In re Washington Mutual, Inc., 2011 WL 4090757 (Bkrtcy.D.Del.)(Sept 13, 2011)
When Washington Mutual Bank—once the nation’s largest savings and loan association—was seized by federal regulators in September 2008, it became the largest bank failure in the nation’s history. That same day, the feds sold substantially all of WaMu’s assets to J.P Morgan Chase Bank, amounting to nearly $147 billion. One day after being placed in receivership, WaMu’s parent company, Washington Mutual Inc., and its investment affiliate filed for bankruptcy.
Three years later, and still no plan. At stake were at least $4 billion in cash and billions in potential tax refunds from carrying forward net operating losses (NOLs). By March 2010, the debtors had proposed a plan of reorganization. Although the bankruptcy court found the plan fair and reasonable, it declined to confirm it due to several deficiencies, primarily involving litigation related to WaMu’s seizure and insider trading claims against the hedge fund investors who helped negotiate the reorganization.
To address the court’s concerns, the debtors re-proposed a plan in July 2011. In essence, the plan would cancel all stock in the debtors, leaving the common and preferred shareholders with nothing, and issue stock in the reorganized entity, giving the most senior creditors and equity investors one share of stock for each dollar of claimed debt. The assets of the reorganized entity would consist primarily of the debtors’ former subsidiary, a mortgage reinsurance company, and the tax attributes of the NOLs.
Not surprisingly, most of the major stakeholders, including JP Morgan/Chase and the FDIC, supported the plan, but the Equity Committee and others reasserted their claims that it was neither fair nor reasonable. They also argued that in its proposal to distribute stock in the reorganized debtor, the plan was substantially undervaluing the stock, thus giving the creditor/recipients more than the amount of their claims (in violation of §1129 of the Bankruptcy Code). Further, the plan objectors argued that this “excess value” should be distributed to other stakeholders—notably, the preferred and common shareholders.
The plan objectors presented a valuation expert to support their positions, and the debtors filed a Daubert objection, claiming the expert did not use accepted methodologies and relied on hypothetical scenarios; namely that the reorganized debtor would raise substantial amounts of debt and equity, and/or or acquire new businesses to maximize the value of the NOLs. In response, the plan objectors pointed out that even the debtors’ valuation expert considered the possible “corporate opportunities” that the reorganized entity would have, and any flaws in such assumptions went to the weight and not the credibility of the expert’s opinion.
In this context, the court did not discuss the parties’ “dueling” expert valuations in much detail. Instead, it summarily concluded that Daubert did not bar the plan objectors’ expert from testifying. Although the expert “did not follow normal methodologies for valuing a business,” the court said, neither was he preparing a complete valuation, but offering only a critique at trial. To that extent, his testimony was relevant and useful to the court, which, as trier of fact, was competent to evaluate the expert’s credibility and his reliance on hypothetical scenarios.
Debtors tend to undervalue, objectors to overvalue. Turning to the more substantive objections to the proposed plan, the court considered the respective values that the parties’ experts assigned to the two main assets of the reorganized debtor:
1. Reinsurance subsidiary. The debtor’s subsidiary was a captive reinsurance company that wrote policies on the mortgage loans issued by WaMu and its affiliates. As of the bankruptcy, the subsidiary had been in a “run-off” mode, not issuing new policies but simply collecting premiums and paying claims on existing ones. The company had no independent management, no independent sales force, and no employees.
Interestingly, the valuation experts weren’t far apart: the debtors’ expert said the company was worth between $115 million and $140 million, while the plan objectors’ expert posited a narrower range, from $129 million to $135 million. In his capacity as rebuttal witness, the latter also highlighted some internal inconsistencies and flaws in the analysis by the debtors’ expert. For instance, the debtors’ expert drew a weighted average cost of capital (WACC) from a December 2010 report, even though that number had fallen by 5% to 10% since then, which would have increased value. Moreover, his selected WACC of 13% to 15% was higher than historical returns for comparable business (8% to 12.5%) and also their current returns (6% to 10%). Finally, the debtor’s expert gave little weight to comparable transactions, which would have yielded a value well above his concluded range, of $145 million to $205 million. Instead, he assigned most of the weight to his discounted cash flow analysis.
