[Updated to reflect April 3, 2014 settlement]
In what may be one of the most significant cases involving the application of fraudulent conveyance laws and environmental liability, the bankruptcy court for the Southern District of New York held that Kerr-McGee had engaged in a fraudulent transfer when it spun off various assets in 2005 into a new firm, Tronox Incorporated (Tronox). The court found that Tronox was laden with overwhelming environmental and tort legacy liability that rendered it insolvent and undercapitalized on the date of formation. As a result, the court ruled that Kerr-McGee could be liable for damages ranging from $5 billion to $14 billon. The precise amount will be determined in later proceeding. In re Tronox Inc., 2013 Bankr. LEXIS 5232 (Bankr. S.D.N.Y12/12/13).
The dense 166-page opinion is packed with highly technical financial and legal analysis that can be mind-numbing to the non-business lawyer. However, it does contain some fascinating peeks into the world of corporate due diligence as well as some interesting statements about the application of the ASTM E2137 guide for estimating environmental liabilities and the relevance of financial disclosure statements to environmental liabilities in corporate transactions.
We discussed in a prior post a settlement of a class action lawsuit filed by shareholders alleging that the Registration Statement issued in connection with the Tronox Initial Public Offering (IPO) contained false and misleading statements. In contrast to the class action lawsuit, the accuracy of the financial statements were not relevant in the decision issued by the bankruptcy court because the lawsuit centered on the size of the legacy liabilities that Kerr-McGee imposed on Tronox and impact of those liabilities on the solvency of Tronox. Indeed, in an interesting aside, the court said that financial statements are of little use in a solvency analysis since generally accepted accounting principles (GAAP) require reserves only for claims that are “probable and reasonably estimable. More on disclosure later.
The Tronox litigation is an outgrowth of the 2009 chapter 11 bankruptcy petition filed by Tronox and 14 of its affiliates. Environmental and tort creditors filed proofs of claim for unliquidated amounts but where quantified totaled more than $6.9 billion. Tronox and subsidiaries Tronox Worldwide LLC, the successor to Kerr-McGee Corporation (“Old Kerr McGee”) and Tronox LLC (f/k/a Kerr-McGee Chemical LLC) filed an adversary complaint against Anadarko Petroleum Corporation (“Anadarko”) and several of Anadarko’s subsidiaries, including Kerr McGee Corporation alleging that through a multi-stage transaction completed in 2005, the defendants segregated valuable oil and gas exploration and production assets from billions of dollars of environmental, tort, and other liabilities. The Complaint asserted that the subsequent spinoff of the “cleansed” oil and gas assets acquired by Anadarko constituted an intentional or constructive fraudulent conveyance that left Tronox insolvent and undercapitalized because of the massive environmental and tort legacy liabilities.
As part of the plan of reorganization which was confirmed in November 2010, the claims of the three debtors were assigned to litigation trust (the “Trust”) that would pursue the lawsuit. The key to the reorganization plan was the Environmental Settlement Agreement (“ESA”) that created an environmental remediation trust funded in part by an equity offering of shares in the reorganized Tronox and in part by the Trust. The creditors that held environmental claims against Tronox, including the federal government, 11 states and the Navajo nation along with individual tort creditors agreed to relinquish their claims in exchange for the right to the proceeds recovered by the Trust. The environmental and tort claimants were named as beneficiaries of the Trust. The Trust subsequently sought $25 billion in damages relating to 2,000 sites across the United States. Meanwhile, the balance of the general unsecured creditors received stock in the reorganized Tronox that was now cleansed of the environmental legacy liabilities. According to the disclosure statement, the General Unsecured Creditors received a recovery of 58-78% on their claims.
Following is a detailed discussion of the transactions that are the heart of the $25B Litigation Trust lawsuit. The findings of facts are those recited by the court in its opinion. Old Kerr-McGee was founded in 1929 as an oil and gas exploration company. In the 1940s and 1950s, Old Kerr-McGee acquired refining, pipeline and marketing operation including more than 800 retail oil and gas outlets in 16 states. The company later acquired a mining and milling uranium operation, a wood treatment business, a manufacturer of ammonium perchlorate, a processor of radioactive thorium and a titanium dioxide pigment business.
As a result of these operations, 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 Liabilities”). The firm was a responsible party for more than 2,700 contaminated sites in 47 states. By 2000, the firm was spending an average of more than $160 million annually on remediation and employed more than 40 professionals in its Safety and Environmental Affairs (“S&EA”) Group just to manage the active environmental sites. During the six-year period ending in 2005, Old Kerr-McGee had settled approximately 15,000 claims of creosote tort liability for $72 million plus $26 million in defense costs and faced an additional 9,450 pending claims.
Starting in 1990, oil and gas exploration and production (E&P) industry was undergoing significant consolidation with almost 80% of the independent North American oil and gas firms being acquired or merged into larger companies. While Old Kerr-McGee had attracted potential suitors during this time, they had all been scared away by the firm’s mammoth Legacy Liabilities.
The bankruptcy court concluded that was clear that the management of Old Kerr-McGee intended from the outset to free the valuable E&P assets from the Legacy liabilities, especially as this burden precluded Kerr-McGee from being an attractive merger. The court said the written record was also absolutely clear that freedom from Old Kerr-McGee’s legacy liabilities was a central consideration in the decision to split the two businesses and in the structure that was devised. The court observed that Lehman Brothers had advised Old Kerr McGee that that if the E&P business was spun-off, “potential exists to isolate E&P operations from historical [Old Kerr-McGee] environmental liabilities.” Indeed, the court pointed out that Anadarko had rejected an acquisition of Kerr-McGee in 2002 after concluding that the costs of remediating the firm’s 500 active contaminated sites and more than 1,000 inactive contaminated consumed most of its free cash flow. The court pointed out that Anadarko determined that, Kerr-McGee’s future environmental liability was “$BILLIONS” and there was “no end in sight for at least 30 more years.”
