Protecting your portfolio against Strategic Defaults

Strategic defaults are on the rise. The LA Times reports that 2008 saw 588,000 homeowners strategically default on their mortgages, more than twice as many as in 2007. The Wall Street Journal has also reported on the phenomenon, reporting that as many as one in four defaults may be strategic, and that the trend is amplified in high-foreclosure areas where homeowners have been emboldened by their neighbors’ actions. What does this have to do with your environmental risk portfolio? Well, several recent bankruptcies demonstrate that this phenomenon may not be limited to the housing market.

In my previous blog entry, I wrote about the January 2009 bankruptcy filing of Kerr-McGee spinoff Tronox.  When Tronox spun off from Kerr McGee in 2005, it took hundreds of millions of environmental liabilities with it. One can see a similar story by looking at Solutia, which filed for bankruptcy protection 6 years after spinning off from Monsanto.  “We simply could not continue to sustain our operations burdened by Monsanto's legacy liabilities”, said John C. Hunter, CEO of Solutia.  Looking at both of these bankruptcies with 20/20 hindsight it seems that these companies were doomed from the start, but were they strategic defaults?

It’s important to remember that strategic default may be used by companies you are financially tied to through multiparty remediation sites. When dealing with multiple PRPs, it is now mandatory under FSP FAS 157-f (now FASB ASC 820) to be able to quantify the risk of a fellow PRP defaulting on its liabilities. ERCI is launching a new product, CounterParty Defender, which allows you to test and quantify long-term non-performance risk of other PRPs.  By combining real-time credit ratings with PRP share data and cash call projections, this framework allows you to monitor third-party companies and end business relationships with the highest-risk companies. 

  

In a previous blog entry, I noted the idea of calculating the ratio of a company’s environmental remediation reserve to spending in the last fiscal year. A ratio of 10:1 would show some long-term thinking about liabilities, while a ratio of 2:1 might deserve some analysis and confirmation.

 

Looking at a recent bankruptcy with significant environmental liabilities, I wondered if an investor could spot a problem using this ratio.

 

Tronox was a publicly-traded spin off of the Kerr-McGee Company, which had an IPO in November 2005. In January 2009, Tronox Chapter 11 filed for reorganization, listing$1.6 billion in assets and $1.2 billion in liabilities, leaving shareholder equity of about $0.4 billion. From their 2007 annual report, Tronox announced an environmental reserve balance of $188.8 million as of 12/31/2007 and fiscal year 2007 spending of $50.2 million. At the 2007 spending rate, the reserve would last another 3.76 years.

 

Tronox was clear about several matters in their 2007 10-K filing – cost overrun allocation with Kerr-McGee, the pending reimbursements from future spending, even the recent reserve increases – to demonstrate transparency to their shareholders. Two tough questions: was $189 million enough? Was four years enough?

 

Some years later, we might learn what a reasonable environmental reserve should have been, but the number in place in December 2007, $189 million, was already a big drain on Tronox’s $430 million in stated shareholder equity. On August 2009, the SEC 8-K filing showed the shareholders equity was already marked down to-$159 million, and that the environmental reserves were larger and not decreasing any time soon.

  

By this time of year, most remediation teams are done budgeting for next year and  have returned their attention to meeting this year’s budget. In managing environmental remediation liabilities and asset retirement obligations, it may be obvious that your company uses the budgeting and reserve update process to confirm any new data available and recent decisions made. Sometimes, reserve review meetings can degrade into decision analysis sessions, where the remedy selection or whether to honor consent decrees comes up for discussion.

 

For forward-looking managers, spending today’s cash on yesterday’s liabilities seems like a tempting target: why not delay? Why not switch to a new strategy like “fence and monitor”? Why not litigate?

 

If you manage an environmental liability portfolio for your company, remember a  rule from baseball: this is a pitch in the dirt, and you don’t have to swing.

 

Participating in consent decrees and cleaning up sites usually goes beyond a financial obligation. Showing commitments and visible progress to regulators and their communities is not just good PR, it’s good business. Contractors are sensitive and reactive to their clients’ stop and start messages.

 

Let’s face a few facts: environmental cleanup projects deal with the unknown. What is the target soil volume? How long will the groundwater treatment system need to run? Is the plume off-site? What cleanup goals will the regulators accept if the technology doesn’t work?

 

Reserve updates are a communication channel to bring new information forward, at least once a year. Using that discussion to revisit old decisions is tempting, but rarely brings the desired outcomes of lower costs, faster closure, or a more valuable brownfield property.

  

In the last several years, a few bankruptcies have triggered significant redistributions of environmental liabilities at CERLA Superfund sites. General Motors, Lyondell, Solutia (originally part of Monsanto) and Tronox (once part of Kerr-McGee) are the latest examples.

