Contingent Claims and Solvency Analysis Part IV

Our third article presented the example of a skin care company that was involved in litigation resulting from higher incidents of skin cancer linked to the use of some of the company's products. The bankruptcy trustee and their financial advisor, using a single-scenario model, estimated the value of the contingent liability related to the litigation at approximately $26.9 million. This balance was calculated based on required payments by the company to the plaintiffs, totaling $10 million a year for 10 years, using a 15 percent discount rate, and assuming a 50 percent probability of an adverse ruling. For this example, and as presented below, assume the fair value of the company’s assets exceed the fair value of it's liabilities by $32 million––excluding the contingent liability balance.

Not completely comfortable with the results of the initial analysis, the bankruptcy trustee again performs a valuation of the contingency, using the same $10 million annual payments and 10-year term, and using the same 50 percent  probability of an adverse ruling. However, for purposes of this revised analysis, the bankruptcy trustee applies a 6 percent discount rate, which is based on borrowing rates as of the date of the analysis. Based on these revised assumptions, the bankruptcy trustee recalculates the value of the contingent liability at approximately $37.9 million. When included with the assets and liabilities of the company, the analysis appears as follows:

As presented in the above comparison, depending on the assumptions used, the resulting conclusion regarding the solvency of the company changes. Under one set of assumptions, the company is presumed to be solvent as of the date of the analysis. Based on a different set of assumptions, the conclusion is that the company was insolvent as of the analysis date.

As the solvency analysis has now become a “make or break” issue, and would impact other areas of the bankruptcy proceedings including the analysis of fraudulent transfers, preferential payments, etc., the bankruptcy trustee and their valuation adviser must be particularly diligent in developing the key assumptions used in the analysis. In this example, the discount rate is one of the key assumptions that will be subjected to significant scrutiny. As such, the bankruptcy trustee and their adviser must carefully consider the reliability, not only of the sources of information used in their analysis, but also the manner in which the discount rates are developed.

Risk Incorporated in a Contingency

When valuing a contingency, and in the development of the various assumptions that will impact the valuation, the concept and the application of risk becomes of utmost importance. In addition, appraisers and bankruptcy professionals must carefully consider the perspective by which they are evaluating a contingent balance. As discussed in article three, the value of an asset is the “value of future economic benefits, calculated using an appropriate discount rate.” As a result, when valuing an asset, the risk faced by the owner of the asset is that the full amount of the economic benefits will never materialize or be received by the owner. From a financial reporting perspective, the risk that the full amount of economic benefits not be received by the company translates to a financial reporting risk of asset overstatement. To both the owner of the asset and the user of the company's financial statements, the risk relating to the asset is that its value will be stated at an amount greater than will be realized. As a result, the discount rate used to value the asset must encompass the risk that the receipt of the economic benefits is uncertain. As there is an inverse relationship between the discount rate applied and the resulting value of the asset, the greater the uncertainty of the economic benefits, the higher the discount rate, and the lower the resulting value.

For liability balances, on the other hand, the opposite is true. The risk relating to a liability balance is that the economic sacrifice required by the company to settle the liability will be greater than the amount anticipated by the company. This risk is similarly incorporated into the way in which a user of financial statements views a liability. To these individuals and institutions, the risk is that the liability balance reflected in the financial statements is understated, and the economic sacrifice required by the company will exceed the amount reflected in the financial statements. As the risk relates to the understatement of the liability, an appraiser will likely select a lower discount rate in his or her analysis to arrive at a value for the liability that is higher.

With these perspectives relating to risk in mind, let's look at ways in which discount rates can be developed to encompass the uncertainty and related risk of the contingency.

Development of Discount Rates

As discussed in article three, the valuation of a contingency can be thought of based on the following formula:

Probability of outcome × present value of cash flows resulting from outcome = value of contingency

Based on this formula, one of the key factors in the valuation of a contingency will be the discount rate used to determine the present value of the cash flows resulting from the contingency.

If a contingency is being valued based on an asset methodology, meaning the ultimate risk to the company and the users of its financial statements is an overstatement of the balance, the appraiser can look to several sources of information relating to rates of return. For example, the appraiser can use public company rate of return data prepared by Morningstar or Duff & Phelps. These resources enable a valuation practitioner to begin with a risk-free rate of return and then add various risk premia––to account for the size of the company, the industry, etc.––to arrive at an overall discount rate to be applied to the contingent balance. These sources of data are well-recognized in the valuation community and are based on extensive study and data gathering of publicly available information relating to historical rates of return realized on public company stocks. In addition, this data can be customized to incorporate the additional risk relating to the specific facts and circumstances of the company being analyzed.