As a result, Kerr-McGee embarked on a two-step strategy in 2001 coined “Operation Focus” to make itself more attractive for acquisition by segregating the Legacy Obligations from the oil and gas business. In a series of 11 transactions, 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”). A new holding company owned by New Kerr-McGee was formed, called Kerr-McGee Worldwide Corporation. Old Kerr-McGee, which was now a subsidiary of New Kerr-McGee, began to transfer billions of dollars of oil and gas assets to the Oil and Gas Business. Old Kerr-McGee then formed a new wholly-owned subsidiary, Kerr-McGee Chemical Worldwide LLC, and merged into it. Kerr-McGee Chemical Worldwide that became Tronox Worldwide LLC retained all of the legacy liabilities of Old Kerr-McGee. The court noted that the CEO of Kerr-McGee testified that the result of Project Focus was that “all of the businesses that were owned by the original Kerr-McGee were transferred out except for the chemical business.
One group of creditors was contractually protected against the transfer out of Old Kerr-McGee of the oil and gas assets — holders of approximately $2 billion in bonds that Old Kerr-McGee had issued approximately $2 billion in bonds. To obtain the consent of the bondholders to the transactions, Old Kerr-McGee covenanted that it would not divest itself of substantial assets unless the transfer involved “substantially all” of its assets and the recipient of those assets assumed its obligations under the bonds. Kerr-McGee represented that Old Kerr-McGee had “distributed substantially all of its assets to its parent” through Project Focus.
As a result of this restructuring, the Legacy Liabilities were only partially segregated since New Kerr-McGee still exercised control (and hence responsibility) over the legacy liabilities sitting in Old Kerr-McGee. The court said that most of the legacy liabilities derived from discontinued businesses and that when a discontinued business could not pay for expenditure, New Kerr-McGee recorded the net payable as an equity contribution or advance from the parent. In other words, New Kerr-McGee continued to pay all the environmental expenses and claims out of its centralized cash management system until the 2005 IPO.
After the E&P subsidiaries were transferred out of Old Kerr-McGee, the next step was to sever the Chemical Business and the Legacy Liabilities from New Kerr-McGee through either a sale or a spin-off. Kerr-McGee’s management requested Lehman Brothers update its analysis. In September 2004, Lehman advised management that there was a “window of opportunity” to separate the companies because of a hot market for chemical companies and high demand for TiO2. Lehman suggested a spinoff would be a better vehicle for a “clean separation” from the legacy liabilities because the environmental liabilities would have to be negotiated in a sale or leveraged buyout
In 2005, the New Kerr-McGee board authorized the company to divest the Chemical Business through sale or spinoff. Lehman identified 60 potential bidders, contacted 16 and 13 signed confidentiality agreements. The field was narrowed to four final bidders, who were given access to a virtual data room to perform due diligence. The data room established for the due diligence contained over 27,000 individual documents pertaining to over 300 contaminated sites. One of the finalists chose not to make a final bid in part because of the cost to diligence the legacy liabilities. Another firm made a final bid that assumed environmental liabilities only for currently operating sites. A third bidder proposed an asset purchase only for assets that are used in the operation of the chemical business. A fourth firm submitted a bid for the Chemical Business in the amount of $1.6B plus the assumption of certain environmental liabilities on the balance sheet (valued at $225MM) but excluded liabilities related to Wood Treatment facilities and the Manville site. Kerr-McGee rejected this proposal because it wanted a “cleaner” separation from the legacy liabilities. Later, another potential bidder was willing to bid $1.2 billion without the legacy liabilities but only $300MM if they were to be assumed. [Disclosure: We worked with a firm that provided a preliminary evaluation for one of the parties that had signed a confidentiality agreement but declined to submit a bid because of the legacy liabilities. This post discusses only the public information disclosed in the litigation and discussed by the court in its opinion.]
According to the court, New Kerr-McGee proceeded with the spin-off because it could dictate the terms of the deal, avoid any third-party due diligence and eliminate any standard representations and warranties regarding its environmental liabilities. To effectuate the spinoff, New Kerr McGee incorporated Tronox as the holding company for the Chemical Business and the Legacy Liabilities. 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.
Tronox and New Kerr-McGee entered into a series of agreements that culminated in a Master Separation Agreement (“MSA”). The court held it was undisputed that the terms of the MSA were dictated by Kerr-McGee, noting that the MSA stated that “Parent will, in its sole and absolute discretion, determine all terms of the Separation. Tronox shall cooperate with Parent in all respects to accomplish the Separation and shall, at Parent’s direction, promptly take any and all actions necessary or desirable to effect the Separation.” The court said that Kerr-McGee CFO was chairman of Tronox’s Board and it was undisputed that New Kerr-McGee exercised control over Tronox’s decisions to enter into significant transactions and the ability to prevent any transactions it did not believe were in New Kerr-McGee’s best interests.
