Wednesday, April 9, 2014

Andarko Gets Caught For Kerr-McGee Subterfuge

Kerr-McGee was founded in 1929 as an exploration and production company.  Over time, it diversified into a number of other extractive industries, such as its 1952 entry into uranium mining and milling.  At a time when the Cold War had the U.S. and Russia in an all out nuclear arms race, this probably seemed like a good business to enter. Uranium mining and processing operations were carried out at multiple locations, including on tribal lands of the Navajo nation.

In 1963, Kerr entered into a creosote business for treating lumber, and in 1967 it acquired American Potash and Chemical Company in Henderson, NV which produced perchlorate ("perc") for use in rocket fuel, targeting demand from government space programs and Defense department projects.

Over time, investors grew disenchanted with the conglomerate or portfolio approach to creating public companies. "Focus" became the mantra, partly because it made investor valuation easier and, the story goes, leads to higher multiples without the conglomerate discount.

Lehman Brothers, as Kerr-McGee's banker, encouraged the company to slim itself down into an E+P company, the original business, and a titanium dioxide business, the critical commodity for all manner of residential and industrial paints.   By 2005, Kerr-McGee had reinvented itself, but court documents note that exploration and production produced $1 billion in income in that year, while the Ti02 business generated a little over $100 million in income.

As early as 2002, Andarko Petroleum had taken a hard look at Kerr-McGee but it clearly had no interest in the peripheral businesses, and Andarko wanted to stay away from the large legacy environmental liabilities from businesses like creosote and uranium mining, among others.

So, the bankers came up with the classic, cookie cutter strategy of creating a corporate entity into which to deposit all the legacy liabilities.  In itself, this is neither new nor inherently sinister strategy, provided that the new entity, called Tronox Worldwide, LLC had adequate funding and prospects for financial viability. This structure has been used successfully for asbestos, lead paint, and other long-tailed, costly liabilities.

Andarko acquired Kerr-Mcgee in 2006, a few weeks after the Kerr had divested the legacy environmental liabilities via Tronox becoming an independent company.  When I first read about the liabilities coming back to Andarko, I wondered if regulators had once again overreached arbitrarily into structures that had been used before in the normal course of business.

Reading the court documents, this is clearly not a case of regulatory overreach, although the suit was based on the theory of fraudulent conveyance in the assignment of liabilities to Tronox, including pension obligations. Kerr also raided the cash coffers of the former subsidiaries.  Bondholders of the old KM didn't protest, because they got some special protections, since their indentures specifically prohibited this kind of financial 'three card Monte.'

The executives at the old Kerr-McGee ran an organization whose normal industrial safety and environmental policies were woefully deficient.  They also had the temerity to suggest that the creation of Tronox had nothing to do with offloading the liabilities and weren't motivated by thoughts of a transaction.  Given the record, and common sense, this is laughable.

Prior to cutting Tronox loose as an independent company, the old Kerr-McGee stripped out 83% of the revenue and 113% of corporate income, according to the court documents. Lehman Brothers had looked for other options for Tronox, including spin-off, but they clearly knew that it was a dog, or in the parlance of the financial crisis, a "piece of ***t."

So, the argument of fraudulent conveyance, ex post, proved to be an easy case to make.  Andarko seems to be able to deal with the now, much larger environmental liabilities and associated fallout from the Tronox bankruptcy.

This unfortunately is an example of agency problems with the interests of executive management as agents lying with the creation of Tronox, either in ignorance or of a cynical assessment that the day of reckoning would be down the road after they were all gone.  So it goes.

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