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Restructuring on the Fair Value Battleground

Originally published in Financier Worldwide on September 2008

Some see the current credit crunch as a precursor to a wave of massive credit defaults suffered by powerless lenders and borrowers that have no alternative source of funds. However, several financial accounting standards issued by the Financial Accounting Standards Board (FASB) are scheduled to take effect this year, and will effectively grant many creditors and their debtors the ability to avoid significant losses and even bankruptcy.

While lack of liquidity is cited as the most common cause of bankruptcy, it is the actions of one or more unsatisfied creditors that truly determine whether a commercial debtor remains in default or is allowed to cure it. The creditor’s ability to grant payment forbearance, covenant waivers, and extensions is often relied upon by both parties to reaffirm a borrowing arrangement when it can remain profitable to do so.  However, if the lender is a bank with a regulatory mandate to raise capital or reduce the size of the loan portfolio, the diligent fiduciary will use any payment or covenant default as an opportunity to improve a collateral position, increase pricing, collect additional restructuring and monitoring fees, or dispose of a deteriorating, capital intensive credit.  During a general economic credit contraction, forced liquidation of the business assets securing the loan is often the lender’s only option, especially when required loan loss reserves exceed any potential restructuring gains.

The lender’s opportunity to restructure or exit deteriorating credits will present itself more frequently when the FASB’s Statement of Financial Accounting Standards 157, Fair Value Measurements (FAS 157) takes full effect later this year. Already effective for financial assets and liabilities, the effective date of FAS 157 for nonfinancial assets and liabilities is deferred to fiscal years and interim periods beginning after December 15, 2008.  FAS 157 requires the reported values of both assets and liabilities to reflect current realizable market prices, whether or not a real market exists.  What the acquirer actually paid for the asset or how it is actually used is, with limited exceptions, ignored under FAS 157.  Its effects are now appearing in the financial statements of companies that experienced a merger, reorganization, goodwill impairment, or other re-valuation event during the first half of 2008.  In an economic environment of generally declining prices and illiquid markets, FAS 157 can be expected to increase the likelihood of covenant defaults.

Both commercial lenders and borrowers with sufficient information to estimate and foresee the fair value adjustments that a debtor is likely to recognize in the next reporting period will have an opportunity to proactively restructure the credit before a technical covenant default occurs. Those with early knowledge of an upcoming asset impairment charge that will result in a loan covenant default should fare much better in a proactive re-negotiation of credit terms.  In a tight credit environment, it will be advantageous for company managements to have such information before their creditors and their auditors do.

FAS 159, The Fair Value Option for Financial Assets and Liabilities became effective on December 15, 2007 and permits entities to choose to measure selected financial instruments and certain other items at fair value that are not currently required to be measured at fair value.  To the extent that it can be used for the stated purpose of presenting a more accurate representation of realizable market value, FAS 159 offers debtors the option to re-value specific financial assets and liabilities in a way that may avoid violation of certain loan covenants.  Declines in the fair value of acquired or elected financial assets are booked as operating losses on the income statement, while increases in value are recognized as gains.  A revaluation of non-financial assets and liabilities required by other FASB pronouncements may offer additional opportunities to pre-empt aggressive creditors who might capitalize on a technical default and attempt to gain control of unprofitable borrowers or liquidate their collateral.

One of the most anticipated effects of FAS 157 that debtors may benefit from is the requirement that the face value of a liability be adjusted to fair value in the event a re-allocation of value is necessary under FAS 141-R, FAS 142, FAS 159, SOP-90, or one of many other FASB pronouncements. This means, for example, that a financially distressed company recognizing a goodwill impairment charge under FAS 142 could also be required to write down its unsecured debt to the extent the fair value of a promissory note has declined due to increased credit risk.  The surprising offsetting entry specified by FAS 157 is to record a gain on the income statement, which has been pointed out by many to be counterintuitive and perhaps even a bad faith representation, in light of the fact that the bank indenture is still in force for the full amount of the outstanding debt.

FAS 157 also operates by way of Statement of Position (SOP) 90-7, which was issued in 1990 to provide guidance on financial reporting for entities that file petitions with the Bankruptcy Court and expect to reorganize as a going concern under Chapter 11 of Title 11 of the United States Code. SOP 90-7 was modified in April, 2008 to require that the reorganization value of the emerging entity be allocated to its assets in conformity with the procedures specified by FASB Statement No. 141, Business Combinations (FAS 141) and FAS 157.

Under SOP 90-7, entities meeting certain criteria are required to adopt Fresh-Start Accounting (FSA), under the assertion that the emerging company is a new and different successor entity, and since historical costs and accounts of the predecessor company are no longer representative of contracts that have been renegotiated, all assets (and now liabilities) should therefore be reported at their current fair value. Paragraph 38 of SOP 90-7 requires, in part, that the reorganization value of the emerging entity be allocated to the entity’s assets in conformity with the procedures specified by FASB Statement No. 141, Business Combinations (FAS 141).

