Can market capitalization be used to evidence the solvency of bankrupt debtors? A recent bankruptcy case out of the District of Delaware suggests that it can.1
Prior to bankruptcy, eToys, Inc. sold toys to retail customers via the internet. On August 10, 1999, eToys and America Online, Inc. (AOL) entered into an Interactive Marketing Services Agreement (Agreement) pursuant to which AOL committed to provide online advertisements and other services for eToys for three years for $18 million, payable in installments. In accordance with the Agreement, eToys paid AOL $7.5 million through July 2000. As a result of AOL's failure to perform its obligations under the Agreement, eToys and AOL amended the Agreement on November 15, 2000. Under the amended Agreement, eToys agreed to pay only $750,000 more and AOL agreed to provide certain advertisements for the following two years without any other further payments by eToys.
After a disastrous holiday season in December of 2000, eToys, unable to meet its projected sales figures, sought to sell its business. On February 26, 2001, after unsuccessful marketing efforts, eToys issued a press release announcing its intent to let go all of its employees, shut down its website and file for bankruptcy protection. Two days later, AOL terminated the Agreement. On March 7, 2001, eToys filed a voluntary petition under Chapter 11 of the Bankruptcy Code.
Approximately two years after eToys filed its chapter 11 case, it commenced an adversary proceeding against AOL. EToys alleged that the November 2000 amendment of the Agreement was avoidable as a constructive fraudulent conveyance under the Bankruptcy Code, because eToys received inadequate consideration for entering into the amendment at a time when eToys was insolvent.
The primary disputed issue before the court was whether eToys was insolvent on November 15, 2000, the date of the amendment. Insolvency is defined in the Bankruptcy Code as a "financial condition such that the sum of such entity's debts is greater than all of such entity's property, at a fair valuation." To evaluate the fair value of a company's assets for purposes of determining the company's solvency, courts value the assets based on either the going concern premise of value or the liquidation premise of value, depending on the circumstances of the company at the relevant time.
In this case, AOL's valuation expert used the going concern premise of value, which the court found to be the appropriate premise. The expert applied three different tests in determining whether eToys was solvent on a going concern basis on November 15, 2000: (1) a Balance Sheet Test; (2) a Cash Flow Test; and (3) a Capital Adequacy Test. EToys disputed the conclusions of AOL's expert witness, but it did not present expert testimony of its own in rebuttal.
The court agreed with AOL's expert that, under each of the three tests, eToys was solvent on November 15, 2000. The court concluded that, as a result, the November 2000 amendment of the Agreement could not be avoided as a constructive fraudulent conveyance. The court denied any relief to eToys. In holding that eToys was solvent under the Balance Sheet test as of November 15, 2000, the Delaware bankruptcy court relied on the market capitalization of eToys in determining the value of eToys' intangible assets. The court's reliance stemmed from the Third Circuit's Campbell Soup Co. case,2 in which the court found that "absent some reason to distrust [market capitalization], the market price is a more reliable measure of...stock value than the subjective estimates of one or two expert witnesses." EToys relied on this decision in finding that "there is no error in 'choosing to rely on the objective evidence from the public equity and debt markets.'"
While the court in eToys found that there was no error in using market capitalization to make an adjustment to the book value of the company's intangible assets, it reached that conclusion because "eToys presented no evidence that these adjustments were not appropriate," which would suggest that the court may have reached a different result had eToys made a showing that there was "some reason to distrust" market capitalization.
As the Third Circuit in Campbell Soup had stated, "[a]ll agree that if the market capitalization was inflated by Campbell's manipulations it was not good evidence of value." Not only can markets be manipulated, but they may be inefficient. Market transactions may be based on the imperfect knowledge of buyers and sellers or, for other reasons, may not accurately reflect the value of a business enterprise or its assets (as evidenced by the recent subprime crisis and the bankruptcies of Enron, Worldcom and other companies in which shareholders and other investors overvalued their investments due to reliance on inaccurate information, inflated balance sheets, unrealistic projections of future revenues or profits and/or a lack of knowledge or appreciation of enterprise risk).
While, as in eToys, courts do consider market capitalization to be a good indicator of enterprise value, they are not foreclosed from admitting and applying any evidence presented to the contrary. Litigators in bankruptcy proceedings in which market capitalization is offered to establish the value of a debtor or its assets should be prepared to present or rebut evidence that the markets could not or did not fairly value the debtor due to market manipulation, incomplete information or other reasons.
Follow these links for additional articles from the March 2008 Insolvency Notes: