Excess Lease Liability and Insolvency

With the recent failures of Heller Ehrman, Thelen Reid & Priest, and Thacher Proffitt & Wood, we may expect someone to raise the obscure issue of excess lease liability in determining when a firm is considered insolvent.

What Is Excess Lease Liability?

Basically, excess lease liability is a measure of a firm's excess office space. If a firm has experienced a significant reduction in head count over a period of time and it has not been able to sublet or otherwise depose of the space, it stands to reason that the firm has excess space. Ultimately, and unfortunately, lawyer exits will be a leading cause of failure since the remaining lawyers are unable to satisfy the operating expenses of the firm.

In addition, it is not uncommon for a firm to have real estate strategy tied to its overall strategic plan. An aggressive growth plan would likely cause a firm to acquire a significant amount of lease space. For example, a 400-attorney firm that projects a 10% head count increase will likely need from 32,000 to 38,000 additional square feet (including space for support functions). It is very probable that acquiring additional space to fuel this “Field of Dreams” approach to planning will result in excess real estate.

Moving our example forward, assume this same firm committed to additional space in anticipation of hiring 80 lawyers over two years. However, after two years, the firm added just 20 lawyers. As a result, the firm has empty space for 60 lawyers. This excess space could range from 48,000 to 57,000 square feet. It is simple math to determine what this unutilized space is costing. Assuming $30 per square-foot, the firm's excess lease liability would range from $1.44 million to $1.71 million before present value computations.

For firms that had even more ambitious growth plans and multiple offices, it would not be impossible to see excess space in the six-figure square footage range.

Why Does Any of This Matter?

Meet the bankruptcy trustee (“trustee”). The most important duty of the trustee is converting the firm's property to cash and locating other money to pay claims of the bankruptcy estate. The most common sources of funds are:

• Work-in-process;
• Accounts receivable;
• Sale of furniture, fixture and equipment;
• Priceless art collections, once considered priceless;
• Partner capital accounts; and
• Prior distributions of profit.

The last item, prior distributions of profit, can be considered “up for grabs.” If the bankruptcy trustee can determine that the firm was actually insolvent during a prior period, before bankruptcy, then the trustee will consider going after the partners to collect amounts paid to them while the firm was insolvent. In the bankruptcy arena, these prior distributions may be considered a fraudulent transfer.

What Constitutes Insolvency?

In order for a trustee to recover a fraudulent transfer pursuant to provisions of the Bankruptcy Code, one key element that must be established is that the debtor was either insolvent on the date that such transfer was made or the obligation was incurred, or became insolvent as a result of such transfer or obligation.

Trustees will try to determine if a firm was insolvent on a balance sheet basis, i.e., if liabilities exceed the fair value of the firm's assets. It's beyond the scope of this article, but determining fair value is a matter of using a going-concern approach or on a liquidation basis.

The balance sheet provides a measure of a partner's interest (equity) in the firm, and if the liabilities exceed the assets fair value, then the firm has no value to the partner.

In determining the fair value of assets, the trustee will likely apply a steep discount to the recorded value (book value) of the firm's work-in-progress and accounts receivable. The discount factor could range from 40% to 60%.

Next, there would be a write down of leasehold improvements, which arguably have no value, along with other of the firm's fixed assets.

Back to Excess Lease Liability

Finally, the trustee may determine the liability associated with excess lease space and suggest that the firm's space exceeded the firm's reasonable requirements for its ongoing operations. An estimate of excess lease liability will be calculated by using, for example, 875 square feet per lawyer and a calculation of the present value of total lease obligations.

Exhibit 1, below, provides an example of an insolvency analysis.

[IMGCAP(1)]

Under this scenario, the trustee makes a strong statement that this negative net worth is prima facie evidence that the firm was insolvent on a balance sheet basis for prior time periods while the partners were receiving distributions.

Accounting Promulgations

I am not aware of any authoritative basis among general accounting principles promulgated by the AICPA to include excess lease space as a firm liability. Excess lease space is not unusual for a business. Most firms that issue financial statements that are either audited or reviewed by CPAs must disclose their lease liabilities as a footnote in the firm's financial statements.

