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  • J.B. Heaton

Why Stock Prices Of Insolvent Firms Can Still Be Positive

On Nov. 29, 2017, Cumulus Media Inc. filed for Chapter 11 bankruptcy protection in the U.S. Bankruptcy Court for the Southern District of New York. The stock price had fallen from $1.06 on Dec. 1, 2016, to just over 15 cents per share at the close of trading on the bankruptcy filing date. The market capitalization had fallen from about $30 million to under $3 million. But $3 million is still greater than zero. Was Cumulus solvent when it filed bankruptcy? The answer is almost surely no. It is important that lawyers dealing with firm solvency have a good understanding of the reasons why.

Financial economists have long understood that the equity of an insolvent company will trade for a positive price so long as there is some probability — however small — that the firm will become solvent at a future date, or, more specifically, that the equity will receive some positive return in the future. More than 40 years ago, option-pricing scholars Fischer Black, Myron Scholes and Robert Merton[1] demonstrated how a firm’s equity can be viewed as a call option on the firm’s underlying assets, with the amount of the debt repayment obligation as the strike price. That call option can have value even when it is deeply “out-of-the-money,” that is, when the firm is quite insolvent. As Judge Frank Easterbrook put it in his characteristically colorful way, “A stumblebum would pay 1 cent for the most hopelessly insolvent firm, as the deal puts none of the bum’s nonexistent assets at risk and could pay off if the debtor unexpectedly strikes it rich."[2] Or as a bankruptcy court put it recently, referring to a plaintiff’s expert’s explanation, “equity market cap may simply reflect ‘option value’ created by investors who think there is little to lose (because the stock price is low) and much to gain (if, against all expectations, the stock price skyrockets), rather than any actual present-day value.”[3]

In a recent article forthcoming in the Journal of Forensic Economics, I use a simple model to show why a positive equity value does not imply solvency under either of two widely used legal solvency tests. That paper’s goal is to link a well-known insight from financial economics to the legal solvency tests that matter in litigation and regulatory proceedings. This is of importance as market evidence becomes more important in solvency litigation[4] and as directors continue to face important questions of shifting fiduciary duties when a firm becomes insolvent.[5]

Legal Solvency Tests

Two solvency tests appear in bankruptcy and corporate law.[6] First is a test of whether the fair value of a firm’s assets exceed the face value of its liabilities (the balance-sheet solvency test, performed on either a going-concern or liquidation basis). Second is a test of whether a firm reasonably can be expected to pay its debts as they come due (the ability-to-pay solvency test, sometimes referred to as cash-flow solvency or equitable solvency). Courts typically describe solvency as a question of fact.[7]

The balance-sheet solvency test asks whether the value of the firm’s assets is greater than the face value of its liabilities. When the U.S. Bankruptcy Code defines the word “insolvent” it calls it the “financial condition such that the sum of such entity's debts is greater than all such entity's property, at a fair valuation.”[8] Fair valuation, in practice, means the application of standard valuation methods, including discounted cash flow and multiples-based valuation for going-concern businesses. Debts are valued at face value for purposes of the balance-sheet solvency test,[9] contingent liabilities are discounted for their probability of occurrence,[10] and a positive accounting book balance does not imply solvency.[11]

The ability-to-pay solvency test asks if the firm can reasonably expect to pay its debts as they come due. In the federal fraudulent conveyance statute, for example, the question is whether the firm “intended to incur, or believed that [it] would incur, debts that would be beyond [its] ability to pay as such debts matured.”[12] The Uniform Fraudulent Transfer Act states the test similarly, whether the transferor “intended to incur, or believed or reasonably should have believed that the debtor would incur, debts beyond the debtor's ability to pay as they became due.”[13] The Uniform Fraudulent Conveyance Act, still the law in New York, asks whether the debtor “intends or believes that he will incur debts beyond his ability to pay as they mature.”[14] It is a forward-looking test: it is not enough to be able to meet current obligations; the firm must be able to meet its future obligations as well.

Equity Prices Can Be Positive for an Insolvent Firm Under Either Solvency Test

While it is well-understood among financial economists that the equity of even an insolvent company may trade for a positive price so long as there is some probability that the firm will become solvent at some future date, that insight derives from models that generally consider the firm to be in default under conditions that do not mirror legal solvency tests applied in, for example, fraudulent transfer litigation.[15] In my forthcoming paper, I establish two basic propositions in the context of legal solvency tests. First, I establish that positive equity value does not imply balance-sheet solvency. Second, I establish that positive equity value does not establish ability-to-pay solvency.

As for the balance-sheet solvency test, the firm is insolvent when the value of its assets is less than the face value of its debts. We can think of the value of its assets a probability-weighted “average” of all possible future values of the assets. If the average of those values — the market value of the assets — is less than the face value of the debt, then the firm is balance-sheet-insolvent. But if there are some possibilities where the assets exceed the face value of the debt, and those possibilities have positive (though possibly very small) probability attached to them, then the equity will trade for a positive value notwithstanding the balance-sheet insolvency.

