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Financial Experts Improve Bankruptcy Litigation Results

Expert Witness: Fulcrum Inquiry
Bankruptcy is largely a financial negotiation. The cost of getting expert appraisal and accounting assistance is a fraction of the “prize” that is being negotiated. We review the bankruptcy process and explain opportunities where financial expert help is necessary.

Chapter 11 is more about negotiation than litigation. For this reason, many bankruptcy lawyers decline to spend resources gathering support for their position in the courtroom. While this works in smaller cases, having expert substantiation in larger matters improves one’s negotiating position. The cost of getting this support is a fraction of the “prize” that is being negotiated. This occurs because (i) the expert advice might actually teach you something that you otherwise did not know, and (ii) having evidence available demonstrates to your opponent that you are serious about your position and have the ability to win the position if negotiations are not successful.

Experts can be used in bankruptcy litigation in the same way as occurs in other federal litigation. Bankruptcy Rule 9017 provides that the Federal Rules of Evidence apply in bankruptcy cases. Further, Bankruptcy Rule 9014(d) provides that “testimony of witnesses with respect to disputed material factual issues shall be taken in the same manner as testimony in an adversary proceeding”.

Despite the evidence rules, there is substantial variation regarding the formality that individual bankruptcy judges maintain in their courtroom on evidence matters. Some bankruptcy judges skip the messy and time-consuming nature of live witnesses. Instead, “evidence” is accepted either by (i) submitted declarations, and /or (ii) proffers made by legal counsel. Even when witnesses are allowed, because of the absence of juries in bankruptcy court, the judge may simply permit witnesses to tell their story without the formal evidence rules being followed strictly. Judges probably do this because (i) they have confidence in their ability to sort out and ignore inadmissible statements, and/or (ii) they are more focused on the overall equity of reaching a commercially-acceptable result than the evidence details of that process.

With this background in mind, this article focuses on those areas where an expert in appraisal, accounting, or finance will improve your overall result.

Adequate Protection and Relief from the Automatic Stay – Under Bankruptcy Code Section 362(d), (e) and (f), a secured creditor can seek relief from the automatic stay by either (i) showing that the debtor has no equity in the collateral and the collateral is not necessary for the debtor’s reorganization, or (ii) the value of the collateral is declining and the secured creditor is not protected (absent other arrangements being made, such as regular adequate protection payments) from such declines. Under Section 362(g), the party requesting relief has the burden of proof on the issue of the debtor’s equity in the property, with the debtor having the burden of proof on other issues.

An appraisal expert witness can be useful with the following:

1. The value of the collateral
2. The expected future collateral value (i.e., how the collateral’s value might decline)
3. The need for the collateral to successfully organize the debtor
4. Determining the proper standard of value for valuing the collateral - Because Section 361 does not specify the method of determining value, different courts have use liquidation value, fair market value, and replacement value, depending on the factual circumstances at hand.

Disputed Claims – Bankruptcy courts determine the amount of claims in which the debtor and creditor cannot agree (i) on the amount owed, or (ii) whether the claim is secured or unsecured. An accounting or appraisal expert witness can be useful with the following:

1. Reconstructing and explaining events surrounding the disagreement
2. The value of the collateral, which determines the amount of the secured claim vs. the unsecured claim (see Adequate Protection above)
3. As occurs with any commercial litigation, the damages sustained by the plaintiff if liability is determined.

Sale of Assets Outside of the Ordinary Course of Business - Bankruptcy Code Section 363 allows the debtor to sell its assets "free and clear” of liens and other third party interests in the assets. This gives the purchaser considerable comfort that the purchaser will not get embroiled in other issues with creditors or the bankruptcy process. Presumably, this enhances the purchase price.

These sales can be substantial, effectively eliminating important options that might otherwise be pursued in a plan of reorganization. Yet, a sale under Section 363(b) does not face the procedural and oversight requirements of a plan of reorganization (see below). Accordingly, to approve a sale, the court will want to (i) understand the business justification of the sale, and (ii) determine that the transaction is in the best interest of the bankruptcy estate. Courts will generally show deference to the debtor's decision in applying the “business judgment” rule.

An accounting or appraisal expert witness can be useful in:

1. Accumulating and presenting financial statements or other accounting information pertaining to the asset that is being sold
2. Assisting the identification of qualified buyers for the sale
3. Gathering financial and market facts that allows one to articulate the justification that the proposed sale is in the best interests of the estate
4. Determining that the proposed purchase price represents the fair market value of what is being sold. This can be a difficult assignment if an entire subsidiary or business division is being sold.
5. If contingent consideration is part of the transaction, evaluating the value and collectability of such contingencies

Preference Payments – Preferences are described in Bankruptcy Code Section 547. The burden of proof rests with the party bringing the preference action (usually the debtor-in-possession or trustee). A payment is a preference if:

1. The transfer benefited a creditor
2. The transfer was made for antecedent debt
3. The debtor was insolvent at the time of the transfer - In determining whether a debtor is insolvent, a balance sheet test applies (i.e., whether the going-concern fair value of assets exceeds the fair value of liabilities). Although the debtor is presumed to be insolvent within 90 days of the bankruptcy petition, this presumption can be rebutted.
4. The transfer occurred within 90 days of the bankruptcy petition (or, in the case of an insider, within one year)
5. The transfer improved the creditor's position compared to what otherwise would occur.

