‘Reasonably Equivalent Value’ Analysis Is Not a Dollars-and-Cents Issue

Mercury Companies, Inc. v. FNF Security Acquisition, Inc. (In re Mercury Companies, Inc.), 2014 Bank. LEXIS 1230 (March 31, 2014)

What does the Bankruptcy Court look for when it assesses “reasonably equivalent value”? A recent decision describes in technical detail the discounted cash flow analyses the parties’ experts performed and the limitations of their calculations. The court also explains what factors it considers to reach a conclusion, other than the contract price and appraisals.

The plaintiff was a title agency organization that began in Colorado but expanded into California, Arizona, and several other states in the 1990s. Its downfall began in 2007 when the California housing market crashed. In April 2008, the plaintiff executed a credit agreement as part of a $45 million loan that was secured by most of its and its subsidiaries’ assets, including accounts receivable. In July 2008, the lead creditor swept $40 million from the plaintiff’s accounts. Based on this event and other considerations, company management decided to stop doing business in 161 locations and close down many subsidiaries.

Since the title company subsidiaries had a 30% share of Colorado’s real estate market, management believed the subsidiaries made for an attractive acquisition target, but their likely buyer, their largest underwriter, rejected the offer to buy. Management then proposed a sale of the subsidiaries to the defendant—a major national title insurance company. On Aug. 5, 2008, the parties executed a purchase agreement, which specified a purchase price of $5 million in cash. The defendant immediately wired $1 million of the amount and took control of the Colorado subsidiaries that same day. A day later, it wired an additional $1.48 million toward the purchase price, leaving just over $2.5 million of the purchase price outstanding. Twenty-three days after the sale, the plaintiff filed for Chapter 11 bankruptcy.

The plaintiff sued in Bankruptcy Court (D. Colo.) to recover the alleged value of the Colorado subsidiaries from the defendant, claiming the sale was a fraudulent transfer under Section 548(a)(1) of the Bankruptcy Code. The transaction was avoidable because the plaintiff received less than reasonable equivalent value for the stock in the four subsidiaries and was insolvent on the date of transfer.

Since both parties agreed on the insolvency issue, the court had to rule on reasonably equivalent value.

It considered expert testimony from both parties. The experts’ approaches, the court found, were remarkably similar, but their conclusions “vastly different.” The plaintiff’s expert determined that, on the date of sale, the stock had a positive value of nearly $15 million, whereas the defendant’s expert assigned a negative value of about $5 million.

As to the similarities, both experts agreed the three title subsidiaries required a different valuation from the fourth subsidiary because the latter was in a different line of business. Both experts used a going concern value because the entities were operating businesses at the time of sale. And both opted for an income approach. For the title companies, this meant employing the discounted cash flow (DCF) method: projecting their revenues and expenses and discounting them back to the date of sale.

Remarkably, both experts projected a 0.1% revenue growth in 2009 and 6.4% growth in 2010 based on national forecasts and assumed 3.0% growth for 2011 and all subsequent years. But they disagreed about projections for 2008 following the sale. In critiquing the defendant expert’s valuation, the plaintiff claimed he excluded “shadow revenue,” confusing it with seasonality of the title business, and even after learning about it failed to modify his valuation. Shadow revenue was an accounting tool encouraging title companies to refer business to the plaintiff’s non-Colorado subsidiaries. In case of a successful referral, both companies received credit for revenue generated on their income statements and qualified for a commission from the parent company. To prevent “double booking” of revenue, at the end of the year, the shadow revenues were deducted from the title companies’ income statements.

The defendant’s expert responded that he “made up” for the exclusion. For example, he used management projections existing before the sweep, which tended to be overly optimistic. He agreed that a projected decline in revenues should be in the 30%-to-40% range, rather than the 22% decrease resulting from the projections. He held onto the rate; it and other factors balanced his earlier exclusion of shadow revenue from the projections.

The court called the expert’s approach “inappropriate” and said it weakened his conclusion of “negative” value.

The plaintiff also claimed the defendant’s expert should not have made a lost business adjustment to account for the effect of the sweep. The court disagreed, finding that fear of lost business was a critical factor in plaintiff management’s decision to offer the stock for $5 million and insist on an immediate sale.

Neither valuation hit the mark, the court found. It agreed with the plaintiff’s expert that a non-immediate sale would have increased the sales price. But there was no certainty it would have been $10 million higher than the agreed-upon price.

Although it disapproved of the way in which the defendant’s expert tried to account for excluding shadow revenue, it approved of his consideration of the immediacy of the sale. But it also found he did not reckon that the defendant was willing to pay $5 million for the four subsidiaries and indeed considered the deal a good one. In sum, one valuation appeared “excessive” and the other “too low.”

Ultimately, the court’s determination of reasonably equivalent value did not require it to compute a specific dollar value, the court explained. The term “reasonably equivalent value” was not defined in the Bankruptcy Code. But relevant case law provided for a two-step analysis: (1) determine whether the debtor received any value at all; and (2) look to the totality of the circumstances to compare the value of what the debtor received with the value of what it gave. As to the second inquiry, a court could look beyond the contract price and the valuations. And it could factor “indirect” or noneconomic benefits into its determination of the value received, the court added.

In this case, the court found there was no question that the debtor received some value. The court found that the company’s president panicked and thought that an immediate sale was required. He contacted the defendant and proposed a discounted $5 million purchase price to enable a quick sale. When the defendant asked for more time to do due diligence, he replied there was no time “for haggling.” Management received what it asked for, the court pointed out. It concluded that the sale was conducted for reasonably equivalent value and, therefore, was not avoidable.

At Rosenfarb LLC we produce well supported, well-reasoned and well communicated valuation calculations that withstand the rigors of litigation. We are a firm of forensic accounting and valuation experts. We understand business, have keen insights and always connect the dots. We understand the litigation process. We frame the issues simply and in alignment with the litigation strategy. We use logic to support our opinions, while creating compelling stories. We are sincere, professional and credible. We are accounting experts with legal acumen.

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