June 16, 2014 | Valuations
In re Tronox Incorporated, 2013 Bankr. LEXIS 5232 (Dec. 12, 2013)
Valuation experts of various stripes took center stage in a recent fraudulent conveyance suit regarding a parent company’s decision to spin off its chemical manufacturing business from its highly profitable oil and gas exploration and production business. The transaction left the former with billions of legacy environmental and tort liabilities and ultimately led to bankruptcy. The litigation trust sued to recover from the defendants the value of the transferred oil and gas assets. The court’s 82-page decision explored claims as to reasonably equivalent value, business enterprise value, and environmental and tort liabilities.
Liberating assets from liabilities. The plaintiffs and defendants started as a many-tentacled enterprise that included an oil and gas exploration business as well as a uranium mining business and various chemical plants. By November 2005, only two businesses remained: the oil and gas exploration and production (E&P) business and the chemical—titanium dioxide—business. The E&P business was dominant, with operating profits of about $1.8 billion for that year; in comparison, the chemical business brought in about $106 million. The conglomerate’s enormous environmental and tort liabilities represented a major problem: Since 2000, it had incurred more than $1 billion in environmental response costs and was spending more than $160 million a year on remediation. This made it an “unattractive” acquisition candidate. In 2002, the eventual buyer of the E&P business rejected a merger, reasoning that future environmental liability would be “$BILLIONS” and could last for “at least 30 more years.” (After the spinoff, it paid more than $18 billion for the nearly liability-free E&P business.)
As early as 2002, the parent company’s top management hired Lehman Brothers to pursue a corporate reorganization. Essentially, it meant transferring the E&P business—the oil and gas assets—to a new holding company (one of the defendants in the suit) and transferring the ownership interests in the E&P subsidiaries to a new company; the old company was refashioned into the stand-alone titanium dioxide company.
In preparation for an IPO/spinoff of the chemical company, management prepared projections but, at the direction of its CFO, abandoned its customary methodology. Until February 2005, it had forecast titanium dioxide pricing using a mean treadline based on decades of historical pricing data, but the March 2005 forecast that was the source of the IPO numbers showed dramatic increases. Specifically, projected results increased by $99 million in 2008 (to a total of $228 million) and $128 million in 2009 (to a total of $325 million).
In November 2005, the split culminated in a master separation agreement in which the parent company dictated the terms. The chemical business would assume every legacy liability of every discontinued business the original company had owned in the prior 75 years. The E&P business would only assume liability based on “currently conducted” E&P operations. The net cash proceeds from the spinoff were $537.1 million, after expenses, but the chemical business was made to pay everything but $40 million in cash to the E&P entities. Last, but not least, it was to assume $442 million in pension obligations and $186 million in unfunded “other post-employment benefits.”
At one point in 2005, Lehman Brothers prepared for a possible sale of the chemical business, but most potential purchasers balked at taking on the large legacy liabilities. Only one of the four finalists, Apollo, made a “final offer,” which envisioned a purchase price of $1.3 billion, $300 million in indemnities from the new entity for the environmental liabilities the buyer would assume, and an additional $200 million indemnity for breaches of representation and warranties. The contract contained numerous open items and terms the new, E&P company previously had rejected. The sale did not go through. As part of doing due diligence, Apollo also hired an environmental consultant to value the legacy liabilities; the latter calculated them to be $556.1 million on an undiscounted basis.
A one-product business, the chemical company floundered almost immediately after the spinoff. From November 2005 through the third quarter of 2008, it lost $199.7 million. As it was struggling with poor cash flow, it had to fund legacy liabilities. It only was able to fund $90 million per year, net of reimbursements, but even that reduced amount was 56% of its 2006 EBITDA and 95% of its 2007 EBITDA. A financial analyst involved in the negotiations leading up to the spinoff summed up the situation in a picture that showed a flower (the chemical business) and a weed (the legacy liabilities) strangling the flower.
