Over several decades, oil and gas, coal, and petrochemical companies have amassed significant environmental liabilities. They have also amassed significant debt, creating unique financial pressures on the industry amid challenges created by coronavirus and pressure to obtain relief. As companies struggle with legacy liabilities, accumulated debt, and new challenges, they may be tempted to try to obscure environmental liabilities to mislead investors or to use bankruptcies – or spin-off companies designed for bankruptcy – to shed these liabilities.
To ensure that investors and creditors have accurate information regarding these liabilities, several securities regulations and generally accepted accounting principles (GAAP) require that issuers disclose environmental liabilities in their public filings. Without inside information, however, it can be difficult to identify inaccurate disclosures.
To identify companies who may be misleading investors or creditors, the Dodd-Frank SEC Whistleblower program allows whistleblowers to make confidential reports about misleading disclosures. Whistleblowers can also report companies who are fraudulently avoiding paying penalties owed to the federal government or certain state governments under the False Claims Act. Under the Dodd-Frank Act, whistleblowers who provide original information that leads to successful prosecution can receive between 10% and 30% of monetary sanctions. Under the False Claims Act, whistleblowers are eligible for 15% and 30% of the monetary sanctions.
In recent years, a series of significant cases against oil and gas and petrochemical companies has drawn attention to how companies may be understating their liabilities, particularly through bankruptcy proceedings. A previous case against Kerr-McGee illustrates how a company might attempt to understate liabilities to spin them off into a company designed for bankruptcy and how such a scheme can lead to a multibillion-dollar liability.
Tronox Inc., et al., v. Kerr-McGee Corp., et al.
By 2000, the petrochemical company Kerr-McGee had accumulated substantial environmental and tort liabilities over the past 70 years through its previous wood-treating, uranium mining and processing, thorium processing, and chemical manufacturing businesses. In 2001, with two successful remaining oil and gas and chemical businesses, the company was looking for a buyer. The remaining liabilities associated with its legacy businesses, however, made it difficult to attract potential purchasers.
In 2001, Kerr-McGee initiated “Project Focus,” a plan to separate its profitable oil and gas business from its legacy liabilities. Kerr-McGee formed a new parent company, along with a new oil and gas subsidiary, to which it transferred the valuable oil and gas assets, while leaving behind the liabilities in the old company, renamed Tronox. After an initial public offering (IPO) of Tronox stock, Kerr-McGee spun-off the company in 2006, and Anadarko Petroleum acquired Kerr-McGee for $18 billion.
Unable to cope with the burden of liabilities it had inherited from Kerr-McGee, Tronox filed for Chapter 11 bankruptcy protection in 2009 in the U.S. Bankruptcy Court for the Southern District of New York. In May of 2009, Tronox commenced litigation in which the United States and the bankruptcy estate (represented by a litigation trust), intervened, filing a complaint against Kerr-McGee and related subsidiaries of Anadarko Petroleum corporation. The complaint alleged that the defendants fraudulently transferred assets to the new Kerr-McGee while imposing the legacy liabilities on Tronox, leaving Tronox without sufficient funds to pay environmental and tort claimants.
On December 12, 2013, the Court decided against Kerr-McGee Corporation on charges of both actual and constructive conveyance, noting “clear and convincing evidence” that the defendants intended “to hinder or delay creditors when they imposed all the legacy liabilities on Tronox.” On November 10, 2014, the Environmental Protection Agency (EPA) and the Department of Justice announced an agreement to resolve the claims of fraudulent conveyance requiring Anadarko Petroleum to pay $5.15 billion plus interest to a litigation trust. The EPA describe the award as the “largest award ever in a bankruptcy for governmental environmental claims and liabilities, and one of the largest environmental enforcement awards ever.”
Tronox shareholders also filed a consolidated class action complaint in the U.S. District of New York against defendants Tronox Inc., Kerr-McGee Corp., and Kerr-McGee successor-in-interest Anadarko Petroleum Corp., along with certain officers and directors of Kerr-McGee and Tronox, and Tronox’s auditor, Ernst & Young. The complaint alleged that defendants made material misstatements and omissions in their filings in order to defraud investors.
In particular, by only disclosing and setting reserves for costs it knew or was certain it would incur, the complaint alleged that the defendants had violated SEC regulation S-K, which requires issuers to disclose contingent liabilities when they are “probable” or “reasonably estimable.” While company had reserved approximately $200 million for environmental remediation reserves, the complaint alleged that they actual amount approached $900 million.
The parties agreed to a $37 million settlement, of which Tronox’s auditor at the time, Ernst & Young, agreed to pay $2 million.
A series of similar securities class action lawsuits against oil & gas and petrochemical companies highlights ongoing concern about the potential for fraud in spin-offs. In December 2017, a complaint alleging fraudulent conveyance was filed against Noble Corporation plc and certain of its current and former officers and directors related to the spin-off of Paragon Offshore and Paragon Offshore’s subsequent bankruptcy. In 2019, complaints alleging fraudulent conveyance were also filed against Dupont, Chemours, and 3M.
Analysts have recently highlighted the potential for companies to use the “bankruptcy as bailout,” by using the Bankruptcy Code to legally avoid billions of dollars in environmental liabilities. The Kerr-McGee case highlights the potential for “bankruptcy as bailout” to also serve as a potential indicator of fraud and suggests that, even without more stringent environmental disclosure requirements, there could be a growing disclosure risks related to environmental liabilities. While proving this type of fraud can be challenging, whistleblowers with original information could play a pivotal role in bringing successful prosecutions and significant penalties and awards.