August 6, 2014

Genco Shipping Valuation Leaves Equity Interests Under Water

A chapter 11 plan can only be confirmed if it does not discriminate unfairly and is “fair and equitable” to any non-accepting impaired class. In this case, the issue was whether the debtor’s projected “reorganization value” exceeded its debts such that the class of equity interests was entitled to a recovery. In re Genco Shipping & Trading, Ltd.[1] presented the court with a complex question of value because the debtors’ industry offered few reliable benchmarks for projecting future earnings – usually the key metric in valuation analysis. The speculative nature of rates for the debtors’ dry bulk shipping business made discounted cash flow (DCF) estimates unreliable and the court instead gave the most weight to an alternative methodology, net asset value (NAV). Unfortunately for the official committee of equity holders, the only valuation that put equity in the money was the rejected DCF.

Genco and Its Plan of Reorganization

Genco Shipping and Trading, Ltd. is one of the world’s largest dry bulk shippers. Faced with a highly leveraged capital structure (over $1.3 billion of senior secured debt and $125 million of unsecured convertible notes) and downward pressure on shipping rates, on April 21, 2014 Genco and its affiliates (Debtors) filed a prepackaged chapter 11 case in the U.S. Bankruptcy Court for the Southern District of New York seeking to implement a largely consensual restructuring. The majority of creditors supported a reorganization plan (Plan) that converted $1.2 billion of debt to equity, provided $100 million through a fully backstopped rights offering and extended maturities on some $350 million of additional debt. The Plan rested on a reorganization value that left equity without any cash recovery. Existing equity holders, who were to receive warrants in exchange for their interests, were therefore deemed to reject the Plan.

Section 1129(a) of the Bankruptcy Code establishes the requirements for confirmation (court approval) of a plan and contemplates that each class of creditors and equity holders will accept the plan. Section 1129(b) permits confirmation if not all classes accept, but only if the plan does not discriminate unfairly and is “fair and equitable” with respect to each non-accepting class that is impaired by the plan. In Genco the official committee of equity holders (Committee) appointed by the U.S. Trustee argued that the Plan undervalued the Debtors as a going concern, and thus unfairly discriminated against equity holders and failed the “fair and equitable” test.

Neither of these arguments proved successful in the valuation contest. Unfair discrimination applies to the treatment of similarly situated classes. Since there was only one class of equity holders, there could be no unfair discrimination. The “fair and equitable” test rests on the value of the debtor and “encompasses a rule that a senior class cannot receive more than full compensation for its claims. (citations omitted)”[2] In Genco, based on the balance of evidence, the court held that the best estimate of value did not require the Plan to provide any recovery to equity in order to pass the “fair and equitable test.”

Valuing Genco – Competing Methodologies

Based on the terms of Genco’s proposed Plan, the critical issue was whether the Debtors’ value exceeded $1.48 billion – the terminal value underlying the Plan’s distribution scheme. If the Debtors’ value was found to be higher, the equity holders would be entitled to some recovery on their shares. The Debtors valued the company between $1.26 and $1.44 billion; the Committee argued for a range between $1.54 and $1.91 billion (with equity in the money).

Bankruptcy courts retain broad discretion to determine the best method of valuation based on the facts of a particular case. The Genco Debtors and the Committee presented the court with  competing approaches. The Debtors relied primarily on a NAV calculation — essentially the estimated aggregate value of the company’s shipping fleet — asserting that this metric was best suited to value a dry bulk shipping company. As described by the court: “NAV is based on independent appraisals that incorporate an impartial assessment of the broadest, most concrete consensus regarding future earnings. NAV is a method that adds together the appraisal values and any other assets, such as ownership stakes in other companies, service contracts, and cash on hand.”

The Committee countered with a weighted average which included NAV as a minor factor but which emphasized three common valuation methods: DCF, market multiples/comparable companies, and precedent transactions. The DCF method estimates value by forecasting future cash flows over a set period of time, adds an estimated terminal value of cash flows after the forecasting period, and applies a discount rate based on the company’s weighted average cost of capital. The market multiples/comparable companies technique seeks to identify similar companies within the debtor’s industry based on a variety of criteria, such as revenue, earnings, or cash flow, which serve as standardized measures of value. Using these standardized measures, the financial expert will estimate the value of the debtor based on the market’s valuation of the comparable companies. A valuation based on precedent transactions surveys the market for sales of companies comparable to the debtor, and then uses the debtor’s earnings, cash flow, or EBITDA to estimate a range of values for the debtor based on the values applied by the market to companies sold in previous transactions.

