In re Nanovation Technologies, Inc.

• Decision Date: 17 May 2007
• Docket Number: Bankruptcy No. 01 B 26090.,Adversary No. 03 A 2300.
• Citation: 364 B.R. 308
• Parties: In re NANOVATION TECHNOLOGIES, INC., and Nanovation Technologies of Michigan, Inc., Debtor. Barry Chatz, Chapter 7 Trustee, Plaintiff, v. BearingPoint Inc., et al., Defendants.
• Court: U.S. Bankruptcy Court — Northern District of Illinois

Page 308

364 B.R. 308

In re NANOVATION TECHNOLOGIES, INC., and Nanovation Technologies of Michigan, Inc., Debtor Barry Chatz, Chapter 7 Trustee, Plaintiff, v. BearingPoint Inc., et al., Defendants.

Bankruptcy No. 01 B 26090.

Adversary No. 03 A 2300.

United States Bankruptcy Court, N.D. Illinois, Eastern Division.

May 17, 2007.

Barry A. Chatz, Arnstein & Lehr LLP, Chicago; IL, Chapter 7 Trustee.

C. Philip Curley, Alan R. Dolinko, Carl Bergetz, Robinson Curley & Clayton PC, Chicago, IL, for the trustee.

Thomas J. Cunningham, P. Russell Perdew, Simon Fleischmann, Lord Bissell & Brook LLP, Chicago, IL, for the Defendants.

MEMORANDUM OPINION

PAMELA S. HOLLIS, Bankruptcy Judge.

I. INTRODUCTION

In the late 1990s, the U.S. economy appeared unstoppable. Unemployment and inflation were low, the growth rate was high, and the Internet revolutionized business. The summer of 2000 was the apogee of the technology boom. The stock market, especially the NASDAQ index, reached astronomical all-time highs in March 2000. The volume of IPOs soared. Companies no longer needed to show 12 quarters of profit before going public — they no longer needed any profits, or even revenues. In the oft-repeated phrase coined by Alan Greenspan, the American economy was in a period of "irrational exuberance."

During this period, no sector was more exuberant than the telecommunications niche.¹ Presumably, companies that could move escalating Internet traffic fastest could make the most money. One method of moving such information was through fiber-optic cable.

The debtor, Nanovation Technologies, Inc., focused on integrated optical solutions for telecommunications, data communications, networking, access, avionics, and other markets. Nanovation believed it had a better, faster way to move data, and its early investors would get a fantastic return. "The telecommunications business was hot, and optical engineers were the hottest commodities of them all ..."²

Unfortunately, in the fall of 2000, members of the fiber-optics community began to realize that too much fiber-optic cable was already deployed. Only 10% of the existing cable was currently being used. Moreover, due to continuing improvements in technology, that 10% would soon be able to carry double or even triple the expected traffic. To compound matters, the expected traffic never materialized:

Telecom has turned into one of history's biggest bubbles because so much money poured into the industry during the stock-market boom, creating some $470 billion in debt and a vast glut of capacity. Once a sleepy industry known for its modest growth, telecom took off like a rocket in the late '90s as companies rushed to lace the world with ultra-fast fiber-optic networks to carry an expected onslaught of Internet traffic. But after a frenzy of spending and hiring, it suddenly became clear in mid-2001 that the Internet wasn't growing nearly as fast as the 1,000-fold annual increases originally predicted. The huge run-up has now been replaced by a merciless ride down. Rumors of foreclosures and marital problems have replaced word of the latest IPO. Some laid-off telecom workers are even turning up in local homeless shelters. So much money was spent buying telecom gear during the frenzy that there is now seven years' worth of excess inventory, says Lonnie Martin, chief executive of White Rock Networks, a Richardson start-up that is trying to hang on. He values the excess supply at some $160 billion. "That is an awful lot of exuberance to get rid of," he says.³

Shortly after the bubble burst, on July 25, 2001, Nanovation voluntarily sought relief under Chapter 11 of the Bankruptcy Code. Eventually the case converted to Chapter 7 and a trustee was appointed to administer the estate. The trustee brought this adversary proceeding against defendants BearingPoint, Inc., f/k/a KPMG Consulting, Inc., f/k/a KPMG Consulting LLC; BearingPoint LLC, f/k/a KPMG Consulting LLC; KPMG Consulting LLC; and KPMG Consulting, Inc. (collectively, "KPMG"). The trustee alleges that KPMG's September 30, 2000 valuation of Nanovation stock was improperly inflated to permit insiders to repay loans from the company with company stock that was virtually worthless. The trustee reasons that, if the stock had not been grossly overvalued by KPMG, the insiders could not have repaid the notes with the stock and would be liable to the bankruptcy estate in an amount exceeding twenty million dollars.

