(In re Lyondell Chem Co.), 567B. R. 55
Financial projections are a routine and critical part of business management, whether they are produced for budgeting purposes, sales and marketing estimates, or cash flow planning. Financial projections supporting mergers and acquisitions are also a critical step in the process often taken by buyers, sellers and their respective advisors. Quite often, financial projections made by either or both disputing parties can also be a future flashpoint of disputes and litigation. Financial experts who might testify in such cases need to not only have the requisite expertise and experience, but they must also understand the underlying assumptions and inputs of forecasts and projections at issue, and they must present their conclusions and judgements with integrity and objectivity. Financial experts who critique financial projections should avoid, among other things: 1) criticism without sufficient or clear support, 2) reliance on the benefit of hindsight, and 3) failure to put historical financial projections into context. A recently concluded bankruptcy case (Weisfelner v. Blavatnik (In re Lyondell Chem. Co.), “Lyondell case”) involving a cross-border merger of industrial chemical firms highlights these specific dangers.
The Lyondell case, a lengthy bankruptcy case dating from the 2008 financial crisis, is a prime example of how expert witnesses need to carefully review and analyze the underlying support and historical context when evaluating financial projections. In fact, this past September, as a result of poor analyses, a judge dismissed almost $6.3 billion in claims brought by unsecured creditors of Lyondell Chemical Co. (“Lyondell”) in relation to its December 2007 acquisition by Basell AF SCA. The legal case proceeded for many years and is quite complex, but the dismissal of $6.3 billion in fraudulent transfer claims brought by unsecured creditors (the “Trustee”) hinged largely on the Court’s view of expert opinions evaluating financial projections made by Lyondell.
On December 20, 2007 Houston-based chemical and plastics firm Lyondell merged with European plastics maker Basell in a deal valued at $12.5 billion. Basell, controlled by billionaire financier Len Blavatnik’s Access Industries (“Blavatnik”), had been pursuing Lyondell since early 2006 and acquired a significant minority position in Lyondell early in 20071. Substantive merger talks ensued during the summer of 2007 and a merger agreement was reached on July 16, 2007. The agreed price was $48 per share ($19.7 billion) and the combined entity was named LyondellBasell Industries (“LBI”). As part of the early merger discussions and agreement, Dan Smith, the CEO of Lyondell, requested that “refreshed projections” of Lyondell’s go-forward financials along with other due diligence materials be prepared and provided to Blavatnik and his bankers 2. These refreshed projections prepared just prior to the merger agreement in July 2007 formed the core of the subsequent fraudulent transfer allegations and disputes.
Throughout the remainder of 2007 Lyondell and Basell worked toward merger closure which took place on December 20, 2007.
The Court was presented with evidence that between the July 2007 merger agreement and merger closure in December 2007, oil prices, a major input cost in the chemical industry, spiked and market conditions grew less stable. During this period, however, the initial unsolicited offer price was almost doubled by the closing date in December.
The defendant further described to the court that 2008 was an even more traumatic year for the combined firm (LBI). The U.S. and world economies slowed rapidly leading up to a stock market crash, oil market collapse, and ensuing financial crisis. Apart from macro events, business setbacks struck LBI including a crane collapse at its Houston refinery facility (“LBI Refinery”) killing four workers and successive hurricanes striking the Texas coast near the LBI Refinery in September 2008. These events combined to force LBI to cease operations at the LBI Refinery for over two weeks. Ultimately, according to the defendant, a plunge in chemical sales and the global credit crisis resulted in LBI declaring bankruptcy in January 2009.
