the 'absolute priority rule' and, in turn, how consideration is distributed pursuant to the reorganization plan. Since the value of the reorganized enterprise is allocated first to the satisfaction of senior claims and equity interests, a lower valuation will require a higher percentage of the reorganized enterprise be reserved for the satisfaction of the claims and equity interests with senior priority rights.

Although valuation experts generally apply essentially the same methodology in determining enterprise or going concern value in connection with a Chapter 11 plan, they frequently reach substantially different conclusions. In some instances, this has led courts to question the use of an adversarial legal process to determine value and/or the credibility of the proposed valuation experts and, in a few cases, to even disqualify the proposed experts from testifying and presenting their valuation reports. In particular, valuation experts may run into trouble where: 1) they may personally profit depending upon their conclusions regarding value; 2) their role appears to expand beyond that of an independent valuation expert and includes that of an advocate, strategist, adviser, and/or consultant with a broader stake in the process; or 3) the proposed expert's independence is otherwise undermined. Of course, a proposed expert must possess the education experience, expertise, credentials, and other qualifications appropriate and necessary to provide an admissible valuation opinion. If the proposed valuation expert is not qualified or presents a report and/or testimony that is not relevant or reliable, the court should act as a gatekeeper and disqualify the proposed expert and/or prevent the proposed expert evidence from being admitted.

Recognizing the Uncertainties Underlying Expert Valuation Conclusions

The courts recognize that valuation experts generally employ the same or similar financial valuation models, but frequently reach substantially different conclusions. For example, in In re Coram Healthcare Corp., the court described that both the Chapter 11 trustee's valuation expert and the equity committee's valuation expert had determined the going concern value of the debtors by applying the three standard valuation methodologies: 1) comparable public company analysis; 2) comparable transaction analysis; and 3) discounted cash flow analysis (DCF), and 'the end results were far from similar.' In re Coram Healthcare Corp., 315 B.R. 321, 337-38 (Bankr. D. Del. 2004). In that case, leading to different conclusions, the experts 'included different assets in reaching their valuation conclusions, attached different weights to the three valuation methodologies, and took different positions regarding management's projections.' Id. Making the same point that valuation experts using the same methodologies frequently reach different conclusions, the court in Peltz v. Hatten stated:

[I]t is clear that experts and industry analysts often disagree on the appropriate valuation of corporate properties, even when employing the same analytical tools such as DCF analysis or a comparable sales method. Sim-ply put, when it comes to valuation issues, reasonable minds can and often do disagree. This is because the output of financial valuation models are driven by their inputs, many of which are subjective in nature ' The DCF method involves projections of future cash flows (which are largely dependent on judgments and assumptions about a company's growth rate) and judgments about liquidity and the cost of capital. Similarly, the comparable sales method involves making subjective judgments as to what transactions are 'comparable' to the property being valued.

Peltz v. Hatten, 279 B.R. 710, 737-38 (D. Del. 2002) (footnote and citation omitted).

The vast differences in the conclusions reached by valuation experts addressing enterprise value in the Chapter 11 plan of reorganization context can be astounding. For example, in In re Oneida Ltd., 2006 Bankr. LEXIS 1985, 18-21 (Bankr. S.D.N.Y. 2002), the midpoint value range of the experts diverged by as much as $90 million. In In re Mirant Corp., 334 B.R. 800, 824 (Bankr. N.D. Tex. 2005), the enterprise values opined to in the expert reports submitted in the case ranged from $7.2 billion to $13.6 billion.

Enterprise/Going Concern Value

Valuation disputes are frequently at the core of contested Chapter 11 reorganization plans. Under a Chapter 11 plan, senior creditors are entitled to be paid in full before any creditor or equity holder with rights that are junior in priority receives anything (See 11 U.S.C. ' 1129(b)). The flip side of this rule of 'absolute priority' is that junior creditors or equity holders are entitled to participate under a plan of reorganization upon the senior claims or interests being satisfied in full and the senior parties are not entitled to receive more than full recovery at the expense of the junior parties. See In re Exide Technologies, 303 B.R. 48, 61 (Bankr. D. Del. 2003).

The Supreme Court has held that a reorganized debtor's value should be based upon earning capacity. [See Consolidated Rock Products, Co. v. Du Bois, 61 S. Ct. 675, 685 (1941) ('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.')]. Courts recognize that determining enterprise or going concern value is not an exact science. In the context of a contested plan confirmation hearing, the Oneida court described the goal of a valuation as follows:

The goal of any valuation is to make an estimate based on an informed judgment which em-braces all facts relevant to future earning capacity and hence to present worth, including, of course, the nature and conditions of the properties, the past earnings record, and all circumstances which indicate whether or not the record is reliable criterion of future performance.