In January 2009, it petitioned for bankruptcy. The litigation trust sued in Bankruptcy Court (S.D.N.Y.) on behalf of a number of plaintiffs, including the three debtor entities that made up the estate of the chemical company and public and private entities that had claims against the debtors for environmental cleanup costs and tort liabilities. The defendants were the parent company and the entities making up the E&P business. The plaintiffs’ principal claim for relief was that the transaction that removed substantially all of the parent company’s assets from the legacy liabilities was an actual or constructive fraudulent conveyance. It left the debtor insolvent. The defendants characterized the transaction as an attempt “to unlock the value inherent in each of [the businesses].”
Actual fraud beyond dispute. Whether the transfers were actually fraudulent was a question of whether they “hinder[ed] and delay[ed] creditors,” the court explained. In this case, it was beyond dispute that [the defendants] acted to free substantially all its assets—“certainly its most valuable assets”—from decades of historic liabilities, said the court. By the defendants’ own admission, the assets represented 86.4% of the old entity’s assets and accounted for 83.2% of its revenue and 112.6% of its net income as of December 2001. As a result, the legacy creditors would be left with a minimal asset base on which to recover in the future; accordingly, they were “hindered or delayed” as a direct consequence of the transaction, the court concluded.
REV expert undergirds constructive fraud claim. Whether the transfers were constructively fraudulent was a question of whether the chemical business received “reasonably equivalent value” for distributing the E&P assets and other property as part of the spinoff, said the court. Both sides used REV experts.
The plaintiffs retained a reputed bankruptcy analyst to show there was no REV. He determined that the debtor companies conveyed property worth approximately $17 billion (including the E&P assets) and received in return $2.6 billion, a $14.5 billion reduction in value. To calculate the market value for the conveyed E&P assets, he compared the company’s oil and gas business to seven independent, comparable E&P companies and determined it was worth approximately $12 billion as of November 2005. He then added a 30% control premium, concluding that the value of the transferred oil and gas assets was approximately $15.8 billion as of that date. His valuation aligned with valuation estimates from Lehman Brothers and Salomon Smith Barney and the actual price the future buyer paid only a few months after the spinoff, he said.
The defendants did not question the calculations, but their REV (and back-up damages) expert, who, the court pointed out, testified for the first time in a fraudulent conveyance suit, objected that the REV and solvency analyses should be on a strict entity-by-entity basis. This would mean that two of the debtor companies did not receive REV, but one did receive REV with the transfer of interests in an Australian titanium dioxide plant. The court dismissed that argument, finding that “the ‘market’ dealt with [the entities] on a consolidated basis.” They appeared as one entity for purposes of the spinoff, and every one of them was liable on the debt issued as either a borrower or guarantor. It adopted the conclusions of the plaintiffs’ REV expert.
Solvency experts with ‘sterling credentials.’ The critical next question was whether the transfers left the chemical company insolvent. The answer lies in a “balance sheet test,” which requires a determination of whether the debts in the aggregate are greater than assets in the aggregate, said the court. In this case, the parties called insolvency experts with “sterling credentials,” it added. In commenting on the experts’ qualifications, it explained that the defendants’ expert was well known for his view that “market prices typically are more reliable evidence of a company’s value than ex post analyses prepared by experts in the context of litigation.” For his solvency opinion, he said he did not rely on any of the defendants’ other experts but strove for a “completely self-contained analysis.”
To determine the chemical company’s business enterprise value (BEV) as of November 2005, both experts used a three-prong approach: a discounted cash flow (DCF) analysis, a comparable company analysis, and a comparable transaction analysis. The plaintiffs’ expert computed a BEV of $1.03 billion, whereas the defendants’ expert said it was $1.7 billion.
1. DCF analysis. The major difference in the experts’ DCF analyses related to the use of cash flow projections. The plaintiff’s expert believed the company’s internal projections required a downward adjustment. As he saw it, they were “sell-side” projections based on overly optimistic assumptions and key numbers “were imposed at the direction of [the parent company’s] chief financial officer.” For this reason, the expert used the February 2005 projections.
