Valuation of contingent liabilities: some risk management considerations for lenders

Benjamin S. Seigel

Finding little information on valuating contingencies beyond FASB's Statement of Financial Accounting Standards No. 5--Accounting for Contingencies, the author, a California attorney, went on to tackle the problem for himself and now shares that information with Journal readers.

Lenders, at least the ones I know, seem to spend a great deal of time, effort, and money evaluating the asset section of their borrowers' balance sheets. They will frequently retain appraisers to provide values of such significant assets as:

* Furniture.

* Fixtures.

* Machinery.

* Equipment.

* Inventory.

* Accounts receivable.

* Patents.

* Trademarks.

* Copyrights.

* Customer lists.

* Real estate.

* Leasehold interests.

* Motor vehicles.

* Rolling stock.

Those lenders also attempt to determine the nature, extent, and validity of the borrower's liabilities, particularly accounts payable, accrued operating expenses, accrued salaries, other employee benefits, and whatever else the borrower or its accountants have chosen to state on the balance sheet.

However, I question the amount of attention devoted to the valuation of contingent liabilities--in particular, pending, threatened, and remotely potential litigation and governmental action--based on the lack of information available to assess their risks. The starting point for my analysis of this problem is the only writing of any substance I have found on the subject:

Statement of Financial Accounting Standards No. 5--Accounting for Contingencies, promulgated by the Financial Accounting Standards Board of the Financial Accounting Foundation.

Statement of Financial Accounting Standards No. 5 defines a contingency as an existing condition, situation, or set of circumstances involving uncertainty as to possible gain or loss to an enterprise. The uncertainty factor would ultimately be resolved when one or more future events occur or fail to occur. SFAS No.5 defines three classes of contingencies: probable (likely to occur), reasonably possible (more than remote but less than likely), and remote (slight chance of occurrence). Although SFAS5 teaches how to identify and report contingencies, it does not provide a standard for valuation of loss contingencies that can be used by a lender, nor does existing literature or law shed any light on such standards.

Some contingencies quickly become unwieldy and difficult to assess: expropriation of assets and catastrophes caused by weather, earth movements, plagues, famine, locusts, frogs, and other events of biblical proportions. Therefore, this article is confined to an exploration of the valuation of risks attendant to litigation and governmental action.

A Hypothetical Borrower

Question of Balance, Inc. (QBI) was formed 10 years ago by a group of high-net-worth engineers who had invented a vehicle that could operate on a combination of salt water, hydrogen, methane, and oxygen. After years of research and development work, QBI developed a prototype vehicle that could go 50 miles per hour for 10 hours at a time without refueling. The small vehicle held only the driver; chemical tanks and equipment used all remaining space. However, QBI was certain that with some additional R&D work, the size and passenger capacity could be increased and demand for the vehicle would be overwhelming.

So certain was the firm that it retained investment bankers to initiate an initial public offering (IPO) of its stock, engaged dealers in 20 states for its soon-to-be-produced four-passenger QBIMobile, and applied to Little Bank of Detroit (the Bank) for a $25 million loan to be repaid from the proceeds of the impending IPO.

While the loan application was being completed, the Securities & Exchange Commission (SEC) raised concerns about the disclosures in the Registration Statement filed in connection with the IPO and threatened to bring action against the company and its principals. The attorneys general of 18 of the 20 states where the new dealers were located raised concerns and threatened to conduct investigations about potential violations of the states' franchise investment laws. When the Federal Trade Commission (FTC) got wind of those state activities, it opened an investigation regarding possible violations of federal franchise investment laws. Those actions received so much press that the federal Environmental Protection Agency (EPA) and similar agencies from 10 states opened investigations regarding possible violations of air pollution laws resulting from the exhaust emitted by the QBIMobile. Meanwhile, four female employees filed suit against the company and four of its principals for sexual harassment resulting from activities following the celebration held to introduce the QBIMobile concept car to the motoring public.

Preparing to Assess the Risk

QBI submitted with its loan application an audited balance sheet prepared by its regular outside CPAs. The liability section of the balance sheet disclosed the actions of the governmental agencies and reflected the pending harassment litigation. QBI also provided reasonably detailed footnotes to the statement; however, no dollar value was assigned to these contingencies. The assets of the company consisted principally of machinery and equipment with a fair market value of $18,000, a commercial building with equity of $7 million, and intellectual property valued at $50 million. The stated liabilities of $400,000 consisted of accounts payable and an accrued amount due to the company's employee benefit plan. There were no tax liabilities shown, nor were there any loans to or from officers or other insiders. The principals agreed to guaranty the Bank's loan and secure their guaranties with improved real property located in major markets.

The combined fair market value of those real estate assets was appraised at $12 million. The Bank retained an appraiser who agreed with the stated values of the machinery and equipment and the net equity in the real property. A second appraiser was retained to value the intellectual property, consisting principally of several patents for the design and technology of the QBIMobile, several copyrights regarding the software used by the computerized planned production facilities, and several federally registered trademarks. That appraisal came in at a liquidation value of $15 million. The Bank's senior loan officer wanted to make the $25 million loan but was concerned about the contingent liabilities. She believed that the collateral value of the machinery, equipment, and real property could satisfy any outstanding debt; with the added comfort provided by the principals' guarantees, the loan would perform even in a liquidation. However, she wondered what would happen if the SEC, the FTC, the EPA, or any one or more of the state attorneys general filed suits against the company. What legal fees would be incurred? What would be the likely outcome? What if the company was forced to file bankruptcy? To help in her loan evaluation, she asked the Bank's VP for Risk Management to perform a valuation of the contingent liabilities and to provide her with a value that should be added to the liability section of QBI's balance sheet.

