The Role of the Institutional Environment in Corporate Failure and ...

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The Role of the Institutional Environment in Corporate Failure and ...

The Role of the Institutional Environment in Corporate Failure

and Restructuring

Bryan P Lewin

This project was submitted for the MSc in Management (Sloan Fellowship 2005) at London

Business School.

Contact:

blewin.sln2005@london.edu

UK +44 (0)7968-163767

TMA Website Version: September 2006


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Executive Summary

This project argues that any analysis of corporate failure and subsequent restructuring needs to

look beyond issues such as poor management and bad strategy, to the institutional environment in

which a company is located in order to fully understand the drivers of failure and the context for

the restructuring. This environment influences the contracts that are struck between creditors,

shareholders and management, and determines the balance of rights between them. When

shareholder and creditor rights are poorly protected, these contracts can create incentives that

result in distortions to management and stakeholder behavior, and eventually to financial distress

and corporate failure.

The world of separated ownership and control as described by Berle and Means (1932), in which

owners are widely dispersed, and reliant on the firms managers to protect their interest forms the

basis of much of current agency and corporate governance theory, but the reality is that this

description does not describe the situation in which the majority of the worlds companies operate,

where controlling block shareholders are quite common, and lenders rights may be restricted. It is

also of declining influence in the UK and USA, where large investment institutions own an

increasing share of the equity market capitalization.

A lesson from institutional economics is that the direction in which these corporate governance

trends emerge is dependant on the institutional framework on which they are based. In other

words, the nature of the creditor and shareholder rights in each country are the result of the

differing social and historical influences on the development of institutional structures such as

common or civil law legal systems, rule of law and judicial efficiency. Consequently, this project

aims to demonstrate that any analysis of the reasons for corporate failure and of the methods of

negotiating a restructuring has to be placed into this context.

Part 1 of this project consists of two papers that use a case study – Stolt Offshore SA – to

illustrate how both weak internal governance and an external lack of creditor and shareholder

rights can lead poor management into corporate failure. The first paper in the project, ‘M&A

Failure and Financial Distress’ shows how the M&A strategy pursued by the ownermanagement

of Stolt Offshore in the late 1990’s was focused more on building revenue than

profitability, and without sufficient attention to business risks, due diligence and post merger

integration. The culture of the company led to a failure to implement both adequate decisionmaking

processes and reporting systems that would have allowed problems to be identified as

they developed. This culture ran to the very top of the organization, where a dominant Chairman

who controlled the majority of the company’s voting rights had put in place a Board of Directors

that bore little resemblance to ideal governance structures such as those proposed in the Higgs

Report. This board presented little oversight or challenge to a corporate strategy that had only the

most superficial justification.

The ‘hubris’ theory of corporate takeovers, in which management over-estimate their ability to

run the expanded company, and the quality of the decisions they make, provides a good initial

explanation for the failure of the strategy pursued by the firm’s management. Solutions to this

problem include strengthening the independence of the board, although institutional investors still

risk board capture by an entrenched CEO who has strong relations with the capital markets.

Encouraging fuller disclosure of institutional voting patterns represents one way to solve this. In


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a perfect world, when management starts behaving in a manner antithetical to the interests of

shareholders and lenders, they should be able to step in and remove the management before it

causes too much damage. Yet too often, they have neither the knowledge of what the

management is up to until it’s too late, or they don’t have the rights to remove the management or

change the strategy when they need to.

Given that senior management may be fully aware of their own rights and those of the

shareholders and lenders when setting strategy, it is arguable that the strategies that they set, and

risks that they take, assume either some level of personal protection from adverse consequences,

or that their own private benefits from their actions somehow exceed what they might gain from

maximizing returns to shareholders. Consequently, the drivers of corporate failure that appear in

Turnarounds-textbook checklists sometimes have to be seen as symptoms of the deeper problems

within the company that led to its failure, and not necessarily as the core problems themselves.

This issue is explored in the second paper ‘The Influence of Pyramid and Split Capital Structures

on Corporate Failure & Financial Distress’ which looks at the contribution of the external

governance environment to corporate failure. It shows how the balance of shareholder and

creditor rights in the country of incorporation can affect the way decisions about corporate

strategy, structure and finance are made, and how this can lead to the situation described in the

first paper. Companies such as Stolt Offshore that are located in civil law countries may have

debt and equity structures that are quite different from companies located in common law

countries and that rely more heavily on publicly-traded equity and debt markets. Companies in

civil law countries typically have a larger proportion of block holders (and often significant

family involvement) than do companies in common law countries, and other claim holders are

forced to structure their contracts differently in order to compensate for deficiencies in their

rights.

The manner in which these claims are structured depends whether the local jurisdiction better

protects creditor, or shareholder rights, or neither. An example of creditor rights problem is

highlighted by the size of banking syndicates in countries with poor protection of creditor rights.

Banks operating in regimes with poor creditor protection might seek larger syndicates to prevent

strategic default than syndicates in common law countries, even though the managers of

companies operating under such regimes may attempt to exploit the consequent free-riding on

monitoring costs taking place between the banks in order to extract higher private benefits.

Examples of the problems of poor rights for minority shareholder rights include the possible

expropriation of value by management, and consequently lower valuations for companies than

those with dispersed shareholders. Governance regimes with low shareholder protection

consequently tend to have fewer, larger, shareholders who may be able to implement some

monitoring, or in cases when they are also the management, participate in such expropriation

themselves. This situation is particularly prevalent in family-owned or dominated companies –

particularly those that have lasted more than a generation, in civil law environments.

In these companies, a major private benefit of control is being able to hand over control of a

company to the next generation, even if outside management could do a better job of running the

company. This can give rise to a situation where owners engage in lower risk business strategies

so that they don't risk losing the private benefits of control, or the company. This low-risk


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strategy means that the management may prefer to forgo riskier decisions that would give more

value to the company and to the minority shareholders, but raise the chance of bankruptcy.

Evidence suggests that these factors tend to lead to cheaper debt for family-dominated

companies. Debt is cheaper because this low-risk strategy aligns the incentives of the

management with the needs of the banks, not with the needs of the minority shareholders, as it

raises the chance that the banks will get repaid, but reduces the monitoring incentives for banks.

Consequently, when a controlling family has effectively disenfranchised the minority

shareholders, and the debt structure has been set-up to minimize bank monitoring, then the

opportunities for extracting private benefits are maximized. If the head of such a company is

actually a risk taker operating without control structures such as an independent board, or

monitoring by external shareholders or by banks, then strategies that lead to failure may well

result. This is what happened at Stolt Offshore.

The second part of the project deals with corporate reconstruction in the light of the problems

described in the first part. The third paper, ‘Strategic Uncertainty and Coordination Problems’

shows that the resolution of the financial distress problems discussed in the second paper is

affected by uncertainty over the incentives and motivation of each of the different stakeholders.

This uncertainty results from the same differences in shareholder and creditor rights described in

the previous paper, and induces a form of prisoner dilemma type games among stakeholders, and

between stakeholders and the company that makes resolution more difficult, and adds to the cost

of financial distress.

The financial restructuring described in the third paper was completed through the resolution of

both the debt overhang and holdout problem. Ironically, it was the very absence of minority

shareholder rights in Stolt Offshore’s registered home that allowed a group of investors to take a

stake in the company, and having made an agreement with the banks, eliminate the pyramid share

holding structure and pay off just enough of the debt and contribute sufficient working capital to

break both the debt overhang problem and potential hold-out problems that might have affected a

public offering.

Two recent developments in the field of European distressed companies have affected both those

involved in restructuring distressed companies, and those that finance or invest in them. These

are the emergence of a mature market in the debt securities of distressed companies, and changes

in the bankruptcy and insolvency codes across the continent. Both sets of developments are

directly or indirectly leading to a weakening of the concept of absolute priority rules, and raising

both challenges and opportunities for investors and for turnaround managers. For turnaround

managers, jurisdiction-shopping – moving the company’s centre of main interest to one most

likely to preserve inside interests - presents a particular problem. Europe-wide regulations such

as the European Insolvency Regulations have attempted to control for this, but it remains a major

issue due to political and historical influences.

For investors, the case demonstrates the financial returns to successfully unraveling these

structures. Debt and/or equity investors that can gain sufficient control during financial distress to

break these structures can capture additional value for their funds perhaps not available from

simply restructuring the debt. Additionally, losses can occur if the scope of the rights accorded to


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each party is not fully taken into account when making an investment, or the failure regime is not

properly identified.

Research into the way the coordination is best handled highlights the need to avoid a preemptive

grab on assets by the most senior creditors. New formal and informal procedures being developed

around the world all have this as their key component. Creditor pools, or creditor committees

which can reach binding agreements between themselves, often feature in these procedures. A

key lesson from these situations is that a critical skill of a Chief Restructuring Officer is to

understand the motivations of each participant, their strategic position, and the restrictions under

which they operate. The role of the CRO in these cases is to break through the strategic

uncertainty to solve these problems by coordinating the actions of each party. However, conflicts

of interest can arise, suggesting the need for a type of licensed professional that combines the

skill set of a CRO with the independence of a UK administrator or a French mandataire ad-hoc.

Changes to lending practices are also part of the solution, and there is an increase in asset-backed

lending as a way of trying to side-step the multi-stakeholder problem.

The Appendix to this project looks at the organizational restructuring of the company used as the

main source of examples throughout this project, in the context of a recent survey of preferred

turnaround techniques conducted among turnaround professionals working in the UK by a

London Business School ‘Sloan Fellowship’ student. The key to the successful reorganization

was a realignment of the company’s business strategy and accompanying organizational changes

that addressed shortcomings in the firm’s business processes. Working capital controls, cost

cutting and asset sales were all part of the restructuring process.

This project used an institutional economics framework to examine the impact ofthe rules of the

game” (North, 1990) on how companies make choices of both corporate structure and corporate

strategy that get them into trouble, and how the changes in the “rules of the game” described in

the preceding paragraphs are leading to changes in the way that they are resolved. The

justification for this framework is that it provides a much richer frame of reference than agency

theory alone to explain the motivations of management and the corporate governance issues.

However, while useful as a framework, some of the underlying approaches, such as transaction

costs analysis and incomplete contracting do not individually provide complete guidelines to

understand what happened, so this project used a case-study approach to analyze the problems

and their resolution within the overall framework.

For the purposes of comparison, and to provide a ‘control’ against which the company’s

performance can be measured, this paper uses data sourced from Compustat to compare Stolt

Offshore to a group of other companies with the same 3 digit Standard Industrial Classification

(SIC) code – 138, and with the entire set of companies within the 4-digit 1389 SIC code group,

and with syndicated bank debt information sourced from DealScan. While more robust results

might have been obtained with a larger dataset, it is also seems possible that the choice of capital

structure in commodity processing business such as oil or sugar would be influenced by the

volatility of the refining spread. The narrow choice of companies aims to control for this effect,

as well as facilitate a direct comparison between companies discussed in this project in the oil

and gas sector.


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Table of Contents

Executive Summary ........................................................................................................................ii

Table of Contents ........................................................................................................................vi

Index of Figures ..........................................................................................................................vi

Index of Tables.......................................................................................................................... vii

Acknowledgements .................................................................................................................. viii

Update for the TMA Website Version ........................................................................................ix

1. M & A Failure & Financial Distress ....................................................................................... 1

2. The Influence of Pyramid and Split Capital Structures on Corporate Failure & Financial

Distress................................................................................................................................. 19

3. Strategic Uncertainty and the Coordination Problem ........................................................... 35

Appendix: The Restructuring Of Stolt Offshore..................................................................... 74

References ..................................................................................................................................... 81

Index of Figures

Figure 1: Worldwide Rig Count and Cash flow from Operations in the Oil Service Sector...........5

Figure 2: Revenues for Stolt Offshore and the 138 SIC Group .......................................................6

Figure 3 Stolt Offshore – Annual Gross and Net Revenues, 1996 – 2004 ......................................8

Figure 4: Ebitda as a Percentage of Interest Costs.........................................................................11

Figure 5: Cash Flow from Operations As A Percentage of Total Liabilities.................................11

Figure 6: Altman Z Scores and Share Price for Stolt Offshore – 1998-2004 ................................12

Figure 7: The Stolt-Nielson Family Pyramid in 1999....................................................................22

Figure 8: Evolution of Control and Cash Flow Rights Over Time ................................................23

Figure 9: Comparison of the Tobin-q for Stolt Offshore and the 1389 SIC Group .......................28

Figure 10: Ratio of Long Term Debt to Shareholders Equity........................................................30

Figure 11: Ratio of Short Term Debt to Long Term Debt 138 Group and Stolt Offshore ............32

Figure 12: Asset Specificity for Stolt Offshore and a Sample of 138 SIC Code Companies ........33

Figure 13: Renegotiation Costs and Syndicate Size.......................................................................41

Figure 14: The Emergence of The European Leverage Loan Market............................................45

Figure 15: Enterprise Value and the Face Value of Debt ..............................................................48

Figure 16: Enterprise Value Implied from Black & Scholes & Face Value of Long-Term Debt .49

Figure 17: Distressed Debt: Market to Face Value Ratios.............................................................50

Figure 18: Stolt Offshore Stakeholder Map ...................................................................................51

Figure 19: New Capital Structure at the End of the Restructuring ...............................................62

Figure 20: Capital Expenditure as Percentage of Revenue............................................................63

Figure 21: Capital Expenditure Ratios for 138 SIC Code Group ..................................................64

Figure 22: Capital Expenditure Targets and Debt Service Ratios .................................................65

Figure 23: Stolt Offshore Share Price Relative to the S&P 500 ....................................................67

Figure 24: Prices of Stolt Offshore Debt in the Secondary Market ...............................................70

Figure 25: Evolution of Accounts Receivables Days.....................................................................79

Figure 26: Market Capitalization of Stolt Offshore .......................................................................80


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Index of Tables

Table 1: Sensitivity of Cash Flow to the Worldwide Rig Count .....................................................4

Table 2: Operating Costs for the 1389 Group and Stolt Offshore as a Percentage of Revenue ......7

Table 3: Sustainable Growth Rate and Growth of Sales for Stolt Offshore ....................................8

Table 4: Comparison of Tobin-q for Stolt Offshore and Petroleum Geo-Services (PGS).............29

Table 5: Capital Structure of Stolt Offshore ..................................................................................29

Table 6: Number of Banks in Oil and Gas Syndicates by Legal Code ..........................................31

Table 7: Creditor Rights Scores and Average Bank Recovery Rates ............................................37

Table 8 Characteristics for a successful out-of-court financial restructuring as determined by the

World Bank. ...................................................................................................................................37

Table 9: Fixed Assets of Stolt Offshore.........................................................................................43

Table 10: Liabilities of Stolt Offshore ..........................................................................................53

Table 11: Valuation of Stolt Offshore at The End of 2003 Assuming Resolution of the Debt

Overhang Problem..........................................................................................................................55

Table 12: Sample Cash-Flow Forecast and Valuation As of December 2003...............................56

Table 13: Industry-Wide Capex and Debt Service Multiples ........................................................64

Table 14: Regression Calculation of Stolt Offshore Beta..............................................................67

Table 15: Equity and Asset Betas of Comparable Companies.......................................................68

Table 16: Calculation of Tax Rate Used for Forecasts ..................................................................69

Table 17: Preferred Turnaround Techniques in the UK.................................................................75

Abbreviations

CoMI Center of Main Interest

CRO Chief Restructuring Officer

EBITDA Earnings Before Interest, Tax, Depreciation Amortization

EIR European Insolvency Regulation

EPIC Engineering, Procurement, Installation, Commissioning

IP

Insolvency Practitioner

LIBOR London Inter-bank Offered Rate

NASDAQ National Association of Securities Dealers

SEC Securities and Exchange Commission, USA

SIC Standard Industry Classification codes.

TMA Turnaround Managers Association


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Acknowledgements

First and foremost, my thanks are due to my supervisor, Paolo Volpin, Assistant Professor of

Finance at London Business School, whose guidance has been critical to my completing this

project. I also had the benefit of taking his Merger, MBO’s and other Corporate Reorganization

course at LBS in the Summer 2005 term. That course, and Stuart Slatter’s ‘Managing Corporate

Turnarounds’ were essential parts of my London Business School education. Thanks are also due

to Denis Gromb, Associate Professor of Finance at London Business School, who introduced me

to many of the concepts in this paper, and much of the literature it refers to, through an invitation

to his series of seminars in the Spring 2005 term.

I have also had the benefit of discussions with a number of turnaround professionals, and with

participants in the private equity, consulting, banking and government policy sectors. I am very

grateful for their time and insights into the financial restructuring and the corporate turnaround

process. Useful additional data was received from the Investor Relations department of Stolt

Offshore, and from firms including HSBC, CSFB, Bank of America and Merrill Lynch.


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Update for the TMA Website Version

Although the paper was submitted for the General prize, much of the material for the paper was

drawn from the examples of a single company, referred to throughout the paper as Stolt Offshore.

Since the paper was written, Stolt Offshore has changed its name to Acergy SA, and the ticker

symbols for the ADR’s listed on NASDAQ has become ACGY.

Reference to the stock data demonstrates the enormous success of the turnaround. The journey

from an intra-day low share price on NASDAQ of $1.05, to the recent high of $19.10 per share

represents the success of the Chief Restructuring Officer in handling the difficulties in

stakeholder negotiation arising from the highly complex debt and equity ownership structures,

and working with new management to bring about a changed business model capable of

delivering results.

The company continues to address corporate governance concerns, but within its current

regulatory environment, which is dominated by the Sarbanes-Oxley legislation applicable to

companies listed on NASDAQ. Some of the outstanding problems referred to in the body of the

project text such as the quarterly reporting standards have been addressed. However, given that

the company’s near-failure was partly facilitated by the inability of minority shareholders to

control the previous management, it is arguable that the company continues to give insufficient

attention to this issue.

As an example, Institutional Investor Services recently advised shareholders to vote against a

management proposal designed to give management full discretion in issuing, and then setting

the conversion terms of convertible bonds, raising questions over preemptive rights and antidilution

rights of existing shareholders. Investors voted in line with all ISS’s recommendation to

reject this proposal, but the company held a further meeting which did not need to be quorate, and

got the proposal passed.

Meanwhile, the company promotes its target of full SOX compliance by November 2006 on its

website, perhaps more generally demonstrating the weakness of rule-based governance over

principles-based.


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1. M & A Failure & Financial Distress

“Many management apparently were overexposed in impressionable childhood years to the story

in which the imprisoned handsome prince is released from a toad’s body by a kiss from a

beautiful princess. Consequently, they are certain their managerial kiss will do wonders for the

profitability of Company T(arget)………We’ve observed many kisses but very few miracles.

Nevertheless, many managerial princesses remain serenely confident about the future potency of

their kisses – even after their corporate backyards are knee-deep in unresponsive toads”

Warren Buffet, 1992

Introduction

The success rate of mergers and acquisitions across all industries is appalling low. A recent study

by Deloitte & Touche estimates that about 60% of mergers and acquisitions destroy value. Their

study shows that on average, very hostile takeovers work best, followed by very friendly ones,

and that anything in between have a much lower chance of success.

Discussions with M&A practitioners for this project highlighted the importance of the

capabilities of the CEO in determining the outcome. A risk taking CEO may be too addicted to

the thrill of doing deals to be able to handle the more mundane business of the integration of the

acquisition. Arguably, deal making and integration are very different skills, but when the CEO is

also an autocrat unwilling to cede control to those better qualified to manage the merger, then the

outcome may be financial distress and corporate failure.

Within the environment of European, family dominated companies 1 , the case of Stolt-Offshore

shows how an expansion strategy based on buying companies can be undermined by poor duediligence

work ahead of the purchase and by poor post-merger integration practices afterwards.

Stolt Offshore is an oil services company that now focuses particularly on deep-sea services. It

was almost brought down by a badly designed and executed mergers and acquisition strategy

designed to buy revenue and propel the company to the top of the league table of company size in

the oil and gas services sector. The problem was compounded by a board of directors that was

full of CEO appointees and by a failure to separate the interests of the controlling family from the

interests from the company.

Warning models of impending financial distress, such as those of Altman (1968) can alert

creditors to impending problems, as they did with Stolt Offshore, but in this case, weak

monitoring by the creditors might explain their failure to act on these signals.

This paper is laid out as follows. Section 1 provides an overview of the company and execution

of the M&A strategy. Section 2 outlines the developing problems. Section 3 looks at warning

1 Note 2 provides an account of the equity structure of Stolt Offshore, and the rights and entitlements of the different

share classes.


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models of financial distress and shows how they signaled the impending failure to anyone who

was looking. The paper concludes (section 4) with a discussion of how these problems arose, and

some possible governance and policy solutions to minimizing their recurrence in companies of

this type.

1. Stolt Offshore and its M&A Strategy

Stolt Offshore was formed from the merger of two companies, Stolt-Nielson Seaway A/S, which

was a shipping company that ran diving support ships, and Comex Services, which specialized in

deepwater diving and sub-sea construction. While the origins of the company go back to 1973, it

only became a public company in May 1993, and it is now jointly listed on NASDAQ and the

Norwegian Stock Exchange. When first listed it had a split capital structure in which the majority

of the control rights but only a minority of the equity remained with the Stolt-Nielson family,

their trusts and the companies that they controlled. The registered office of the company is in

Luxembourg, under whose laws it is governed, but its operations are run from the UK.

