U.S. Appeals Court Agrees That "Indirect Benefits" Have Little Value
By Sylvia Golden, JD, Legal Editor, Business Valuation Update
In re Global Technovations, Inc., 2012 U.S. App. LEXIS 19209 (6th Cir. Sept. 13, 2012)
This case began in bankruptcy court and has now passed through the U.S. Court of Appeals for the Sixth Circuit. The debtor, which had acquired the American division of a Japanese automotive technology company for $25 million—$13 million in cash and $12 million in a three-year promissory note—sued the seller claiming the purchase was fraudulent, and that the fraud led to the bankruptcy.
Actual vs. projected earnings. At trial, experts for both parties used the comparable transactions method to calculate the fair market value of the target company. Based on four transactions, the plaintiff’s expert developed an earnings multiple, which, when applied to the target’s 12-month trailing EBITDA, yielded a FMV of $6.9 million. He also valued the promissory notes at face value (because they were short-term notes). He further stated that the economic value of any “indirect benefits” that the debtor allegedly received from the acquisition was zero.
The appraiser was cross-examined on the risks of applying hindsight in his calculation of the multiple, as well as his determination of EBITDA. He acknowledged that the target’s actual earnings after the August 31, 2000 closing date “are not to be used unless again you would have predicted those results based on information you would have known.” As for using comparable transactions that took place after the closing date, he said it was acceptable to use those that occurred within a reasonable range of time.
By contrast, the defendants’ expert used the target’s projected EBITDA for 2000, including his own projections for the target’s performance after the closing date, to arrive at an equity value of $45 million. As for valuing the promissory notes, he applied a discount based on the market rate of interest for comparable unsecured debt to arrive at a value of $8.6 million. He also provided a separate opinion that the acquisition did not cause the debtor to become insolvent.
The bankruptcy court discredited the defendants’ expert for using “unreasonable” projections. Relying on the debtor’s expert’s opinion, it concluded that the target company was worth only $6.9 million and that after the acquisition, the debtor’s liabilities exceeded its assets by $12.2 million.
At the same time, the court accepted the $8.6 million discounted value that the defendants’ expert assigned to the promissory notes. And it largely dismissed the defendants’ claim that the debtor received many indirect benefits from the acquisition.
Finding that the debtor paid $21.6 million but received equity worth only $6.9 million, the court concluded the debtor did not receive a “reasonably equivalent” value. (Applicable Florida law presumes that if a debtor receives 70% or less of the value it gives, it has not received “reasonably equivalent” value.) The court also found the debtor became insolvent as a result of the acquisition.
The defendants then challenged the bankruptcy court’s findings in federal district court, again claiming that the debtor did receive “reasonably equivalent value," and that the bankruptcy court erred when it adopted the reduced value the defendants’ expert had assigned to the promissory notes, but declined to adopt the expert’s conclusion as to solvency. As the district court saw it, there was no inextricable link between the discount rate applied to unsecured debt and the debtor’s solvency.
And, again, the defendants argued that the $6.9 million value disregarded the indirect benefits that accompanied the transaction.
However, the district court agreed with the bankruptcy court's ruling on three issues.
One more time. So, the defendants next appealed to the U.S. Court of Appeals for the Sixth Circuit, raising almost the same issues: 1) the debtor failed to prove the value of all the economic benefits it received from the transaction, direct as well as indirect; 2) the bankruptcy court relied on hindsight when it determined the value of the target’s stock; and 3) the debtor failed to prove the value of its promissory notes. The Sixth Circuit revisited the claims:
1. Indirect benefits: The Court of Appeals found that the bankruptcy court heard extensive and sufficient testimony on whether these benefits had any value to the debtor, and upheld its conclusion that only one, the avoidance of delisting, had any tangible value; the rest had “minimal” value. Moreover, even if the promissory notes had a zero value, reducing the purchase price to $13 million, the defendants failed to show that the value of the indirect benefits was sufficient to reach the critical 70% level.
The Sixth Circuit also affirmed the bankruptcy court’s decision not to require the debtor’s expert to prove the value of the indirect benefits. While it acknowledged the general requirement that the plaintiff calculate the value of indirect benefits, it found that this case fell under the established exception to the rule. Specifically, the bankruptcy court had sufficient evidence from witness testimony to conclude the value of the non-stock benefits was negligible.
2. Hindsight value: The defendants next raised a new challenge, claiming the debtor’s expert used improper hindsight when calculating the FMV under the comparable transactions method, as he used a transaction that occurred after the valuation date to select a multiple. “The methodology centers on transactions that are similar in nature,” the Sixth Circuit observed, and there is no precedent that precludes an expert from examining a post-hoc transaction simply “because to do so would draw on hindsight.” The record showed that the debtor’s expert expressly stated during cross-examination that he was not relying on hindsight, the Court of Appeals found. Furthermore, the bankruptcy court was fully cognizant of the expert’s valuation method and “of the potential problems with using hindsight to determine [the target’s] value.” Accordingly, the bankruptcy court did not err when it adopted the debtor’s expert’s FMV for the target.
3. Promissory notes: Not only did the debtor’s expert fail to value the promissory notes, the defendants claimed, but the bankruptcy court erred by adopting their expert’s discounted value for the notes without also accepting his FMV and solvency conclusions.
The Sixth Circuit found the record clearly showed the debtor’s expert valued the short-term notes at face value. Furthermore, a bankruptcy court need not credit all aspects of an expert’s testimony; accordingly, in this case, it did not err by accepting the discounted value of the notes by the defendants’ expert but disregarding his ultimate conclusions. Nor did any bankruptcy rule require discounting promissory notes in a fraudulent transfer case in which their acquisition helped render the debtor insolvent, the court held, and affirmed all aspects of the lower courts’ decisions.