Extending the Market Valuation Approach to Determining Solvency

Extending the Market Valuation Approach to Determining Solvency

By Gregory A. Horowitz

Excerpt from 2011 Emerging Issues 6113


Does Positive Equity Value Always Indicate Solvency?

Both Iridium and VFB presented situations in which the debtor had substantial market equity capitalization, in the billions of dollars, at the relevant time. Perhaps for this reason (or perhaps because of parties' strategic litigation decisions) neither court deemed it necessary to explore the logic behind equating positive equity value with solvency. At first glance, the logic appears surpassingly simple. Equity by definition is the value remaining after all of an entity's debt claims are satisfied.  As insolvency is defined as the condition where an entity's debt claims exceed the value of its assets, a positive equity value would seem to require that asset values be sufficient to satisfy all debt claims with something left over. Put another way, the fact that a company has a meaningful positive stock price is taken to reflect the market's belief that the company will be able to satisfy all of its debt claims and still be able (perhaps at length, but eventually) to pay dividends to its shareholders.

The reasoning seems sound at first blush, but it is overly simplistic. Positive stock value can be consistent with actual insolvency under a number of circumstances, not all of which were anticipated in the Iridium and VFB decisions.

When Can a Company with Positive Equity Value Nonetheless Be Insolvent?

Fraud on the Market/Imperfect Information. The first case for ignoring (or at least discounting) positive equity value is the most obvious: the market cannot reach a reliable conclusion as to a company's value if it is deprived of information material to that judgment. Recall that the classic definition of fair market value requires knowledge of all material facts. A transaction made in the absence of such knowledge is not a reliable indication of value.

Recognizing this, both the Iridium and VFB courts emphasized that they had not been given any reason to believe the market had been deprived of relevant information. In Iridium, Judge Peck found that:

In multiple public filings ... Iridium described the limitations of the satellite voice service. In the context of what Iridium knew at the time, these descriptions were reasonable and accurate in describing the Iridium system's projected performance. As a result, third parties were on notice as to the characteristics and limitations of the Iridium System.

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GREGORY A. HOROWITZ is a litigation partner at Kramer Levin Naftalis & Frankel LLP, in New York City, where he specializes in bankruptcy and complex commercial litigation involving sophisticated valuation, economic analysis, and accounting issues. Mr. Horowitz particularly concentrates on presenting and cross-examining expert witnesses, having written and lectured extensively on the subject. He has worked with, and against, virtually every leading restructuring financial advisory firm and economic consulting group in the country, numerous prominent accounting firms and investment banks, and many of the nation's most prominent economists and accounting experts. Mr. Horowitz has had prominent litigation roles in the bankruptcies of Smurfit Stone Container, Capmark Financial, ASARCO, Calpine, W.R. Grace, WCI Steel, Owens Corning, MCI/WorldCom, and Bennett Funding. Mr. Horowitz was recently recognized as a Local Litigation Star in the 2010 Edition of Benchmark Litigation and named to the Avenue magazine Legal Elite list. Mr. Horowitz graduated magna cum laude from Wesleyan University and received his J.D. from Yale Law School, where he was Note Editor of the Yale Law Journal. Following graduation he clerked for Judge Walter K. Stapleton of the United States Court of Appeals for the Third Circuit.