The following post comes to us from Michelle Harner, Professor of Law and Director of the Business Law Program at the University of Maryland Francis King Carey School of Law. It is based on her recent paper entitled “The Value of Soft Variables in Corporate Reorganizations,” which is forthcoming in the University of Illinois Law Review and is available here.
When a company is worth more as a going concern than on a liquidation basis, what creates that additional value? Is it the people, management decisions, the simple synergies of the operating business, or some combination of these types of soft variables? And perhaps more importantly, who owns or has an interest in such soft variables? These questions are important in all contexts, but hold particular significance in corporate reorganizations, where a company’s liabilities frequently exceed the value of its assets. The value available to satisfy creditors’ claims is limited, and determining the parties’ respective rights to that value is often hotly contested and critical to an effective resolution. My article, The Value of Soft Variables in Corporate Reorganizations, 2015 U. Ill. L. Rev. ___ (forthcoming), explores these questions under existing legal doctrine and practice norms.
The basic thesis of the article is that soft variables contribute meaningful value to the operation of a company as a going concern but are often overlooked or undervalued in corporate reorganizations. The article defines “soft variables” as those factors commonly classified as unidentifiable intangibles, including management, employees, and their respective talents and ideas (including the value of an “assembled workforce”); synergies created by operational efficiencies among divisions and affiliates, as well as strategic decisions, business plans, and applicable law (including the value of “assembled assets”); and relationships among the company’s people and its customers, vendors, and community. This definition is loosely based on the accounting concept of unidentifiable intangibles and is related to the concepts of “soft assets” and “soft inputs” used in other disciplines. The term “soft variables” also is invoked in statistical analysis to refer to variables that are not “readily quantifiable.” See, e.g., Lawrence Tribe, Trial by Mathematics: Precision and Ritual in the Legal Process, 84 Harv. L. Rev. 1329, 1361-62 (1971). That description applies with equal force to the people, synergy, and relationships discussed in the article that are rarely factored into reorganization value.
So does a company own soft variables related to its business, and can it pledge those variables to a secured creditor? A company does derive value from the intellect of its people, the relationships developed by their people, strategic use of tax or bankruptcy laws, etc. A company may in fact own that value as personal property once recognized, but it does not own the people, their relationships, or their ideas (subject to certain employment-contract-based exceptions, common in the intellectual property context). This conclusion flows not only from the bundle of rights conception of property and the accounting treatment of unidentifiable intangibles, but also from long-standing public policy and Constitutional concerns. As such, the article suggests that soft variables are not a debtor’s personal property and may not serve as collateral under Article 9 of the Uniform Commercial Code.
The inability to characterize soft variables as a company’s personal property does not, however, completely extinguish their value to a company. The company may claim an interest in any value generated by those variables. This property interest should come into existence if and when the value is recognized, either in the purchase price or on the balance sheet of the company or its successor. At that point, an asset emerges that is separate and identifiable and in which the company may claim a property interest. Moreover, such value recognition is not necessarily a one-time occurrence. A company may sell or acquire a division or product line that generates value and supports an adjustment to the company’s balance sheet; a company may restructure or reorganize in a manner that generates value above book or liquidation value.
A company’s soft variables hold potential value both in- and outside of bankruptcy. Yet soft variables are not directly addressed under the Bankruptcy Code and typically are not mentioned in the context of chapter 11 valuation and allocation issues. The primary exception is section 552 of the Bankruptcy Code, which establishes the extent and continuation of a creditor’s prepetition security interest in the debtor’s property. Under section 552(a), a strong argument exists that, absent a recognition trigger prior to the petition date, the value of any soft variables relating to the debtor’s business is property of the estate. That value, in turn, would be unencumbered and available for distribution to the debtor’s creditors. Whether that value is earmarked for certain creditors or distributed in accordance with the priorities set forth in the Bankruptcy Code is a separate question. The article suggests a distribution scheme that would allocate at least part of that value to those contributing to its creation—e.g., employees and counterparties.
Unfortunately, the treatment of soft variables and any value realized from them in a chapter 11 case is not as simple as it may first appear. For example, excluding soft variables and postpetition value from a secured creditor’s prepetition collateral package would not prevent a court from granting a lien in the postpetition value as adequate protection of prepetition security interests. In addition, measuring any prepetition or postpetition value is challenging, and the valuation itself may do little for the debtor’s reorganization efforts. Creditors also may work to structure around this principle with securitization vehicles. Ultimately, the desirability and utility of recognizing soft variables and their value as unencumbered likely turns on Congress’ public policy priorities.
Soft variables play a vital role in the reorganization—whether through a plan or a sale—of viable companies. Ignoring the nature of soft variables and their potential value to a company not only does a disservice to those working hardest to save the company but also arguably steals value from the company and those constituencies. If a company’s soft variables do not hold such value, it may indicate that a chapter 7 liquidation is the more appropriate resolution for the company. But if the company invokes the chapter 11 process and the resolution generates value above liquidation or book value, the court and the parties should identify the relevant soft variables and allocate value accordingly.