Valuation of contingent liabilities: some risk management considerations for lenders

RMA Journal, The, Sept, 2005 by Benjamin S. Seigel

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.