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Lessons from the Tronox Bankruptcy

Anadarko shares plunged 9.3 percent in after-hours trading on December 12, 2013, cutting its market value from approximately $42 billion to approximately $38 billion after a judge ruled money can be recovered from a successor to a polluting company, even after bankruptcy has seemingly cleansed the slate of obligations. The case stems from Kerr-McGee’s spin-off of its chemicals business along with its old environmental liabilities as a new company, Tronox, on March 30, 2006.

In 2000, Kerr-McGee began the execution of a plan to restructure its corporate structure to match its businesses units, the chemicals unit and the oil and gas exploration and production unit. This was based on advice from their investment bankers that the units would be worth more as separate entities than as a combined unit. Once the units legal structure matched the business unit structure, they were able to maximize shareholder value by separating the two units.

The spin-off of the chemicals unit was effectuated by providing 0.20164 of a share of Tronox Class B common stock for every outstanding share of Kerr-McGee’s stock. At the time of the spin-off, Tronox was capitalized with $57.3 million in available cash and cash equivalents, and $549.5 million in total debt. Tronox also recorded approximately $140 million in environmental remediation and/or restoration liabilities and approximately $230 million in other liabilities (which included asset retirement obligations and pension obligations).

On June 22, 2006, about three months after the spin-off transaction was completed, Anadarko and Kerr-McGee’s announced their agreement to merge Kerr-McGee into Anadarko in a stock transaction for $18 billion. The transaction took the form of $16.4 billion in cash (or $70.50 for each share of Kerr-McGee). Anadarko also assumed $1.4 billion in Kerr-McGee debt.

Tronox filed for bankruptcy on January 12, 2009, and sued Anadarko and Kerr-McGee the same year under the assertion that the spin-off left Tronox insolvent, undercapitalized, and was not made for reasonably equivalent value. Anadarko has asserted that Kerr-McGee had reorganized to separate the chemical business from the oil-and-gas business and maximize shareholder value.

“This is a very interesting and chilling development,” stated Robert L. Moore, Jr., Managing Director at Stout Risius Ross. “It points to the dangers of acquiring the stock in a public company (the Anadarko/Kerr-McGee deal), transactions in which there are typically few reps, warranties, and remedies for the acquirer. In these situations such elements must be vetted and quantified by the acquirer.”

The Tronox spin-off was only one of a number of reorganizations that have occurred in recent years to unlock shareholder value by decoupling assets. Others include the Conoco Phillips spin-off of Phillips 66, the Valero spin-off of its retail business, CST Brands Inc., and the Marathon Oil Corporation’s spin-off of its downstream business into Marathon Petroleum Corporation, which encompasses its refining, marketing, terminals, and pipelines, as well as its Speedway gasoline and convenience stores.

As the judge moves this case into the damages stage and the appellate process begins, it is worth looking at a couple of good questions for executives and business advisors to consider:

How do you value environmental or other contingent liabilities when evaluating a transaction?

Consideration of contingent assets and liabilities represents one of the more unique and difficult issues encountered by companies and their advisors. Contingent assets and liabilities result from an existing condition, situation, or set of circumstances that involve uncertainty given their dependence upon the outcome of future events. These amounts often pertain to potential litigation settlements, environmental costs, product liability claims, earn-out payments, or other future uncertain events. By definition, the final calculation of the contingent asset or liability cannot be determined with certainty until the actual occurrence of a future event, thus rendering the valuation of these amounts prior to such event, a particularly difficult challenge for the acquirer and advisors. Nevertheless, such assets and liabilities can be valued using multiple valuation methodologies, including Discounted Cash Flow, Binomial Option Pricing Method, and the Monte Carlo Method. In addition, consideration should be given to insurance coverage and anticipated costs.

Discounted Cash Flow Method

The Discounted Cash Flow (“DCF”) Method is a valuation technique in which the value of an asset or liability is estimated based on the present value of its expected future cash inflows or outflows. To perform a DCF analysis, the expected Cash Flows are projected into the future. Each period’s Cash Flow is then discounted to the valuation date at a rate of return commensurate with the risk involved in realizing those Cash Flows. An investor would accept a rate of return no lower than that available from other investments with equivalent risk and would value the investment accordingly. A potential limitation of the DCF Method is that it typically involves modeling only the most likely or representative outcomes. This limitation may be addressed, in part, by preparing multiple iterations of the DCF Method by adjusting the anticipated Cash Flows, discount factors, and time requirements, and then applying a probability weighting to each scenario. However, in general, given the number of scenarios often required in this type of analysis, a DCF Method on its own may not provide the level of flexibility required to handle the complex nature of many contingent items.

Binomial Option Pricing Method

Contingent assets and liabilities inherently maintain a significant degree of uncertainty, as they involve a number of potential outcomes dependent upon the resolution of multiple factors. As a result, the uncertainty inherent in contingent assets and liabilities may be more appropriately addressed through valuation methodologies applied for financial options, such as the Binomial Option Pricing Method (“BOPM”), which provides a greater degree of flexibility.

From a financial point of view, the BOPM is an arbitrage-pricing model that is premised on the concept that if two assets have identical payoffs, they must have identical values to prevent arbitrage (i.e., riskless profit). The BOPM utilizes a “decision tree” framework whereby movement in future contingent Cash Flows is estimated based on a volatility factor. The application of the BOPM may generally be performed in several steps. First, the amounts and timing of the future contingent Cash Flows are estimated under multiple scenarios. For each time period, the model assumes that at least two price movements are possible. The resulting lattice model represents the evolution of the Cash Flows attributable to a particular contingent asset or liability. These amounts are then discounted to their present value equivalent utilizing a rate of return consistent with the risk of the Cash Flows. The resulting present values of the contingent payments under each scenario are then weighted in accordance with the likelihood of each scenario.

