Valuation of Health CarePharmaceutical Entities for Bankruptcy Purposes

Journal Issue

Mar 2006

Column Name

Value & Cents

Citation

ABI Journal, Vol. XXV, No. 2, p. 38, March 2006

Topic Tags

Health Care

Journal HTML Content

In the last few years, there has been an
increase in the number of bankruptcy filings related to companies in the
health care services and medical/ pharmaceutical products market
segments. While the recent number of filings in this industry are less
than the "record" numbers of annual filings in the late 1990s, the
current trend indicates an increase (not a decrease) in health
care-related filings. A number of factors have contributed to this
recent increase in health care/pharmaceutical industry bankruptcies.
These factors include (1) a generally stagnant economy, (2) an increase
in foreign competition, (3) overcapacity (and the related price
competition) in the domestic market segments, (4) continually increasing
R&D expenditure requirements and (5) the increasing costs of debt and
equity financing.
The bankruptcy of a health care or pharmaceutical industry company often
involves the valuation of the assets, properties and business interests
included in the bankruptcy estate. This article summarizes many of the
reasons for conducting a valuation of the health care or pharmaceutical
company business or assets for bankruptcy purposes. However, this
article is not intended to provide a comprehensive listing of all of the
reasons to conduct a bankruptcy-related valuation. This article also
summarizes some of the industry-specific factors that the analyst should
consider in the bankruptcy valuation of a health care or pharmaceutical
company.

The Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA)
involves significant changes to the Bankruptcy Code regarding business
bankruptcies. Accordingly, this is an appropriate opportunity to review
some of the valuation aspects of corporate bankruptcies.

<h4>Reasons to Conduct a Bankruptcy Valuation</h4>

1. Adequate Protection of Creditor Security Interests. Under
the Code, a creditor with a secured claim is entitled to adequate
protection of the property interests when that creditor requests relief
from the §362 automatic stay. Immediately after the bankruptcy
petition, the §362 automatic stay generally bars all
debt-collection efforts against the debtor corporation on the bankruptcy
estate. Adequate protection for the creditor property interest is also
required before the debtor-in-possession (DIP) or the bankruptcy trustee
can use, sell or lease certain kinds of collateral.

One of the provisions related to creditor "adequate protection"
specifically concerns the value of the creditor's collateral. If the
value of the creditor's collateral property will decrease during the
bankruptcy proceedings, then the bankruptcy trustee may be required to
make payments to the creditor in order to provide for that adequate
protection. However, with regard to this creditor collateral valuation,
the Code does not specify either (1) what business/asset valuation
methods are to be used or (2) what is the appropriate valuation date to
be used.

For purposes of ensuring adequate protection, the courts have allowed
various premises of value with regard to the valuation of the creditor's
secured claim. For example, various courts have allowed as acceptable
premises of value with regard to the valuation of a creditor's
collateral a (1) going-concern value, (2) wholesale price indication of
value and (3) sale price at a court-ordered asset sale. Within the
going-concern premise of value, the courts have generally accepted the
income approach/discounted cash-flow method to value the creditor's
security interest.

2. "Splitting" Undersecured Creditor Claims. This "splitting"
procedure occurs when the fair market value of a secured creditor claim
is less than the face amount of the creditor claim. In that event, the
creditor claim is divided into two parts: (1) a secured claim to the
extent of the actual collateral market value and (2) an unsecured claim
to the extent of the collateral value deficiency. This collateral
property valuation should consider both (1) the current use of the
collateral property and (2) the proposed disposition or use of the
collateral property.

Under the Code, the determination of these factors that affect
collateral value should be made in conjunction with a judicial hearing
related to (1) the disposition or use of the subject collateral assets
or (2) a reorganization plan affecting the creditor security interest.
The collateral valuation may affect the creditor's voting power to
accept or reject a proposed reorganization plan. In addition, the
collateral valuation may affect the amount of distributions made to the
creditor under a reorganization plan.

3. Determining Debtor Insolvency. The debtor's insolvency is a
required condition for certain actions under the Code. For example, in
order for certain payments to creditors to be considered preference
items or fraudulent transfers (and therefore voidable), the debtor must
be insolvent at the time of the transfer.

Under the Code, the term "insolvent" means that the debtor's
liabilities exceed the debtor's assets, at fair value (exclusive of
fraudulent transfers), at the time of the transfers. Accordingly, the
determination of insolvency requires a valuation of both (1) the
debtor's assets (both tangible and intangible) and (2) the debtor's
liabilities. The valuation is typically performed as of the date of the
transfers from the debtor to the creditor. However, the Code is not
specific as to the appropriate valuation approaches, methods or
procedures to use with regard to the valuation of the debtor's assets
and liabilities.

