Recoveries from fraudulent conveyance lawsuits can be a significant source of recovery for creditors of bankruptcy estates.  Because a plaintiff seeking to avoid a prepetition transfer as constructively fraudulent must demonstrate that the debtor was insolvent or inadequately capitalized at the time of the challenged transfer, valuation analyses that support allegations of insolvency are critical.

A recent opinion issued by the Bankruptcy Court for the Southern District of New York in Adelphia Recovery Trust v. FPL Group, Inc. (In re Adelphia Communs. Corp.), Adv. Pro. No. 04-03295, 2014 Bankr. LEXIS 2011 (Bankr. S.D.N.Y. May 6, 2014), a chapter 11 case precipitated by a massive fraud perpetrated by the debtor’s management, demonstrates how accounting and other forms of corporate fraud can impact these analyses.

Valuation is by nature more of an art than a science, and testifying experts and finders of fact are free to utilize any number of methods to determine solvency on a case by case basis.  The existence of fraud can significantly affect valuations based on a balance sheet analysis.  TheAdelphia opinion demonstrates that where the company’s historical financial records are fraudulent or suspect, the best method for proving solvency is through the introduction of evidence of market comparables as opposed to use of the more traditionally favored discounted cash flow method.

In Adelphia, a trust established under the cable television operator’s chapter 11 plan was vested with a $150 million fraudulent transfer claim against defendants FPL Group, Inc. and its affiliate, Mayberry Investments Inc., arising from a pre-petition stock repurchase transaction that was consummated by the debtor for the benefit of former management.  The repurchase occurred a mere three months before the company borrowed over $3 billion, a transaction that the court described as having “a crushing effect on Adelphia’s solvency.”

A threshold question addressed by the court was the precise date on which Adelpia’s solvency should be tested.  The Trust argued that the stock repurchase encompassed a series of transactions, including (i) the stock repurchase itself, through which Adelphia paid $150 million for the repurchase of its own stock, and (ii) a subsequent stock redemption, over eight months later, in which Adelphia affiliate Olympus Communications, L.P. made a second purchase from FPL Group, redeeming FPL’s interest in a joint venture partnership between Olympus and FPL.

Given the profound impact of Adelphia’s entry into the $3 billion facility during the period between these two stock deals on the company’s solvency, the Trust sought to “collapse” these stock purchases into one unitary transaction, and argued that, even though it was seeking to avoid the initial stock repurchase, solvency should be measured from the date of the latter redemption.  The court found that the transactions did not constitute a single integrated scheme, and focused on the evidence provided regarding the company’s financial condition at the time of the first stock repurchase.

At trial, the Trust’s testifying expert sought to demonstrate that Adelphia was insolvent at the time of the stock repurchase by using a discounted cash flow method that was based on his own projections for Adelphia’s cash flow over ten years.  The Trust’s expert ultimately concluded that Adelphia was insolvent by approximately $1 billion.  The defendants’ expert relied on a valuation based on comparable company methodologies in reaching the opposite conclusion, finding that Adelphia had an equity cushion of approximately $3.7 billion at the time of the stock repurchase.

The Trust’s discounted cash flow analysis was challenged by the defendants, who asserted that the Adelphia fraud rendered any projections of future cash flow performance too unreliable to be meaningful or probative.  The court agreed, finding that the assumptions underlying the Trust’s valuation were too arbitrary and speculative.  The court noted that the discounted cash flow method is useful only if a company has (i) accurate projections of future cash flows; (ii) not been tainted by fraud; and (iii) some cash flows that are positive.  Here, the court rightly characterized Adelphia as the “poster child” for why discounted cash flow analyses are not always compelling.  In contrast, the court found that the defendants’ analysis, based on market comparables derived from cable subscriber data, was a more reliable indicator of the debtor’s value.

The court also stated that subsequently discovered information of fraud can shed light on the true going concern value at the time of a challenged transaction and must be taken into account in any solvency analysis.  While the court noted that in “extreme” cases of pervasive fraud, application of a liquidation value (as opposed to a going concern value measured by the discounted cash flow, comparable companies or comparable transactions methods) would be appropriate, the court found that Adelphia’s going concern value was the proper metric for evaluating its solvency because the fraud that brought down the company was only in its nascent stages at the time of the stock repurchase.

On the question of whether Adelphia was left with insufficient capital at the time of the stock repurchase, the Trust’s expert contended that Adelphia lacked capital to maintain operations due to negative free cash flow, persistent high leverage ratios, restrictive debt covenants, and the presence of fraud that would have deterred lenders and investors from providing Adelphia with capital had they been aware of it.  The defendants’ expert opined that Adelphia’s equity cushion and access to third party loan facilities were sufficient to enable the company to sustain operations, and pointed out that a number of other large companies were able to obtain financing after disclosing similar fraudulent activity.

The court determined that the impact of the fraud on Adelphia’s ability to access the capital markets was the most critical factor in determining adequate capitalization.  The court concluded that, if known to the markets, the fraud would not have deterred third party lenders because the fraud was in its infancy and not sufficiently pervasive to preclude new lending.  In finding that Adelphia was adequately capitalized, the court also observed that Adelphia could have sold assets to provide sufficient capital if necessary.

Judge Gerber’s decision provides a noteworthy primer on how prepetition fraud can impact the application of traditionally accepted valuation methods, most notably the discounted cash flow method, in avoidance actions.  Persuasive expert testimony in such cases should present evidence of solvency (or insolvency) using a variety of methods, and should not rely solely on projections that, even in part, are based on assumptions derived from financial information that is in any way tainted by the debtor’s pre-bankruptcy malfeasance.