January/February 2016

The Deceptive Balance Sheet: Determining Value in Liquidation Analysis

A customer’s balance sheet can appear straightforward, but there are hidden triggers that can cause unexpected problems during chapter 11 proceedings. Kenneth Rosen, who leads the bankruptcy department at Lowenstein Sandler, reveals these unexpected traps.



Kenneth Rosen, Partner, Lowenstein Sandler LLP

Kenneth Rosen, Partner, Lowenstein Sandler LLP

A customer’s balance sheet is one of the many things that a credit executive reviews in analyzing the risk of nonpayment. As a bankruptcy attorney, I have learned that balance sheets and liquidation analyses can be deceptive and that value is more of an art than a science.

Certain liabilities do not show up on a balance sheet when determining how much you will recover if your customer is forced to liquidate, so you must be conscious of claims that arise in or as a consequence of bankruptcy, liquidation or the discontinuation of the customer’s business. These “springing” claims can be senior to general unsecured creditor’s claims or they can severely dilute (by sharing in the distributable funds) the percentage recovery that unsecured creditors would otherwise receive. Whether the numerator is reduced or the denominator is increased, the percentage recovery to general unsecured creditors declines.

Looking at Employee Claims

One category of claims fall under the Federal Workers and Retraining Notification Act (WARN Act). Generally, WARN Act liabilities are employees’ claims for compensation if they were terminated with fewer than 60 days’ notice. Many states have their own version of the WARN Act and include longer notice periods. Certain exceptions to the federal WARN Act may not be applicable under state law. Under federal law, for example, there is an exception for employee terminations due to events that could not reasonably be anticipated. The exception does not apply in several states’ version of the WARN Act.

If the WARN notice was given to employees after the date a bankruptcy petition is filed, then the claims of the terminated employees may have administrative status (“paid off the top”) in the bankruptcy case — meaning that the claim has a higher priority of payment than claims of pre-bankruptcy general unsecured creditors. Trade creditors typically are general unsecured creditors without priority status. Whether the WARN claim is equal in status to general unsecured claims or senior to general unsecured claims, it dilutes the dividend paid to general unsecured creditors and would not show up on a balance sheet of a distressed customer. Some debtors will avoid giving timely WARN notification because of the potentially damaging effect that it has on the business. Failing to provide the requisite notice risks reducing the recovery for unsecured creditors in the event of bankruptcy because larger WARN claims arise.

Anticipating Environmental Liabilities

Another item that may not be on a balance sheet is the true extent of environmental liabilities. When a debtor ceases operations, cleanup obligations may arise that would not have been triggered had the debtor continued operating. The cleanup cost associated with a sale or foreclosure of the debtor’s property can be much greater if the intended future use of the property is different than the debtor’s use. Normally a debtor will only carry on its balance sheet liabilities associated with environmental obligations that are required to be recorded by contract, law or regulation. Many environmental obligations that occur when the business closes are not required to be booked. These claims may be significant and can have a priority for payment that is senior to general unsecured claims. Therefore they dilute the recovery.

Other forms of liability not on a balance sheet are contract rejection claims — claims for damages stemming from the termination of a lease or contract during the bankruptcy case. For retailers who reject (terminate or disavow) real property leases in bankruptcy, the landlord’s damages can be as much as one year’s rent. For a retailer with many stores to close, lease rejection claims can overwhelm the claims of trade creditors. In order to properly assess the balance sheet of a retailer, it would be necessary to determine the number of leases that are above market value, the number of leases that are below market and the estimated sale value of the below market leases. Leases of photocopiers, fax machines, trucks, automobiles, machinery and equipment are treated similarly. Termination triggers damage claims that inflate the pool of general unsecured claims.

Of course, the flip side of lease rejections and of lessor damage claims is valuable, below market real estate leases. In bankruptcy cases, leases are assignable despite lease provisions that expressly prohibit tenants from assigning the lease. In fact, leases for locations in shopping areas that are in great demand may sell at a premium above the present value of the differential between fair market rental stream and the contract rental stream. Leases may be valuable assets that do not show up on a balance sheet and, therefore, should be considered in a liquidation analysis.