Arguably, some of the causes of the later problems can be found in the way this original merger

was carried out, as the merged company suffered from a lack of sound business decision-making

processes. The business case for the merger does seems to have been sound - the two companies

provided a complementary match, and the merged company claimed to be a world-leading

supplier of these services. In the 1999 Report and Accounts, Bernard Vossier, then the Chief

Executive Officer wrote a statement of the merged company’s core competency:

The core skill of the Company is the ability to undertake the installation and tie-in of all types of

sub-sea pipelines, flow-lines and structures in all water depths and in any part of the world

regardless of the environmental conditions.”

By the time that statement was written, the management was already acting as though it had lost

sight of its core competencies and had just completed the acquisitions that would bring it so much

trouble. According to sources close to the company, the company was buying turnover, looking

for an opportunity to propel the company into the ranks of the world’s major oil and gas services

industry players. In 1997, a decision was taken by the management of Stolt Offshore to become a

full Engineering Procurement, Installation and Commissioning (EPIC) company, and this led to a

series of purchases. With this M&A strategy, the company set out to become a global player

instead of a North Sea regional specialist. Where it has previously been a focused deepwater

service company, it now set out to design, build and maintain oil installations.

One justification for the strategy was of risk reduction. The oil services business is highly

seasonal, and a focus on the North Sea region made Stolt Offshore vulnerable to adverse

conditions that could occur there even in its peak earnings seasons. For this reason, the company

adopted a policy of trying to reduce the dependency on the North Sea to around 25% of its total

by buying companies.

Over a period of time, the company bought Paragon in Houston, Ceanic, and ETPM (described to

me as a “lifestyle” company by an industry professional) in France, which doubled the size of the

company. Note 1 outlines the timetable of acquisitions with announcement dates where available.

Unfortunately, it soon became clear that the company had heavily overpaid for these acquisitions,


3

and had then added these inflated values to the balance sheet. Part of the financial restructuring

strategy that followed involved writing off these acquisition premiums.

While the core competency of Stolt Offshore was as described above by the CEO, the company’s

Norwegian parent company, Stolt Nielson SA, had a very different profile. It was both a shipping

company and an aquaculture business, and was still run very much as the family firm it had once

been. Its acquisition strategy had led to a conglomerate structure, paid for primarily with retained

earnings and debt, of companies and businesses that were both outside of the core competency of

Stolt Comex Seaway, and outside the parent company’s ability to manage what it had created.

The culture that the Stolt-Nielson family brought to Stolt Comex Seaway was very similar to the

one suitable for a family shipping company, and with the same frames of reference. However, the

culture may not have been appropriate in an oil-services company. Corporate performance

measures such as shipping utilization rates became dominant in an inappropriate setting. The

governance structure of the company was not suited to a publicly listed company: for example,

all the directors were appointed through their connections to SNSA and none were truly

independent.

In the pursuit of its expansion strategy, the company lost sight of its core business - at the same

time as Jacob Stolt-Nielson told shareholders that the core business was still the best performing

part of the business overall, he also told shareholders:

“We have failed so far, however, to integrate all of our different companies and cultures into a

single efficient organization which is capable of managing these major EPIC contracts..…. We

have not always had the right people in some crucial positions….. We have made too many

mistakes in calculating costs and evaluating risks…resulting in large cost overruns” 2 .

These cost overruns, and in particular, the failure to properly control risk and contracting, are

typical of the type of problem that research has identified as being likely to cause companies to

fail. Slatter and Lovett (1999) highlight 13 causes of corporate decline that may be present in

some combination in a situation of corporate failure, and this is a good example of several of

them. The failure of Stolt Offshore to either complete full due diligence on its proposed takeover

targets, and to properly handle post-merger integration were a major cause of the firms near

failure.

From a strategic perspective, some of the actions of Stolt Offshore’s management suggest a

failure to understand that the purchase of these companies was not just a purchase of resources,

but that these resources came with their own processes and corporate cultures which had to be

fully integrated into that of Stolt Offshore. The initial failure to understand the cultural shift from

Stolt-Nielson Transportation to Stolt Offshore is reflected in the failure of the subsequent postmerger

integration of processes embedded in the acquisition targets. The primary example of this

is that the management of Stolt Offshore appears not to have properly understood just how lax

were the financial controls at ETPM. From the perspective of the acquisition targets, it was also

unclear what parenting advantages Stolt Offshore brought to the companies it bought. This

acquisition strategy led Stolt Offshore into what Campbell (1995) describes as a “Value Trap”,

2 Chairman’s Statement, Report and Accounts, 2002


4

where it offers little advantages to the new acquisitions, but acts as a value-destroying distraction

to its own management.

2. Competition in The Oil and Gas Sector

A primary driver of profitability in the oil and gas services industry is the worldwide rig count,

which is partly dependant on the oil price. Table 1 below shows the elasticity of the cash flow

from operations for this industry group to the worldwide oilrig count. Changes in the rig count

are seen to be a significant factor.

Table 1: Sensitivity of Cash Flow to the Worldwide Rig Count

Dependent Variable: LOG(CASH_FLOW)

Method: Least Squares

Sample: 1995 2004

Included observations: 10

Variable Coefficient Std. Error t-Statistic Prob.

C -1.80 5.45 -0.332201 0.7495

LOG(RIG_COUNT) 1.83 0.71 2.595031 0.0357

@TREND(1995) 0.11 0.045 2.504674 0.0407

R-squared 0.816 Mean dependent var 13.13

Adjusted R-squared 0.764 S.D. dependent var 0.69

S.E. of regression 0.33 Akaike info criterion 0.88

Sum squared resid 0.776 Schwarz criterion 0.97

Log likelihood -1.41 F-statistic 15.59

Durbin-Watson stat 2.53 Prob(F-statistic) 0.003

Source: authors calculations

Figure 1 below shows the relationship graphically between cash flow from operations in the 1389

group sample, and the rig count. The sensitivity of one to the other highlights the potential for

asset illiquidity problems for the oil sector as outlined by Shleifer and Vishny (1992), in which

the value and resale potential of assets held as collateral during financial distress are positively

correlated with the probability of that distress occurring. The consequence is that if a company

gets into trouble during an industry downturn, there maybe only a limited market for its assets

when it most needs to sell them.

Cost and delivery problems were occurring in Stolt Offshore’s contracts in both Europe and in

Africa – particularly in Nigeria. These problems were primarily within the legacy contracts

included in the purchase of ETPM. However, Stolt Offshore’s problems here also reflect

structural changes in the way the major oil companies were contracting for services from the

support firms.


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Figure 1: Worldwide Rig Count and Cash flow from Operations in the Oil Service Sector

1,400,000

3500

1,200,000

3300

3100

1,000,000

Cash Flow from Operations (US$000's)

800,000

600,000

400,000

2900

2700

2500

2300

World Wide Rig Count

2100

200,000

1900

0

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

1700

1389 SIC Code Group: Cash Flow From Operations World Wide Rig Count

Sources: Baker Hughes Inc., authors calculations from company reports and accounts.

In a press release accompanying the third Quarter, 2002 results, Niels Stolt-Nielson told

shareholders:

Despite expected growth in the accessible market for our business from $10 billion this year to

$15 billion in 2004, our entire industry is currently suffering with low profit levels due to

customers loading more and more risks on their EPIC contractors without the necessary

improved rewards. This situation must change for the offshore construction sector to become a

healthy and viable industry.

This complaint about customer behavior perhaps fails to capture the full effect of the changes in

the relative power of supplier and customer in the oil services business at this time, and the

reason for margins being squeezed. The company was competing for a share of a declining

volume of available business. The decline in the number of European and African rigs (Stolt

Offshore’s main markets) in 2002 was greater than the decline worldwide. Stolt Offshore

competed aggressively for a larger share of that smaller amount of business.

The consequence of this was that while the 1389 SIC code companies had declining revenues,

Stolt Offshore grabbed market share as illustrated in Figure 2 above 3 , which shows falling

revenue for most of the 1389 group, but revenue gains for Stolt Offshore, which was apparently

the most successful bidder for new contracts among all its competitors in that period.

3 A further anecdotal illustration of this situation came at the end of 2002, when the Italian company, Saipem, beat

Stolt Offshore for a contract in Libya, only then to be told to reduce the price even further by the Libyan government.


6

Figure 2: Revenues for Stolt Offshore and the 138 SIC Group

1389 SIC: Total Sales

Revenue

8,000,000

7,000,000

6,000,000

5,000,000

4,000,000

3,000,000

2,000,000

1998 1999 2000 2001 2002 2003 2004

1,600

1,500

1,400

1,300

1,200

1,100

1,000

900

800

700

600

Stolt OffShore Revenue

1389 SIC: Total Sales Revenue Stolt Offshore Revenue

Source: Authors’ calculations from data extracted from Annual Reports

However, Stolt Offshore had used fixed price contracts that failed to take into account the

vulnerability of the profit margins from cost over-runs, including those caused by weather and

other natural phenomena. In fact, in company years 2003, 2002 and 2001, approximately 87%,

88% and 72%, respectively, of total revenue respectively was derived from fixed-price contracts,

according to SEC filings. A leading consultant in the field told an oil and gas supply conference

in New Orleans at that time:

"Risk and reward for the contractor community has got out of balance…..Lump-sum contracts

are fine for commodity products; I don't think they are appropriate for the leading edge of such a

demanding industry. In the final analysis, the deep-water oil and gas industry is dependent upon

the existence of profitable contractors. 4 "

There are significant doubts about the viability of the strategy of becoming an EPIC contractor,

and interviews with oil professionals suggest most firms have avoided this strategy, while those

that have tried it have failed, with the possible exception of Saipem - an Italian firm. The

primary problem is one of risk management. Given the behavior of the oil companies as

described by the consultant quoted above, companies have found that they need to offload as

much risk as possible, and that the best way to do this is to focus on core competency and leave

others to carry the risk. Contractors in this sector often have high working capital requirements

which they borrow against contracts, but financial distress can result if the risks are greater than

they plan for.

4 Source: The Times-Picayune, 10/14/2002, reporting comments by John Westwood at the Deep Offshore

Technology Conference held in New Orleans, La.


7

The consequence of these factors, and the lack of internal controls at Stolt Offshore, was that

costs were taking an increasing share of the revenues, as shown in Table 2 below, which

compares the cost structure of Stolt Offshore with the other companies within the 1389 SIC code

group 5 .

Table 2: Operating Costs for the 1389 Group and Stolt Offshore as a Percentage of

Revenue

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

1389 86.4% 83.7% 82.0% 80.8% 87.3% 81.2% 73.2% 80.6% 80.4% 77.3%

Stolt Offsho 85.7% 94.7% 83.3% 84.8% 88.0% 92.4% 90.3% 95.4% 106.3% 95.1%

Source: authors calculations from Compustat data

Financial Issues

An analysis of revenue and earnings figures exposes how the company was building revenue, but

without building profitability. Figure 3 below shows Gross Revenue and Net income – revenues

were building while net earnings were failing to follow the trend.

This partly looks like overtrading, or attempting to grow the business faster than the company’s

sustainable growth rate (SGR). The sustainable growth rate is defined as:

SGR = (1-dividend payout ratio) * Return on beginning-of-period equity. (1)

If a company attempts to grow sales faster than its SGR, it will either have to raise more capital

(either equity or debt), or it is going to hit a financing problem or possible bankruptcy. As Stolt

Offshore has never paid a dividend, its sustainable growth rate is equal to its return on equity.

Table 3 below shows annual growth in revenues compared to the component parts of the return

on equity which can be broken down as follows:

NetIncome Sales Assets

ReturnOnEquity = * *

(2)

Sales Assets ShareholdersEquity

5 Cost of goods sold, plus SGAE, but before exceptional items.


8

Figure 3 Stolt Offshore – Annual Gross and Net Revenues, 1996 – 2004

1,500

1,300

1,100

900

$1,000's of US Dollars

700

500

300

100

-100

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

-300

-500

revenue Net income

Source: Authors Calculations from data extracted from Annual Reports

Table 3 below shows the data for Stolt Offshore from 1996 to 2004 6 . It demonstrates how the

sales growth rate regularly exceeded the sustainable growth rate.

Table 3: Sustainable Growth Rate and Growth of Sales for Stolt Offshore

Year 1997 1998 1999 2000 2001 2002 2003 2004

Net Income/Sales 0.091 0.088 0.025 -0.035 -0.011 -0.106 -0.282 0.004

Sales/Assets 0.943 0.741 0.76 0.701 0.805 0.986 1.192 1.12

Assets/shareholders

equity 5.95 2.52 2.11 3.43 2.33 2.21 2.41 10.33

ROE 50.72% 16.47% 4.04% -8.42% -2.12% -23.1% -80.8% 4.75%

Change in Revenue 37.6% 50.73% -1.40% 53.49% 27.71% 14.46% 3.12% -16.2%

Source: Authors calculations from data extracted from Annual Reports

Debt levels were soaring as a result of both the acquisitions and the overtrading, but there seem to

have been no monitoring by the banks (there were no bonds) that were lending this money. The

banks were relying on the collateral they held, and the long-term relationship with the Stolt

Nielson family, whose shipping companies dated back to the late nineteenth century.

6 The calculations shown here use the previous years shareholder equity when calculating sustainable growth rates,

as recommended in Higgins R. “Analysis for Financial Management, Intl Edition” McGraw Hill


9

Increasing Signs of Failure

In May 2002, Stolt Offshore had indicated the developing problems in its SEC filings when it

found that if it calculated its tangible net worth to debt covenants, the impact of the exercise of a

guarantee for the repurchase of shares that was included in one of the acquisitions would lead to a

covenant breach. Notably, the firm was able to tell the SEC that SNSA would stand behind the

company and provide the money to bring the company back into compliance by exchanging debt

owed to it for equity.

The problems with both the integration of all the acquisitions and the implementation of the EPIC

strategy was becoming increasingly clear by late 2002. The company reduced its profits forecasts

throughout the year, blaming problems with contracts in Egypt and Nigeria as the main sources

of the problems. At the same time, the company had also announced that it was forecasting only a

very narrow compliance with its debt covenants and would probably have to renegotiate these

with its banks. In December 2002, the ADR price fell from $2.20 to $1.58 in two days.

As the problems became evident, the banks might be thought to have reason to call their loans,

but they did not. Rather, they threatened to force conversion of the debt to equity, thus

eliminating the insider control rights. Discussions with the banks suggest that initially there

were few issues about the 2002 covenant breach that really concerned them, and that the

amendments to the covenants to allow the company to continue operating were rather routine.

Certainly an examination of the legal documentation that followed the agreement seems to

support the idea that the banks simply modified the Debt/EBITDA requirements of the covenants

to match the outcomes that occurred.

Further cost problems with the Egyptian and Nigerian legacy contracts that were embedded in the

ETPM business were highlighted by the company in the remainder of the first half of 2003, and it

became evident that the company would again breach default terms if the debt covenants were

not changed. On July l 2003, Stolt Offshore announced to the market that as a result of financial

problems caused by difficulties with a small number of large West African contracts, the

company would again breach the terms of its covenants with its banks. Additionally, as internal

data was showing that the company was clearly moving into trouble – SNSA, which was a joint

guarantor to the banks of Stolt Offshore’s debt clarified to the financial institutions that they were

not standing behind their subsidiary financially beyond its existing commitments, and that the

banks would have to deal with Stolt Offshore direct.

The banks were persuaded to allow the company to continue to operate, although by the end of

2003, the company was again forecasting default as a result of the legacy contracts but on

December 29 th 2003, the company was given covenant waiver until late-April 2004 in order to

solve the companies problems. However, this covenant breaches was symptoms of the deeper

problems that had already destroyed a substantial proportion of shareholder value.

This second set of defaults led to the financial restructuring. The changes that were made in the

capital structure were primarily geared to unwinding the entrenchment effects of the previous

capital set-up and reducing the gearing. In particular, it removed the split capital structure and

introduced a one-share-one-vote principal by removing all other share classes. The banks insisted


10

on the deconsolidation of Stolt Offshore from SNSA, as a result of which the pyramid structure

was fully eliminated when the Stolt Nielson companies and trusts disposed of all their holdings in

the company 7 . Finally, all the debt was renegotiated and replaced. However, it is not clear that

the final capital structure was the optimal one, even if it was the best that could be negotiated.

Asset sales had already started at this point, although the oil services market was only now

recovering. Capital investment was reduced at this time also. While these changes were setting

the company up for recovery, the company was still subject to the consequences of its legacy

businesses, and it was problems with these legacy businesses that led to the breaches of debt

covenants and the appointment of the CRO that occurred at the end of that year. Much of the

operational change was already in place by this time, and the focus was then on completing and

consolidating the operational improvements, and putting in place the financial restructuring.

A critical part of the solution was a condition imposed by the banks which separated Stolt

Offshore from its parent company – a move initially resisted by SNSA because of potential

problems with cross default clauses in debt and net worth calculations. During the course of

2004, Jacob Stolt-Nielson resigned as Chairman of the company and was replaced by Mark

Woolridge, previously a member of the Board, apparently at the demand by the creditors, who

had given the firm a deadline of September 30 th of that year to put two independent directors on

the board as part of the new financing facility.

3. Early Signs of Financial Distress & the Altman Prediction Model

A number of definitions of financial distress exist, but the primary definition in current use is

derived from the paper by Asquith, Gertner and Scharfstein (1994) 8 , which defines financial

distress in two different ways as a function of interest coverage ratios:

“A firm is classified as financially distressed if in any two consecutive years, the firms earnings

before interest, taxes, depreciation and amortization (EBITDA 9 ) is less than its reported interest

expense, or if in any one year, its EBITDA is less than 80% of its interest expense 10 .” In the case

of Stolt Offshore, this condition had already started to apply in 2001, (Figure 4, below) while the

EBITDA/interest cost ratio of 84% in 2002 is only narrowly outside the range.

Financial versus Economic Distress

Financial and economic distress is not necessarily the same things, although some times one will

result from the other, and the definitions get blurred. Generally, in financial distress, the company

would be able to operate normally if it were not for problems caused by the capital structure,

while in economic distress it unlikely that any further changes in the capital structure would

rescue the company. In the case of Stolt Offshore, there were economic issues – in particular the

downturn in the oil services industry evidenced by the rig count data shown earlier.

7 The Pyramid structure, and entrenchment effects are the subject of the next chapter.

8 Referred to as AGS 1994 for the rest of this project.

9 The definition of EBITDA adopted by Stolt Offshore is shown in Note 3.

10 The authors did not count firms that had this condition in only 1 year, as they usually had enough cash to get

themselves through the problem period.


11

Figure 4: Ebitda as a Percentage of Interest Costs

1000.0%

970.5%

EBITDA as % of Debt Service Cost

800.0%

600.0%

551.4%

400.0%

200.0%

0.0%

164.8%

1997 1998

110.8%

1999

84.4%

-31.5%

2000 2001 2002

-98.2%

2003 2004

-200.0%

-400.0%

-600.0%

-800.0%

-749.9%

EBITDA as % of Debt Service Cost

Source: Authors’ calculations from data extracted from Annual Reports

Some key ratios shown in charts below illustrate how the problems evolved over time. (Some of

these ratios appear to have been volatile in the past due to the oil price sensitivity of earnings).

Figure 5 below shows two ratios, cash flow from operations as a percentage of total liabilities,

and liabilities as a percentage of shareholders equity.

Another indication of a possible forthcoming problem at Stolt Offshore was available to the

banks from predictive models. Altman (1968) developed such a model for predicting financial

distress, which occurs in slightly different forms for public and private companies. For publicly

traded companies, a ‘Z’ score is given by equation (3) below:

WorkingCapital RetainedEarnings EBIT

Z = 1.2* + 1.4* + 3.3*

+

TotalAssets TotalAssets TotalAssets

MarketValueofEquity Sales

0.6*

+

TotalLiabilites Assets

(3)

Figure 5: Cash Flow from Operations As A Percentage of Total Liabilities


12

25.00%

Cash Flow From Operations as % of Total Liabilites

20.00%

15.00%

10.00%

5.00%

0.00%

1996 1997 1998 1999 2000 2001 2002 2003 2004

-5.00%

Source: Authors’ calculations from data extracted from Annual Reports

The Z score is used as a predictor of financial distress, with good record of predictive capability.

Any Z score below 1.8 signifies a problem within two years, while a score above 3 indicates a

healthy company, although the exact numbers do vary slightly by industry. Figure 6 below

shows how the Z score for Stolt Offshore changed from 1998 to 2004.

The falling share price – which is an input into the Z score – also gave an indication of the

developing problem. While Stolt’s share prices are linked to both oil prices and the broader stock

market, the decisive drop in the Z scores between 1999 and 2002 highlights the scale of the

problems developing within the company. As of November 2004 the Z score had not yet climbed

back above 3, but the significant rise in the share price during 2005, would suggest a Z score well

above 3 if none of the component ratios had worsened 11 . However, using the Altman scale of

bond ratings to Z scores, this would still only be a debt ranking of about CCC+ to B, which

would still be well below investment grade.

Figure 6: Altman Z Scores and Share Price for Stolt Offshore – 1998-2004

11 At the time of writing, the full year 2005 results were not available.


13

3.00

14

2.50

12

2.00

10

Altman Z Score

1.50

8

6

Share Price in US$

1.00

4

0.50

2

0.00

1998 1999 2000 2001 2002 2003 2004

0

Z = 3.3 * (EBIT/Total Assets) + 1.2 * (Net working capital/ Total Assets) + 1.0 * (Sales/Total assets) + 0.6 * (Market Value of Equity / Book Value of

Equity) + 1.4 * (Accumulated retained earnings / Total Assets)

Share price

Source: Authors’ Calculations from data extracted from Annual Reports

4. Issues Raised by the Failure

Two particular issues arise in any analysis of what happened at Stolt Offshore – the role of the

owner-management, and the role of the board of directors.

