Business Valuation Review Volume 33 N Number 4 ’ 2014, American Society of Appraisers

Letter to the Editor: Key Takeaways from and Updates to the Three Papers

I confronted two problems while writing these papers. ents), whereas the defendant is often analogous to the First, it is difficult to condense lengthy discussions person who says ‘‘it’s in there.’’ Interestingly, PregoH is into simple themes. Second, I became aware of new owned by Campbell Soup Company (‘‘Campbell’’). information after the drafts were submitted (which was Campbell was the defendant in Vlasic and essentially several months prior to the publication of each paper). responded ‘‘it’s in there’’ every time the plaintiff argued a This letter endeavors to address these two problems. piece of information was not disclosed and thus not incorporated in contemporaneous market prices. The Key Takeaways from Part I courts (district and appellate) in Vlasic essentially found My first paper focused on the debtor’s contemporane- that the information was, in fact, all ‘‘in there.’’ ous security prices. While the paper took up twenty-six The parties’ roles can reverse when contemporaneous pages in this journal, it could be summarized in just three market data suggest the debtor was insolvent. For words: ‘‘the market, stupid.’’ This phrase is derived from example, the defendant may contend that the market did ‘‘the economy, stupid’’ theme from Bill Clinton’s not fully reflect the value of recent strategic changes to presidential campaign during the 1992 election. Courts the debtor’s business model. The plaintiff in this situation have consistently focused on the market in the context of can respond ‘‘it’s in there’’ by arguing the expected value retrospective solvency analyses, just as Bill Clinton (i.e., probability-weighted value of potential outcomes) of consistently focused on the economy while campaigning these strategic changes was incorporated in the contem- for president in 1992. poraneous value of the debtor’s securities. Absent proof that the market was misled, courts have There may be an exception to the courts’ deference to consistently deferred to contemporaneous market data in contemporaneous data from reasonably informed markets the context of retrospective solvency analyses. Every case in the context of retrospective solvency analyses. My discussed in my first paper arrived at determinations that second paper contained a discussion regarding Tronox, were consistent with contemporaneous market data. This which was decided after the first paper was submitted. outcome does not appear to be due to selection bias, The court in Tronox, following in the footsteps of the because ‘‘irrational exuberance’’ has never been used to court in W. R. Grace, would not defer to contemporane- reject contemporaneous market data in the context of a ous market data even if the market was perfectly 2 retrospective solvency analysis.1 efficient. The common denominator in Tronox and W. Thus, the reliability of contemporaneous market data R. Grace was the presence of sympathetic plaintiffs. typically boils down to arguments over disclosure. These Gregory Horowitz predicted, prior to the court’s ruling in disputes remind me of the 1980s-era PregoH sauce Tronox, that: commercials. In these commercials, a person does not [t]he irrational exuberance argument may be most believe a good tomato sauce could be found in a grocery effectively pressed by ‘‘involuntary creditors,’’ such as store. This person asks if a jar of PregoH sauce contains this mass tort claimants who may effectively contend that they ingredient or that ingredient (assuming the ingredients were did nothing to choose their debtor and should not be made to suffer for the foolhardy optimism of the investing not included) and is repeatedly told: ‘‘It’s in there.’’ The community.3 skeptic is won over when he (or she) tastes the sauce and confirms that the ingredients were, in fact, all ‘‘in there.’’ 2The court stated ‘‘In the W. R. Grace case, the fulcrum issue relating to The plaintiff in these lawsuits is often analogous to the insolvency was the size of its asbestos liability. In the instant case, it is the person tasting the sauce (with skepticism over disclosures size of Tronox’s environmental liability. In both cases, the market as a whole, no matter how efficient or inefficient, cannot be relied on to replacing skepticism over the inclusion of certain ingredi- determine solvency or insolvency. In this case, as further discussed below, there is no substitute for a solvency analysis (emphasis added).’’ Tronox, 2013 WL 6596696, *42. 1Gregory Horowitz, ‘‘Market Pricing.’’ Chap. 4 in Contested Valuation in 3Gregory Horowitz, ‘‘Market Pricing.’’ Chap. 4 in Contested Valuation in Corporate Bankruptcy: A Collier Monograph. Eds. Robert J. Stark, Howard Corporate Bankruptcy: A Collier Monograph. Eds. Robert J. Stark, Howard L. Siefel, and Edward S. Weisfelner, (LexisNexis, 2011), 4–16. L. Siefel, and Edward S. Weisfelner, (LexisNexis, 2011), 4–17.

