Solvency Opinions: What Borrowers and Lenders Need to Know

“Neither a borrower nor a lender be[.]”¹

In a business context, it is not possible to heed the bit of advice offered above.  Borrowing and lending are common, and the commercial situations in which they occur and the forms they take are varied.  Those of us involved in the professional art (or is it a science?) of providing independent solvency and fairness opinions encounter borrowing and lending in merger transactions, standard financing and refinancing transactions, leveraged buyouts, and many other contexts.  We are frequently requested to provide an objective opinion, in the case of a merger or acquisition, as to the fairness of the consideration from a financial perspective.  In standard refinancing, leveraged buyouts, or similar transactions, we are often asked to analyze the financial standing of the borrower; the party incurring an obligation, as in the form of a guarantee; or the party providing security, and to opine as to the solvency of that party at the time of or as a result of the proposed transaction.  Some of the above situations present more apparent risk than others; the recent bankrupty court case involving TOUSA² illustrates such risks.

With various articles already written by lawyers about the bankruptcy court opinion in the TOUSA case, in hindsight, it should have been easy to foresee the risk inherent in the transaction involving the Transeastern Lenders.  At the time the solvency opinion at issue in that case was delivered (summer 2007), the writing was on the wall for residential real estate developers, especially in South Florida.  That, together with certain business decisions undertaken by TOUSA’s management and TOUSA’s already overleveraged financial situation, created a perfect storm of events that led to TOUSA’s Chapter 11 filing in January 2008.

The TOUSA bankruptcy court opinion resulted from an adversary proceeding related to TOUSA’s Chapter 11 case.  TOUSA’s Official Creditors’ Committee initiated the proceeding to avoid pre-bankruptcy indebtedness incurred and liens granted by certain subsidiaries of TOUSA to the Transeastern Lenders in connection with borrowings used to pay judgment creditors of TOUSA.  Only one of those subsidiaries was a judgment debtor.  None of the subsidiaries received any proceeds from the borrowings from the Transeastern Lenders.  Six months later, TOUSA and many of its subsidiaries filed Chapter 11 petitions.  The bankruptcy court opinion (currently being appealed), which is intensely fact specific, is principally cited for the bankruptcy court’s determination that the subsidiaries had received little or no “reasonably equivalent value” in exchange for the debt incurred, and were (i) insolvent at the time of and as a result of the transaction, (ii) left with unreasonably small capital as a result of the transaction, and (iii) unable to pay their debts as they became due as a result of the transaction.  In familiar parlance, the transactions with the Transeastern Lenders and the utilization of the proceeds to pay existing judgment creditors were determined to have constituted “fraudulent transfers.”

In a third-party transaction, once it has been determined that, within certain defined time periods before the filing of a bankruptcy petition, a debtor did not receive reasonably equivalent value in exchange for a transfer made or an obligation incurred, such transfer or obligation may be avoided if one of three tests related to solvency at the time of the transaction is failed.  TOUSA, said Bankruptcy Judge John K. Olson, failed all three of those tests.

The tests of solvency involve very detailed valuation analyses, and include (i) the balance sheet test, (ii) the cash flow test, (iii) the capital adequacy test, and, if applicable (iv) the shareholder distribution test.

For the balance sheet test, valuation professionals review whether the fair value and present fair salable value of the aggregate assets, as represented by the operating business earnings and cash flows of the entity, exceed its aggregate liabilities (stated and contingent) on a going-concern basis.  The value of the aggregate assets, as represented by the operating business earnings and cash flows, is determined using standard valuation methodologies such as the income (discounted cash flow) and market approaches, and is often tailored to consider industry specific benchmarks and valuation metrics.  Total liabilities (including both stated and contingent) are subtracted to determine the excess of assets over liabilities, also referred to as the equity cushion.  This equity cushion is then assessed in the context of the economic and industry conditions and outlook, as well as by comparison with similar transactions. 