Was Over-Confident Management to blame?

A dominant CEO poses particular problems for the turnaround industry. Sometimes the problem

manifests itself either as an outright denial of the existence of company difficulties by owner-

CEO’s, or if they acknowledge the problems, that anyone else is capable of solving them. The

attitude towards advisors from owner-CEO’s of businesses in trouble is often characterized by

those advisors as being based on “what makes you think you know my business better than I do”.

It is noticeable that Jacob Stolt Nielson placed most of the blame for what happened on the

management of EPTM. In 2004 he told a journalist – who described him as “unrepentant” - that

his decision to buy ETPM was “well considered” and was the right decision at the time. He

blamed the management of ETPM for what had happened:


14

They had the kind of steel we needed. They were established in West Africa, where the future

is….The price did not exceed our resources. The strategy was right – also in retrospect…. Both

the management and the contract portfolio were bad and we did not see it 12 ”

The concept of the over-confident CEO outlined in Roll (1986) is based on his view that “There

is little reason to expect that a particular individual bidder will refrain from bidding because he

has learned from his own past errors” partly derived from the view that most managers

undertake too few takeovers to learn from their mistakes. If markets correctly price the takeover

target, then valuation errors are a function of hubris by management, which will manifest itself

through the winners curse in takeover battles 13 in which the winner of the takeover battle has

overpaid. Roll’s view is that hubris is the best explanation of this type of management behavior.

Malmendier & Tate (2003) extends Roll’s work to situations in which CEO’s with access to

internal financial resources in particular, destroy value through poor acquisition choices and/or

badly managed post-merger integration. There is a direct relevance to Stolt Offshore, which never

paid dividends or made other distributions to shareholders – all the internal resources were used

to fund acquisitions. As Malmendier & Tate put it:

“A CEO who conducts a merger is ostensibly replacing the current management of the firm with

himself. Therefore he is likely to feel the illusion of control over the outcome and to

underestimate the likelihood of eventual failure”

This reference to “illusion” is critical. Slatter and Lovett (1999) talk of a “reality gap” - a way to

characterize the differences between the way the management perceive the situation, and the real

situation on the ground. Management can play down the problems in the Annual Reports, and in

the case of Stolt Offshore, they did. Some types of numerical analysis of the accounts such as

Altman Z-score can expose the underlying problems, even if the company’s management is in

denial about them 14 .

Malmendier & Tate’s test for overconfidence combines an examination of the CEO’s behavior

with regard to his exercise of stock options granted under the remuneration plan with an analysis

of press coverage of the personality and style of the CEO as found on sources such as Factiva,

focusing on the extent to which press coverage describes the CEO as either “optimistic” or

“confident” on one hand, compared to the number of articles describing the CEO as “cautious.”

While the English-language press had little coverage of Jacob Stolt-Nielson, the overall tone of

his messages to shareholders could best be paraphrased as ‘everything will be better next year’.

Most of his statements to shareholders display the ‘hockey-stick’ phenomena in describing the

likely future trajectory of the firm. One banker (unidentified) close to the Stolt Offshore

refinancing told a newspaper:

12 Lloyds List, 26 th August, 2004

13 Roll dispenses with the argument that if companies are fairly prices, then shareholders will remove managers

displaying the hubris problem by arguing that shareholders neither win nor lose because the costs and benefits are

averaged out across their portfolios.

14 Perhaps nowhere was the Reality Gap more evident than in the 2001 reports and accounts. While financial

performance was deteriorating, the 2001 document was a glossy 65 page document full of photographs of smiling

staff on location.


15

"We see that frequently, when push comes to shove, some banks may want owners to reduce their

balance sheet, to sell off assets. At the same time the owners are claiming they have reached the

bottom and are now set for a tremendous upside. It's a very common dispute 15 "

There is some indication of the over-confidence hypothesis from an options-based valuation of

the firm at the time of the first major default. This is covered in depth in Chapter 3, but an

options-based valuation of Stolt Offshore suggests that at the end of 2002, the market value of the

enterprise (i.e. market value of debt plus market value of equity) was worth less than the book

value of its debt. However, the banks forced SNSA to put up an additional $50 million of loan

capital as a condition for moving the covenants to avoid a default. If Stolt Offshore had a

negative enterprise value, then Stolt–Nielson’s decision to put in more money may reflect more

his own confidence in his ability to turnaround the company, than a ‘rational’ decision. The high

sensitivity of revenues to the oil market demonstrated in Figure 1 might however imply that he

was willing to gamble on the recovery in the oil sector being forecast at the time to lift

performance, regardless of management success in turning around the company.

Jacob Stolt-Nielson was also undoubtedly a risk-taker. A spokesman for his company told the

press:

"There's no denying that Mr Stolt-Nielsen speaks his mind and often in refreshingly frank terms.

He's also a man who knows how to take risks. He pioneered three industries - chemical transport,

offshore construction and aquaculture-building businesses - that are today worth more than

$1.6bn. So it's understandable how he might take pleasure in tweaking the company's risk-averse

lenders from time to time"

This problem of CEO behavior has led to some high-profile failures. In the UK, a particularly

noted example was Robert Maxwell, who took a small Bristol-based printing company and

turned into a successful newspaper publishing business which was undermined by poor controls

and governance. In the USA, the recent convictions and jailing of high-profile CEO’s shows that

these problem can occur in many types of environment. Looking back at the eventual failure of

Enron, Eichenwald (2005) reports that even as far back as 1987, Ken Lay admitted to employees

that “We became involved in businesses whose risks we did not appreciate,” but this was a

mistake that he and others still went to repeat.

The Role of the Board of Directors?

Documents of the company are very specific about the role and duties of the board in

Luxembourg – the board is accountable to the company, rather than the shareholders. This is

different from other legal environments where the board is responsible to the shareholders. At the

time the acquisition strategy was begun, there were 6 members of the board, 3 of who were from

directly inside SNSA, a company controlled by the Stolt Nielson family. A fourth member was

primarily a shipping expert and the remaining two had board-level experience of oil companies,

but were long-retired from those positions. Later, Niels Stolt-Nielson, a son of Jacob Stolt-

Nielson, also joined the board. The board was also increased in size by the addition of directors

from within the acquired companies.

15 Tradewinds, 27 th August 2004


16

An indication of the weakness of the board can be seen by comparing the board structure at Stolt

Offshore at the time of the acquisitions to that recommended by the Higgs Report (2003). This

recommended that at least half of the board should be independent, and that one of the

independent directors should be the Chairman. Consequently, this does not look like a board that

was capable of standing up to a dominant CEO.

A question worth further consideration is whether these problems would have occurred if there

were better controls on the management from independent board members; a more open culture

of questioning and discussion within the company and better monitoring by investors and

creditors? Over-confident CEO’s do get their companies into trouble even when there are good

controls. Jacob Stolt Nielson recently told the press that he continues to believe that strategy was

the right one and blamed the failures on almost everyone else. When Stolt Offshore is seen within

its institutional environment, it is possible to have some limited sympathy with his point of view.

It is not clear that in the current environment, resolving these problems is just a case of

restructuring the board and the internal processes, as companies in countries which promote this

as best practice still have companies that fail due to the abuse of CEO power. One reason for this

can be seen from looking at changes in shareholder profiles. The characterization of the

shareholding system in the UK and US basically conforming to the model laid out by Berle and

Means (1932) is not really relevant, in a world in which institutions dominate investment. The

point is illustrated by a recent Conference Board 16 report, which showed that US pension funds

owned 40% of the US equity market, and that a significant proportion of the remainder is owned

by other investment institutions.

When long-standing management become too close to a group of large institutional investors, the

potential for management capture of the Board though influence on the voting investors becomes

very real. Even when this capture does not occur, many institutional investors are passive, others

defer their decision making processes to proxy services such Institutional Shareholder Services

Inc.

A potential solution to this problem is to impose mandatory rules for shareholder disclosure.

European regulations and practices are starting to move closer to some recent developments in

the USA, where institutional investors are expected to disclose how they vote. Increasingly it will

be possible to see how often institutional investors go against the recommendations of the

management when those recommendations have at least the appearance of being self-serving.

Eichenwald’s encapsulation of what happened at Enron, apart from the fraud, has many parallels

with Stolt Offshore, given the lack of controls on the senior management. As he put it:

“No single person bore responsibility for the debacle; no single person could. Instead, the

shortcomings of a handful of executives – along with a community of lawyers and

accountants…merged to create an enterprise destined to fail. But in the end… the underlying

cause of the collapse was fairly simple: the company spent much of its money on lousy

businesses. And the market exacted its revenge”

16 ‘US Institutional Investors Boost Control of US Equity Market Assets’, Conference Board ‘Institutional Investor

Report, October 2005.


17

Note 1: The Stolt Offshore Acquisitions & Their Timing

Date Target Business Price

1992 Comex Services Subsea diving $82mln (750,000 shares, $30mln

in cash and $37mln in debt)

1992 Stolt Nielsen Subsea robots DP diving $85mln

June 9, 1998

(Announcement)

Seaway ships

Ceanic Corp Shallow water offshore

diving and

equipment in the Gulf of

Mexico

1998 Dolphin 21 remotely operated

vehicles (ROVs) in

Norway

December 7, 1999

(announcement date).

4 9% of NKT Flexible and dynamic

risers factory

$218.9mln (plus $8mln in debt)

29% Premium to Ceanic preannouncement

price.

$16.9mln

$36mlm including $10.5mln in

cash and1,758,242 class A

shares ($14.75)

December 16 th , 1999 ETPM Subsea construction with a

strong presence in Africa

$330mln ($130m cash,

6,142,847 class A shares at a

minimum of $18.5 per share and

$86m in debt) i.e. Stolt gave

Ceanic a $18.50 strike put option

on its shares.

2001 (March 30) Paragon 350 engineers based in $10mln

Houston and Paris

July 18 2001 Ingerop Litwin Design and Engineering $6.7 million

Sources inc. Annual accounts & CDC IXIS Securities

Note 2: A Note On the Stolt Offshore Share Structure

Stolt Offshore went through several changes in its equity structure after the original merger in

1993. In this paper, all the data has been calculated using the common share equivalents provided

by the company in its Annual Reports. There were at times up to 4 different share types

(including Treasury Shares) with different voting rights and economic interests. Class A shares

and common stock were described by the company as being economically equivalent, but the

class A shares had no voting rights. In March 2001 the Class A shares ceased to exist, having

been converted to common stock. The class B shares did have voting rights and were convertible

at any time into half the numbers of common stock at the option of the holders. They were all

owned by the Stolt-Nielson family, either directly or through the trusts and/or through SNSA

subsidiaries.

The numbers of Class B shares rose to 34 million by 1997, or 43 % of the equity and 60% of the

voting rights, and remained at that number until they were all converted to common shares in

February 2004, thus significantly reducing the Stolt Nielson share of the voting rights. Several

issues of new shares took place over time, some of them as part payment for acquisitions, as

shown in Note 1 above, and in some cases through the conversion of outstanding debts to SNSA.

Following the covenant breaches, the company was able to raise further funds in the equity

markets, some of which was used to pay down debt to the banks, however the buyers imposed a

condition that the controlling class of shares be eliminated.


18

.

Note 3: Definitions of EBITDA used by Stolt Offshore 17

The calculation of EBITDA equates to net income after adding back taxes, interest, depreciation,

amortization (including dry dock amortization) and gains and losses on sales of investments and

fixed assets. Management believes that EBITDA is a useful measure of operating performance, to

help determine the ability to incur capital expenditure or service indebtedness, because it is not

affected by non-operating factors such as leverage and the historic cost of assets. However,

EBITDA does not represent cash flow from operations as defined by US generally accepted

accounting principles, is not necessarily indicative of cash available to fund all cash flow needs

and should not be considered as an alternative to earnings from operations under US generally

accepted accounting principles for purposes of evaluating results of operations.

17 Source: Correspondence with Investor Relations team, July 2005


19

2. The Influence of Pyramid and Split Capital Structures

on Corporate Failure & Financial Distress

Introduction

A notable feature of the ownership profile of companies in European countries is the

predominance of features such as family companies, large block shareholders, pyramid and split

capital structures in which the control rights of certain groups of shareholders can be well in

excess of their ownership, or cash-flow rights. This results in a very different world than that

described by Berle and Means (1932) of many small shareholders and managers as their agents.

Concerns about the nature of pyramid and split capital structures focus on the potential for these

structures to allow the appropriation of private benefits by management at the expense of

shareholders. When the management of such companies is also the largest shareholder, the

potential for the appropriation of private benefits is substantial.

The first paper in this project presented a picture of a company brought down by poor execution

of its M&A strategy, an overconfident CEO and a weak board, but highlighted the rationalization

for the strategy as it was presented to shareholders. The paper showed how the motivation for the

strategy was given as risk reduction – reducing the volatility of earnings by increasing the global

spread of operations into areas where the earning streams were uncorrelated with the existing

business. This was to be done by buying companies already active in the appropriate areas.

However, shareholders that want this earnings smoothing could have bought shares in the

individual companies purchased by Stolt Offshore for themselves. Due to the options-like effect

in equity pricing, the effect of this reduction in volatility is to depress the value of the equity, and

to improve the value of the debt, thus risk reduction also more closely aligns the companies goals

with the interests of the creditors. When the largest shareholder is also family management, and

the minority shareholders have no say, risk reduction improves the likelihood of the controlling

family staying in control, which is a purely private benefit.

Although less clearly stated, the second motivation seems to have been the pursuit of ‘big

company’ status. This goal, and the high leverage that supported it, could be regarded as a highly

speculative strategy carried out by a controlling family member as the company has since

demonstrated quite successfully that there is a role for regional specialists in the oil and gas

support services sector.


20

Given that a consequence of the M&A and expansion strategy was the appropriation of private

benefits from the minority shareholders, the problems that arose as a result of that strategy raises

some key questions:

1. To what extent can the company’s problems be traced back through the company’s ownership

and control structures - in which the main shareholders were also the firms managers - to the

decision over which institutional and legal structure to place the firm?

2. What impact does that decision have on how creditors design an optimal debt contract to

protect themselves from the types of strategic behavior that can result from it?

In their paper ‘Law and Finance (1998)’ LLSV build a model linking shareholder rights, creditor

rights, and the strength of the legal system. Subsequent works by other researchers using these

models have resulted in theories to explain capital structure choices, use of the bankruptcy codes

and the behavior of family companies. The ability of these models to explain the situation at Stolt

Offshore is demonstrated empirically below. By placing the analysis of corporate governance at

Stolt Offshore into an institutional economics framework, it does becomes clear that the legal

structures that give rise to different governance regimes can have a big impact on corporate

decision making, on capital structure and on ownership concentration and rights.

This paper first reviews some models of corporate control that appear to offer answers to the

questions above, and then tests their applicability by comparing aggregate data for companies in

the oil and gas services sector with data on Stolt Offshore. The paper concludes with a discussion

of the applicability of the findings to rescuing distressed companies.

1. Stakeholder Rights and Capital Structure

LLSV (1998) highlights the fact that civil law countries protect creditor and shareholder rights

less well on average than do common law countries, with the consequence that lenders and

investors have to take action to protect themselves according to the relative strength of the

different sets of rights. In some jurisdictions such as Belgium, LLSV (1998) reports little

protection for either creditors or shareholders, while in France, employees’ rights rank high

relative to other stakeholders. The result is that minority shareholders may be disenfranchised or

may be unable to block expropriation of value either by management or by a block shareholder.

As a consequence, there are a much smaller proportion of small shareholders in companies in

common law countries, and fewer, but proportionally larger shareholders than in common law

countries. Very often, this argument explains both the predominance of family companies in the

European civil law countries, as well as the continuing presence of pyramid and split capital

structures.

Stolt Offshore provides a further example of how the legal regime restricts shareholder rights.

Regimes such as Luxembourg allow companies to restrict individual ownership to 20% of the

outstanding shares unless agreed by the Board of Directors. That law also allows a company to

take action against anyone attempting to build such a stake. Stolt Offshore admitted in its SEC

filings that this might have the effect of restricting the ability of shareholders to sell to a higher

bidder. Given the high proportion of Stolt Offshore that was controlled by SNSA, it seems

unlikely that any hostile bidder for the company not approved by the board would have paid a


21

control premium over the market price, thus denying the minority shareholders the benefit of a

takeover to remove poor management.

The problems for shareholders of poor rights outlined in LLSV (1998) have a parallel for debt

holders also. Restrictions in creditor rights affect both the mixture of market and private debt, and

the levels of debt concentration. In contrast to a pure Modigliani-Miller Proposition 1 world, the

Static Trade-off theory says that firms choose the balance of debt and equity that maximizes firm

value. However, as noted by LLSV (1999), changing the capital structure alters the balance of

power both insiders and outsiders, and can have a direct impact on firm valuation. Additionally,

Hackbarth, Henessey & Leland (2003) show that the restructuring or reorganization costs will

vary depending on the nature of the debt as the balance of power between different types of debt

holders changes according to relative claimholder rights and the bankruptcy code. This impacts

the value of the firm when the discounted value of any possible financial distress is included in

the valuation.

Consequently, when agreeing capital structure decisions with their clients, banks could be

expected to limit their exposure to firms with strong negotiating positions in order to minimize

the cost of strategic default. When this exposure level is below the borrowers optimal debt level

to maximize the value of the tax shield, firms benefit from adding market debt. Weak firms might

use banks only, adjusting the coupon to maximize the tax shield, but giving the banks more

power in renegotiation in order to avoid the risk of premature liquidation.

In the light of this discussion, there are four features of Stolt Offshore capital structure that stand

out:

1. Pyramid structure of equity ownership

2. Private (bank) debt rather than public (bonds) debt.

3. Long-term debt rather than short term debt

4. The debt was collateralized

As a result of the issues discussed above, each of these four factors can have a major influence on

the behavior of the company, the ability of the banks to control it, and the coordination problem

in the event of financial distress.

Pyramids, Split Capital, and the Problem of Tunneling

Stolt Offshore occupies a position at the bottom of a family-dominated pyramid (shown in Figure

7 below) of the type that evolved across Scandinavia in the first half of the 20 th century (Holmen

and Hogfeldt 2005). The Stolt-Nielson family held its shares in SNSA and other parts of the

group through a family trust - Fiducia. This trust owned just over 40% of SNSA, while Jacob

Stolt Nielson owned another 21% of the company directly. While SNSA in turn owned 45% of

Stolt-Offshore, it also owned 61% of its voting rights. Consequently, the Stolt Nielson family

was able to control Stolt Offshore despite only directly owning about 29% of the shares.


22

Figure 7: The Stolt-Nielson Family Pyramid in 1999

Source: Reports and Accounts, SEC Filings

Figure 8 shows the differences over time between cash flow and control rights accruing to the

Stolt-Nielsen’s, assuming that their own and Fiducia’s stake in SNSA was stable 18 . The

difference between cash flow rights and control rights of 32% is at the top end of the range

identified by Claessens et al in East Asian corporations. Their paper shows that those companies

where this difference between cash flow and control rights is in the range of 31-35%, average

Tobin q is about 0.9, compared to a q of over 1.4 for companies where the difference between

cash and control rights is between 11-15%.

A problem of pyramid structures is that they can lead to tunneling – the provision of over-priced

goods and services between related companies as a way of extracting benefits not available to

minority shareholders. In some jurisdictions, the tax system limits the attractiveness of intercompany

transfers, and the payment of dividends, while the tax-free nature of the family trust

reduces the incentives of the controlling family to extract direct financial private benefits

18 It seems unlikely that this was exactly the case. In particular, part of the reason for the sale of the entire Stolt

Offshore stake in early 2005 may have been to deal with financial problems at SNSA.


23

Figure 8: Evolution of Control and Cash Flow Rights Over Time

70.0%

60.0%

50.0%

% of total rights

40.0%

30.0%

20.0%

10.0%

0.0%

11/29/1998 11/30/1999 11/30/2000 11/30/2001 11/30/2002 11/30/2003 11/30/2004 28/2/05

Control Rights o Stolt Nielson Family

Effective Cash Flow Rights to Stolt Nielson Family

Source: Annual Reports and Accounts, SEC Filings.

Cash Flow Rights to SNSA

Difference between cash flow and control rights

There were indirect tunneling effects at Stolt Offshore. The major point here is that the majority

controllers – the Stolt Nielson’s – were able to block the payment of dividends to shareholders

and use the companies cash-flow to help pay for a corporate strategy that transferred value from

the minority shareholders, to themselves. They were able to do this despite owning a minority of

the cash flow rights. Retained earnings are the cheapest source of finance for companies because

of the absence of any agency or information asymmetry effects seen in other funding sources.

Consequently, there were no dividends paid by Stolt-Offshore, and apart from a small amount of

short-term subordinated debt, there was no attempt to load the Stolt Offshore balance sheet with

debt owed to SNSA.

This explanation of indirect tunneling removes a possible objection to the hubris hypothesis of

takeovers discussed in the first paper – that in an efficient market, shareholders will remove

management who repeatedly overpay for takeovers. If minority shareholders have no controls

over management, then those managers can overpay for assets using money belonging to

minority shareholders, and extract private benefits. Minority shareholders have no power to stop

them.

