Bankruptcy Court Addresses Effects of COVID-19 on Value
The COVID-19 pandemic has caused many businesses to struggle financially, forcing some to file for bankruptcy. A critical factor when valuing a debtor in bankruptcy is current economic conditions. A recent case — In re Body Transit, Inc. — demonstrates that expert opinions may not pass muster today if they fail to fully consider the effects of the COVID-19 pandemic on value.
In this case, the debtor operated three fitness clubs and filed a voluntary petition under Chapter 11 of the U.S. Bankruptcy Code in January 2020. It sold the assets of two clubs and sought to reorganize through the operations of the remaining club.
A creditor with a $970,000 unpaid balance filed an election to have its claim treated as fully secured, pursuant to Section 1111(b) of the bankruptcy code. The debtor objected to the election on grounds that the creditor’s interest in property securing its claim was of “inconsequential value,” an exception to a Sec. 1111(b) election. To resolve this issue, the U.S. Bankruptcy Court for the Eastern District of Pennsylvania needed to determine the value of the debtor’s business and evaluate whether that value was inconsequential compared to the creditor’s claim.
The debtor presented two witnesses, but neither was qualified as a business valuation expert. The first, a fitness industry consultant, testified that the pandemic had caused the industry to be illiquid. He opined that a traditional business valuation wouldn’t present an accurate picture of the debtor’s value because historical data had “lost its predictive power.” He concluded that the only basis for valuing the business was liquidation value.
The second witness, a fitness equipment broker, concluded that the debtor’s equipment was worth between $28,000 and $30,000. Additionally, the expert opined that the equipment’s value had fallen at least 10% more by the hearing date.
The creditor presented two witnesses who were both accredited in business valuation. The first appraised the debtor’s equipment “based on limited information and assumptions . . . and a limited appraisal of market conditions.” Although he didn’t inspect the equipment, he valued it at roughly $130,000. He used the market approach, but his report didn’t discuss the specific data he analyzed.
The creditor’s second expert valued the business using the market approach. He analyzed approximately 30 sales of fitness and yoga businesses between January 2019 and March 2020. He applied revenue multiples from those comparable transactions to the debtor’s projected revenue for the first and third post-confirmation years, then he reduced those amounts to present value.
The witness acknowledged that COVID-19 had temporarily affected the company’s value. But, citing the stock market’s speedy recovery, he was optimistic about the future of the debtor’s business. He reduced his multiples for the first year for the impact of the pandemic, but he used pre-pandemic multiples for the third year. He also increased the discount rate used to estimate present value to reflect uncertainty over the gym’s ability to achieve projected revenue. Based on these assumptions, he valued the debtor at $170,000 and allocated $130,000 to tangible assets.
The bankruptcy court didn’t fully accept any of the valuation evidence provided in this case. Neither of the debtor’s witnesses were accredited in business valuation, and the creditor’s first expert, though accredited, performed a limited “desktop” valuation. The court followed the approach used by the creditor’s second expert, but it doubled the risk factor in his discount rate, arriving at a value of $80,000.
Because this value was inconsequential to the creditor’s total claim, the court rejected the Sec. 1111(b) election. This case demonstrates the importance of using credentialed financial experts and fully considering current market data when valuing a business for bankruptcy purposes.