A recent Chapter 11 bankruptcy ruling on the creditor’s election to treat its claim fully secured turned on valuation issues. On a basic level, the question was how to value a fitness club in the context of COVID-19 and the resulting economic uncertainty. The parties’ valuation experts disagreed about the extent to which they considered the effects of COVID-19. The court found the creditor’s expert failed to account for the present health and market conditions properly and produced a valuation that was not entirely credible. At the same time, the court rejected the position the debtor’s expert took, which was valuing the company based on the liquidation value of its tangible assets. The court performed its valuation, providing an informative, timely analysis.

Section 1111(b) election

The debtor owned three fitness clubs in various locations in Pennsylvania. On Jan. 2, 2020, it filed for Chapter 11 bankruptcy and later asked the court to proceed under the Small Business Reorganization Act (SBRA). The court granted the motion. In response to the bankruptcy filing, First Bank filed claims to position itself as a secured creditor. The unpaid balance of its prepetition shares was about $970,000.The debtor closed two of its locations but sought to reorganize by operating in one remaining location. For this purpose, in April 2020, the debtor filed a proposed Chapter11 reorganization plan, which is awaiting court confirmation. In response, the bank filed a § 1111(b) election. As the court says, section 1111(b) of the bankruptcy code is a complex statutory provision“with several moving parts that interact with other Code provisions.”In essence, § 1111(b)“permits an under secured creditor to elect to have its claim treated as fully secured for certain purposes in a chapter11 reorganization.”Here, the debtor objected to the election; under the debtor’s reorganization strategy, it offered to treat the bank as a secured creditor, but only up to about $317,000. In repaying this amount, in monthly installments, it proposed to pay about $29,000 in interest. The remainder of the bank’s allowed claim would be treated as unsecured components and repaid under the same standard for unsecured creditors holding allowed claims. In objecting to the bank’s § 1111(b) election, the debtor argued the bank’s interest in the property of the bankruptcy estate is of“inconsequential value,” as contemplated (but not defined) in the Bankruptcy Code. The Code, in essence, provides that a § 1111(b) election is not available to a creditor where the latter’s interest is“inconsequential.”

First Bank countered this objection by arguing that it was undisputed that First Bank had a security interest in the debtor’s property, which had value.“Inconsequential value,” according to First Bank, meant no value whatsoever. Alternatively, First Bank argued it held a first position lien, and its lien’s value was not inconsequential compared to the value of the creditor’s collateral. Regarding the second argument, the debtor argued that the correct method is to compare the value of the creditor’s lien to the total amount of the creditor’s claim. The court, in an earlier ruling and this ruling, found that“inconsequential value” did not mean zero value and that the determination of whether the creditor’s interest was inconsequential required a comparison of the value of the creditor’s lien position (value of its interest in the debtor’s property) to the total amount of the creditor’s claim.

Solid, but not fully convincing, valuation testimony.

The Bankruptcy Court had to decide whether or not to approve the bank’s § 1111(b) election. The court first had to determine the value of the bank’s secured position on the debtor’s assets to make the decision. As the court noted, both parties testified “knowledgeable witnesses, with solid credentials, each of whom has offered an opinion supported by a considered rationale.”As the court also found, “no single opinion offered at the [evidentiary] hearing was persuasive.”

Debtor’s valuation testimony.

The debtor testified to two witnesses. One was the managing partner of a business that advised companies in the fitness industry regarding the sale or acquisition of fitness and sports-related enterprises and equipment. Although the witness was not qualified as an expert, the court noted that there was no objection to his offering an opinion on the value of the debtor’s entity. The witness’s report said that, due to the COVID-19 pandemic, the industry was such that the debtor could not sell its business as a going concern. If the debtor could survive the current climate, it could have value in the future. At present, its only value was its liquidation value, the witness said. The witness acknowledged that he had not done a valuation following the American Society of Appraisers (ASA). He said his opinion was based on his view of the state of the fitness industry as it currently was. He noted that a traditional business valuation (particularly one based on the discounted cash flow analysis) would not offer an accurate picture of the value of a fitness business. According to the witness, historical data had lost its predictive power in light of the dramatic changes in the industry resulting from the pandemic. He noted that most fitness clubs would reopen with half capacity compared to 2019 and would need sufficient reserves to fund the significant operating losses for the first six to nine months following reopening.

