The current fiscal crisis is now providing test cases for bankruptcy courts and financial experts. These three (one is an outgrowth of the S&L scandal) provide a sobering look at what plagues the economy and how valuation analysts are critical to the ensuing litigation.
Caught between boom and bust. After rapidly expanding during the housing boom, the TOUSA homebuilding company made a last, disastrous acquisition in 2005, funded with over $675 million in secured financing. When the bubble burst in 2007, TOUSA defaulted and the bank (Citigroup) insisted that the company cause its subsidiaries to borrow $500 million secured by liens on substantially all their assets. According to court records:
- The company’s restructuring advisor (Lehman Bros.) called the $500 million deal the “best alternative” for TOUSA shareholders, but declined to provide a fairness opinion.
- An email from the CEO warned the company was “dangerously overleveraged” and in “desperate need” of equity. Even if de-leveraging was successful, he said, the company could probably not service its debts and would “crash and burn.”
- Even Citicorp harbored significant doubts about TOUSA’s solvency, but pressed forward, “motivated by the prospect of substantial fees.”
- The CEO’s multi-million incentive bonus was contingent on completing the refinancing, as was $2.9 million in Lehman Bros. fees.
- The firm that provided a fairness opinion whipped up a draft in two weeks, relying heavily on management projections and the promise of a $2 million fee for finding solvency.
In a 186-page opinion, the court examines the testimony from the parties’ insolvency experts in great detail, including their assumptions, methodologies, and possible motives. It found “serious problems” with the lenders’ first expert, including his “cherry-picking” of data. Even more problematic, the lenders’ second expert claimed that “no court” had ever rejected his opinion as unreliable, but the court found this was “simply not true.” Worse, the expert contradicted his deposition testimony in court, which “served only to erode [his] overall credibility further.” Finally, the fairness opinion was incredible, undermined by conflict of interest and haste.
By contrast, each of the analyses provided by the plaintiffs’ experts was reliable. In combination, “the analyses derive even greater force,” and persuaded the court’s to find that TOUSA and its subsidiaries were “grossly insolvent” as a result of the July 2007 transaction.
Another desperate cram-down. In In re: DBSD North America, Inc., 2009 WL 3491060 (Bankr. S.D.N.Y.) (Oct. 26, 2009), the debtors were a next-generation mobile satellite service provider. Despite obtaining over $51 million in secured “first tier” financing and a $752 million secured, second tier facility, the debtors were unable to rent their broadcast spectrum and sought Chapter 11 relief. They filed a deleveraging pan that would exchange 95% of their stock for the $752 million in second-lien notes. The first-tier lenders objected, contending the cram-down failed to provide them the “indubitable equivalent” of their secured claims.
The parties’ experts applied three methods to determine the debtors’ total enterprise value (TEV)—a guideline comparables analysis, comparable transactions, and discounted cash flow (DCF). With varying assumptions and weightings, however, their opinions created a wide, multi-billion dollar spectrum of value, ranging from as low as $70 million to a high of $3.1.billion.
The court found “serious problems” with both experts’ DCF approach. In particular, the lenders’ expert assumed a continuous stream of “unrelenting” negative cash flows, which the court found unrealistic, serving only to skew his opinion to the low extreme. Only the comparable company analysis was reliable, the court concluded, in part because both experts used the same guideline companies and produced mean values that were “only” $45 million apart. Because the debtors’ expert gave more weight to this approach than the lenders’ expert, the court found his was the “best assessment” of TEV, in the range of $492 million to $692 million, sufficient to keep the secured lenders’ investment “safe” during the proposed restructuring.
Government breach left bank ‘in shambles.’ In First Annapolis Bancorp., Inc. v. U.S., 2009 WL 349020 (Fed. Cl.)(Oct. 26, 2009), the plaintiff/bank agreed to purchase a failing federal thrift for $13.7 million. In exchange, the government agreed to relax its capital and supervisory goodwill requirements. Within a year, however, it passed the Financial Institutions Reform, Recovery, and Enforcement Act (1989)(FIRREA), effectively eliminating those forbearances and causing the plaintiff to fail, the court held.
The government presented two experts to obviate damages. The first claimed the bank was in such dire financial condition at the time of the acquisition that it would have failed regardless of the government’s breach. Its second expert said the government’s forbearances were “essentially worthless” and even without them, the bank would have failed.
The court rejected the government’s position. Neither expert specifically analyzed when the bank became non-viable, and both admitted that FIRREA negatively impacted the bank. They tried to cite a myriad of causes for the bank’s demise, but failed to establish that any had the same dramatic impact as FIRREA, which “destroyed [the bank’s] ability to operate, the court held. It cited credible evidence from the plaintiff’s expert showing the bank was viable at the time of the purchase and was meeting its capital benchmarks until the government’s breach “put it on an unavoidable course to insolvency.” Based on these findings, the court awarded full restitution of the bank’s $13.7 million investment.