Valuation is a critical and indispensable element of the Chapter 11 bankruptcy process. It drives many aspects of a Chapter 11 case, from petition to plan confirmation, in all circumstances. But the COVID-19 pandemic has added a layer of complexity—and volatility—to bankruptcy valuation issues. This is likely to affect decisions about whether and when a company should enter Chapter 11, and how creditors and shareholders will be treated as a result of Chapter 11 filings.
The valuations of collateral, estate assets and claims determine a myriad of issues in Chapter 11. The right of a company to use its own cash during a Chapter 11 case, the right of a secured creditor to be paid interest during a Chapter 11 case, and the right of a secured or unsecured creditor to challenge a Chapter 11 plan of reorganization are all based on valuation determinations. Although valuation is central to the bankruptcy process, the Bankruptcy Code provides little guidance with respect to how assets and liabilities should be valued. Indeed, the Bankruptcy Code does not contain a definition of the term ‘value’. Section 506(a)—concerning the valuation of property securing a creditor’s claim—is one of the few Bankruptcy Code sections providing any guidance on valuation, and it simply provides that ‘value shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property…’. 11 USC s 506(a).
The COVID-19 crisis has upended public equity markets and has caused unprecedented economic upheaval in many sectors. Corporate borrowers are taking on more debt, whether under existing credit facilities or new government-sponsored programs, and certain businesses are anticipating massive changes to short and medium-term financial projections. It may be obvious that the crisis will also affect the value of assets, liabilities and claims, both in and outside the Chapter 11 context. But the crisis may also change the way that courts look at valuation determinations in Chapter 11—both value itself, and the way that value is measured, may be transformed by the COVID-19 crisis. 
I. Valuation Issues at the Outset of Chapter 11 Cases: Debtor-in-Possession Financing, Cash Collateral and Adequate Protection
DIP financing. The effects of the COVID-19 pandemic on the market may affect a company’s bankruptcy before the petition is even filed. For example, in considering whether to reorganize, a company will often consider its ability to obtain (and subsequently pay down) a debtor-in-possession (DIP) loan to finance its expenses through the Chapter 11 process. DIP loans are generally subject to special protections under the Bankruptcy Code, making them a relatively safe investment for lenders, while offering the opportunity to collect large transaction fees and interest. DIP loans can be especially appealing to existing lenders, who may be able to use a DIP loan facility to convert their prepetition secured debt into post-petition debt with a higher priority. However, a recent spate of debtors suffering from covenant defaults (or near covenant defaults) under their DIP loans (eg, in Craftworks, Murray Energy and others), alongside a general tightening of the credit markets, may make lenders more wary of extending such financing, significantly decreasing the availability of DIP loans in the marketplace. Even when lenders do extend DIP loans, they will likely insist on terms less favorable to the debtor. Because the Bankruptcy Code requires a debtor to demonstrate that any proposed DIP loan is on the best-available terms under the circumstances, a restricted and more costly DIP loan market may create challenges in obtaining court approval for DIP loans.
A debtor’s inability to procure, afford or obtain approval of DIP financing may make the company’s restructuring untenable. This may result in more companies opting to liquidate, potentially destroying going-concern value. Recently, the debtors in VIP Cinemas abandoned their prepackaged plan of reorganization, highlighting their inability to honor their DIP loan obligations.
Problems arising from the scarcity of DIP financing may be mitigated by the effects of recent legislation, in the form of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), especially for those businesses that qualify as ‘small businesses’ under Subchapter V of the Bankruptcy Code. The CARES Act may provide such debtors with the funds needed to remain out of bankruptcy. In addition, the CARES Act raises the debt limit for businesses to qualify for Subchapter V, which streamlines bankruptcy procedure and lowers costs for small-business reorganization. However, the lending and grant provisions within the CARES Act may not presently be available for DIP financing, and while it is possible that future legislation or regulatory guidance could loosen or eliminate those restrictions, there is no guarantee that will happen.
DIP financing issues attributable to market instability are not limited to bankruptcy planning. For those DIP facilities that are already in place, a debtor’s inability to pay the loan, based on changes driven by the COVID-19 crisis, may induce lenders to resort to unusual arrangements in an attempt to recover what may be only a fraction of their investment. A prime example of such an arrangement arose in the Sanchez Energy bankruptcy cases, where the debtors announced an agreement with the DIP lenders to entirely equitize the DIP claims, a substantial downgrade from the lenders’ expected payment in full.
Cash collateral/adequate protection. COVID-19’s effect on asset value may also affect whether a company can file and survive a Chapter 11 case, even if it has sufficient cash to operate without DIP financing. Under the Bankruptcy Code, a debtor-in-possession may not use a secured creditor’s ‘cash collateral’—for a company with all-asset-secured debt, this means all of the company’s own cash—without first obtaining the consent of the secured party or authorization by the court. That consent or approval is obtained by providing the secured creditor with ‘adequate protection’ for the risk that its collateral will be diminished in value over the course of the Chapter 11 case.
As noted above, Section 506(a) provides only minimal guidance as to how the value of collateral should be determined for this purpose, but precedent and common sense require a comparison of the value of the company’s assets at the start of the Chapter 11 case and the projected value of the company’s assets at the end of the Chapter 11 case. In times such as these where there is significant market uncertainty, such valuations can be difficult and can give rise to valuation disputes between parties that are both costly and time-consuming, involving expert testimony and protracted litigation.