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The court in Tronox did not proclaim that it ignored hypothesis.7 That is, the hypothesis is dependent on the contemporaneous market data because the plaintiffs were actions of active investors who seek to profit from long sympathetic. The court instead asserted that the environ- positions on ‘‘undervalued’’ securities and/or short mental liabilities could not be reliably valued by the positions on ‘‘overvalued’’ securities. However, accord- market due to insufficient disclosures that are inherent in ing to the hypothesis, these active investors are doomed financial reporting.4 This is an interesting assertion as the to fail because they incur costs that exceed the benefits court in Iridium deferred to market data for hard-to-value from their actions. Passive investors are the ‘‘winners’’ assets (a multibillion-dollar satellite phone system that because they benefit from the active investors’ actions by had not yet activated its system), whereas the court in getting to trade in efficient markets. The hypothesis is a Tronox would ignore market data for hard-to-value paradox because its efficacy can increase when more (environmental) liabilities.5 There does not appear to be people disagree with it. The hypothesis is built on the an economic-related reason for treating debtors with hard- assumption that nonbelievers will try, but fail, in their to-value liabilities differently than debtors with hard-to- attempt to beat the market. Thus, believers in the value assets. hypothesis require the existence of nonbelievers. Perhaps a main takeaway from Tronox is that a picture The paradox that is the debate over the efficient market is worth a thousand words, but a cartoon is worth more. hypothesis reminds me of the classic Saturday Night Live The fact witnesses employed by the debtor testified that skit about the recording of ‘‘Don’t Fear the Reaper.’’ In they believed the debtor was solvent. However, a the skit, the band keeps stopping midrecording because contemporaneous cartoon drawn by an investment banker one member (played by Will Ferrell) annoyingly plays a that depicted a weed (legacy liabilities) choking a flower cowbell, which distracts the other band members. The (the debtor’s business) appears to have been given more producer (played by Christopher Walken) enters the weight by the court. recording studio to find out why the band won’t finish the recording. The band members tell the producer they Updates to Part I stopped because the cowbell was distracting. Any viewer There were two additional developments after the first would agree that the cowbell was distracting. However, to paper was submitted that could make the debate over the their surprise, the producer tells the band members that he reliability of contemporaneous market data more inter- wants Ferrell to become even more distracting, as he esting going forward. The first was the identification of states: ‘‘I got a fever, and the only prescription is more the recipients for the 2013 Nobel Prize in economics. The cowbell!’’ The band members relent because the producer second was the Supreme Court’s opinion in Halliburton. was very successful,8 whereas the band had not recorded The 2013 Nobel Prize in economics was awarded to any hits up until that point. This skit is similar to debates economists on opposite ends of the spectrum regarding over the efficient market hypothesis because believers market efficiency. Eugene Fama is the founder of the should ironically want to encourage the distracting efficient market hypothesis. Robert Shiller is a leading arguments from nonbelievers. Thus, the believers should critic of that hypothesis. The fact that both economists want ‘‘more cowbell.’’ Of course, a nonbeliever is not won the award may suggest that there is still room to swayed by this circular reasoning. debate the efficacy of the efficient market hypothesis.6 Halliburton9 was an attempt by the defendant in a There is clearly some dispute among economists and shareholder lawsuit to overturn Basic. The Supreme business valuation practitioners over the efficacy of the Court in Basic allowed individual shareholders to be efficient market hypothesis. The hypothesis can be certified as a class in so-called ‘‘fraud-on-the-market’’ difficult to defend because it relies on the actions of cases under the premise (based on the efficient market people who are insane according to believers in the hypothesis) that all of these shareholders were affected by the alleged misinformation. The defendant in Halliburton 4The court also found that the market for the debtor’s securities in this particular instance was not aware of material information. argued that the efficient market theory has ‘‘lost its 5This is an oversimplification, as the court in Iridium found that the plaintiff luster,’’ which takes away the basis for certifying did not carry its burden of proof. Thus, it is possible that a different shareholders as a class. The Supreme Court in Hallibur- argument sponsored by the plaintiff could have, in theory, convinced the court that the market was ‘‘wrong.’’ 6For example, an article in The New York Times stated ‘‘[y]et in jointly 7A definition of insanity that is often attributed to Albert Einstein is ‘‘doing honoring the work of Mr. Fama and Mr. Shiller, the committee also the same thing over and over again and expecting different results.’’ highlighted how far the economics profession remains from agreeing on the 8He was, after all, ‘‘The Bruce Dickinson.’’ He may put his pants on one leg answer to a basic and consequential question: How do markets work?’’ at a time like everyone else, but he made gold records after his pants were Binyamin Appelbaum, ‘‘Economists Clash on Theory, but Will Still Share on. (One has to be familiar with the skit to appreciate this reference.) the Nobel,’’ The New York Times, October 14, 2013. 9This is a recently decided case that does not yet have a case caption.