Any direct tunneling appears to have been minimal. SNSA did levy management charges on

Stolt-Offshore, but these were small relative to overall revenues, and various company

documents state that the company believed, although could not verify, that all transactions

between Stolt-Offshore and parts of SNSA had been done at market prices. One possible

exception to this is in the price of debt – for example, in mid-2003, SNSA lent US$50 million to


24

the company at an interest rate of 12%, when LIBOR was nearer 1.5% and the Merrill Lynch

High-yield debt index was about 9.5%.

Influence of Family Ownership on Capital Structure

There are two streams of recent research on the influence of family ownership on capital structure

and debt costs that are relevant to Stolt Offshore and which might help to explain what happened

within the company. In the first case, following the argument in Anderson et al (2003) it can be

argued that a reliance on family relationships such as occurred in the Stolt-Nielson family

banking relationships might not be quite the abandonment of responsibility by the banks that it

might seem. Recent work on the agency effects of family ownership on the price of corporate

debt does suggest that the long-term strategic focus of family firms is more closely aligned with

the interests of the lenders than those of minority shareholders because of a tendency to avoid

riskier projects.

However, while Stolt Offshore’s lenders may have perceived this effect in a relationship they

assumed to be based on Norwegian norms, the fact that the company was legally located in

Luxembourg gave the management the opportunity to play under a very different set of rules. The

behavior of the banks suggests a failure to understand this fact, and it is this failure that led to so

much of the cost of distress in this particular case.

Separately, a study of East Asian firms (excluding Japan) by Claessens et al (2002) shows that

firm value can increase to a certain level when cash flow ownership is aligned with voting

control, but as these become unaligned, firm value falls as an entrenchment effect takes hold

under which the majority shareholders extract benefit. This is particularly true when family firms

are concerned, and the management is made up of the family. However, these results do seem to

suggest that there are situations in which an equity voting structure of one-share-one-vote may

not always be optimal. While Claessens et al focused on East Asian companies, their work is

relevant to those involved in restructuring or investing in distressed European companies because

of the high prevalence of block and family ownership seen in mainland Europe, and the lack of

shareholder rights that gives rise to it.

There is a link between these two papers in the case of Stolt Offshore. Anderson et al go on to

point out that in two cases in particular, the agency cost benefit of a family ownership disappear

and that problems such as entrenchment as discussed by Claessens come out instead. This is

firstly that the agency cost of debt rises when the descendant of a founder takes over as a senior

manager, and that firm value can fall when the founder manager has been in position for too long

and is at the end of their career. For example, Jacob Stolt-Nielson had had a long, successful

career, built partly on moving into new business areas outside the family’s core competency, such

as aquaculture, and become ‘overconfident’ about his ability to run different business lines.

Creditor Rights

Stolt Offshore’s long-term debt was a revolving credit facility negotiated with the company’s

main lenders. The principal covenants were not unusual – they contained maximum permissible

Debt/EBITDA ratios, and changes in the ratio over time were also used to determine the interest

rate premium charged over LIBOR. The covenants also specified minimum levels of Debt/Net


25

worth on an annual and quarterly basis, and minimum tangible net worth figures that rose each

year by 50% of the total earnings in the previous year, presumably in order to ensure some

retention of earnings to fund the debt service. Although the data from DealScan shows that there

were originally 20 financial institutions in the original loan, that number has grown because

members of the initial syndicate sold their loans to other financial institutions. (Although not

specifically part of the capital structure, the Performance Bonds were also an integral part of the

debt arrangement and were linked into the relationship with SNSA. This issue is dealt with in

depth later in the paper).

The Role of Collateral

One explanation for the nature of the relationships between Stolt Offshore and its creditors, and

the lack of monitoring, is derived from the alignment of family and creditor incentives in family

companies. Given that the Stolt-Nielson group stretches back to 1897, this seems plausible.

However, an additional factor may have been the availability of collateral. Once again, the

institutional environment has a direct impact on the use and the value of collateral.

The model developed by Shleifer and Vishny (1992) shows how the ability of the banks to sell

collateral such as an oilrig or supply ship when a company is in financial distress may be limited

when the financial distress is also a function of economic distress affecting the entire industry.

Pulvino (1998) uses data on aircraft sale prices to show how widespread economic distress in an

industry leads to fire-sale prices of industry-specific assets. This can raise substantially the costs

of premature liquidation and of strategic default. For this reason, Shleifer and Vishny (1992) take

issue with the view proposed by Williamson and others that the best approach to dealing with

financial distress is to auction off the assets of the company. If this is a forced “fire-sale” of the

assets below their continuation value, it transfers value from the shareholders to the creditors.

These potential costs and transfers have an impact on capital structure. In countries with good

creditor rights, companies with very industry-specific assets could be expected to borrow less,

and use more equity capital; in countries with poor creditor rights, companies with industryspecific

assets can use more debt (Acharya et al, 2005). Lenders will adjust their lending

practices to compensate. For example, Davydenko and Franks (2005) find that banks that lend to

French companies demand more collateral than the value of the debt it is being used to support.

This is because the French courts do not have to accept the highest bid for an asset if a lower

bidder intends to use the asset to maintain the failed company as a going concern.

A question that arises from the case of Stolt Offshore is whether or not the reliance on collateral

and relationships induced some form of moral hazard that led to insufficient monitoring. The

story outlined in the preceding paper certainly raises questions of why the banks did not intervene

earlier than they did, and why they decided to amend the covenants in 2002, rather than use the

default as an opportunity to solve the structural problems with both the debt and the with the

company.

Manove, Padilla and Pagano (2000) demonstrate a model in which the availability of collateral

for lending arrangements leads “lazy banks” to use the collateral as a substitute for effective

project screening when making lending decisions. Certainly, the fact that the debt was


26

collateralized was not necessarily to the banks advantage in the presence of moral hazard. As

Manove et al point out:

“history is replete with examples in which bankers have carelessly expanded credit to

entrepreneurs who post collateral only to be sorry later when massive defaults and declines in

the value of the posted collateral threatened the financial soundness of their own institutions.”

While neither Stolt Offshore, nor its performance bonds and their cross-default clauses with

SNSA probably ever threatened any of the lending institutions, the combined liabilities were

substantial. While the statement does seem to describe the beginnings of the problems at Stolt

Offshore, discussions with turnaround practitioners suggests that at least today, this is no longer

such an important issue as the big expansion in leveraged deals in the last few years has led to

banks having to pay more attention to the assets that they are lending against, and to the rise of

the collateralized debt markets.

The outcome of this discussion is that it would have been potentially expensive for Stolt Offshore

to pledge industry-specific assets to creditors in a legal environment where those creditors have

few other recourses for reimbursement other than seizing the collateral assets.

Public –verses-Private Debt & the Number of Creditors

As identified in the introduction, the number and identity of the creditors and other stakeholders

affects the likelihood of a successful restructuring of a distressed company. When previously,

banks may have sought to retain relationships with these companies, trading off the reputation

effects of not being seen to liquidate companies prematurely with the cost of bad debt, now they

can sell the loans to other institutions without those ties or business interests.

Stolt Offshore used only bank debt, plus subordinated loans to the parent company unlike other

members in the 138 group that have a mix of public and private debt 19 . The concentrated control

rights and the lack of creditor rights in Luxembourg raises the question of why the banks did not

insist on some market debt to increase renegotiation costs in the event of strategic default. Part of

the reason appears to lie in the choice of the number of banks in the syndicate.

Several theories exist to explain the motivation for the choice of the number of creditors,

particularly in situations such as Stolt Offshore when there is no public debt. The Dealscan data

for the 138 SIC code companies shows a wide range in the numbers of banks used by those

companies in the oil and gas sector, and generally confirms the rareness of single bank

relationships around the world (Ongena and Smith, 2000). Bolton & Scharfstein (1996)

determined how the optimal capital structure relative to the number of creditors was that which

minimized the transaction costs of renegotiation. However, as these costs also depend on the

level of creditor protection, judicial efficiency, and the effectiveness of the rule of law, some of

these costs are rooted in the institutional structure and informal rules of the country in which they

are located.

19 In this case, US government Marine bonds are treated as public debt, and assumed to be non-renegotiable.


27

Another possibility is that the banks seek to determine the number of lenders in order to restrict

free-riding on monitoring costs - a corollary of the ‘lazy banks’ discussion above. This is not

entirely consistent with the Bolton and Scharfstein (1996) argument that focus on minimizing

renegotiation costs. Finally, the borrower may also have an impact on the number of banks,

choosing to use several banks to protect itself against possible bank failure or other withdrawal of

credit facilities should it use only one bank.

2. Empirical Analysis

The discussion above suggests that the nature of shareholder and creditor rights affects the way

both groups invest in the company, and is that these influences are reflected in the capital

structure and valuation of companies. This section first tests the hypotheses that the equity

structure was disadvantageous to the minority shareholders and the company valuation. It then

tests the hypothesis that the debt structure was set up to protect “lazy banks” from the company

by building in debt features that are a substitute for direct monitoring.

Shareholder Rights and Tobin-q

Claessens et al, and other parts of the corporate governance literature use tobins-q as a measure

of firm value. Tobin’s-q compares the market value of a company with the replacement value of

its assets. Variations on the original formula have become extremely data-intensive, so this paper

uses the calculations suggested by Chung & Pruitt (1994) due to its very high correlation with the

results from highly data intensive versions. :

Approximate q = (MVE + PS + DEBT)/TA (1)

where MVE is the company’s equity market capitalization, PS is the liquidating value of the

firm's outstanding preferred stock, DEBT is the value of the firm's short-term liabilities minus the

short-term assets, plus the book value of the firm's long-term debt, and TA is the book value of

the total assets of the firm.

Values for q vary widely according to industry and company, although in any context, values less

than 1 reflect a company that is not making efficient use of its assets. The market view of Stolt

Offshore in comparison to the rest of the sector can be evaluated by comparing the Tobin-q of the

entire 1389 SEC code to the Tobin-q for Stolt Offshore. Figure 9 below shows the results. Stolt

Offshore had a Tobin-q well below that of the rest of the sector even before the peak of the

acquisition phase, and after 2000, dropped below 1 and stayed there until the turnaround was

complete.

This approach to comparisons is quite common in the corporate governance literature, but a

possible weakness of this argument in the current case is that it assumes that each of the 34

million Class B shares would have the same valuation in the market as 0.5 of each common

share. If the Class B were worth significantly more than the common shares to reflect their

control rights, then the Tobin-q for Stolt Offshore could well be closer to that of the rest of the

sector.


28

Figure 9: Comparison of the Tobin-q for Stolt Offshore and the 1389 SIC Group

3

2.5

2

1.5

1

0.5

0

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Stolt Offshore - q

Source: authors calculations from Compustat data

1389 - q

Such a hypothesis would be supported by the view expressed in LLSV (1999), where the authors

find that controlling shareholders are often resistant to removing their control rights because of

the loss of value. However, the controlling shareholders that LLSV refer to might not have had a

direct financial justification for retaining control, but rather, may be focused on alternative

benefits such as reputation or image among their peers, or by guaranteed employment for other

family members. In the case of Stolt Offshore, the controlling shares were converted to common

shares in the restructuring without any premium. Alternative explanations also focus on the

ability of a controlling family to determine whether to put the most productive projects into the

public or the private parts of the pyramid.

While the low value of Tobin-q is not solely a function of the differences in governance, the

degree of separation between cash flow and control rights, and the lack of any independent

“audit” of management thinking about strategy can have a major impact on valuation, and

suggests that the level of Stolt-Nielson’s family control over Stolt Offshore may have been highly

detrimental to the minority shareholders.

Another useful comparison to the situation at Stolt Offshore is that of Petroleum Geo-Services

(PGS). PGS is an oil services company based in Norway, which like Stolt-Offshore, is listed on

the Oslo Borse and in the USA. Although it had a one-share-one-vote equity structure, it too had

an aggressive founder-CEO that was able to pack the board with compliant members, even if they

were nominally independent, and then enter a speculative investment spree. PGS did not have the


29

split between voting and control rights evident in Stolt Offshore, and so seems to have had a

higher rating in the market than Stolt Offshore. A comparison of the Tobin-q statistics as shown

in Table 4 below shows that the Tobin-q for PGS has remained above that of Stolt Offshore

throughout the period shown. This is despite the fact that in its restructuring, the original equity

holders lost 96% of their investment – a significantly worse outcome than that suffered by the

shareholders of Stolt Offshore.

Table 4: Comparison of Tobin-q for Stolt Offshore and Petroleum Geo-Services (PGS)

year 1998 1999 2000 2001 2002 2003 2004

PGS: Tobin q 9.43 12.08 9.93 6.05 1.43 0.89 1.12

Stolt Offshore: Tobin

q 0.79 1.13 0.83 0.53 0.34 0.62 1.07

Source: authors calculations based on data provided by Carnegie ASA, Oslo

Some care is needed in the interpretation of this data as it became clear that PGS was

manipulating some of its data – capitalizing expenses as investments, in particular. Although the

company became very highly geared, sufficient of the assets it bought were generating enough

cash to ensure that it did not breach Debt/EBITDA covenants. However, in 2002, when problems

developed in the oil services, the financial edifice collapsed, as it did at Stolt Offshore.

Creditor Rights and Debt Structure

This section looks at the structure of the debt in the context of both the comparative legal and

governance environment in which Stolt Offshore and its creditors were operating. A major

feature of the evolution of Stolt Offshore’s capital structure was the big increase in gearing as the

company borrowed more to fund its M&A strategy. However, the company has relied heavily on

syndicated bank debt, and has not recently issued bonds, except the subordinated notes that were

issued to SNSA, the last tranche of which was converted to equity as part of the restructuring.

Table 5 below shows the evolution of the capital structure of Stolt Offshore along with ratios of

debt to shareholders equity.

Table 5: Capital Structure of Stolt Offshore

1996 1997 1998 1999 2000 2001 2002 2003 2004

Short TermBank Overdrafts 7.8 13.4 17.6 22.3 1.8 5.2 16.0 2.5 0.0

Short TermNotes to Stolt Offshore 0.0 0.0 0.0 2.9 8.5 9.5 0.6 18.4 2.0

Subordinated Loans fromStolt- Nielson 35.2 0.0 0.0 50.0 0.0 0.0 0.0 50.0 0.0

Current Portion of LongTermDebt 12.7 0.4 2.7 0.6 3.8 23.7 0.0 91.5 0.0

Long TermDebt and Capital Leases 0.0 2.6 221.2 200.7 292.5 335.0 335.0 293.5 69.7

Shareholders Equity 76.9 348.0 400.6 408.4 669.5 660.0 517.0 107.3 314.6

Short TermDebt as %of Total Debt 77.1% 81.7% 7.3% 27.2% 3.4% 3.9% 4.7% 15.6% 2.8%

Long TermDebt/Shareholders Equity 0.0% 0.7% 55.2% 49.1% 43.7% 50.8% 64.8% 273.5% 22.2%

Long TermDebt/Total Capital 0.0% 0.7% 34.4% 29.3% 30.0% 32.4% 38.6% 52.1% 18.0%

Source: Authors’ calculations from data extracted from Annual Reports


30

Figure 10 below shows the capital structure of Stolt Offshore compared to the sample group

drawn from the 1389 SIC database. In the current case, figure 10 shows that in the period prior to

the acquisition activity; Stolt Offshore had less debt on its balance sheet than its competitors. In

1997, Stolt Offshore reduced its long-term debt through improvements in its cash management –

there was a considerable improvement in outstanding receivables 20 . From 1997 until 2002, Stolt

Offshore maintained a gearing that was close to, or better than its competitors, to some extent,

tracking their capital structure, but at a lower level.

Figure 10: Ratio of Long Term Debt to Shareholders Equity

100.00%

90.00%

80.00%

70.00%

60.00%

50.00%

40.00%

30.00%

20.00%

10.00%

0.00%

1996 1997 1998 1999 2000 2001 2002 2003 2004

Stolt Offshore

1389 Group: Debt/Shareholders Equity Ratio

Source: authors’ calculations from data extracted from Annual Reports

Turning first to the issue of the number of creditors in the syndicate, an analysis of the DealScan

bank loan data for the oil and gas services sector seems to confirm the theoretical expectations

that better protection of creditor rights leads to smaller syndicates that are focused on improved

monitoring, and that as legal protections weaken, the number of creditors rises, either to allow

free-riding on monitoring, or to make strategic default more costly.

Table 6 below shows the results of the analysis. The Dealscan data does suggest that there are

more banks in the sample of syndicates that are in common law countries than in civil law

countries. LLSV (19998) show that creditor and shareholder rights are generally better protected

in common law countries, and the results are in line with those of Esty and Megginson (2003)

using a much larger sample of syndicates across multiple industries.

20 Some other companies in the sample such as Cal Dive International also took steps to reduce their gearing - in this

case, by an equity issue to pay down debt.


31

Table 6: Number of Banks in Oil and Gas Syndicates by Legal Code

Common Law

Civil Law

Relationship to Debt Size None Linear, Positive

Median Number of Banks 3 10

Source: authors calculations from Dealscan data

While there is insufficient data to draw conclusions about the influence of each of the

institutional or economic factors described by LLSV (1998), this result is roughly in line with the

findings of Claessens and Klapper (2005), who highlight that with the exception of the influence

of an absence of automatic stay, it is generally difficult to isolate the particular factors controlling

access to credit from the LLSV (1998) totals of creditor and anti-director rights.

There were 20 banks in the Stolt Offshore syndicate, which is significantly higher than average.

Discussion with the banks confirms that they were focused on the collateral, and on the long-term

relationship with the Stolt Nielson family, rather than on direct monitoring. In one sense, this

could be consistent with a goal of the banks to prevent any strategic default i.e. in line with the

conclusions of Bolton and Scharfstein (1966).

However, where this argument seems to be internally inconsistent is that the easiest way to

discourage strategic default is to issue bonds. If the company had wanted to signal a commitment

not to default strategically, it would have chosen this action. LLSV (1997) shows that bond

market are much less liquid, or are more expensive to access in countries where creditor rights

are poor, thus forcing borrowers to use the banks. In cases such as Stolt Offshore, where

shareholder rights are weak and takeover possibilities are excluded, but strategic default is not

expected by the borrower, choosing many banks leads to less monitoring and thus allows the

borrower to extract private benefits unimpeded.

The finding of fewer banks in common law countries as shown in Table 6 above is also

consistent with this argument. If shareholder protection is better in common law countries, then

management will choose less banks to achieve greater monitoring. This leads to less private

benefits, but higher market valuations for the company, making it more likely that the managers

will keep their jobs.

One last issue not addressed here is that the data on the sizes of the syndicates does not tell us

much about the control structures within it. Very often, these syndicates consist of a handful of

relationship banks that bring in other banks to share the risk. If these additional banks work on

the basis of accepting any renegotiation outcomes of the lead banks, then it is questionable

whether the syndicate should be examined for its total size, or only for the size of the lead bank

group. Evidence from syndicate loan contracts examined by Esty and Megginson (2003) show

that syndicate concentration is a decreasing function of both the creditor rights and shareholder

rights scores, and of debt size. Seen in the context of the results in table 6, a determining factor in

syndicate size still seems to be whether the borrower is located in a civil, or a common law

country.


32

Maturity Structure of Debt – Long-versus-Short

The split between short-term debt and long-term debt was shown in Table 5, and a comparison

with the rest of the oil and gas sector is shown in Figure 11 below. Viewing equity as an option

on the assets leads to the view that longer the debt, the greater the option value of equity. Shortterm

debt that has to be regularly renewed imposes renegotiation costs. This is because if banks

believe that the firm will not be able to repay, then there is the possibility of premature

liquidation before the investments made with the loans have paid off. In the case of Stolt

Offshore, the debt was mostly long-term, which is not consistent with any form of monitoring,

but which supports the idea that the banks were more focused on preventing strategic default.

Figure 11: Ratio of Short Term Debt to Long Term Debt 138 Group and Stolt Offshore

60.00%

50.00%

40.00%

30.00%

20.00%

10.00%

0.00%

1998 1999 2000 2001 2002 2003 2004

1389 - ST/LT Stolt Offshore

Source: authors calculations from balance sheet data

Collateralized Debt & Asset Specificity

Discussions with the banks and other advisors certainly suggest that the availability of collateral

was a key part of the relationship with the company. The Stolt Offshore bank loans were secured

against some of the company’s ships, which were very application-specific. Asset specificity is

defined for these purposes as the proportion of tangible fixed assets whose value is realizable by

sale to companies outside the sector in which the company operates. These assets are primarily

land and buildings; their book value is easily derived from the company balance sheets. The asset

specificity measure is calculated as the gross value of:

Land + Buildings

AssetSpecificity = 1− (2)

TotalFixedAssets


33

Figure 12 below illustrates the asset specificity differences between Stolt Offshore and other

companies. The chart – which is based on contemporaneous balance sheet data, suggests that

Stolt Offshore’s total assets were more industry-specific than those of the rest of the sector, and

suggests that Stolt Offshore should have lower leverage than the sector, not more. The fact that it

did not do so adds further confirmation that either the banks were relying on their relationships

with the Stolt-Nielson family; that the family relied on the relationship in order to be sure that

secured assets would not be seized; that the company saw that it was able to borrow beyond what

it should do due to low monitoring, or some combination of all three. Eventually, asset specificity

problems did turn out to be an issue when in 2002 and 2003 the company tried to sell assets and

found that they could not get the prices that they sought due to an industry downturn. This

highlights the expectations of Shleifer and Vishny case previously referred..

