As this case illustrates, it is imperative that valuation experts remain independent and use as much third-party research and market data as possible to corroborate the underlying assumptions in a solvency opinion.

April 01, 2010

On October 13, 2009, the United States Bankruptcy Court for the Southern District of Florida voided, as a fraudulent conveyance, approximately $500 million in obligations and transfers by homebuilder TOUSA, Inc., and subsidiaries (“TOUSA”). TOUSA was a publicly traded homebuilder that filed for bankruptcy protection on January 29, 2008. In June 2005, a TOUSA subsidiary created a joint venture to acquire certain homebuilding assets of Transeastern Properties, Inc. (“Transeastern”). The funding of the Transeastern transaction obligated TOUSA, as a guarantor, on approximately $650 million of debt. Due to the rapid decline in the homebuilding industry in 2006, the debt went into default and litigation ensued between TOUSA, the joint venture, and its lenders. Ultimately, TOUSA and the joint venture settled the litigation by paying the Transeastern lenders $420 million. In order to finance the Transeastern settlement, TOUSA borrowed $500 million on July 31, 2007 (the “Transaction”) and caused two of its formerly unencumbered subsidiaries (the “Conveying Subsidiaries”) to become obligated for the new debt. It is important to note that the Conveying Subsidiaries were not defendants in the Transeastern litigation and were not liable to the lenders that financed the Transaction. Nonetheless, the Conveying Subsidiaries, which held most of the homebuilding assets of TOUSA, incurred the debt and granted liens to secure TOUSA’s liabilities but did not receive any of the $500 million in proceeds.

In January 2008, only six months after the Transaction, TOUSA filed for bankruptcy. The Creditors’ Committee (the “Committee”) representing the interests of the unsecured creditors, primarily bondholders that were owed slightly over $1 billion, sued to avoid (as a fraudulent transfer) and recover $500 million in liens granted by the Conveying Subsidiaries contending that they were insolvent at the time of the Transaction. The defendants were the holders of a $200 million first lien term loan and a $300 million second lien term loan from the Transaction, as well as the lenders in the Transeastern transaction. After a lengthy trial, the Bankruptcy Court found that, as a result of the Transaction, the Conveying Subsidiaries did not receive reasonably equivalent value in exchange for the liens they granted, were insolvent both before and after the Transaction, were left with unreasonably small capital to operate, and were unable to pay their debts as they became due. A constructive fraudulent transfer occurs when a debtor transfers property without receiving “reasonably equivalent value” in exchange for the transfer, and the debtor is insolvent at the time of the transfer or is rendered insolvent as a result of the transfer. In order for a company to be solvent, it must pass three tests: 1) Balance Sheet Test; 2) Cash Flow Test; and 3) Reasonable Capital Test.

Balance Sheet Test – Enterprise Value Testimony 

The most critical component of the balance sheet test for solvency is a determination of the enterprise value (“EV”) of the company. With respect to TOUSA, the valuation methodologies employed by the experts consisted of an Adjusted Book Value Method, Comparable Public Company Method, Discounted Cash Flow Method, and an analysis of the observable market values.

Adjusted Book Value Method

With respect to the Adjusted Book Value analysis, the expert for the Committee presented adjusted balance sheets reflecting the equity, on a fair value basis, of TOUSA, Inc., and the Conveying Subsidiaries. His starting point was TOUSA’s trial balance sheets, which he adjusted, both up and down, to reflect the fair value of the assets and liabilities. The most significant adjustment was to the value of the homebuilding inventory assets in order to reflect the fair value based on a real estate appraisal provided by the Committee’s real estate expert. The Court concluded that the Committee’s real estate expert’s fair value conclusions for TOUSA’s homebuilding inventory were credible and reliable. Overall, the Court was persuaded by the Committee’s real estate expert’s discounted cash flow analysis that was applied at the local residential community level. The Committee’s real estate expert used a bottom-up approach to determine the fair value of each community and then rolled up the values into divisions and legal entities.

In contrast, the Court criticized the defendants’ real estate expert’s analysis as less reliable and credible. The Court noted that the defendants’ real estate expert’s revenue projections were not specific enough and were not sensitive to TOUSA’s geographic markets, ignored contemporaneous market evidence, were at odds with the testimony of other witnesses, provided little support or assumptions, and relied on divisional sales pace assumptions instead of the sales history in the individual community. A lesson that can be learned from this case is that when the detailed information is available (as it was in this case), it is critical that a valuation expert analyze and incorporate all relevant information into the analysis and not simply rely on general averages and rules of thumb.

