Caesars Entertainment Operating Company (“CEOC” or the “Debtor”) filed for bankruptcy protection on January 15, 2015. CEOC was a subsidiary of Caesars Entertainment Corp. (“CEC”), a publicly traded company, and owned and managed a number of Caesars’ casino properties. CEC also owned other casino properties through two other subsidiaries: Caesars Entertainment Resort Properties (“CERP” (100% owned) and Caesars Growth Partners (“CGP”) (57% owned). In total, the Caesars gaming empire consisted of 43 casino properties, of which 28 were owned by CEOC.
The Debtor engaged in a series of complex sales of casinos and intellectual property as well as financings and related party transactions in the years prior to the bankruptcy filing. After the bankruptcy filing, an Examiner was appointed to investigate and report on various pre-petition transactions entered into by CEOC. Alvarez & Marsal (“A&M”) was retained as financial advisor to the Examiner.
The Financial Times’s blog, FTAlphaville, describes the Examiner’s report: For anyone who has followed the machinations at Caesars, the blow-by-blow accounts behind all the deals makes for an incredible read — the first 100 or so pages of executive summary has plenty of dirt. And even if you have not, just reading the lengths private equity firms will go to salvage bad investments is mind-blowing. The Examiner concluded that the value of claims related to fraudulent transfers, breaches of fiduciary duty, aiding and abetting breaches of Caesars management and its sponsors, and other actions ranged between $3.6 billion to $5.1 billion.
This is the first of a four-part series highlighting some of the key investigation issues and findings of the Examiners report.
CEOC’s Liquidity vs. Solvency
The Examiner’s evaluation of the potential claims resulting from the transactions under investigation required an analysis of CEOC’s financial condition at the time of those transactions. This analysis included an evaluation of whether, at the time of the transfer the entity was: (i) insolvent, or rendered insolvent as a result of the transfer; (ii) had unreasonably small capital; or (iii) was unable to pay its debts as they came due.
The evaluation of the financial condition and solvency analysis for this matter considered, but was not limited to:
- Contemporaneous market assessments;
- Determining multiples for a multi-state multi-jurisdictional entity;
- Analyzing solvency when transfer dates differ from year end or quarterly financial data;
- Analyzing a company’s ability to pay debts when due when the business has continued to operate for several years;
- Analyzing the adequacy of a company’s capital; and
- Measuring the impact of a parent’s guarantee on a subsidiary’s solvency.
A discussion related to the above factors as well as the Examiner’s overall conclusions follow.
Contemporaneous Market Assessments
Courts may look to contemporaneous market evidence to determine whether a company is solvent. Market evidence can include the value of publicly traded stock and debt instruments at the time of the transaction, other valuations resulting from private transactions, and market data regarding similar assets or contemporaneous transactions. While contemporaneous market evidence may, in certain circumstances, be strong evidence of solvency, it is not necessarily conclusive. Contemporaneous market evidence is not always reliable. Similarly, if a large number of contingent liabilities have to be valued, a company’s substantial market capitalization alone is not sufficient to establish solvency.
A number of analysts followed both the equity of CEC and the debt of CEOC since the inception of the LBO. Therefore, historical analyst reports were reviewed to gather additional market sentiment regarding the solvency of CEOC, as well as the market’s assessments of the asset transfers. By and large, analysts voiced significant concerns regarding CEC’s financial condition, its ability to pay its creditors at par, and the impact of the asset transfers. These reports provided further support to the findings and conclusions of the analytical steps performed through the traditional solvency analyses.
Although CEOC was not publicly-traded, its parent company, CEC, was. In fact, CEC owned significant assets aside from CEOC. Accordingly, the market value of the publicly-traded shares of CEC was not indicative of the market value of CEOC’s equity. Although CEC’s market value was unable to be used as a proxy for CEOC, the majority of CEOC’s debt was publicly-traded and consistently traded at a discount from par, sometimes significantly. The discounting of CEOC’s debt by market participants reflected contemporaneous evidence that the company’s creditors did not believe they would be repaid the face value of the debt. Therefore, while not a standalone test for insolvency, this market data provided additional evidence that the Debtor was insolvent.
In addition to market evidence, courts also rely on testimony from valuation experts to determine solvency. This is especially true where, for some specific reason, the market evidence “cannot be relied on to determine solvency or insolvency.”
