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    Archive for March, 2010

    The Value of Valuation

    Monday, March 29th, 2010

    Many readers of this blog understand the importance of asset and enterprise valuation at a number of stages of the bankruptcy process.  Whether it be specific collateral (to address a secured creditor’s concerns) or enterprise value (to determine the viability of a Chapter 11 plan), or for purposes of a fraudulent transfer or an asset sale, the discipline and methodology of valuation forms a fundamental touchstone of business insolvency practice.

    A recent Delaware Bankruptcy Court decision highlights the use of valuation in yet another context:  The appointment of equity committees.  In the Chapter 11 cases of Spansion, Inc. and its affiliates, Judge Kevin Carey reviewed the request of an ad hoc equity committee’s request for official sanction and appointment by the Office of the US Trustee.  To evaluate the committee’s request, Judge Carey turned to case law holding that the appointment of an equity committee depends upon:

    - the substantial likelihood of a distribution to equity holders after all creditors are paid; and

    - equity holders’ inability to represent themselves without such an official committee.

    Central to Judge Carey’s decision was a detailed analysis of the anticipated distribution to equity holders.  Spansion’s disclosure statement, submitted with its proposed Chapter 11 plan, valued the debtors’ enterprise value at less than the amount of creditors’ claims and therefore left nothing for equity.  The ad hoc equity committee (not surprisingly) believed enterprise value after payment was sufficient that equity holders should have a collective voice with respect to the proposed plan.

    Both sides submitted extensive evidence in support of their positions.  Unlike the debtors’ “full-blown” valuation, however, the ad hoc equity committee submitted a “sensitivity analysis” based on the debtors’ numbers and including an analysis of “precedent transactions,” comparable trading multiple analysis, and a discounted cash flow (DCF) analysis.

    A substantial portion of Judge Carey’s 20-page decision denying the ad hoc equity committee’s request revolves around a careful weighing of the parties’ competing valuation evidence.  The ad hoc equity committee’s valuation evidence ultimately faltered on four points:

    - The future of the debtors’ market:  For Judge Carey, the ad hoc equity committee’s analysis was not sensitive enough.  It inferred growth estimates based on the broader semiconductor and memory markets rather than for the debtors’ smaller (and much less healthy) specific memory market.

    - The estimated DCF terminal value:  The ad hoc equity committee’s valuations assumed constant cash flow growth (a view not shared by the debtors), higher EBITDA multiples, and higher terminal values.  By contrast, the debtors’ valuation assumed flat to negative growth, and a lower terminal value.

    - Valuation of specific assets:  The ad hoc equity committee claimed certain valuable assets – such as cash, litigiation claims held by the debtors, and net operating losses – were not accounted for in the debtors’ estimate of enterprise value.  While acknowledging that cash ought to be included in enterprise value, Judge Carey nevertheless found that the ad hoc equity committee offered no support for its valuation of the litigation claims at issue.  He found, further, that ambiguity surrounding the effect of the debtors’ net operating losses was not sufficiently resolved by the ad hoc equity committee to assign it any value for the committee’s analysis.

    - Total amount of claims:  The ad hoc equity committee’s claimed equity stake derived at least in part from its estimate of claims.  However, Judge Carey found that the committee had neglected to include administrative claims and cash requirements necessary to exit from Chapter 11.  The committee also had neglected to estimate the value of claims from as-yet-to-be-rejected contracts.

    In the end, Judge Carey found that “[t]he only thing certain . . . is the uncertainty of the valuations” – and that, as a result, the ad hoc equity committee’s “uncertain” estimate had not established the “substantial likelihood” of distribution required for official appointment.

    Judge Carey’s valuation analysis is instructive.  Specifically, it highlights the evidentiary burden that can attend valuation fights in a bankruptcy case, as well as the thoroughness with which a court may investigate enterprise value.

    Something to consider in a variety of bankruptcy contexts.

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    The Deafening Silence

    Monday, March 22nd, 2010

    A number of advanced commercial jurisdictions – such as the US, the UK, Germany, and Japan – permit a debtor’s bankruptcy administrator or trustee to pursue and recover preferential or fraudulent transfers.  Unwinding such transfers, typically made from the debtor to a third party located in the same country, is often an important source of recovery for creditors.

