The bankruptcy saga of the fraud-ridden Doctors Hospital in Chicago has taken yet another intriguing spin. In an opinion by Judge Frank Easterbrook, long respected for “his creative applications of economic theory to legal issues,” according to Professor Robert Lloyd (a contributor to BVR’s Comprehensive Guide to Lost Profits Damages, for Experts and Attorneys, 2010 Ed.), the U.S. Court of Appeals for the 7th Circuit has just decided two issues of first impression among the federal circuits.

The first—which has bankruptcy bloggers buzzing, held that the trustee of securitized assets was not a “mere conduit” for the transfer of loan proceeds from the troubled hospital, but was an “initial transferee,” sufficient to fall within the preferential transfer provision of the federal Bankruptcy Code.” If the hospital had made a preferential transfer to Exxon, the [bankruptcy] trustee would sue the corporation—and not its millions of stockholders,” Judge Easterbrook observed. “Similarly with a preferential transfer to a hedge fund,” he added, in what could open the door to suits against such investment pools in the future, regardless of whether they still have assets to tap for any liability payments, or would have to sue investors for reimbursement.

The second issue should alert valuation analysts: Until it filed bankruptcy in 2000, the hospital had paid all its debts and posted positive earnings. “Yet the bankruptcy judge concluded that it had been insolvent [since 1997],” Judge Easterbrook observed. “How was that possible?” Even after subtracting $18.5 million for the hospital’s fraud (under investigation in 1997 but not incurred until 2000), the S corporation was still in the black. It took a 40% tax-affecting discount to reach red—and this, the Judge said, “was a mistake.” How much a buyer might pay for a revenue stream does not tell us whether a firm is insolvent, except indirectly. Attorneys on the case could not find one decision, from any court, that applied either a liquidity or a tax-effect discount to the asset side of a corporation’s balance sheet for the purpose of determining solvency—and neither could the Judge. Accordingly, he sent the case back for a determination whether the hospital might have been insolvent at any time before its 2000 bankruptcy. The complete digest of Paloian v. LaSalle Bank, 2010 WL 3363596 (C.A.7)(Aug. 27, 2010) will be in the Nov. 2010 Business Valuation Update™, and a copy of the court opinion will be available at BVLaw™.