Here is a common scenario:
Prior to filing for bankruptcy protection, a debtor company discovered that its flagship product was defective and could cause some form of economic harm to its customers. The debtor may have issued a recall and the defects are well publicized, or the trustee may have discovered after the bankruptcy filing that the debtor had known of these defects for years but had continued to sell the product in spite of this knowledge. Perhaps some claimants have filed claims, and the debtor is disputing them. Still, other customers have not filed claims, but it is probable that they eventually will.
After obtaining knowledge of the defects but before the filing of bankruptcy, the owners of the debtor company paid large dividends or distributions to the shareholders. In addition, management fees to related party companies were increased. Meanwhile, sales of the defective product continued. Eighteen months later, the debtor company filed for bankruptcy.
The trustee may take action to recover preferential or fraudulent transfers, under sections 547 and 548 of the Bankruptcy Code. The trustee must establish insolvency on the date of the transaction to seek recoveries. In a preference action, there is a presumption of insolvency for the 90 days prior to the filing for bankruptcy or one year prior to the filing for bankruptcy for payments to insiders. For a fraudulent conveyance action, the trustee must also establish insolvency on the date of the transaction. If the trustee can demonstrate that a fraudulent transfer occurred when the debtor was insolvent or if completion of the transfer caused the debtor to become insolvent, the court may require the funds to be returned to the estate of the entity in bankruptcy.
Thus, a fair valuation must be undertaken to determine whether the business was insolvent on the date(s) of the transaction(s). “Insolvent” is defined as follows:
with reference to an entity other than a partnership and a municipality, financial condition such that the sum of such entity’s debts is greater than all of such entity’s property, at a fair valuation, exclusive of (i) property transferred, concealed, or removed with intent to hinder, delay, or defraud such entity’s creditors; and (ii) property that may be exempted from property of the estate under section 522.
11 U.S.C. §101(32)(A).
Put simply, a business is considered insolvent if the fair market value of its debts is greater than the fair market value of its assets. Case law generally interprets “fair valuation” for purposes of recovery actions to mean fair market value. See Andrew Johnson Props., Inc., CCH Dec. ¶ 65254 (D.C. Tenn. 1974).
Under the definition of “insolvent” as presented in the Bankruptcy Code, a company’s financial statements can provide guidance relating to the financial condition of the business. However, under generally accepted accounting principles (GAAP), many asset and liability balances are stated at their historical cost and not their fair market value. As a result, while the company’s financial statements may provide information that is useful to the court for making decisions, they may not provide sufficient information to determine whether the company was insolvent at a certain point in time. In addition, if a company’s financial information is not presented in accordance with GAAP, its usefulness to the court will be limited.
Because a company’s financial statements usually do not provide sufficient information to determine whether the company is insolvent, it usually is necessary to use business valuation methods to determine the value of the company’s assets and liabilities and address the question of insolvency. Valuation standards require an analyst to consider all available information that would affect the value of the business as of the valuation date. The valuation literature instructs the valuation analyst to restate the various assets and liabilities at their fair market value (as opposed to their historical costs). This guidance specifically includes instructions to make adjustments to the balance sheet for contingent liabilities.
A valuation begins with an analysis of the debtor’s financial statements at the appropriate valuation date or, in this example, the date of the transaction. The analyst will need to consider the condition of the financial records when performing the work. Financial statements are normally recorded at historical costs with adjustments made for accruals, impairments, depreciation and amortization, and other accounting adjustments. Any accruals for revenue earned but not received or expenses incurred but not paid should be recorded. The assets and liabilities are then adjusted to their values under a “fair market value” standard.
In addition, an assessment for contingencies should be made. One example of a contingency is the collectibility of receivables. The analyst should consider the probability that accounts and notes receivable will not be collected. Some companies account for this on an ongoing basis in the routine process of producing their monthly financial statements. Other companies do not record these adjustments and write off accounts when they are determined to be uncollectible.
Other loss contingencies include obligations related to product warranties and product defects, such as the presence of asbestos or defective silicone breast implants; pending or threatened litigation; actual or possible claims and assessments; and obligations of commercial banks under “standby letters of credit.”
