GAAP ‘Not Controlling’ in Valuation

After an Internet business collapsed, the bankruptcy trustee unsuccessfully sued its venture capital investors and directors over a $9 million transfer to one of the company’s founders. The Bankruptcy Court found that the trustee failed to prove insolvency, by relying on a problematic valuation. The expert who performed it failed to value the business as a going concern and slavishly followed generally accepted accounting principles in analyzing assets and liabilities. The trustee attacked the ruling in an appeal with the district court.

Interlocking transactions. In the late 1990s, a wife and husband formed an Internet service provider that resold digital subscriber line (DSL) service to consumers and businesses. Several venture capital (VC) funds invested $15 million to buy preferred stock and obtained the right to appoint three of the company’s five-member board of directors; the husband and wife occupied the other two seats. When the majority of the board decided the wife’s management style interfered with customer, vendor, and strategic partner relations, she demanded a substantial amount of money in exchange for her withdrawal. Eventually, she threatened litigation against the company, the VC investors, the directors, including the husband, and management. To raise money and resolve all disputes with the wife, the VC funds arranged for another round of financing. They committed to buying $5.7 million in Series B shares but insisted that settling matters with the wife was vital to proceeding with the financing. They also made bridge loans in the amount of $9 million to the company, as short-term working capital to keep operations going before the financing.

Ultimately, the investors, the company, and the wife executed a stock purchase agreement under which the company would repurchase some of the wife’s common stock for $9 million. Relatedly, under a settlement and release agreement, the wife would abandon her claims against the various parties. The $9 million transfer, in turn, was conditioned on the company’s ability to raise at least $40 million through a Series B offering. This condition was satisfied. On Feb. 23, 2000, the company raised $84 million in an offering that actually was oversubscribed; the same day, it bought out the wife by way of a $9 million wire transfer and reaped $75 million in proceeds. Subsequently, it even contemplated an IPO but was unable to secure additional financing. Ultimately, the economic downturn contributed to its filing for bankruptcy at the end of 2000.

Going concern or barely standing? The bankruptcy trustee pursued various legal strategies and theories to recover the $9 million from the VC funds and directors, the defendants-appellees. In a pretrial motion in Bankruptcy Court (C.D. Cal.), she argued that the transaction was a constructive fraudulent transfer because the company received nothing in return for the redemption of the wife’s stock in exchange for the $9 million payment.

The Bankruptcy Court disagreed, finding that the transfer left “no negative effect” on the company’s estate. It was appropriate to consider the entire context in which the transaction occurred. Without the wife’s relinquishing all claims against the company, investors would not have completed the Series B financing. The wife, however, would not have released the company without receiving a $9 million payment for her stock. In the final analysis, the company benefited from the exchange by securing $75 million of new financing and an end to the threat of litigation. At trial, the trustee tried to avoid the $9 million transfer by showing that the company was insolvent at the time of the transfer, February 2000. Both parties presented valuation experts to shore up their arguments.

The company’s expert determined that the company was worth approximately $400 million on a going-concern basis just prior to the transfer. The calculation included $21.9 million for subscriber contracts as of the transfer date based on book value. He explained that, if the company had put up its subscriber contracts for sale at that time, the market would have considered them “very valuable” and “there would have been a bidding war to purchase [the] contracts.”

In contrast, the trustee’s expert said he had not valued the company “as an entire entity on a going-concern basis.” In determining assets and liabilities, the expert believed the $5.7 million of funds from the investors should not be treated as assets under generally accepted accounting principles (GAAP) because they had not closed at the date of transfer. At the same time, he testified that at that date it was more likely that 100% of the legally committed Series B proceeds would be received than the projected 90% of the company’s accounts receivable that he did include as assets in his solvency analysis. He also counted $6.7 million in bridge loans as a liability, even if they were not absolute, because “liabilities include debts that are contingent or disputed.” Further, relying on the opinion of the trustee’s subscriber valuation expert, he determined the contracts would only generate approximately $3.3 million in an orderly sale.

The Bankruptcy Court gave numerous reasons why the company should be valued as a going concern, including: (1) it was able to raise $84 million in an oversubscribed Series B financing; (2) its vendors were willing to extend it substantial credit; (3) investors seemed uniformly optimistic about its prospects; and (4) it received 1,500 new orders for subscriber lines each week.