Business Valuation Review — Winter 2014 Page 97 Business Valuation Review ton ultimately made a small modification to Basic but I’ve laid out in my will…My advice to the trustee could not allowed the main precedent to remain in force.10 be more simple: Put 10% of the cash in short-term Halliburton was a unanimous decision in judgment government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s (presumably due to the narrow opinion), but the justices long-term results from this policy will be superior to those did not share the same views regarding the efficient attained by most investors—whether pension funds, market hypothesis. More specifically, three of the justices institutions, or individuals—who employ high-fee manag- believed Basic ‘‘should be overruled,’’ in part because ers (emphasis in original).13 the efficient market hypothesis ‘‘has garnered substantial To the extent there is a legitimate debate over the criticism since Basic.’’ Interestingly, one of the justices efficacy of the semistrong form of the efficient market who sponsored this opinion wrote the dissent in Till ten 11 hypothesis, practitioners should recognize that the years ago. The dissent in Till would defer to the prepetition terms of a used car loan given to a subprime criticism should only go so far. This observation is borrower in the context of a cramdown loan based on an particularly relevant in retrospective solvency matters due argument that the market for prepetition used truck loans to the binary (pass/fail) nature of the financial tests. There to subprime borrowers was reasonably efficient. It seems may very well be a legitimate debate over the valuation of hard to reconcile a view that the market for loans to shares in a company within an order magnitude (say subprime used car borrowers is reasonably efficient, yet between $45 and $50 per share). However, it is much the market for shares that trade on a large stock exchange more difficult to credibly argue a stock that traded at $50 is not reasonably efficient. There were other issues that per share was really only worth a few dollars (option affected the matters in Halliburton and Till, so practi- value) per share due solely to a ‘‘mispricing’’ of the tioners should consider that context when assessing stock. specific statements regarding market efficiency in these Key Takeaways from Part II (and other) matters. My second paper was an extension of the first paper as Many advocates for the belief that the efficient market they both focused on contemporaneous indicators of a hypothesis has not been proven, or has ‘‘lost its luster,’’ debtor’s solvency or insolvency. My first paper focused would point to Warren Buffet’s sustained success in on security prices, whereas the second paper focused on picking stocks. However, that argument is perhaps best other indicators. rebutted by…Buffet himself. Buffet may believe that he can identify ‘‘mispriced’’ securities, but he also believes Some practitioners have argued that the cases men- that his previous success is extremely difficult to replicate. tioned in the first paper only focus on security prices. Thus, Buffet appears to be generally supportive of the That is not a fair argument as these cases focused on other efficient market hypothesis because he believes it is nearly contemporaneous indicators too. Schwartz and Bryan impossible to consistently beat the market on a risk- published an article in The Business Lawyer that adjusted and cost-adjusted basis.12 Buffet stated in his most demonstrated the variety of contemporaneous solvency recent letter to Berkshire Hathaway shareholders: indicators that were not based on security prices. My second paper builds on their observations by focusing on …the ‘‘know-nothing’’ investor who both diversifies and other indicators of solvency (e.g., fairness and solvency keeps his cost minimal is virtually certain to get satisfactory opinions) and indicators of insolvency (such as those that results. Indeed, the unsophisticated investor who is realistic about his shortcomings is likely to obtain better long-term were found in TOUSA and ASARCO). results than the knowledgeable professional who is blind to Schwartz and Bryan proposed a new motion require- even a single weakness… ment for many valuation-related cases. They propose that My money, I should add, is where my mouth is: What I valuation-related testimony should not automatically be advise here is essentially identical to certain instructions accepted by courts. Some may find it interesting that this proposal, which was made by lawyers, is based on the 10The defendant can now introduce evidence prior to class certification to belief that the best way to adjudicate matters centered on rebut the presumption that the asserted misrepresentation affected the stock price. business valuation is to increase the role of lawyers and 11The time period is relevant because some of the studies cited in reduce the role of valuation-related testifying experts. I Halliburton regarding criticism of the efficient market hypothesis were am not a lawyer and have no opinion on this proposed published prior to the date of the opinion in Till. 12Any assessment of a stock picker’s performance must take into account requirement. relative risk (to control for differences in the trade-off between risk and return) and costs (to account for the fact that a stock picker wins the battle but loses the war if he or she generates excess returns that are exceeded by 13Available at http://www.berkshirehathaway.com/letters/2013ltr.pdf (ac- the costs incurred to generate them). cessed July 21, 2014).