Kerr-McGee arranged for Tronox’s financing that resulted in Tronox becoming indebted for an advance of $200MM and a revolving line of credit of $250MM that was provided by a group of lenders on a secured basis. Tronox also issued unsecured notes of $350MM at an interest rate of 9.5 % (increased from 7% initially contemplated). The net cash proceeds were $537.1MM after expenses. New Kerr-McGee also received approximately $26MM in cash, which represented all of Tronox’s cash in excess of $40 million. The court said New Kerr-McGee had deemed $40MM as adequate cash for the new company but found the record was not clear on how that amount was reached.
In addition, the parties negotiated an Assignment, Assumption & Indemnity Agreement (Indemnity Agreement) that provided that the Tronox would be solely responsible for all of the legacy liabilities except for those liabilities directly associated with the “currently conducted” E&P operations. While the Indemnity agreement was being finalized, EPA demanded that New Kerr-McGee reimburse the agency for approximately $179MM in response costs incurred at the Manville Superfund site. New Kerr-McGee denied liability and amended the Indemnity Agreement to provide that Tronox was obligated to indemnify New Kerr-McGee for any Legacy Liabilities Tronox had been required to assume and that were imposed on New Kerr-McGee. The court found that Tronox did not receive any consideration in exchange for assuming these liabilities or agreeing to indemnify New Kerr-McGee. Indeed, the court observed, to eliminate the risk that Tronox (i.e., the Chemical Business) could potentially seek contribution from New Kerr-McGee for the Legacy Liabilities following a sale or spin-off, New Kerr-McGee backdated the Indemnity Agreement so that it was purportedly effective as of December 31, 2002.
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 bankruptcy found 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. The court explained that to access the indemnity, Tronox had to spend $200K more than the existing environmental reserve for each individual site. However, the Tronox started its separate existence with a mere $40 million and never had enough cash to trigger the reimbursement obligation. Indeed, when the bankruptcy petition was filed, Tronox had received less than $5 million from Kerr-McGee under the MSA.
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 IPO which generated $225MM in proceeds. The results were disappointing to Kerr-McGee because Tronox had been marketed as a specialty chemical company but because the market considered it a commodity business, the stock traded at a lower multiple. After the IPO, New Kerr-McGee continued to hold 56.7% of Tronox’s outstanding common stock. The Class A Tronox stock issued to the public had only 11.3% of the combined voting power of all outstanding issues.
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 in August 2006, and New Kerr-McGee Corporation became a wholly owned subsidiary of Anadarko.
Tronox began to struggle almost immediately after the March 2006 spinoff. Tronox had anticipated that its financial position would be substantially bolstered by the sale of land in Henderson, Nevada. However, the property was extensively contaminated from ammonium perchlorate waste in ponds that potentially endangered the Las Vegas water supply. Because of cash flow issues, Tronox was unable to fund the Legacy Liabilities at the previous levels. Even with the reduced expenditures, the Legacy Liabilities amounted to 56% of Tronox’s 2006 EBITDA and 95% of its 2007 EBITDA.
Following a series of motions that reduced the scope of the claims, 34-day trial was held that involved 28 expert witnesses, over 6,100 exhibits and thousands of pages of deposition testimony of 40 witnesses. The court began its analysis by stating that litigation appeared to raise a novel of first impression-namely under what circumstances can an enterprise rid itself of its legacy environmental and tort liabilities by spinning off substantially all of its assets and leaving behind property incapable of supporting the liabilities. The court went on to say that the question was important because of the limited circumstances under which the owner or operator of property can avoid remediation obligations imposed by Federal and State environmental laws.
We limit our discussion on the court’s holdings to the claims for actual and constructive fraudulent conveyance claims.
Actual Fraudulent Conveyance Claim
Plaintiffs alleged that the transactions that culminated in the spinoff were made “with actual intent to hinder, delay, or defraud” creditors within the meaning of the federal Bankruptcy Code and the Oklahoma Uniform Fraudulent Conveyance Act. The court said that although there was no disclosure of the scheme in December 2002 and the disclosure in March 2003 was minimal and ineffective, the defendants made it clear in the S-1 Registration Statement that Tronox was being left with all of the Legacy Liabilities. Indeed, the court explained, this was also clear to the potential purchasers of Tronox who declined to submit bids because of their concerns about Legacy Liabilities. Moreover, the court said that the plan to impose the legacy liabilities on Tronox was what triggered the EPA demand letter in 2005.
What the defendants did not disclose, the court said, was that Tronox would not be able to support the legacy liabilities that were to be imposed on it by the restructuring plan. However, the court said that disclosure of a scheme is no defense and that liability may be imposed for an intentional fraudulent conveyance where the fact and purpose of a conveyance may have been known to creditors but the transferor intended to hinder or delay them.
The court rejected the defendant’s contention that plaintiffs had to prove that the defendants intended to damage a creditor by preventing them from collecting a debt. Instead, the court said the defendant’s interpretation of the phrase “actual intent to hinder, delay, or defraud” was too narrow. Relying on the definition of “intent” set forth in the Restatement (Second) of Torts and prior caselaw, the court explained that a transfer may be made with fraudulent intent even though the debtor did not intend to harm creditors but knew that by entering the transaction, creditors would inevitably be hindered, delayed or defrauded.
The court found that it was undisputed that New Kerr-McGee acted to free substantially all its assets from 85 years of environmental and tort liabilities. Without recourse to these assets and given the “minimal asset base” of Tronox, the court said the obvious consequence of this restructuring was to hinder and delay the legacy creditors. The court held that such a result was substantially certain to occur as a result of the restructuring.