 

When there is a major bankruptcy, your company may find out that it is…was…in business with a well-known company that is now going to discharge future environmental liabilities very quickly.

 

In 2006, the Financial Accounting Standards Board released Statement 157 on Fair Value Measurement. This standard applies not just to assets, but to environmental liabilities as well. One new obligation is that environmental remediation liabilities (covered under FASB 5) and asset retirement obligations(FASB 143) now need to contain a company’s definition of counterparty risk.

 

Counterparty risk is the expected value of default from a company on the other side of a transaction.

 

If your company if jointly funding an RI/FS with a ten-party group, and two of those parties go bankrupt, your company may not see any future cash calls paid for the RI/FS, and may be implementing the remedy without them. Filing a claim with the bankruptcy court, typically through common counsel, is often the only step available in this game of musical chairs.

 

The rule for PRP bankruptcies: next time the music stops, get ready to file aclaim.

  

In 2006, the Financial Accounting Standards Board released Statement 157 on Fair Value Measurement. This standard applies not just to assets, but to environmental liabilities as well. One new obligation is that environmental remediation liabilities (covered under FASB 5) and asset retirement obligations (FASB 143) now need to contain a company’s self-assessment of their own creditworthiness.

 

In other words, a company needs to state its environmental liabilities and then discount that liability if there is doubt that it will actually pay them.

 

Dun & Bradstreet notes that the general default rate for US companies is about 1.4% a year. This isn’t a “bankruptcy rate”, but will be a proxy for our example. During good times, with a growing client base and ample credit, a company may determine its own chances of filing bankruptcy at <1%. During a recession, after losing key clients and credit facilities, it may determine that there is a 10% or 15% chance of filing bankruptcy.

 

Under FASB 157, an environmental liability of $10 million would still be about $10 million in good times, but when a company decides it is less creditworthy, it should revalue the liabilities to $9 million or less. By changing the self-assessment of bankruptcy from 1% to 10%, the income statement shows a liability write-down of $1 million; in other words, a paper profit. If you see this in an income statement, stay on your toes. It’s a deadbeat dividend.

 

Think about that moment, when a company decides it is time to confront its credit condition, it cuts environmental liabilities because the “ability to pay” is diminishing, and the reward is… a book profit.

 

Fast forward two years, the same company survives, and the ability to pay improves. The reward is… a book loss for marking the liability up to the full, original value.

 

Environmental liabilities are never going to be simple again.

  

An accounting professor at Georgetown told me about his audit of the construction of the Watergate complex in Washington, DC. The way I remember it, he found four sets of books: one for the prime contractor in Italy, one for the limited partners in the US, one for tax calculations, and one more just to keep the stories straight. With currencies and layers of corporations, this all seems normal today.

 

Do environmental liabilities need multiple sets of books?

 

We have found the answer is simply “yes.”

 

One set of books is needed for reserve estimation, under FAS 5 or GASB 49. The duration of a company’s reserve horizon and the phase of a project usually mean reserve numbers can be robust and rigorous, or vague to non-existent for early-stage projects.

 

A second set of books is needed for cost recovery. When cashing out a small PRP or an insurer, the risk premiums and inflation of sunk costs, along with speculation about future costs, can trigger a widely different liability estimate from a reserve forecast.

 

A third set of books is important for an operating facility. Not every environmental  project is funded with reserve dollars. Often, there are capital expenditures or asset impairments which create different assets or liabilities on the balance sheet. Plus, there are normal environmental operating expenses.

 

Now that there are three sets of books, keep in mind that the backup may be different. The raw estimates, with price and quantity assumptions, are essential but volatile. The data displayed to management, in a portfolio summary, applies program-wide assumptions to each project. The disclosure to shareholders requires the application of rules regarding materiality and consistency across environmental projects and other contingent liabilities.

 

More than one set of books is just a part of our business.

  

In comparing different remedial strategies for a cleanup site, the present value of cost is always a valuable benchmark. But is there a benefit to being proactive? Quantifying this is difficult, but answering these questions can help in selection of a winning cleanup strategy:

 

Are receptors nearby? If the contaminant fate/transport window is short, there is less impact on receptors.

Are regulatory relationships important?  It’s easier to build a positive relationship with a track record of prevention and compliance.

Been down this road before?  Applying best practices or lessons learned from similar projects can lead to a faster implementation, maybe at a lower unit cost too.

Is time your friend? Some problems do not need aggressive human intervention, but cleanup problems that were “small, cheap, easy” belong to another generation.

Does the corporate reputation matter?  Given enough time, everyone notices a cleanup. Employees, neighbors, contractors all find cleanup projects admirable. It’s good housekeeping, and usually a great photo opportunity.

