United States: Valuing Forbearance In Fraudulent Transfer Actions: An Introduction*

Co-written by Neil Steinkamp, Stout Risius Ross Inc.; New York

As a business descends into financial distress, it commonly enters into discussions with its creditors concerning a viable path forward. As part of those discussions, creditors often agree to forbear from pursuing collection remedies against the company or the collateral for a period. In return, the company may transfer money or property to the creditors or incur additional debt. If, in a subsequent bankruptcy proceeding, the estate representative sues a given creditor for a fraudulent transfer based on the receipt of the money or property or a fraudulent incurrence of the additional obligation, then the creditor may well defend by claiming that the forbearance provided "value" to the debtor. Perhaps in conjunction with other benefits received by the debtor, the creditor will argue that it gave "reasonably equivalent value" and thus may defeat the fraudulent-transfer action. In the resolution to that litigation, the creditor's liability may turn on whether and to what extent a court ascribes value to the forbearance.

Legal Introduction to the Value of Forbearance
Section 548(a)(1)(B) of the Bankruptcy Code—the constructive fraudulent-transfer section—states in relevant part that a trustee may avoid any transfer ... of an interest of the debtor in property, or any obligation ... incurred by the debtor, that was made or incurred on or within 2 years before the date of the filing of the petition, if the debtor voluntarily or involuntarily ... received less than a reasonably equivalent value in exchange for such transfer or obligation and ... was insolvent on the date that such transfer was made or such obligation was incurred, or became insolvent as a result of such transfer or obligation.[2]

Section 548(d)(2) defines "value" as "property, or satisfaction or securing of a present or antecedent debt of the debtor, but does not include an unperformed promise to furnish support to the debtor or to a relative of the debtor." In addition, "[v]alue has been defined as that which provides an economic benefit, either direct or indirect, to the debtor."[3] However, whether the value provided in a given case rises to the level of "reasonably equivalent value" requires a more searching inquiry. "There is no fixed mathematical formula for determining reasonably equivalent value; rather, the determination depends on all the facts of each case."[4]

Courts have routinely recognized that forbearance can comprise a component of reasonably equivalent value with respect to a fraudulent-transfer analysis.[5] Two relatively recent cases, however, show that courts at times reach a summary conclusion with respect to valuing forbearance without readily providing significant detail around the attendant calculations.[6]

In In re Positive Health Management Inc., the court found that the creditor's forbearance provided value to the debtor because it allowed the debtor "to engage in ongoing business operations to generate continued cash flow."[7] Likewise, the court in In re Propex found that the agreement to forbear and the relaxing of the covenants constituted reasonably equivalent value as a matter of law for an increase in interest rate.[8]

These decisions demonstrate that forbearance provides legitimate benefits to the debtor but they do not set forth any underlying calculations or methodology as to how the court concluded that the forbearance provided reasonably equivalent value compared to the challenged payment. Other courts may not be as willing to reach such conclusions without more quantitative analysis on the relative valuations.[9]

Financial Introduction to the Value of Forbearance
Greek orator Antiphon noted more than 2,000 years ago that "the most costly outlay is time."[10] Benjamin Franklin later transformed this into its common form when he wrote "[r]emember that time is money. He that idly loses five shillings' worth of time loses five shillings, and might as prudently throw five shillings into the sea."[11] Indeed, perhaps in no time in history has the adage "time is money" been more true than today.

However, if time is money, can the two be equated mathematically? Fundamental to valuation theory is the concept that an asset's value must incorporate the risks inherent from the passage of time. Value is generally the present value of expected future cash flows. To arrive at that present value, one must apply reasonable financial theory to compensate for the passage of time and the expectation that there is risk in the outcomes that may be achieved in the future.

In the context of distressed businesses, there are often strategic risks that are faced and critical decision points. The results of these decisions may result in businesses surviving or failing. The efforts to restructure a business can involve many parties working together to preserve what value may exist in the business or can be realized from its liquidation or sale. For lenders, one common consideration is forbearance, which is simply defined as "a refraining from the enforcement of something (as a debt, right or obligation) that is due."[12] However, conceptually, if the lender provides a business with forbearance, it must receive something in exchange of reasonably equivalent value, which raises the following question: What is the value of forbearance? From the debtor's perspective, one could ponder "what would a buyer pay for this option in the market" or "what would the company pay to secure this option."[13] Of course, the answer involves a complex analysis of specific facts and circumstances. A complete review of the methods utilized and information considered for such an analysis is certainly beyond the scope of this article. However, certain concepts and calculations are worth considering.

One of the complexities in determining the value of forbearance is that one must consider several perspectives and several potential outcomes. Put simply, the value of forbearance could be conceptualized as the difference between the present value of expected future cash flows if forbearance is provided and the same in the circumstance where forbearance is not provided. One could certainly interpret the opinions of the courts in In re Positive Health Management Inc. and In re Propex Inc. as reflective of this perspective. While the courts did not offer a mathematical or financial method to determine this value, they suggested that had the forbearance not been extended, the circumstances would have been very different, suggesting that value could be measured by the difference. For these situations, valuation techniques can be employed that consider the decision-tree of reasonable outcomes, which are techniques that can be employed in various circumstances, each having certain similarities:

• real options;[14]
• valuation of claims arising out of litigation; and
• valuation of contingent assets/liabilities.

For each of these, the valuation practitioner typically considers certain assumptions or inputs to the calculation of value. While the specifics of each methodology may include or exclude certain factors, generally, the practitioner considers the following:

• the different events that are likely to occur under certain scenarios;
• the time that it will take for these scenarios to develop;
• the probability of the expected outcomes in each scenario;
• the cash flow associated with each of the potential outcomes; and
• the risks associated with the receipts of those cash flows.

The facts and circumstances often surrounding forbearance naturally lead to the use of the decision-tree valuation techniques due to the multiple potential outcomes and restructuring events that may arise with or without forbearance.

The first step in developing an analysis using decision-tree valuation techniques typically involves estimating the amounts and timing of the future cash flows estimated under multiple scenarios. These amounts are discounted to a present value utilizing a rate of return consistent with the risk inherent in the projected cash flows. The present value of the total cash flows in each scenario is then weighted based on the probability of each scenario occurring, as projected.[15]

The decision-tree framework provides for flexibility that is not typically found in the discounted cash flow method. However, decision-tree valuation techniques can also require additional assumptions that can be challenging to quantify. In addition, there are practical limitations to the number of possible scenarios that can either be modeled or reasonably estimated. As such, one must carefully weigh the benefits of additional flexibility with the challenges and complexity of the resultant financial models.

Conclusion
Courts have made it clear that forbearance has value. Further, they have stated that forbearance is an element of consideration when reviewing reasonably equivalent value for purposes of fraudulent transfers, and the published opinions have provided little guidance as to the specific factors considered in valuing forbearance or specific methods that are to be applied. However, the essential characteristics of forbearance are similar to other circumstances in which valuation theory is commonly applied. In these circumstances, such as the valuation of claims arising out of litigation (often considered a contingent asset or liability), decision-tree valuation methodologies are employed to assess the value of assets based on the probabilities, cash flows and risks of cash flows associated with certain expected outcomes. This analysis is certainly complex and requires a careful analysis of available facts in any matter, however, the value of forbearance can be determined if sensible inputs are applied reasonably.