The defendants argued in their brief that the every witness that testified on their behalf agreed that the Legacy Liabilities were not a driver behind the separation. However, the court said the record supported the finding that a principal goal of the separation of the E&P assets from the chemical business was to cleanse the E&P assets of every legacy liability resulting from the 85-year history of the company and to make the cleansed company more attractive as a target of an acquisition. Some of the evidence that the court relied on to support this conclusion was:
- Lehman’s files make clear the centrality of the liability issues to the transactions undertaken and that the effect on creditors was well understood;
- Lehman recognized that the environmental liabilities being left with Tronox were unique;
- Lehman’s principal witness testified that “other chemical companies didn’t have legacy liabilities of other businesses attached to an ongoing operation;
- A Lehman email stated that the deal to sell to Apollo appeared to have “cratered” because Kerr-McGee would not represent that it was not aware of any other material liabilities outside of the 27,000 documents in the data room;
- The testimony of CEO and CFO that the effect on creditors was never considered was contradicted by the record and by defendants’ efforts to cleanse the record. The court noted that senior management had instructed Lehman to delete slides form its presentation that discussed the complications of the Legacy Obligations;
- The credibility of the denials by the principal witnesses for the Defendants was further undermined by the destruction of documents in violation of an agreement with the Justice Department. For example, the court observed that the senior management directed their secretaries to destroy all files relating to the spinoff when they retired later in 2006, a few months after the tolling agreement was signed.
Badges of Fraud For Inferring Fraudulent Intent
Because of the difficulty of proving actual fraudulent intent, plaintiffs may rely on so-called “badges of fraud” which involve circumstances that are so commonly associated with fraudulent transfers that their presence gives rise to an inference of intent. The UFTA identifies eleven specific “badges of fraud”. Any one of these factors can create a presumption that the transaction was fraudulent which the defendant must then rebut. The court said that the presence of several badges of fraud constitute strong and clear evidence of fraudulent intent. The court found the following five factors supported the conclusion that the defendants acted with actual intent to hinder or delay creditors:
- The transfer or obligation was to an insider (i.e., substantially all of Kerr-McGee’s assets were transferred to a corporate affiliate in the 2002 transactions, and then transferred additional consideration to an affiliate in the IPO);
- Old Kerr-McGee retained possession and control of the assets after the 2002 transfers as well as after the November 2005 IPO;
- The transfer or obligation was disclosed or concealed-(The court previously concluded that the disclosure for the 2002 transfers was ineffective and insubstantial) ;
- Before the transfer was made or obligation was incurred, the debtor had been sued or threatened with suit-(Kerr-McGee of course had been in litigation for years regarding its environmental and tort liabilities); and
- The transfer was of substantially all of the debtor’s assets-(the assets transferred represented more than 80% of the assets of the consolidated enterprise)
To overcome the presumption of fraud, the defendants had to show a legitimate supervening purpose for the conveyances. The defendants advanced three “legitimate supervening purposes” as defenses to Plaintiffs’ contention that they acted with “actual intent to hinder or delay creditors” that is actionable under the UFTA.
First Legitimate Supervening Purpose
First, they contended that the record showed that Kerr-McGee intended and believed at all times that Tronox was and would be solvent and able to pay its debts and a successful independent company. The court disagreed, noting that Tronox started life with a capital structure that included $550 million in debt, a mere $40 million in cash and environmental liabilities that had cost Kerr-McGee more than $1 billion in the years prior to the IPO. The court also noted that Tronox’s projected cash flow was inadequate to service its debt without significant land sales that were not assured, and its prospects were clouded by a down-turn in the business cycle of its one product. In any event, the court said that the question was not if Tronox was “doomed to fail,” nor if defendants wanted Tronox to be a “big success.” Instead, the court said the real question was if Defendants had a good faith belief that Tronox would be able to support the Legacy Liabilities that had been imposed on it. The court said one of the most compelling facts in the enormous record of the case was the absence of any contemporaneous analysis of Tronox’s ability to support the legacy liabilities being imposed on it.
The defendants argued they and their advisors spent substantial time and took multiple steps to ensure that Tronox would be a viable standalone and that creditors would not be adversely impacted by its separation. Defendants claimed the controller worked with the external accounting firm analyzing cash-flow models prepared by Tronox’s management in connection with Tronox’s S-1 Registration Statement that projected Tronox’s cash flow through 2011. However, the court said that the cash flow was not thorough, observing that even though the “Provision for Environmental Remediation” was broken out on a pro forma basis for Tronox prior to 2005, it was apparently included in “Other” expenses for 2010 and 2011 with an entry of zero. The court said there was no support in the record for the proposition that Tronox’s environmental expenses would diminish to zero in 2010. The court noted the cover memo from the external audit stated that he was informed that “Kerr-McGee management believe … Tronox should experience a much diminished level of environmental charges going forward, reducing the historical operating losses related to the discontinued operations as well as the related cash flow requirements.” The court found estimate was “anecdotal and not rooted in reality,” stating in a footnote that “it would have been more reasonable for Kerr-McGee to anticipate paying more for environmental expenditures in the future.” The court noted that from 2002 to 2005, Kerr-McGee added more to its environmental reserves than the amount spent in each of those years. The amount reserved for expected future expenses increased over 47% from 2001 to 2005. The auditor’s memo stated that “Kerr-McGee has agreed to support Tronox, related to these and other environmental matters with the 50% cost reimbursement provided over the next seven years.” As previously discussed, the court said this reimbursement support was largely illusory.