II. Plan-Related Valuation Issues: Feasibility and 'Best Interests' Test
Plan feasibility. The COVID-19 pandemic and the resulting weakened economy have already played a significant role in valuation issues in the Chapter 11 plan context. Confirmation of a plan of reorganization under the Bankruptcy Code requires that a plan be feasible; that is, it is ‘not likely to be followed by the liquidation, or the need for further financial reorganization of the debtor’. 11 USC s 1129(a)(11). Following the sudden market downturn instigated by the current pandemic, proposed plans have faced increased scrutiny from creditors regarding whether such plans are in fact ‘feasible’ in the current market climate.
For example, in the bankruptcy cases of Pioneer Energy Services, Corp., an ad hoc group of noteholders questioned the feasibility of the proposed plan in light of the debtors’ most recent projections, which showed the debtors’ 2020 EBITDA would be ‘approximately one-half of the 2020 EBITDA’ originally projected in the debtors’ disclosure statement.  The noteholder group filed an emergency motion for a status conference, stating that ‘the events of the past few weeks—and their consequences, which,…will have a material negative impact last[ing] for at least five years—require, at a minimum, that all estate stakeholders carefully evaluate whether the contemplated restructuring can, or should, be consummated as planned'.  Similarly, another ad hoc group of noteholders scrutinized the Sanchez Energy debtors’ proposed valuation in light of the CARES Act, which, the group alleged, could provide additional sources of value. The ad hoc group noted that ‘[t]his new, potential value is not likely considered in the Debtors’ proposed valuation’, and therefore the group argued that confirmation on the expedited timeline proposed by the debtors was unreasonable. 
‘Best interests’ test/liquidation analysis. The ‘best interests’ test, which must be met in order to confirm a Chapter 11 plan, requires that each creditor of the company receive under that plan at least as much as it would receive in a liquidation of the company under Chapter 7 of the Bankruptcy Code. 11 U.S.C. s 1129(a)(7). Satisfaction of this test requires that the company perform a ‘liquidation analysis’ demonstrating the value of the Chapter 11 plan consideration (cash, new debt, new equity, etc) as compared with the value of its assets in a fast-tracked liquidation. Uncertainties in securities markets and the valuation of assets in general under the circumstances of the COVID-19 crisis will make this analysis more difficult. Paradoxically, at a time when creditor interests may be particularly at risk because of valuation declines in a company’s assets, the best interests test may be a lower hurdle for a company to meet than in the pre-crisis environment. If a company’s liquidation value is low in the crisis environment, even a marginally better outcome for creditors in Chapter 11 may satisfy the best interests test. But conversely, and related to the feasibility discussion above, if the ability of a company to survive after Chapter 11 is in serious doubt, the best interests test may allow creditors to push a company toward liquidation.
Valuation issues are often complex and litigation-prone in the Chapter 11 context, even in ordinary times. The economic effects of the COVID-19 crisis have further complicated valuation issues as companies struggle to reorganize in these economically challenging times. And as with many aspects of the crisis, thoughtful debtors and creditors may attempt to use the unique economic circumstances presented by the pandemic to protect and further their interests. One certainty is that debtors and creditors with a nuanced and flexible understanding of Chapter 11 valuation issues will fare better than those who rigidly hold on to pre-crisis precedent.
This analysis is fact-intensive and requires consideration of multiple factors. Please reach out to the authors listed above or to your regular contact at WilmerHale if you have questions or to analyze your company’s particular situation and make the decision best suited to your goals.
A summary of this post first appeared on the Harvard Bankruptcy Roundtable here.
Andrew N Goldman is a Partner at Wilmer Cutler Pickering Hale and Dorr LLP.
George W Shuster Jr is a Partner at Wilmer Cutler Pickering Hale and Dorr LLP.
Benjamin W Loveland is a Partner at Wilmer Cutler Pickering Hale and Dorr LLP.
Lauren R Lifland is a Counsel at Wilmer Cutler Pickering Hale and Dorr LLP.
 See Craig Jacobson, Dan Korczyk and Richard Peil, 'The Valuation Paradigm of COVID-19: Using the Discounted Cash Flow Method After an Economic Crisis', 26(5) Business Valuation Update (May 2020) (discussing the effects that COVID-19 may have on valuation methods, in particular on a discounted cash flow (DCF) analysis, which relies on forward-looking projections).
 See Chapter 11 Plan of Reorganization of Sanchez Energy Corporation and Its Debtor Affiliates, Art IV.C.1, In re Sanchez Energy Corporation, et al, No. 19-34508 (MI) (Bankr SD Tx Apr 6, 2020), ECF No 1109.
3] (Emergency Motion of the Ad Hoc Noteholder Group for a Telephonic Status Conference ¶ 7, In re Pioneer Energy Servs. Corp., et al, No. 20-31425 (DRJ) (Bankr SD Tex Apr 6, 2020), ECF No 179.)
 Id at ¶ 8.
 Ad Hoc Group of Unsecured Noteholders’ Objection to Debtors’ Emergency Motion Concerning Disclosure Statement and Plan Confirmation Scheduling and Procedure ¶ 7, In re Sanchez Energy Corporation, et al, No. 19-34508 (MI) (Bankr SD Tex Apr 8, 2020), ECF No 1113.