Documents Produced in Discovery That Can Inform an Assessment of Solvency

Documents produced in discovery can often allow a financial expert to explore solvency between public reporting dates. Unlike most publicly disclosed information, documents produced in discovery that might be pertinent to assessing solvency are often less structured, lack consistency across time frames, and are not necessarily subject to auditor review. All these factors can make potentially relevant documents more difficult to interpret.

Solvency assessments can encompass three tests: the balance sheet test, the “ability to pay debts as they come due” test, and the minimum adequate capital test. (For a more complete discussion of solvency tests identified in corporate and bankruptcy law, see J.B. Heaton, “Solvency Tests,” 62 Bus. Law. 982–1006 (May 2007). See also Robert J. Stearn Jr., “Proving Solvency: Defending Preference and Fraudulent Transfer Litigation,” 62 Bus. Law. 359–95 (Feb. 2007).) For each of these tests, certain types of documents produced in discovery may be particularly useful to a financial expert when assessing solvency and are described in greater detail below.

Balance Sheet Test

Under the balance sheet test, a company is considered solvent as of a specific date if the fair value of assets exceeds the face value of liabilities. (Heaton, supra, at 991; Stearn, supra, at 360–61.) While the face value of liabilities is often readily observable from publicly available documents, it can be much more challenging to assess the fair value of assets. (It may also be necessary to consider the fair value of the assets under a going concern assumption (the company will continue to operate) or at liquidation value, a distinction not directly addressed in this article.) Documents produced in discovery that may be useful in assessing solvency under this test include the following:

• Contemporaneous forecasts, budgets, or strategic plans. Iterations of an evolving budget for the upcoming year can identify management’s expectations around the transfer date and can also help identify a date range when management’s assumptions about future business performance were formed or changed.
• Interim “dashboard” or earnings “flash” reports distributed to management between regular reporting periods. While brief, these types of reports can be useful when the company’s financial situation is changing rapidly and may also help pinpoint when changes started to manifest themselves.
•  Contemporaneous or near-contemporaneous valuations or appraisals of any assets. These types of reports can sometimes be a starting point from which to roll forward or backward to the solvency date and can also assist in understanding management’s assumptions about future growth expectations.
• Audit workpapers supporting the valuation of assets or impairment analyses conducted to support the value of intangibles. Audit workpapers can sometimes further explain management’s views regarding valuation drivers and may offer documentation and discussion of assumptions made.

Ability to Pay Debts as They Come Due

Under the “ability to pay debts as they come due” test, a company is considered solvent if future cash inflows are sufficient to satisfy required cash outflows. (Heaton, supra, at 988–89; Stearn, supra, at 391.) This test is typically based on an assessment of future cash flows, including net operating cash flows, as well as necessary capital expenditures or required contractual payments. Documents produced in discovery that may be useful in assessing solvency under this test include the following:

• Cash flow management documentation and forecasts or daily borrowing reports. Similar to earnings flash reports discussed above, these types of reports can be brief but useful documents, especially when the company’s financial situation is changing rapidly. Unlike earnings flashes, these types of reports typically focus on cash flows as opposed to income and expense items.
• Forecasts related to compliance with debt covenant ratios or, conversely, any forecasts surrounding the possible violation of certain debt covenant ratios, including any associated correspondence. These types of documents may offer additional information on the ability to pay debts as they come due because they typically involve calculations regarding “room” on covenants (or how much a financial metric can deteriorate before a covenant is breached); however, they may not necessarily be indicative of management’s contemporaneous expectations for future performance.

Minimum Adequate Capital

Under the minimum adequate capital test, a company is considered solvent if it has adequate capital, or access to enough capital, to weather a reasonable range of business outcomes. (Heaton, supra, at 995–96; Stearn, supra, at 385–87.) This test is similar to and often assessed with the ability to pay debts test discussed above. In addition, this test includes an assessment of the company’s ability to access additional capital—internally or through the debt or equity markets. Accordingly, many of the documents identified for the ability to pay test will also be useful in assessing minimum adequate capital. Other documents produced in discovery that may be useful in assessing solvency under this test include the following:

• Any internal assessments of adequacy of capital. Many companies regularly assess the strength of their internal capital and have metrics that they report internally. Identifying those metrics and attempting to update them to the transfer date at issue can help assess solvency.
• All correspondence pertaining to the willingness of shareholders and owners to contribute additional capital. This type of correspondence can often be found contemporaneous with presentations to the board or meetings with the owners of the company.
• Documentation of materials provided to bankers to support obtaining additional financing. These types of documents may also cover the restructuring of current financing arrangements and include stress testing analyses highlighting available liquidity.
• Any presentations made to credit ratings agencies or correspondence with credit ratings agencies. Company presentations to credit ratings agencies will often include a discussion of liquidity that may be helpful in assessing solvency under this test.

Summary

The documents cited above represent just some of the types of documents produced in discovery that may be useful to a financial expert assessing solvency and are not intended to represent an all-inclusive list. Like any other type of information, documents produced in discovery should be considered in conjunction with all other available information, including publicly available information, the remaining documents produced in discovery, and relevant deposition testimony.

Ann Hughes is a vice president at Coherent Economics in Chicago, Illinois.

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