The second piece of evidence that Defendants relied for the proposition that they took numerous steps to ensure that Tronox would be viable and creditors would not be adversely affected was a solvency opinion that concluded after four pages of caveats and conditions that “the fair value and present fair saleable value of the Company’s assets would exceed the Company’s stated liabilities and identified contingent liabilities.” The court said the critical issue in this case was the amount of Tronox’s contingent liabilities but the solvency opinion simply used the reserve in Tronox’s financial statements as Tronox’s anticipated contingent liabilities. The court then went on to say that a reserve for contingent liabilities in a financial statement has no probative value in determining liabilities or solvency for fraudulent conveyance purposes. Furthermore, the court said there was no evidence that the author of solvency opinion was even aware of the importance of the legacy liabilities to Tronox’s solvency. The court noted that the firm that prepared the solvency opinion testified that its concern from a fraudulent conveyance perspective was that Tronox had incurred of debt in the IPO and was not going to retain the proceeds from the debt issuance but instead dividend the proceeds up to its parent, Old Kerr-McGee. The court went on to say that while the dividending of proceeds to a parent was the usual concern in a leveraged buy-out (“LBO”), the real issue in this case was the amount and effect of the legacy liabilities.
Defendants’ final reason for their asserted belief in Tronox’s future was that the cash flow projections of the parties’ respective experts agreed that Tronox experience positive cash-flow for all projected years, except for 2006 when Tronox would be less than $1 million cash flow negative.” However, the court said that the problem with the expert reports were that they were performed after the transaction to support the litigation positions. Such post-transaction reports, the court said, could not serve as substitute for the absence of any internal contemporaneous analysis of the effect of the transfers on Kerr-McGee’s legacy creditors. Based on the record, the court concluded that neither the Board nor management ever reviewed a contemporaneous analysis of the effect of the transactions on the legacy liability creditors, and there is no evidence that one was ever prepared.
Second Legitimate Supervening Purpose-
The defendant’s second defense to badge of fraud inference was that the purpose of the restructuring was to unlock the inherent value of each of Kerr-McGee’s businesses by creating two successful standalone companies, and thereby maximize shareholder value. However, the court said that the defendants were not being sued because they made a business decision to spin off the chemical business from the E&P but because they to spin off “substantially all the assets” of the enterprise (the E&P assets) and imposed 85 years of the legacy liabilities on a fraction of the assets. The court said the defendant’s burden was not to prove if there were some legitimate business reasons for the challenged transactions but to prove a legitimate supervening purpose for the “manner in which the transfer was structured.” In concluding that the defendants failed to meet this burden, court noted the following facts:
- Defendant’s investment banker testified that every chemical business has some environmental liabilities but “not like this they don’t.”
- The liabilities imposed on Tronox included those associated with every discontinued business that Kerr-McGee had owned or operated;
- Senior management rejected an April 2001 presentation Lehman to allocate the legacy liabilities in a manner proportionate to the asset values of the two lines of business;
- Defendants never articulated a legitimate business reason for imposing all of the legacy liabilities on Tronox;
- Before the spinoff, Old Kerr-McGee was an unattractive merger candidate as evidenced by the fact that Anadarko had rejected a merger in 2004 because of future environmental liability for which there was “no end in sight for at least 30 more years.”After the divestiture, Anadarko acquired the E&P business at a 40% premium.
Third Legitimate Supervening Purpose
Defendant’s final argument to rebut the badge of fraud inference was that they merely attempted to limit the overall environmental liability of the group. The court said defendants were trying to equate the conveyances as simply a risk management strategy but that this was not a situation where a company’s management used lawful ways to reduce the adverse impact of contingent liabilities. Instead, the court said the restructuring placed substantially all of the assets of Kerr-McGee out of the reach of the legacy liability creditors. In addition the court found that the defendants:
- did not pay consideration for the December 2002 transfer of the stock of the E&P subsidiaries and did not pay fair consideration or reasonably equivalent value in connection with the spinoff;
- were acutely aware of the legacy liabilities, and if they did not have a precise amount, the reason is they assiduously avoided performing the analysis necessary to obtain one;
- Did not rely on fairness opinions. Indeed Lehman’s managing director believed that the legacy liabilities would choke the flower that was Tronox’s TiO2 business; and
- carefully preserved the attorney-client privilege as to the legal advice they received and therefore cannot rely on an advice-of-counsel defense
The court said that if defendants’ conduct were simply management of legacy liabilities, then all enterprises with substantial existing environmental liability would be encouraged to do exactly what Defendants did — manage the liabilities so as to leave them attached to a fraction of the assets unable to bear them. Thus, the court found that plaintiffs have proved by clear and convincing evidence that defendants acted with actual intent to hinder or delay creditors, and Defendants wholly failed to rebut the evidence
Constructive Fraudulent Conveyance
To prevail on constructive fraudulent conveyance claim, plaintiff had to prove that (i) there was a conveyance of an interest in property or the incurrence of an obligation; (ii) receipt of less than reasonably equivalent value; and (iii) that the transferor was or was rendered by the conveyance insolvent, inadequately capitalized, or unable to pay its debts as they came due
There was limited dispute on the first point and the court easily found that Plaintiffs satisfied their burden of proof that Tronox as a consolidated entity received less than reasonably equivalent value (REV) since at the conclusion of the IPO, $17 billion in assets had been spun off and only $2.6 billion had been transferred in.
The more hotly contested question was if Plaintiffs satisfied their burden of showing that Tronox was insolvent because of the transactions. The defendants relied on a “market” defense, asserting that Tronox was not insolvent at the time of the IPO because it was able to issue $450MM in senior secured debt and sell $350MM in bonds to “market participants” who performed independent due diligence that extended well beyond publicly available information.
