Houlihan Smith Solvency Opinion

A Houlihan Smith solvency opinion, by design, aims to assure the Board of Directors and/or a company’s lenders that the transaction is not likely to subject the company and their other creditors to undue financial distress. Houlihan Smith will undertake a solvency opinion assignment for companies engaging in highly leveraged transactions which may include leveraged buyouts, leveraged recapitalizations, leveraged dividends, or other such situations where there may be minimal equity involved.

The Federal Bankruptcy Code defines “insolvent” as the condition in which the total of a person’s debts exceed the value of its property at a fair valuation. Recent case law suggests that the fair valuation of property is its value on a going concern basis. A solvency opinion expresses an independent expert’s opinion on a borrower’s ability to remain solvent under the burden of additional liability, to pay debts as they mature, and to continue operations as a going-concern in dynamic economic conditions.

Some of the advantages of incorporating a Solvency Opinion into a leveraged transaction include:

• Establishing the lender’s trust in making the loan
• Proffering a form of due diligence and evidence of good faith
• Mitigating the risk of bankruptcy liability for all parties involved in the transaction

In the event that a company enters bankruptcy proceedings, the security interests of creditors may be challenged as a fraudulent conveyance. Leveraged transactions, by their nature and structure, extend the opportunity for creditors to legally challenge the insolvency of the borrower several years after the deal closes. For such a claim to be upheld, the courts must find that the exchange was not made for “reasonably equivalent value.” Prerequisites for such a claim include insolvency of the borrower, inability to pay debts as they mature, or inadequate capital to fund operations. A successful charge of fraudulent conveyance can result in the reversal or unwinding of an entire transaction, impacting interested parties with extensive litigation, and potentially massive economic losses.

In connection with a leveraged recapitalization, interested parties such as new secured lenders and sellers will often seek an independent determination and opinion as to the impact of the acquisition debt on working capital, cash flow, and equity value due to fraudulent conveyance concerns.

Fraudulent conveyance laws apply when a company enters bankruptcy proceedings following a highly leveraged transaction. The laws and statutes protect unsecured creditors from the claims and interests of equity investors and secured creditors. Whereas the original statute identifies only the “intent” to defraud creditors, the modern version recognizes the possibility of “constructive” fraud—an act, statement or omission operating as a fraud regardless of intent. Codified on the state level in the 1919 Uniform Fraudulent Conveyance Act (which later evolved into the Uniform Fraudulent Transfer Act) and on the federal level in § 548 of the Bankruptcy Code, these statutes declare a transaction fraudulent when there is either:

1. Actual Fraud: intent to hinder, delay, or defraud creditors, or

2. Constructive Fraud: the transfer was made without “adequate consideration”; and, at the time of the transfer, the company was rendered insolvent, or the company was credited with unreasonably small capital to fund operations, or the company was left with debt obligations beyond its ability to service as they matured. The term “adequate consideration” is synonymous with “reasonably equivalent value,” and refers to the relative value between that which the debtor surrenders and that which they receive. Constructive fraud does not require proof of intent but only an objective determination of the first and at least one of the preceding requirements.

All parties involved in a leveraged transaction can be adversely impacted by a successful attack claiming fraudulent conveyance. Directors and controlling shareholders risk a breach of fiduciary duty to creditors and may face personal liability for the insolvency of their company. Selling shareholders risk the return of proceeds from the sale; senior lenders risk the revocation of their security interests and the subordination of their claims to other creditors, and the accountants, appraisers, lawyers, and investment banks risk the forfeiture of fees earned through the transaction. At the extreme, the entire transaction can, and will, be reversed, possibly years after the initial transfer. It is clear why investment banks, lenders and equity sponsors increasingly address the risk of fraudulent conveyance at the time of a transaction.

The codification of fraudulent conveyance law provides a systematic approach to solvency analysis. Consequently, the solvency of any company evaluating a highly leveraged transaction must be examined both at the time of the transaction and from a pre- and post-transaction perspective.

A Houlihan Smith Solvency Opinion™ requires comprehensive due diligence including, but not limited to, the following:

• The Balance Sheet Test
• The Cash Flow Test
• The Capitalization Test
• Analysis of historical and projected financial statements
• Identification of all contingent liabilities, including letters of credit, convertible securities, tax liabilities, pending litigation, etc.
• Interviews with management, industry experts, consultants, attorneys, accountants, analysts, lawyers, lenders, equity sponsors, investment bankers, and other advisors
• Thorough documents review; including SEC filings, loan covenants, operating plans, etc.
• Consultation with legal counsel

The expectation of solvency analysis is to comfort the participants in a highly leveraged transaction amidst the uncertainty at the time of the transaction. Three tests provide the foundation for a comprehensive analysis of the Company’s ability to sustain the burden of debt and the going-concern status quo. The Company must pass judgment on each test to be considered solvent. The answers to the following questions, if insufficient, provide legal standards that could result in the unwinding of the transaction.

Other Important Case Law

• See Weiboldt Stores, Inc. v. Schottenstein, et al., 94 B.R. 488 (N.D. Ill 1988). The Court found that if a LBO leaves a company insolvent and it was done in an attempt to deceive creditors it will be deemed a fraudulent conveyance.
• See Crowthers McCall Patterns, Inc. v. Lewis, 129 B.R. 992 (SDNY 1991). The Court held that LBO lenders are obligated to consider the post-transaction solvency of the target company and the rights of its post-transaction creditors when lending funds that flow out of the borrower to the selling shareholders.
• See Klang v. Smith's Food and Drug Centers, 702 A.2d 150 (Del. 1997). The Court stated that Boards of Directors are entitled to rely on a Solvency Opinion.