August 20th, 2012
The 2009 bankruptcy filing of Tronox, Inc. has spawned some interesting litigation. A trial commenced in May in the bankruptcy court for the Southern District of New York where a Litigation Trust formed as part of the Tronox reorganization plan is seeking $25B in damages from Kerr-McGee, a subsidiary of Anadarko Petroleum. Tronox, a manufacturer of titanium dioxide, a white pigment used in a variety of products, filed for bankruptcy largely because of staggering environmental liabilities it inherited when it was spun-off from Kerr-McGee in 2005.
While the trial has received much attention, a significant settlement was recently announced in a consolidated class action filed by Tronox shareholders who purchased common shares of Tronox between November 28, 2005 and January 12, 2009. The Stipulation and Agreement of Settlement may have implications for environmental disclosure as well as D&O insurance. In Re Tronox Inc., Securities Litigation, No. 09-CV-0662 (S.D.N.Y).
The complaint named as defendants certain former directors and officers of Tronox, Kerr-McGee Corporation and Anadarko Petroleum Corporation. The Complaint alleged that the defendants violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, 15 U.S.C. Sec. 78j(b) and 78t(a), and Rule 10b-5 by failing to disclose material adverse facts about the Company’s true financial condition, business and prospects. Specifically, the Complaint alleged that the defendants orchestrated a scheme to transfer massive environmental liabilities of Kerr-McGee to Tronox in the filings for the Tronox IPO.
The plaintiffs alleged that while company has reserved approximately $200MM for environmental remediation reserves, it actually had liabilities approaching $900MM legacy liabilities, most of which came from the historic operations of Kerr-McGee. The plaintiffs also pointed to filings made in 2009 where Tronox admitted that its prior filings “should no longer be relied on because the Company failed to establish adequate reserves as required by applicable accounting pronouncements” and noted that the Company had not yet completed a review of “all known sites where the company may have environmental remediation and other related liabilities” and that the adjustments would likely be material. The complaint further alleged that as a result of these fraudulent acts the individual Kerr-McGee directors and officers reaped a windfall in personal profits.
The defendants filed separate motions to dismiss the Section 20(a) claims. In January 2011, the district court issued an opinion preserving most of the claims but dismissed the successor liability claims against Anadarko. In re Tronox Securities Litigation, 769 F. Supp. 2d 202 (S.D.N.Y. 2011). On August 7th, the parties announced a $37MM settlement. All but $2MM of the settlement will come from D&O insurance. Tronox’s auditor, Ernst & Young, agreed to pay $2MM.
This case is interesting because it is one of the first cases where the failure to publicly disclose environmental liabilities has resulted in a substantial settlement. The settlement also reflects the growing risk public companies face for improper disclosure of environmental liabilities. It also illustrates the importance of ensuring that the standard pollution exclusion contained in D&O policies had a carve-out for securities claims and derivative claims based on environmental disclosures.
Following is a detailed discussion of the transactions that are the heart of the $25B Litigation Trust lawsuit. The allegations are taken from the adversary complaint as reported by the bankruptcy court in Tronox Inc. v. Anadarko Petroleum Corp. (In re Tronox Inc.), 429 B.R. 73 (Bankr. S.D.N.Y. 2010).
Over the course of 70 years, Kerr-McGee had accumulated massive environmental liabilities associated with various lines of businesses including petroleum terminals, offshore drilling operations, gasoline stations, wood-treatment sites and agrochemical operations (“Legacy Obligations”). By 200, Kerr-McGee had terminated most of these historic operations and was left with two core businesses: a large and thriving oil and gas exploration and production operation and a much smaller chemical business. Several potential suitors had considered purchasing Kerr-McGee because of what viewed as undervalued oil and gas operations but had been scared away by size of the potential environmental liabilities.
In 2001, Kerr-McGee embarked on a two-step strategy coined “Operation Focus” to make itself more attractive for acquisition by segregating the Legacy Obligations from the oil and gas business. The firm formed a new “clean” parent company (“New Kerr-McGee”) along with a new “clean” subsidiary, Kerr-McGee Oil and Gas Corporation (“Oil and Gas Business”). Old Kerr-McGee, which was now a subsidiary of New Kerr-McGee then began to transfer billions of dollars of oil and gas assets to Oil and Gas Business.
As a result of this restructuring, Legacy Obligations were only partially segregated since New Kerr-McGee still exercised control (and hence responsibility) over the legacy liabilities sitting in Old Kerr-McGee. The next step was to sever the Chemical Business and the Legacy Obligations from New Kerr-McGee through either a sale or a spin-off. However, Kerr-McGee concluded the Chemical Business was too small to credibility take on the Legacy Obligations. As a result, the firm went on an acquisition binge to inflate the balance sheet of the Chemical Business. Old Kerr-McGee acquired the titanium dioxide (TO2) business of Kemira Pigments Oy (“Kemira”) without performing any meaningful due diligence. According to the adversary complaint, had Kerr-McGee conducted due diligence it would have learned of significant environmental issues associated with Kemira. By carrying the Kemira assets at an inflated acquisition cost, Old Kerr-McGee allegedly was able to cover the Legacy Obligations.
