Investing

On February 11th, Seahawk Drilling (HAWK) announced that they were selling substantially all of their assets to Hercules Offshore (HERO). Since the announcement the share price has settled around the mid $4s for a 40% drop. The sale will be conducted through a Chapter 11 bankruptcy to separate the assets from some, unassociated, liabilities. This is a wonderful acquisition for HERO. It may be able to turn HERO’s terminal debt problem into a manageable debt problem. HAWK holders are likely, subject to the long, complex points below, to end up with shares in HERO thereby maintaining exposure to the sold assets. There is a reasonable chance that HAWK holders will end up with HERO shares at least to the value of HAWK’s shares pre-filing. There are some lower probability cases where HAWK holders end up with more than that (assuming HERO’s price is constant around $5) and cases where HAWK holders end up with just a dollar or two.

The treatment of a few key issues is going to define the payout:

Most Likely does not mean that it is likely to occur, just out of all the outcomes it’s the most likely (consider 10 cases each with 9% chance except for the final case which has a 19% chance of occurring. That would be the most likely even though it has <20% chance of occurring).

Brief History

On August 4th 2009, Pride approved a plan to separate into two companies through the spinoff of Seahawk. The spinoff occurred on August 24th, 2009. There are four agreements that define the relationship between Pride and HAWK post spinoff. The Master Separation Agreement, The Transition Services Agreement , The The Tax Sharing Agreement and The Tax Support Agreement.

The combination of the downturn in the drilling market both due to the price of Natural Gas and the de-facto moratorium combined to exhaust Seahawk's liquidity. In November 2010 HAWK announced a process to explore strategic alternatives. Ultimately this process contacted over 100 parties with a view to mergers, acquirers and financial investors. HAWK was interested in an outright sale, sales of certain assets, debt and equity investments. HAWK received their first term sheet on 5th November 2010. Three more term sheets were submitted in late November as the process expanded. The initial term sheet was revised in mid-November but by late November they withdrew. HAWK negotiated with one of the three parties through mid-December 2010. In Mid December an LOI was executed and exclusive negotiations began. HAWK worked exclusively with this company until 21st January 2011. On 20th January HAWK received a substantially revised offer. HAWK rejected the revised offer and suggested that the offer needed to look like the offer in the LOI. On 21st January HAWK received another revised offer that was even worse and HAWK terminated the LOI with the company. Simmons and Company, who were handling the deal, then contacted bidders that had previously shown an interest, with updated data. HERO and one other responded. In February 2011 HAWK’s board entered an Asset Purchase Agreement (APA) with HERO after evaluating the other available offers.

HAWK currently have 7 of their 20 rigs working.

The executed APA contemplates the acquisition by Hercules of substantially all of HAWK’s assets and jackup rigs through a sale pursuant to section 363 of the Bankruptcy Code.

The APA includes the purchase of Rigs, Contracts, Equipment, Vehicles (including leased vehicles), All tangible assets, Accounts Receivable, Insurance Benefits arising from the business (but excluding certain claims), Cash, Prepaid Deposits and Expenses, Claims relating to the business, Permits, Photocopies of all records, warranties, all other assets not excluded.

The excluded assets include The proceeds from the sale, Rigs that are written off, Contracts & Permits that are explicitly excluded, Insurance benefits relating to the sold rigs, Original records, Third party property, Equity interests in subsidiaries, Bankruptcy Claims, Pride Claims, Warranties, leased real property, Software, Trademarks, Websites, Intangibles, Goodwill and other listed excluded assets.

HAWK have secured Debtor in Possession (DIP) financing of $35M of which they plan to draw $25m. Seahawk have received approval regarding the use of DIP proceeds to pay severance to employees terminated within 15 days following the Petition Date as well as incentive payments to non-insider employees under existing employee programs up to approximately $2.0 million in the aggregate. 

The outstanding indebtedness under the Revolving Credit Facility is approximately $18.1 million. The Revolving Credit Facility has an initial facility amount of up to $36.0 million.  The Revolving Credit Facility is secured by fifteen of HAWKs’ rigs and substantially all of the HAWKs’ other assets, including accounts receivable, spare parts and certain cash and equivalents. It’s important to note, in terms of the fraudulent conveyance discussion later, that 75% of HAWK’s assets could only secure a highly restrictive facility for 36M.