As for the ability-to-pay test, the firm is insolvent when it is not expected to pay its debts when they come due. We can think of this as requiring that there be a sufficiently high probability that the firm can pay the maturing debts. Suppose that probability was 50 percent, that is, the firm must be at least 50 percent likely to pay its maturing debts to be solvent under the ability-to-pay test. In that case, the firm is ability-to-pay-insolvent if the probability of paying maturing debts is only 10 percent. But that 10 percent probability of paying the debts when they mature — if it will leave excess assets available after debt repayment — will generate a positive equity price as well.

Dealing with Market Evidence in Solvency Litigation

Understanding how insolvency can be reflected in market prices is critical in solvency litigation. I know from personal litigation experience how an adversary’s failure to properly understand the market evidence can cost the adversary dearly in terms of the settlement value of its case. Many experts who perform solvency tests have a poor understanding of the underlying law of solvency tests, while the lawyers who know the law understandably may lack the familiarity with financial economics at play in solvency. Solvency itself is not a well-studied phenomenon in financial economics, and traditional tools like discounted cash flow valuation and comparable companies or comparable transactions can miss important aspects of the solvency inquiry. At the same time, market evidence advocates may miss reasons that prices can make firms appear to be solvent when they are not. For example, in other research currently under submission at a finance journal, I have shown that firms with literally worthless assets can have equity prices that trade with positive prices and debt that trades near par as well, because the values of those securities can reflect the probability of acquisition by an irrational acquirer.[16]

The bottom line is that lawyers dealing with important questions of solvency in bankruptcy litigation and negotiation, and in the boardroom dealing with questions of fiduciary duty, will become even more effective with a deeper understanding of market evidence of solvency.

[1] Black, F., Scholes, M. (1973). The pricing of options and corporate liabilities. J. Pol. Econ. 81, 637-659; Merton, R., (1974); On the pricing of corporate debt: the risk structure of interest rates. J. Finance. 29, 449-470.

[2] Covey v. Commercial National Bank of Peoria, 960 F.2d 657, 660 (7th Cir. 1992).

[3] In re TOUSA Inc., 422 B.R. 783, 827 (Bankr. S.D. Fla. 2009), quashed in part, 444 B.R. 613 (S.D. Fla. 2011), aff’d in part, rev’d in part, 680 F.3d 1298 (11th Cir. 2012). See also In re Aéropostale Inc., 555 B.R. 369, 394 (Bankr. S.D.N.Y. 2016) (“Professor Pritchard opined that based on his review, Aéropostale’s stock had only option value by December 2015 and needed ‘a miracle to turn it around.’”)

[4] Schwartz, M., Bryan, D. (2012). Campbell, Iridium, and the future of valuation litigation. Business Lawyer. 67, 939-955.

[5] See N. Am. Catholic Educ. Programming Found. Inc. v. Gheewalla, 930 A.2d 92, 101 (Del. 2007) (“[T]he creditors of an insolvent corporation have standing to maintain derivative claims against directors on behalf of the corporation for breaches of fiduciary duties.”)

[6] I provide an overview of legal solvency tests in Heaton, J.B. (2007). Solvency tests. Business Lawyer. 62, 983-1006.

[7] See, e.g., In re Weinberg, 410 B.R. 19, 27–28 (B.A.P. 9th Cir. 2009), aff'd, 407 F. App'x 176 (9th Cir. 2010)(“The bankruptcy court's determinations regarding insolvency resolve questions of fact which are reviewed for clear error.”); Taberna Preferred Funding II Ltd. v. Advance Realty Grp. LLC, 45 Misc. 3d 1204(A), 5 N.Y.S.3d 330 (N.Y. Sup. Ct. 2014)(“solvency is a question of fact that cannot be resolved on a motion to dismiss.”)

[8] See 11 U.S.C.A. § 101(32)(A) (West).

[9] See, e.g., Hanna v. Crenshaw (In re ORBCOMM Global LP), Adv. No. 02-1914 (MFW), 2003 Bankr. LEXIS 759, *8 (Bankr. D. Del. June 12, 2003) (holding that “for purposes of determining whether a debtor is insolvent under section 547, the liabilities of the debtor must be valued at face value.”).

[10] In re Xonics Photochemical Inc., 841 F.2d 198, 200-01 (7th Cir. 1988); Covey v. Commercial Nat'l Bank of Peoria, 960 F.2d 657, 660 (7th Cir. 1992).

[11] See, e.g., DeRosa v. Buildex Inc. (In re F & S Cent. Mfg. Corp.), 53 B.R. 842, 849 (Bankr. E.D.N.Y. 1985) (“Asset values carried on a balance sheet, even if derived in accordance with ‘generally accepted accounting principles,’ do not necessarily reflect fair value: ‘Generally accepted accounting principles' are not synonymous with any specific [valuation] policy.”’).

[12] 11 U.S.C.A. §548(a)(1)(B)(III)(West).

[13] Uniform Fraudulent Transfer Act, 7A Pt. II U.L.A. 1, § 4(a)(i) (1984).

[14] Uniform Fraudulent Conveyance Act, 7A Pt. 11 U.L.A. 245 § 6.28 (1918).

[15] See, e.g., In re Tronox Inc., 503 B.R. 239 (Bankr. S.D.N.Y. 2013); Baird (1991). Baird, D. (1991). Fraudulent conveyances, agency costs, and leveraged buyouts. J. Legal Studies. 20, 1-24.

[16] J.B. Heaton, Worthless Companies, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3070575.