In the last few years, there has been an increase in the number of bankruptcy filings related to companies in the health care services and medical/ pharmaceutical products market segments. While the recent number of filings in this industry are less than the "record" numbers of annual filings in the late 1990s, the current trend indicates an increase (not a decrease) in health care-related filings. A number of factors have contributed to this recent increase in health care/pharmaceutical industry bankruptcies. These factors include (1) a generally stagnant economy, (2) an increase in foreign competition, (3) overcapacity (and the related price competition) in the domestic market segments, (4) continually increasing R&D expenditure requirements and (5) the increasing costs of debt and equity financing. The bankruptcy of a health care or pharmaceutical industry company often involves the valuation of the assets, properties and business interests included in the bankruptcy estate. This article summarizes many of the reasons for conducting a valuation of the health care or pharmaceutical company business or assets for bankruptcy purposes. However, this article is not intended to provide a comprehensive listing of all of the reasons to conduct a bankruptcy-related valuation. This article also summarizes some of the industry-specific factors that the analyst should consider in the bankruptcy valuation of a health care or pharmaceutical company.

The Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) involves significant changes to the Bankruptcy Code regarding business bankruptcies. Accordingly, this is an appropriate opportunity to review some of the valuation aspects of corporate bankruptcies.

Reasons to Conduct a Bankruptcy Valuation

1. Adequate Protection of Creditor Security Interests. Under the Code, a creditor with a secured claim is entitled to adequate protection of the property interests when that creditor requests relief from the §362 automatic stay. Immediately after the bankruptcy petition, the §362 automatic stay generally bars all debt-collection efforts against the debtor corporation on the bankruptcy estate. Adequate protection for the creditor property interest is also required before the debtor-in-possession (DIP) or the bankruptcy trustee can use, sell or lease certain kinds of collateral.

One of the provisions related to creditor "adequate protection" specifically concerns the value of the creditor's collateral. If the value of the creditor's collateral property will decrease during the bankruptcy proceedings, then the bankruptcy trustee may be required to make payments to the creditor in order to provide for that adequate protection. However, with regard to this creditor collateral valuation, the Code does not specify either (1) what business/asset valuation methods are to be used or (2) what is the appropriate valuation date to be used.

For purposes of ensuring adequate protection, the courts have allowed various premises of value with regard to the valuation of the creditor's secured claim. For example, various courts have allowed as acceptable premises of value with regard to the valuation of a creditor's collateral a (1) going-concern value, (2) wholesale price indication of value and (3) sale price at a court-ordered asset sale. Within the going-concern premise of value, the courts have generally accepted the income approach/discounted cash-flow method to value the creditor's security interest.

2. "Splitting" Undersecured Creditor Claims. This "splitting" procedure occurs when the fair market value of a secured creditor claim is less than the face amount of the creditor claim. In that event, the creditor claim is divided into two parts: (1) a secured claim to the extent of the actual collateral market value and (2) an unsecured claim to the extent of the collateral value deficiency. This collateral property valuation should consider both (1) the current use of the collateral property and (2) the proposed disposition or use of the collateral property.

Under the Code, the determination of these factors that affect collateral value should be made in conjunction with a judicial hearing related to (1) the disposition or use of the subject collateral assets or (2) a reorganization plan affecting the creditor security interest. The collateral valuation may affect the creditor's voting power to accept or reject a proposed reorganization plan. In addition, the collateral valuation may affect the amount of distributions made to the creditor under a reorganization plan.

3. Determining Debtor Insolvency. The debtor's insolvency is a required condition for certain actions under the Code. For example, in order for certain payments to creditors to be considered preference items or fraudulent transfers (and therefore voidable), the debtor must be insolvent at the time of the transfer.

Under the Code, the term "insolvent" means that the debtor's liabilities exceed the debtor's assets, at fair value (exclusive of fraudulent transfers), at the time of the transfers. Accordingly, the determination of insolvency requires a valuation of both (1) the debtor's assets (both tangible and intangible) and (2) the debtor's liabilities. The valuation is typically performed as of the date of the transfers from the debtor to the creditor. However, the Code is not specific as to the appropriate valuation approaches, methods or procedures to use with regard to the valuation of the debtor's assets and liabilities.