Figure 12: Asset Specificity for Stolt Offshore and a Sample of 138 SIC Code Companies

100.0%

97.5%

95.0%

92.5%

90.0%

87.5%

85.0%

1997 1998 Asset Specificity 1999 - 1382000 Group 2001 Asset Specificity 2002 - Stolt 2003Offshore

2004

Source: authors calculations from balance sheet data

3. Conclusions

This paper opened with an assertion that the pyramid and split capital structure that can emerge in

regimes with weak creditor and minority shareholder rights creates an opportunity for a

controlling family to extract private benefits. In the case of Stolt Offshore, the controlling

shareholders entered into a speculative expansion strategy that was justified in terms of risk

reduction, but was paid for out with debt funded out of cash flow that could have been paid to the

minority shareholders. This risk reduction strategy would have transferred value from the

minority shareholders to the controlling family, and to the debt holders. The consequence was


34

that comparative measures of firm value such as Tobin-q indicate that there was price to this

strategy in reduction in firm value.

The creditors are reported to have relied on their long-run family relationship and access to

collateral to mitigate their risks of lending in a legal environment that gave few creditor rights.

The direct collateral was highly industry specific, with the result that the premature liquidation

costs would have been high if the creditors were able to seize the assets in default. However, the

institutional environment restricted access to the market debt that would have been the best way

to prevent strategic default. The conclusion that best fits the data is that over-confident

management opted for a debt structure that minimized the likelihood of lender interference in

day-to-day actions.

Overall, the evidence presented above suggest that a pecking-order theory of capital structure in

which companies will use retained earnings, then bank debt, then equity as the order of preferred

sources of finance may best explain Stolt Offshore’s capital structure. A 100% retention ratio,

followed by the use of bank debt and only then equity suggests that this theory may best explain

the decision to fully retain earnings as the first source of funds for investment, and then exploit

the moral hazard aspects of the banking relationships.


35

3. Strategic Uncertainty and the Coordination Problem

the workout game is not a financial numbers game, but rather an exercise in group dynamics”

Introduction

This paper focuses first on the problems caused by the uncertainty over both the likely behavior

of creditors, shareholders and managers (strategic uncertainty) 21 and the value of their claims

(fundamental uncertainty) once a company becomes distressed, and then on how the problems of

coordinating this behavior are solved in order to facilitate a successful restructuring. The second

paper in this project illustrated how a corporate strategy and a financial structure can result from

the legal and institutional environment in which the company is placed, and how this can give

rise to the problems described in the first paper in this project. Consequently, dealing with the

strategic uncertainty and the coordination problem is an essential prerequisite before the full

restructuring of a distressed company can be completed, but the solutions used may be as

dependant on the institutional environment as were the underlying problems.

The primary concerns of the claims holders are the value of their claims, the priority of their

claims, and how the total value of the firm is going to be divided up (Carapeto 2005). At its very

simplest, the coordination problem could be seen as the difficulty of getting a diverse group of

claimholders with different rights to agree to a single package of solutions in a zero sum game,

but as the strategic uncertainty increases, so does the variability of the potential outcome and

value. It is this interaction between the ultimate value of the company, and the negotiating

strategies used to get to it that explains the comment quoted at the head of this paper, and why

this issue is worth exploring.

Financial distress and its resolution impose costs on claimholders: transaction costs of resolving

the distress, as well as business disruption costs. Transaction costs largely vary by jurisdiction,

while business disruption costs vary by industry. In a theoretical, frictionless world, there would

be no such financial distress costs, because in the presence of a threat of such costs, claim holders

would always be able to negotiate a resolution that would avoid them 22 . These costs result from

interaction of the differing rights of creditors and shareholders in each jurisdiction when it is not

possible to irrevocably commit to never renegotiate a financial contract. The trade-off of

monitoring costs versus expected renegotiation costs in distress accepted by each party when the

debt was being negotiated has an impact on outcomes afterwards when the borrower has

repayment problems.

Any successful strategy for out-of-court negotiation must have underlying it a credible threat to

resort to court administration if either the likely total costs exceed that of an in-court

restructuring, or some parties decide to pursue their particular rights in a non-consensual manner.

However, if the costs and benefits of resolving financial distress out-of-court are capped by value

21 Morris and Shin, 2004

22 This is an outcome of the Coase Theorem that underpins much of the analysis of contracting failure in corporate

finance and theories of financial distress and its costs.


36

of the rights given to creditors in court-based proceedings, then any changes in the bankruptcy

codes, or changes in the identity and location of the parties involved, changes all the relative

bargaining positions. There are two developments that are changing the relative costs and

benefits of negotiating an out-of-court restructuring, and thus have an impact both on those

involved in restructuring distressed companies, and those that finance or invest in them. These

are the emergence of a mature market in the debt securities of distressed companies, and changes

in the bankruptcy and insolvency codes across the continent. Both sets of developments are

directly or indirectly leading to a weakening of the concept of absolute priority rules, and raising

new challenges for investors and for turnaround managers. These challenges include the manner

of managing strategic default, shareholder and creditor conflicts in asset sales and inter-creditor

conflicts over priority.

A role of the CRO in stakeholder negotiations is to persuade the stakeholders that there will be a

better recovery for all parties if none of them rush to grab the assets under any legal rights, but

rather, they allow a full workout of the problem. An additional stakeholder that may need to be

‘managed’ by the CRO is the management, who may well be in denial of the scale of the crisis

affecting the company at this time.

The layout of this paper is as follows. Section 1 looks at the decision whether to use informal or

formal resolution of corporate distress when there are different forms of strategic games present

in corporate behavior and stakeholders, and at the costs of those games. Section 2 looks at how

some of these games were played out in the case of Stolt Offshore and the role of the CRO in

negotiating through them. Section 3 considers first whether the financial restructuring led to the

optimal capital structure. In demonstrating that it might not have been optimal, it then shows how

the lenders protected themselves against any negative consequences. However, because there has

been no change to the underlying institutional environment, governance problems still remain.

1. Workouts, or Insolvency?

Given that the cost and coordination inefficiencies described in the introduction exists,

claimholders have the option of either trying to negotiate a resolution out-of-court, or of using the

courts. The choice made will depend on both the relative claimholder rights and the cost and

benefits for each alternative. Studies of the use of bankruptcy law around the world such as those

by Claessens and Klapper (2001) show this effect. In particular, by using the indicators

developed by LLSV (1998), they show that the variation of different rights between different

countries affects the likely use of bankruptcy law. For example, high levels of judicial efficiency

leads to more use of formal bankruptcy, and an absence of an automatic stay on assets leads to

less 23 .

Good examples of jurisdictions that represent opposite extremes of creditor rights are the UK and

USA. Studies of bankruptcy law around the world such as by Claessens and Klapper (2005) and

Franks and others, and work on ideal bankruptcy codes by the World Bank place most codes

somewhere between these two. In the UK (prior to the Enterprise Act 2002) the senior secured

creditors could seize their collateral without delay, regardless of the consequences to the business

or the other creditors, leading to possibly inefficient liquidations. In the USA, the absence of an

automatic stay on assets under Chapter 11 gives the debtor a chance to restructure the business

23 It is possible that the absence of an automatic stay leads to less risky behaviour by management.


37

before the creditors get their collateral, leading to inefficient extensions of corporate existence

but reducing the costs of financial distress.

The effects of these differences in rights have can be seen by comparing the creditor rights score

in LLSV (1998) with the outcome of bankruptcy usage in countries examined by Davydenko and

Franks (2005), as in Table 7 below:

Table 7: Creditor Rights Scores and Average Bank Recovery Rates

UK Germany France

Proportion of Bank 74% 60.6% 53.7%

Recovery Rates

Creditor Rights 4 3 0

Score

Source: LLSV (1998), Davydenko and Franks (2005)

The picture that emerges is that as creditor rights reduce, then in general, so do the creditor

advantages of out-of-court restructuring over bankruptcy. However, managerial and shareholder

motivation is an important factor in managing the costs as this relationship between the creditor

rights score and the recovery rates is not absolute. As an example, the USA, which scores just 1

on the LLSV (1998) creditor rights, gives the management the right to file for Chapter 11,

without the permission of the creditors, and then allows that management to remain in place.

Gilson (1997) demonstrates that in this instance, transaction costs are lower in Chapter 11 than

they are out of court, and companies end up with lower leverage on average at the end of the

Chapter 11 process than they do in an out of court arrangement.

As a consequence of this type of research, some characteristics of the restructuring environment

that may need to be present for the successful management of an out-of-court workout have been

published by the World Bank as part of their Report on Standards and Codes. These are shown in

Table 8 below. Of these 8 characteristics, characteristic 3 is really the outcome of characteristic 6,

while aspects of the German banking system described below suggests only limited applicability

of characteristic 7.

Table 8 Characteristics for a successful out-of-court financial restructuring as determined

by the World Bank.

1 A significant amount of debt owed to a number of main bank or financial

institution creditors.

2 The inability of the debtor to service that debt.

3 The attitude that it may be preferable to negotiate an arrangement for the

financial difficulties of the debtor—not only between the debtor and the creditors

but also between the creditors.

4 The availability of relatively sophisticated refinancing, security and other

commercial techniques that might be used to alter, rearrange or restructure the

debts of the debtor or the debtor itself.

5 The sanction that if the negotiation process cannot be started or breaks down


38

there can be swift and effective resort to the insolvency law.

6 The prospect that there may be more benefit for all through the negotiation

process than through direct and immediate resort to the insolvency law (in part

because the outcome is subject to the control of the negotiating parties and the

process is less expensive and can be accomplished more quickly without

disrupting the business).

7 The debtor does not need relief from trade debt, or the benefits of formal

insolvency, such as the automatic stay or the ability to reject burdensome

contracts.

8 Favorable or neutral tax treatment for restructuring both in the debtor’s

jurisdiction and the jurisdictions of foreign creditors.

Several of these characteristics are directly applicable to the case of Stolt Offshore, although

because they are so interconnected, they are difficult to analyze independently

Differences in Bankruptcy Codes: the COMI issue and Jurisdiction-Shopping

Despite the work of theThe European Commission Best Project on Restructuring, Bankruptcy

and a Fresh Start’ to produce proposals that could be become the basis of some commonality in

European law, a number of changes have occurred in European bankruptcy codes, but without a

consistent outcome. As examples, changes such as the introduction of the Enterprise Act in the

UK, the Insolvenzordnung in Germany, and the new bankruptcy law in Spain are making

insolvency laws in those countries much more equity-friendly. 24 In Italy, changes to the

bankruptcy code have made it more like the new French code, in which the claims of other

stakeholders such as employees or the state still rank above those of creditors or of shareholders.

While Article 3 of the European Insolvency Regulations implies that the proper place to start

such proceeding is in the country of the Head Office of the company it can be very difficult to

identify the CoMI for many companies. Subsequent to the adoption of this regulations, there have

been many incidences in Europe of courts in one country attempting to over-rule decisions in one

country that have an impact on a subsidiary in another.

The World Bank highlighted the importance of the threat of: ‘The sanction that if the negotiation

process cannot be started or breaks down there can be swift and effective resort to the insolvency

law’, so these differences between national codes have become important, because as at the same

time that companies have found themselves subject to the changing identities of their creditors,

those creditors have found that they may have little influence on the ability of multinational

companies to move their centers of main interest to jurisdictions more favorable to the

circumstances in which they find themselves.

This will have been an unintended effect of a ‘first-to-court’ provision that gives EU-wide

jurisdiction to the first court that rules. This has led to a number of examples of jurisdiction

shopping. For example, in 2005, a British company (Bluegrid) was made insolvent in Sweden

and a German company was made insolvent in Austria. In the USA, companies keep a foot-hold

24 As the jurisdiction in which creditors are located is also important, it is noteworthy that changes to the US

bankruptcy code have made it a little less equity-friendly than before.


39

in the southern district of New York because of the very debtor-friendly record of the bankruptcy

court there.

In the current case, the impact of this type of problem is evident from a comparison of the

behavior of Stolt Offshore with that of Petroleum Geo-Services (PGS), the company first

discussed in paper 2. Petroleum Geo-Services’s financial restructuring decision illustrates the role

of ‘jurisdiction-shopping’ in corporate planning and stakeholder negotiations after the onset of

financial distress, rather than the precautionary choice of location beforehand. At the same time

that Stolt Offshore was renegotiating its covenants in an out-of-court restructuring, PGS chose to

file for Chapter 11 in the USA. 25 It did this by relying on the fact that it had a just sufficient

share of its business in the USA to qualify, thus escaping the more onerous restrictions of courtsupervised

restructuring in Norway, run under a civil-law like regime, to one based more on

common law, but in which creditor rights are severely restricted.

An implication of Article 3 of the EIR is that rights are somehow consistent across the EU.

However, Stolt Offshore was run from the UK, registered in Luxembourg and joint-listed in

Norway. Given that Stolt Offshore was located in a jurisdiction with few creditor rights

compared to the location of PGS, it was more likely that it would remain where it was.

Highlighting the sensitivity of this particular issue, Stolt Offshore specifically refused to enter

any discussions of it whatsoever. 26

Another example of the problems caused by differences between jurisdictions is caused on tax

codes, and highlights the implication of the environment in which both creditors and borrower

are operating. While the World Bank’s calls for: “Favorable or neutral tax treatment for

restructuring both in the debtor’s jurisdiction and the jurisdictions of foreign creditors”, some

European countries, (and previously also Japan) have tax codes that only allow a creditor to

obtain a tax write-off of a bad loan if the borrower closes. Unless the percentage of the face value

of the debt that will be written off is greater than the tax rate in the country of the creditor, the

creditor will obtain a better economic result by closing down the company rather than allowing a

restructuring. More recent work on this subject (Johnson 2005) highlights that these tax

disincentives to restructure are more likely to occur in civil law countries than in common law

ones.

Strategic Games

The case of Stolt Offshore demonstrates how management, creditors and shareholders can all

play varying strategic games, and that these games usually result from information asymmetry or

other types of market failure. Some types of strategic uncertainty in corporate restructuring have

the characteristics of Prisoner Dilemma payoffs. In the Prisoners Dilemma, decisions taken by

individual actors may appear to be optimal to them, but the collective consequence of each

individual decision is that everyone is worse off than they would have been had they been able to

coordinate their decision-making. Examples of these situations are:

• Each claim holder determines that the outcome of the restructuring negotiations are

independent of their individual actions, and so that they fail to accept restructuring

25 The first Norwegian company to do so, according to Tyrhaug, (2003).

26 Email correspondence between the author and the Investor Relations department of Stolt Offshore


40

proposals that might leave them worse off than their notional claims, but better off than if

no agreement is struck and the company is liquidated.

• Management succeeds in persuading claim holders to accept a proposal to restructure their

claims, when they would be either better off, or at least no worse off, than by rejecting the

proposal (Gertner and Scharfstein, 1991).

• no party has an incentive to state what they believe to be the true value of the firm and their

claims. Consequently, debt holders have an incentive to undervalue the firm in order to

get a higher proportion of the total, while equity holder will have an incentive to

overvalue the firm to get a higher share. Junior claim holders will act either like senior

claim holders or like equity holders depending on whether they privately see any value of

their claim.

Two major influences on the scale of these games are the number of creditors and the distribution

of the size of the loans. Brunner and Krahnen (2004) make a number of findings that indicate

conditions under which out-of-court workouts can function, and which are anecdotally, at least,

confirmed in other countries too. These include:

The number of banks: The more banks that are involved in the pool, the more difficult it is to

get consensus – a finding consistent with the Bolton and Scharfstein (1996) arguments discussed

in the previous paper, However, they also find that this effect is not monotonic – if there are very

few banks then they are more likely to try to hang on to their positions, but negotiations gets

easier as the number increases, and then falls again (Figure 13). This reflects some of the

experiences related to the roundtable from which the quote that heads this paper is drawn. One

participant told the roundtable about negotiating with a group of 6 bankers:

“About 10 years ago, I sat in a room with six of the largest banks in America. The Bank of

America was there, Citibank was there, and we ended up negotiating for six months. We couldn’t

get the deal done because the various creditors in the room had written down the loans to

different levels. One guy had already written it down 25%, and he was more than willing to take

75 cents on the dollar in cash. The other guy was carrying the same loan at 80 cents on the

dollar, and there was no way in the world he was going to write his loan down”. 27

27 Sam Zell, at that time Chairman of Equity and Financial Management Company. The deal eventually got done by

packaging securities and cash in a way that allowed the most favorable treatment to each investor according to the

needs of their balance sheet, even though the actual value was the same for each.


41

Figure 13: Renegotiation Costs and Syndicate Size

Renegotiation

Costs

Syndicate Size

Source: authors illustration derived from results in Brunner and Krahnen (2004).

A perspective on what happens when a few more banks are added to the workout group came

from another speaker:

“Renegotiating our revolver was also easier because we did not have any small banks. Ten years

ago we had banks with exposures as little as $750,000 and we had to accommodate them all.

This time we have only major players, with a minimum loan of about $50 million. With just 38

lenders, you can get everybody into one room at one time”.

Share of loans: as the number of loans increases, so does the likelihood of free riding on

monitoring costs and negotiations. A factor that affects the likelihood of this happening is the

distribution of the shares of the outstanding debt. If there are one or two large debt holders, there

may be attempts to free ride on the monitoring before distress and negotiations after it. If the debt

is evenly distributed, this incentive is much reduced, particularly if it is realized by all the

syndicate members that no one has an incentive to monitor. However, there are some

contradictory signals generated by the lead banks. The first is an adverse selection problem, as

evidence suggests that the lead banks can signal private information they have about the quality

of the debtor by the proportion of the loan it retains for itself i.e. higher levels of retention

indicate a higher quality loan (Esty and Megginson, 2003). Working against this is the portfolio

affect within the lead banks, which may need to hold a lower proportion of the total debt due to

their internal diversification strategy than that required for an accurate signal to the market about

the quality of the borrower.

Strategic Uncertainty and the Costs of Financial Distress

A component of the decision over whether or not to proceed to an informal workout is likely to

be the result of an analysis of the costs. Four types of costs are relevant in this case: transaction


42

costs; business disruption costs and the costs associated with asset sales. A fourth set of costs are

those that result from strategic games and other forms of market failure.

Underlying the strategic uncertainty is an information asymmetry problem. For example, when

assessing restructuring proposals from management, claims holders are unable to tell if the

management has more complete information than they are providing. These market failures

impose an additional layer of costs in financial distress when they lead to premature liquidation,

or the destruction of value when they allow companies to survive too long. 28

A key role of a CRO is in unblocking these problems in jurisdictions where disclosure rules are

not as strong, and being able to make effective use of the threat to switch from informal to courtbased

restructuring. A potential cost of a ‘strategic game’ to claimholders is that they may endup

in a court restructuring when an out-of-court would have been better. In the USA, the full

mandatory disclosure clause of Chapter 11 helps removes the information asymmetry problem.

This is an example of how effective regulation can also contribute to lowering the costs of

financial distress costs.

Transaction Costs

Transaction costs arise primarily from the need to resolve conflicts between different groups of

stakeholders. These may include considerable professional fees to be paid, such as those for

insolvency practitioners, turnaround managers, lawyers and accountants. These costs may be

particularly exacerbated by information asymmetry as each participant employs its own advisors

to assess the situation, and then places these costs onto the restructuring. This was clear in the

case of Stolt Offshore where there were a large number of different advisors involved, including

seven sets of financial advisors and 25-30 legal firms.

Business Disruption Costs

Business disruption can be a major source of cost in financial distress and are estimated by

Passov (2003) at about 20% of the value of the company in the oil and gas sector. This is

probably higher in the case where economic distress is also present given the high asset

specificity typical of the oil and gas exploration sector.

Customers will expect to see that a business has the ability to survive to deliver what it is

contracted to, and concerns over this can be self-reinforcing if it leads to a rapid decline in the

level of business. Some examples demonstrate this. In the USA, the Chapter 11 filing by Delta

Airlines was reportedly caused by the bank that processes its Visa and MasterCard transactions.

The bank reportedly withheld some cash owed to Delta Airlines in case it filed for Chapter 11

protection, thus helping to precipitate the very act it was concerned about. In the UK, the Rover

Group was forced to stop trading when concerns by automobile parts suppliers that they might

not get paid led them to stop deliveries of the very parts needed to complete and sell the cars that

might have enabled the company to stay solvent. In Italy, Parmalat had to pay cash to dairy

farmers to ensure milk supplies.

Any part of the bankruptcy code that introduces resolution delays risks creating losses.

Discussions with turnaround practitioners suggest that a substantial part of a business can be lost

28 These costs might also include social costs, if companies are liquidated unnecessarily.


43

within just a few weeks after distress sets in. Chapter 11 restricts the rights of the creditors to

hold up reorganization plans, reducing the resultant disruption costs.

In the case of Stolt Offshore, the availability of performance bonds was a key part of the

company’s ability to generate business. They were partly backed by bank guarantees that were an

extension of its debt facilities, and partly by SNSA. Had these guarantees been cancelled during

the period of financial distress, this may well have led to the loss of the entire business. There

were in any event, some disruption costs. In particular, oil industry experts interviewed for this

project talk of the difficulties faced by Stolt Offshore in retaining key technical experts as cost

cutting sometimes made it difficult to pay competitive salaries for the top people.

Costs Related to Asset Sales

There are two important reasons for asset sales in a restructuring, and both are relevant to the

case of Stolt Offshore. These are firstly, to raise cash to pay down debt, and secondly, as part of a

strategy for implementing better management controls. (This latter issue is dealt with more fully

in the Appendix). There might also be business disruption cost if the asset sales results in the loss

of ability undertake the core business.

