12.6 Chapter 6: option value and pre-insolvency scheme

In this chapter the role of option value in respect of pre-insolvency schemes has been investigated. The direct reason for doing so, was the 2014 report of the American Bankruptcy Institute with suggestions to reform the U.S. Bankruptcy Code: “Final Report and Recommendations on the Reform of Chapter 11”. Valuation reports used in respect of reorganization plans are based on a valuation at a certain moment in time. Such a valuation is carried out while a company is in distress and although the reorganization value is based on the restructured capital structure, the valuation can still be negatively impacted by the fact that the company is recovering and exiting Chapter 11.

According to the ABI, although the valuation at any point in time will necessarily reflect the debtor’s future potential, the valuation may occur during a trough in the debtor’s business cycle or the economy as a whole, and relying on a valuation at such a time may result in a reallocation of the reorganized firm’s future value in favor of senior stakeholders and away from junior stakeholders in a manner that is subjectively unfair and inconsistent with the Bankruptcy Code’s principle of providing a breathing spell from business adversity.

The ABI is of the opinion that the class that is just out of the money should receive an allocation of value to recognize that the future possibilities of the firm include the possibility that such an immediately junior class might have been in the money or received a greater recovery if the firm had been valued at a later date. Such an immediately junior class should be offered the “redemption option value”, which would reflect the possibility that, between the plan effective date and the third anniversary of the petition date (the “redemption period”), the value of the firm might have been sufficient to pay the senior class in full with interest and provide incremental value to such immediately junior class.

As also concluded by the ABI, there remains uncertainty about the implementation of such an option value. From a valuation perspective, the use of it can be questioned. First of all, valuations can already include the element of cyclicity. Also, the possibility that in the future, the value may be more or less than the value at the date of the restructuring, may also imply that the valuation at the date of the implementation of the plan was incorrect, i.e. possibly too high or too low. Obviously, assumptions may prove to be wrong, or cash flow expectations were not entirely correct, but in principle the valuation at a certain date should reflect all possible future value creation. Both the upside and the downside of such a valuation error or risk, can be accounted to the continuing equity or debt provider.