Company boards often seek third-party solvency opinions in connection with leveraged transactions to assist them in fulfilling their board duties. A solvency opinion is a third-party expert’s opinion as to whether i) a company’s assets exceed its liabilities, (ii) it is reasonable to conclude that a subject company will be able to pay its debts when they mature or come due; and (iii) the subject company has unreasonably small capital.
It is critical for a board to seek an experienced, third-party provider who can not only illustrate the full breadth and depth of its solvency analysis capabilities through a comprehensive and extensive list of clients but also have the ability to defend their opinion in the event of future litigation. A good solvency analysis will provide a board with the third-party provider’s opinion that reasonably concludes as to whether a company is solvent and will have adequate capital in a leveraged financing transaction.
Every solvency opinion is subject to a unique analysis since the solvency opinion is – by definition – only applicable to one, single, unique business entity. No “hard and fast” rules of thumb apply to complete a solvency analysis. Each company has its own weaknesses and vulnerabilities, and boards of directors need to ensure the solvency opinion provider they select has fully accounted for them in developing an opinion.
Capital Adequacy Opinions
In addition to providing a solvency opinion, VRC will often provide a capital adequacy opinion (also referred to as a capital surplus opinion). In many states, when a company contemplates a repurchase of stock or payment of a special dividend to shareholders, some state statutes require that the enterprise demonstrate that it would not be left with impaired par capital. VRC provides an opinion as to whether the fair value of a company’s assets exceeds the company’s liabilities by an amount in excess of a proposed repurchase or special dividend payment and the par value of the stock.
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Transactions that Trigger a Need for Solvency Opinions
Company boards may seek to obtain an outside solvency opinion for:
- Leveraged buyout (LBO) deals where leverage is significant
- Public company share repurchase programs
- Dividend recapitalization transactions
- Reasonably equivalent value or capital surplus testing
- Corporate spin-off
A solvency opinion rendered at the time of a transaction is one of the most cost-effective ways to mitigate the risks.
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Solvency Opinion Critical to Fiduciary Duties
One of the most cost-effective ways to for a board of directors to fulfill its fiduciary duty is for it to receive a third-party solvency opinion at the time of a transaction. Risks stem from the potential use of constructive fraudulent conveyance claims by creditors to contest a leveraged transaction.
Directors and controlling shareholders risk a breach of fiduciary duty to the company, and may face personal liability for the insolvency of the company, particularly in connection with a payment of an unlawful dividend.
In Delaware, directors can be held personally liable under state law for approving an unlawful dividend. Board members can further demonstrate that in fulfilling their fiduciary duties, that they have relied upon the opinion of a third-party expert. Solvency opinions provide critical information to the board in assessing the company’s ability to pay a special dividend.
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Constructive Fraudulent Conveyance Risks
A solvency opinion addresses potential attacks under the constructive fraud theories of the fraudulent conveyance laws. Constructive fraud is concerned with the result of the transaction, not with the intent of the parties to the transactions. A transfer may be avoided where the leveraged company does not receive reasonably equivalent value for the transfer and if either of the following circumstances exists:
- The company is insolvent at the time of the transfer or is rendered insolvent by the transfer
- The target is left with unreasonably small assets (capital) for its business
Given such risks, it is critical to obtain a thorough, third-party opinion of the proposed transaction, at the time of the transaction, with respect to the solvency of the company.
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Solvency Tests
A solvency opinion typically addresses three tests:
- The fair value of the assets exceeds the liabilities (the balance sheet test)
- It is reasonable to believe that the entity has the ability to repay its debts as they mature
- The entity does not have unreasonably small capital for its business
The balance sheet test establishes the fair value of company equity on a post-transaction basis. If the debtor is a business enterprise and is expected to continue operating as a going concern after the deal, then valuation of the business as a going concern is the appropriate basis of valuation.
The second and third tests are related and accomplished by projecting future cash flows. A company will pass these tests in any projected period if it generates or has access to sufficient cash to fund operations and is able to pay its debts as they come due.
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Capital Adequacy Opinion Test
Boards of directors also often request a capital adequacy opinions (also referred to as capital surplus opinions) when issuing a significant dividend.
This test is similar to the balance sheet test for a solvency opinion. Capital surplus is concerned with whether the value of a company’s equity (surplus) is greater than its stated (par) value and the amount of the contemplated dividend.
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Why Work with VRC?
VRC’s fairness & solvency opinions practice group delivers judgment beyond modeling – meaning that we develop objective analyses for our clients that includes not only a valuation, but also a review of the relevant transaction’s financial structure, the type and timing of consideration and the transaction’s financial consequences. VRC has issued over 1,000 fairness, solvency and capital adequacy opinions for lenders, boards of directors, buyers and sellers and creditors for transactions ranging in value from $10 million to $10 billion in market capitalization.