Should Solvency Valuation Include Ongoing but Undiscovered Fraud?
Business Valuation Advisor, Winter 2008
In re Edgewater Medical Center, 2007 Bankr. LEXIS 2696 (August 15, 2007)
Most attorneys are well aware of the prohibition against including hindsight in the valuation of a business interest. But what about a current condition—present at the time of valuation—but unknown to all but company insiders, such as a pervasive accounting or Medicare fraud? This case examines both elements in the bankruptcy context and makes an interesting distinction between fraud that conceals insolvency and fraud that causes it.
$13 million Medicare fraud
In 1994, the principal owner of a hospital corporation and related holding company (which owned the hospital’s real estate assets) sold most of his interest to a nonprofit company, doing business as Edgewater Medical Center (EMC). The holding company retained ownership of certain properties adjacent to the hospital; two years later, in 1996, it granted EMC a ten-year lease and option to purchase the adjacent properties.
In 2001, EMC ceased operations and filed its Chapter 11 proceedings. At the time, the owner of the real estate holding company (the same one who sold the hospital operations to EMC) was charged with extensive Medicare fraud and related claims. After a lengthy trial—and fines and forfeitures of $13 million–the owner abruptly fired his lawyers and left the country.
In this next phase of proceedings, EMC attempted to recover the substantial (nearly $18,000 per month) rental payments made pursuant to the lease agreement as fraudulent or preferential transfers. Interestingly, it also included the holding company’s failure to exercise the lease option among its claims—all of which depended on EMC proving that it was bankrupt at the time of the transfers.
Fraud was pervasive but hidden
Neither party disputed that the Medicare fraud took place during the relevant valuation period. At trial, however, the defendant holding company claimed that EMC was solvent during the time, because—pursuant to the definitions under both the federal Bankruptcy Code and the local (Illinois) Uniform Fraudulent Transfer Act—its assets exceeded its debts. Evidence showed that EMC held over $29 million in cash and investments at the time of the transfers.
EMC didn’t directly challenge this valuation evidence. Instead, it presented credible expert testimony that had the ongoing Medicare fraud come to light in 1996, federal reimbursements would have ceased and the debtors would have been bankrupt. To advance its argument, EMC cited a New York bankruptcy case in which a debtor’s insolvency was hidden behind false accounts receivable and other financial misrepresentations.
In theory, the Bankruptcy Court agreed. Whether valued on a going concern or liquidation basis, EMC was insolvent if the effect of the Medicare fraud was included in its valuation. But it distinguished the New York precedent. In that case:
The company actually was insolvent. It only appeared to be solvent because it was ‘cooking the books.’ In the case at bar, the debtor [EMC] might have been rendered insolvent if the Medicare fraud had been uncovered.
Further, in the case of falsified accounting records, there was no need to incorporate any hypothetical fines, penalties, or cessation of payments to make a finding of insolvency. "But that is exactly what [EMC] is asking the Court to do here." To find insolvency, the Court would have to disregard the company’s actual cash position and speculate on what would have happened had the government discovered the Medicare fraud. The Court declined to do so, and found that EMC was solvent at the time of the transfers, because its assets "clearly outweighed" its debts.
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