An Economist’s View Of Market Evidence In Valuation And Bankruptcy Litigation

Courts often face many challenges when assessing the solvency of a company whether public or privately held. Examples of difficult valuation questions include: would a company with a market capitalization of several hundred million dollars possibly be insolvent? Or, would publicly-traded debt at or near par be conclusive evidence that the issuer is solvent at the time? Or, would a company's inability to raise funds or maintain its investment grade rating at a given time be sufficient to rule on solvency?

It is common in valuation and solvency disputes to have qualified experts with very different opinions on the fair market value of a company, often using the same standard approaches of discounted cash flows and comparables. How would the courts or the arbitrators decide and what is the role of contemporaneous market evidence in such disputes? In this article, we discuss the role of market evidence and possible misinterpretations of such evidence and highlight recent court decisions in the United States.

We start with a few basic definitions. The fair market value is defined as the price at which an asset would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. The three standard valuation approaches are the discounted cash flow approach, the market comparables approach, and the asset approach. The discounted cash flow approach estimates the value of the business based on the present value of expected future cash flows. A market comparable approach estimates the value of a business using performance metrics of comparable companies such as earnings. The asset approach estimates the business value as the sum of the values of its tangible and intangible assets less any liabilities. There are three common measures of solvency. A company is deemed solvent at a given point in time if: 1) the fair market value of its assets exceeds the value of its liabilities; 2) it was adequately capitalized; and 3) it had the ability to pay its debts. Finally, market evidence can take various forms including equity prices, prices of debt and derivatives, ratings, contemporaneous projections of revenues, management projections, and analysts' recommendations, among others.

In the 2005 Campbell decision, the lower court ruled (and the appeals court later affirmed) that a spin-off entity was...