Winter 2014


Focus on Bankruptcy and Reorganization Financial Advisory Services

Editor for This Issue: C Ryan Stewart Bankruptcy Transaction and Structure Insights

Best Practices:
Investing in Distressed or Underperforming Companies: Recent Challenges to Favored Deal Structures

Nancy A Peterman, Esq, and Kevin P Ray, Esq
As the distressed deal market becomes more competitive, with more money and fewer deals, a recent trend has developed. Losing bidders or creditors, who are attempting to leverage a recovery (or a better recovery), are challenging acquisition structures typically used by distressed investors in Chapter 11 cases. These challenges relate to reorganization plans, claims that have been purchased for use as a credit bid in a sale process, and Section 363 sales. This discussion focuses on some of these trends. First, the discussion explores whether plans, in which management, equity holders or insiders retain some interest, may need to be subject to competitive bidding. Next, the discussion analyzes recent case law in the claims trading area and how creditors or others may challenge purchased claims and attempt to limit use of the purchased claim to credit bid for a debtor corporation’s assets. Finally, the discussion explores recent challenges to Section 363 sales made by losing bidders in an effort to re-open the auction process. To ensure that they win the deal, any participants in the distressed marketplace should carefully structure any proposed acquisition and be prepared for these challenges.

The Importance of Sellers’ Representations in M&A Transaction Purchase Agreements
John C Ramirez, Aaron M Rotkowski, and Irina V Borushko
It is virtually impossible for the corporate buyer to verify every detail about an acquisition transaction target. For this reason, the corporate buyer typically demands representations from the corporate seller in order to complete the acquisition transaction. Valuation analysts and other transaction professionals should understand such sellers’ representations in order to provide effective transaction-related consulting services. This discussion summarizes both what a seller’s representation is and why a seller’s representation is an integral part of the transaction purchase agreements.

Though Leadership
What Is “Investment Plus”? Understanding a Private Equity Fund’s Liability for a Portfolio Company’s Pension Shortfall
John M Wirtshafter, Esq, Shawn M Riley, Esq, and John A Polinko, Esq
A recent federal court decision calls into question an assumption many private equity firms make regarding their portfolio companies: that the liabilities of such companies are not liabilities of the private equity firm. In Sun Capital Partners III, LP v. New England Teamsters & Trucking Industry Pension Fund,1 the First Circuit turned that assumption on its head. While the decision applies only in the First Circuit (federal courts in Maine, Massachusetts, New Hampshire, Puerto Rico, and Rhode Island), the holding—that any activity beyond mere investment in a portfolio company could trigger control group liability—should be a concern to all private equity funds, particularly funds that invest in financially distressed companies or participate in Bankruptcy Code Section 363 sales transactions. With a better understanding and with reasoned expert guidance, private equity funds can take steps to insulate themselves from the pitfalls of this type of liability which could potentially include financial distress or bankruptcy of the private equity firm.

Recent Development in S Corporation and Qualified Subchapter S Subsidiary Tax Status in Bankruptcy: In re Majestic Star Casino
Brett Berlin, Esq.
This discussion reviews a recent judicial decision at the intersection of tax law and bankruptcy law: The Majestic Star Casino, LLC, et al. v. Barden Development, Inc., et al. The decision is the first federal appellate court case to examine whether S corporation and qualified subchapter S subsidiary (Q subsidiary) tax status constitute property of a debtor corporation’s bankruptcy estate. The United States Court of Appeals for the Third Circuit concluded that taxable status is not property of the bankruptcy estate. Therefore, in courts subject to Majestic Star Casino as controlling precedent, taxable status is not protected by the “automatic stay,” and the debtor corporation or a bankruptcy trustee may not use bankruptcy “avoidance powers” to undo a transaction that results in the revocation or termination of S corporation or Q subsidiary tax status. Notably, the court reached the opposite conclusion from several lower courts that previously considered the same issue. Owners of S corporations presumably will welcome the holding. Professional advisers to, and creditors of, financially distressed S corporations and their Q subsidiaries should take a cautionary note from the decision. Legal counsel, tax planners, and financial advisers should give due consideration to these issues during the pre-bankruptcy planning process, if possible, to anticipate potential consequences.

Bankruptcy Valuation and Solvency Insights

Due Diligence and Analytical Procedures for Fraudulent Conveyance Opinions
Katherine A. Gilbert and Kyle J. Wishing
The considerations related to fraudulent conveyance opinions can be complicated. Often, fraudulent conveyance opinions are at the center of Bankruptcy Code Section 548 transfer avoidance actions. A fraudulent conveyance analysis involves the following three tests: (1) the balance sheet test (i.e., a solvency analysis), (2) the cash flow test, and (3) the capital adequacy test. If the three tests are passed, then the transfer is generally not considered to be a fraudulent conveyance. This discussion describes each of the tests and illustrates the related analyses. This discussion also presents a procedural and due diligence checklist that may be useful to valuation analysts, the debtor corporation management, creditors, legal counsel, and other users of a fraudulent conveyance opinion.

