In bankruptcy, as in corporate law, valuation drives disputes. Prior bankruptcy scholarship points to disagreements about valuation and judicial valuation error as key drivers of Chapter 11 outcomes, including the decision whether to reorganize the distressed firm or sell it off pursuant to a Section 363 sale. Avoiding valuation disputes and valuation errors is also the underlying driver of most proposed reforms to Chapter 11, from Douglas Baird’s mandatory auctions to Lucian Bebchuk’s options approach.
In a new paper, we undertake a detailed examination of bankruptcy court opinions involving valuation disputes. We study all reported cases filed between 1990 and mid-2017 that provided sufficient detail about the valuation dispute and methodologies employed. Our paper has two goals. The first is to understand how parties and their expert witnesses justify opposing views, and how judges decide between them. The second is to provide practical guidance to judges in resolving valuation disputes.
Looking across cases, we find sharper disagreement among experts regarding inputs to the discounted cash flow method (DCF) than regarding inputs to multiples-based methods. In nearly half of cases involving DCF, experts fight over the discount rate; in nearly three quarters, they fight over cash flow projections. By contrast, disagreement over an input to multiples-based methods, such as the choice of comparable companies, occurs in less than a fifth of the cases. This pattern helps explain why many judges view DCF as far more complex and error-prone than multiples-based methods.
We also find sharper expert disagreement when valuation is done in a backward-looking context (eg, fraudulent transfer litigation) than when it is done in the context of valuing a company on a going-forward basis. This pattern is consistent with hindsight bias.
When we look more closely at the judicial opinions, we find surprisingly pervasive (and often self-serving) errors in expert testimony. This is particularly true when valuation experts apply DCF. The choice of discount rates is frequently unsupported by, and often at odds with, finance theory and evidence. We also find experts averaging valuations from different methods, but strategically weighting methods with values most favorable to their clients.
We propose simple strategies based in finance theory that judges can employ to reduce the scope for valuation disagreements in Chapter 11. For example, we argue that courts should reject the use of company-specific risk premia in discount rates and be highly skeptical whenever experts weight some valuation methods more than others in calculating ‘average’ estimated values.
This post was first published in the CLS Blue Sky Blog.
Kenneth Ayotte is Professor of Law at U.C. Berkeley School of Law.
Edward Morrison is the Charles Evans Gerber Professor of Law at Columbia Law School.