 

In our work at ERCI, project delays are often part of the reserve-setting landscape. Not every cleanup can be implemented immediately with an open-ended budget. Instead, prioritization and good capital stewardship play a vital role.

  

Over the past several years, ERCI has assembled the historical environmental reserve balance data from major corporations. We have been trying to learn if environmental remediation liabilities have been increasing, flat or decreasing,and whether industry consolidation alters trends.

 

On our website, http://www.erci.com/Reserver.aspx we present the environmental remediation liabilities and exploration and production reserves of the oil industry since 1991. Using publicly-filed data,we combined the reserves of legacy companies to give a long-term view.

 

Our conclusions? Environmental reserves are not following a pattern. BP, Chevron and ConocoPhillips saw their reserves go up the first year or two after a major merger or acquisition, but there, each company’s experience diverges: BP’s was worked down, Chevron’s went up, and ConocoPhillips stayed more or less even.

 

We also tried to gauge the “effective lifespan” of environmental reserves, by dividing the reserve by then-year spending. Our finding is that companies are changing the rate at which they work down their environmental reserves,sometimes dramatically. Chevron and ExxonMobil are somewhat stable, but Shell and BP have changed the intensity of their spending over the last five years.

 

While E&P reserves are not measured the same way as remediation liabilities, the dollars reserved are much higher, and have basically gone one direction since SFAS 143 and FIN 47 (conditional asset retirement obligations): up. The factors behind this increase would be a great research topic. Weaker dollar? More wells to abandon? Higher unit costs? Better measurement?

 

Please take a look at our research, and if you’re in the academic field, we may be able to provide you with our raw data. We hope you find this useful.

  

On September 9, I participated in a webinar on implementing Government Accounting Standards Board Statement No. 49 (GASB 49) – Accounting and Financial Reporting for Pollution Remediation Obligations. This event was moderated by Gayle Koch of the Brattle Group, and was hosted by the American Bar Association (www.abanet.org). The lead speaker was GASB’s Wesley Galloway, who presented a short summary of the scope of GASB 49, the expected impact of the new regulations and a description of the nature of disclosure requirements for government agencies.  I spoke next about the practical methods used to estimate cleanup liabilities and what I see as the best practices to be used for solid, auditable financial reporting. Dave Kleiber, environmental finance manager at the Port of Seattle, spoke next on his practical experiences implementing the new rules, as did two representatives from the Idaho State Controller’s office, Brandon Purcell and Carol Bearce. These presentations are available from the speakers. If you’re fine-tuning a new compliance program for GASB 49, Wesley and Dave presented useful case studies.

 

I thought the presentations were interesting because this topic is timely and there is still some significant uncertainty about where and how to apply GASB 49. The speakers brought useful points of view in ABA’s low-cost webinar format. This content will likely be available from the ABA archive, but the speakers would likely share their presentations individually as well.

 

One question concerned which standards or common practices to use in generating cost estimates under GASB 49. I pointed out that the American Society for Testing and Materials Standard Guide for Estimating Monetary Costs and Liabilities for Environmental Matters (ASTM E2137-06) remains the best resource. There is no substitute for good professional judgment and, for higher cost projects, a peer review by experts.

  

The simple answer is a promise to pay, or an IOU. It is a liability on a balance sheet.

It is not a dedicated account with liquid assets. It is not cash waiting to be spent. Environmental liabilities are not matched with sequestered capital – unless a regulator or counterparty agrees that funds should be in a letter of credit or insurance policy. Otherwise, future environmental cleanup costs are offset by the working capital, goodwill, and other co-mingled assets in the business.

The reserves are today’s recognition of future spending on environmental clean ups. Judgment calls occur when an asset – especially one which can be used as collateral – is created or improved.

For example, a plant has a wastewater treatment plant, primarily to handle process and stormwater from the facility. This plant has a discharge permit and an on-site laboratory to check water quality. The costs to build and maintain this plant are capital expenditures and the routine period costs, like electricity, are operating expenses. As a capital expenditure, the asset cost is deducted from taxable income gradually, over the life of the plant. If this wastewater treatment plant is modified to handle the water from a groundwater remediation system, that incremental cost is usually a reserve expense, meaning the costs are estimated in advance and deducted (from taxes) as spent.

Where does judgment come in? A spill or discontinued waste handling practices are basis for reserving associated future costs. In other words, if a wastewater treatment plant has a diesel fuel spill, the costs to cleanup that spill are reservable, while the routine operating costs are expensed without a reserve.

The rule of thumb is if the cost would stop when production stops, it is an operating cost. If a cost would continue after production stops, it is likely either an asset retirement cost (like asbestos removal or demolition) or an environmental remediation cost.

While operating, the same plant can be discharging a mix of stormwater, process water and remediated groundwater, but the costs probably need to be split out.