A Simplified Approach to the Best-interests Test in Complex Bankruptcies

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Apr 2003

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In order for a reorganization plan to be confirmed by the bankruptcy court, the
plan proponent (ordinarily the debtor) must demonstrate that the plan is in the
best interests of the creditors. Specifically, §1128(a)(7) of the
Bankruptcy Code requires that the creditor, "with respect to each
impaired class of claims or interests, (i) has accepted the plan or (ii) will
receive or retain under the plan on account of such claim or interest property
of a value, as of the effective date of the plan, that is not less than the
amount that such holder would receive or retain if the debtor were liquidated
under chapter 7 of this title on such date."

The best-interests test analysis is therefore focused on performing a hypothetical
liquidation analysis of the debtor, commencing at the effective date of the
plan. The results obtained from this hypothetical liquidation are then compared
to the distributions proposed under the plan. If the estimated plan distributions
exceed the hypothetical recoveries to each class of creditors or
interest-holders under the hypothetical chapter 7 liquidation, then the plan is
deemed to be in the best interest of the creditors. In other words, creditors
are better off with the plan than they would be if, in the alternative, the
debtor were liquidated.

In most large corporate bankruptcies, there are multiple debtors over a number of
cases. In some complex cases, the number of filed entities can range from
hundreds to even thousands. In such cases, it is not uncommon for the filing
entities to be "administratively" consolidated in first-day orders
as a means for minimizing administrative costs. This means that while
individual bankruptcy cases continue to exist, administratively the cases are
treated as one. Since many of these large companies conduct their business as
one entity and operate with a consolidated cash-management system,
administrative consolidation makes practical sense. Further, at the point of
filing the reorganization plan in such large cases, especially consensual
plans, the debtors are "substantively" consolidated, meaning the
estates are consolidated for purposes of voting and confirming a reorganization
plan. However, the best-interests test analysis is a hypothetical chapter 7
liquidation, and arguably, each filed entity must be liquidated as a separate
estate. The consequence of this requirement for the turnaround practitioner
could be overwhelming if, in turn, the practitioner were required to prepare a
liquidation analysis for each debtor entity.

We think that a more appropriate and practical approach to addressing multiple
debtor analyses is to group the entities into logical groupings based on
commonalities of claimants. In many cases, the hundreds or thousands of
entities can be grouped into just a few entities based on common claimants.
Banks may have guarantees from a subset of entities. Claimants may be
distinguished based on business divisions that correspond to groups of filed
entities. Grouping the entities based on logical groupings has several
advantages to the practitioner: (1) it reduces the complexity of the task to a
manageable level without sacrificing the precision of the outcome, (2) it makes
the analysis and its conclusions more easily understood by the various
constituencies that will be evaluating the information and thus serves to
accommodate agreement on the conclusions, and (3) it puts the analysis into a
format that can be presented clearly and concisely. This approach is generally
consistent with elements the courts consider in deciding whether substantive
consolidation is appropriate.

<h3>The Liquidation Analysis Framework</h3>

The first step in developing the liquidation analysis is to develop the analytical
framework used in preparing both a consolidated and deconsolidated estimate of
recoveries. This framework consists of three key elements: (1) gross proceeds
from recoveries, (2) costs associated with obtaining the recoveries and (3) the
distribution of the net recoveries to claimants. It is advisable to organize
the analysis into a logical "waterfall" that flows much like a
statement of revenue and expense, with summary information provided in the body
of the analysis and detailed calculations provided in the form of supporting
schedules, endnotes or footnotes. For example, a logical flow in an analysis
may be as follows:

<h3>The Consolidated Analysis</h3>

A great deal of attention should be given to the development and documentation of
the liquidation assumptions to be reflected in the consolidated analysis. The
credibility of the entire analysis rests on these assumptions. A plausible
liquidation scenario requires not only an assessment of the liquidation value
of the company's assets, but also the timeframe and operating
requirements for achieving those values.

Since the analysis intends to establish a reasonable range for likely recoveries, at
least two liquidating scenarios should be developed to establish both a
"high" and "low" estimate of recovery value. In
establishing the recovery range, the normal convention is to match the
high-proceeds estimate with the high-claims estimate. From the estimation of
asset proceeds down through the estimation of general unsecured claims, the
lowest dollar values all are contained in the low-range estimate, and the
largest dollar values are contained in the high-range estimate. An alternative
method for establishing the low and high range is to net the lowest proceeds
from asset liquidations against the highest expense and claims estimates (low),
and to net the highest proceeds from asset liquidations against the lowest
estimates for expenses and claims (high). This alternative method generally
results in a wider range of recoveries.