High asset specificity imposes indirect costs when asset sale proceeds are affected by the state of

the industry, as discussed in the second paper. These costs can arise indirectly prior to financial

distress. Company managers know that financial distress leads to increased management turnover

(redundancies) and reduced managerial compensation. This may lead to another strategic game in

which mangers sell core assets unnecessarily in order to prevent the occurrence of financial

distress that the claimholders could have resolved for themselves.

As part of its restructuring, Stolt Offshore undertook an extensive program of asset sales, selling

both physical assets such as ships as well as entire business divisions. Stolt Offshore’ assets took

two forms – companies that could be sold outright, and physical assets, particularly ships. Table 9

below provides an overview of the major assets of Stolt Offshore. Accumulated depreciation

figures prior to 2002 are interpolated. The bank loans were secured against some of the

company’s ships, as listed in the table. The company commissioned a valuation from a

shipbroker in September 2003. The Report and Accounts for 2003 noted that:

The broker provided guidance as to the prices that could be obtained under current market

conditions. These prices were at a level substantially below the carrying values of the ships, and

were confirmed by a formal valuation in January 2004.

Table 9: Fixed Assets of Stolt Offshore

Gross Value

Accumulated Depreciation

construction

support ships

operating

equipment

land and

buildings other assets TOTAL

construction

support ships

operating

equipment

land and

buildings

other

assets TOTAL

construction

support ships

operating

equipment

land and

buildings

other

assets TOTAL

1998 270.2 247.2 17.0 14.9 549.3 -80.6 -53.2 -3.2 -3.5 -140.5 189.6 194.0 13.8 11.5 408.8

1999 333.0 239.8 21.4 20.2 614.3 -102.2 -67.6 -4.0 -4.4 -178.2 230.7 172.2 17.3 15.8 436.1

2000 711.1 281.8 19.9 30.2 1,043.0 -133.5 -88.2 -5.3 -5.7 -232.6 577.6 193.6 14.6 24.5 810.3

2001 715.4 322.3 20.0 38.7 1,096.3 -181.8 -120.1 -7.2 -7.8 -316.9 533.6 202.2 12.8 30.9 779.5

2002 768.4 354.4 20.6 45.2 1,188.6 -232.8 -153.8 -9.2 -10.0 -405.8 535.6 200.6 11.4 35.2 782.8

2003 618.5 277.3 24.2 13.3 933.3 -240.2 -158.7 -9.5 -10.3 -418.7 378.3 118.6 14.7 3.0 514.6

2004 623.1 279.6 38.6 14.8 956.1 -276.0 -154.9 -11.5 -13.9 -456.3 347.1 124.7 27.1 0.9 499.8

Source: 10-K Filings by Stolt Offshore

NBV


44

This statement highlights the problem of relying on highly industry-specific assets described by

Shliefer and Vishny (1992) and Pulvino (1998). Over the previous two years, there had been a

significant fall in the profitability of the main companies in the 1389 group that might account for

the fall in the resale value of the assets, The company acknowledges in its documents that its

ships (in particular) are very specialized and have very little use outside the oil services industry

This fall in asset resale value, in combination with other asset value problems, led to a US$176

million charge for fixed asset impairment in the 2003 accounts and suggests that the companies

debts were not matched by collateral to the extent that the banks thought they were.

Resale values may by affected by the choice of jurisdiction in a restructuring. If the company

sells assets within a court-based system in which the liabilities associated with the asset such as

environmental clean-up costs for oil companies are retained with the seller, not the asset, then this

leads to a likelihood of more bidders for the asset and higher realized prices.

However, asset sales can lead to conflicts between debt holders and shareholders and between

management and all classes of claimholders. If the asset base is reduced, and the proceeds are

used to pay down the most senior debt then there is a transfer of value from the shareholders to

the debt-holders and a decline in both the share prices and the remaining debt price when the

sales are announced (Asquith, Gertner & Scharstein, 1994). The debt price may fall because there

are now fewer assets to support the remaining junior creditor claims. A particular concern in the

case of Stolt Offshore was that the share price might fall because the reduction of the asset base

would lower the growth rate of the company as it emerges from financial distress.

Development of the European Distressed Debt Market

A major change in the coordination problem has come about due to the development of a market

for distressed European debt. Singer and Burke (2004) document how the secondary market for

leveraged assets really took off in the late 1990’s with the telecoms and media business debt

particularly prominent. Since then, secondary markets for bank debt have developed also.

However, these markets still remain largely opaque and are not widely traded.

One explanation of the growth in the market for distressed securities is changes in the banking

regulatory regime – particularly Basel II. To date, the types of companies described in the second

paper of this project have been a good source of business for the banks, but changes in the

banking regulatory regime such as Basel II have led to higher capital adequacy costs when those

lending clients become distressed. Consequently, a market has developed for these distressed

loans as banks have sought to remove them from their balance sheets. Figure 14 below shows the

evolution of this market.


45

Figure 14: The Emergence of The European Leverage Loan Market

800

140

700

120

600

100

500

80

400

60

300

200

40

100

20

0

1999 2000 2001 2002 2003

0

Volume

Number of Deals

Source: Singer I., Burke J (2004)

The evolution of the market has brought in a wide range of investors and a diverse range of

investment strategies – not all of them consistent with the goals of lenders. The analysis of these

strategies involves a different skill than conventional investment approaches and analysis. An

outcome of section 2 of this project is that very often, the decisive factor in determining the

success of an investment in a European country is an understanding of the bankruptcy codes and

capital structure rules that derive from it. The different approaches include:

1. Special opportunity funds that look to buy debt securities at significant discounts and

profit as companies work themselves out of the troubled situations. This can include strategies

such as buying the bonds of distressed companies, and simultaneously selling short the company

stock. Profit will be maximized if the bonds are repaid but the original equity is worthless.

2. Finance investors that concentrate on active participation in restructuring the balance

sheet. This might involve buying sufficient debt to block a restructuring arrangement, and then

force the existing equity holders to make concessions.

3. Control investors that intend to not only restructure the balance sheet but also take an

active role in the management of the company. This is typically private equity fund territory, but

is increasingly drawing the attention of hedge funds, thus blurring the boundary between the two

types of investors.

However, the case of Stolt Offshore illustrates the returns to engaging with the company’s

structure. The second paper in this project showed the equity valuation discount resulting from

structures that compromise minority shareholders rights. Investors that are able to take action to


46

resolve this problem can give capture additional profits that may not be available from other

strategies.

These different strategies and the differences between the bankruptcy and corporate governance

codes in different European countries have added considerable complexity to the coordination

problem when rescuing failed European companies in a number of ways. Firstly, although banks

prefer their debt to be the most senior, and for market debt to be subordinated to it, banks have to

respond to the demands of distressed debt investors for access to collateral as an investment

condition (Roberts 2004), thus making the application of absolute priority rules in liquidation

much less clear.

Secondly, short-term traders may be willing to accept negotiated outcomes that might be deeply

unsatisfactory for original lenders that are still involved in the company. For example, if a hedge

fund buys debt at 40%, uses its APR position as a negotiating tool, and very quickly is able to get

an agreement to restructure all the debt at 50%, then it may book significant profits with a higher

IRR than waiting for extended negotiations to complete. Those lenders still holding the debt face

a 50% write down on their investment. This is perhaps the starkest example of how strategy and

value can be interlinked.

Finally, the problem can be exacerbated and negotiations unwound when investors are involved

in the negotiations, but see an opportunity to trade out of the debt at a critical moment just before

the deal is signed.

Companies in financial distress that find their debts held by short-term debt traders rather than

the relationship banks from where they borrowed might not always benefit these strategies. The

investment strategy described in the previous paragraph may be benign for distressed companies,

but other short-term strategies such as seizing and redeploying the available collateral in

situations in which a relationship bank might be prepared to work with the borrower can have

pernicious effects.

The evolution of the distressed market really highlights the two main types of uncertainty

discussed in this paper. It also demonstrates that more accurate fundamental valuation techniques

do not allow a complete answer to what will happen to a company in the absence of information

about the incentives and about the regulatory or governance regimes of some of the creditors or

other actors.

2. Strategic Uncertainty at the Corporate Level: Was there Strategic Default?

One type of ‘game’ worth examining in the case of Stolt Offshore is Strategic Default. 29 This is a

voluntary default. Equity holders may decide to default strategically when they determine that the

value of assets has fallen to point where the option value of continuation is too low to be viable

and liquidation becomes preferable. It can occur when it is management know that it will

expensive for the creditors to liquidate a firm – perhaps – as in the case of Stolt Offshore -

29 There are two principal types of default: payment defaults, in which a company fails to meet payments on time,

and technical defaults, where the company is in breach of a covenant or other condition, allowing the creditors to

force reorganization (Bolton & Scharfstein 1996).


47

because the assets are highly specific and are in an industry in a downturn, leaving the debt

holders unable to call on the collateral.

Research into the location of the point at which shareholders would consider it optimal to default

strategically on debt has not yielded any clear indication of where the default point lies

(Davydenko 2005). The difficulty is in separating out what a company is worth in liquidation

from its continuation value i.e. at any time except at the moment of liquidation, the value of the

company includes some value of an option to continue operating in the hope of recovery. This

problem makes determining whether there was a strategic element to the default quite difficult.

One possible answer is in the work of Crosbie and Bohn (2003) who claim that default typically

occurs when the value of assets is less than the sum of the short-term debt plus half the long-term

debt. They use a proprietary model within the KMV/Moody’s credit rating service, so they never

explain the origin of this formula.

The relationship between the enterprise value of Stolt Offshore and its debt is shown in Figure 15

below. It illustrates how precarious the shareholders situation became in the period between the

defaults, using data provided in the quarterly reports.

As the debt was privately traded, there is not much information about the market value of the

debt except a small number of recorded quotations by a market maker, but if at the end February

2003 the debt had been trading at much less than 75% of its face value due to the problems,

enterprise value would have been less than the net debt – in other words, the shareholders might

well have had an incentive to strategically default unless the option value of continuation was

high enough to make it worthwhile putting in more money to prevent premature liquidation.

An alternative methodology is to use options-pricing theory to extract the value of the company

from the equity prices, the face value of the debt, and the equity volatility using Black and

Scholes. Option pricing is applicable because the equity can be seen as a limited liability claim on

the value of the assets after all the debt has been repaid.

This technique allows for only one class of debt – a zero coupon bond with one final payment

date. Stolt had only its bank debt, with a fixed term that ended in 2005. However, the covenants

allow for the debt to become fully repayable if the Debt/EBITDA limits are breached. Using

Black and Scholes therefore presents a lower bound to the value of the company by assuming that

the debt is only repaid at the end of the revolver term.


48

Figure 15: Enterprise Value and the Face Value of Debt

1,800,000

1,600,000

1,400,000

1,200,000

US$ Value

1,000,000

800,000

600,000

400,000

200,000

0

-200,000

Feb-00

Apr-00

Jun-00

Aug-00

Oct-00

Dec-00

Feb-01

Apr-01

Jun-01

Aug-01

Oct-01

Dec-01

Feb-02

Apr-02

Jun-02

Aug-02

Oct-02

Dec-02

Feb-03

Apr-03

Jun-03

Aug-03

Oct-03

Dec-03

Net Debt (Face Value) Equity Market Capitalization Enterprise Value

Source: authors calculations from data in Stolt Offshore quarterly reports

Feb-04

Apr-04

Jun-04

Aug-04

Oct-04

Dec-04

Feb-05

Apr-05

Assuming that the value of the company follows a Wiener process as outlined by Black and

Scholes (1973), then Crosbie and Bohn (2003) show that the terms described above are

connected by the following expressions (1) and (2)

−rt

V = V N( d1) − e XN( d2)

(1)

E

A

Where Ve is the value of equity; Va is the value of the company; X is the face value of the debt,

and r is the yield on US treasury bonds 30 , and where

2

ln( V σ

A

A

X

) + ( r+

)* T

d1

= 2 and d2= d1−

σ

A

T

σ T

A

The volatility of the assets can be found from solving equations (1) and (2) jointly as pair of

simultaneous equations.

VA

σ

A

= ∆ σ

E

(2)

V

E

30 Sourced from the Federal Reserve website


49

Figure 16: Enterprise Value Implied from Black & Scholes & Face Value of Long-Term Debt

1,200,000

1,000,000

800,000

600,000

400,000

200,000

0

Feb-

02

Mar-

02

Apr-

02

May-

02

Jun-

02

Jul-

02

Aug-

02

Sep-

02

Oct-

02

Nov-

02

Dec-

02

Jan-

03

Feb-

03

Mar-

03

Apr-

03

May-

03

Jun-

03

Jul-

03

Aug-

03

Sep-

03

Oct-

03

Nov-

03

Dec-

03

Jan-

04

Feb-

04

Long-term debt and capital lease obligations

Implied EV

Source: Authors’ calculations from data extracted from Annual Reports and NASDASQ

Figure 16 above shows graphically the enterprise value calculated from solving the equations,

deriving what is likely to be the upper bound of the market value of debt. As there are no options

on Stolt Offshore, volatility was calculated from annualized standard deviation of the logarithm

of the daily equity returns of the NASDAQ share price.

As can be seen, the consequences of the fact that the debt probably fell to little more than 50% of

its face value following the first announcement of impending default and the third profit warning,

is that enterprise value probably fell below the face value of the debt at the end of 2002, but does

not appear to have dropped below the potential default point of the sum of the short-term debt

plus 50% of the long term debt identified by Crosbie and Bohn (2003).

There were also market factors in play also at this point, as around this time distressed debt

market indicies such as those compiled by the NYU Salomon Centre, Merrill Lynch and CSFB

were all showing steep declines in valuations of distressed debt, as the default rate on these

instruments increased substantially from about 2001. Data for the value of Stolt Offshore debt is

available for parts of 2004, and when combined with the implied prices from the options

valuation, shows a valuation that partly reflects the path of the distressed debt markets overall

(Figure 17).


50

Figure 17: Distressed Debt: Market to Face Value Ratios

0.90

Defaulted Debt Indexes:

Market-to-Face Value Ratios

(Annual 1986 – March 2005)

0.80

Market-to-Face Ratio

0.70

0.60

0.50

0.40

0.30

0.20

Loans Median

Loans

Bonds M edian

Bonds

0.10

0.00

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Mar-05

Loans Median Market-to-Face value is 0.62 and Average M arket-to-Face value is 0.63

Bonds Median Market-to-Face value is 0.45 and Average M arket-to-Face value is 0.39

Source: Altman-NYU Salomon Center Defaulted Debt Indexes

One possible course of action open to the shareholders was to put up more equity capital, or to

lend the firm more money in the form of new debt that was subordinate to that of the banks as

allowed by the covenants, in order to lower the debt. Consequently, significant questions arise

over why the shareholders allowed these defaults to happen.

It is arguable that they assumed that the debt holders did not understand the relationship between

the parent company and the subsidiary - in particular, that there was no direct claims on the

parent company assets, so it is possible that the banks might would not have allowed debt levels

to get where they did.

For the shareholders, the liquidation of strategic assets such as its ships at the time of a market

downturn and the fact that default would have led to the cancellation of the performance bond

thus ending the ability to bid for contracts implies that the cost of default may have been very

high. In this particular instance, the banks insisted that SNSA put up a $50 million credit line for

the company as a condition of the covenant waiver.

3. Strategic Uncertainty At The Claimholder Level & The Role of the CRO

Solving the different strategy games and conflicts that can occur in restructuring is perhaps the

principal challenge of stakeholder negotiations and for a Chief Restructuring Officer (CRO).

Interviews with turnaround managers conducted for this paper have highlighted the need for the

CRO to understand both the incentives and the possible restrictions on creditors. These include


51

the tax issue described above, and the fact that each claimholder may be testing the offers

available against the alternative of forcing a switch to a court-based administration.

The case of Stolt Offshore represents a good example of the strategic uncertainty problem and of

how the role of the CRO has developed in a way that helps resolve it. Figure 18 below illustrates

the complexity of the task in this case. The stakeholder map - drawn from a company

presentation given during the restructuring period – shows the interrelationship between the

various different groups of advisors and their clients, in addition to the direct creditors of Stolt

Offshore.

Figure 18: Stolt Offshore Stakeholder Map

Alix

Partners

Pareto

Houlihan Lokey

Akin Gump

Delingscheider

Noteholders

$28m FX

SNSA

Lessors

SNSA

Minority

shareholders

ABG Sundal

Unencumbered

Brunswick Collier

Assets $100m

$150m Asset

$150m Long Term

Sales MBLY

Restructuring

$ Restructuring

Value over $ Impairment

W & C

LTV $170m $ Revenue Recognition

Cashflow Positive

$ Projects

Linklaters

SNSA $200m Liquidity

Earnings

SNSA $50m

$125 - $???m

Liquidity

SOSA

Clients

New Equity

Covenant Waivers

Debt Bonds

15 Oct 26 Nov ???

19 Banks

$100m Working

Capital

6 Banks 7 Banks

CoComm

$100m

bonds

Unsecured

New Business

$252m

bond

Renewals Resolution of OGGS,

3 Banks

Hubline and Burullus

Secondary

KPMG

WGM

Asset Sale

Proceeds

$350m Revolving

Bond Line

©

Bank Market

25-30 Legal firms, 7 financial advisers, 120+ creditors

________________________________________________________________________________________________________________________________________________

Source: Stolt Offshore

The reason for this complexity was that several of the banks in the syndicate had sold some, or all

of their debt to other financial institutions. Although the syndicated bank debt started as a

syndicate of 19, by the time the negotiations started, there were over 120 creditors, illustrating the

problem that can arise from the development of the secondary market in bank debt.

Additionally, although there were only few asset classes in the capital structure of Stolt Offshore

– bank debt (with the highest priority claims); debt to Stolt Nielson, and equity, the financial

structure was actually more complex than this list suggests. In fact, there were several sets of debt

and obligations, and stakeholder groups involved. These included:

the secured Revolving Credit facility

• Performance Bonds


52

the guarantees issued by Stolt Nielson SA to the Stolt Offshore lenders, underwritten by

SNSA’s lenders and backed by unsecured tradable notes

• debt issued to the sellers of the company’s purchased by Stolt Offshore

To complicate matters, some of the banks involved in Stolt Offshore’s revolving credit facility

were also part of the original syndicate of loans and performance bonds of SNSA as negotiated in

1996, and were therefore caught up in cross-default clauses between the loans. A further

complication was that several of the banks in the syndicate had sold some, or all of their debt to

other financial institutions.

The banks agreed to give the company sufficient time for a financial restructuring only on the

condition that the company agreed to the appointment of a Chief Restructuring Officer among the

changes. Once appointed, the CRO undertook an extensive round of meetings with creditors. The

achievement of the CRO was to secure the agreement of all parties – the shareholders, creditors,

management, and other stakeholders, in the face of the coordination and hold-out problems, and

the different regulatory regimes of the many different stakeholders involved.

Initially, there was no consensus among the stakeholders about how to proceed. Interviews

undertaken by the CRO among some financial institutions suggest that some of them regarded the

task as being only to repair the company to the point where it could be sold. Then in October

2003, some of the syndicate banks that were considering whether to liquidate the company

commissioned a valuation from a major management consultancy. The report apparently 31

concluded that the senior claimholders could get $0.75 per $1 of debt if the company were

liquidated. This valuation was in line with the market price of the debt at that time as quoted by

the special situations desks of the banks, although lower than the theoretical valuation of $0.85

per $1 implied by the options valuations used above (Figure 25, in Note 3, page 72, illustrates the

small sample of actual debt prices made available to the author). The CRO set out to demonstrate

that the consultancy firms’ valuation was too low, and that the company was worth rescuing. As a

result of this, the relationship banks became more supportive of the company and the various

waivers were extended into April 2004.

A key step for a CRO is to determine from the institutions involved the critical factors that are

most likely to lead them to support a financial restructuring, rather than liquidate the company.

In the case of Stolt Offshore, the 6 problems that were most emphasized by the creditors as in

need of resolution, in order of importance, were:

Corporate Governance (c. 80% of responses)

• Bonding

• Lack of Parental Support

• Viability Backlog (


53

By effectively determining the core requirements of the stakeholders, the CRO was able to create

the conditions in which the negotiations – however hard they later proved to be – could take

place.

The value of the debt that would need to be covered by the restructuring is shown as of the end of

2003 in Table 10. The exact seniority position of the Other Liabilities would have depended on

the jurisdiction in which a formal insolvency process would have taken place – an issue the

company refused to discuss. For example, the short term liabilities include staff costs, while the

long-term liabilities includes pension costs. The recapitalization would need to cover the longterm

debt and probably the short term credit lines as these came from the same banks as the longterm

debt. It was always likely that SNSA would convert their debt to equity.

Table 10: Liabilities of Stolt Offshore

2002 2003

Long-term debt and capital lease obligations 335.0 293.5

Current maturities of long-term debt and capital lease obligations 0.0 91.5

Bank overdrafts and lines of short-term credit 16.0 2.5

Short-term payables due to Stolt-Nielsen S.A. 0.6 18.4

Subordinated note due to SNSA 0.0 50.0

Accounts payable and accrued liabilities 387.6 430.8

Other Short Term Liabilities 151.6 200.4

Others Long Term Liabilities 50.8 48.3

Total Liabilities 941.6 1,135.4

Source: Balance sheet

It was previously shown using options valuation techniques that the enterprise value was

probably less than the face value of the long-term debt at the end of 2002. Those results also

suggested that the company’s situation changed sufficiently by the end of 2003 that the enterprise

value implied by options pricing now exceeded the face value of the debt. As such, the model

valued the equity as an out-of-the-money call option on the assets at $1.26 33 .

