September 01, 2014

Background

Adelphia Communications Corporation (“Adelphia” or the “Company”), once one of the largest cable operators in the United States, sought Chapter 11 protection in 2002, after authorities filed charges that its founder, John Rigas, and his sons stole hundreds of millions of dollars from the Company. Post confirmation, the Adelphia Recovery Trust (the “Plaintiff”) sought to recover $150 million from FPL Group and certain of its affiliates (“FPL” or the “Defendants”) related to Adelphia’s 1999 repurchase of certain Adelphia stock owned by the Defendants, based on the allegation that the transaction was a fraudulent transfer. As such, the Court needed to “engage in a traditional fraudulent transfer analysis to determine the extent to which Adelphia was insolvent (or rendered insolvent), left with inadequate capital, or rendered equitably insolvent at the time it paid $150 million to repurchase certain Adelphia stock owned by FPL.”

Primary Valuation Issue in Dispute

The primary issue in the case was the valuation methodology that was appropriate to rely upon. The Plaintiff’s expert relied solely on the Discounted Cash Flow (“DCF”) method, while the Defendants’ expert rejected the DCF method and relied on a combination of the Guideline Public Company (“GPC”) method (based on analyzing multiples of comparable public companies) and the Precedent Transactions (“PT”) method (based on analyzing multiples paid for companies similar to the subject in the merger and acquisition market).

Both experts concluded that any projections prepared by management or any third-party industry analysts were unreliable as they would have been based on fraudulent and inaccurate financial information prepared by the Company. In response to this conclusion, the Defendants’ expert rejected the use of the DCF method altogether. On the other hand, the Plaintiff’s expert decided to develop his own cash flow projections for Adelphia for the next 10 years based on information he compiled from contemporaneous industry analyst reports from Paul Kagan Associates (“PKA”) and Donaldson Lufkin Jenrette (“DLJ”) so that he could apply the DCF method.

The Defendants’ expert relied on the GPC and PT methods based on a value per subscriber multiple. The Plaintiff’s expert declined to rely on either the GPC or the PT method, as in his view, they required “a measure of historical or forward earnings for the subject company and the comparable companies” but data of this character was unavailable due to “misstatements of Adelphia’s financial performance and the unavailability of reliable data for Adelphia and the comparable companies for the time period at issue.”

The Plaintiff’s expert also disagreed with the type of multiple that the Defendants’ expert relied upon — value per subscriber. While both experts agreed that “value per subscriber” was commonly used by market participants to value cable systems, the Plaintiff’s expert concluded that such a multiple could not be relied upon due to the differences between Adelphia and the comparable companies in terms of system upgrade status and profitability. The Defendants’ expert took a contrary view; while he agreed that there were differences between Adelphia and the comparable companies, he incorporated these differences in the process of selecting a multiple from the range indicated. For example, with respect to the GPC method, he selected a multiple in the lower quartile of the range observed to account for Adelphia’s lower relative upgrade status and profitability.

Experts’ Relative Conclusions

Ultimately, the Plaintiff’s expert concluded that the total enterprise value of the Company was approximately $2.8 billion, which was substantially lower than the Company’s liabilities and, thus, he concluded that Adelphia was insolvent at the time of the subject alleged fraudulent transfers by over $1 billion. On the other hand, the Defendants’ expert concluded that the total enterprise value of the Company was approximately $6.7 billion and therefore, that the Company was solvent from a balance sheet perspective.

Court Decision

The Court decided that the Plaintiff’s expert’s reliance on the DCF method alone was not appropriate and that the assumptions underlying his DCF analysis were “arbitrary and speculative.” The Court listed three conditions that typically must be present for the DCF method to be relevant and reliable: i) when a company has accurate projections of future cash flows; ii) when such projections are not tainted by fraud; and iii) when at least some of the cash flows are positive. The Court stated that “this case is a poster child for deficiencies in that regard.”

The Court found the Plaintiff’s expert’s attempt to develop alternative projections to be fatally flawed and fraught with cherry picking data from third-party sources. For example, capital expenditure assumptions were derived from DLJ (which drove cash flow down), but he did not utilize DLJ’s revenue assumptions. Instead, he relied upon lower growth projections from an alternative third-party source, PKA.

On the other hand, the Court noted that Adelphia’s count of the number of subscribers was one of the most accurate metrics of its financial data, thus making the Defendants’ expert’s market-based value per subscriber analysis much more reliable. This was especially true given the very narrow range within which the comparable public companies traded. The Court acknowledged the Plaintiff’s position that the lack of comparability between the comparable companies and Adelphia with respect to upgrade status and profitability made the GPC method less reliable. However, the Court also stated that no valuation methodology is certain and devoid of the need to introduce some level of the expert’s judgment. In conclusion on this issue, the Court decided that the Plaintiff’s analysis allowed too much room for judgment and that the Defendants’ analysis was much more closely tied to the market and the price that Adelphia could actually receive for its assets in a sale.

In its decision, the Court also mentioned various “sanity checks” that it deemed relevant, which neither expert employed. First, while not fatal to the Defendants’ analysis, the Court did note that the Defendants’ expert’s valuation would have been even more thorough had it included at least an attempt at a DCF analysis for purposes of a reasonableness check.

Even more glaring, the Court found the Defendants’ Expert’s valuation conclusion to be overstated from a sanity check perspective when compared to the actual value of Adelphia based on its market capitalization. The Defendants’ valuation conclusion was 19% higher than the actual market capitalization of Adelphia at a time when Adelphia’s fraud was in existence but not known to market participants. The Court found this to be unreasonable, and made various adjustments to the Defendants’ positions with respect to the value of various nonoperating assets and various investments that needed to be calculated separately. But ultimately, even after these adjustments, the Court found that the Company had assets with value in excess of its liabilities, and was, therefore, solvent from a balance sheet test perspective.

Observations

The Plaintiff-stated reason for not applying a form of the market approach such as the GPC method or the PT method was simply not persuasive in this case. As the Court noted, in virtually any application of the GPC method (or in any valuation method for that matter), some level of judgment typically enters the picture.

The relative level of judgment that was required to prepare projections in light of the fraud at Adelphia was determined to be more extreme than the level of judgment that was required to analyze and consider the value-per-subscriber multiples observed in the market.

One interesting aspect of this case is that both experts, including the Defendants’ expert (who rejected the DCF method in his valuation due to a lack of reliable projections), formulated cash flow projections to rely upon to perform their capital adequacy analyses (i.e., another one of the solvency tests beyond the balance sheet test that needs to be passed in order for a company to be deemed solvent). It is interesting that the Court concluded that projections were not reliable for the valuation required under the balance sheet test of solvency, but then had no choice but to rely on projections to assess Adelphia’s capital adequacy in the short-term. In its opinion, the Court noted that it remained troubled that the “projections made by each side were in significant respects speculative,” but that it had no choice but to rely on projections as well in considering the capital adequacy of Adelphia.