Comparable Public Company Method

With respect to the Comparable Public Company analysis, the expert for the Committee focused on the book value of TOUSA’s homebuilding inventory as the most appropriate valuation metric, noting that the peer group’s ratios of EV to inventory were much more consistent than earnings. In addition, the Committee’s expert did not simply rely on the mean or median observable multiple. Rather, the Committee’s expert gave the following eight specific reasons in support of why his selected multiple was below the mean and median of the range: 1) TOUSA’s historical trading levels; 2) high leverage; 3) lack of geographic diversity; 4) perceived low quality assets; 5) perceived low quality management; 6) perceived overstatement of assets on the balance sheet (i.e., under impairment); 7) overhang of concentrated shareholder base; and 8) concerns about the Transaction. The expert for the defendants criticized the Committee’s expert for using a single balance sheet item and his failure to employ an income based metric, such as EBITDA, to determine value. The expert for the defendants was also critical of the Committee’s expert’s use of a range of values, suggesting that the use of a mean or median multiple was more appropriate. Despite these arguments, the Court sided with the Committee’s expert, noting his findings were reliable and credible given his specific analysis and comparison of TOUSA to the comparable public companies. The Court also noted that such departures from the mean or median are standard practice in circumstances where there are reasons to believe a company to be worse off (or better off) than its peers.

It should be noted that the Court’s decision does not preclude the reliance on a mean or median multiple. Rather, based on the Court’s decision, it is critical for a valuation expert to not just blindly rely on the mean or median multiple in a comparable company analysis, but to compare and contrast the subject company to the comparable companies in determining the appropriate pricing multiple. (This is similar to the conclusion reached in Bush Industries (315 B.R. 292, September 16, 2004) regarding the selection of public market pricing multiples.)

Discounted Cash Flow Method

With respect to the Discounted Cash Flow analysis, the expert for the Committee based his cash flow projections on the forecast model created by TOUSA and its advisors, but lowered the projected average sales price per home because it was an unreasonably high assumption in his opinion, which was corroborated by supporting testimony. For the terminal value, he assumed that TOUSA would be priced at 60% of his projected 2012 homebuilding inventory balance. He then applied a 20% weighted average cost of capital to the resulting cash flows and terminal value to arrive at EV. In addition, the Committee’s expert presented a sensitivity analysis in further support of his conclusions. The sensitivity analysis confirmed that, even under significantly more optimistic assumptions, he would still conclude that TOUSA was insolvent on the date of the Transaction. The expert for the defendants criticized the Committee’s expert for his use of a terminal multiple instead of an approach that modeled the growth of a company into perpetuity. However, the Court sided with the Committee’s expert, noting that the Committee’s expert cross-checked his analysis using a perpetual growth method (which resulted in a consistent value) while observing that the use of an exit multiple was not uncommon.

The important information to take from this decision is that it is likely reasonable to use either a perpetual growth model or a terminal multiple in most situations, but it is imperative that an expert understands what the other method would imply.

Observable Market Values

On July 31, 2007 (the date of the Transaction), TOUSA had an equity market capitalization of $170.5 million. The expert for the defendants suggested that this positive market capitalization was indicative of a solvent entity, noting that TOUSA’s stock was actively traded and followed by market analysts. The Committee’s expert claimed that the positive stock price was not necessarily indicative of true value but merely “option value” created by speculators that had little to lose and much to gain by investing in TOUSA stock. The Court agreed with the Committee’s expert’s assessment, observing that even notoriously bankrupt companies trade at a positive equity price even after it is clear that the stock interests will be worthless as a result of the bankruptcy process.

In the extremely difficult economic environment over the last several years, this phenomenon has been quite prevalent, even with companies that are in complete liquidation mode or that have been bailed out by the government with no hope of a recovery for equity holders (e.g., General Motors stock continued to trade actively well after the government announced that all of the old equity in the company would be worthless in the very near future).