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However, I worked with Schwartz and Bryan on the Interestingly, there should be no need, in theory, to Vlasic matter and consulted with them on their article and enact a new motion requirement in order to accomplish appreciate why they made their proposal. Their reaction Schwartz’s and Bryan’s objectives. This observation is to the way some of these cases are tried reminds me of based on: a recurring skit on Saturday Night Live during the [t]he often-inconvenient reality of facts; the requirement ‘‘Weekend Update’’ segment. This skit focused on a that lawyers may only advance arguments where there is a statement (or action) that was made (or taken) during the colorable good-faith basis; and the (too often overlooked) week that was so contrary to common sense that the ethical obligation that experts testifying under oath must statement (or action) could be rebutted (or ridiculed) with present only opinions that they sincerely and objectively 15 a one word response: ‘‘Really!?!?’’ hold. In the Vlasic matter, the plaintiff focused on an alleged Many of the issues that are addressed in this debate can lack of disclosure. However, the debtor’s chief executive be addressed with a common sense solution. Practitioners officer (CEO) wrote a letter to his shareholders about a should not sponsor an opinion that can be effectively year after the transfer date that essentially said, ‘‘If we rebutted with one word: ‘‘Really!?!?!?’’ knew then what we know now (i.e., the information that was allegedly not disclosed), the debtor’s stock price Key Takeaways from Part III would be lower but the debtor would still be solvent by a My third paper is independent of the first two papers. comfortable margin.’’ Overall market conditions deteri- While my first two papers focused on the role of orated between the transfer date and the date of this letter. contemporaneous indicators of solvency or insolvency, Shortly after this letter was written, the debtor raised a my third paper focused on the nuts and bolts of the three substantial amount of new debt that was unsecured, financial tests. A few themes were developed in this subordinated, and not convertible into equity. The paper. debtor’s stock traded at prices that suggested the debtor First, the standard of value can be very relevant, and was solvent at this time. Notwithstanding this fact pattern, the precedent may be a bit confusing. Case law the plaintiff sponsored testifying experts who opined that consistently refers to a hypothetical sale standard, but the debtor was insolvent on the transfer date. The some cases (e.g., Vlasic) recognize that a willing seller defendant’s rebuttal of these testifying experts could be would not consent to a value-destroying sale. Our summarized in one word: ‘‘Really!?!?!?’’ profession tends to get bogged down in the weeds when Some attorneys are sympathetic with the views we argue that this synergy should be considered in the espoused by Schwartz and Bryan to an extent but do valuation, while that synergy should not. I propose a not believe that their proposed motion requirement should simple question to address these issues: What would be enacted. The second paper contained a discussion rational business managers do? If it is rational for the related to the views proffered by Stark, Williams, and debtor to not sell, then assume the business would remain Maxwell. Unfortunately, in an oversight on my part, I in the hands of the current owners. If it is rational for a was not aware of another rebuttal that was published at synergistic buyer to ‘‘overpay’’ for the debtor’s business, the time.14 Gregory Horowitz agrees with Schwartz and then assume the synergistic buyer will do so. Simply put, Bryan on the ‘‘primacy of market evidence,’’ but he our valuations should conform to what was reasonably differs with them in the sense that he believes market expected to happen in the real world. evidence should be interpreted by testifying experts. Second, the key disputes among the parties are often Horowitz explains that insolvent firms can have positive binary. One side will often argue that the contemporane- market capitalizations, and solvent firms can have debt ous projections were reasonable, while the other side will that trades at a discount to par. The economic-related say they were not reasonable. Similarly, one side will views espoused by Horowitz are generally consistent with often argue that there are guideline companies that are the views contained in my first paper. My first paper reasonably similar to the debtor, whereas the other side provided some guidance related to finding information in will disagree. These are fundamental debates that result in the fact record to address these issues. I defer to the legal a wide chasm of valuations sponsored by the parties. It is profession as to whether that information always needs to perhaps for this reason that courts have often placed more be interpreted by testifying experts. emphasis on contemporaneous indicators of solvency or insolvency when this type of evidence is available.

14Gregory Horowitz, ‘‘A Further Comment on the Complexities of Market Evidence in Valuation Litigation,’’ The Business Lawyer 69 (2013):1071. 15Ibid. at 1079.