The court finally determined that the value of the reinsurance company, assuming it acquired no new business, was at the high end of range posed by the debtors’ expert, or $140 million.
2. Net operating losses. The face value of the reinsurance company’s NOLs amounted to nearly $17.7 billion. Much of this could be lost, however, due to the company’s change in ownership under the debtors’ proposed plan and the application of IRC §382, which disallows a new entity from claiming loss-carry forwards attributable to a predecessor, and/or IRC §269, which disallows deductions from a corporate transaction if the main purpose was tax avoidance.
The debtor’s expert attempted to determine the net present value of the subsidiary’s NOLs under two alternative scenarios: as a static, “run-off” business and a potential future business with ongoing operations. Under the first, he testified that that IRC §382 would limit the value of the NOLs to the run-off business to $10 million to $20 million on a present value basis. The plan objectors did not really dispute this value, except to note that it did not take into account possible future revenues that could be generated by the income. Accordingly, the court adopted the highest value posited by the debtors’ expert, or $20 million.
The debtors’ expert valued the NOLs used by the future business between $10 million and $25 million. The plan objectors’ criticized his approach for using a liquidation rather than going concern value, which would recognize the ability of the subsidiary or even the reorganized debtor to apply the NOLs through the acquisition of new businesses. Their expert also critiqued his use of a 25% to 35% WACC for future acquisitions, but then adjusted this downward by 33% to account for the risks associated with the same. The plan objectors’ expert characterized this as “double-discounting” resulting in an effective WACC of 38% to 52%, when he believed a more appropriate rate ranged from15.8 % to 20%
Moreover, the plan objectors’ expert testified that the reorganized debtor could have a net present value of $275 million, based on assuming a mix of capital and debt infusions totaling approximately $500 million. The reinsurance market is a “prime area for new investment given the recent turmoil in the real estate market,” he added. The new entity could even reach a value of $240 to $420 million, if it raised “billions of dollars in additional equity,” he said.
The plan supporters once again accused the expert of failing to use typical methodologies to perform a “conventional” valuation of the reorganized debtor. It also pointed out these technical flaws in his analysis:
- His comparables for the debt to equity ratios were not reinsurance companies;
- His cost of debt was based on double-B rated securities though none of the reinsurance comparables had that high a rating;
- His rate of return was based on going-concern reinsurance companies rather than start-ups or run-offs; and
- He gave 40% weight to precedent transactions, despite his “normal” practice, because he mistakenly believed the debtors’ expert had also.
- He did not account for any tax risk, ignoring the possibility that the IRS could disallow all the NOLs.
- Finally, the plan supporters said that any assumption the reinsurance company would continue as a going concern was speculative, because it was not based on the proposed reorganization plan—or indeed, any existing business plan or strategy by the future shareholders.
At the same time, the court agreed with the critique by the plan objectors’ expert of the valuation done by the debtors’ expert, which gave “too little value to the possible future earning capacity of the reorganized debtor” due to “imaginary” tax restrictions. Any value of the NOLs must account for the tax risks, the court stated, but after a review of the applicable IRS regulations and case law, in concluded the risk wasn’t as great as the debtors’ expert assumed.
“Based on the two expert opinions, one of which is too conservative and the other of which is too aggressive,” the court concluded that the present value of the NOLs to the reorganized debtor was $50 million. This assumed that the new entity should be able to raise additional capital and debt over the next 20 years equal to twice the value of its current assets, by investing these assets either in regenerating its reinsurance business or acquiring new businesses.
Based on all of the evidence presented, the court found the reorganized debtor and it NOLs would have a value of $210 million. Given this value and an extensive review of the facts already on record, the court also found that the debtors’ proposed reorganization plan was fair and feasible, and in the best interest of creditors.
However, the court was still troubled by the outstanding legal claims against the debtors and its findings (after another extensive review of facts and case law) that the Equity Committee and others had stated an actionable claim of insider trading against several hedge fund investors who helped negotiate the settlement process. Concerned that the case could “devolve into a litigation morass,” the court declined to confirm the plan for a second time, and ordered the parties to mediate the issues in an attempt to resolve the litigation along with any other outstanding issues.