In a recent decision, the United States Bankruptcy Court for the Southern District of New York found that the Statutory Committee of Unsecured Creditors (the “Committee”) of Iridium, a failed Motorola spin-off venture, was unable to prove that Iridium was insolvent or had unreasonably small capital during the four-year period prior to commencement of its bankruptcy case. As a result of this ruling, Iridium’s creditors were precluded from pursuing fraudulent conveyance and preference claims on behalf of the Iridium chapter 11 estate seeking to recover transfers made by Iridium to Motorola totaling approximately $3.7 billion. In so finding, Judge Peck followed the reasoning of a recent Third Circuit case, VFB LLC v. Campbell Soup Co.,1 which validated the use of market data for purposes of valuing a public company for fraudulent conveyance purposes and established that the public markets constitute the preferred standard of valuation.
Under the Bankruptcy Code, a debtor can commence actions to recover property that it transferred pre-petition if the debtor did not receive reasonably equivalent value in return. In order to do so, however, the debtor must prove that the transfer occurred while the debtor was insolvent or while the debtor had insufficient capital to operate its business. When the debtor possesses such a claim against a related entity, it often fails to rigorously pursue such an action, and the creditors committee will request permission to do so on behalf of the estate. In Iridium, the Committee was given authority to pursue an action against Motorola in accordance with this procedure in order to recover payments made during a four year period prior to Iridium filing for bankruptcy.
After the action was commenced, the Committee and Motorola agreed to bifurcate the trial on these claims. The case discussed in this article addresses the first phase of the trial in which the Court decided whether Iridium was insolvent or had unreasonably small capital during the period of time in which the transfers sought to be recovered were made.
Iridium IP LLC v. Motorola, Inc. (In re Iridium Operating LLC)2
Iridium was a global satellite telecommunications system designed to provide voice communication and paging services anywhere in the world as long as the antenna of the portable telephone handset or paging unit was in the “line of sight” of one of the system’s sixty-six orbiting satellites.3 The concept was developed by Motorola engineers in the late 1980s, but Iridium was later incorporated as a separate and distinct entity from Motorola in 1991. Iridium activated its service in November 1998 and ended up in bankruptcy approximately nine months later. From the time that Iridium was spun off from Motorola and prior to its bankruptcy, Motorola served as Iridium’s patron and contract counterparty, providing substantial technical and financial support and receiving payments from Iridium during the four years prior to Iridium’s bankruptcy filing aggregating $3.7 billion.4
In determining whether Iridium was insolvent or had inadequate capital at the time the transfers from Iridium to Motorola were made, the Court found that the Committee had the burden of proof on this issue. The Committee had argued that the burden had shifted to Motorola because the equitable insolvency of Iridium at the time of the transfer was proved by its failure to pay its debts as they became due. The Court found that the deferral of both a $900 million debt payment to Motorola, with its consent, and a $90 million interest payment on public bonds did not establish that Iridium was not paying its debts as they become due, and therefore, the burden of proving insolvency remained with the Committee.5
In addressing the issue of whether Iridium was insolvent or had insufficient capital, the Court considered two competing valuation philosophies. The first, the view promoted by Motorola, focused on the market’s perception of the company’s value. According to this view, if the company’s reasonable projections at the time of the transfers indicated that it was solvent, and these projections, having been analyzed by market experts, supported the extension of financing to Iridium by lenders and the sale of its debt and equity to the public, Iridium’s solvency should not be secondguessed. The second view, used by the Committee, relied upon hindsight and pure discounted cash flow valuations. Under this approach, all of Iridium’s miscalculations should be considered and new adjusted cash flow projections created. When the revised projections were used to value Iridium under a discounted cash flow approach, Iridium would prove to be insolvent. After adopting the market view, the Court found that the Committee had not proved that Iridium was insolvent or inadequately capitalized at the time of the transfers.