The aggregate consideration for the Purchased Assets is 22,321,425 shares of HERO plus $25,000,012 Cash , subject to certain adjustments. There is a $3M termination fee plus expenses in the event of a termination for reasons such as a better deal for HAWK.

Upon the closing of the sale, the cash portion paid by Hercules shall be used to repay the outstanding principal amount of the debtor in possession financing, various working capital needs and accrued interest and fees due as of the closing date.  The Hercules Shares, as the remainder of the consideration for the Sale, will be held in escrow and will be distributed to creditors and interest holders pursuant to a confirmed chapter 11 plan.

 

Need for Chapter 11

Outside of bankruptcy there is greater risk that a sale of substantially all of a companies assets will inherit some of the liabilities. Another benefit is that certain contracts can be cherry picked and there is certainty around the liabilities that do and do not attach to the sold assets. While they are excellent reasons for conducting the asset sale under Section 363 a Chapter 11 filing also permits the Debtor (HAWK) to challenge certain contracts, that they convince a court to deem as, a constructive fraudulent transfer.

Mexican Tax

Once such contract relates to HAWK’s liabilities for taxes to the Mexican government.

Pursuant to the Tax Support Agreement between Seahawk and Pride, entered into at the time of the Spin-Off, Pride has agreed to provide a guarantee or indemnity in favor of the issuer of any surety bonds or other collateral issued for the account of Seahawk or any of its subsidiaries in respect of the Mexican tax  assessments for tax years 2001 through 2004 made prior to the Spin-Off Date, to the extent requested by Seahawk.  The Mexican government previously assessed claims for taxes for the years 2001 through 2006 against certain non-Debtor (are not included in the the bankruptcy) subsidiaries of Seahawk.

Reviewing the most recent Pride 10K indicates that HAWK will attempt to have the tax support agreement set aside:

Risk Factors About Our Spin-Off of Seahawk Drilling

Seahawk’s pending bankruptcy proceeding may result in claims against us, the reduction or elimination of amounts owed to us by Seahawk, and termination of our rights to make indemnification claims against Seahawk …

In addition, the bankruptcy laws permit a debtor in bankruptcy, under certain circumstances, to challenge pre-bankruptcy payments or transfers of the debtor’s assets if the debtor received less than reasonably equivalent value while insolvent, or if the transfers were made with the actual intent to hinder, delay or defraud a creditor, or were made while insolvent on account of a pre-existing debt that has the effect of preferring the transferee over the debtor’s other creditors during the so-called preference period. Authorized representatives of the bankruptcy estate could seek to challenge transactions effected in connection with the spin-off under the bankruptcy laws.

In 2006, 2007 and 2009, Seahawk received tax assessments from the Mexican government related to the operations of certain of its subsidiaries. Pursuant to local statutory requirements, Seahawk has provided and may provide additional surety bonds, letters of credit, or other suitable collateral to contest these assessments. Pursuant to a tax support agreement between us and Seahawk, we agreed, at Seahawk’s request, to guarantee or indemnify the issuer …. On September 15, 2010, Seahawk requested that we provide credit support for four letters of credit … The amount of the request totalled approximately $48.4 million, … On October 28, 2010, we provided credit support ... Seahawk’s quarterly fee payment [A fee for the credit support] due on December 31, 2010 was not made, which had the effect of terminating our obligation to provide further credit support under the tax support agreement. Further, on February 9, 2011, we sent a notice to Seahawk requesting that they provide cash collateral for the credit support that we previously provided on their behalf, as provided under the terms of the agreement. In connection with its bankruptcy filing, Seahawk is seeking to terminate its reimbursement obligations under the tax support agreement.

If certain of Seahawk’s claims and requests were granted, the adverse effect on us could be material…

Even though the parties may not have had fraudulent intent, transfers and the obligation to transfer, could be deemed a constructive fraudulent transfer as defined in Section of the bankruptcy code:

§ 548. Fraudulent transfers and obligations

(a)(1) The trustee may avoid any transfer (including any transfer to or for the benefit of an insider under an employment contract) of an interest of the debtor in property, or any obligation … incurred by the debtor, that was made or incurred on or within 2 years before the date of the filing of the petition, if the debtor voluntarily or involuntarily—

(A) made such transfer or incurred such obligation with actual intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made or such obligation was incurred, indebted; or

(B) (i) received less than a reasonably equivalent value in exchange for such transfer or obligation; and

(ii)

(I) was insolvent on the date that such transfer was made or such obligation was incurred, or became insolvent as a result of such transfer or obligation;

(II) was engaged in business or a transaction, or was about to engage in business or a transaction, for which any property remaining with the debtor was an unreasonably small capital;

(III) intended to incur, or believed that the debtor would incur, debts that would be beyond the debtor’s ability to pay as such debts matured; or

(IV) made such transfer to or for the benefit of an insider, or incurred such obligation to or for the benefit of an insider, under an employment contract and not in the ordinary course of business.