It discredited the trustee expert’s valuation, finding it should have counted the $5.7 million in Series B proceeds as an asset because the “investors were contractually committed to fund their obligation to purchase Series B shares, and [the company] would have had a claim against these investors if the payment was not made.” At the same time, the valuation incorrectly included $6.7 million in bridge loans as a liability. Under controlling case law, “[t]o determine a contingent liability, one must discount it by the probability that the contingency will occur and the liability will become real.” In this case, the promissory notes for the loans stated that they automatically would convert to equity once the company received at least $30 million in Series B proceeds. There was an “extremely low” probability that the company would have to pay for the notes,” the court found. The trustee’s expert had failed to consider this eventuality in his analysis. As for the value of the subscriber contracts, the court noted that the trustee’s expert relied on a subscriber valuation expert who by his own admission had not considered all of the testimony key members of the company’s management and board had given. Further, other trial witnesses described his data as unreliable compared with the data the competing subscriber valuation expert used.

Adopting the company expert’s valuation, the Bankruptcy Court found the company was solvent on the date of transfer.

Subscription value dispute. The trustee next appealed the Bankruptcy Court’s decisions with the district court (C.D. Cal.). First, the trustee argued error as to the ruling that there was no fraudulent conveyance.

The District Court dealt with that claim quickly. At issue in the case was an “integrated transaction,” whose effect was a net financial gain for the company of $75 million in new equity, it said. Consequently, the company did not receive less than a reasonably equivalent value in exchange.

Second, the trustee challenged the Bankruptcy Court’s insolvency ruling, honing in on three errors. Were it not for these errors, the Bankruptcy Court “would have had no choice but to conclude” that the company was insolvent at the transfer date, the trustee contended.

At the outset of its analysis, the district court noted that a “fair valuation” in the context of the Bankruptcy Code involves a two-step process: First, the court determines whether the debtor company was a “going concern” or “on its deathbed.” Second, the court values the debtor’s assets based on the status it assigned in the first part of its analysis. If it designated the company as a going concern, it determines the fair market price of its assets; if it finds that the company is barely alive, it determines the liquidation value.

Here, the Bankruptcy Court correctly held that the company should be valued as a going concern. Because the trustee’s expert “declined to provide a [going concern] valuation,” the $400 million valuation the company’s expert presented was uncontroverted evidence and by itself “enough for the court to conclude that the Trustee did not meet her burden” of showing insolvency, the reviewing court concluded.

Next, the district court addressed the three errors the trustee alleged.

1. Under the GAAP, it was error to include cash—specifically the $5.7 million in Series B funds—as an asset because it arrived after the $9 million transfer to the wife.

The reviewing court found no error. “GAAP is not controlling in determining the fair market value of assets or the insolvency of the debtor,” it said. To find otherwise “would make accountants and the board which promulgate GAAP the arbiters of insolvency questions.” But the Bankruptcy Code “clearly” left the decisions to judges. Moreover, no rationale existed “why judges should not be allowed to consider subsequent events … in valuing assets and determining liabilities.” Here, the Bankruptcy Court correctly found that the investors had a contractual obligation to buy Series B shares. “In any event, the Series B proceeds arrived two days later.” Also, the trustee’s expert testified to the strong likelihood that 100% of the Series B proceeds would be received as opposed to only 90% of accounts receivable, which he designated as assets.

2. It was error not to count debts—that is, the bridge loans, which the company owed at the transfer date—as liabilities. Even if the loans were not an absolute liability, they were a contingent liability, which “must be reduced … to its present or expected amount before a determination on insolvency can be made.”

According to the reviewing court, the Bankruptcy Court correctly assessed the probability—extremely low—that the liability would become real by looking at the provisions in the related promissory notes. Accordingly, it properly determined not to include them as a liability in its analysis.

3. It was error to value the DSL subscriber contracts in place, not as if sold.

“Book value does not necessarily prove fair market value,” the district court acknowledged, but nonetheless “is competent evidence.” Here, the company’s expert testified to the high value the contracts would have held in the market had they been offered for sale at the time of transfer. His statements suggested that the contracts were valued as if sold, said the court. Also, statements from the trustee’s contracts valuation expert and other witnesses supported the Bankruptcy Court’s decision not to give great weight to the much lower estimate the trustee’s valuation assigned to the contracts.

For all these reasons, the district court affirmed the Bankruptcy Court’s ruling.