When Good Spinoffs Go Bad- A Lump Of Patriot Coal In Every Stocking

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Spinoffs are supposed to be a clean break; an opportunity for two new companies to seek their own fortunes.  But, as David Nicklaus points out at the St. Louis Post Dispatch, when things go sour with the child, the former parent may still be on the hook. He writes about Patriot Coal (PCXCQ) which was spun off from Peabody Energy(BTU) several years ago, and recently declared bankruptcy.

Patriot’s former parent company, Peabody Energy, will be more than an interested spectator during the case. Peabody has already disclosed that it may be responsible for payments to a fund for black lung disease victims “should Patriot not fund these obligations as they come due.”Lawyers may look for other ways to tap Peabody’s deep pockets. When a spun-off company fails, creditors often accuse the former parent of fraud, charging that it didn’t fully disclose the liabilities it was off-loading on its offspring.

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“There is always a risk that the parent is going to face a suit down the road if some of their predictions didn’t come true,” says Daniel Doyle, a bankruptcy attorney with Lathrop & Gage in Clayton.

If such a claim, called a fraudulent transfer, becomes an issue in the Patriot case, Chief Executive Irl Engelhardt may find himself in a difficult position. He was chairman of Peabody when the decision to spin off Patriot was made.

“The debtor in possession is supposed to act as a trustee for the benefit of creditors, and he would ultimately be the guy who would decide whether to go after Peabody,” Doyle said. “If he does not and there are creditors who think he should, it would make for an interesting dynamic.”

Lawyers for Patriot’s creditors probably will comb through statements like one Rick Navarre, Peabody’s chief financial officer at the time, made in a November 2007 conference call.

Navarre explained how bills for retiree health care, workers’ compensation and a multi-employer pension fund would now go to Patriot. “In total, our legacy liabilities, expenses and cash flows will be nearly cut in half,” he said.

Not all spinoffs are done for the purpose of eliminating liabilities. Sometimes a company has a hidden gem of a subsidiary that it thinks will thrive on its own.

For a short time, Patriot looked like such a gem. Its stock price quadrupled in the first five months of trading.

That may let Peabody argue that it was being opportunistic, setting up a company that had a chance to be wildly successful. If you look back at what Peabody said at the time, though, it seemed more excited about the liabilities it was dumping than the opportunity it was creating.

The demise of Patriot Coal has already cost its shareholders a great deal of money, but they were aware of the company’s precarious position. For shareholders of Peabody Energy, there may be a large liability that they had no expectation of. An important lesson to keep in mind when evaluating and investing in spinoffs.

Disclosure: The author has no position in any stock mentioned.

 

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