In re Oneida Ltd., 2006 Bankr. LEXIS 1985, 27-28 (quotations and citations omitted).

In the Chapter 11 case of In re Mirant Corporation, the court addressed the issue of how to determine the total enterprise value of the entities that made up the Mirant Group. The valuation hearing in the Mirant case was conducted for 27 days over a span of 11 weeks. Separate valuation experts testified for the debtors, several creditor constituencies, and equity holders (In re Mirant Corp., 334 B.R. at 809). The valuation conclusions of the experts diverged dramatically, with a low enterprise value presented of $ 7.2 billion and a high value presented of $ 13.6 billion (Id. at 824).

In addressing competing Chapter 11 plans and valuations, the court in In re Coram Healthcare Corp., perhaps cynically (or just realistically), recognized 'each side's incentives to either overvalue or undervalue the Debtors.' In re Coram Healthcare Corp., 315 B.R. at 339. Further, the Coram court emphasized what it viewed as the key point that [a]lthough valuations are subjective, there are proper and improper methods of performing a valuation.' Id.

Credibility

In light of conflicting enterprise valuations frequently presented by the parties in connection with contested and/or competing plans of reorganization, it is essential that valuation experts maintain credibility with the court. Some courts have found the adversarial process and the temptation or pressure on expert valuation witnesses to serve as advocates, strategists, consultants and/or advisors, rather than disinterested experts, create an environment where credibility is almost automatically in question. In the Med Diversified case, a bankruptcy court, disillusioned with what it perceived to be the bias and lack of objectivity of the valuation reports presented in connection with litigation involving an alleged constructive fraudulent transfer, stated:

If a court of record cannot rely on its 'officers' to ensure it that their retained experts prepare valuation reports in as objective and unbiased manner as can reasonably be achieved under the current state of the appraisal art, then those officers will suffer the adverse consequences from an excess of vigorous advocacy that impairs the truth-seeking duties of the court. The whole point of experts is to assist the court in determining the relevant facts, not in adding to the court's burden in having to redeem unreliable testimony by its own likes.

Chartwell Litigation Trust v. Addus Health Care, Inc. (In re Med Diversified, Inc.), 2006 Bankr. LEXIS 1677, 27 (Bankr. E.D.N.Y. 2006).

In In re Oneida Ltd., 2006 Bankr. LEXIS 1985, 31 (Bankr. S.D.N.Y. 2006), the court found that a contingent fee arrangement entered by a valuation expert's firm with the official equity committee (a monthly advisory fee, plus a 'success fee' of 1% of any recovery by equity holders) seriously undermined the expert's credibility. In Coram Healthcare Corp., 2006 U.S. Dist. LEXIS 14935, 2-6 (D. Del. 2006), the unsecured creditors' committee retained a valuation expert under terms, approved by the court, providing for payment of $700,000 on the effective date of the plan of reorganization proposed by the debtors. However, the debtors were unable to successfully confirm a plan of reorganization, a Chapter 11 trustee was appointed and, ultimately, the bankruptcy court confirmed a plan of reorganization proposed by the trustee. Query whether this arrangement created a conflict of interest unduly predisposing the expert to reaching a valuation conclusion in support of confirmation of a plan of reorganization presented by the debtors. In any event, presumably just as bad from the expert's point of view, the court determined that the expert was not entitled to any compensation since its engagement agreement (as approved by the court) required payment only upon the effective date of a plan proposed by the debtors and the confirmed reorganization plan in the case was proposed by the trustee (Id. at 4-5).

The court in In re Mirant Corp. faced an equity committee valuation expert who negotiated an incentive based fee arrangement to receive an additional $1 million plus 0.4% of any recovery by shareholders in excess of $400 million. The court recognized that the presentation materials submitted by the valuation expert to the equity committee could be read as identifying the valuation expert as not simply a disinterested neutral, but as an advocate for the equity committee. Nonetheless, in contrast to the approach of the Oneida court, the court found it neither startling nor enough reason to disregard their testimony that experts may be anxious to serve the interests of the parties retaining them, may receive additional compensation depending on the results of the case and, in some circumstances, would even have some commitment to a strategy (and its factual underpinnings) that they may have helped devise. In re Mirant Corp., 334 B.R. at 815.

Next month, we discuss admissibility of expert evidence, and disqualification of experts.

David S. Kupetz is a partner with SulmeyerKupetz in Los Angeles. He is an expert in business reorganization, debt restructuring, bankruptcy, and other insolvency alternatives. He can be reached at [email protected].