Increasing numbers of businesses are turning to the U.S. Bankruptcy Code for economic survival. Bankruptcy filings for the year ending June 30, 2022 were 35% higher than the previous year-to-year period ending June 30, 2021. The ongoing challenges in the economy continue to impact individuals and businesses significantly. Within that same time span, Chapter 11 bankruptcies alone witnessed a five percent increase. To successfully navigate the Chapter 11 process, a business is required to present a reorganization plan for court approval. Emerging from Chapter 11 involves addressing numerous critical issues, such as determining the company's "reorganization value."
Reorganization value generally approximates fair value of the entity before considering liabilities, and approximates the amount a willing buyer would pay for the assets of the entity immediately after the restructuring Reorganization value also addresses the amount of resources currently and potentially available to satisfy post-petition liabilities and allowed claims. It encompasses the sum of the value attributed to the reconstituted entity and other assets of the debtor not included in the reconstituted entity.
The Absolute Priority Doctrine
The Absolute Priority Doctrine provides that if an impaired class does not vote in favor of a plan, the court may confirm the plan under the cram-down provisions of the Bankruptcy Code. The doctrine states that all members of a senior class of creditors must be satisfied in full before the next senior class of creditors can receive anything and, in turn, the next senior class must be fully satisfied before the third senior class receives any value, and so on. In addition, if the amount of post-petition liabilities and allowed claims exceeds the reorganization value of the emerging entity, existing shareholders lose their legal right to any economic interest. That right can only be reinstated with the consent of creditors. Consequently, upon emergence from Chapter 11, the entity is required to adopt fresh start reporting.
Financial Reporting Consequences
Accounting Standards Codification (ASC) 852 addresses the financial reporting requirements required by U.S. GAAP for fresh start reporting. It requires that the value of the emerging entity be determined using the Fair Value standard and specifically discusses use of the Discounted Cash Flow (DCF) method of valuation.
One of the primary components of the DCF method is the development of forecasted financial statements. When forecasting the outcome of an emerging entity, it would not be good to rely on pre-petition financial statements. The pre-petition entity is likely to be radically different from the emerging entity. Instead, the following elements should be considered:
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- The costs of corporate restructuring and other operating program changes
- Limitations on the use of available net operating loss carryovers and other tax attributes resulting from the reorganization plan and other events
- The anticipated discounted residual value at the end of the forecast period based on the capitalized cash flows for the final year of the period
- Market share and position
- Competition and general economic considerations
- Forecasted sales growth
- Potential profitability
- Seasonality and working capital requirements
Fresh start reporting is not an altogether typical appraisal process. It requires technical ability in the form of understanding the value drivers of a business, the ability to translate those drivers into meaningful relationships and, ultimately, the use of those factors to forecast financial statements of a business while taking the GAAP treatment of the issues into consideration. The ultimate determination of value is subject to the scrutiny of the Bankruptcy Court, as it must be measured against the post-petition debts and claims of the petitioner.
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