In the event of liquidation, the salvage value of Net PPE + Realizable Current Assets 34 –

Impairment Charges was about $930 million, suggesting that unless the senior creditors were able

to enforce absolute priority rules, creditors would get only 82% of their face value if the junior

creditors could force an identical settlement in all creditor classes, and there would be nothing for

the shareholders. This figure is close to the estimated value of the debt at 85% of face value that

was provided by the options valuation.

were focused on the corporate governance and on resolving the bonding issue, which is closely linked to preventing

further strategic default.

33 After converting the Stolt-Nielson debt to equity.

34 Including cash.


54

Changes to the Equity Structure: Resolution of Debt Overhang and Hold-Out Problems

Prior to the restructuring, Stolt Offshore’s equity structure changed only occasionally, with shares

issued either in connection with employees exercising their share options; used to pay for

acquisitions, or issued to SNSA as a conversion of debt. In February 2004 the company was able

to raise a considerable amount of new equity finance to pay down some of the debt and provide

working capital resources to the company. In addition, in April 2004, some of the debt owed to

SNSA was converted into equity. Although the non-voting shares had been converted to common

share before the restructuring started, the split capital structure was removed by a new group of

Norwegian investors into the company, who demanded the cancellation of the B shares and their

conversion to the economic equivalent of common shares but without any allowance for a control

premium. In doing so, they broke through both the debt overhang and hold-out problems

affecting the negotiations.

By December 2003, it was already clear that the company was going to need a considerable

degree of additional cash – possibly as much as $180 million. A group of Norwegian investors

offered to purchase $75 million in value of new shares at $2.20 per share, but with a set of

conditions, some of which the management apparently rejected, but which are not public.

In January 2003, the company and the investor group agreed on a larger placement on improved

terms. Critically, the company used this offer to secure the agreement of the banks to renegotiate

the outstanding debt. It may have been this offer that effectively removed the debt overhang

problem. The January agreement also had the effect of reducing the SNSA shareholding below

50%, thus deconsolidating the company from its parent.

On February 11 th the company held an EGM in Luxembourg in which some of the existing

shareholders – dominated by the Stolt-Nielson family and their company’s - voted to suspend the

pre-emptive purchase rights of the minority shareholders, i.e. there was a forced dilution of

existing shareholders. On February 12 th , the $50 million Subordinated Note issued to SNSA

became due, although it is unclear if Stolt Offshore could have met this without dropping below

minimum working cash requirements. The new bonding facilities and the debt restructuring took

place on the same day. On February 13 th the company placed the 45.5 million shares at the

revised terms with the investors, although the price was maintained at $2.20. A decision was also

taken to sell a further 29.9 million shares to existing shareholders with the exception of those

who participated in the 45.5 million shares issue, and at the same price.

The private placement was the most significant placement of new shares undertaken by the

company. New investors bought 45.5 million shares $2.20 per share, even though the Air’s

closed on the previous day at $2.80. A few days later the price peaked at $3.90, a level that was

only surpassed in August 2004. The company justification of the discount was that it had been

agreed in mid-December 2003, although it effectively gave a free option to the buyers. However,

an alternative rationale is that this increase in the price of the common stock may have

represented a revaluation of the common stock given the removal of the control rights, and in line

with the findings of Anderson et al (2003) on the affect on value of non-proportionality.

An assessment of what happened can be seen from a valuation of the company based on the

situation in December 2003/January 2004. This is based on the ‘BluePrint’ created by Ehret and


55

Jackson, who envisaged a series of asset sales to raise $100-150 million to pay down debt, new

equity capital, and a 21% reduction in the headcount resulting both from those sales and costreduction,

particularly of SGAE. The asset sales were also expected to reduce revenue by about

15% in the short term..

As a result of the rapidly changing debt/equity ratio within these scenarios, the valuation of Stolt

Offshore presented here uses Adjusted Present Value. The Net Operating Losses are discounted

at the cost of equity, assuming industry-wide capital structure, the primary cash flows are valued

at the return on assets and the tax shield is valued at the cost of debt. This latter is influenced

heavily by the restrictions on dividend payments and other cash distributions placed on the firm

by the banks.

Table 11: Valuation of Stolt Offshore at The End of 2003 Assuming Resolution of the Debt

Overhang Problem

Cash Flow Value 51,444

Terminal Value 731,882

Interest Tax Shield Value 31,065

NOL Tax Shield Value 119,493

Enterprise Value 933,884

Debt 345,500

Value of Equity 588,384

Price per Share 6.3

Source: based on company documents and authors assumptions

Return on Assets 8.5%

Cost of Equity 12.5%

Cost of Debt 7.0%

Terminal Growth Rate 3.0%

No of shares 93,000

Tax Rate 33.5%

Capex Multiple 14.0%

Depreciation Rate 8.5%

Target Operating Margin 11.5%

The cash flow model shown assumes that these restrictions are all lifted at the end of the current

debt contract, following which the firm targets a Debt service ratio of 8. The values of the

described inputs are shown in Table 11. 35 The detailed scenario underlying it is shown in Table

12.

35 Although the $50 million subordinated debt was due on February 12 th 2004, the fact that the company could

exercise the conversion feature until December 2004 suggests that it had a potential life of longer than 1 year, which

was still the case in November 2003. For this reason, the company’s decision to list the Subordinated Note as a

Current Liability in the 2003 Report and Accounts has not been followed in valuations for this project, where it has

been added to the long term debt figure in Table 11.


56

Table 12: Sample Cash-Flow Forecast and Valuation As of December 2003

Actual Forecast as Might Have Been Seen By Potential Large Investors During Negotiations in December 2003

ummary)

Year 2003 2004 2005 2006 2007 2008 2009 2010 2011 Terminal

Value

REVENUE 1,482,300 1,259,955 1,297,754 1,336,686 1,376,787 1,418,090 1,460,633 1,504,452 1,549,586

COGS, SGAE. Etc 1,561,532 1,220,141 1,158,419 1,185,438 1,213,009 1,234,050 1,262,535 1,276,544 1,313,467

depreciation 107,500 39,814 42,003 44,314 46,751 49,322 52,035 54,897 57,916

1,669,032 1,259,955 1,200,422 1,229,751 1,259,760 1,283,372 1,314,570 1,331,440 1,371,383

Margin -12.6% 0.0% 7.5% 8.0% 8.5% 9.5% 10.0% 11.5% 11.5%

Impairment of Fixed Assets 176,000

Restructuring & Others 17,800 20,000

Asset Sales 100,000 50,000

EBIT -380,532 -120,000 47,332 106,935 117,027 134,719 146,063 173,012 178,202

Interest Expense/Received -23,700 -14,812 -15,765 -18,588 -14,335 -9,164 -1,154 6,266 -2,287

Profit Before Tax -404,232 -134,812 31,567 88,347 102,691 125,555 144,910 179,278 175,915

Tax Before NOL's 0 0 10,575 29,596 34,402 42,061 48,545 60,058 58,932

Net Income -404,232 -134,812 20,992 58,751 68,290 83,494 96,365 119,220 116,984

EBIAT -253,054 -79,800 31,475 71,112 77,823 89,588 97,132 115,053 118,505

depreciation 107,500 39,814 42,003 44,314 46,751 49,322 52,035 54,897 57,916

Capex -21,895 -65,575 -69,182 -72,987 -77,001 -81,236 -85,704 -90,418 -95,391

change in NWC -150,000 25,000 50,000 5,150 5,305 5,464 5,628 5,796 5,970

FCF -17,449 -130,562 -45,703 37,288 42,268 52,210 57,835 73,735 75,059 1,405,655

NPV -120,333 -38,823 29,193 30,499 34,722 35,450 41,655 39,081 731,882

Opening Cumulative NOL -101,000 -505,232 -640,044 -608,477 -520,130 -417,439 -291,884 -146,975 0

Current NOL -404,232 -134,812 0 0 0 0 0 0 0

Taxable Profit 0 0 31,567 88,347 102,691 125,555 144,910 179,278 175,915

Shielded Income 0 0 31,567 88,347 102,691 125,555 144,910 146,975 0

Closing NOL -505,232 -640,044 -608,477 -520,130 -417,439 -291,884 -146,975 0 0

NOL Tax Shield 0 0 10,575 29,596 34,402 42,061 48,545 49,237 0


57

NPV NOL Tax Shield 0 0 8,355 20,786 21,477 23,341 23,946 21,588 0

Interest Paid -27,100 -20,545 -21,498 -19,600 -14,700 -9,664 -3,277 0 -9,287

Interest Received 3,400 5,733 5,733 1,012 365 500 2,123 6,266 7,000

Total -23,700 -14,812 -15,765 -18,588 -14,335 -9,164 -1,154 6,266 -2,287

Tax Saving 7,940 4,962 5,281 6,227 4,802 3,070 387 -2,099 766 19,729

NPV Tax Shield 4,637 4,613 5,083 3,664 2,189 258 -1,307 446 11,483

Opening Net PPE 554,000 468,395 494,157 521,335 550,009 580,259 612,174 645,843 681,364

Capital Expenditure 21,895 65,575 69,182 72,987 77,001 81,236 85,704 90,418 95,391

Depreciation 107,500 39,814 42,003 44,314 46,751 49,322 52,035 54,897 57,916

Net PPE 468,395 494,157 521,335 550,009 580,259 612,174 645,843 681,364 718,839

Debt Service

EBITDA -97,032 -80,186 89,335 151,248 163,778 184,041 198,098 227,909 236,118

Interest -23,700 -14,812 -15,765 -18,588 -14,335 -9,164 -1,154 6,266 -2,287

Tax -7,940 -4,962 -5,281 -6,227 -4,802 -3,070 -387 12,921 58,165

Less Capex -21,895 -65,575 -69,182 -72,987 -77,001 -81,236 -85,704 -90,418 -95,391

Less Change in NWC -150,000 25,000 50,000 5,150 5,305 5,464 5,628 5,796 5,970

Cash to Repay Debt 15,313 -180,612 -40,331 60,750 71,939 91,247 105,999 125,040 74,305

Opening Long Term Debt -335,007 -293,500 -307,112 -280,000 -210,000 -138,061 -46,815 0 -132,673

Opening Long-Term Debt to Stolt

-50,000

Nielson

Equity Issues 167,000

Cashflow -180,612 -40,331 60,750 71,939 91,247 105,999 125,040 74,305

Other Funding Changes (Net) -50,000 50,000

4cast Psotion -307,112 -347,442 -219,250 -138,061 -46,815 59,184 125,040 -58,368

Maximum Allowable Debt -350,000 -280,000 -210,000 -140,000 -70,000 0 -132,673

Additional Debt Repayment Needed 67,442 9,250 0 0 0 0 58,368

Transfer to Reserves 0 0 1,939 23,185 59,184 257,712 0

Closing Debt -293500 -307,112 -280,000 -210,000 -138,061 -46,815 0 -132,673 0

Opening Cash Balance 81,900 81,900 14,458 5,208 7,147 30,332 89,517 100,000

Cash To Settle Shortfall 0 -67,442 -9,250 0 0 0 0 -58,368


58

Cash To Reserves 0 0 0 1,939 23,185 59,184 257,712 0

Closing Cash Balance 81,900 81,900 14,458 5,208 7,147 30,332 89,517 100,000 100,000

Debt Service Ratio 0.57 -8.79 -1.88 3.10 4.89 9.44 32.34 0.00 8.00

The derivation of the asset beta is shown in Note 1 and the derivation of the tax rate used is shown in Note 2. Capital Expenditure and

depreciation are both driven by the PPE figures shown in the table except for the first two years in which capital expenditure is heavily

reduced.


59

This particular scenario shown has been prepared from the perspective of intending large

investors assuming that the recapitalization would occur as a result of their investment as

described above. This valuation suggests that if the company is first recapitalized, and then

achieves target operating margins and capital expenditure ratios in line with the rest of the sector,

then a share price of $6.30 seems possible.

The Hold-Out Problem At Stolt Offshore

In alternative scenario in which the company only raises a small amount of money but

insufficient to continue as a going concern, the company would have been liquidated with no

remaining value to the shareholders as the new money gets used to redeem debt. Consequently, it

would not have make sense for small minority shareholders to make an investment, as they could

not be sure that enough other investors would do so in order to save the company. The optimum

position for most small shareholders is therefore to hold back from further investment.

However, an investment would make sense for a few large shareholders if they knew that

between them, they could eliminate the debt-overhang problem. An alternative solution would

have been that an underwriter agrees to buy the unsold equity in a public share offering, but given

that the company was in financial distress, the fees involved given that the underwriter may have

been left with the stock may have been substantial.

A probability-weighted valuation in the absence of the recapitalization knowledge as described

above must be significantly lower than $6.30, but above the pure option valuation of $1.26. In a

purely binary outcome of $6.30 or $0, a 50/50 chance of a successful outcome would value the

company at $3.15, a little above the highest price of $3.29 that traded during the negotiation

period 36 . Immediately after the negotiations were complete the price rose to $3.90 intraday, and

reached a share price of $6.30 in December 2004.

The Private Placement does highlight some of the problems for minority shareholders that were

raised by LLSV (1998). The minority shareholders suffered a 52% dilution initially from the new

share issues and the debt conversion. However, it does seem questionable that a conventional

fund-raising would have been successful because of both the debt overhang and hold-out

problems. In this example, a small investment in Stolt Offshore would have been worthless, as it

would have improved the payout to debt holders, but without improving the chances of the

company’s survival. The fact that speed is essential in a restructuring may have played a role.

The Investor Relations department of Stolt Offshore said 37 :

“Norwegian investors can be relied upon to support any company which is fundamentally sound.

In our case the Oslo financial community knew us well. They were aware of our problems and

had seen us bring in a new management team with a clear plan to turn the company around.

Unlike the US, where it takes you three months to get a prospectus ready to go, if the SEC decide

36 A valuation of Stolt Offshore by multiples from an analysis of the Compustat data shows that in both 2002 and

2003, companies in the 138 SIC code group traded at an average Enterprise Value/Sales ratio of 2, which if it were

not for the financial distress, would value Stolt Offshore at $13 per share – close to its highest price in 2005.

37 Source: correspondence from Stolt Offshore, September 29, 2005


60

not to review, in Oslo you can solicit commitments to raise the cash first and write the prospectus

later”.

Arguably, this strategy did benefit the minority shareholders. They were given the opportunity to

increase their shareholdings at the same price as the other new investors, but after the debt

overhang problem had been resolved, At this point, the company could be regarded as being

worth substantially more than the $2.20 the new shareholders were asked to pay.

However, the case does highlight the problem of ongoing governance issues. LLSV (1998)

suggests that Norwegian law extends moderate rights to genuine minority shareholders, although

Stolt Offshore’s account 38 of the manner in which the equity component of the refinancing of the

company seems to have happened does call into question the LLSV (1998) pre-emptive rights

score for Norway, at least. Given that the prospectus was published only after the placement was

made, the circumstances of the approach made to the company by the investor group has never

been disclosed. Also undisclosed is the manner in which the timing and the investment conditions

of the investor group were coordinated. Even so, the Oslo Borse appears to have sanctioned the

listing of the new share issue despite the lack of transparency in the fund-raising

Debt Restructuring: Removal of Strategic Default Incentives

The outstanding debt at the time of the restructuring was shown in Table 10. The key to the debt

restructuring was raising new equity finance. Sometime in 2003 the banks had already threatened

to convert debt to equity and therefore eliminate the Stolt-Nielson control rights, but the new

equity, along with planned asset sales, and the conversion of the Stolt-Nielson convertible debt

into equity effectively allowed the recapitalization. However, this was not without conditions.

Performance Bonds & ‘Lockboxes’

The performance bonds are important for companies in financial distress as they provide the

certainty to customers who may be put off by the fact of financial distress, thus help preventing

the collapse. However, this need for the bonds creates real dilemmas for the banks. If they lend

too much, and the company goes down after the bonds have been called, their losses would be

even greater than feared. On the other hand, if they don’t guarantee enough of the bonds, then the

company goes down anyway through a lack of business, perhaps taking the original debt with it,

as well as the outstanding bonds, given that company cannot now finish the work. This was

exactly the situation faced by the banks that lent to Stolt Offshore.

Although Jacob Stolt-Nielson blamed the management of ETPM for the financial problems that

hit Stolt Offshore 39 , there was a real problem caused by the fact that the French banks that

provided the performance bonds withdrew then after the takeover.

The problem faced by the banks was compounded for the banks by the fact that there were crossdefault

clauses with SNSA’s own debt, where there was also trouble, and which was owed to

some of the same banks. The bankruptcy of Stolt Offshore would have affected the net worth

clauses in SNSA’s debt. At the end of 2003 there was more than US$300 million of performance

bonds outstanding. Discussions with bankers close to the case suggest that the cross-default

38 Based on authors correspondence with Stolt Offshore.

39 Described more fully in paper 1.


61

problems led to a combined problem that was too big too allow failing 40 . The extract from

Monove, Padilla and Pagano (2000) quoted in the second paper of this project may be

particularly apt here.

Once companies such as Stolt Offshore acquire a reputation for default, creditors are forced to

find a way to protect themselves against such actions. Consequently, a condition of the

restructuring of the performance bonds and the firm was that the company agreed to keep on

deposit a proportion of the cash balances that arose from the disposal of assets, in addition to any

additional cash reserves over $75 million.

Reasons for this can be found in evidence about the relationship between strategic and liquidity

defaults. One model indicates that in times when raising new debt is expensive, firms that service

existing debt because it suits them strategically to do so, may keep larger cash holdings on the

balance sheet, knowing that the money remains theirs, but also knowing that they risk losing this

money in a non-strategic, technical default, because it is an easy asset for creditors to seize.

However, the greater the cash balances that the company maintains as a result of the presence of

strategic debt service, the lower is the probability of a liquidity default, because the company now

has the resources to meet its commitments i.e. keeping large amounts of cash on deposit reduces

the incentive for strategic default by increasing the cost, as well as reducing the possibility of a

payment default. (The end of this paper considers whether the final capital structure was optimal

– it clearly indicates that it was not, but that the insistence on retaining cash was a key component

of minimizing the possibility of another default, and thus allowing the restructuring to go ahead).

A further incentive for the use of lockboxes in the UK has resulted from a recent court decision

that blurred the distinctions between types of charges over collateral. Banks are protecting

themselves from this by demanding that asset sale proceeds are paid into these lockboxes.

Subordinated Debt

In July 2003, SNSA had lent $US50 million to Stolt-Offshore as part of the liquidity package. At

a point unspecified in the company’s filing, but seemingly sometime after November 30 th 2003,

SNSA agreed to convert this loan into equity at an equivalent price of $2.20 per share by the end

of December 2004 i.e. SNSA was to receive 22,727,272 shares. The company claims that it used

an independent valuation of the subordinated note when it converted it at face value, although the

market price to sell the most senior debt - the revolving credit facility - was about $90 on the day

before the conversion 41 .

However, although the closing price on the last day of trading in November 2003 was $2.14 per

share, the price never traded below $2.20 again, suggesting the possibility that the company

wrote an in-the-money call option to Stolt-Nielson. This debt did carry a 12% interest rate,

suggesting an equivalent strike price of about $2.45 if held until maturity without payment of the

coupon. In fact, SNSA exercised this option in April 2004, when the price was about $2.90. The

40 The decision by Stolt Nielson to sell some of their holding in 2004 did in fact trigger a battle with SNSA’s

unsecured note-holders. Due to the deconsolidation that resulted, the note holders claimed that the effect of the

deconsolidation was to put SNSA in breach of its covenants, and they tried to pursue immediate repayment of the

full amounts outstanding.

41 It is interesting to note that the 2003 Report and Accounts specifically claims justification of valuing the debt at

face value, when it was in fact quoted in the market at just $75 at the preparation date of the Report and Accounts.


62

profit on this conversion gave them some compensation for the loss of control, given that the

price was negotiated while the market was at pre-refinancing levels.

Final Debt Exchange

By November 2004 the situation had improved sufficiently that the banks exchanged all the

outstanding debt and the performance guarantee bond for a new $350 million multi-currency

revolving credit and guarantee facility. However, this was not without demands and restrictions

on the company, which included a bar on paying dividends, and restrictions on pledging assets

for further debt. It also required the firm to go on selling assets to raise cash – a process that was

still on-going in late 2005 with the sale and leaseback of ships to Cal-Dive Intl to support work in

the Gulf of Mexico

The outcome of the financial restructuring was lowered debt and gearing ratios as shown in

Figure 19 below. With the financial restructuring completed, the CRO’s appointment ended in

March 2004.

Figure 19: New Capital Structure at the End of the Restructuring

800,000

350%

700,000

300%

600,000

250%

500,000

400,000

200%

150%

% Gearing

300,000

100%

200,000

50%

100,000

0%

0

Feb-

00

May-

00

Aug-

00

Nov-

00

Feb-

01

May-

01

Aug-

01

Nov-

01

Feb-

02

May-

02

Aug-

02

Nov-

02

Feb-

03

May-

03

Aug-

03

Nov-

03

Total shareholders’ equity Net Debt Gearing

Feb-

04

May-

04

Aug-

04

Nov-

04

Feb-

05

-50%

Source: Authors calculations from Stolt Offshore quarterly reports

Was the New Capital Structure an Optimal One?