Initially the chemical business operation struggled because of economic conditions. When business conditions improved, New Kerr-McGee replaced senior management of the Chemical Business with executives who did not understand the magnitude of the legacy liability. In 2005, the New Kerr-McGee board authorized the company to divest the Chemical Business through sale or spinoff.
While the firm and its investment banker, Lehman Brothers were promoting the sale of the Chemical Business, EPA demanded that New Kerr-McGee reimburse the agency for approximately $179MM in response costs incurred at the Manville,New Jerseysuperfund site. In response, New Kerr-McGee required the Chemical Business to enter into an Assignment, Assumption and Indemnity Agreement in May 2005. The Chemical Business did not receive any consideration in exchange for assuming these liabilities or agreeing to indemnify the Oil and Gas Business. Indeed, to eliminate the risk that the Chemical Business could potentially seek contribution from New Kerr-McGee for the Legacy Obligations following a sale or spin-off, New Kerr-McGee backdated the Assignment, Assumption and Indemnity Agreement so that it was purportedly made effective as of December 31, 2002.
Several potential purchasers were scared away by the potential environmental liabilities. The firm did receive one bid for the Chemical Business in the amount of $1.6B but was conditioned that all liabilities related to wood treatment facilities, including the Manville site, would be retained by the seller. New Kerr-McGee initially offered to provide the purchaser with a $400 million indemnity if it assumed the Legacy Obligations. However, New Kerr-McGee ultimately decided it needed a “cleaner” separation from the Legacy Obligations and opted to pursue a spin-off. New Kerr-McGee proceeded with the spin-off even after being advised by Lehman Brothers that the proposed sale would yield more than $500MM in additional after-tax cash proceeds than the spin-off. However, a spin-off meant that New Kerr-McGee could dictate the terms of the deal, avoid any third-party due diligence and eliminate any standard representations and warranties regarding its environmental liabilities.
In the fall of 2005, New Kerr McGee incorporated Tronox, Inc as the holding company for the Chemical Business and the Legacy Obligations. A Master Separation Agreement was drafted. While New Kerr-McGee retained an attorney to represent the interests of the Chemical Business, New Kerr-McGee limited the attorney’s participation, disregarding his substantive comments and excluding him from meetings after he raised concerns on behalf of his client.
The master separation agreement provided that Tronox would assume $550 million in debt in connection with the spin-off. New Kerr-McGee also received approximately $26 million in cash, which represented all of Tronox’s cash in excess of $40 million. Tronox also provide a broad indemnification to New Kerr-McGee for the Legacy Obligations. New Kerr-McGee did agree to provide Tronox with a limited indemnity expiring in 2012 of up to $100 million, covering 50% of certain environmental costs actually paid above the amounts reserved for specified sites for a seven-year period. The Complaint alleged that the indemnity was illusory since New Kerr-McGee knew that the Tronox would not have sufficient cash flow to spend the reserved amounts and thus trigger the indemnification.
Upon execution of the master separation agreement, New Kerr-McGee received 100% of the Tronox stock. In November 2005, New Kerr-McGee sold 17.5 million shares of Tronox Class A shares in an initial public offering (the “IPO”) which generated $225MM in proceeds. After the IPO, Kerr-McGee continued to hold 56.7% of Tronox’s outstanding common stock. In March 2006, Kerr-McGee distributed the balance of the shares that it owned as Class B shares to its shareholders as a dividend.
According to the complaint, New Kerr-McGee materially understated the Legacy Obligations. When the SEC regulation S-K, issuers of stock are required to disclose contingent liabilities that “probable” and “reasonably estimable”. However, New Kerr-McGee only set reserves for those costs that it knew it was going to incur or almost certain it would incur. The company also avoided estimating ranges of possible costs and estimated costs based on low-probability “best-case scenarios”. The company even failed to disclose to its accountants that it had potential environmental liabilities at certain sites. The result was that although New Kerr-McGee was aware of numerous sites where it had potential environmental liability, it did not disclose or reserve for these potential liabilities. According to Kerr-McGee documents, these undisclosed sites were referred to internally as the “secret sites.
Less than three months after the completion of the Tronox spin-off, Anadarko offered to acquire New Kerr-McGee for $16.4 billion in cash and the assumption of $1.6 billion of New Kerr-McGee’s debt. The purchase price was a 40% premium above New Kerr-McGee’s current stock price. New Kerr-McGee shareholders approved the offer on August 10, 2006, and New Kerr-McGee Corporation became a wholly owned subsidiary of Anadarko.