It is noteworthy that BAPCPA made substantial changes to preference
law. In particular, the new law is generally considered to be much more
friendly to creditor/defendants. In particular, BAPCPA amends the Code
to expand the look-back period for fraudulent transfers for the benefit
of insiders who are under employment contracts that are not in the
ordinary course of business. A detailed explanation of the changes to
§547 (for preference items) and §548 (for fraudulent
convenience) is beyond the scope of this valuation discussion. Valuation
analysts who perform solvency analyses related to preference or
fraudulent transfer claims should review the BAPCPA changes related to
§§547 and 548.

4. Determining the Best Interest of a Creditor under Chapter
11. Under the Code, a creditor must (1) accept a reorganization plan
or (2) receive/retain property under a reorganization plan that is not
less than the amount the creditor would receive/retain if the debtor
were in liquidation. The appropriate valuation date for this purpose is
the effective date of the reorganization plan. With regard to
determining the best interest of the creditor, valuations are typically
performed under the premise of value in exchange on an orderly
disposition basis—and not under the premise of value in exchange on
a forced-liquidation basis.

For this purpose, the premise of value in exchange on a liquidation
basis is usually used to determine if the reorganization plan (as
opposed to a liquidation plan) is in the best interest of the creditors.
However, the valuation premise of value in continued use, as a going
concern, is usually used in determining whether a creditor class should
accept or reject the reorganization plan.

5. Determining if a Reorganization Plan Is Fair and Equitable to a
Dissenting Creditor Class in Chapter 11. To determine whether a
proposed reorganization plan is fair and equitable to a dissenting
creditor class, values are typically determined for the creditors'
collateral. In addition, the present value of expected future payments
under the reorganization plan are typically quantified. The present
value of the expected future payments is typically determined by
discounting the dollar amounts expected to be received under the plan to
a present value. However, for this purpose, the Code does not define the
basis for determining the appropriate present value discount rate.

If the existing shareholders are to receive nothing under the
reorganization plan, then a valuation of the subject business equity may
be required. This business valuation is used to demonstrate that the
existing stockholders have no equity left in the subject business.

Alternatively, let's assume that the existing shareholders will have
control of the debtor corporation after the bankruptcy. In that case,
the shareholders either (1) must demonstrate that the unsecured
creditors will retain or receive property with a present value equal to
the amount of their unsecured claims (to satisfy the "absolute priority
rule") or (2) must contribute sufficient "new value" to repurchase
control of the debtor (sometimes called the "new value exception" to the
"absolute priority rule"). It is noteworthy that some courts have not
recognized the so-called "new value exception."

In addition, the debtor corporation's equity valuation is typically
important to the determination of whether the proposed reorganization
plan is eligible for a "cramdown." In a bankruptcy, of course, a
"cramdown" occurs when the court confirms the chapter 11 (or chapter 12
or 13) plan, notwithstanding opposition from the creditors.

6. Determining the Feasibility of the Proposed Reorganization
Plan. The feasibility of the proposed reorganization plan relates to
the soundness of the proposed capital structure of the debtor. The
proposed reorganization plan feasibility also relates to whether the
debtor has a reasonable prospect for financial recovery.

Confirmation of the proposed plan may not be approved by the court if
the reorganization plan is likely to be followed by (1) the liquidation
of the debtor corporation or (2) the need for further financial
reorganization of the debtor corporation. Accordingly, a debtor business
valuation may be required to demonstrate the feasibility (or
reasonableness) of the proposed plan.

7. Bankruptcy Estate Property of Inconsequential Value. The
concept of inconsequential value is important in several
bankruptcy-related instances. A secured creditor will lose its election
to forego the unsecured deficiency claim in exchange for considering all
of the claims secured in a chapter 11 proceeding (the so-called
"§1111(b)(2) election"). This is true if the secured creditor's
interest in the debtor's property is of an "inconsequential value."

As another example, the bankruptcy trustee may abandon (or be
required to abandon) property of the bankruptcy estate that is of
"inconsequential value" to the estate. Accordingly, a valuation of the
debtor corporation assets may be required to demonstrate which assets
are of "inconsequential value."

8. Planning Corporate Transactions During the Bankruptcy. Debtor
corporation business valuations are typically needed in situations where
the DIP (or trustee) is planning a significant corporate transaction,
such as a merger or acquisition. Similarly, when assets of the
bankruptcy estate are to be transferred in other than an arm's-length
transaction, a valuation of the debtor corporation's assets is typically
necessary. For example, valuation issues often arise during a §363
sale of the debtor corporation's assets. This occurs even when the
§363 transaction involves the sale of the debtor corporation's
assets as part of a going-concern business enterprise.