The court said the $450 million in debt did not deserve any weight in the solvency analysis. The court explained that these “market participants” were not representative of “the market” because the debt was secured by all of the assets of all of the Tronox companies, and the sophisticated lenders who bought this debt well knew they would come first in any bankruptcy or liquidation of the enterprise. Moreover, the court said these “market participants” received millions of dollars in fees from Kerr-McGee or anticipated significant fees from financing the purchase of the assets. Further, the court noted, none of these entities independently valued Tronox’s environmental or tort liabilities. The court went on to say that the defendants never explained how the diligence performed by these “market participants” and the information they obtained gave them any independent insight into the legacy liabilities. Instead, the court found ample evidence in the record that Morgan, CSFB and Lehman all took account of the obvious fact that if Tronox failed regardless of the reason, their debt would be protected.
While the court agreed that Tronox’s ability to issue unsecured bond debt and stock was Defendants’ strongest indication of solvency, the court found that plaintiff’s expert testimony convincingly demonstrated that the projections on which the IPO was based were inflated, sell-side projections, and that key numbers were imposed at the direction of Kerr-McGee’s chief financial officer. The court said the record was also clear that the financial statements omitted certain critical contingencies and potential liabilities. As an example, the court pointed out that EPA sent Kerr-McGee a formal demand for reimbursement of $350MM in past response costs and interest for the Manville superfund site but Kerr-McGee included no disclosure of the potential liability for that site. The defendants justified this omission on the existence of auditors’ letters and comments from the partner in charge at Covington that Kerr-McGee had “substantial defenses” to liability but the court pointed to four legal memoranda from Kerr-McGee’s counsel concluding that it was likely that Kerr-McGee had liability as the successor to American Creosoting Corp.
Similarly, the court noted that Kerr-McGee omitted any disclosure in the IPO Registration Statement of contingencies related to the contract for the sale of land in Henderson, Nevada. At the time of the IPO, Centex Homes and the Landwell Company had an ostensible contract to purchase the Henderson site for a total of $515 million, $154 million of which would be payable to Tronox on account of its 30% interest in the property. The Henderson proceeds were included in Tronox’s projections and were essential elements of its future cash flow. However, there was no disclosure of the risks relating to the land sale contract. It was not disclosed that the land had previously been contaminated and that “no action letters” had to be obtained from the Nevada Division of Environmental Protection (NDEP) for each of the four parcels being sold. The court noted an August 2005 Lehman email warning that a leadership change within the NDEP would “definitely delay” and “possibly could kill” the deal. It was not disclosed that, by the time of the IPO, the first three of four closing dates for the contract had passed and been extended. Most important, it was not disclosed that the contract was merely the economic equivalent of an option, in that it gave the purchasers the right to walk away for $2 million in liquidated damages (less than 1% of the purchase price).
The defendants also argued that supplementing this general market evidence was two critical “bookends” that established Tronox’s solvency. The first so-called bookend relied upon by the defendants was an offer to purchase the Chemical Business by Apollo that was based on six months and millions of dollars in diligence. The other “bookend” that defendants propound as evidence of Tronox’s solvency was the confidence of its officers and directors in its future as well in the form of the contemporaneous statements and actions of Tronox’s own officers and managers, including, including statements subject to the securities laws.
The defendants argued that Apollo’s bid was unassailable evidence of Tronox’s solvency because the Apollo submitted its bid after performing exhaustive due diligence. The defendants contended that Apollo and its advisors accessed the virtual data room more than 24,000 times and were intimately familiar with the issues facing the Company, including the so-called “secret’ sites,” the Henderson Property contract, Tronox’s financial performance and projections, and the TiO2 industry’s anticipated future performance.” However, the court said defendants overstated the nature and significance of the Apollo bid, explaining that Apollo did not make a “final and binding” offer for Tronox of $1.3 billion. For support, the court cited the opinion expressed by JP Morgan, Kerr-McGee’s investment banker on the deal, that the Apollo bid contained open items and that critical parts of the contract remained to be negotiated such as additional disclosures that could trigger Apollo’s rights of termination. Significantly, Apollo’s bid contained indemnities or environmental and tort liability totaling $504 million. The court noted that Kerr-McGee had previously rejected all indemnities and other guarantees relating to the legacy liabilities since this would not result in the “clean break” that Kerr-McGee demanded.
Moreover, the court said the trial record was inadequate to give Apollo’s analysis of Tronox’s environmental and tort liabilities the weight that Defendants demand. The court said there was no dispute that Apollo performed “‘significant diligence assessing the nature of the environmental liabilities, including retaining environmental consultant and environmental counsel. However, the court pointed to a memo prepared by Apollo that suggested the firm did not perform a true risk analysis but simply determined it could manage the liabilities over the period of time it would own Tronox. For purpose of a UFTA, the court said this did not constitute the basis for a solvency analysis. As a result, the court concluded that the unaccepted Apollo bid did not provide “unassailable” or even probative evidence of Tronox’s solvency at the time of the IPO.
The other “bookend” that the defendant argued was evidence of Tronox’s solvency was the confidence of its officers and directors in its future. Defendants said all of the witnesses who were employed by Tronox testified that at the time of the spinoff they believed Tronox was “solvent” and not doomed to fail. The court said, however, that the optimism of some of Tronox’s management was not evidence of solvency under the UFTA and certainly no more proof of Tronox’s solvency than those who believed the Legacy Liabilities would be fatal.