While not quite "irrational", the trustee's exuberant pursuit of KPMG was seriously misguided. Two critical errors haunted the trial of this case. First, to establish damages the trustee had to contradict himself by accepting KPMG's valuation methodology before September 30, 2000 but rejecting it on September 30 and thereafter.

Nanovation's loans to its directors and officers never involved the transfer of cash from the company to these insiders. The loans merely enabled them to purchase Nanovation stock. The amount of the loans was based on the value of stock or options given to the directors and officers. If the stock was worthless despite KPMG's valuation methods on September 30, then the stock was similarly worthless months earlier when KPMG used identical assumptions to value the stock at the time of the insiders' purchase. Accordingly, the face amount of the notes to purchase the "worthless" stock would be miniscule at best, and not the twenty million dollars or so that the trustee seeks to recover here.

The trustee's failure to ask his expert Robert Reilly to value Nanovation stock at the time the stock loans were given exposes this incongruity. If Reilly valued the stock at the time of the purchase, his choice of a 5% perpetual growth rate (which he insists is realistic as opposed to KPMG's 15%) in the discounted cash flow analysis, or his selection of only one pricing fundamental for the market multiple approach, would not have changed from his September 30 valuation. So, Reilly would have to conclude that the stock was also nearly worthless when it was purchased with the loans. As a result, the loans from Nanovation to the insiders would be small or non-existent. In all likelihood, loans would not be necessary to purchase a "penny" stock in contrast to the actual loans given to purchase a $9.00 stock.

The trustee depended on KPMG's valuation methods at the time the loans were extended but assailed the same valuation approach when the loans were repaid. By accepting KPMG's valuation of the stock before September 30, but rejecting the same approach taken on September 30 and after, the trustee aims to invent damages. The court is not fooled. If Reilly's valuation methods were superior as of September 30, then they were superior prior to that time. If KPMG adopted Reilly's techniques on both occasions, there would be little or no insider loans to collect because large sums of money were not required to buy worthless stock. Instead KPMG used a different approach that was consistent both before and after September 30, which also ended up with no insider loans to collect. The end result is the same, no matter which valuation approach is used, as long as the approach is consistently applied. Damages can only accrue if KPMG's approach is valid at the time the stock is purchased and suddenly invalid when the notes are repaid.

The second major flaw in the trustee's case was his expert's refusal to take into account any real market transactions involving the purchase and sale of Nanovation's stock. KPMG valued Nanovation's stock at $9.20 a share on September 30, 2000, while Reilly valued the stock at fifteen cents a share on that same day. When the stock was actually bought and sold by third parties shortly before September 30, its price nearly always exceeded KPMG's $9.20 valuation. Not one stock sale came close to fifteen cents. While there are reasons to discount some of those real world transactions, it is imprudent to completely ignore them. What appraiser considers theoretical textbook valuation methods exclusively when the asset is repeatedly bought and sold in the real world?

This case consumed eight days of trial time. Thousands of pages of exhibits were offered and accepted into evidence. The trustee's proposed findings of facts consisted of 219 pages, with 907 paragraphs of findings. KPMG submitted 138 pages of post trial proposed findings with 768 paragraphs. The court's own personal trial notes exceeded 50 pages. After pouring through this material, the court is left with the firm conviction that KPMG's September 30 valuation was not only within the bounds of professional care and applicable standards, it was at least as credible as Reilly's. On the other hand, had KPMG adopted Reilly's 5% perpetual growth rate or his other valuation methods at the time the stock was sold to insiders, KPMG's valuation of Nanovation's stock would have been dramatically lower. If the stock was worth almost nothing when initially transferred to the insiders, then no loans were needed to exercise the stock options, leaving the trustee with nothing to collect — and no damages here.

There are three counts in the Complaint. Count I alleges a breach of contract, asserting that KPMG failed to properly ascertain the fair market value of Nanovation stock on or about September 30, 2000. It is asserted this valuation was used by Nanovation to determine the amount of stock that had to be returned to retire the loans. Count II alleges defendants were negligent in their preparation of the September 30 valuation. Count III further alleges that defendants aided and abetted insiders in breaching their fiduciary duties to Nanovation. For the reasons stated below, the court enters judgment in favor of KPMG and against the trustee on all counts.

II. FINDINGS OF FACT

Debtor's History and Products

1. Debtor, Nanovation, a Delaware Corporation, was formed in 1999 as a successor company to U.S. Integrated Optics ("USIO"), which was established in 1996.

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