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Third, courts and practitioners often urge against the There was no valuation approach that was unaffected use of hindsight, yet they frequently use it anyway. by the fraudulent activity. The plaintiff’s expert had to Hindsight can be confusing, as one party may argue that it develop his own projections in order to execute the DCF ‘‘confirms’’ what was knowable on the transfer date, method because the contemporaneous projections were while the other party can respond that it does not. Two unreliable. The defendant’s expert had to rely on rules should be followed regarding hindsight. First, if historical financial information that was affected by the hindsight is to be used, all of it should be considered. One fraud in order to execute the guideline company and side should not ‘‘cherry pick’’ certain information while guideline transaction methods. the other side ‘‘cherry-pit picks’’ other information. The court found the defendant’s testifying expert’s Second, some hindsight is much more relevant than other methodology and assumptions to be more reliable than hindsight. Vlasic is an example where a specific piece of the plaintiff’s testifying expert’s methodology and hindsight (i.e., the subsequent sale of unsecured, assumptions. The debtor’s industry appears to have subordinated bonds) was used to compellingly demon- played an important role in this dispute, as cable strate the ‘‘line in the sand’’ that a backwards projection companies are often valued based on a multiple of (retrojection) of the debtor’s subsequent bankruptcy filing subscribers. The court found that the debtor’s ‘‘count of could not cross. the number of its subscribers was one of the most Fourth, the adequate capital test may become increas- accurate of its financial data.’’ Thus, the defendant’s ingly important, yet its application can be confusing. testifying expert’s application of the guideline company There is no formal definition of this test or what is and guideline transaction methods was deemed to be required to pass it, which is why this test has been called more reliable than the plaintiff’s testifying expert’s ‘‘fuzzy.’’ Some may say that the practical definition for application of the DCF method, which was based on this test is similar to Justice Potter Stewart’s definition of projections prepared in connection with the litigation. hardcore pornography: ‘‘I know it when I see it.’’ This The debate over the capital adequacy test centered paper explores some of the themes developed in case law primarily on the debtor’s ability to meet its capital needs. and proposes some additional concepts that may be The plaintiff argued that the debtor could not meet its applicable in future matters. capital needs due to the cascading effect of too much debt, which would lead to covenant defaults, which in Update to Part III turn would lead to the inability to sell assets. To the An interesting case (Adelphia)16 was published after extent that the debtor would somehow still have access to this paper was submitted. This case is related to the capital after taking into account these factors, the plaintiff buyback of approximately $150 million of stock in a large argued that the debtor’s access would be ‘‘cut off’’ after cable company. The plaintiff sought to claw back the the ‘‘fraud at the [debtor] became known to investors.’’ proceeds by arguing that it was a fraudulent conveyance. The defendant countered that the debtor (and a Adelphia is interesting because there was a large fraud guideline company) proved that it could access the at the debtor, but the fraud had not yet reached its massive capital markets notwithstanding high leverage ratios, the proportions (which ultimately led to its bankruptcy filing) debt covenants did not prohibit the debtor from selling as of the transfer date. Thus, it was possible that the assets to deleverage, and other debtors have been able to fraudulent activity was not large enough to render the raise additional capital after disclosures of a fraud.17 debtor insolvent on the transfer date. The court found that the plaintiff ‘‘failed to meet its Adelphia is unusual for two reasons. First, there was burden in proving that capital markets would be closed to a relatively ‘‘blank slate,’’ as the fraudulent activity [the debtor] if [the debtor’s] fraud, which was in its infancy rendered contemporaneous indicators of solvency unreli- [on the transfer date], was disclosed.’’ The court found the able. Second, the testifying experts chose to paint on defendant’s testifying expert’s analysis of other debtors different canvases: The plaintiff’s expert relied solely on that raised capital after disclosures of a fraud to be the the discounted cash flow (DCF) method, whereas the ‘‘most persuasive aspect of [the defendant’s] position.’’ defendant’s expert relied only on the guideline company and guideline transaction methods. This resulted in a true 17The defendant’s testifying expert opined that the debtor could still borrow, ‘‘battle of the approaches,’’ as there was no overlap. but the cost would increase by approximately 100 basis points. This conclusion was based on ‘‘an empirical study on access to capital markets after disclosure of fraud,’’ which included ‘‘five large companies that had 16In re Adelphia Communications Corp., No. 02-41729 (REG) (Bankr. disclosed fraudulent activities (Cendant, Waste Management, Rite-Aid, S.D.N.Y. May 6, 2014). Enron, and WorldCom).’’

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The third paper may be independent from the first two they are consistent with the contemporaneous indicators papers, but the underlying issues within the three papers of solvency and/or insolvency. should be synthesized because the financial tests are not executed in a vacuum. Courts will often find the Michael Vitti, CFA, Managing Director conclusion from the DCF method (comparable company Duff & Phelps LLC method) to be more credible when it is reliably buttressed Dispute Consulting with a conclusion from the comparable company method Morristown, New Jersey 07960 (DCF method) too. Similarly, courts will often find a United States testifying expert’s conclusions to be more credible when [email protected]

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