    But what happens when the transfer crosses international borders?  More specifically, which country’s avoidance law applies:  The law of the jurisdiction where the transfer was initiated?  Or the law of the “destination” jurisdiction?

    An important decision issued last Thursday by the Fifth Circuit Court of Appeals provides a preliminary answer for at least a portion of this question.

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     “Before” Chapter 15.

    Prior to the enactment of Chapter 15, US bankruptcy courts disagreed on whether – and how – the administrator of a foreign insolvency proceeding could pursue such transfers in the US.  Some courts permitted non-US administrators to pursue such recovery efforts directly (through an ancillary proceeding), under the fraudulent transfer law of the debtor’s home jurisdiction.  Others permitted such recoveries only under US law, and only through a separately filed (and far more expensive and time-consuming) Chapter 11 or 7 bankruptcy case.

    After” Chapter 15.

    Chapter 15 resolved at least a portion of this debate.  Section 1521(a)(7) provides that upon recognition of a foreign proceeding, the court may grant “any appropriate relief” including “additional relief that may be available to a trustee, except for relief available under [the avoidance sections of the US Bankruptcy Code].” Section 1523(b) authorizes the bankruptcy court to order relief necessary to avoid acts that are “detrimental to creditors,” providing that, upon recognition of a foreign proceeding, a foreign representative has “standing in [the debtor’s US bankruptcy] case . . . to initiate [avoidance] actions.”  In other words, Congress appeared to clear up the question where recovery efforts are initiated under US law:  A full Chapter 11 (or 7) case is required.

    But what about recovery efforts commenced under non­-US law?

    Courts visiting this issue under Chapter 15 appear almost as divided as those who looked at it prior to the Bankruptcy Code’s 2005 amendments.

    Two cases, both addressing the question in dicta, have gone in opposite directions.  In one, the Bankruptcy Court forbade a sale “free and clear” of an avoidable English lien on procedural grounds – but along the way, acknowledged that avoidance actions under the US Bankruptcy Code are cognizable only if the debtor is the subject of a case under another chapter of the Bankruptcy Code.  In another, the Bankruptcy Court denied a request by the administrator of a Danish insolvency proceeding for turnover of previously-garnished funds on the grounds that such turnover provisions were not applicable in Chapter 15 – but nevertheless went out of its way to note that nothing in Chapter 15’s legislative history – or in prior US cross-border law – prohibited avoidance actions commenced under the law of the debtor’s home jurisdiction.

    To date, however, only one case has addressed the issue directly.

    Condor Insurance and the Bankruptcy Code’s Deafening Silence.

    Condor Insurance, Limited (“Condor”), a Nevis-incorporated insurer and surety bond issuer, was placed into a winding-up proceeding in its home jurisdiction in 2007.  The following year, Condor’s liquidators sought recognition in Mississippi – in part, to pursue alleged fraudulent transfers aggregating more than $313 million to Condor affiliates and principals.

    The Bankruptcy Court and District Court Decisions.

    The Condor defendants moved to dismiss, claiming the Bankruptcy Court lacked jurisdiction to grant the relief requested. The Bankruptcy Court agreed, and – on appeal, and in a published decision – the District Court affirmed.  Central to the District Court’s reasoning was the idea that, in US courts, “the choice of law that is to be applied to a lawsuit is determined by a court having jurisdiction over the case, and the parties are not permitted to choose whatever law they wish when filing a lawsuit.”  As a result, the District Court found it lacked jurisdiction to hear the avoidance action.  Instead, it suggested that the liquidators commence and resolve the avoidance claims in Nevis – and then, upon procurement of a judgment, seek enforcement under principles of international comity.

    The Fifth Circuit Decision.

    In a decision issued last week, the Fifth Circuit Court of Appeals respectfully disagreed.  Writing for a 3-judge panel, Judge Patrick Higgenbotham observed Chapter 15’s “international origins” to encompass “international law.”  For the panel, Chapter 15 is not merely a procedural vehicle by which foreign administrators may cost-effectively protect assets domiciled, or control litigation originating, in the US.  Instead, foreign administrators may import the substantive insolvency law of foreign jurisdictions into US courts, which have jurisdiction to apply such law to disputes pending in the US.  See pp. 8-9 (“Whatever its full reach, Chapter 15 does not constrain the federal court’s exercise of the powers of foreign law it is to apply.”).