More relevant to the court was that within six weeks of the spinoff, Tronox management was forced to adopt what were termed “draconian” cost-cutting measures by its CEO. While the court acknowledged that the Tronox’s need to cut costs was not proof of balance sheet insolvency, it was evidence that management’s good faith efforts to keep the enterprise going and their belief that this was possible do not constitute a “bookend” that proves or disproves Tronox’s solvency. The court said there was no question that Tronox’s cash-starved position made it increasingly difficult to pay any expenses relating to the Legacy Liabilities as well as prevented Tronox from accessing the indemnification provided by Kerr-McGee. In the end, the court conclude, there was no substitute for performing an analysis of the fair value of Tronox’s assets as at the date of the IPO and measuring them against the fair value of its liabilities.
The court then proceeded with a solvency analysis. Plaintiff’s expert submitted reports totaling over 2,600 pages to attempt to value the environmental liabilities. Defendants called two expert witnesses and adduced over 8,000 pages of reports to dispute Plaintiffs’ expert. Separate experts and reports were relied on in connection with the tort liabilities. The defendants calculated the Legacy Liabilities at $278.1MM on a net present value basis while plaintiffs’ present value of the liabilities as of the IPO date was between $1.0 and $1.2 billion.
The court found the plaintiff’s estimation of the Legacy Liabilities more persuasive, characterizing plaintiff’s analysis as the only comprehensive valuation in the vast record of this case of Tronox’s environmental liabilities. The court noted that plaintiff’s expert spent more than 40,000 hours preparing a comprehensive report that was designed to calculate the cost of remediation at the 2,746 sites where Kerr-McGee had potential liability. In his 2,042-page report and 580-page rebuttal report, plaintiff’s expert assigned costs to only 372 of the 2,746 sites. 214 of the sites he chose were being remediated in 2005 or the subject of existing Kerr-McGee reserves, and therefore included on Schedule 2.5(a) of the MSA. He included 157 additional sites that they were similar to the “listed” sites in terms of contaminants and that would likely require remediation. He reduced his net costs by reimbursement from third parties such as the United States and certain States, and also apportioned costs among other liable parties but did not reduce the costs estimates for insurance, the indemnity under the MSA. He also did not adjust the amounts for the net tax impact since the tax benefits were treated as a contingent asset in the solvency analysis.
In contrast, the court said, Kerr-McGee never performed a comprehensive analysis of the Legacy Liabilities but simply relied on the accounting reserves for the environmental liabilities which the court said were applicable in a UFTA solvency analysis. The court said defendant’s expert report as well as his testimony was simply prepared as a rebuttal to plaintiff’s report. In a scathing footnote, the court reviewed criticisms of the defendant’s expert in other cases, noting that one court characterized his opinions as “naked guesses” or “far too speculative” and having “no firm grounding in science. Another judge rejected his responses in answer to the Court’s questions as “rank speculation,” concluding, “[t]here is simply no evidence to support [his] view,” and rejected his “suppositions … as unfounded and lacking all credibility.
In rejecting defendants position that the net present value of the remediation costs of Tronox as of November 2005 was $278.1MM, the court noted that Old Kerr-McGee’s environmental expenditures during the five years prior to the IPO had averaged $160MM per year, that it had spent $580MM just at the West Chicago Thorium site, that it had received a demand from the EPA for $179MM for the Manville superfund site and that Tronox had succeeded to virtually all of the Kerr-McGee sites. In other words, the court said that defendant’s expert concluded that Tronox’s future environmental liabilities should have been valued at approximately the amount that Kerr-McGee had paid over the preceding two-year period. This opinion, the court said, did not pass the “common sense test”.
Defendant’s expert evaluated plaintiff’s net present value of the remediation costs using a “conceptual probability” matrix. He assigned a 10% probability to response actions that he deemed “unlikely but possible,” a 30% probability to response actions that were “possible,” a 50% probability to response actions that were “equally likely,” a 70% probability to response actions that were “more likely than not”, and a 90% probability to response actions that were highly likely. The court said that while such a matrix provides an aura of scientific precision, the analysis was dependent on the judgment of those who use it– and found that defendant’s expert did not support his probability allocations fairly. To illustrate its point, the court noted that for the former Kerr-McGee wood-treating facility in Wilmington, North Carolina, defendant’s expert claimed his choice of a remedy, in situ solidification, was the most likely approach and assigned it a conceptual probability of 50%. He claimed at trial that his decision was based on project documents, site-specific information, and site-specific technical analysis, but Plaintiffs established that at deposition he had conceded that in situ solidification had never been used at any other Kerr-McGee wood-treating site, and such assumption materially understated the reasonably anticipated remediation cost. Likewise, at the Riley Pass uranium site, the court observed that defendant’s expert concluded the remedy would consist only of institutional controls such as fencing at a cost of $340K even though regulators had already rejected this approach in 2005 and instead proposed a $12MM remedy.
Application of ASTM E2137 To Solvency Analysis
The court said the defendants argued that the “preferred methodology” for estimating future environmental costs was the “expected value” probabilistic described in the ASTM “Standard Guide for Disclosure of Environmental Liabilities”. It appears the court intended to refer to ASTM E2137 “Standard Guide for Estimating Monetary Costs and Liabilities for Environmental Matters.” Nevertheless, the court cited to section 5.2.2 stating that a probabilistic approach may not always provide the ‘best estimate for a given set of circumstances” and referred to section 5.2.3 providing that the approach used should be based on the “number of events and quality of information available or obtainable.” The court found that plaintiff’s expert adequately explained that he did not use an expected value approach because he concluded that sites were either sufficiently well-developed to conclude that one remedy was likely or information was insufficient to assign reliable probabilities to remedial outcomes. Accordingly, the court ruled that the plaintiff’s expert properly exercised his judgment when he used the “most likely value” approach recognized by E2137.