It is noteworthy that BAPCPA made substantial changes to preference law. In particular, the new law is generally considered to be much more friendly to creditor/defendants. In particular, BAPCPA amends the Code to expand the look-back period for fraudulent transfers for the benefit of insiders who are under employment contracts that are not in the ordinary course of business. A detailed explanation of the changes to §547 (for preference items) and §548 (for fraudulent convenience) is beyond the scope of this valuation discussion. Valuation analysts who perform solvency analyses related to preference or fraudulent transfer claims should review the BAPCPA changes related to §§547 and 548.

4. Determining the Best Interest of a Creditor under Chapter 11. Under the Code, a creditor must (1) accept a reorganization plan or (2) receive/retain property under a reorganization plan that is not less than the amount the creditor would receive/retain if the debtor were in liquidation. The appropriate valuation date for this purpose is the effective date of the reorganization plan. With regard to determining the best interest of the creditor, valuations are typically performed under the premise of value in exchange on an orderly disposition basis—and not under the premise of value in exchange on a forced-liquidation basis.

For this purpose, the premise of value in exchange on a liquidation basis is usually used to determine if the reorganization plan (as opposed to a liquidation plan) is in the best interest of the creditors. However, the valuation premise of value in continued use, as a going concern, is usually used in determining whether a creditor class should accept or reject the reorganization plan.

5. Determining if a Reorganization Plan Is Fair and Equitable to a Dissenting Creditor Class in Chapter 11. To determine whether a proposed reorganization plan is fair and equitable to a dissenting creditor class, values are typically determined for the creditors' collateral. In addition, the present value of expected future payments under the reorganization plan are typically quantified. The present value of the expected future payments is typically determined by discounting the dollar amounts expected to be received under the plan to a present value. However, for this purpose, the Code does not define the basis for determining the appropriate present value discount rate.

If the existing shareholders are to receive nothing under the reorganization plan, then a valuation of the subject business equity may be required. This business valuation is used to demonstrate that the existing stockholders have no equity left in the subject business.

Alternatively, let's assume that the existing shareholders will have control of the debtor corporation after the bankruptcy. In that case, the shareholders either (1) must demonstrate that the unsecured creditors will retain or receive property with a present value equal to the amount of their unsecured claims (to satisfy the "absolute priority rule") or (2) must contribute sufficient "new value" to repurchase control of the debtor (sometimes called the "new value exception" to the "absolute priority rule"). It is noteworthy that some courts have not recognized the so-called "new value exception."

In addition, the debtor corporation's equity valuation is typically important to the determination of whether the proposed reorganization plan is eligible for a "cramdown." In a bankruptcy, of course, a "cramdown" occurs when the court confirms the chapter 11 (or chapter 12 or 13) plan, notwithstanding opposition from the creditors.

6. Determining the Feasibility of the Proposed Reorganization Plan. The feasibility of the proposed reorganization plan relates to the soundness of the proposed capital structure of the debtor. The proposed reorganization plan feasibility also relates to whether the debtor has a reasonable prospect for financial recovery.

Confirmation of the proposed plan may not be approved by the court if the reorganization plan is likely to be followed by (1) the liquidation of the debtor corporation or (2) the need for further financial reorganization of the debtor corporation. Accordingly, a debtor business valuation may be required to demonstrate the feasibility (or reasonableness) of the proposed plan.

7. Bankruptcy Estate Property of Inconsequential Value. The concept of inconsequential value is important in several bankruptcy-related instances. A secured creditor will lose its election to forego the unsecured deficiency claim in exchange for considering all of the claims secured in a chapter 11 proceeding (the so-called "§1111(b)(2) election"). This is true if the secured creditor's interest in the debtor's property is of an "inconsequential value."

As another example, the bankruptcy trustee may abandon (or be required to abandon) property of the bankruptcy estate that is of "inconsequential value" to the estate. Accordingly, a valuation of the debtor corporation assets may be required to demonstrate which assets are of "inconsequential value."

