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June/July
2006 |
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The Definition of Value in Bankruptcy
| By:
Jeffery M. Risus and Cory J. Thompson
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Introduction
A precise definition of the term value is critical
in the valuation of a business enterprise and in the valuation
of specific tangible and intangible assets. The term value can
imply a different meaning to different people and can change based
on a different set of circumstances. Thus, depending on the specific
definition of value employed, results of the valuation can significantly
vary. As a consequence, without a concerted definition of the
term value as it applies to the instant circumstances, the conclusions
reached by the valuation expert have no basis or context.
Bankruptcy courts determine the applicable definition
of value on a case by case basis and in light of the purpose and
circumstances of each valuation. Therefore, different definitions
of value may be required for different purposes, and the definition
of value applicable to a certain purpose may not be binding with
respect to other purposes. For example, a valuation prepared to
analyze the best interest of the creditors may differ from a valuation
prepared to assess whether a certain transaction constituted a
fraudulent transfer.
To appropriately define value, all parties in
interest to the valuation must be cognizant of its intended purpose
– as the value of the same business enterprise or asset
may change given the specific purpose of the valuation. Therefore,
when defining value, the valuation expert, as well as the intended
users of the valuation, must specify the following: 1) standard
of value – or the type of value sought; and 2) premise of
value – or the assumption as to the set of actual or hypothetical
transactional circumstances applicable to the subject valuation.
The Definition of Value in Bankruptcy
The standard of value terminology applicable
to valuations in bankruptcy may differ from the terminology in
traditional valuation circumstances (e.g., federal tax reporting
purposes), and it is often the case that value is not clearly
defined in the Bankruptcy Code or applicable state statutes.
Moreover, the premise of value decision in certain
bankruptcy matters is not straightforward and may require consideration
of court precedent, characteristics specific to the subject company
and the circumstances related to and the intended use of the valuation.
In these cases, the choice of the applicable premise of value
may have the single largest impact on valuation results and therefore,
the outcome of the matter. Addressed in further detail below are
the different standards and premises of value that merit consideration
in bankruptcy matters.
Standards of Value
Traditional business enterprise and asset valuations
are typically performed under one of three basic standards of
value: Fair Market Value, Investment Value, or Fair Value. However,
the valuation terminology that applies in bankruptcy matters may
differ from traditional valuation and, as stated above, is most
often not clearly defined in the Bankruptcy Code or applicable
state statutes.
As a result, in many cases, the appropriate standard
of value terminology must be derived from case law, and the valuation
expert should work closely with an experienced bankruptcy attorney
in determining and applying precise meanings (1).
Standards of value terminology often encountered in bankruptcy
matters are presented in the following chart:
| Standards of Value Often
Encountered in Bankruptcy Matters |
| Bankruptcy Code and Case Law |
• Fair Value (often interpreted
as Fair Market Value in Case Law)
• Reasonably Equivalent Value
• Present Fair Salable Value |
| State Fraudulent Transfer Act |
• Fair Valuation |
| State Fraudulent Conveyance Act |
• Present Fair Salable Value |
| Source: AICPA Consulting
Services Practice Aid 02-1, Business Valuation in Bankruptcy
(New York: AICPA, 2002), p. 5.02. |
Premises of Value
The selected premise of value should reflect
the facts and circumstances underlying each valuation engagement.
Traditional valuation incorporates the concept of highest and
best use. Accordingly, the value of a company as a whole or a
specific asset is assessed on either a going-concern or liquidation
basis, depending on which generates the highest value.
However, in the bankruptcy context, the valuation
expert must ensure that the highest and best use is reasonably
available to the debtor and property in question, and is not otherwise
predetermined by the Bankruptcy Code, case law or other applicable
laws(2). Essentially, all valuations, including
valuations involving bankruptcy matters, are performed under one
of the following three alternative premises of value:
| Alternative Premises
of Value |
| Value as a/an: |
| Going-concern |
Value in continued use, as a
mass assemblage of income producing assets, and as a going-concern
business enterprise. |
| Orderly Disposition |
Value-in-exchange, on a piecemeal basis
(not part of a mass assemblage of assets), as part of an orderly
disposition; this premise contemplates that all of the assets
of the business enterprise will be sold individually and that
they will enjoy normal exposure to their appropriate secondary
market. |
| Forced Liquidation |
Value-in-exchange, on a piecemeal basis
(not part of a mass assemblage of assets), as part of a forced
liquidation; this premise contemplates that the assets of
the business enterprise will be sold individually and that
they will experience less than normal exposure to their appropriate
secondary market. |
| Source: Shannon P. Pratt,
Robert F. Reilly, Robert P. Schweihs, Valuing a Business,
The Analysis and Appraisal of Closely Held Companies, Fourth
Edition, McGraw-Hill, 2000, pp. 33 and 34. |
The going-concern premise of value represents
an on-going, “business as usual” mentality. Therefore,
a going-concern premise generally allows the valuation expert
to exercise the widest latitude in terms of consideration and
application of valuation approaches and methodologies.
As opposed to a “business as usual”
mentality, the disposition or liquidation premises of value contemplate
either an orderly or forced sale of the assets of the subject
business, with the primary difference being the length and circumstances
surrounding the liquidation or sale period. Accordingly, in most
cases, liquidation values are much lower than going-concern values.
In selecting the appropriate time period under
an orderly disposition premise of value, the ideal time period
selected enables the subject company to realize the largest liquidation
value possible in a reasonable time period, as warranted by the
circumstances. Whereas under a forced liquidation premise of value,
it is assumed that all assets are sold piecemeal as quickly as
possible rather than as a result of normal exposure to the asset’s
typical marketplace.