For some industries such as supermarkets, the value of a retail lease is not simply a function of comparing contract rates to current market rates. For operating supermarkets, the profitability of the store on a four wall basis, despite the lease being at or above market, is a key factor. Even if a retailer has a portfolio of leases at or above market, the lease portfolio may have value to another retailer who sees the opportunity to build instant critical mass with lower legal, negotiating and search costs.

In the world of bankruptcy and low interest rates, underfunded pension obligations have become common. The Pension Benefit Guarantee Corporation, which guarantees many pension obligations, frequently is the largest unsecured creditor in a bankruptcy case. This potential liability is often absent or understated on a balance sheet.

Evaluating Intellectual Property

Intellectual property is another asset category where the value on a balance sheet generally does not reflect actual value. In cases where intellectual property was developed in-house or is the product of generations of business use, overvaluation is likely. The debtor may have an unrealistic view of the value of its intellectual property or fail to recognize that its brand’s glow has faded. Graveyards are full of formerly iconic brands.

Polaroid, Sharper Image, Loehmann’s, Memorex, Twinkies and Prince Tennis are iconic brands of bankrupt companies that come to mind where IP was a significant element of value. An industry has developed in bankruptcy cases in which investors purchase intellectual property and use the name recognition to sell products not previously associated with the brand. A recent example is Polaroid branded televisions which are available for sale at Target stores.

It is very difficult to determine the value of intellectual property and its likely sale price in a chapter 11 proceeding. One example is the iconic name Loehmann’s — the first off-price retail store for designer clothes — that sold in bankruptcy for only $850,000. Was the name not worth more because consumer tastes shifted, or did it sell for a relatively low price because of the market conditions? On the other hand, the Hostess case is an example of intellectual property having under-recognized value.

Either way, intellectual property values are subjective and highly speculative. Companies that have been in business for long periods of time may have patents and other intellectual property no longer used in their current business operations which can be repurposed in ways that do not compete with the debtor. In a bankruptcy proceeding (or an out of court restructuring), the question may be, is the debtor fully exploiting its intangible assets? Underutilized or underexploited intellectual property is value that does not appear on a balance sheet. A debtor may use its intellectual property in the routine operation of its business, but can it license the use of a patent to a user that makes a product that does not compete with this business and thereby generate additional revenue? Or, does the debtor have intellectual property assets in its porfolio that it no longer uses and which are no longer necessary for its strategic plan but may be sold and yield significant recoveries?

By evaluating credit risk and performing a liquidation analysis, the prudent credit executive takes into account much more than outside-of-bankruptcy going-concern asset values. Bankruptcy has a negative impact on asset values, except in relatively few industries where the customers purchase goods or services without much lead time, and where the unexpected unavailability of a product from a failed debtor will not harm the business of the debtor’s customer.

The High Cost of Bankruptcy

Most companies that enter chapter 11 find bankruptcy is costly, not just in terms of professional fees but in the amount of valuable time management must devote to dealing with counsel, responding to creditors committee demands and objections, assuring vendors, assuring customers and dealing with secured lenders. This is time that would be better spent managing the company.

Plus, there is the often unquantifiable cost that results when assets are sold in bankruptcy proceedings. Often, assets of a business in bankruptcy are sold based upon cost or liquidation value rather than a multiple of earnings. While a turnaround consultant, chief restructuring officer or company executive may be able to present a cogent plan to restore revenue and earnings, the incremental value from a turnaround normally fails to reach creditors of the debtor. One reason is chapter 11 cases have become abbreviated partially because secured creditors prefer a quick sale or peaceful surrender of their collateral to giving a chapter 11 debtor time to restore value for its other creditors.

In analyzing downside risk, a prudent creditor must take into account more than stated asset values and liabilities. Bankruptcy, liquidation and closure may trigger large claims that would not exist or are not required to be stated on financial statements outside of bankruptcy. And bankruptcy triggers a scheme of priorities that does not exist outside of bankruptcy court. Balance sheets are good places to begin analyzing sources of value and potential recoveries, but they are only a place of embarkation. Intended use, market conditions, regulatory requirements, applicable law and contingent assets and liabilities must all be accounted for in assessing potential recoveries of a distressed debtor.