In deciding which method to use, the turnaround practitioner would be well advised
to consider the impact on the various constituents in adopting a particular
convention. For example, if a matching of high proceeds/low claims and low
proceeds/high claims approach is adopted, the resulting wide range of recovery
value could produce a high recovery estimate that brushes up against or
surpasses the reorganized company's projected enterprise value. While
this possibility in and of itself is not a particular problem, the reality of a
liquidation effort resulting in maximum recoveries and low claims is fairly
remote, particularly in complex cases. Therefore, to adopt such an approach
could possibly lead one to reach a "false positive" conclusion for
liquidation. Of the two approaches noted above, our belief is that the high
proceeds/high claims and low proceeds/low claims approach generates a more
realistic estimate, as it is more likely that recoveries and claims will come
in both higher and lower than expected and will generate a result that will
fall within the range established by the high proceeds/high claims and low
proceeds/low claims approach.

While the analysis will ultimately be viewed on an unconsolidated basis, estimating
gross proceeds from asset liquidations and other sources is best determined on
a consolidated basis. Using a consolidated approach is not only easier to model
but will, in all likelihood, portray a more realistic scenario of a liquidation
en masse, regardless of legal-entity asset ownership. In addition to recoveries
from balance-sheet assets, additional contributions to gross proceeds can come
from proceeds from litigation, the sale of non-balance-sheet assets such as
customer lists and proceeds from avoidance actions such as those associated
with recoveries of preference-period transactions. The law of preferential
transfers is a unique but potentially controversial provision of the Bankruptcy
Code. Special care needs to be taken in evaluating potential preference
recoveries. Frequently this is a highly contentious issue in the reorganization
plan, and the liquidation estimate for potential preference recoveries is
sometimes taken out of context, as certain creditors may view the preference
recoveries in liquidation as a more viable means for maximizing recoveries.
Similarly, if the estimate of potential preference recoveries is unusually
high, creditor classes not subject to preference actions may be less inclined
to waive their rights to pursuing these actions while those creditor classes
subject to potential preference actions insist on such waivers as a condition
for supporting any plan. Recognizing the potential for such controversy, when
developing an estimated range for preference recoveries, one should consider
not only the pool of preference period payments but also the likely defenses
against such actions.

The assumptions developed in establishing the liquidating scenarios should be used
as a basis for determining the detailed estimate of the expenses associated
with achieving the gross recoveries. The hypothetical liquidation can be broken
down into discrete phases such as an asset-liquidation phase, a corporate
wind-down phase and a bankruptcy wind-down phase.

In most liquidation and wind-down scenarios, there will be a need to retain key
employees. Retaining those key employees to execute the liquidation plan can
prove challenging. Accordingly, it is appropriate to construct appropriate
retention and severance programs to induce these key employees to remain with
the company for the duration of each phase for which they are required. It
would not be unreasonable to craft a plan by wind-down phase that can pay
employees bonuses of 50 percent or higher on their base wages for that
liquidation phase as an inducement to stay through the end of a particular
phase. The retention and severance plan should be viewed as a necessary
insurance premium for achieving the maximum amount of gross proceeds in the
asset-liquidation effort.

Like the estimation of gross and net proceeds, the estimate of general unsecured
claims should be presented in the form of both a high and low estimate with the
recoveries on those claims being shown in terms of both dollars and as a
percentage of the total claim or claim category.

<h3>The Unconsolidated Analysis</h3>

While the unconsolidated analysis is an analysis completely separate from the
consolidated analysis, its preparation should follow that of the consolidated
analysis, as it is developed off of the assumptions developed in and recoveries
projected from the consolidated analysis.

Following the determination of which, if any, of the debtor entities are to be grouped
together for purposes of the analysis, the initial task is to be able to
construct a pro forma balance sheet for
each legal entity. This may prove problematic as very few companies maintain
financial records or prepare financial projections on a legal-entity basis. In
the case where neither the company's corporate planning nor the
accounting departments maintain such records and projections, the corporate tax
department likely will have prepared an annual balance sheet by legal entity
for state compliance purposes. Using these balance sheets as a starting point,
along with certain key assumptions regarding allocation of interim results, the
legal-entity balance sheets may be projected forward to the date of the commencement
of the hypothetical liquidation. Particular attention should be placed in
rolling forward the intercompany accounts that could play a key roll in the
outcome of the deconsolidated analysis. The resulting pro forma legal-entity balance sheets will serve as the basis
for preparing the unconsolidated analysis, and therefore a high level of detail
and accuracy must be placed into preparing these statements.