A. Evidence of Solvency or Insolvency
In presenting its case, the Committee argued that Iridium’s failure just nine months after it publicly launched its system supported the fact that Iridium could not possibly have been solvent when the transfers in question were made. The Committee asserted that the Iridium system was never suitable for its intended target market due to its connectivity inadequacies and the awkwardness and size of the telephone handset as compared to smaller, more attractive cellular telephone handsets. The Committee alleged that the capital cost to launch Iridium’s business was much greater than Iridium could have been worth at fair valuation because potential subscribers would not be satisfied with the available level of service.6 The Committee’s discounted cash flow analyses also reflected a negative outlook on the company’s future.
In contrast, Motorola pointed to Iridium’s success in the capital and public trading markets, even after disclosing the products’ possible inadequacies, as evidence of Iridium’s solvency. Motorola maintained that Iridium and its Board were informed about the system’s voice quality and expected performance in various environments, and that Iridium publicly disclosed the system’s limitations to investors through multiple public filings. Iridium went through numerous iterations of its business plan, and tailored its plans to be consistent with market research. Motorola presented the Court with a marketing expert who testified to the reasonableness of Iridium’s business plan and the validity of the underlying market research.
Motorola presented evidence that showed that, based in part on the market research and Iridium’s business plans, Iridium was able to secure bank loans and credit facilities. In fact, the 1997 credit facility was 1.7 times over-subscribed and was increased to $1 billion from the originally proposed amount of $750 million because of the excellent response by the banks involved.7 Iridium also engaged in two successful public equity offerings, the second of which raised approximately $242 million after commercial activation and only seven months before the bankruptcy filing.8 Evidence presented revealed that, as part of these financings and offerings, extensive due diligence was performed by various parties throughout the critical four-year period prior to bankruptcy.
B. The Witnesses
The Committee and Motorola called several witnesses in an attempt to prove their respective cases. Three experts appeared on behalf of Motorola to testify regarding Iridium’s solvency and capital adequacy.9 One of Motorola’s witnesses, a Stanford Professor,10 testified that research indicates that market judgments are the most reliable tools for measuring the enterprise value of a company. The Court found the witness credible and candid and ultimately agreed with his conclusion that “the value implied by an efficient market fairly reflected the underlying enterprise value of Iridium.”11 Motorola also used the testimony of Bruce Den Uyl, an expert in valuation and solvency, to prove its case. Den Uyl utilized several valuation methodologies, including the discounted cash flow approach and the market approach. Den Uyl performed both a “base case” discounted cash flow as well as a “downside case” discounted cash flow at various points during the four years preceding Iridium’s petition date, concluding that at all points Iridium was solvent. Although the Court found Den Uyl’s valuation work derivative of the work of others, the Court concluded that this analysis, combined with Den Uyl’s market analysis, showed Iridium was solvent at all relevant points prior to the bankruptcy filing.
In contrast, the Court found disappointing the solvency analysis presented by the Committee’s experts. The Committee presented the testimony of two solvency experts from FTI Consulting, Inc. in support of their contention that Iridium was insolvent for the four-year period prior to bankruptcy. These experts analyzed Iridium’s solvency using a discounted cash flow analysis based on their own projections and using a discount rate of 34.5%.12 Although the experts considered all of the standard valuation methodologies, they concluded that only the discounted cash flow methodology should be used to value Iridium. FTI performed two discounted cash flow analyses, neither one of which was done for the almost two-and-a-halfyear period immediately prior to the petition date. The Court concluded that not addressing the period of time in which important capital markets transactions took place, including the issuance of debt and equity of Iridium, led to the inference that the analysis was manipulated to enable FTI to express the opinion that Iridium was insolvent.13 After evaluating all of the material presented by FTI, the Court ultimately found that the Committee’s expert’s work was biased, in that it was created for the express purpose of proving that Iridium was insolvent.14
C. Legal Conclusion
The Court considered the totality of the circumstances, including a variety of valuation methodologies, in determining whether Iridium’s debt exceeded the value of its assets at fair valuation for solvency purposes. This included consideration of Iridium’s post-petition insolvency, the trading price of its stock, projections made during the operative period, and Iridium’s ability to access capital markets.