Testifying at the hearing, this witness said there currently was a glut of equipment resulting from the COVID-19 shutdown, which meant the equipment was worth about 10% less than he had stated in his earlier report. Moreover, fitness clubs that planned to reopen would Need additional capital to pay for extra marketing and membership acquisition programs. The witness said it could take two years before the fitness industry settled into a“new normal.”The debtor presented testimony from a second witness, a fitness equipment broker, who had inspected the debtor’s equipment and initially found the latter was worth between$28,000 and $30,000. This valuation also was not based on the ASA’s standards.

Creditor’s valuation testimony.

First Bank also testified to two valuation witnesses. The first witness was the president of a well-known auctioneer and appraisal company in Philadelphia. He was a member of ASA and qualified as an expert in equipment valuation when liquidated in place. His two valuation reports were admitted into evidence. He offered a“DesktopAppraisal,” which he defined as “an expert’s opinion of value based on limited information and assumptions … and a limited appraisal of market conditions.” The appraiser did not inspect the equipment but relied on the information First Bank provided. The expert report said the market approach was the most helpful approach for valuing fitness equipment. The description provided a list of the pieces of equipment and their value at the location to stay open. The total value of the equipment was about$130,000. The court noted the report referenced research data but nowhere discussed the analysis of the data. The court also said the testimony of this expert “was relatively brief and conclusory.” First Bank’s second witness was a highly experienced business valuator and member of ASA who was retained to value the debtor’s intangible assets. This expert reviewed the debtor’s 2018 tax return, the most recent version of the debtors’ reorganization plan, the report of the other appraiser the creditor retained, and the debtor’s disposable income projections submitted to the court in April 2020. The business valuation expert used a market approach to conclude the value of the debtor was $170,000. Accepting the other appraiser’s $130,000 value determination for tangible assets, the business appraiser concluded the value of the intangible assets was about$40,000.

The market approach, he explained, examines“the relationship between prices that buyers have been willing to pay for the stock in companies that provide a reasonable basis for comparison to the relevant characteristics of the company being valued and various quantifiable facts,” after which“derived ratios are applied to the subject company to establish value.”The analysis considered two rules of thumb applicable to fitness centers (from an accepted commercial guide). One posits that value equals 70% to 100% of annual revenue, plus inventory. The other declares that value is 2 to 3.5 times the seller’s discretionary earnings (SDE), plus stock. He said he looked at about 30 fitness and yoga businesses between January 2019 and March 2020. He found the median value was 60% of net sales, which was nearly double the SDE. The business valuator looked at projected revenue in the first year following plan confirmation and the third year. He assigned great weight to the SDE derived from historical data. 

As these data preceded COVID-19 and its effect on the economy, the expert explained that COVID-19 did impact value but that the stock markets could recover most of the losses posted early in the pandemic. Further, regardless of uncertainty, there was optimism about the recovery, the expert proclaimed. The analysis of the first-year projections resulted in a value of $165,000. He said he reduced his multiples (estimated value/sales and estimated value/SDE) to account forCOVID-19’s impact. In analyzing the third-year post-confirmation, the expert did not reduce the multipliers but applied pre-COVID-19 multipliers. However, he gave more weight to the SDE benchmark. He arrived at a fair market value of $395,000 based on Year 3 revenue. He then discounted the value to account for the uncertainty of the company’s achieving this level of performance (as the court noted, “presumably due to COVID-19”). He used a 30%discount rate, assuming an investor buying a company today would expect a 30% return. Under this analysis, the business valuation expert arrived at a present value of almost$180,000.Given the two relative values, his research achieved, First Bank’s business valuation expert determined the present-day value of the business was $170,000.