Also of note, TOUSA’s debt traded at below face value. The expert for the defendants argued that TOUSA’s debt price was merely depressed as of the Transaction date and was not reflective of its actual creditworthiness. This argument seems reasonable at first, given the deterioration in the economy, and particularly in the housing industry, just prior to the Transaction. Because the price of debt securities declines as required yields rise, it would seem possible that the depressed price of TOUSA’s debt was merely a result of increasing required yields in the debt markets, and not an indication of the creditworthiness of the company. However, the Committee’s expert countered this theory by comparing the Credit Suisse High Yield Index, which was trading at or near par, with TOUSA’s bonds that were trading at a 50% discount. The Court sided with the Committee’s expert’s reasoning that, given the fact that the high yield index was still trading at par as of the date of the Transaction, the significant decline in the price of TOUSA’s debt was not strictly a symptom of a deteriorating debt market, but was an indictment of the specific creditworthiness of TOUSA and the market’s perception that there was considerable risk that the debt would not be repaid.

Conclusion of Enterprise Value

Overall, based on each of the four valuation methods previously described, it was the Court’s finding that the Committee’s experts had proven that TOUSA was insolvent under the balance sheet test, both before and after the Transaction, based upon each and every method of valuation that was presented.

Cash Flow Test

With respect to the cash flow test of solvency, there were a number of factors that impacted the Committee’s expert’s opinion that TOUSA would not have the ability to pay its debts as they came due. First, TOUSA’s bonds were trading at a deep discount to par value, indicating that the market did not expect the bond debt to be repaid in full. Second, the Committee’s expert’s modified discounted cash flow model predicted that TOUSA would fail one of the covenants on its secured debt within six months of the Transaction. He also noted that even under the more optimistic cash flow assumptions used by TOUSA and its advisors, the company was still projected to fail covenants in the near future. The Court agreed with the Committee’s expert, noting that his conclusions mirrored the downgrades from both Moody’s and Standard & Poor’s around the time of the Transaction, which advised the market that TOUSA was unlikely to meet its debt obligations.

Reasonable Capital Test

In addition to concluding that TOUSA was insolvent based on the balance sheet test and cash flow test, the Committee’s expert also concluded that the company had unreasonably small capital as of the Transaction date. The Committee’s expert showed that after the Transaction, TOUSA would be left with a very high debt-to-capital ratio of 71.3%, higher than any of the comparable homebuilders. In his view, TOUSA was left with little room to maneuver in a deteriorating marketplace and would be unable to take advantage of any new opportunities. In fact, numerous documents that were produced during the trial uncovered that even TOUSA’s own management was extremely worried about the company’s prospects and viability going forward given the extremely high leverage being placed on the company. The Committee’s expert also observed that TOUSA’s plan for survival was predicated on unreasonable assumptions about home prices and the company’s ability to dispose of assets, including bulk land sales. The sensitivity analysis performed by the Committee’s expert further showed that TOUSA had virtually no room for error going forward given the enormous debt load and the corresponding covenants that were placed on the company. In other words, the company was doomed to fail.

Reasonable Equivalent Value

The Court found that TOUSA was clearly insolvent both before and after the Transaction. However, the Committee still needed to prove that the Conveying Subsidiaries did not receive reasonably equivalent value.

The Court concluded that the Conveying Subsidiaries did not receive reasonably equivalent value and, if they did receive anything at all, it was minimal, and did not amount to anything near the $403 million of debt that was apportioned between TOUSA and the Conveying Subsidiaries. In the Court’s view, the Conveying Subsidiaries did not receive any direct benefits. The Conveying Subsidiaries did not receive any of the proceeds, they did not benefit from any debt relief, they did not benefit from the acquisition of any homebuilding inventory, and they did not receive any value in the form of tax benefits which would have happened without the Transaction. According to the Court, the defendants failed to show that the Conveying Subsidiaries received reasonably equivalent value, or any substantial value at all, as a result of the Transaction.

Conclusions

Concluding on the issue of solvency for a company that is in distress is a complicated endeavor. A valuation expert must conduct several independent tests that scrutinize the company’s cash flows and operations before a solvency opinion can be given. Given the complexity of these issues, these conclusions often involve significant judgment. However, it is imperative that the valuation expert remain independent and use as much third-party research and market data as possible to corroborate the underlying assumptions. In the case of TOUSA, the company was led to believe that it could handle the debt load of the Transaction, despite the rapidly deteriorating industry and economy. Ultimately, the Court concluded that TOUSA’s management and advisors were determined to consummate the Transaction no matter the cost, and it ultimately left the company severely over-levered and on a crash course toward bankruptcy.

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