Determining multiples for a multi-state multi-jurisdictional entity
CEOC’s revenue and EBITDA reflected results from both large destination properties on the Las Vegas Strip and regional properties located throughout the country. In performing the CEOC valuation analysis, multiples for other casino gaming companies were analyzed. However, we noted that no other company had a similar mix of properties; some were exclusively Las Vegas Strip based, others solely regional operators. Further, the market placed distinctly higher multiples for Las Vegas Strip based properties than for regional properties, many of which were less comparable to Caesars’ properties as they included, for example, riverboats and racinos. For similar reasons, the EBITDA multiple reflected by the market for CEC itself would not be indicative of an appropriate market multiple for CEOC. CEC’s financial results, which included CEOC, were also impacted by Las Vegas Strip properties held in other subsidiaries as well as a growing online gaming business. As a result, it was determined that the multiple should reflect the market’s views and distinctions between Las Vegas Strip properties and regional properties. Based upon that determination, various analyses were performed to derive an applicable multiple for CEOC based upon the guideline public companies using the Las Vegas Strip properties and regional properties.
The concept of “Retrojection”
The financial data utilized in analyzing solvency captures cumulative data as of a particular point in time; in this case as of each year-end. By definition, a solvency analysis cannot make specific determinations at every point in time over the lengthy period during which the alleged transfers occurred. Accordingly, a concept termed “retrojection” was used to evaluate the intermediate points in time subject to a solvency analysis. The retrojection rule provides that a debtor who is shown to be insolvent on the first known date and the last relevant date, and there is an absence of any substantial or radical changes in the assets or liabilities of the debtor between the two dates, then the debtor is deemed to be insolvent at all intermediate times. In the case of CEOC, solvency was determined as of year-end, and retrojection was used to determine the solvency at various intermediate dates.
Analyzing a company’s ability to pay debts when due when the business has continued to operate for several years
CEOC operated for seven years after the LBO before it filed for bankruptcy protection. Outward appearances would suggest that CEOC was paying its debts when due as CEC found sufficient liquidity to allow CEOC to pay its debt.
However, in the context of solvency analyses, the “cash flow test” focuses on the ability of an entity to pay its debt as they come due. It is a forward-looking concept that addresses not only whether a debtor can meet its current obligations, but also whether it can meet its future obligations. The debt that is coming due and the debtor’s liquidity can be evaluated, for example, in the context of the debtor’s financial projections as well as other analyses including:
- CEOC’s internal projections – free cash flow prior to debt maturity
- CEOC’s long-range plans – EBITDA
- Actual EBITDA generated
- Interest coverage ratio
- Cash flow generated by operation
- Internal analysis on liquidity
- CEOC’s operating performance and condition
- CEOC’s public disclosure regarding ability to pay debts when due
In all cases CEOC’s detailed entity-level projections, covering revenues, operating expenses, interest, and taxes, but prior to repayment of debt maturities reflected that CEOC would be cash flow negative prior to repayment of maturing debt. In addition, CEC long-range plans projecting revenue and operating expenses to arrive at EBITDA for each casino property demonstrated that the EBITDA for CEOC’s properties would be insufficient to pay interest expenses and capital expenditures.
CEOC’s actual results also indicated that CEOC did not generate sufficient EBITDA to meet its interest expense. Likewise, its interest coverage ratios showed ratios of less than one which indicates that interest expenses could not be covered.
The operating performance of the Debtor from 2008 through 2014 showed that CEOC’s revenue and EBITDA significantly decreased over time, whereas competitors in the industry eventually recovered from the Great Recession. Its operating margins also declined over time and were lower than its industry peers. Internal CEOC analyses also demonstrated that CEOC was aware that it did not have sufficient capital to meet its liquidity needs.
In fact, CEOC consistently failed to generate sufficient cash flow from operations to pay its operating expenses, inclusive of interest expense. In other words, the company’s cash cost to operate its business exceeded its cash collections from operations. The ability of an entity to consistently generate positive cash flow from operations is critical to its long-term survival and ability to pay its debts when due. When this does not occur over an extended period of time, it is a sign of insolvency.
Finally, CEC’s 10-K’s reflected numerous disclosures related to CEOC’s risk of not being able to generate sufficient cash to meet its obligations. Although it appeared CEOC was paying its debts when due, in essence CEOC was only able to pay its operating expenses, including interest, by borrowing more money and selling assets. While CEC viewed this as “extending runway,” these actions only contributed to CEOC’s increased level of insolvency.
All of these analyses demonstrated that CEOC never projected or actually generated sufficient cash flow to pay its debts when due. Instead, the Debtor survived by selling assets to pay its expenses, thus reducing the earning power of the company while, to the company’s detriment, maintaining a consistent level of interest bearing debt.