The Financial Accounting Standards Board (“FASB”) issued SFAS 5, Accounting for Contingencies, in March 1975 to address accounting for loss contingencies including potential losses from pending or threatened litigation. SFAS 5 describes the framework by which contingencies should be handled in company financial statements. A contingency is defined as “an existing condition, situation, or set of circumstances involving uncertainty as to possible loss (hereinafter a 'loss contingency') to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur.”

SFAS 5 states that an “estimated loss from a loss contingency shall be accrued by a charge to income if both of the following conditions are met:

a. Information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss.

b. The amount of loss can be reasonably estimated.”

SFAS 5 further states that “if no accrual is made for a loss contingency because one or both of the conditions in the preceding paragraph (probable and reasonably estimated) are not met, or if an exposure to loss exists in excess of the amount accrued ' disclosure of the contingency shall be made when there is at least a reasonable possibility that a loss or an additional loss may have been incurred. The disclosure shall indicate the nature of the contingency and shall give an estimate of the possible loss or range of loss or state that such an estimate cannot be made.”

Currently, many loss contingencies fall into the category of a reasonable possibility instead of probable. Therefore, significant litigation is usually disclosed in the notes to the financial statements by describing the nature of the litigation and stating that an estimate of possible loss or range of losses cannot be made.

FASB issued an Exposure Draft titled “Disclosure of Certain Loss Contingencies” on June 5, 2008. This Exposure Draft proposed amendments to FASB Statements No. 5 and 141(R) that are primarily related to disclosures in company financial statements including potential losses from pending and threatened litigation.

As a result of SFAS 5 (including the recently released exposure draft), it appears that excess lease liability does not require a loss accrual.

Conclusion

Based on SFAS 5 and in my opinion, excess lease liability is not an event or item that should be included as a liability for purposes of determining insolvency or for financial statements issued in compliance with generally accepted accounting principles (“GAAP”). It should be noted however, there are no generally accepted accounting principles (that I am aware of) that govern insolvency accounting. This means the inclusion of excess lease liability would be up to the bankruptcy court to decide.

Stephen M. (Pete) Peterson is the CEO of the accounting and business advisory firm Maxfield Peterson Richards (http://www.maxfieldpeterson.com/), and a member of this newsletter's Board of Editors.

With the recent failures of Heller Ehrman, Thelen Reid & Priest, and Thacher Proffitt & Wood, we may expect someone to raise the obscure issue of excess lease liability in determining when a firm is considered insolvent.

What Is Excess Lease Liability?

Basically, excess lease liability is a measure of a firm's excess office space. If a firm has experienced a significant reduction in head count over a period of time and it has not been able to sublet or otherwise depose of the space, it stands to reason that the firm has excess space. Ultimately, and unfortunately, lawyer exits will be a leading cause of failure since the remaining lawyers are unable to satisfy the operating expenses of the firm.

In addition, it is not uncommon for a firm to have real estate strategy tied to its overall strategic plan. An aggressive growth plan would likely cause a firm to acquire a significant amount of lease space. For example, a 400-attorney firm that projects a 10% head count increase will likely need from 32,000 to 38,000 additional square feet (including space for support functions). It is very probable that acquiring additional space to fuel this “Field of Dreams” approach to planning will result in excess real estate.

Moving our example forward, assume this same firm committed to additional space in anticipation of hiring 80 lawyers over two years. However, after two years, the firm added just 20 lawyers. As a result, the firm has empty space for 60 lawyers. This excess space could range from 48,000 to 57,000 square feet. It is simple math to determine what this unutilized space is costing. Assuming $30 per square-foot, the firm's excess lease liability would range from $1.44 million to $1.71 million before present value computations.

For firms that had even more ambitious growth plans and multiple offices, it would not be impossible to see excess space in the six-figure square footage range.

Why Does Any of This Matter?

Meet the bankruptcy trustee (“trustee”). The most important duty of the trustee is converting the firm's property to cash and locating other money to pay claims of the bankruptcy estate. The most common sources of funds are:

• Work-in-process;
• Accounts receivable;
• Sale of furniture, fixture and equipment;
• Priceless art collections, once considered priceless;
• Partner capital accounts; and
• Prior distributions of profit.