Guidance Regarding Selection of the
Applicable Premise of Value
The judgment and experience of the valuation
expert (along with other parties in interest, such as bankruptcy
attorneys) is often required in the determination of the premise
of value that is relevant and appropriate for a particular valuation
assignment. Sources of guidance utilized to resolve the issue
of the appropriate premise of value are outlined in the following
chart:
| Sources of Guidance
in Selecting the Applicable Premise of Value |
|
- Directives issued by the court
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- Operating characteristics of the subject
company
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- Valuator’s experience and judgment
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- Intended use of the property
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| Source: Shannon
P. Pratt, Robert F. Reilly, Robert P. Schweihs, Valuing a
Business, The Analysis and Appraisal of Closely Held Companies,
Fourth Edition, McGraw-Hill, 2000, pp. 34 and 35. |
Additionally, answers to the following questions
regarding the subject company’s operating characteristics,
as detailed in the AICPA Business Valuation in Bankruptcy Practice
Aid,
may assist the valuation expert (and
other parties in interest) in identifying and selecting the most
appropriate premise of value under the attendant circumstances:
• Did the company have a recent history
of losses?
• Was the company being operated under “business
as usual” conditions?
• Was the company able to pay its bills on time, or was
it on a cash on delivery basis?
• If the company was not paying on time, what were the
trade creditors being told?
• Was the company, or parts of it, being offered for sale,
and if so, on what basis?
• Had crisis management or turnaround professionals been
employed?
• Were employees leaving the company?
• What was the local or national press reporting about
the company’s activities?
Valuation experts and other practitioners in
bankruptcy matters should also be aware that unless clear and
convincing evidence exists to the contrary, bankruptcy courts
often require a going-concern premise of value. For example, In
re Hechinger Investment Company of Delaware (3),
the court ultimately mandated use of a going-concern premise of
value.
Case Background
The specific proceeding related to the premise
of value definition issue in this case was initiated in connection
to the bankruptcy petition filed in June 1999 by Hechinger Company
and its affiliates under Chapter 11 of the Bankruptcy Code. The
plaintiff’s claims arose from a complex series of transactions,
which were consummated in September 1997, resulting in the acquisition
and subsequent combination of the assets of two do-it-yourself
home improvement retail store chains (the “Transaction”)
– Hechinger Company (“Hechinger”) and Builders
Square, Inc. (“Builders Square”) by Leonard Green
& Partners L.P. (“Leonard Green”), the equity
sponsor for the Transaction.
Certain claims of the plaintiff were based on
the assertion that Hechinger was insolvent at the time of the
Transaction or was rendered insolvent as a result of the Transaction.
As opined by the court, “the first issue of material fact
that must be addressed, therefore, is whether Hechinger was insolvent
or was operating in the vicinity of insolvency at the time of
the Transaction.”
In making this determination, the court drew guidance from the
Bankruptcy Code. Specifically, Section 101(32) of Title 11 defines
“insolvent” as a “financial condition such that
the sum of [a corporation’s] debts is greater than all of
such entity’s property, at a fair valuation…”
The court went on further to state that “[t]he Bankruptcy
Code does not mandate what constitutes a ‘fair valuation’;
however, in the context of determining insolvency under 11 U.S.C.
§548(a)(1)(B)(ii)(I), the Third Circuit has stated that ‘where
bankruptcy is not ‘clearly imminent’ on the date of
the challenged conveyance, the weight of authority holds that
assets should be valued on a going-concern basis [emphasis added].’”
Facts of the case support the court’s determination
that bankruptcy was not “clearly imminent” in September
1997 at the time of the Transaction, as the court stated “…it
cannot be disputed that Hechinger continued to operate and satisfy
all of its obligations to its creditor constituency for well over
a year subsequent to the Transaction.”
As previously stated, in most cases, liquidation
values are much lower than going-concern values. Accordingly,
as Hechinger’s business enterprise value would most likely
be greater under a going-concern premise of value as opposed to
a disposition or liquidation premise of value, the plaintiff’s
task of demonstrating that Hechinger was insolvent or in the vicinity
of insolvency at the time of the Transaction will be a more difficult
hurdle to clear under the court’s mandated going-concern
premise of value.
Conclusion
As a result of the significant variation in valuation
results that may arise under different circumstances, a precise
definition of the term value is critical in the valuation of a
business enterprise and in the valuation of specific tangible
and intangible assets (particularly in light of the fact that
the choice of the premise of value to apply may be the single
most significant factor in the determination of value). Moreover,
under certain circumstances, it may be relevant and critical to
value the subject business enterprise or asset under alternative
premises of value in order to substantiate the range of value
under differing circumstances.
End
Notes:
1 AICPA
Consulting Services Practice Aid 02-1, Business Valuation in Bankruptcy
(New York: AICPA, 2002), p. 5.02.
2 AICPA Consulting Services Practice Aid 02-1,
Business Valuation in Bankruptcy (New York: AICPA, 2002), p. 6.02.
3 In re Hechinger Investment Company of Delaware,
2005 U.S. Dist. LEXIS 14386 (D. Del., July 19, 2005).
Jeffrey
Risius, a managing director, and Cory Thompson, a manager, are
members of the Valuation and Litigation Advisory Services Group
of Stout Risius Ross, Inc. They both specialize in providing business
and intellectual property valuation analyses in bankruptcy and
restructuring matters.
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