The fraudulent transfer claim ultimately made by the Trustee upon the bankruptcy filing hinged on the “refreshed projections” provided by Lyondell to Blavatnik and the financing banks in July 2007. The Trustee asserted that the “refreshed projections were manufactured by Lyondell in reckless disregard for the truth, and that they showed billions of dollars of unrealistic future earnings. The Trustee blames Smith for ordering the unrealistic numbers to support a higher acquisition price.”3
To prevail on its claims regarding fraudulent conveyance, the Trustee needed to satisfy at least one of three conditions, one of which was whether LBI was insolvent on December 20, 20074. The Trustee alleged that the refreshed projections falsely supported an excessively high merger price and that “a merger based on these refreshed projections necessarily left LBI with inadequate capital.”5 Therefore, a key issue was whether, in spite of these projections, the Court felt LBI was insolvent on December 20, 2007. The Trustee, and its industry and financial experts, alleged these refreshed projections were wildly optimistic, “showed billions of dollars of unrealistic future earnings,” and were sought to falsely assert a higher acquisition price, all of which combined to hide the fact that LBI was effectively insolvent as of the date of the merger.6
The Court, however, found that the Trustee’s experts made several errors in their analyses and conclusions.7 The Court determined that the Trustee’s allegations were not reasonable and lacked support. In particular, the Court found that the projections themselves did not differ materially from Lyondell’s normal projections it performed annually.8 Further, the Court concluded that the Trustee’s industry experts produced a forecasting model that was described as a “black box” with “hidden assumptions and ‘proprietary’ elements that precluded the Defendant’s experts, and the Court, from fully apprising the methods and merits of the model.”9 The Trustee’s financial and solvency experts then relied on the industry experts’ flawed model. The Court also determined that some of the Trustee’s experts represented different parties at different times prior to and during the case thereby creating inconsistent expert conclusions over time.10
According to the Court, the defendant’s financial and industry experts presented a far more credible case that the refreshed projections were compelling and persuasive at the time of the merger. The Court was persuaded by the testimony that the refreshed projections did not differ dramatically from Lyondell’s prior financial projections, and the refreshed projections were in line with the prevailing, contemporaneous industry outlook in 2007, including increasing demand for oil refining, stable profit margins and sufficient future cash flow from the LBI Refinery.11
The Court was also strongly influenced by the support for the transaction from the banks financing the deal. The banks’ financing exceeded $20 billion and multiple banks had large teams analyzing Lyondell’s historical performance and current financial position, including the refreshed projections. The Court viewed the banks’ collective $20 billion at stake and extensive due diligence, including review of refreshed projections, as strong evidence that they perceived LBI as a financially viable and even attractive combined entity. Ultimately, the Court felt that Blavatnik (who lost tens of millions in the eventual bankruptcy of LBI) and the banks had vetted the transaction in 2007 adequately, and their financial stakes did not provide incentives to make unreasonable projections. Finally, the Court opined that the significant drop in demand for petrochemical products, the onset of the financial crisis, and LBI’s subsequent bankruptcy was not predicted by anyone associated with the transaction and, as a result, could not have been reflected in the projections.
The Lyondell refreshed projections proved to be spectacularly wrong in retrospect given the ensuing industry and market downturn and LBI’s eventual bankruptcy. The Court’s decision, however, reveals the importance of evaluating financial projections in a litigation setting without the benefit of hindsight. Further, the incentives, perspectives, and knowledge levels of the persons assembling the financial projections should be considered when critiquing projections in a litigation setting. Projections evolve and can change over time. What is important for experts’ credibility, however, is that the assumptions and evidence supporting judgements made in the process of preparing projections are sound, appropriately consistent, documented, and supported.
1 On May 9, 2007 AI Chemical, an Access subsidiary, acquired 20,990,070 share of Lyondell common stock at 32.11 per share ($674.3 million) – referred to as the “toehold position.” From Weisfelner v. Blavatnik (In re Lyondell Chem. Co.) Decision Opinion dated April 21, 2017 at 17.
2 From Weisfelner v. Blavatnik (In re Lyondell Chem. Co.) Decision Opinion dated April 21, 2017 at 18. Banks participating in the financing of the transaction included Goldman Sachs, Merrill Lynch, Citibank, ABN AMRO, UBS Securities LLC. Goldman Sachs, Merrill Lynch, and Citibank were the first banks to agree to finance the deal and each conducted an intensive financial due diligence of Lyondell during July 2007, including generating their own financial projections of Lyondell’s business. Ultimately, the five banks were jointly responsible for $21 billion in financing. From Weisfelner v. Blavatnik (In re Lyondell Chem. Co.) Decision Opinion dated April 21, 2017 at 21 and 27.
3 Weisfelner v. Blavatnik (In re Lyondell Chem. Co.) Decision Opinion dated April 21, 2017 at 18.
4 The three financial condition tests are: i) balance-sheet insolvency, (ii) unreasonably small capital, and (iii) the intent to incur debts. For a more detailed description, see U.S. Code § 548- Fraudulent Transfers and obligations.
5 Weisfelner v. Blavatnik (In re Lyondell Chem. Co.) Decision Opinion dated April 21, 2017 at 10.
6 Weisfelner v. Blavatnik (In re Lyondell Chem. Co.) Decision Opinion dated April 21, 2017 at 18. Further, EBITDA refers to “Earnings Before Interest, Taxes, Depreciation, and Amortization” and is a balance sheet accounting proxy for a firm’s cash flow. “Terminal EBITDA” refers to the present value of the last projection of EBITDA after the final EBITDA projection year; it is used normally in a Discounted Cash Flow modeling concept.
7 Judge Martin Glenn of the US Bankruptcy Court for the Southern District of New York presided on the April 21, 2017 Case Decision.
8 “LRP projections” at Lyondell refer to annual long-range plans Lyondell personnel and consultants assembled. These long-range plans also set the budget for the upcoming fiscal year. The long-range plans involved a deliberate process of collecting data on recent business outcomes, industry and market information, and senior management plans. See Weisfelner v. Blavatnik (In re Lyondell Chem. Co.) Decision Opinion dated April 21, 2017 at 18.
9 Id. at 10.
10 Id. at 10.
11 Expert testimony that the HRO (Houston Refinery) was “more than capable of generating EBITDA levels forecasted by Lyondell for the years 2008 and beyond. HRO was a “reliable operating asset” with a strong operating track record. Lyondell purchased the remaining outstanding equity in the LBI Refinery in 2006, the year prior to the acquisition.