The last item, prior distributions of profit, can be considered “up for grabs.” If the bankruptcy trustee can determine that the firm was actually insolvent during a prior period, before bankruptcy, then the trustee will consider going after the partners to collect amounts paid to them while the firm was insolvent. In the bankruptcy arena, these prior distributions may be considered a fraudulent transfer.

What Constitutes Insolvency?

In order for a trustee to recover a fraudulent transfer pursuant to provisions of the Bankruptcy Code, one key element that must be established is that the debtor was either insolvent on the date that such transfer was made or the obligation was incurred, or became insolvent as a result of such transfer or obligation.

Trustees will try to determine if a firm was insolvent on a balance sheet basis, i.e., if liabilities exceed the fair value of the firm's assets. It's beyond the scope of this article, but determining fair value is a matter of using a going-concern approach or on a liquidation basis.

The balance sheet provides a measure of a partner's interest (equity) in the firm, and if the liabilities exceed the assets fair value, then the firm has no value to the partner.

In determining the fair value of assets, the trustee will likely apply a steep discount to the recorded value (book value) of the firm's work-in-progress and accounts receivable. The discount factor could range from 40% to 60%.

Next, there would be a write down of leasehold improvements, which arguably have no value, along with other of the firm's fixed assets.

Back to Excess Lease Liability

Finally, the trustee may determine the liability associated with excess lease space and suggest that the firm's space exceeded the firm's reasonable requirements for its ongoing operations. An estimate of excess lease liability will be calculated by using, for example, 875 square feet per lawyer and a calculation of the present value of total lease obligations.

Exhibit 1, below, provides an example of an insolvency analysis.

[IMGCAP(1)]

Under this scenario, the trustee makes a strong statement that this negative net worth is prima facie evidence that the firm was insolvent on a balance sheet basis for prior time periods while the partners were receiving distributions.

Accounting Promulgations

I am not aware of any authoritative basis among general accounting principles promulgated by the AICPA to include excess lease space as a firm liability. Excess lease space is not unusual for a business. Most firms that issue financial statements that are either audited or reviewed by CPAs must disclose their lease liabilities as a footnote in the firm's financial statements.

The Financial Accounting Standards Board (“FASB”) issued SFAS 5, Accounting for Contingencies, in March 1975 to address accounting for loss contingencies including potential losses from pending or threatened litigation. SFAS 5 describes the framework by which contingencies should be handled in company financial statements. A contingency is defined as “an existing condition, situation, or set of circumstances involving uncertainty as to possible loss (hereinafter a 'loss contingency') to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur.”

SFAS 5 states that an “estimated loss from a loss contingency shall be accrued by a charge to income if both of the following conditions are met:

a. Information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss.

b. The amount of loss can be reasonably estimated.”

SFAS 5 further states that “if no accrual is made for a loss contingency because one or both of the conditions in the preceding paragraph (probable and reasonably estimated) are not met, or if an exposure to loss exists in excess of the amount accrued ' disclosure of the contingency shall be made when there is at least a reasonable possibility that a loss or an additional loss may have been incurred. The disclosure shall indicate the nature of the contingency and shall give an estimate of the possible loss or range of loss or state that such an estimate cannot be made.”

Currently, many loss contingencies fall into the category of a reasonable possibility instead of probable. Therefore, significant litigation is usually disclosed in the notes to the financial statements by describing the nature of the litigation and stating that an estimate of possible loss or range of losses cannot be made.

FASB issued an Exposure Draft titled “Disclosure of Certain Loss Contingencies” on June 5, 2008. This Exposure Draft proposed amendments to FASB Statements No. 5 and 141(R) that are primarily related to disclosures in company financial statements including potential losses from pending and threatened litigation.

As a result of SFAS 5 (including the recently released exposure draft), it appears that excess lease liability does not require a loss accrual.

Conclusion

Based on SFAS 5 and in my opinion, excess lease liability is not an event or item that should be included as a liability for purposes of determining insolvency or for financial statements issued in compliance with generally accepted accounting principles (“GAAP”). It should be noted however, there are no generally accepted accounting principles (that I am aware of) that govern insolvency accounting. This means the inclusion of excess lease liability would be up to the bankruptcy court to decide.

Stephen M. (Pete) Peterson is the CEO of the accounting and business advisory firm Maxfield Peterson Richards (http://www.maxfieldpeterson.com/), and a member of this newsletter's Board of Editors.