For a transfer/ obligation to be fraudulent it must satisfy 548(a)(1)(B)(i) and one of 548(a)(1)(B)(ii) (I-IV).

At face value Seahawk received no value in exchange for the obligations under the tax support agreement. Tax Support Agreement Section 3.1 – Events of Default:"

Section 3.1   Events of Default.   If any of the following events (“Events of Default”) shall occur:

… (h)   Seahawk or any of its Designated Subsidiaries shall (i) voluntarily commence any proceeding or file any petition seeking liquidation, reorganization or other relief under any Federal, state or foreign bankruptcy, insolvency, receivership or similar law now or hereafter in effect, (ii) consent to the institution of, or fail to contest in a timely and appropriate manner, any proceeding or petition described in clause (f) of this Section 3.1, (iii) apply for or consent to the appointment of a receiver, trustee, custodian, sequestrator, conservator or similar official for Seahawk or any of its Designated Subsidiaries or for a substantial part of its assets, (iv) file  an answer admitting the material allegations of a petition filed against it in any such proceeding, (v) make a general assignment for the benefit of creditors or (vi) take any action for the purpose of effecting any of the foregoing;…

Section 3.2   Events of Default Requiring Cash Collateralization.   If any of the following events shall occur:
(a)   any Event of Default described in clause (a), (b), (c)(ii), (c)(iii), (g), (h), (i) or (j) of Section 3.1 shall occur; …

and in case of any event described in Section 3.1(g) or (h), Seahawk shall forthwith, without any demand or the taking of any other action by Pride, cash collateralize the Aggregate Credit Support Exposure by paying to Pride immediately available funds in an amount equal to the then Aggregate Credit Support Exposure, which funds shall be deposited into the Cash Collateral Account.

Remember that HAWK is under no obligation with Pride to pay the Hacienda. The obligation to Pride is only around cash collateralizing the credit support account. The Hacienda is not going to call on the credit support at this time because the Mexican subsidiaries are not in default (they were deliberately excluded). So the situation is simply that Pride has provided credit support to HAWK so that HAWK could maintain the statutory credit to support an appeal for their tax assessments. Pride offered the support as part of the spinoff as it was contemplated at the time that HAWK may not be able to provide the credit support as a stand alone entity. Which would tend to prove that 548(a)(1)(B)(ii) (III) applied – intended to incur, or believed that the debtor would incur, debts that would be beyond the debtor’s ability to pay as such debts matured -  i.e. HAWK would not be able to post the cash collateral because if they could post it then they wouldn’t have needed the Pride credit support.

Worst case HAWK has to cash collateralize the credit support account and 50M worth of cash/ HERO shares go into the credit support account until the Mexican tax issues are resolved which could be a very long time in the absence of a settlement. If the requirement to cash collateralize is set aside then Pride’s credit support stands. Pride doesn’t have an actual loss that they can claim against HAWK here because the Hacienda have not made a claim against the credit support. If the credit support was deemed to be a constructive fraudulent transfer then the credit support fees may also be set aside. It was foolish of Pride to not provide support to HAWK until August 2011.

Tax Sharing (losses incurred by Pride due to the loss of tax free status from the spinoff)

Similarly HAWK is responsible for covering any and all Taxes that arise from certain actions. Under the terms of the Tax Sharing Agreement:

“in the event that the Spin-Off and/or certain related transactions were to fail to qualify for tax-free treatment, Seahawk would generally be responsible for 50% of the tax resulting from such failure.  However, if the Spin-Off and/or certain related transactions were to fail to qualify for tax-free treatment because of certain actions or failures to act by Seahawk or by Pride, the party taking or failing to take such actions would be responsible for all of the tax resulting from such failure. “

The Asset Purchase Agreement with HERO is a restricted action. In the Tax Support Agreement SECTION 8:

Restriction on Certain Actions of Pride and Seahawk

8.1   General Restrictions.   Following the Effective Time, Seahawk shall not, and shall cause the members of the Seahawk Group not to, take any action that, or fail to take any action the failure of which, (i) would be inconsistent with the Internal Distribution qualifying, or preclude the Internal Distribution from qualifying, as a tax-free transaction …