Contingent Liabilities and Disputed Claims in the Context of a Bankruptcy Solvency Analysis
C. Ryan Stewart
Valuation is an integral part of the bankruptcy solvency or insolvency analysis. As part of the solvency analysis, all of the debtor’s assets and liabilities, including off-balancesheet liabilities are analyzed and valued. As a debtor becomes financially distressed on its journey toward bankruptcy, it may become involved in financing schemes or become the target of lawsuits that ultimately contribute to its bankruptcy. These types of contingent liabilities and disputed claims that exist prior to the petition date can play a significant role in the determination of a debtor’s solvency in the context of a bankruptcy proceeding. This discussion focuses on the differences between disputed claims and contingent liabilities and how to estimate their values. In addition, this discussion illustrates an erroneous valuation of debtor liabilities. That example highlights the implications of that error.

Valuation Analyses and the Commercial Bankruptcy
Robert F. Reilly, CPA
There are valuation issues involved in most commercial bankruptcy matters. These valuation issues are often important to the debtor in possession, the various classes of creditors, the various contract counterparties and other interested parties, and the legal counsel for all of the above. First, this discussion summarizes many of the reasons to conduct a valuation within a bankruptcy environment. Second, this discussion considers many of the issues the valuation analyst typically encounters within a bankruptcy context. And, third, this discussion presents numerous caveats for the analyst who is performing a bankruptcy-related valuation.

U.S. Bank National Association v. Verizon Communications, Inc.: What Was the Value of Idearc?
Irina V. Borushko
The focus of this discussion is the U.S. Bank National Association v. Verizon Communications, Inc., decision as it relates to the spin-off of the Verizon Communications, Inc. (“Verizon”) directories business, Idearc, Inc., (“Idearc”). Idearc filed for bankruptcy 28 months following its spin-off from Verizon. Amidst reorganization, Idearc filed an action against Verizon, contending that Idearc was loaded with so much debt in the spin-off that it was insolvent and destined to collapse. The Verizon decision highlights various factors a valuation analyst should consider in the application of (1) the guideline publicly traded company method, (2) the guideline merged and acquired company method, and (3) the discounted cash flow method. The Verizon decision also highlights factors and procedures a valuation analyst should consider when reconciling the values estimated using the selected valuation methods.

Income Tax Consequences to the Troubled Debtor’s Property Abandonment, Foreclosure, or Repossession
Robert F. Reilly, CPA
When a debtor (whether a business or an individual) cannot pay its secured obligations, the debtor has a number of options. However, all of those options generally involve the debtor losing the collateral property (through either abandonment, foreclosure, or repossession). In addition, the debtor may have to recognize taxable income related to the cancellation of the debt related to any of these options. This discussion summarizes the income tax considerations related to the secured debtor’s property abandonment.

Bankruptcy Litigation Insights

Trends in ESOP Litigation from 1990–2013: Special Focus on Recent Valuation and Bankruptcy Cases
Corey Rosen
Since 1990, there have been two large waves of “stock drop” litigation, the first following the accounting scandals of the early 2000s and the second following the financial crisis of 2008. The large majority of this litigation involved public company 401(k) plans where employer stock was an optional investment and/or the company matched employee deferrals in employee shares. In cases where there was an employee stock ownership plan (ESOP), it was almost always used as a match to the employer corporation 401(k) plan, and it usually owned relatively little sponsor company stock. These kinds of plans are noticeably different from private company ESOPs. Approximately 97 percent of ESOPs are in closely held sponsor companies. Most of these ESOPs own 30 percent or more of the employer corporation stock, with perhaps 40 percent of these ESOPs owning or planning to own 100 percent of the employer corporation stock.1 Public companies with ESOPs or 401(k) plans with employer corporation stock rarely have more than five percent of their shares in these plans. Due to the readily determinable nature of the publicly traded employer corporation share prices, they are not required to have independent appraisals performed. The lack of readily available closely held employer corporation share price data creates the need for independent valuations and also creates the circumstances that give rise to issues such as breaches of fiduciary duty, disputes the over fair market value of sponsor company shares, disputes over transaction fairness and other points of disagreement that result in litigation. This discussion focuses on the trends in ESOP litigation over the last 23 years, with a special focus on valuation and bankruptcy issues.

Defending Fraudulent-Transfer Avoidance Actions in Ponzi-Scheme Cases
Michael F Holbein, Esq, and Sean C Kulka, Esq
It is generally not a good way to start off the week by tearing into an envelope holding a demand letter (or, even worse, a complaint) from a bankruptcy trustee claiming that over three years ago, some unfamiliar company paid the hundreds of thousands of dollars in debt accumulated by its affiliate, a name you only remember because of the big bill you thought would not get paid. To make matters worse, you learn that the trustee is claiming that the unfamiliar company was part of a Ponzi-scheme and that you may be on the hook for decades of actual fraud and perhaps millions of dollars in potentially avoidable transfers. This discussion focuses on the reach-back period applicable to avoidance of actual and constructive fraudulent transfers under the Uniform Fraudulent Transfer Act (the “UFTA”) versus the U. S. Bankruptcy Code, including the possibility of an indefinite reach-back period for actual-fraud claims under the UFTA. This discussion also highlights strategies for defending an actual-fraud Ponzi-scheme lawsuit.