In contrast, the defendants’ expert adopted the management projections without independent analysis or view to the chemical business’s historical performance. He said his BEV aligned with the BEV that would result from using the projections of future cash flow of third parties “who were either potential bidders or banks that served as advisors and/or lenders” to such bidders.
The court strongly rejected the defendant expert’s approach. The use of “sell-side” projections was “particularly insupportable,” it said, because titanium dioxide prices began to erode in April 2005, as the defendants’ industry expert admitted. They also far exceeded the chemical business’s “peak” and “very strong” years of 2000 and 2005. And they were “particularly unreasonable” given uncontroverted evidence that the company’s titanium dioxide business peaked in early 2005 and “was on the downturn” by November 2005. Further, use of the third-party projections would result in a BEV of only $1.5 million—almost $200 million lower than the defendants’ expert had calculated. Moreover, it was clear that nearly all of the third-party projections used the company’s inflated IPO forecasts or outdated data as their starting point, the court added.
For all of these reasons, the plaintiffs’ expert was correct to use the earlier projections.
The court found little disagreement as to other inputs. The plaintiffs’ expert determined 11% was an appropriate weighted average cost of capital, while the defendants’ expert used one that was slightly lower (not specified). The plaintiffs’ expert calculated the terminal values based on the Gordon growth model and applied a constant growth rate in perpetuity of 2.5%. The defendants’ expert agreed that this was an accepted method but proposed a slightly higher 2.87% rate, which, he said, was based on a market approach.
The plaintiffs’ expert concluded the DCF-derived BEV was $1.01 billion; the defendants’ expert arrived at $1.7 billion. The court credited the value the plaintiffs’ expert proposed.
2. Comparable company analysis. The plaintiffs’ expert chose 10 commodity chemical companies, calculated EBIT and EBITDA for each, and added a reasonable control premium of 5%. His selection resulted in a LTM EBITDA multiple of 6.2. Based on this method, he arrived at an IPO value of between $770 million and $1.23 billion, with a midpoint value of $1.0 billion.
The defendants’ expert selected 15 companies based on whether potential buyers or industry analysts considered the company comparable to the subject company. He admitted he had not performed an independent analysis of the comparables. He calculated a substantially higher LTM EBITDA multiple of 7.63 and concluded the subject company’s BEV was between $1.48 billion and $1.6 billion.
The court found the defendant expert’s comparables were not sufficiently similar to the subject company. They included DuPont, which was much larger and more diversified; some other diversified companies; and some specialty companies that “typically trade at a higher multiple than commodity chemical companies like [the subject company].” Consequently, his LTM EBITDA was too high, and his BEV was not persuasive.
3. Comparable transactions. The plaintiffs’ expert identified seven comparable transactions, calculated EBITDA and EBIT for each, and applied the median to the subject company’s adjusted LTM September 2005 operating results. Based on this approach, the company’s BEV was between $960 million and $1.24 billion, with a midpoint of $1.1 billion.
The defendants’ expert used three data sources (Capital IQ, FactSet, and Thomson SDC) to select comparable companies and included a transaction if it involved chemicals, took place during the three years prior to the IPO, and had a value greater than $50 million. The resulting LTM EBITDA multiple was 8.0, which again was significantly higher than the 6.6x the competing expert determined. Applying it to the management projections, he arrived at a BEV of $1.7 billion.
The court noted that the defendant expert’s selection process included transactions involving an Indian fertilizer company, a Swiss company that manufactured waterproofing materials and parts for car manufacturers, and a company making foam-related products for diapers and adult incontinence products. Applying the multiple to the “overstated” internal projections added another flaw to the analysis.
Averaging his three BEVs, the plaintiffs’ expert arrived at a BEV of $1.03 billion. Adding the value of nonoperating assets, he calculated a total of $1.22 billion. In contrast, the defendants’ expert determined the total asset value was $1.81 billion. The court found the latter value “not persuasive.”