Defendants also contended that the use of the “most likely value” approach was also flawed because it failed to address future uncertainty. Instead, defendant’s expert opined that plaintiff’s expert should have applied a “gating” analysis to determine the likelihood that Tronox would incur costs at a site. However, the court said that the objective of a solvency analysis was to assign a “fair valuation” to all debts, which the court said was defined as a liability on a bankruptcy “claim.” The court explained that a solvency analysis is often used in bankruptcy filings where all debts are “accelerated” and debtors are obligated to send notices to every known potential environmental creditor. The court noted that defendant’s expert admitted that he had previously never used a probabilistic analysis to estimate environmental costs in a fraudulent transfer case and that his probabilistic analysis assumed that the environmental claims were mere contingent claims that should be subject to a discount for the probability they will never be pursued. In contrast, the environmental claims would have been accelerated by the bankruptcy filing because the creditors would have become aware that they would lose the claims if they did not file and pursue their claims. As a result, the court found that the decision by the plaintiff’s expert to assign remediation costs to only 372 of Tronox’s 2,746 sites amply accounted for the fact that some potential remediation would never be pursued notwithstanding the fact that an insolvency case would accelerate them.
Relevance of Financial statements
Plaintiffs attempted to overcome the evidence of Tronox’s issuance of unsecured debt and stock in connection with the IPO by demonstrating that the financial statements on which the market relied were false and misleading, and the court agreed there was much evidence in the record regarding the insufficiencies of the Tronox financial statements. However, the court said it was not necessary for Plaintiffs in this case to prove that the IPO financial statements were false and misleading because this case is about the Legacy Liabilities that Kerr-McGee imposed on Tronox and their impact on Tronox’s solvency. In this case, the court emphasized, there was no contention that Tronox’s financial statements issued in connection with the IPO would be useful in determining Tronox’s solvency. The court pointed out that no party or any expert in the case suggested that financial statements and the reserves taken for environmental and tort liabilities were useful in a determination of solvency under the UFTA
The court said the principal reason why financial statements are of little use in a solvency analysis is that generally accepted accounting principles (GAAP) require reserves only for claims that are “probable” and “reasonably estimable.” Nevertheless, the court said the record was replete with evidence that Kerr-McGee misapplied even this lenient standard and thereby understated its liabilities for GAAP purposes. The court pointed to testimony that Kerr-McGee only established reserves for those costs that it knew it was going to incur or almost certain it would incur. The court mentioned in a footnote that the personnel in Kerr-McGee’s S&EA Department prepared internal Sarbanes-Oxley certifications that covered only “known and reasonably estimable liabilities” and that its law department’s control documentation similarly misstated the standard, providing that reserves should be established “where a judgment or loss [was] considered probable and measurable.” The court said that New Kerr-McGee was aware of numerous sites where it had potential environmental liability but did not disclose or reserve for these potential liabilities. These undisclosed sites were referred to internally as the “secret sites.
The practical effect of this misapplication of GAAP, the court said, was that Kerr-McGee did not assess a potential environmental contingency at a site prior to receiving a demand or complaint from a third party. The court noted that Tronox’s new controller and chief accounting officer raised concerns about this practice carried over from Kerr-McGee of reserving for environmental liabilities only after a demand was received from a third party. However, as the court observed, the MSA required Tronox to continue to use Kerr-McGee’s reserve setting methodology after the spinoff. Indeed, after a review of the 2008 reserves for 11 sites, Tronox concluded that the 2008 reserves were understated by $68.5 million and the financials were withdrawn. In October 2011, Tronox issued revised financial statements for the years ended December 2008-2010, concluding that its $189MM environmental reserve was understated by $303.2MM.
The court also found that since Kerr-McGee’s public financial statements were reported on a consolidated basis, the restricting transactions were not meaningfully disclosed in the company’s public financials. There was no disclosure, the court explained, that the “reorganization” diverted substantially all of the assets of the parent to a new holding company that would eventually disclaim liability for the Legacy Liabilities. As a result, the court concluded, it was impossible to determine the effect of the distribution to “a newly formed intermediate holding company,” and there was no disclosure that Kerr-McGee had this “newly formed intermediate holding company” assume more than $2 billion in debt owed to the group’s largest creditors because those creditors had the protection of covenants in their loan agreements.
However, the court said that financial statement reserves for environmental liabilities had no probative value in a solvency analysis because generally accepted accounting principles (GAAP) require reserves only for claims that are “probable and reasonably estimable.”
The remaining issue for the court to determine is the measure of damages. The parties will brief the issue over the next 60 days. Regardless of the outcome, though, there is little doubt that this case will be appealed.
On April 3, 2014, EPA and the Department of Justice (DOJ) announced an agreement to resolve fraudulent conveyance claims against Kerr-McGee Anadarko . Under the settlement, Anadarko will pay $5.15 billion to the litigation trust so that the settlement proceeds can be distributed to the trust’s environmental and tort beneficiaries. Specifically, the trust’s environmental and tort beneficiaries will receive approximately $4.475 billion and $605 million, respectively. More information on the settlement is available from the EPA website by clicking here