8.3   Certain Seahawk Actions Following the Effective Time.   … during the two-year period following the Effective Time, Seahawk shall not take, nor enter into a binding agreement to take, any of the following actions: (i) sell all or substantially all of the assets …  (iii) transfer all or substantially all of the assets that constitute the Seahawk Business as of the Effective Time …

in each case, without first obtaining and delivering to Pride at Seahawk’s own expense a Supplemental Tax Opinion with respect to such action, or a suitable form of financial security issued by a Permitted Financial Institution, in such form and on such terms as Pride may reasonably direct, and of a sufficient amount which Pride may determine in its sole discretion to cover any and all Taxes that may arise as a result of taking such action.

This appears to be a similarly unreasonable obligation and HAWK may try to have it set aside. Pride notes in their 10k:

If certain internal restructuring transactions and the spin-off of our mat-supported jackup rig business are determined to be taxable for U.S. federal income tax purposes, we and our stockholders that are subject to U.S. federal income tax could incur significant U.S. federal income tax liabilities.

Certain internal restructuring transactions were undertaken in preparation for the spin-off of our mat-supported jackup rig business in 2009. These transactions are complex and could cause us to incur significant tax liabilities. We received a ruling from the Internal Revenue Service that these transactions and the spin-off qualified for favorable tax treatment. … If any of these are incorrect or not otherwise satisfied, then we and our stockholders may not be able to rely on the ruling … and could be subject to significant tax liabilities … if the spin-off should become taxable … including as a result of significant changes in stock ownership after the spin-off or the proposed purchase of Seahawk’s assets in its pending bankruptcy proceeding.

Intercompany Claims

There are $387.6M in intercompany claims noted in HAWKs’ filings offset by intercompany Receivables of $194M. The majority are owed to Central American Drilling and Peninsula Drilling, HAWK subsidiaries that are not included in the Chapter 11 filing. There is insufficient detail to determine the nature of the intercompany claims. To the extent that the wholly owned, non bankrupt subsidiaries, do not assert a claim then there is no issue.

Employee Contracts

Normally in a bankruptcy severance is paid out at no more than 1 years salary.

§ 502.  Allowance of claims or interests

(a) A claim or interest, proof of which is filed under section 501 of this title, is deemed allowed, unless a party in interest, including a creditor of a general partner in a partnership that is a debtor in a case under chapter 7 of this title, objects.

(b) Except as provided in subsections (e)(2), (f), (g), (h) and (i) of this section, if such objection to a claim is made, the court, after notice and a hearing, shall determine the amount of such claim in lawful currency of the United States as of the date of the filing of the petition, and shall allow such claim in such amount, except to the extent that—…

(7) if such claim is the claim of an employee for damages resulting from the termination of an employment contract, such claim exceeds--

(A) the compensation provided by such contract, without acceleration, for one year following the earlier of--

(i) the date of the filing of the petition; or

(ii) the date on which the employer directed the employee to terminate, or such employee terminated, performance under such contract; plus

(B) any unpaid compensation due under such contract, without acceleration, on the earlier of such dates;

Based on 2009 Numbers that is 1.64M.

 

  Though the claims for cash are probably limited as above there are also change of control provisions that impact options and restricted stock units. For key employees, options are supposed to be modified to provide at least three additional years outstanding and restricted stock units are to be paid in full after a change of control. Assuming complete dilution from these terms an extra 643k shares would be issued. The HAWK 10K indicates the options strike price is around $25. The 409k restricted stock units will likely be issued. The “Notice of proposed interim DIP Financing budget” notes approximately $15m of “payments for change of control agreements”. The Def14-A issued around March 31, 2010 notes around $15m in total compensation for key employees in the event of a change of control. I think this is the basis for the number in the “budget”. In fact, the options component is worth zero, the restricted stock were valued at $22.54 in the proxy filing and the cash compensation will be reduced through the bankruptcy (which based on the table above would be adjusted to $650k for Stilley down from 2.5M in the proxy). Making similar adjustments for all the key employees sets the cash liabilities at around $1.65M and dilution of around 409k shares.

It’s worth noting that Stilley is not doing particularly well from a Chapter 11 filing and most of the value he is going to receive will be as a result of returns to equity. Alignment is always good!

