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.

The Liquidation Analysis Framework

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:

The Consolidated Analysis

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.

The Unconsolidated Analysis

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.

Presentation of Results

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.

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Footnotes

¹ 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. Return to article

² 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. Return to article

³ 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. Return to article