The Court found that, “Iridium’s indisputable pre-petition insolvency does not prove that Iridium was insolvent at any point during the four years prior to the filing for bankruptcy.”15 The fact that the company’s pre-petition projections revealed solvency was important to the Court. Citing In re Mirant Corp.,16 the Court further stated that, if projections are reasonable and prudent when made (they have supportable assumptions, logically consistent computations, and include the input of management), they are useful evidence of a company’s expected performance, and alternative projections should be rejected. The Court also considered whether contemporaneous evidence of the market’s perception and evaluation of Iridium proved that it was solvent and had adequate capital at the time of the transfers to Motorola. Relying on VFB LLC v. Campbell Soup, a case in which the court found that a company’s stock price is an “ideal datapoint” for determining value, the Court found that, in the absence of evidence that the stock price was not indicative of the company’s value, it is a more reliable indicator of value than the subjective estimates of one or two expert witnesses.17
The Court also found persuasive the fact that expert analyses of investment bankers, analysts and lenders both confirmed solvency valuations and supported financings from the private and public markets. The Court explained that a powerful indication of a contemporary, informed opinion as to value can be determined from assessments made by public and private investors, who expended substantial resources to investigate the company, and concluded its prospects were promising. In Iridium’s case, the fact that underwriters, including Merrill Lynch and Solomon Smith Barney, were willing to underwrite equity and debt offerings, and other notable institutions were willing to close syndicated bank loans with Iridium, was an indication of both solvency and capital adequacy.18 Further, the Court gave weight to the fact that, at the time of these valuations, telecom analysts were aware of the line-of-sight limitations applicable to Iridium service, but nevertheless felt optimistic about the company’s future.19 The Court explained that, in determining whether Iridium had adequate capital to operate, “[w]hile a company must be adequately capitalized, it does not need resources sufficient to withstand any and all setbacks.”20
Citing Peltz v. Hatten21, the Court rejected the Committee’s expert’s discounted cash flow done after the fact because it was too “subjective and subject to manipulation.”22 The Court also dismissed the evidence presented by the Committee because it disregarded projections and contemporaneous market data. Quoting VFB, the Court found that “[a] solvency analysis lacks credibility when an expert uses projections that ‘fly in the face of what everyone [ ] believed at the time.’ ”23
The Court concluded that the Committee failed to carry its burden on the central themes of insolvency and capital adequacy by a preponderance of evidence. The Court explained, “[t]he fact that Iridium failed in such a spectacular fashion stands out as a disturbing counterpoint to the market’s optimistic predictions of present and future value for Iridium, but in the end, the market evidence could not be denied.”24 The Court surmised, “[g]iven the overwhelming weight of [the] market evidence, it may be that the burden of proving insolvency and unreasonably small capital simply could not be met under any circumstances, regardless of the evidence adduced, in the wake of the Third Circuit’s VFB decision, an influential case that has helped to illuminate the proper way to resolve the valuation questions presented here.”25
While the telecom era of the 90s was a time in which many company’s predictions of their future prospects proved to be significantly offbase, hindsight cannot be used to determine what a company was worth at the time the challenged transfers are made. The Court in Iridium thus correctly respected the totality of circumstances. At the time of the transfers at issue, the market thought that Iridium’s future was promising, and it was anxious to finance its operations and trade its stock.
The Iridium decision, however, leaves open the question of whether market forces should be ignored or deemed irrelevant under different facts or circumstances. For example, if the Committee had made a stronger case, and their experts had seemed less like hired guns, might a Court have come to a different conclusion? Further, can “irrational exuberance” in the market be respected, even if pure valuation methods prove a different valuation is supportable? Finally, if a company actively deceives the public with inaccurate public disclosures, or fraudulent accounting, will a court come to a different conclusion?
While the Court seemed tolerant of the elated market’s prediction of Iridium’s prospects, the same would likely not be the case if the company had engaged in fraud and misrepresentation. Important to its ruling was the fact that the risks of the Iridium enterprise were accurately disclosed to investors, and known to the general public. Conscious of these risks, the public continued to trade Iridium’s stock and lenders continued to finance its operations. If risks had been concealed, a different decision may well have been made.
In the end, while reactions of the public market remain the ultimate valuation device, the holding of Iridium may yet have limitation that will play out over time.