8. Planning Corporate Transactions During the Bankruptcy. Debtor corporation business valuations are typically needed in situations where the DIP (or trustee) is planning a significant corporate transaction, such as a merger or acquisition. Similarly, when assets of the bankruptcy estate are to be transferred in other than an arm's-length transaction, a valuation of the debtor corporation's assets is typically necessary. For example, valuation issues often arise during a §363 sale of the debtor corporation's assets. This occurs even when the §363 transaction involves the sale of the debtor corporation's assets as part of a going-concern business enterprise.

9. Avoidance of Fraudulent Transfers. Transfers by a debtor corporation may be avoided as fraudulent if the assets are transferred for less than their reasonably equivalent value. A fraudulent transfer occurs if the debtor (1) was insolvent or becomes insolvent due to the transfer, (2) was engaged after the transfer in a business with an unreasonably small amount of capital or (3) intended to incur debts that would be beyond the debtor's ability to repay.

In assessing a fraudulent creditor transfer, the "reasonably equivalent value" may consist of (1) property, (2) satisfaction or (3) the securing of either a present or antecedent debt. Accordingly, the determination of a fraudulent transfer may require both (1) a valuation of the property transferred by the debtor corporation and (2) a valuation of the property received by the debtor corporation.

10. Securities Given to a Creditor Class as Part of a Proposed Reorganization Plan. Consideration or compensation distributed under a reorganization plan in a chapter 11 proceeding may consist primarily of securities of the reorganized debtor. The value of these distributed securities, which determines the amount of compensation given to a creditor class, depends on the valuation of the reorganized debtor that the securities represent.

Accordingly, valuations are typically required for both the debtor corporation business enterprise under the plan or reorganization and the particular debtor securities subject to distribution to a creditor class under the reorganization plan.

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[T]he valuation premise of value in continued use, as a going concern, is usually used in determining whether a creditor class should accept or reject the reorganization plan.

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Industry-Specific Valuation Considerations

In a valuation of the debtor corporation business enterprise, securities or assets, the analyst should consider health care or pharmaceutical industry-specific factors. Some of these factors include:

1. the federal and state regulations that affect health care entities, including the Stark laws, Medicare and other program reimbursement requirements, and particular regulations affecting nonprofit health care entities (including the prohibition of transactions involving private inurement);
2. the dichotomous buyer/seller markets in the health care industry involving (1) for-profit entities that price transactions based on an after-tax cost of capital and (2) nonprofit entities that price transactions based on a pre-tax cost of capital but that cannot pay more than fair market value for transactions;
3. the unique intangible assets that exist within health care entities—and the effect of industry regulations (e.g., a prohibition on the payment for physician referrals) on the value of certain intangibles;
4. antitrust considerations with regard to pharmaceutical company mergers and consolidations;
5. the impact of FAA and other governmental regulation with regard to the development, commercialization and transfer of pharmaceutical products; and
6. the economic effects of (a) a prolonged product life cycle development phase, (b) large R&D expenditure requirements and (c) intellectual property protections on pharmaceutical companies.

Valuation analysts should consider these and other industry-specific factors in the bankruptcy valuation of any health care or pharmaceutical company.

Summary and Conclusion

When a health care or pharmaceutical industry entity files for bankruptcy protection, there are numerous reasons to perform a valuation of the bankruptcy estate assets, properties or business interests. This article presented a "top 10" listing of the common reasons to perform a bankruptcy-related valuation. However, it should be noted that this "top 10" list is not intended to be a comprehensive list and is not presented in order of importance or priority.

When one of these "top 10" valuation reasons arises in a bankruptcy proceeding, parties to a health care or pharmaceutical industry bankruptcy (including the debtor, creditors and legal counsel) should retain a valuation analyst who is experienced in bankruptcy-related issues. Valuation analysts are not bankruptcy lawyers, of course. However, the valuation analyst should be generally familiar with the related statutory authority and administrative procedures with regard to a bankruptcy proceeding.

In particular, valuation analysts who regularly practice in the bankruptcy area should be familiar with the changes in the Bankruptcy Code that resulted from the 2005 Act. In addition, parties to the bankruptcy should be aware that there are unique regulatory, accounting and competitive issues that affect health care and pharmaceutical industry valuations. Therefore, the valuation analyst should have specific experience and expertise with regard to the valuation of health care and pharmaceutical industry business, business securities, and tangible and intangible assets.

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