Trade Creditors, Pride Claims (and Counterclaims)

There are around $25.7M worth of trade creditors. HAWK has stated that they plan to pay them in full except for Pride; $16.7M of this is owed to Pride:

Risk Factors About Our Spin-Off of Seahawk Drilling …

In August 2009, we completed the spin-off of Seahawk, which holds the assets and liabilities that were associated with our mat-supported jackup rig business. In February 2011, Seahawk and several of its affiliates filed for protection under Chapter 11 of the Bankruptcy Code. In the bankruptcy filings, we were listed as Seahawk’s largest unsecured creditor with a contingent, disputed, and unliquidated claim in the amount of approximately $16 million. The debt was listed as a trade payable, subject to setoff. … Prior to the commencement of the bankruptcy, Seahawk indicated an intention to seek, among other things, (i) to reject its outstanding contracts with us, thereby replacing Seahawk’s future performance obligations under the contracts with general unsecured claims in the bankruptcy, (ii) to seek a judicial determination or estimation of all of our claims against Seahawk, including indemnity claims and contract damage claims, and (iii) to set off claims Seahawk alleges it is owed for spin-off transition and other matters against all amounts currently payable from Seahawk to us in respect of transition services and rig management services, and to seek to recover any positive balance after such netting.

…As of December 31, 2010, we had a receivable from Seahawk of $16.0 million, net of allowance, which is included in “Other current assets,” pursuant to a transition services agreement and management agreements for the operation of the Pride Wisconsin and the Pride Tennessee in connection with the spin-off.

I have assumed in the “good case” valuation that claims for an against Pride nets out to zero though in the best case it could provide a larger, positive amount. From an equity perspective it doesn’t much matter if the Pride claims are obligations or general unsecured claims as they both rate ahead of equity. The interesting parts are the judicial determination of totals owing and the recovery of a positive balance!

The unsecured creditors committee has been formed and comprises the Pride, Offshore Towing and Dooley Tackaberry. If there were other major creditors it’s reasonable to assume that they would have revealed themselves.

Other Contingent Claims

There is a long list (90) of outstanding litigation matters against HAWK, many relating to personal injury and a few to asbestos. Some of these have been inherited from Pride and may be set aside. The company does not attempt to identify the amounts owing under these claims. There are claims against BP, East Cameron Partners, Blake international and Pride (as noted above) which are listed under contingent assets. The last HAWK 10Q notes:

We are routinely involved in litigation, claims and disputes incidental to our business, which at times involve claims for significant monetary amounts, some of which would not be covered by insurance. In the opinion of management, none of the existing litigation will have a material adverse effect on our financial position, results of operations or cash flows. However, a substantial settlement payment or judgment in excess of our recorded accruals could have a material adverse effect on our financial position, results of operations or cash flows.

Which is the basis for assuming a net position of zero.

Equity Committee

An Official Committee of Equity Holders has been formed comprising MHR Fund Management, Seadrill Americas, Hayman Capital, HSBC Distressed Opportunities Fund and The Keffi Group. Seahawk made a limited objection noting that they were still responsible to act for the equity and requesting that the Equity committee have a limited scope. The order granted by the judge does not limit the equity committees scope. The main areas of disagreement will likely be around key employee contracts. Aside from that, management and equity holders are quite well aligned.

Value of HERO

I haven’t taken the time to do a valuation of HERO. With an improvement in drilling and this terrific deal a price to tangible book equal to that for the sector seems achievable for a price of $8. Their large debt load provides substantial leverage to an improvement in the shallow drilling situation. It also provides leverage to the downside. As noted in the conclusion an increase in HERO to $8 makes it extremely likely that HAWK equity holders will do better than the pre-petition price and possibly a lot better.

Conclusion

Good case, claims senior to equity consume around $35m and 10m of that is met from HERO shares. The rest of the HERO shares are distributed to HAWK holders to the value of around $8 at today’s price for HERO. A bad outcome would require payment to Pride of their trade debt along with cash collateralizing the letters of credit. This leaves around $2.50 for equity holders plus an interest in the eventual outcome of the Mexican tax dispute. An increase in the price of HERO to around $8 substantially improves both cases to around $13.50 for the good case and $8.10 for the poor case. Handicapping the outcomes is difficult. Based on binary outcomes of $2.50 or $8.00 the market is handicapping around a 45% chance of the better outcome. I’d estimate a higher chance than that though I wouldn’t be a buyer or a seller at $5.