The framework of assumptions established in preparing the consolidated analysis
should also serve as the framework for the unconsolidated analysis. Within this
framework, a combination of entity-specific information from the legal-entity
balance sheets and prorated information from the consolidated analysis will be
used as a basis for determining, at the legal-entity level, the proceeds
available to and the value of each class of claims. To illustrate this concept,
assume that one legal entity must
be deconsolidated from the consolidated entity because that entity has provided
guarantees on certain debt that might allow for its creditors to receive a
higher distribution on their claims than in a consolidated liquidation. Thus,
in this example, the result would be two unconsolidated entities: the
"guarantor entity" and the "non-guarantor entity."

A review of the legal-entity-level balance sheets for the guarantor entity would
likely result in the determination that certain asset categories may be pulled
directly from the balance sheet into the best-interests test analysis. On a
claims side, the same rationale holds true. There will be certain liabilities
that can be directly attributed to the specific legal entity under analysis.
For assets and liabilities that cannot be traced to a specific legal entity yet
clearly are attributable to the deconsolidated entity, a value can be estimated
by applying an allocation method such as percentage of total assets or
percentage of total inventory. This allocation method can also be used for
claims such as the debtor-in-possession facility, administrative claims, priority
claims and certain unsecured claims that are not attributable directly to a
specific legal entity. This allocation method should also be used to allocate a
portion of the corporate expenses, wind-down expenses and professional fees
developed in the consolidated analysis to the best-interests test analysis for
the guarantor entity.

Once the guarantor entity analysis has been prepared, the analysis for the
non-guarantor entity is calculated as the difference between the consolidated
best-interests test analysis and the guarantor entity best interests test
analysis. In essence, the guarantor-entity analysis sweeps out that portion
that belongs to the guarantor entity, and therefore the remainder is assumed to
belong to the non-guarantor entity. The results of the unconsolidated analysis
allow independent views of the theoretical liquidation of both guarantor and
non-guarantor entities.

One part of the unconsolidated analysis that requires special attention is the
interaction between the company's intercompany accounts. The intercompany
accounts play a major role in determining the analysis results. When the
analysis is performed on a consolidated level, the intercompany accounts are
not an issue because they are eliminated. However, in the deconsolidation
process, both the pre-petition and post-petition intercompany accounts may play
a major role in determining the recoveries available to each legal entity. It
is important to note that in a deconsolidated scenario, the post-petition
intercompany claims are treated as administrative claims and are satisfied
before the unsecured claims of that legal entity.

<h3>Presentation of Results</h3>

The results of preparing both the consolidated and unconsolidated analysis are two
separate recovery scenarios. Since the purpose of performing the deconsolidated
analysis is to demonstrate the results of liquidating the entities separately,
how are these two analyses reconciled? A complete reconciliation should be
performed as part of the analysis. The reconciliation is complicated by
several factors. First, the total recoveries will be greater for the
unconsolidated case on account of recoveries on intercompany claims that do not
exist for the consolidated case. Second, the total claims pool will be greater
for the unconsolidated case than the consolidated case, again on account of the
inclusion of intercompany claims in the unconsolidated analysis that are
excluded from the consolidated analysis. Finally, in some deconsolidation
analyses, one or more of the entities may be administratively insolvent, even
though the consolidated entity is administratively solvent. This partial
insolvency causes further variations on recovery rates between the consolidated
and deconsolidated cases.

It is our view that presenting this complex reconciliation is beyond the scope of
the presentation of the liquidation analysis in the disclosure statement to the
reorganization plan. The reconciliation should be a part of the working papers
and is a useful tool for helping other advisors in the case understand the
liquidation analysis. The results of the liquidation analysis should be
presented in a summary format with the consolidated results adjusted up or down
to reflect the effects of the deconsolidation. An example of this presentation
is shown below.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> Tom Morrow is a senior associate
with AlixPartners LLC and has more than 18 years of experience providing
expertise in financial, operational and business analysis, loan workouts and
restructurings, and creditor negotiations. <a href="#1a">Return to article</a>

<a name="2">2</a> Tim Kreatschman is a senior
associate with AlixPartners LLC and has assisted a wide variety of companies in
the creation, enhancement, maximization, recovery and realization of enterprise
and shareholder value. <a href="#2a">Return to article</a>

<a name="3">3</a> Mark Hojnakci is a consultant with
AlixPartners LLC. He is skilled in executing quantitative and qualitative
analysis and provides a wide range of financial services to a diverse industry
set. <a href="#3a">Return to article</a>

Journal Authors

Mark W. Hojnacki

Thomas A. Morrow

Timothy Kreatschman

Journal Date

Tuesday, April 1, 2003 - 12:00

Bankruptcy Rule

2003