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    As a result, the statute’s silence speaks volumes.  Once recognized in the US court system through Chapter 15, foreign administrators have direct access to the panoply of federal judicial powers available to assist their administration of insolvency-related matters in the US, limited only by the specific “carve-outs” for US avoidance actions reserved in Section 1521:

    “The structure of Chapter 15 provides authority to the district court to assist foreign representatives once a foreign proceeding has been recognized by the district court. Neither text nor structure suggests additional exceptions to available relief. Though the language does not explicitly address the use of foreign avoidance law, it suggests a broad reading of the powers granted to the district court in order to advance the goals of comity to foreign jurisdictions.  And this silence is loud given the history of the statute including the efforts of the United States to create processes for transnational businesses in extremis.”  Decision at pp. 9-10.

    –          What About “Section Shopping?”

    The Fifth Circuit recognized the appellees’ concern over “section shopping” – i.e., the strategic use of Chapter 15 (rather than Chapter 11 or Chapter 7) by foreign administrators to leverage the benefits of foreign avoidance law in US forums.  But where Congress had not taken further steps to guard against this threat, the Fifth Circuit overruled the District Court’s own efforts to do so.  In fact, Judge Higgenbotham and his colleagues did not appear bothered by the spectre of “section shopping,” noting that in the case before it – that of a foreign insurance company – Chapters 7 and 11 were not eligible relief.  Moreover, the District Court’s suggestion that the foreign administrator should simply obtain an avoidance judgment in Nevis, then seek enforcement of that judgment in the US, was “no answer.  Not all defendants are necessarily within the jurisdictional reach of the Nevis court.”  Decision at p.14.

    –          What Of “Mixing and Matching?”

    Instead of “section shopping,” Judge Higgenbotham saw the danger of “mixing and matching” foreign insolvency proceedings with US avoidance law, arising in connection with a Chapter 11 or Chapter 7 case.  See p. 11 (“When courts mix and match different aspects of bankruptcy law, the goals of any particular bankruptcy regime may be thwarted and the end result may be that the final distribution is contrary to the result that either system applied alone would have reached.”).  The Fifth Circuit traced the development of the UNCITRAL’s efforts to address choice of law in avoidance actions while drafting the model law that forms the basis for Chapter 15, concluding:

    “The application of foreign avoidance law in a Chapter 15 ancillary proceeding raises fewer choice of law concerns as the court is not required to create a separate bankruptcy estate.  It accepts the helpful marriage of avoidance and distribution whether the proceeding is ancillary applying foreign law or a full proceeding applying domestic law—a marriage that avoids the more difficult depecage rules of conflict law presented by avoidance and distribution decisions governed by different sources of law.”  Decision at p.13.

    The Fifth Circuit panel also found its own approach more consistent with that of US cross-border law that pre-dated Chapter 15, noting Bankruptcy Courts could – and sometimes did – apply either US avoidance law or foreign avoidance law to an action pending in an ancillary case under former Section 304.  At least one court, however, had criticized this approach for the same “mixing and matching” of foreign and domestic insolvency law noted by the Fifth Circuit.  See p.16 (citing and discussing In re Metzeler, 78  B.R. 674, 677 (Bankr. S.D.N.Y. 1987)):

    “In sum, under section 304, avoidance actions under foreign law were permitted when foreign law applied and would provide for such relief.  Congress essentially made explicit In re Metzeler’s articulation of the bar on access to avoidance powers created by the U.S. Code by foreign representatives in ancillary proceedings.”  Decision at p.16.

    –          Wholesale Importation of Foreign Avoidance Actions?

