Bankruptcy filings are on the rise—dramatically! With a meltdown in the financial markets and the resulting destruction of wealth and employment, the number of companies that filed for Chapter 11 bankruptcy protection surged in 2008 and will continue to increase in 2009.
Bankruptcy filings among publicly traded companies, for example, rose by 74% in 2008, according to BankruptcyData.com. There were 136 bankruptcy filings by publicly traded companies in 2008, compared with 78 in 2007, according to the data. And, although, the results in 2008 were still short of the record 263 bankruptcy filings in 2001, that will most probably change in 2009.
While the year-to-year growth in bankruptcies was rapid, the value of the firms seeking protection grew by an even higher rate. Of the 136 companies seeking protection in 2008, their collective assets were approximately $1.16 trillion, versus just $70.5 billion in assets for firms filing for bankruptcy in 2007.
Many of these firms will seek to reorganize and emerge as a new going concern with restructured operations and a deleveraged balance sheet. To get there, however, they will need access to capital during the bankruptcy/reorganization process, and that generally means a fight with existing creditors over the use of cash collateral or the incurrence of new debt.
To bridge the discord, an “Adequate Protection” hearing is often conducted to determine whether sufficient equity exists in the enterprise whereby using cash or incurring new debt would be inconsequential to existing secured creditors.
To resolve this issue, a valuation of the bankruptcy estate and/or property is used to determine whether the prepetition lender is “adequately protected.” In addition, valuation analysis is used during the process at other key points including for fresh start accounting purposes usually in the context of seeking confirmation of a plan of reorganization in anticipation of emergence from bankruptcy. In all, valuation of the firm or its assets plays a key role during the bankruptcy/reorganization process.
Valuation to Demonstrate Adequate Protection
Section 363(a) of the Bankruptcy Code defines cash and cash equivalents as “cash collateral.” Often a secured creditor holds a security interest in such cash collateral. Under Section 363(c)(2), the debtor is prohibited from spending cash collateral without the consent of all parties that have an interest in the collateral, or a court order.
If no agreement regarding the use of cash collateral is reached then a lender must be prepared to demonstrate to the bankruptcy court that it is not adequately protected. While the debtor technically has the burden of proof that the lender is adequately protected, the lender must be fully prepared to show that the debtor’s offer of protection is insufficient, and this is where the issue of valuation becomes crucial, wherein the burden is to demonstrate that for every expenditure of a dollar of collateral, a dollar or more of value is created.
Similarly, under Bankruptcy Code § 364(d), after notice and hearing, the court may authorize a debtor to obtain credit or incur debt secured by a senior or equal lien on property of the estate that is already subject to a lien if the debtor shows two things: (i) the debtor is unable to obtain such credit otherwise, and (ii) the interests of the current lien holder will be “adequately protected” should the proposed senior or equal lien be granted.
A debtor’s ability to secure post-petition debtor-in-possession (“DIP”) financing under Bankruptcy Code § 364(d) of the Bankruptcy Code (i.e., a “priming lien”) hinges on the second requirement of Bankruptcy Code § 364(d). At issue in determining whether a creditor is adequately protected is whether the interest of the secured creditor whose lien is to be primed is being unjustifiably jeopardized. Typically, the most difficult requirement in connection with obtaining DIP financing is the establishment of adequate protection, which under Bankruptcy Code §364(d)(2) is the burden of the debtor. Adequate protection can be demonstrated in one of three ways: (i) when the debtor’s DIP financing is used to pay down the pre-petition lender’s outstanding debt, (ii) when the debtor agrees to make monthly payments to the lender; or (iii) when the court finds that the lender is protected by the existence of a sufficient “equity cushion.” Of these, the most common method is to establish the existence of a sufficient “equity cushion.”
In re Hubbard Power & Light, 202 B.R. 680, 685 (Bankr. E.D.N.Y. 1996), “The goal of adequate protection for purposes of the provision entitling a debtor to obtain financing secured by liens senior to all other interests is to safeguard the secured creditor from diminution in the value of its interests.” Toward this end, valuation of the estate and/or property is critical to the determination of whether the pre-petition lender is adequately protected. The judge hearing the motion will be required after submission of valuation evidence to decide whether a sufficient equity cushion is found to exist and whether to grant use of cash collateral or DIP financing.
Other Needs for Valuation during Bankruptcy
In addition to resolving issues early in the bankruptcy/reorganization process, valuation analyses are needed at various other points. Specifically, liquidation and going concern valuations are required for various reasons under Section 1126 of the Bankruptcy Code. In addition, any divisions or assets that are sold will need to be valued, and for fresh start accounting purposes in anticipation of emergence from bankruptcy, a valuation of underlying assets is required. With regard to this last item, new accounting rules including Statement of Financial
Accounting Standard (“SFAS”) 141R (Business Combinations (revised)) and SFAS 157 (Fair Value Measurements) will change how the value of distressed companies are determined and reported. This is particularly relevant in bankruptcy because the values reported in accordance with the AICPA’s SOP 90-7 are the same ones that appear in the disclosure statement, plan of reorganization, and are submitted as evidence to support or defend against various motions that ultimately determine claimholder recoveries.
More specifically, SFAS 141R specifies what assets and liabilities must be identified and valued, while SFAS 157 provides the guidance by which those value estimates are made. Accordingly, valuation analysis of underlying assets or the enterprise will have more significance in the process because of the new standards that will require more objective evidence in determining reorganization value, identification of previously unrecognized or undervalued intangible assets, and application of the revised fair value standard under SFAS 157.
With greater emphasis on valuation stemming from these new rules, new opportunities will emerge for informed companies and their claimholders to identify undervalued or overvalued assets, which will enhance the prospects for recovery of some constituents while diminishing those of others. In the final analysis, valuation in the bankruptcy/reorganization process will be a paramount issue in the years ahead.
With the implementation of FAS 141R and FAS 157, there has emerged a critical need for independent, robust opinions of value that will withstand scrutiny during the bankruptcy process. And, as new pronouncements are imposed, and existing standards are revised, navigating the reporting landscape will become ever more challenging. VALCOR Consulting is uniquely qualified to help companies with their valuation needs by providing comprehensive solutions that are based on substantial experience and reputation for integrity and independence.