The risk manager burned some midnight oil to compile the following list of 31 questions that he felt must be answered to assess the risk of the contingent liabilities (see Table 1).

Valuating the Risk

Armed with this list, the risk manager believed that if he could place a significance value on each of the 31 factors, he could assign a dollar value to each contingency. He decided on a 10-point scale--10 being very significant and 1 being of little significance. By way of example, both questions 5 and 6 (statutory and case law) were given ratings of 10. Question 29 (media coverage) was given a 6. Question 1 was given a 2.

After going through all of the questions, conducting investigations, assigning values, determining mathematical averages, and relating them to each contingent liability, the risk manager created a schedule of worst-case liabilities, including estimated defense fees and costs and "significance values" for each class. Although the significance values are admittedly subjective, they were based on the risk manager's many years of experience in the lending industry. By converting the significance values to percentages, each class of liability could be assigned a dollar value (see Table 2).

The risk manager then applied the significance values as percentages to the worst-case liability amounts and came up with a value of $18.6 million.

Using this information, the loan officer computed that although the fair market value of the assets was $87 million, the liquidation value would be substantially less, and so she assigned a value of $40 million. She added an additional $8 million as the liquidation value of the guarantor's real estate, yielding a net liquidation value of $48 million. Her analysis concluded that if the company liquidated, there would be an equity cushion of $4 million. She further analyzed that when the IPO goes through, probably within the next six months, the Bank would be repaid in full and QBI couldn't possibly burn through the $25 million loan within that time. She recommended that the loan be approved and sent the package to the loan committee of the Bank.

The Loan Committee

The Loan Committee's role in evaluating the information provided by the risk manager and the loan officer is equally important. Consider if you were the sole member of the Bank's Loan Committee and had to decide whether or not to approve the $25 million loan. What would you decide if this loan proposal were submitted to you and why? Do you require any more information before making your decision? If so, what types of additional information would assist you in your review of the loan proposal? These and similar questions will be addressed in a subsequent article, "Using Contingent Liability Valuations in the Loan Approval Process."

Contact Benjamin Seigel by e-mail at bseigel@buchalter.com.

[c] 2005 by RMA. Benjamin S. Seigel, Esq., is chair of the Insolvency Practice Group of Buchalter, Nemer, Fields & Younger. This article was prepared with the able assistance of Sandra L. Stevens, Esq., Christian R. Greene, Esq, and Alexandra Rhim, Esq. This is Mr. Seigel's first contribution to The RMA Journal.

Table 1
Assessing the Risk of Contingent Liabilities

1. What treatment has been given to these contingent liabilities
in prior financial statements?

2. Has FAS5 been complied with in this financial statement and
in prior financial statements?

3. Has an opinion of counsel been obtained in connection with
the financial statements or otherwise?

4. If so, was there mention of the contingent liabilities?

5. What state and federal statutory law applies to the
contingent liabilities?

6. What state and federal case law, Attorney General Opinions,
legal writings, and articles exist that are applicable to the
contingent liabilities?

7. Has a chronological factual statement of activities related to
the liabilities been prepared?

8. Has an expert been retained, considered, interviewed, etc.?

9. What is the range of potential liability--dollars and other
damages?

10. What is the posture of the litigation or potential
litigation (suit threatened, filed, discovery, motions, etc.)?

11. What are the motivation and dedication of the prosecuting
authorities (for example, a superaggressive state attorney general
planning to run for governor as opposed to a local city attorney
about to retire)?

12. What acts constitute the offending conduct?

13. What are the history, nature, and extent of the offending
conduct?

14. What are the relative bargaining positions of the parties?

15. What defenses are available?

16. What has been the prior success or failure in defending or
settling similar actions in the jurisdictions where litigation
is likely?

17. What volume of litigation is anticipated?

18. What are the present nature and extent of any governmental
investigations?

19. What are the present nature and extent of any private
investigations?

20. What have been the nature and extent of media coverage of the
contingent liabilities?

21. What "damage control" measures have been taken (to counter or
answer media releases)?

22. What are the relative experience and ability of prosecutors
versus defense counsel?

23. What is the anticipated cost of defense?

24. Is there any basis for an award of attorneys' fees against
the borrower if governmental or private parties prevail?

25. What are the likely consequences of Chapter 11 bankruptcy
(preferences, fraudulent transfers, recharacterization, and
subordination)?

26. What are the nature and extent of possible insurance coverage?

27. Has anyone affiliated with the company been contacted by any
governmental agency regarding any contingent liability?

28. If any affiliated person was contacted, what were the nature
and extent of the contact?

29. Have the names of affiliated or formerly affiliated persons
who have spoken to or who have been interviewed or named by
the media or by representatives of governmental agencies been
obtained?

30. If so, have any of them been contacted or interviewed by
representatives of the company?

31. Have any of the company's business records been subpoenaed or
otherwise turned over to governmental or investigative agencies?

Table 2
Dollar Value Assigned by Significance

Contingent                                Potential    Significance
Liability                                Worst Case       Value

SEC investigation and threatened         $10 million        8
action

State attorneys general investigations
and potential actions                    $10 million        6

FTC investigation and threatened         $5 million         5
action

Federal EPA investigation and            $3 million         3
threatened action

State environmental investigations
and threatened actions                   $3 million         4

                                              0
Sexual harassment litigation             (covered by        0
                                         insurance)

COPYRIGHT 2005 The Risk Management Association
COPYRIGHT 2008 Gale, Cengage Learning