Section 547(c) provides nine defenses to the claimed preference. Most notably, these include:

1. The transfer discharged a debt that was paid under ordinary business terms.
2. The creditor provided subsequent new value (i.e., additional credit extension).
3. The transfer was a contemporaneous exchange (e.g. a COD sale).

An accounting or appraisal expert witness can be useful with the following:

1. For the party wishing to pursue preferences, reviewing accounting records to identifying claims that should be made
2. Reconstructing and explaining events surrounding any disagreement regarding the circumstances of a payment
3. Determining whether the debtor was insolvent by determining the fair value of assets and liabilities
4. In making the insolvency determination, identifying and valuing intangible assets that accounting principles might not even include in the financial statements
5. Assessing what payment terms are considered normal under ordinary business terms

Avoidance of Fraudulent Conveyances – fraudulent conveyances are described in Bankruptcy Code Section 548. A fraudulent conveyance occurs when a debtor transfers an asset or incurs an obligation with the actual intent to hinder, delay, or defraud any creditor. This requires actual intent, and so is usually more difficult to prove. Alternatively, regardless of the intention, a transaction can be avoided (i.e., the transaction undone and property returned to the bankruptcy estate) if the transaction occurred (i) while the debtor was insolvent, and (ii) the transaction occurred for less than reasonably equivalent value.

An accounting or appraisal expert witness can be useful with the following:

1. As with preferences (see preceding section), determining whether the debtor was insolvent by determining the fair value of assets and liabilities
2. Determining whether the debtor was insolvent because the debtor was unable to pay its obligations as they became due
3. Determining the fair value of what was purchased in the transaction at issue

Equitable Subordination – The court may equitably subordinate a senior claim to junior claimants to avoid fraud, injustice, or inequity under Bankruptcy Code section 510(c). The burden of proof rests with the party seeking to change the status of the creditor. To equitably subordinate a claim the proponent of such an action must show:

1. The claimant engaged in inequitable conduct, although such conduct need not rise to the level of fraud. Generally, the conduct need not be unlawful, but is egregious.
2. The conduct resulted in injury to other creditors, or provided an unfair advantage to the senior creditor.

Examples of inequitable conduct include:

1. Outright fraud in dealing with the debtor
2. Breach of fiduciary duties, as would occur when a controlling shareholder, officer or director makes loans to the debtor
3. Undercapitalization, in which it is reasonably known that the secured loan cannot be repaid, and/or a similar loan could not have been borrowed from another independent source
4. Alter-ego allegations, in which the lender exerts undue influence and control that would not normally occur in a comparable lending transaction

A financial expert witness can be useful with the following:

1. Reconstructing and explaining events surrounding any alleged fraud or breach of fiduciary duty
2. The financial circumstances and results that would determine whether the debtor was undercapitalized, both in terms of (i) the debtor’s financial condition, and (ii) market-based transactions that were occurring at the same time
3. Determining whether the lender exerted undue influence or control as a basis for an alter ego allegations – See Alter-Ego Allegations Require Expert Accounting Assistance for additional information.

Contested Plans of Reorganization – A Chapter 11 plan typically classifies claims against the debtor, specifies the treatment to be given each creditor class, and provides the means for carrying out the plan. In order for a plan to be approved or confirmed by the bankruptcy court, the plan must:

1. Be approved confirmed by at least one class of impaired creditor claims. To seek creditor approval, the plan proponent must provide adequate disclosure of the plan and its economics in a document called a Disclosure Statement.
2. Be feasible, meaning that the plan is not likely to lead to a subsequent need to further reorganize.
3. Pay each claim holder as much as he would have received under a Chapter 7 liquidation, unless those who receive less than would occur in liquidation accept the plan.
4. Pay each secured claim either the entire value of the property securing the claim, or the entire value of the claim, whichever is smaller.

Disputes often arise regarding the above. A financial expert witness can be useful with the following:

1. Determining the value of approved claims and the classification of such claims
2. Determining the value of assets and the payment amounts that are being proposed under the plan of reorganization
3. Assembling the (i) liquidation analysis, (ii) financial projections to show plan feasibility and (iii) other financial information required in the Disclosure Statement
4. Demonstrating with financial analysis and/or appraisal assistance that the plan proponent has met all of the requirements described above. If a creditor objects to the plan, expert witness assistance is often necessary to convince the bankruptcy court that the proposed plan is proper and confirmable under the financial requirements of the bankruptcy code.

Fulcrum inquiry performs forensic accounting and appraisal services.

Mr. Nolte has 30 years experience in financial and economic consulting. He has served as an expert witness in over 100 trials. He has also regularly served as an arbitrator. Mr. Nolte has achieved the following credentials: CPA, MBA, CMA and ASA.

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Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.

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