FASB Statement No. 141 (revised 2007) Business Combinations, (“FAS 141R”), nullifies or replaces five other existing FASB pronouncements, and makes significant amendments to 80 others.  One of those affected is SOP 90-7, in which two key paragraphs were modified to read as follows (additions underlined; deletions struck out):

  1. Paragraph .38:Entities that adopt fresh-start reporting in conformity with paragraph .36 should apply the following principles:
    • The reorganization value of the entity should be assigned to the entity’s assets and liabilities in conformity with the procedures specified by FASB Statement No. 141 (revised 2007), Business Combinations. If any portion of the reorganization value cannot be attributed to specific tangible or identified intangible assets of the emerging entity, such amounts should be reported as goodwill in accordance with paragraph 6 of FASB Statement No. 142, Goodwill and Other Intangible Assets.
    • Each liability existing at the plan confirmation date, other than deferred taxes, should be stated at present values of amounts to be paid determined at appropriate current interest rates.
  2. Paragraph .64:A general restructuring of liabilities involves negotiation between the parties in interest. The negotiation and distribution under the confirmed plan constitutes an exchange of resources and obligations. By analogy, the guidance provided by APB Opinion 16 FASB Statement 141(R) for recording liabilities assumed in a business combination accounted for as a purchase should be applied in reporting liabilities by an entity emerging from Chapter 11.

These seemingly minor changes to SOP 90-7 create a link to existing and new FASB fair value accounting standards that will become effective on December 15th of this year.  The effect is not minor however, and it will change how reorganization value and intangible asset values of distressed companies are determined and reported.  This is particularly relevant in a bankruptcy setting, because the values reported in accordance with SOP 90-7 are the very same ones that appear in the disclosure statement, plan of reorganization, and are submitted as evidence to support or defend against various motions that ultimately determine claimholder recoveries.

To the extent that the values determined under generally accepted accounting principles (GAAP) will continue to be used and accepted by bankruptcy courts and creditors in negotiating asset values in relation to adequate protection, fraudulent transfers, avoidable preferences, equitable subordination and confirmation of a plan, a claimholder’s command of the new valuation requirements and acceptable methodologies will be a critical determinant of a successful recovery. This is even more important since the passage of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, which limits a debtor’s ability to obtain extensions of the exclusive period to file and solicit acceptance of its own plan of reorganization.

Intended to benefit the users of financial statements generally, the increased rigor of the valuation methodology mandated by the recent FASB pronouncements can be expected, through their application to fresh start accounting rules, to increase the importance of actively participating in the valuation process in a bankruptcy or out of court restructuring. To understand why this is so, it is helpful to understand some of the major provisions of FAS 141R and FAS 157, and how they might interact with SOP 90-7 in a reorganization setting.

FAS 141R turns one of the oldest generally accepted accounting principles on its head. The conservatism principle essentially mandates that estimates of asset value should be the lower of two traditional reference points- cost or market value. For acquired companies (and now companies emerging from Chapter 11) however, FAS 141R will require asset and liability values to consist of estimates that reflect the fair value standard as defined by FASB Statement No. 157, Fair Value Measurement (FAS 157).  The two statements are coordinated: FAS 141R specifies what assets and liabilities must be identified and valued in an acquisition scenario, and then directs us to FAS 157 for guidance on how those value estimates should be made.

The result is that asset values will be reported at fair value, even if the sum of the parts is different than the cost paid by the acquirer. FAS 141R requires immediate recognition of this difference in the form of a gain or loss reported on the new or emerging entity’s opening income statement.  Some of the other significant changes introduced by FAS 141R are:

  • Transaction costs must be expensed, and not capitalized as part of the purchase price.
  • Contingent consideration (e.g. earnout payments) must be estimated and booked on the balance sheet as an assumed liability, which will increase the amount of goodwill.
  • The value of potential impairments of assets and contingent liabilities must be quantified and recognized.
  • Future restructuring costs will no longer be recognized as an accrued liability, and instead must be expensed in the period they are incurred.

Arriving at these estimates will be challenging for any acquirer, and to the extent they will determine reorganization value, soliciting agreement among claimholders will be particularly challenging.

For example, to predict the amount for which a lawsuit against the company will be settled, FASB’s Concepts Statement 7 points to the use of a probability matrix as an acceptable methodology, but it does not specify how the probabilities of total victory, partial settlement, or total loss are to be determined. In contrast, the known restructuring costs to be incurred as part of a reorganization will not be reported on the balance sheet, although they will surely enter into the reorganization value analysis as a predictable and quantifiable reduction in cash flow.  The effect of any inaccuracies in the estimates made under FAS 141R will extend to future years because periodic fair value adjustments to the assets and liabilities must be reported on the income statement as gains, losses, expenses and income.

The full effect of these changes on the reorganization and restructuring process remains to be seen, but they will increase the focus on the valuation analysis and its power as a negotiating tool. This should present significant opportunities for well-informed claimholders to identify undervalued or overvalued assets, and to improve their prospects for recovery.

FAS 159 and SOP 90-7 create a link to the other FASB fair value standards that will change how asset and liability values of financially distressed companies are determined and reported. This will present significant opportunities for well-informed creditors and debtors to identify undervalued or overvalued assets, and to proactively improve their respective positions in a restructuring scenario.

For more information, contact us at info@anewvalue.com.