Abstract: Every valuation report is created as of a specific time and for a specific purpose, which may affect the standard of value an expert uses. That’s why a single valuation report can’t necessarily be recycled for multiple purposes without an expert’s express written consent. This article describes a recent bankruptcy case in which the court decided that a valuation report prepared for the business owner’s divorce proceeding couldn’t be used to confirm a bankruptcy repayment plan. A sidebar shows how courts may use the buyout provisions of a shareholders’ agreement to establish the value of a business interest.
In re Cole, Bankr. E.D. Va. No. 15-30979-KLP, March 24, 2016
Can you recycle a valuation?
Court rules report for divorce can’t be reused for bankruptcy
All valuation reports are not created equal. In fact, every valuation report is unique, created as of a specific date and for a specific purpose, which may affect the standard of value the valuation expert uses. That’s why a single valuation report can’t necessarily be recycled for multiple purposes without an expert’s express written consent. For example, a business valuation report prepared for a divorce case shouldn’t also be used in subsequent bankruptcy proceedings, as the recent case In re Cole illustrates.
One valuation can’t serve two purposes
This bankruptcy case involved a divorced dentist who owned a 25% interest in a dental practice. For purposes of equitable distribution of assets in the divorce proceedings, the trial court was required to determine the value of the husband’s interest in his dental practice. The divorce court noted that the relevant standard of value was the “intrinsic value” of the business interest “to these parties.”
During the divorce proceedings, the wife’s expert had valued the interest at $212,000, assigning considerable value to ongoing patient relationships and goodwill. The husband’s expert declined to assign any value to the practice’s patient records or goodwill and valued the husband’s interest at $15,782. The divorce court adopted the $212,000 value.
The husband then filed for Chapter 13 bankruptcy and sought confirmation of his repayment plan. The bankruptcy court had to determine whether the repayment plan would meet the liquidation test under the Bankruptcy Code. The code requires a court to ask: Would the creditors receive payments with a present value that’s at least equal to what they would receive in a Chapter 7 case? The answer depended primarily on the value of the debtor’s interest in the dental practice.
The dentist’s ex-wife was the primary unsecured creditor. She opposed the plan and argued that collateral estoppel barred her ex-husband from relitigating the value of his interest in the dental practice and required the bankruptcy court to value the interest at $212,000.
One size doesn’t fit all
Echoing the divorce court, the bankruptcy court defined value for equitable distribution purposes as “that value which represents the property’s intrinsic worth” to the parties. The court added that intrinsic value is “a very subjective concept that looks to the worth of the property to the parties.” In divorce court, the value set forth by the wife’s expert, therefore, established the value of the husband’s interest in the practice to those two spouses, not necessarily hypothetical buyers and sellers.
By contrast, in a Chapter 13 bankruptcy proceeding, the court must determine the value of the interest in the context of a hypothetical Chapter 7 liquidation. The Bankruptcy Code requires a Chapter 7 trustee “to reduce to money” the property of the bankruptcy estate. According to the court, this requirement clearly contemplates a sale or other disposition of the property, which is different from determining the intrinsic value for a divorce proceeding.
During divorce proceedings, the court said the amount that a Chapter 7 trustee would receive by liquidating the debtor’s interest in the practice was not the basis for establishing its value. In other words, the issue decided by the divorce court wasn’t the same as the issue before the bankruptcy court, and collateral estoppel didn’t apply.
The court also rejected the wife’s alternative argument — that her expert’s value should be applied because his “going concern” value was the appropriate standard for valuing a business interest. The court pointed out that this value represented 25% of the going-concern value of the practice as a whole. Moreover, there was nothing in the practice’s shareholder agreement or any other evidence that suggested the husband (or a Chapter 7 trustee stepping into his shoes) had the ability to force a sale of the practice to maximize his 25% interest in the proceeds.
Different standards call for different valuations
In uncertain economic times, you can’t blame a client for wanting to leverage a valuation report for multiple purposes. Unfortunately, valuations are valid only for the specific purpose (or purposes) that they’re originally developed for.
Sidebar: Set value with shareholder agreement’s buyout formula
The debtor in the In re Cole bankruptcy case claimed that his interest in a dental practice had no value, based on the testimony of an experienced Chapter 7 trustee. The trustee testified that, if he were administering the debtor’s estate, he would abandon the interest because he didn’t think anyone would pay anything for it in the open market.
The court, however, found that the practice’s shareholder agreement suggested the interest would have significant value in a Chapter 7 liquidation. Under the agreement, the debtor (or trustee) could compel the other shareholders to buy out his interest for a price determined by a formula in the agreement. The court ruled that the price would be $161,268, according to the buyout formula. Therefore, the bankruptcy court valued the interest at that amount and, as a result, denied confirmation to the debtor’s plan.