The Valuation Paradox


In the program Who Killed the Company? Tips and Trends in Claims and Defenses, Judge Marvin Isgur and his fellow panelists confronted issues such as in pari delicto, insurance coverage and waiver of fiduciary duties. However, one discussion led by Judge Isgur focused on whether solvency should be determined based on what was known at the time of the valuation or what was known at a later date. The discussion highlighted that valuation can be a moving target based on what is known at a given point in time. 

Judge Isgur gave an example from his life before he became a lawyer. In 1984, the price of oil took a precipitous drop causing Houston to lose 300,000 residents. The day before oil collapsed, an apartment complex might be valued at $10 million based on comparable sales. However, there were no comparable sales for the next two years. When property started moving again, the same apartment complex would sell for $1.5 million. So what was the complex worth during the intervening years? If viewed based on the latest comparable sales, it would be worth $10 million. However, there were no willing buyers and willing sellers at this or any other price. A cynic might say that the apartment complex was worth $0 since there were no buyers at any price. However, this was clearly wrong because the real estate and the improvements clearly had some value. When real estate started moving again, it had a value of $1.5 million. Did it drop 85% in one day or was there a curve of declining value which only became apparent in retrospect?

Judge Isgur gave a second example of an unknown liability. A company sold tainted grape juice which ultimately killed many people. If a solvency analysis were prepared on the day the first toxic juice hit stores, the company might appear solvent because the nature of the liability was unknown. Once the claims were liquidated years later, the extent of the liability and its impact on solvency would become known. However, how would a solvency analysis value the company while the crisis was still ongoing?Perhaps an epidemiologist could extrapolate the total number of expected deaths and injuries from the number of gallons sold and then a litigation expert could estimate the value of each type of injury. However, the true nature of the liability would only be known in retrospect. 

I think that the point Judge Isgur was making (and this is my interpretation) is that sometimes valuation can only be seen in hindsight and will change as more information is received. In the absence of an efficient market, valuation at different points in time may be little more than an educated guess until sufficient information is received.  

He gave another example of a case where he performed a valuation at one point and then after the case was reversed, he made another finding of valuation on remand. Both valuations were based on the same point in time. However, because he had more information at the time of the second valuation, the amounts differed. The first valuation wasn't wrong; it was simply based on incomplete information. As more information was developed, the valuation would become more refined. Thus, the valuation of a specific asset at a specific point in time might vary dramatically based on the information available. While there may only be one "true" valuation, that number might only become apparent some time after the fact.

The same theme was picked up in the panel on The Next Generation of Bankruptcy Cases. While there is a general presumption that cases should proceed swiftly, in a case filed during a period of economic uncertainty, delay may be the best course.  The Covid pandemic turned the world on its head. Hertz filed its bankruptcy case on May 22, 2020 during the early days of the pandemic. Had the case gone to a prompt resolution, there probably would not have been enough funds to pay all creditors. Because the case was allowed to move more slowly, the case paid all creditors in full and returned money to equity. What this illustrates is that at the time Hertz filed its bankruptcy, its true value was unknown due to the unprecedented event of a once in a century pandemic. Its value was always there but it couldn't be seen at the time. Because Hertz was not required to be valued at a time when the true value was unknown, it avoided a negative result. On the other hand, if the company had not had the resources to weather the Covid storm, it could have crashed and burned before its true value was realized.

It seems like valuation is a bit like Shrodinger's Cat.