Federal court asks experts for the ‘just right’ discount rate

A bankrupt chemical business didn’t owe $16.3 million in damages for breach of contract, because the claims were barred by the statute of limitations and a prior settlement. But just in case—the federal district court considered an issue that was certain to come up on an appeal: calculation of the discount rate to present value the future stream of contract payments. Not surprisingly, the plaintiff’s expert argued for applying a very low range (less than 3%), based on the “Ask Yield” rate for U.S. Treasury bonds. (When asked why he chose this rate, he essentially replied: because the plaintiff’s attorney told me to.) In contrast, the defendant’s expert used the company’s weighted average cost of capital (WACC) of 11.75% at the time of bankruptcy--which more accurately reflected its ability to perform on the contract, he said.

A ‘Goldilocks’ problem. The court agreed that the risk-free rate was too low—but found that the debtors’ proposed rate was “much too high.” The debtors’ WACC dealt with the company as it had evolved up and through bankruptcy, but only a subset of those risks would have impacted it at the time of the contract (1991). Not satisfied with either party’s research, the court did its own, finding Teachers Ins. & Annuity Ass’n of America v. Ormesa Geothermal, 791 F.Supp 401 (S.D.N.Y. 1991)—a case which rejects the risk-free rate in favor of a rate that reflects the same risk that the plaintiff would have made in a similar contract with an alternate obligor. Thus, the discount rate “must…correspond to the risk of nonperformance” at the time the parties originally entered the contract, the court held, but since neither had offered this evidence, it ordered them to “attempt to” agree on a discount rate, based on its ruling. If they failed, “they can always come back to me,” the court added, leaving the door open for additional expert findings on the all-important discount rate in contract damages actions.

Read the entire digest of In re Chemtura Corp., 2011 WL 1496327 (Bkrtcy. S.D.N.Y)(April 19, 2011) in the next (August 2011) Business Valuation Update; the court’s opinion will be posted soon at BVLaw.