As part of this analysis, the analyst will need to consider adjustments for claims of creditors, some of which could be contingent. A claim is defined in the Bankruptcy Code as follows:
right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured; or right to an equitable remedy for breach of performance if such breach gives rise to a right to payment, whether or not such right to an equitable remedy is reduced to judgment, fixed, contingent, matured, unmatured, disputed, undisputed, secured, or unsecured.
11 U.S.C. § 101(5).
The estimation of contingencies has been a long-standing practice among accountants in the preparation or audit of financial statements. However, these procedures in preparation and auditing of financial statements are employed in a different context than when they are applied in a bankruptcy solvency analysis context. The users of the financial statements are assessing the risk in the business and estimating contingency losses to identify and quantify that risk. These procedures often rely on third-party information, such as letters from attorneys or confirmations from financial institutions. Presumably, these procedures and the resulting financial statements establish a foundation of accounting evidence for a company’s financial condition.
Courts have acknowledged the relevance of contingent liabilities in evaluating insolvency. In re Trans World Airlines, Inc., 134 F.3d 188, 197 (3d Cir. 1998) (“We agree with the bankruptcy court that it is proper to consider contingent liabilities when evaluating the insolvency of a corporation pursuant to 11 U.S.C. § 101(32)(A).”). In the Matter of Xonics Petrochemical, Inc., 841 F.2d 198 (7th Cir. 1988), the court stated that a loan guarantee and note cosigned by the debtor for the benefit of a subsidiary company created only a contingent liability, which must be devalued to evaluate whether the debtor was insolvent at the time of the transfer. “To value the contingent liability it is necessary to discount it by the probability that the contingency will occur and the liability become real.” Id.at 200. See also Lids Corp. v. Marathon Inv. Partners, L.P. (In re Lids Corp.), 281 B.R. 535, 546 (Bankr. D. Del. 2002); Katz v. Wells (In re Wallace’s Bookstores), 316 B.R. 254, 262–63 (Bankr. E.D. Ky. 2004).
In In re Advanced Telecommunication Network, Inc., 490 F.3d 1325 (11th Cir. 2007), cert. denied, 128 S. Ct. 1326 (2008), the court of appeals held that in determining the solvency of the debtor, an ongoing contract dispute in which a creditor claimed $39 million to be owed by the debtor should have been taken into account. The court held that this debt was a “contingent liability” that should be taken into account. “The ‘fair value’ of a contingent liability, of course, should be discounted according to the possibility of its ever becoming real.” Id.at 1335. The court erred in its position that the uncertainty about the ultimate resolution of the claim was to assign a dollar value of zero to the liability. Id.at 1336. See also Susan H. Seabury, Jack F. Williams & Hon. Michael G. Williamson, American Bankruptcy Institute Plenary Session: Business Bankruptcy Update, July 16–19, 2008.
Still other courts have eliminated, ignored, or rejected the inclusion of contingent liabilities. See In re Longview Aluminum, L.L.C., 2005 Westlaw 3021173 (Bankr. N.D. Ill. 2005). They have done so for a variety of reasons, but among those reasons is the difficulty in valuing the contingent liabilities. Estimation of contingent liabilities requires discounting the amount based on the probability of the liability becoming payable. At times, this can be a difficult process if the facts supporting the contingent claim were not known at the valuation date.
Various approaches can be taken to apply these principles in different contexts. So, a financial expert, whether a certified public accountant, accredited appraiser, or both, must consider the following:
- Valuation standards
- Accounting standards
- Best available evidence
- Burden of proof and the preponderance of the evidence standard
- Daubert standards of relevance and reliability
- A wide array of court decisions, from total acceptance to total rejection
The trustee must consider whether to pursue the claims and how to present them to the court. What options does the trustee have? Will the court accept opinion testimony of experts on the value of contingent liabilities? For acceptance by the court, would the court prefer a specific amount opinion, an opinion with ranges of value, or an opinion as to solvency or insolvency? What is relevant and useful to the court?
Part 2 of this series of articles will address how contingencies are measured under financial accounting standards. Part 3 of this series of articles will address how contingencies are valued using valuation methodologies. Part 4 will synthesize this information.