Case Update - November 2011
provided by BV Resources
Sherrye Henry, editor
sherryeh@bvresources.com

Valuation Lessons from Previous Crisis Are Applicable to This One

AmBase Corp. v. United States, 2011 WL 3891942 (Fed. Cl.)(Aug. 31, 2011)

As the U.S. Court of Federal Claims notes at the beginning of its opinion, this is one of the last of the Winstar-related cases to come out of the savings and loan crisis of the late 1980s and the government’s enactment of the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA). As with the prior Winstar cases, the lessons gleaned from this one may very well carry over into current economic and litigation climate.

Acquisitions during the troubled 80’s. By 1986, and at the behest of federal regulators, the Cateret Savings Bank had acquired four failing, FSLIC-backed thrifts. Prior to the “supervisory mergers,” the bank posted net profits of $37 million. As a result of its acquisitions, however, its net worth fell to a negative $212 million and the bank would have failed if not for the government’s express agreement permitting it to book approximately $238 million of “supervisory” goodwill as regulatory capital.

In 1987, the AmBase corporation acquired Cateret’s holding company for $266 million, and within a year, the bank became the 19th largest savings and loan association in the country, with assets of almost $6 billion. The bank also held $322 million in regulatory capital, more than half of which ($182 million) was supervisory goodwill.

Just a year later, however, Congress passed FIRREA and eliminated supervisory goodwill as counting toward regulatory capital requirements. To comply with the new law, Cateret took immediate action, shedding $2.3 billion worth of assets and beefing up loan loss reserves from $8.4 million to $27.5 million. In 1991, the bank also successfully enjoined federal regulators from disregarding its supervisory goodwill and briefly returned to profitability. Despite capital infusions from its parent, however, the bank couldn’t maintain sufficient capital and was placed in receivership. The bank and its parent company subsequently sued the federal government, claiming its enactment of FIRREA breached the supervisory merger agreements, and, in a first opinion, the Federal Court of Claims found the government liable for breach of contract.

As a preliminary matter, the court found that the plaintiffs satisfied the first two requirements of federal law on contract damages: foreseeability and causation. Further, “the breach significantly impacted Cateret’s regulatory capital profile and set off a resulting chain of negative events that eventually led to the bank’s seizure.” Thus, there was sufficient evidence that the breach was a “substantial factor” in the bank’s failure.

The government argued that the more stringent “but for” test applied. (“But for” the breach, the bank would have remained profitable) but the court disagreed.

Market value trumps earnings models. As a third and final issue, the court determined damages. The plaintiffs’ expert, a University finance professor, presented three alternative calculations:

• $251.4 million, based on the market value of the bank at the time of its 1989 acquisition by AmBase;
   
• $782.2 million, based on the bank’s 1989 cash flows and its 2008 terminal value; or,
   
• $920.7 million, representing the bank’s market value in a “non-breach” world.

The court rejected the latter two approaches, based primarily on the expert’s use of the Gordon Growth Model. As one of the defendants’ rebuttal witnesses testified, the GGM “can only be used with firms with…very stable growth over time.” In this case, the banks’ earnings varied considerable over the years—and the effect of investment opportunities, sources of funding, and other options the “but for” bank might have enjoyed were ignored.

On the whole, the court accepted the expert’s market value approach, which began with the price that AmBase paid for the bank ($266 million) in 1989. At the time, two investment banks had evaluated the deal and concluded that it was fair. In addition, the stock market independently valued the bank at $198 million just before the transaction. In light of the additional obligations that AmBase undertook as part of the deal, even one of the defense experts admitted that the final purchase price reflected a control premium that was “within the realm of reason.” 

Accordingly, the court agreed that the $266 million sale price was a “reasonable measure of the fair market value of the bank prior to the breach.” After the acquisition, however, the bank was longer publicly traded; as a result, the plaintiffs’ expert could no longer use the bank’s market-to-book ratios to determine value. Instead, he applied the average rate of increase in the market-to-book ratios from 46 publicly traded comparable thrifts (7.4%) to the bank’s pre-acquisition ratio (0.869) to calculate a post-acquisition ratio (0.934). Applying the latter to the bank’s post-acquisition book value ($269.3 million) resulted in a market value of $251.4 million at the time of the breach.

The court accepted the expert’s use of an industry “index,” derived from his selection of comparables. It also found that tracking the thrift industry’s growth in 1989 was conservative because—even though FIRREA didn’t pass until the end of the year, the market was already absorbing the impact of the legislation, which helped to suppress thrift values. Finally, the plaintiffs’ expert effectively captured the increase in the bank’s “classified assets,” which took place just before the 1989 breach.

At the same time, one of the defendant’s experts reduced the bank’s pre-breach value ($269.3 million) by the $77.2 million in loan loss reserves that federal regulators were requiring from the bank several months before FIRREA. Applying the mean market-to-book ratio of the industry (0.934) to this adjusted book value yielded an adjusted market value of $179.4 million for the bank.

In response, the plaintiffs argued that regulators actually reduced the required loan loss reserves to $49.8 million, and the court accepted this lesser amount. After applying the industry ratios, it concluded that the adjusted market value of the bank at the time of the breach was $205 million, and ordered the defendant to pay damages in this amount.

For a full transcript of the case, go to http://www.bvresources.com/asa