For a cash flow test of solvency, the analyst must determine whether projected cash flow will be sufficient to repay debts and other obligations as they become due.  In doing so, valuation professionals rely on cash flow projections supplied by the entity’s management.  While the solvency analyst may be able to rely on the projections, the underlying assumptions are stress tested for reasonableness in light of economic-, industry-, and entity-specific factors.  In the capital adequacy test component of a solvency analysis, an entity must have “adequate capital,” or reasonable capital with which to conduct its business.  Factors in this analysis include, but are not limited to (i) the overall industry outlook and the entity’s position within that industry, (ii) company-specific performance, (iii) management’s experience within the company and the industry, (iv) the company’s access to the capital markets including financing alternatives, (v) the quality of assets and maintenance programs for the assets, and (vi) sufficient cash flow from operations to pay debt and meet other obligations as necessary.

Bankruptcy Judge Olson conducted an extensive review of the solvency opinion obtained by TOUSA’s Board as a condition of the financing transaction, and analyzed the expert testimony offered at trial.  Judge Olson essentially found that the solvency opinion was largely unpersuasive because, inter alia, it was (i) obtained from TOUSA’s pre-bankruptcy financial advisor using an inappropriate industry standard; (ii) prepared on a consolidated “common enterprise” basis rather than analyzing the financial impact of the transaction on each “conveying subsidiary”; (iii) prepared in an inordinately brief period of time; (iv) reliant on TOUSA’s stale projections and underlying assumptions, which the opinion provider had neither rolled forward nor stress tested; (v) prepared on a contingent fee basis, providing the option for a larger potential fee if the opinion determined solvency; and (vi) prepared by an advisor without current homebuilding industry experience.  Judge Olson made other noteworthy comments regarding the solvency opinion and expert testimony offered by the Debtors, but they are beyond the point of this brief discussion.³

Judge Olson’s decision is currently being appealed, and we cannot predict with any degree of certainty what the final outcome will be.  However, even if the decision is reversed in its totality, there are nonetheless lessons to be learned from TOUSA (beyond “Florida, Florida, Florida”) ⁴ that should be remembered by those seeking and providing solvency opinions in these types of transactions: 

• An independent solvency opinion is a critical condition for a Board when it is engaged in a refinancing, restructuring, or transaction of the nature described in the TOUSA case.
• The fees paid to the independent solvency opinion provider should not be contingent upon a preordained result.
• A favorable solvency opinion is not an insurance policy.  Just as comprehensive loan documentation and a myriad of financial covenants will not collect your loan, a solvency opinion without a proper independent analysis and without adherence to industry standards with respect to valuation methodology will not provide the protection desired.
• To have evidentiary value, the solvency opinion should be based on accepted and industry-appropriate methodologies and metrics.
• A solvency opinion must incorporate the best available and most up-to-date financial, economic, and industry information, conditions, and outlook.  An opinion provided in isolation can lead to the wrong conclusion.
• A solvency opinion may need to take into consideration an analysis of subsidiary entities that provide cash flow or assets that support or possibly guarantee debt on a parent level.  The analysis may also need to take into consideration whether reasonably equivalent value is received by a subsidiary entity supporting and/or guaranteeing the debt of a parent.  It is feasible that solvency tests may be needed on entities other than the consolidated entity, due to cash flow or other subsidiary guarantees on all or select entities in the consolidated business organization.

“Neither a borrower nor a lender be[.]”

All quotes are taken out of context, and this admonition from an old busybody to his young, impetuous son is no exception.  In today’s business environment, however, the results of a borrower default can be even more drastic than Polonius imagined.  Due to a number of recent court decisions, including the TOUSA case discussed here, the spotlight on lenders is now brighter than ever.  Borrowers and lenders need to understand that a solvency opinion is only as good as the analysis that supports it.

¹Shakespeare’s Hamlet, act 1, scene 3
²Official Committee of Unsecured Creditors of TOUSA, Inc., et al., Debtors, v. Citicorp North America, Inc., et al. (In re TOUSA), 422 B.R. 783 (Bankr. S.D. Fla. 2009)
³Also beyond our scope is a discussion of the remedies and sanctions imposed by the Bankruptcy Judge, and his determination regarding the unenforceability of the “savings clauses” in the subsidiary guaranties.
⁴Tim Russert, Election Night, 2000