The Court Rejects DCF, Opts For a Weighted Average Based on NAV

The dispute in Genco centered on the appropriate method for valuing the company. The Debtors prevailed based on a strong evidentiary record supporting the merits of their valuation analysis, including, critically, the suitability of their preferred NAV method for the dry bulk shipping industry. The Debtors presented a written report and live testimony which educated the court about the nature of dry bulk shipping as a competitive and highly fragmented industry, with low barriers to entry and little brand loyalty or other features to distinguish competitors, making earnings and profits highly contingent and hard to predict. The court then determined that the NAV method, focusing on the aggregate value of the shipping fleet, was a better and more reliable measure of value than typical valuation methods. Because the evidence suggested that the future cash flows of a dry bulk shipper are unreliably difficult to predict, the court rejected the DCF method.[3] This ruling was critical because only a DCF valuation yielded a recovery for equity. Although it characterized the Committee’s “dismissive attitude” regarding NAV as out of step with the “nature of dry bulk shipping,” the court nonetheless held that NAV should not be the sole basis for valuing the Debtors’ business. Instead, the court ruled that valuation should be a weighted average, with NAV as the centerpiece alongside lesser-weighted estimates based on comparable companies and precedent transactions.

When Contesting Valuation, Don’t Let Key Elements of An Opposing Analysis Go Undisputed

In several instances, the court noted that key elements of the Debtors’ valuation argument went unchallenged, most notably by the absence of a countering analysis under the NAV method. Although the Committee argued for its own methodology and conclusions, the court’s opinion suggests that it did not adequately argue against the expert testimony supporting the Debtor’s valuation.

For example, the court noted that the Committee “did not question” the methodology of the Debtors’ valuation expert, and rather than challenge the substance of his NAV opinion, the Committee argued that NAV was the wrong method for valuation of the Debtors as a going concern. But, because the Debtors persuaded the court that the NAV method was better suited to the dry bulk shipping industry, the Committee’s failure to counter the Debtor’s analysis with its own NAV calculation was a missed opportunity to regain some balance in the weight of evidence: “The Committee does not dispute [the Debtor’s] characterization of the industry, but nonetheless stubbornly insists on according little weight to NAV in the overall valuation analysis.”

While the Debtors and the Committee used “essentially the same methodology” for their market multiples/comparable companies analysis, they disagreed on the range of suitably comparable companies. The Equity Committee sought to exclude two companies from the comparables analysis; the court agreed to exclude one but held that it did not have a material impact. But the Court sided with the Debtors that the second company was comparable and that its inclusion would significantly reduce the value implied by the Committee’s analysis. As with the Debtors’ NAV presentation, the Committee failed to rebut the implications of including the second comparable company: “The Equity Committee provided no answer to the Court’s inquiry about the impact of including Paragon, and did not attempt to rebut the analysis on this issue presented by the Noteholders.”[4]

The Federal Rules of Evidence invite the sort of challenge the court found lacking in the Committee’s arguments. Specifically, Rule  702 “Testimony by Expert Witnesses” (made applicable in bankruptcy via Rule 9017), provides that an expert witness may offer opinion testimony if, among other criteria, the testimony is based on “sufficient facts or data,” is the product of  “reliable principles and methods” and if the expert has “reliably applied the principles and methods to the facts of the case.” An opposing party may dispute an expert’s opinion through targeted counter-testimony which asserts that one or more of these criteria are lacking. But in Genco, in the absence of a direct challenge to the admissibility or merits of the Debtors’ expert testimony, the court was free to presume that the conclusions reached by the Debtors’ experts were entitled to “substantial weight.” This was enough to tip the evidentiary balance in favor of the Debtors’ valuation.

Conclusion – Valuation is a Two-Part Contest

Valuation contests present a complex mix of financial analysis and basic matters of evidence under the Federal Rules where no one factor or estimate is dispositive. Tactically speaking, the Genco opinion is instructive on several points. First, the particulars of the debtor’s industry always matter. If the industry is unique, step one is persuading the court that your method best suits that industry. Second, there are elements of offense and defense in any valuation dispute. It is not enough simply to oppose one valuation methodology by advocating for another. Genco counsels that parties should instead directly rebut key elements of a competing valuation, lest the court credit it as undisputed. By directly challenging the foundation of an opposing estimate, a party can potentially reduce the overall weight afforded to it in the court’s final analysis — and every little bit helps.

[1] 2014 WL 2978371 (Bankr. S.D.N.Y. July 2, 2014). Of note, the opinion also offers an extended discussion of the availability of third-party releases in conjunction with a proposed plan. Although beyond the scope of this article, the Genco opinion is significant on this rapidly evolving issue of chapter 11 practice.

[2] Id. at *4.

[3] See opinion, pp. 30-34 (discussing unsuitability of DCF method).

[4] The noteholders also supported the Plan and offered evidence in support of confirmation.