What Is a Solvency Opinion?
With the rise of corporate bankruptcies, a lot of leveraged transactions that occurred pre-COVID are going to be scrutinized. The musings here consider solvency opinions conceptually, but many bankruptcy courts, such as the one that oversaw the restructuring of Neiman Marcus, will consider the issue retroactively and may ask stockholders to return distributions that were deemed to have been obtained via fraudulent conveyance.
The Business Judgement Rule
The Business Judgement Rule, an English case law doctrine followed in the U.S. and Canada, provides directors with great latitude in running the affairs of a corporation provided directors do not breach their fiduciary duties to act in good faith, loyalty, and due care. However, there are instances when state law prohibits certain actions including the fraudulent transfer of assets to stockholders that would leave a company insolvent.
This straightforward statutory prescription has taken on more meaning over the past decade because corporate America has significantly increased its use of debt given very low interest rates. Investors have been willing to fund the increase because negligible rates on “safe” assets have pushed individuals and institutions out of the risk curve to produce income.
Transactions that may meaningfully alter the capitalization of a company include leveraged dividend recapitalizations, leveraged buyouts, significant share repurchases, and special dividends funded with existing assets. Often a board contemplating such actions will be required to obtain a solvency opinion at the direction of its lenders or corporate counsel to provide evidence that the board exercised its duty of care to make an informed decision should the decision later be challenged.
A solvency opinion addresses four questions:
- Does the fair value of the company’s assets exceed its liabilities after giving effect to the proposed action?
- Will the company be able to pay its debts (or refinance them) as they mature?
- Will the company be left with inadequate capital?
- Does the fair value of the company’s assets exceed its liabilities and surplus to fund the transaction?
A solvency opinion is typically performed by a financial advisor who is independent, meaning the advisor has not arranged financing or provided other services related to the contemplated transaction. The opinion is based upon financial analysis to address the valuation of the corporation and its cash flow potential to assess its debt service capacity.
Also, the opinion is just that—it is an informed opinion. It is not a pseudo-statement of fact predicated upon the “known” future performance of the company. It provides a reasonable perspective concerning the future performance of the company while neither promising to stakeholders that those projections will be met, nor obligating the company to meet those projections.
Test 1: The Balance Sheet Test
The balance sheet test asks: Does the fair value and present fair saleable value of the company’s total assets exceed the company’s total liabilities, including all identified contingent liabilities?
The balance sheet test is a valuation test in which the value of the company’s liabilities are subtracted not from the assets recorded on the balance sheet, but rather the fair market value of the company on a total invested capital basis. The value of the company on a debt-free basis is estimated via traditional valuation methodologies, including Discounted Cash Flow (“DCF”), Guideline Public Company, and Guideline Transactions (M&A) Methods. In some instances, the Net Asset Value (“NAV”) Method may be appropriate for certain types of holding companies in which assets can be marked-to-market.
Test 2: The Cash Flow Test
Will the company be able to pay its liabilities, including any identified contingent liabilities, as they become due or mature?
This question addresses whether projected cash flows are sufficient for debt service. A more nuanced view evaluates the question along three general dimensions:
- Revolver Capacity: If financial results approximate the forecast, does the company have sufficient capacity, relying upon its revolving credit facility if necessary, to manage cash flow needs through each year?
- Covenant Violations: Does the projected financial performance imply that the company will violate covenants of the credit or loan agreement, or the terms of any other credit facility currently in place or under consideration as part of the subject transaction?
- Ability to Refinance: Is it likely that the company will be able to refinance any remaining balance at maturity?
Test 3: The Capital Adequacy Test
Does the company have unreasonably small capital with which to operate the business in which it is engaged, as management has indicated such businesses are now conducted and as management has indicated such businesses are proposed to be conducted following the transaction?
The capital adequacy test is related to the cash flow test. A company may be projected to service its debt as it comes due, but a proposed transaction may leave the margin to do so too thin – something many companies discovered this year in which they were able to operate with high leverage as long as business conditions were good.
There is no bright line test for what “unreasonably small capital” means. We typically evaluate this concept based upon pro forma and projected leverage multiples (Debt/EBITDA and EBITDA/Interest Expense) relative to public market comps and rating agency benchmarks. While management’s projections represent a baseline scenario, alternative downside scenarios are constructed to asses the “unreasonably small capital” question in the same way downside scenario analyses are constructed to address the question of whether debts can be paid or refinanced when they come due.
Test 4: The Capital Surplus Test
The capital surplus test asks: Does the fair value of the company’s assets exceed the sum of (a) its total liabilities (including identified contingent liabilities) and (b) its capital (as such capital is calculated pursuant to Section 154 of the Delaware General Corporation Law)?
The capital surplus test replicates the valuation analysis prescribed under the balance sheet test, but also includes the company’s capital in the subtrahend (Hey! There is a word we haven’t seen since early primary school. The subtrahend is the value being subtracted.)
Section 154 of the Delaware General Corporation Law defines statutory capital as (a) the par value of the stock; or in instances when there is no par value as (b) the entire consideration received for the issuance of the stock. “Capital” as defined here is nuanced. Often it may be a small amount if par is some nominal amount such as a penny a share, but that may not always be the case. What is excluded is retained earnings (or deficit) from the equity account.
The Mosaic of Solvency
The tests described above are straightforward. Sometimes proposed transactions are straightforward regarding solvency, but often it is less clear—especially when the subject company operates in a cyclical industry. Every solvency analysis is unique to the subject transaction and company under review and requires an objective perspective to address the solvency issue.
Mercer Capital renders solvency opinions on behalf of private equity, independent committees, lenders and other stakeholders that are contemplating a transaction in which a significant amount of debt is assumed to fund shareholder dividends, an LBO, acquisition or other such transaction that materially levers the company’s capital structure. For more information or if we can assist you, please contact us.