However, if a contingency is being valued from a liability perspective, finding relevant and reliable sources of data becomes somewhat more challenging. Under a liability perspective and methodology, the appraiser can view the contingency balance in one of two ways: the contingency can be valued based on the expected cash flows to be paid by the company over the time frame the cash flows are expected to be paid, or the contingency can be valued based on the amount the company would have to pay a third-party to relieve them (the company) of the liability. For example, the company may have the ability to pay an insurance or other financial service company to assume the liability. Using this approach, the appraiser would likely discount the cash flow stream relating to the contingency, using a discount rate similar to the interest rate the company would pay if it borrowed the funds required to make the contingency payments. In addition, if this approach is followed by the appraiser, he or she must keep in mind the concept of “insurer’s mark-up.” The insurer’s mark-up reflects the concept that if a third-party were to assume the liability balance, not only would the third-party require compensation for the payments, but also the company assuming the liability would require a rate of return on top of those payments as additional compensation––the insurers’ mark-up.

Regardless of the approach utilized, appraisers and bankruptcy professionals should carefully consider the source(s) of data used to develop the discount rates used in their analysis and be prepared to answer questions from both the bankruptcy court and adverse parties regarding the general acceptance and reliability of such data. In addition, the appraiser may want to consider preparing alternative calculations in which they make adjustments to the discount rate to determine the impact to the overall analysis frequently referred to as ”sensitivity testing” or “stress testing.”

Development of the Probability Rate

In addition to the development of the discount rate, another key element in the valuation of a contingency relates to the probability of the adverse event taking place. In the example presented earlier, the bankruptcy trustee and valuation professional determined that applying a 50 percent probability of an adverse ruling was appropriate for purposes of their analysis. Unlike developing a discount rate, frequently there is very little independent information a valuation professional can refer upon to develop a probability rate. As a result, the valuation professional will be required to gather information from as many sources as possible and practical––company management, legal counsel, and similar case law, etc.––in order to develop a probability rate that can be reasonably supported. In addition and similar to the testing described in the discount rate discussion, the valuation professional will likely want to perform a sensitivity analysis of his or her valuation, using a range of probability factors. By doing so, the valuation professional may be able to buttress his or her analysis against criticism and cross-examination.

Summary

Frequently in bankruptcy proceedings, one of the key questions that must be addressed early in the process is to determine at what point the bankrupt company became insolvent. Answering this question will impact several other areas of the bankruptcy proceedings, including the analysis and evaluation of fraudulent transfers and preferential payments.

Financial reporting standards provide guidance relating to the point at which a contingency is recorded by a company, indicating that a contingent liability should be recorded by a company at the point in time at which incurring the loss is probable and the amount can be reasonably estimated. However, the accounting literature does not provide a great deal of guidance regarding the manner in which a contingent liability should be valued. In addition, even in valuation literature, best practices relating to the valuation of contingent liabilities are still evolving.

When valuing a contingency, a valuation practitioner has several options relating to the methodology by which he or she values a contingency. Depending on the needs and financial sophistication of the participants in the bankruptcy proceedings, an appraiser may choose to use a single-scenario valuation model in which a single set of financial analysis is performed, or he or she may choose to develop a multiple-scenario model in which a series of analyses are performed. Each of these approaches has strengths and weaknesses, depending on the needs of the audience utilizing the analysis.

In addition to the overall approach, the appraiser must also be diligent as he or she develops the significant assumptions incorporated into his or her analysis. The appraiser must ensure he or she is viewing the contingency from the proper perspective, either from an asset or liability perspective. Ensuring the contingency is being viewed from the proper perspective will help the appraiser evaluate the risk that needs to be incorporated into his or her analysis, which in turn will drive the development of the significant assumptions incorporated into the value.

The trustee and solvency expert must also address the acceptance of the analysis by the court. Will the court accept an opinion that is up or down, solvent or insolvent, at certain points in time? Or will the court prefer an analysis of the contingencies with multiple discount rates and probability rates to understand the likelihood of insolvency? What will be relevant and useful to the court and also reliable? When dealing with debtor financial statements that require significant adjustments, these questions can present considerable challenges to a trustee and solvency expert.

This is the fourth article in a four-part series. Read parts one, two and three.

Keywords: bankruptcy, litigation, contingencies, valuation, fair value

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