Analyzing the adequacy of a company’s capital
Capital generally refers to financial resources available for use and includes all reasonably anticipated sources of operating funds, including new equity infusions, cash from operations, or cash from secured or unsecured loans. Capital, however, is different from cash; it is more durable and used to generate wealth through investment. Inadequate capital means the inability to generate sufficient capital to sustain operations and protect creditors.
CEOC’s financial statements as of each year end from December 31, 2008, through December 31, 2014, reflected that the book value of its liabilities exceeded the book value of its assets by a wide margin. In other words, the Debtor had no equity capital to provide protection to its creditors. Further, when the Debtor’s balance sheet is adjusted to eliminate goodwill, CEOC’s capital reflected an even more distressed company.
In addition, the lack of availability of working capital (the excess of a company’s current assets over its current liabilities) as well as higher traditional debt to equity ratios over time compared to the industry suggested the Debtor was not sufficiently capitalized.
Impact of the Parent Guarantee
The debt of CEOC was guaranteed by CEC for a period of time and then purportedly released. Assuming the guarantee was still valid, if the guarantee could make the bondholders whole, then an argument could be made that CEOC was solvent. However, various analyses used to assess CEC’s ability to satisfy the guarantee showed that, even assuming that the guarantee was in place, CEC’s financial position was insufficient to make the bondholders whole.
Summary of Conclusion
Based upon the analysis undertaken, which included traditional solvency analyses as well as other market data and considerations some of which were discussed above, the Examiner concluded that CEOC was insolvent at all relevant times from year end 2008 through its bankruptcy filing in early 2015.
 The bankruptcy code allows for the appointment of an examiner, as noted in the bankruptcy code, and examiner shall perform an investigation of the acts, conduct, assets and financial condition of the debtor and other duties as ordered by the court.
 Examiner’s Report at p. 78-80.
 Examiner’s Report at p. 129.
 VFB LLC v. Campbell Soup Co., 2005 WL 2234606 at *31 (D. Del. Sept. 13, 2005), aff’d, 482 F.3d 624, 632-34 (3d Cir. 2007); Iridium Operating LLC, 373 B.R. at 352 (same).
 The Seventh Circuit has cautioned, however, that a positive price for a firm’s stock does not conclusively establish solvency. Paloian v. LaSalle Bank, N.A. (In re Doctors Hosp. of Hyde Park, Inc.), 619 F.3d 688, 694 (7th Cir. 2010) (positive price is only “very likely” as opposed to “certain” in connection with establishing solvency because even stock of a bankrupt company has option value). Here, of course, as discussed elsewhere in this Report, CEOC had no publicly traded stock and a negative equity value, and its debt, in particular its second lien and unsecured debt, was trading at a deep discount to par when most of the transactions under investigation occurred.
 See, e.g., VFB, 2005 WL 2234606, at *22 (citing Peltz v. Hatten, 279 B.R. 710, 738 (D. Del. 2002); Cooper v. Ashley Commc’n Inc. (In re Morris Commc’n NC, Inc., I.D. No. 56-13357778, Debtor), 914 F. 2d 458, 469 (4th Cir. 1990); PHP Liquidating, LLC v. Robbins (In re PHP Healthcare Corp.), 128 F. App’x. 839, 848 (3d Cir. 2005)). Proof of insolvency can also include “the use of balance sheets, financial statements, appraisals, expert testimony, and other affirmative evidence.” A company’s GAAP financial statements may “provide a starting point” but they “are not automatically dispositive.” Quadrant Structured Products Co., Ltd., 2015 WL 6157759, at *16; Barber v. Production Credit Services of West Central Ill. (In re KZK Livestock, Inc.), 290 B.R. 622, 625 (Bankr. C.D. Ill. 2002) (“[N]o GAAP exist for analyzing the insolvency of a company.”); Lids Corp., 281 B.R. at 542-43.
 In re W.R. Grace & Co., 446 B.R. 96, 106 (Bankr. D. Del. 2011).
 W.R. Grace & Co., 446 B.R. at 105-106, and n. 11.
 Tronox II, 503 B.R. at 296 (market did not efficiently determine size of Tronox’s environmental liabilities); W.R. Grace & Co., 446 B.R. at 105-06, n.11 (market evidence was “not conclusive” relating to size of asbestos liability).
 Examiner Report at p. 160-161.
 Earnings Before Interest, Taxes, Depreciation, and Amortization (“EBITDA”).
 Examiner Report at p. 137, FN 283.
 Examiner Report at p. 165-175.
 Examiner Report at p. 175-189.
 Goodwill is an accounting asset that does not generate revenue or cash flow, nor can it be sold or leveraged to the benefit of creditors.
 Examiner Report at p. 189-195.
 Examiner Report at p. 137-141.