    As for concerns that US insolvency courts – and US businesses – might find themselves awash in avoidance claims arising under non-US law, the Fifth Circuit again reverted to the international policies undergirding the legislation:

    “Providing access to domestic federal courts to proceedings ancillary to foreign main proceedings springs from distinct impulses of providing protection to domestic business and its creditors as they develop foreign markets. Settled expectations of the rules that will govern their efforts on distant shores is an important ingredient to the risk calculations of lenders and corporate management. In short, Chapter 15 is a congressional implementation of efforts to achieve the cooperative relationships with other countries essential to this objective.”

    The Unanswered Question.

    The Fifth Circuit’s Condor decision leaves unanswered the question of whether avoidance actions commenced under Section 544 of the Bankruptcy Code – which itself references “applicable [non-bankruptcy] law” – includes foreign law.  Section 1521, by its terms, excludes avoidance actions predicated on this section.  But the Bankruptcy Court, the District Court, and the Fifth Circuit all ducked this issue.

    One Manhattan bankruptcy judge recently observed, in dicta, that Section 544(b) gives the trustee the standing of a judgment lien creditor.  Because a preference action under foreign law would not appear to depend on status as a judgment lien creditor, this section would appear inapplicable to preference claims. A preference action under foreign law might therefore be available as “additional assistance” under § 1507.  See In re Atlas Shipping A/S, 404 B.R. 726, 744 at n.16 (Bankr. S.D.N.Y. 2009).

    But Condor’s brief analysis didn’t address preference claims.  It addressed avoidance actions, which – at least in the US – do depend upon judgment lien creditor status.  As a result, the availability of foreign avoidance actions, while resolved in the Fifth Circuit – remains likely unanswered elsewhere.

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    Taking Derivative Risk Out of the Code

    Sunday, March 14th, 2010

    In light of the tumultuous economic events of 2008 and 2009, a number of proposals for significant bankruptcy reform have surfaced – many of which have been summarized on this blog.

    One of last year’s posts focused on the ongoing debate over the impact of credit derivatives on failing companies, and on the continued usefulness of Bankruptcy Code provisions designed to insulate the financial markets from the bankruptcy process.

    Last week, Harvard’s Mark Roe added to that discussion with a paper entitled “Bankruptcy’s Financial Crisis Accelerator: The Derivatives Players’ Priorities in Chapter 11

    The essence of Professor Roe’s proposal is set forth at p. 3:

    Although several of [the Bankruptcy Code’s safe-harbor super-priorities for derivatives and repurchase agreements] are functional and ought to be kept, the full range is far too broad. Most are more likely to destabilize financial markets than to stabilize them and most need to be repealed.

    Professor Roe’s thoughtful analysis is a worthwhile read.

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    Chapter 15 Round-Up

    Tuesday, March 9th, 2010

    JSC BTA Bank – A recent post appearing here discussed JSC BTA Bank (BTA)’s petition for recognition in the Southern District of New York’s U.S. Bankruptcy Court.  BTA, reportedly Khazakstan’s second-largest bank, sought recognition of its state-sponsored restructuring in Khazakstan as a “foreign main proceeding.”  On March 2, Judge James Peck in Manhattan granted the bank’s request.  A copy of Judge Peck’s ruling is available here.

    White Birch Paper Co.  – The second-largest newsprint company in North America – Greenwich, Conn.’s White Birch Paper – followed the largest (Montreal’s AbitibiBowater Inc.), into bankruptcy in both Canada and the US on February 24.

    White Birch and 10 affiliates, which together operate paper mills in Gatineau, Quebec; Riviere-du-Loup, Quebec; and Quebec City filed their request for protection under the Canadian Companies’ Creditors Arrangement Act in Montreal, and a concurrent request for recognition of 6 of those proceedings in Virginia’s Eastern District before Chief Bankruptcy Judge Douglas O. Tice, Jr.  They were joined by US affiliate Bear Island Paper Co. of Ashland, which sought protection under Chapter 11.

    Pleadings filed in White Birch’s cases claim that the companies controlled approximately 12% of the North American newsprint market as of last December.  The filings were triggered by the continued shift from print to digital media and the attendant decline in revenues.  In addition, the widening spread between the Canadian and US currencies also hurt operations, as payables are frequently accepted in US dollars, while expenses are paid in Canadian dollars.  Finally, the companies’ operational woes were compounded by the burden of a January 2008 purchase of SP Newsprint Co. for approximately $350 million.