Enterprise value as the starting point.

At the outset of its analysis, the court explained a value determination had to consider the purpose of the valuation and the proposed disposition or use of the property. Considering the debtor intended to use its assets to reorganize as a going concern, the court said it could not accept the debtor’s premise that value consisted of the liquidation value of the tangible assets.

The court further noted that in determining whether First Bank should be permitted to make a § 1111(b) election, it was essential to consider the debtor’s future revenue stream and the potential increase in the creditor’s collateral value the anticipated increase in the revenue stream. The court said that the appropriate starting point was determining the debtor’s enterprise value rather than a liquidation analysis of tangible assets. Although this starting point might support First Bank’s business valuation expert’s approach, the court found the expert’s analysis wanting. He had not fully considered the present economic conditions in the fitness industry resulting fromCOVID-19, and his degree of optimism was unwarranted, the court said. It also said it could not see a“valid nexus between the state of the stock market over the past few months and the state of the fitness industry or the Debtor’s potential reorganization prospects.”The court said it tended to agree with the opposing industry witness who commented on the state of the industry and who found the debtor’s projections overly optimistic. The court noted,“[I]t is not presently possible to project when public health and market conditions will support the growth of business revenues the Debtor posits as the foundation of its reorganization.”

Further, the court said, the debtor seemed to recognize the uncertainty. The court noted (in a footnote) the proposed reorganization plan did not predict when there would be sufficient revenue to perform its plan obligations. The underlying projections were generic (i.e., running from Month 1 to Month 60) rather than starting on a specific date in the future. The court said it was unlikely that an investor would buy the debtor’s business as a going concern, except at a substantial discount. However, this did not mean there was no value to the debtor’s business. The court noted that the owner of the debtor entity wanted to retain the company, expecting potential future growth. This meant there was value independent of the liquidation value of its assets. The plan also projected that even considering the debtor’s financial obligations, the entity would still pay the owner an amount that increased from $48,000 per year to $108,000 per year. Neither side’s valuation was entirely satisfactory, the court said. However, as the court was required to make a value determination before it could decide whether the creditor’s interest was of“inconsequential value,” the court agreed that an“entrepreneur-purchaser” would be willing to pay a premium of $50,000 over the $30,000 value of tangible assets to buy the debtor’s entity as a going concern. This low premium accounted for the high degree of risk in purchasing a fitness club“in the present environment,” the court said. (It used a 60% risk factor.) Although possible, there was no guarantee that the debtor would be able to survive the economic challenges facing the industry and then generated enough revenue to pay the entrepreneur-purchaser any salary at all, much less the amount assumed in the debtor’s“optimistic projections,” the court said.

The court found the creditor’s interest in the debtor’s assets was worth$80,000, which qualified as inconsequential concerning the creditor’s total claim of $970,000. Therefore, the court said First Bank was precluded from making a § 1111(b) election. The court noted that the debtor’s financial problems, starting in January 2020 with its Chapter 11 filing and continuing through the COVID-19 crisis that began in March 2020, caused a“precipitous decline in the value of the Debtor’s business and First Bank’s lien position.”If the business can survive, the evidence suggests the company’s value will not increase in the foreseeable future, the court noted. In closing remarks, the court noted that, while the debtor won on this particular issue, there was a real question about whether plan confirmation was feasible. The court said it credited the debtor’s industry witness who testified to the current dismal state of the fitness industry. This testimony raised questions as to whether the debtor would be able to reorganize in the absence of some cash infusion, the court said.“Perhaps there is a Goldilocks zone, a narrow path that a debtor can navigate between inconsequential value left in the business and feasibility of a proposed Chapter 11 plan; perhaps not,” the court said.