9. Avoidance of Fraudulent Transfers. Transfers by a debtor
corporation may be avoided as fraudulent if the assets are transferred
for less than their reasonably equivalent value. A fraudulent transfer
occurs if the debtor (1) was insolvent or becomes insolvent due to the
transfer, (2) was engaged after the transfer in a business with an
unreasonably small amount of capital or (3) intended to incur debts that
would be beyond the debtor's ability to repay.

In assessing a fraudulent creditor transfer, the "reasonably
equivalent value" may consist of (1) property, (2) satisfaction or (3)
the securing of either a present or antecedent debt. Accordingly, the
determination of a fraudulent transfer may require both (1) a valuation
of the property transferred by the debtor corporation and (2) a
valuation of the property received by the debtor corporation.

10. Securities Given to a Creditor Class as Part of a Proposed
Reorganization Plan. Consideration or compensation distributed under
a reorganization plan in a chapter 11 proceeding may consist primarily
of securities of the reorganized debtor. The value of these distributed
securities, which determines the amount of compensation given to a
creditor class, depends on the valuation of the reorganized debtor that
the securities represent.

Accordingly, valuations are typically required for both the debtor
corporation business enterprise under the plan or reorganization and the
particular debtor securities subject to distribution to a creditor class
under the reorganization plan.

<blockquote><blockquote>
<hr>
<big><center>
[T]he valuation premise of value in continued use, as a going concern,
is usually used in determining whether a creditor class should accept or
reject the reorganization plan.
</center></big>
<hr>
</blockquote></blockquote>

<h4>Industry-Specific Valuation Considerations</h4>

In a valuation of the debtor corporation business enterprise,
securities or assets, the analyst should consider health care or
pharmaceutical industry-specific factors. Some of these factors include:

<ol>
<li>the federal and state regulations that affect health care entities,
including the Stark laws, Medicare and other program reimbursement
requirements, and particular regulations affecting nonprofit health care
entities (including the prohibition of transactions involving private
inurement);
</li><li>the dichotomous buyer/seller markets in the health care industry
involving (1) for-profit entities that price transactions based on an
after-tax cost of capital and (2) nonprofit entities that price
transactions based on a pre-tax cost of capital but that cannot pay more
than fair market value for transactions;
</li><li>the unique intangible assets that exist within health care
entities—and the effect of industry regulations (e.g., a
prohibition on the payment for physician referrals) on the value of
certain intangibles;
</li><li>antitrust considerations with regard to pharmaceutical company
mergers and consolidations;
</li><li>the impact of FAA and other governmental regulation with regard to
the development, commercialization and transfer of pharmaceutical
products; and
</li><li>the economic effects of (a) a prolonged product life cycle
development phase, (b) large R&D expenditure requirements and (c)
intellectual property protections on pharmaceutical companies.
</li></ol>

Valuation analysts should consider these and other industry-specific
factors in the bankruptcy valuation of any health care or pharmaceutical
company.

<h4>Summary and Conclusion</h4>

When a health care or pharmaceutical industry entity files for
bankruptcy protection, there are numerous reasons to perform a valuation
of the bankruptcy estate assets, properties or business interests. This
article presented a "top 10" listing of the common reasons to perform a
bankruptcy-related valuation. However, it should be noted that this "top
10" list is not intended to be a comprehensive list and is not
presented in order of importance or priority.

When one of these "top 10" valuation reasons arises in a bankruptcy
proceeding, parties to a health care or pharmaceutical industry
bankruptcy (including the debtor, creditors and legal counsel) should
retain a valuation analyst who is experienced in bankruptcy-related
issues. Valuation analysts are not bankruptcy lawyers, of course.
However, the valuation analyst should be generally familiar with the
related statutory authority and administrative procedures with regard to
a bankruptcy proceeding.

In particular, valuation analysts who regularly practice in the
bankruptcy area should be familiar with the changes in the Bankruptcy
Code that resulted from the 2005 Act. In addition, parties to the
bankruptcy should be aware that there are unique regulatory, accounting
and competitive issues that affect health care and pharmaceutical
industry valuations. Therefore, the valuation analyst should have
specific experience and expertise with regard to the valuation of health
care and pharmaceutical industry business, business securities, and
tangible and intangible assets.

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Journal Authors

Robert F. Reilly

Journal Date

Wednesday, March 1, 2006 - 12:00

Bankruptcy Rule

valuation

2006

none