The BOPM provides a greater level of flexibility relative to the DCF Method by allowing for incorporation of multiple scenarios. However, this method is limited given that it requires an increased number of assumptions that are difficult to accurately quantify, in particular with respect to the volatility in the Cash Flows and the probabilities assigned to each scenario. Further, although it does provide increased flexibility, it remains limited by the number of scenarios that can practically be modeled.

Monte Carlo Method

Given the limitations of the DCF and BOPM methodologies, the Monte Carlo Method often is considered to provide the maximum level of flexibility required to address the significant degree of uncertainty inherent in many contingent assets and liabilities. As a result, a Monte Carlo analysis is often applied in lieu of, or at least as a supplement to, the more traditional income-based valuation approaches, including the DCF Method and the BOPM. Monte Carlo methods are probabilistic in nature and involve statistical random sampling techniques that simulate the various sources of uncertainty and calculate an average or expected value over a range of thousands of resultant outcomes. In other words, since the analysis provides a range of possible outcomes and the probabilities that they will occur for any particular action, it more accurately accounts for claims with several sources of uncertainty and those with complicated features.

A Monte Carlo analysis essentially allows for the simulation of multiple inputs and outcomes in an income-based analysis specifically modeled to incorporate the unique characteristics of the particular asset or liability. Thus, the application of a Monte Carlo analysis involves first developing an analytical model similar to the DCF Method that incorporates many of the same drivers of value. The key assumptions revolve around the assumed probability distributions and distribution parameters for a particular action. A Monte Carlo simulation analysis can then be performed on the model by running multiple scenarios incorporating a range of random values for the key value drivers. The Monte Carlo simulation ultimately returns an expected value based on the outcomes for the numerous scenarios and, in this regard, provides a more comprehensive and robust analysis. Thus, the valuation professional should have experience with statistical modeling in general and Monte Carlo analyses in particular.

Insurance Coverage

Given the nature of certain claims, a more straightforward analysis may be applicable and practical. In particular, the incremental cost to obtain adequate insurance coverage sufficient to satisfy any potential liability may provide a reasonable benchmark from a valuation perspective. One caveat to this approach is the importance of considering the availability of insurance products for a particular liability. For example, insurance products generally exist in some form of liabilities such as environmental remediation costs, medical claims, and product liabilities. However, insurance products for various types of litigation may not necessarily be available in the marketplace, thus limiting or precluding the usefulness of this method as a reliable indication of value.

Anticipated Costs

To the extent that they can be reasonably estimated, the anticipated costs to be incurred in remediating, settling, or litigating a claim may provide a compelling proxy of value. For example, a contingent environmental liability could be based on the anticipated fines and remediation costs including excavation, transportation, capping costs, lab analysis, disposal, and environmental engineer and attorney fees required to resolve an enforcement action.

How should contingent future liabilities be considered in your analysis of adequacy of capital?

To address these risks, companies and their directors often choose to engage a financial advisor to prepare a solvency opinion, which is an analysis of whether a company will remain solvent in consideration of, and taking into account, the amount of debt in the new entity. Most solvency opinions apply three financial tests to assess a subject company’s solvency: 1) the Balance Sheet Test, 2) the Cash Flow Test, and 3) the Capital Adequacy Test. While an in-depth discussion of each of these tests is beyond the scope of this article, each of them is intended to address the following factors that affect solvency:

aI Whether or not the Fair Value of a company’s assets exceeds its liabilities (including stated liabilities and identified contingent liabilities)

bI Whether or not the company should be able to satisfy its debt obligations—related to existing debt as well as any new debt incurred as a result of the transaction—as those debts mature

cI Whether or not the company should have a reasonable level of capital following a transaction for the business in which the company is engaged

Although a solvency opinion performed in connection with a transaction cannot in and of itself ensure that the business will not ultimately become financially distressed in the future, or even enter bankruptcy, it can assist corporate directors in carrying out their fiduciary duties to a company’s stakeholders in connection with the transaction.

When acquiring another entity, how do you perform due diligence on transactions that have been recently completed that would transfer environmental liability or other contingencies?

Every recent transaction should be carefully evaluated to determine what was actually transferred that is apparent and not so apparent. So even if the transaction is small, or just an internal transfer of assets between sister companies, it should be closely reviewed to determine:

aI What assets and liabilities were transferred?

bI Were contingent future obligations evaluated and considered in the price? In many transactions, identifying environmental risks and liabilities is a critical first step in the transaction process. Once identified and quantified, an informed negotiation on risk allocation, value implications, and risk management solutions can take place.

cI Was a fairness opinion issued and did the fairness opinion address contingent liabilities?

dI How was the transfer pricing of intercompany transactions determined?

Due diligence of acquisitions where recent transactions have occurred is critical and requires a real analysis of the value of all identified contingent liabilities to determine if a fair price was received.

Conclusion

Contingent assets and liabilities exist in many forms and generally maintain significantly different risks, payout streams, and timing requirements. As a result, the unique facts and circumstances of each particular situation warrant consideration by the parties in any transaction. What we have seen from the Tronox situation is that the implications of these transactions can follow a successor and as a result must be considered by executives and advisors during corporate restructures and spin-offs.