Only one in-depth liabilities valuation. The second component in the solvency analysis was the amount of debt that the chemical business faced at the time of the IPO. There was little argument over many of the liabilities, including the company’s financial debt, tax liabilities, liabilities for discontinued operations, and unfunded retiree liability. Instead, the parties’ disagreement concentrated on the amount of environmental and tort liabilities, “which, again, is what this case is all about,” said the court. Expert testimony figured prominently in this part of the trial, as well.
The plaintiffs’ expert had decades of experience in environmental engineering, site remediation, and cost accounting. He concluded that the present value of the future response costs of environmental remediation at over 2,740 sites related to the parent company’s activities was between $1.5 billion and $1.7 billion as of November 2005.
The defendants recruited two experts, but, as the court noted, the latter made it clear that the resulting 8,000-page report was not a comprehensive analysis, just a rebuttal. The final expert report estimated costs to be approximately $376 million.
“It is significant that [the plaintiff expert’s] analysis is the only comprehensive valuation in the vast record of this case of [the chemical business’s] environmental liabilities,” the court said at the outset of its analysis. The defendants’ failure to come forward with a comprehensive analysis at any point represented a “major failure of proof.”
In keeping with his principle to rely on contemporaneous market information, the defendants’ solvency expert “built his solvency analysis around” the findings in Apollo’s 2005 environmental study. However, the court found this analysis unreliable because it only considered “known environmental sites,” where a third party actually had filed a claim and even the solvency expert admitted on cross-examination that it did not measure the enterprise’s “total environmental footprint.”
The 2005 “Standard Guide for Disclosure of Environmental Liabilities” described four cost-estimating approaches: expected value, most likely value, range of values, and known minimum values. The plaintiffs’ expert used a “most likely value” approach because, he said, he concluded that “the sites were either sufficiently well-developed to conclude that one remedy was likely or information was insufficient to assign reliable probabilities to remedial outcomes.”
The defendants contended that the “expected value” approach was a probabilistic approach and the preferred methodology for estimating future environmental costs. The plaintiff expert’s approach “fail[ed] to address future uncertainty, particularly the question of whether any environmental response action would be required at a site.”
The court found the plaintiff expert’s had used his judgment and reasonably decided to adopt another acceptable methodology. Also, it explained, the object of a solvency analysis was “to assign a ‘fair valuation’ to all debts, with the term ‘debt’ defined as a liability on a claim, and ‘claim’ defined in the ‘broadest possible sense’ to include contingent, unmatured and unliquidated claims.” The resulting solvency analysis often accompanied a bankruptcy filing, “where all debts are accelerated and debtors are obligated to send notice of the requirement of filing a proof of claim to every known potential environmental creditor.” Ultimately, the court used the plaintiff expert’s lower figure, valuing the environmental liabilities at $1.5 billion.
The value of the chemical company’s other liabilities, it said, was not disputed and totaled approximately $803 million. Accordingly, the fair value of its liabilities was nearly $2.1 billion. These findings meant that the chemical business was insolvent as of the IPO/spinoff date “in that its liabilities at a fair valuation exceeded the value of its assets, even if we use Defendants’ highest and most aggressive value for the assets,” the Bankruptcy Court concluded.
Still awaiting final conclusion. Resolution of the fraudulent conveyance claim did not spell the end of litigation. The Bankruptcy Court recognized the defendants’ right under the Bankruptcy Code to pursue claims against the debtors for, among other things, their failure to adhere to the terms of the spinoff generally and the MSA in particular. The defendants argue that damages the debtors owed would offset the damages the debtors were allowed to recover.
Editor’s note: The court’s discussion of what methodology to use in assessing environmental liabilities brings to mind a session at the November 2013 AICPA that explored the issue of how to deal with uncertainty in a conceptually correct way but did so in a different context: projecting and discounting future lost profits. According to the presenters, only the “expected value” was statistically valid, whereas the “most likely value” might “work by accident” but failed to account for the range of possible outcomes and ignored the possibilities of extreme outcomes.