    Cost-cutting efforts commenced in late 2009 were not sufficient to prevent White Birch’s default on first- and second-lien credit facilities.  Attempts to restructure the debt out of court were likewise unsuccessful.  Judge Tice’s Order granting recognition and entering a preliminary injunction was entered yesterday.

    JSC Alliance Bank – Khazakstan’s sixth-largest bank followed BTA’s lead, seeking similar recognition in Manhattan’s Southern District less than 2 weeks after the larger Kazakh institution did so. 

    Like BTA, Alliance sought relief from creditors and litigation in the US while it restructures itself out of debt defaults and liquidity problems arising, in part, from its need to foreclose on bad loans and its subsequent difficulty selling foreclosed assets.  In its papers, Alliance claims that last December, it obtained approval for a restructuring plan from creditors holding more than 94 percent of its claims.

    Mega Brands Inc. – Toymaker Mega Brands has sought recognition in Delaware before Bankruptcy Judge Christopher Sontchi for its Canadian restructuring, commenced in mid-February before the Superior Court of Quebec in Montreal.

    The global supplier of construction toys, stationery and other children’s toys and activity instruments plans to implement a global restructuring, which is reportedly supported by more than 70% of the company’s secured debt holders and all of its debenture holders – and on which lenders and shareholders will vote on March 16.  In pleadings submitted with the petition, the company blames its need to restructure on the downturn in global demand, resulting stagnation in the North American toy industry, and fluctuations in raw materials prices.

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    Japan Airlines – On January 19, Japan Airlines (JAL), Asia’s largest airline, sought Chapter 15 protection in New York in furtherance of its reorganization in the Tokyo District Court under Japan’s Corporate Reorganization Act.  Bankruptcy Judge James Peck – the same judge presiding over BTA Bank’s Chapter 15 proceeding (see above) – recognized the Japanese proceeding in mid-February.  According to JAL’s Court pleadings, US assets protected by the Chapter 15 recognition order include aircraft and real estate interests in New York and Los Angeles.  Judge Peck’s Order granting JAL’s recognition is here.

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    Buying Assets in Bankruptcy – To Be or Not to Be . . . a Stalking Horse?!

    Monday, March 1st, 2010

    With both the global and regional Southern California economies showing early signs of life – but still lacking the broad-based demand for goods and services required for robust growth – opportunities abound for strong industry players to make strategic acquisitions of troubled competitors or their distressed assets.

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    Ray Clark, CFA, ASA and Senior Managing Director of VALCOR Consulting, LLC, is no stranger to middle-market deals.  His advisory firm provides middle market restructuring, transactional and valuation services throughout the Southwestern United States from offices in Orange County, San Francisco, and Phoenix.

    As most readers are likely aware, distressed mergers and acquisitions can be handled through a variety of deal structures.  Last week, Ray dropped by South Bay Law Firm to offer his thoughts on a process commonly known in bankruptcy parlance as a “Section 363 sale.”

    In particular, Ray covers the “pros and cons” of this approach.

    The floor is yours, Ray.

    Today’s economic environment has created an opportunity to acquire assets of financially distressed entities at deeply discounted prices, and one of the most effective ways to make those acquisitions is through a purchase in the context of a bankruptcy under Section 363 of the Bankruptcy Code (the “Code”).  When purchasing the assets of a failed company under Section 363, there are distinct advantages to being first in line.  Depending on the circumstances, however, it may be best to wait and let the process unfold – and then, only after surveying the entire landscape, submit a bid.

    The 363 Sale Process

    A so-called “363 Sale” is a sale of assets of a bankrupt debtor, wherein certain discrete assets such as equipment or real estate – or substantially all the debtor’s business assets – are sold pursuant to Section 363 of the Bankruptcy Code (11 USC §363).  Upon bankruptcy court approval, the assets will be conveyed to the purchaser free and clear of any liens or encumbrances. Those liens or encumbrances will then attach to the net proceeds of the sale and be paid as ordered by the Bankruptcy Court.

