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Bankruptcy Valuations: A Pair of Modest Proposals

posted by Adam Levitin

I want to take up Michelle Harner's call for "innovation and new approaches to valuation". Valuation may well be the most important issue in bankruptcy, and it is also the issue that is least subject to meaningful judicial review. Imagine a Court of Appeals trying to parse through discounted cash flow models or what are proper comparables. The lack of meaningful appellate review makes it all the more important that we get valuation right. 

Our current valuation system is fundamentally adversarial.  Both sides put up evidence in the form of valuation compurgators experts, and the court then has to decide on a valuation, which need not be either of the experts'. The use of expert witnesses always has problems--the expert is employed by a litigant, which creates a concern about expert objectivity.  (I say this as someone who sometimes serves as an expert witness.) The normal solution in our litigation system is to have experts are paid for their time, not their opinions (which are their own) or the results in the case.

Unfortunately, and for reasons I do not understand, this civil procedure norm is not always the case with bankruptcy valuation experts. For example, in Chemtura, the Equity Committee's expert (UBS) received not ony a monthly fee, but a "transaction fee" that increased with higher returns to shareholders, which would, in turn, require higher valuations. UBS was, in effect, a party in interest in the bankruptcy because it's compensation turned on the valuation court the bankruptcy court accepted. Apparently such a compensation arrangement goes to credibility, not admissibility. This is not how things should work. 

What else could we do? One move would be some sort of market test.  Asset sales clearly get to a market test, although it's often a strange and distorted market depending on what bundle of assets are being sold, who can bid, etc. Even if one likes market tests in bankruptcy, however, they just aren't possible in many situations, such as for adequate protection valuations. So let me offer two possible alternatives.

First, why rely on experts retained by the parties?  Instead, have the court retain its own special master for valuation issues, paid for by the estate as an administrative expense. This would have two benefits. First, the cost would be for one expert, not two.  Second, the expert would not have the lurking conflicts of having been retained by one of the parties. It's not a perfect solution by any means, however, as there could still be methodological flaws in the valuation, but there wouldn't be the concern of self-serving valuations. Using a special master for valuation harkens back to the SEC advisory opinions on valuation in Chapter X of the Bankruptcy Act. No one thinks those worked very well (Atlas Pipeline is a posterchild case for this), but the problems were not so much about competence, as about how slow the SEC was. If the valuation were to be done under contract and deadline with a special master, the speed problem might well disappear.  

If you're not buying the special master approach, however, perhaps I can interest you in another modest proposal:  how about adopting the basic form of baseball salary arbitration to bankruptcy? (fwiw, there was a legislative proposal a few years ago to apply this model to interchange fee regulation.) 

My understanding of baseball salary arbitration is that both the player and the team make an offer. The arbitration is confined to pick between the two offers; the arbitrator is not allowed to split the baby and come up with its own valuation. The idea behind such a system (however well it works in practice) is to push the parties' valuations closer together because they are risk averse and hopefully encourage a settlement and thus avoid the need for a judicial valuation at all. Not sure how well this could be adapted to bankruptcy situations in which there could be multiple parties with different valuation positions. 

I'm curious to hear thoughts on these proposals and other ideas.  Comments are open. 


Since you're starting from Michelle Harmer's post, I take it that the court special master suggestion is primarily for valuations in Ch. 11 cases, rather than consumer Ch. 13s, especially given that valuations battles are over higher amounts. (Not more important assets or even more tenacious battles.). But with these court appointed appraisers paid from the estate, the more meager assets in a Ch. 13 illustrate a problem even for larger bankruptcies- a debtor already has to value an asset in preparing a bankruptcy petition and bear the cost for doing such, whether relatively small like with looking up an NADA value online for a car, more modest like paying a couple hundred dollars for a real estate agent value, or more significant like getting a CPA to value a business. If a creditor can always come along and insist that the debtor use estate assets to pay for another appraisal, that harms the estate with no cost to the creditor. Better (and I've done this in Ch. 13 with creditors) is to share the cost of a mutually acceptable appraiser. (Of course, after I let a mortgage servicer pick an appraiser that came in with a value even lower than I started, the servicer tried to renege.)

Adam--Great post; thanks for keeping the valuation conversation going. Two quick thoughts: On the special master approach, I think the Commission's "estate neutral" recommendation could facilitate that appointment; we would just need the clarification that the court would not consider other valuations if the matter went to trial. I also am intrigued by the concept underlying the baseball salary arbitration approach. If we could institute a default process against which parties could more effectively (and reasonably) negotiate, that might add real value.

Why bother with a special master, to be paid law firm rates? The FDIC has done a pretty good job of insolvency valuation with reasonable speeds, at civil service salaries, no less. Admittedly, it is an industry specialist, but the FDIC is a reasonable proof of concept. Court-appointed "experts" introduce an element of corruption that isn't there with civil service types. We see this a lot with state probate courts--I'm not sure that federal judges have a special purity that state judges lack.

The problem with baseball valuation is that it assumes that there are only two parties. It doesn't work all that well with large numbers.

Here's an article discussing "pendulum arbitration" and the situations in which the authors suggest it doesn't work, including corporate valuation questions: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1889768

This is really very silly. There's a perceived substantive problem, which is that courts get valuation cases (like every other kind) wrong sometimes. The proposal is to add several layers of additional procedure and expense. Do we think that the parties won't hire their own experts to challenge the special master's conclusions? Do we think the parties won't litigate in front of the master? If courts are bad at resolving valuation matters, why do we think they'll be any better at picking special masters and reviewing the masters' conclusions?

Moreover, if bankruptcy judges aren't capable of adjudicating valuation issues efficiently and effectively, then why do we need bankruptcy judges at all?

This kind of limp reasoning is the process by which our system continues to accumulate layer after layer of expensive procedural detritus without actually becoming more effective at discerning the truth.

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