    A Section 363 sale looks much like a traditional controlled auction.  Basic Section 363 sale mechanics include an initial bidder, often referred to as the “stalking horse,” who reaches an agreement to purchase assets – typically from the Chapter 11 debtor, or “debtor-in-possession” (DIP).  The buyer and the DIP negotiate an asset purchase agreement (APA), which rewards the stalking horse for investing the effort and expense to sign a transaction that will be exposed to “higher and better” or “over” bids.  The Bankruptcy Court will approve the bidding procedures, including the incentives, i.e., a “bust-up” fee, for the stalking horse bidder, and will pronounce clear rules for the remainder of the sale process.  Notice of the sale will be given, qualified bids will arrive and there will be an auction.  The sale to the highest bidder will commonly close within four to six weeks after the notice and the stalking horse will either acquire the assets or take home its bust-up fee and expense reimbursement as a consolation. 

    Advantages for the Stalking Horse Bidder

    Bidding Protections - During negotiations with the debtor for the purchase of assets, the stalking horse will also typically negotiate certain protections for itself during the bidding process.  These bidding protections, which include a bust-up fee and expense reimbursement, will be set forth in the 363 sale motion and are generally approved by the bankruptcy Court.  As a result, stalking horse bidders seek to insulate themselves against the risk of being out-bid.  To do so, proposed stalking-horse bidders commonly require that any outside bidder will typically have to submit not only a bid that is higher than that of the stalking horse, but will also need to include an amount to cover the stalking horse’s transactional fees and expenses.

    Bidding Procedures – The stalking horse will also negotiate certain bidding procedures with the debtor, which will be set forth in the 363 sale motion that will be evaluated, and most likely approved, by the Court.  The sale procedures generally include the time frame during which other potential bidders must complete their due diligence and the date by which competing bids must be submitted.

    Other delineated procedures typically included in the motion include the amount of any deposit accompanying a bid and the incremental amount by which a competing bid must exceed the stalking horse bid.  In addition, if the sale procedures provide for an abbreviated time frame in which to complete an investigation of the assets, a competing bidder will be at a distinct disadvantage and may be unable, as a result, to even submit a bid.

    Deal Structure – As the first in line, the stalking horse bidder will also negotiate all of the important elements of the transaction, including which assets to acquire, what contracts – if any – to assume, the purchase price and other terms and conditions.  In doing so, it establishes the ground rules by which the sale process will unfold and the framework for the transaction, which will be difficult, if not impossible, for another outside bidder to change. 

    “First Mover” Advantage – The stalking horse bidder will typically be viewed by the Court as the favored asset purchaser in that it will have negotiated all of the relevant terms and procedures, and established its financial ability and intent to acquire the assets.  As a result, short of an overbid by an outside party, which typically involves an additional amount to cover the stalking horse’s bust-up fee and expenses, the stalking horse bidder will prevail.

    Cooperation of Stakeholders – As the lead bidder, the stalking horse also has an opportunity to negotiate with other key stakeholders in the process and establish a close relationship with those parties that may prove advantageous when all offers are evaluated.

    Bust-up Fee and Expense Coverage – Lastly, if an outside party happens to submit the high bid, the stalking horse will typically receive its bust-up fee and expense reimbursement. This generally includes items such as due diligence fees, legal and accounting fees, and similar expenses, but is limited by negotiation. 

    Disadvantages to the Stalking Horse Bidder

    Risk of Being Outbid – As noted, the stalking horse will expend a great deal of time, energy, and resources analyzing and negotiating for the purchase of the assets.  All a competing bidder must do is show up to the sale and submit an over-bid.  If the competing over-bidder prevails, the stalking horse runs the risk of walking away with only its bust-up fee and expense reimbursement.

    Risk of Bidding Too High – After negotiating the APA, the stalking horse then participates in the 363 sale process.  If no other bidders materialize, it may be because the stalking horse effectively over-paid for the assets. 

    Inability to Alter Terms – If some new information comes to light that would otherwise suggest a reduction in the price or alteration of the terms, the stalking horse may have difficulty altering either of these and may be locked in to the negotiated structure.

    Questions?

    Contact rclark@valcoronline.com or mgood@southbaylawfirm.com.

    Meanwhile, happy hunting.

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