While the changes to the Stolt Offshore capital structure solved the immediate problem, it is

arguable that the new capital structure may not have been optimal, either in terms of the amount

of debt. In particular, necessary capital expenditure seems to have suffered. From an operational

perspective, the optimal capital structure might have better preserved the ability of the firm to


63

maintain capital expenditure at least in line with the rest of the industry. At the same time as the

company had been taking on more, investment was falling as a percentage of sales (Figure 20

below), calling into question the long-term ability of the company to maintain essential assets for

these projects.

Figure 20: Capital Expenditure as Percentage of Revenue

12.0%

10.0%

8.0%

6.0%

4.0%

2.0%

0.0%

May-00

Jul-00

Sep-00

Nov-00

Jan-01

Mar-01

May-01

Jul-01

Sep-01

Nov-01

Jan-02

Mar-02

May-02

Jul-02

Capital expenditures as a % of Revenue

Sep-02

Nov-02

Jan-03

Capital Expenditure as a % of Fixed Assets

Source: Authors calculations from Stolt Offshore quarterly reports.

Mar-03

May-03

Jul-03

Sep-03

Nov-03

Jan-04

Mar-04

May-04

Jul-04

Sep-04

Nov-04

Jan-05

Even in the high value scenario presented in Table 12, the chances of the company again

breaching covenants is very high. An examination of the last two lines of Table 12 show that the

debt service capability as given by Fragen (2005):

EBITDA −∆NetWorkingCapital −CapitalExpenditure

InterestCosts

,

Is extremely low after the restructuring, and consequently even a small shortfall on the target

margins effectively means the company runs out of cash and debt facilities and would have to

either return to its shareholders for more equity, or be liquidated.

An alternative capital structure based on preserving that investment capability sets the level of

debt such that the debt service ratio is in line with the industry average. Figure 21 below shows

the development over time for the 138 SIC group of the ratio of capital expenditure to fixed

assets, and of debt service coverage. It shows that debt service coverage for the sector is very

volatile, varying between 0 -8 times the interest costs, while annual Capital Expenditure varies

between 10-20% of fixed assets. A visual comparison of the two series in Figure 21 with the


64

worldwide oilrig count shown in Figure 1 illustrates how dependant both these ratios are on

worldwide conditions.

Figure 21: Capital Expenditure Ratios for 138 SIC Code Group

8

20%

7

18%

6

16%

5

14%

Debt Service Coverage

4

3

`

12%

10%

8%

Capex/PPE

2

6%

1

4%

0

1995 1996 1997 1998 1999 2000 2001 2002 2003

2%

-1

0%

EBITDA-Change in NWC - Capex/INTEREST

Source: authors calculations from Compustat data

Capex/PPE

Table 13 below shows the range of possible data points that could be used in a scenario analysis

to value the firm and derive the optimal level of debt as at late 2003. These points represent the

extremes of the two data sets shown in Figure 19 above. An additional factor is that revenues in

the oil services industry do not grow linearly but seem to be cyclical along with the oil price.

Rather than show all the possible simulation outputs here, Table 12 showed the output for a

single simulation, assuming that capital expenditure ratio and operating margins converge on the

long-term average of the industry. Perhaps equally important is the debt service ratio, which in

Table 12 starts negative, but builds through the quoted period. However, it is very sensitive to the

other variables. For example, if the management had been unable to grow gross margins above

11.5%, then the company would very quickly run out of money, and probably could not sustain a

20% capital expenditure rate.

Table 13: Industry-Wide Capex and Debt Service Multiples

Capital Expenditure/(Plant, Property and Equipment) as Percentage

Debt

Low

High

Service High 10% 8 Multiple 20% 8X Multiple

Multiple Low 10% 0X Multiple 10% 0X Multiple

Figure 22 below shows the debt service capability changes with capital expenditure targets and

the amount of leverage in the additional financing. The eventual plan gave the firm $167 million

of new equity, and new debt capacity of $350 million. Figure 20 shows that this would have


65

given a debt service ratio a little below the average of the last 10 years, but only if capital

expenditure was kept at a the lowest levels seen in the industry over that time. If the company

wanted to maintain a debt service ratio at the industry high of 8 it should have had about 80%

equity and 20% debt. A position close to the industry average for both data sets would have

required 60% in the new financing.

Figure 22: Capital Expenditure Targets and Debt Service Ratios

75%

Equity Share of New Finance

50%

25%

0%

0 1 2 3 4 5 6 7 8 9 10

Debt Service Ratio Assuming Capex = 10% Debt Service Ratio Assuming Capex = 14%

Source: authors calculations based on quoted assumptions

This result highlights the importance of the restriction placed by the banks on not paying

dividends, or distributing the proceeds from asset sales. By forcing the shareholders to keep cash

on deposit, they ensured that in the early period after the restructuring when operating

performance improvements could not be relied on, the company had sufficient cash to get though

a difficult period.

Residual Corporate Governance Issues

Despite the apparent success of the restructuring, the situation at Stolt Offshore still suffers from

a lack of transparency, and financial institutions complain of inconsistent and non-transparent

reporting quarter-by-quarter. 42 The legal structure of Stolt Offshore is still relatively complex.

This is a company that is based in the UK, is registered in Luxembourg and run under

Luxembourg law, but whose shares are listed in Norway with ADR’s traded in the USA on

NASDAQ. There was clearly a range of choices of jurisdiction available to the Stolt-Nielsen’s,

given the companies multiple listings and choice of operating home (the UK), Luxembourg was a

specific choice, although no public information on the reason for that choice is available.

42 See Kaupthing Research, June 28 2005, as an example


66

These multiple listings have the risk of allowing a company to list their shares in one jurisdiction

while hiding some of their practices behind more opaque ones. There was clear evidence of this

problem in the Stolt Offshore case. For example, the company made repeated reference in its

Reports and Accounts to actions undertaken to comply with NASDAQ listing requirement, yet

the creditors had to make the refinancing contingent on the company falling into line with a set of

NASDAQ requirements that the company was not adhering too.

The fact that investors forced a one-share-one-vote holding structure on the company does not

solve some of the long-term issues given the continued location of the company in Luxembourg.

If, as the second paper attempted to demonstrate, share holding structures are determined by the

level and type of shareholder rights, then it may well prove that there will be a movement back

towards block shareholding – recent data shows that the ownership concentration of Stolt

Offshore is higher than of comparable companies. This would not be a problem for the minority

shareholders if the board had not kept its right to suspend the pre-emptive rights for four more

years, or if there was full disclosure of block shareholder activity. However, jurisdictions with

weak shareholder and creditor rights tend not to be strong on institutional disclosure requirements

or enforcements either.

The difficulties of resolving these issues in this case highlights the weakness in calls for a onesize-fits-all

shareholder structure based on one-share-one-vote that does not take into account the

differences between the legal codes prevalent in different jurisdictions.

PostScript

There is one postscript to the restructuring. In February 2005, the Stolt Nielson’s severed all

connection with Stolt Offshore by selling their entire remaining shareholding. Jacob Stolt-

Nielson attributed the rescue of the company to the decision to sell equity in the company, but

used this as an opportunity to again attack the role of the banks:

“It is clear that out of all the actions taken, it was the raising of equity in both Stolt Offshore and

Stolt-Nielsen that were the turning points of the crisis. While the lenders were panicking,

fighting, screaming and actually making things more difficult than they needed to be, the equity

market looked at the quality and value of the companies.”


67

Note 1: Estimation of Stolt Offshore’s Cost of Capital

Stolt Offshore’s is a UK based company but registered in Luxembourg. Its shares are traded on

two exchanges – NASDAQ (Symbol SOSA) and the Oslo Borse. Most of its contracts are

denominated in $US. Figure 23 below shows the share price as quoted on NASDAQ, overlaid

with the price of the S&P 500.

Figure 23: Stolt Offshore Share Price Relative to the S&P 500

20

1650

18

1550

16

1450

14

1350

12

S&P 500

1250

1150

10

8

Stolt Offshore

1050

6

950

4

850

750

26/06/1998

26/09/1998

26/12/1998

26/03/1999

26/06/1999

26/09/1999

26/12/1999

26/03/2000

26/06/2000

26/09/2000

26/12/2000

26/03/2001

26/06/2001

26/09/2001

26/12/2001

26/03/2002

26/06/2002

26/09/2002

26/12/2002

26/03/2003

26/06/2003

26/09/2003

26/12/2003

26/03/2004

26/06/2004

26/09/2004

26/12/2004

26/03/2005

2

0

S&P 500

Stolt Offshore

Sources: NASDAQ website, Standard & Poor’s

The correlation between the two series is very low, and the beta (the regression of one on the

other) is evidently unstable also. Estimates of betas of companies in financial distress are known

to be unreliable. Computer output of a regression analysis below shows that the beta for the entire

sample is 0.6, (Table 14 below) although recent brokerage reports about Stolt Offshore have used

estimates of the equity beta of about 1.1.

Table 14: Regression Calculation of Stolt Offshore Beta

Dependent Variable: LOG(STOLT/STOLT(-1))

Included observations: 1737

Excluded observations: 2 after adjusting endpoints

Variable

Coefficie Std. Error t-Statistic Prob.

nt

C -0.001 0.001104 -0.560870 0.5750

LOG(SP500/SP500(-1)) 0.603 0.087952 6.852938 0.0000

R-squared 0.0264 Mean dependent var -0.000598

Adjusted R-squared 0.02579 S.D. dependent var 0.046614

S.E. of regression 0.04601 Akaike info criterion -3.318798


68

Sum squared resid 3.67274 Schwarz criterion -3.312511

Log likelihood 2884.38 F-statistic 46.96276

Durbin-Watson stat 1.97065 Prob(F-statistic) 0.000000

As betas of companies in financial distress are unreliable, this paper used the alternative approach

of averaging the betas of a group of companies that are comparable. The equity betas were

estimated against the S&P 500 using daily data, from the equation

P & 500

(

t

S P

Log ) = α + β* Log( ) + ε

P S P

t

(1)

t

t−1 & 500t−

1

where P was the daily closing price of the market. The asset betas were then unlevered using

equation (X) to unlever the equity betas and the results are shown in Table 15.

β

β

E

A

=

1+

D E

(2)

Table 15: Equity and Asset Betas of Comparable Companies

Equity Beta Debt/Equity Ratio Asset Beta LT Debt No Of Shares Share Price Market Cap

BJS 0.62 11.98% 0.554 489,062 156,981 26 4,081,506

CDIS 0.63 31.23% 0.480 223,576 35,504 20.167 716,009

GLBL 0.71 29.38% 0.549 120,730 99,511 4.13 410,980

OII 0.48 17.94% 0.407 112,800 24,700 25.45 628,615

WG 0.6 0.62% 0.596 1,171 18,271 10.38 189,653

PDE 0.73 104.11% 0.359 1,804,130 133,305 13 1,732,965

0.63 Average 0.491

SOSA 1.29 163.22% 335024 93300 2.2 205,260

Source: authors calculations from equity price data and company balance sheets

The results suggest that for the period until late 2002, an asset beta of 0.49 could be applied to

value Stolt Offshore, and that given the ratio of debt to market capitalization, an equity beta of

1.29 is appropriate.. The yield on the 10-year Treasury bond fell sharply in the second half of

2002 but averaged about 4.5%. This would suggest that if the market risk premium was about

6%, then using the CAPM, the cost of equity was about 12.3%. The 2002 annual report shows

that it paid an average of about 3% on its long-term debt for a WACC of about 7%. However,

given that it was in breach of the covenants by this point, new debt would probably not be

available at those rates - the Merrill Lynch High Yield bond index was yielding close to 12% at

that time, which may present a better indication of the cost of new debt.

Note 2: Calculation of Stolt Offshore Average Tax Rate

The data in Table 16 below, including the details of the tax rates that applied in each area in

which Stolt Offshore had taxable income, was taken from the Annual Reports. Stolt Offshore

does not report its regional segment earnings by tax jurisdiction, so some of the allocation has

been made using data provided in the prospectus for the February 2004 share issue. It was not

always clear from the Reports and Accounts which business unit handles which region, and some


69

allocations have been assumed by the author. The weighted average tax rate is 33.5%, compared

to an unweighted average of 32%.

Table 16: Calculation of Tax Rate Used for Forecasts

Country Tax Rate Revenue Proportion Rate

US 34% 242,472 16.9% 5.7%

Scandinavia 28% 105,830 7.4% 2.1%

UK 30% 229,795 16.0% 4.8%

France 35.30% 702,764 48.9% 17.3%

Other 33.70% 156,627 10.9% 3.7%

Total 1,437,488 100.0% 33.5%

Unweighted

Average

32%

N America 190,460

South America 52,012

UK 229,795

Norway 105,830

AFMED 702,764

AP 25,677

Corporate 130,950

1,437,488

Source: authors calculations based on annual reports and accounts, and 2004 Share Prospectus


70

Note 3.

Prices of Stolt Offshore Debt

A small sample of debt prices for Stolt Offshore was available from various banking sources, and

are shown in Figure 24 below. Although there are data points missing in 2003, the chart

highlights that in late-2003, the debt was trading at a price roughly in line with the estimate of the

value of the debt provided by a management consultancy firm to the major creditors.

Figure 24: Prices of Stolt Offshore Debt in the Secondary Market

100

90

80

70

8/25/2003

9/8/2003

9/22/2003

10/6/2003

10/20/2003

11/3/2003

11/17/2003

12/1/2003

12/15/2003

12/29/2003

1/12/2004

1/26/2004

2/9/2004

2/23/2004

3/8/2004

3/22/2004

4/5/2004

4/19/2004

5/3/2004

5/17/2004

% of Face Value

Source: compiled by the author from banking and investment sources


71

Lessons Learnt & Issues Arising

1. Banks may have only limited power to resolve corporate structural problems beyond

getting their money back. Bank debt in countries with poor creditor protection may allow for

some monitoring, but as companies cannot commit to not increase the number of creditors, the

banks themselves do not represent a full solution to agency problems when claimholder rights are

weak. The bank’s own solution of forced retention of cash (lockboxes) as a protection against

strategic default protects themselves, but possibly at the expense of shareholders, who could have

used the money more profitably.

2. The market for corporate control does not necessarily solve the entrenchment problem.

This is particularly true in countries with weak protection of minority shareholders. The law in

some countries allows the concentration of control at the board, encouraging the development of

large shareholders. Consequently, the lack of minority shareholder rights means that even if

control does change, a self-serving concentration of ownership can begin again. EU proposals to

break pyramid structures and dual share structures will help, but there may still be a need for

legislation to protect minority shareholders across the EU. Until then, the case study

demonstrates that there will be profitable opportunities for investors to break the equity structure

themselves when a company is in distress, and capture additional returns. In the current case,

while the elimination of anti-dilution rights is questionable under broader corporate governance

norms, this is quite acceptable in a number of jurisdictions. LLSV (1998) shows that only 26 out

of the 44 countries analyzed in their paper require that companies protect the pre-emptive rights

of minority shareholders. In the current case, the right of the board to suppress preemptive rights

when issuing new shares is included in Luxembourg laws.

3. Changes to the bankruptcy law do not work in isolation: they need to be part of a broader

set of reforms. Part 2 of this project showed how the balance of creditor and shareholder rights

affects almost every aspect of strategic and corporate financing decisions, leading to very

different solutions for the same business in different countries, such as the number of banks in a

syndicate. Consequently, while the direct level of transaction costs for negotiations between

claimholders during distress is caused by a combination of the level of concentration and

dispersion of claimholders; different priorities and seniorities between holders of different claims;

and different incentives between claimholders and managers, these are second order effects of the

institutional environment. Perhaps the most significant outcome of this argument is that the while

idea of a common code of governance for the European Union may be appealing to those in

Brussels, the very different legal structures that have developed among the EU members over the

centuries makes such a code impossible without a significant body of additional law to support

the conceptual basis and the reality of corporate structures on which such a code is built.

4. The CRO is ideally placed to break the strategic uncertainty problem and thus facilitate

the organizational restructuring. Changes to legislation and the legal and cultural environment of

corporate rescue highlight some important issues related to the role of the CRO. The UK and the

USA present some real examples. In the UK, the Insolvency Practitioner (IP), who customarily

specialized in liquidating insolvent companies, still retains powers not available to CRO’s. Of

particular note is that exemption from some directors’ liabilities such as pensions deficits when

companies become distressed is only available to an IP, not a CRO. Given that the culture has

changed from liquidation to rescue, then the legal status of those involved also needs to change.


72

In the USA there is a requirement to prove that companies in distressed are being steered by

someone qualified to do so. Education and certification programs such as that proposed by the

Turnaround Management Association help them to do this.

However, in the UK, the Enterprise Act doesn’t solve the problem of to whom the CRO is

responsible. At present, the Administrator has a duty of fairness to all sides, but is unlikely to be

qualified to go into a company and implement a solution as a manager. A CRO employed by the

company might assume to be working for the shareholders, but is often put in place at the

insistence of the bank.

What makes Stolt Offshore so interesting is that the CRO in this case effectively helped

coordinate the creditors too, thus creating an environment in which a consensual restructuring

could take place. The case provides a useful lesson in the benefit of having a CRO handling

either both, or any one of the functions. However, currently, no legal framework really exists in

which an operational expert is also truly independent from the claimholders, and some form of

contracting framework is still needed to do this. The French concept of a mandataire ad-hoc with

the ability to negotiate a solution with all parties is a possible solution, as an alternative to the UK

model where there has been a legal entrenchment of Insolvency Practitioners despite the cultural

and practical differences between the role of the IP and the Turnaround Managers. Action is

needed to raise the professional standing of the turnaround manager to where the IP is now, and a

certification program such as that pursued by the TMA and which could acceptable to the courts

as being of equal standing to the IP could be a solution.

5. World Bank guidelines on the development of insolvency codes offer a way to resolve

many of the problems discussed in this project, although only after a company enters a distress,

as even the EU proposals on the elimination of pyramid and split capital schemes fails to deal

with the weaknesses in claimholders rights found in some civil law environments. Additionally,

the US environment in which the World Bank proposals were written needs to be acknowledged..

Consequently they are not always suitable for civil law environments, which need to focus on the

implementation of better minority shareholder protection. The proposals are very similar to

developing legal and informal changes emerging elsewhere, such as from the European Union

Best Practices Committee on Restructuring and Insolvency designed more for rescue than

liquidation.

The World Bank (2001) points out that many techniques for a successful workout have their

origin in the London Approach 43 for informal creditor coordination worked out by the Bank of

England and developed by practitioners since then. However, these different techniques have the

same basic aim, which is to prevent a senior creditor led run on the firms assets which might lead

to a premature liquidation or otherwise inefficient outcomes, without unduly compromising the

rights of the creditors. The World Bank favors the adoption of an automatic stay on assets as part

of the design of new insolvency codes and creditor rights. An automatic stay on assets protects

43 Sometimes wrongly referred to as the London Rules, a name that originated in a Financial Times in November

1990 by mistake, but which the Bank of England was unable to prevent entering common usage. The Bank of

England was always worried that any reference to Rules would bring about conflict with overseas regulators, given

the multinational nature of the London banking community


73

junior creditors (and shareholders) at the expense of senior creditors, so it is not clear that this is

generally good, or bad, for creditors overall.

The German method of achieving restructuring has been particularly well received, and the

World Bank has highlighted it as role model (Johnson 2005). Brunner and Krahnen describe how

creditor coordination works in Germany with an agreement between banks designed to form a

creditor pool and prevent a creditor-run on assets. Members of the creditor pool agreement

commit not to seize assets or to reduce credit lines – a fact that helps provide something close to

debtor-in-possession financing. They also commit to share information and an equitable share of

costs. While these agreements tend to only apply to uncollateralized debt, informal agreements

about collateralized debt are also struck. This is often because banks (particularly the house

banks) hold both collateralized and unsecured debt together. However, calls for more reliance on

the ‘hausbank’ method have been generally rejected on the basis that it places too steep an

obligation on just one institution, particularly in countries with fragmented, sometimes highly

regional, banking systems.

Changes introduced into German legislation have strengthened senior creditors rights and

strengthened the role of the courts by imposing a requirement on directors to report to the local

court if the company believes it may become insolvent. This was not expected to seriously

weaken the pool arrangement, as each bank knows that it relies on mutual cooperation with other

banks to ensure that on balance, it benefits from the scheme, even if in some transactions its

outcome is suboptimal. The Bank of England put considerable emphasis on this ‘portfolio’-like

approach to dealing with workouts in its justification for the London Approach, Kent, (1997).

In the UK, the Enterprise Act 2002 was intended to be a significant shift away from the very

creditor-friendly regime that prevailed before, towards one that is more like Chapter 11 of the US

Bankruptcy code in its effect. Previous to the passage of Enterprise Act the UK regime was

among the most creditor-friendly anywhere, and absolute priority rules dominated restructurings.

The changes introduced by the EA basically gave companies an opportunity to file for

administration during which time it is protected from its creditors and can form a reorganization

plan. However, there is still no debtor-in-possession financing arrangement, which while

beneficial to the priority of the existing claim, badly restricts the ability of the administrator to fix

the company.

Government has a role to play so far as it needs to create a policy environment conducive to the

work of the CRO, but market solutions in which claims are traded into the hands of those willing

to work to resolve the distress tend to outperform the limited global experience of governmentcreated

restructuring vehicles. 44 However, markets depend on non-asymmetric distribution of

information to work properly, along with reliable enforcement of its rules. While the latter point

is less of an issue in Europe, the implementation across Europe of Chapter 11 style disclosure

rules would considerably aid the development of the market for distressed assets, and enhance

prospects of corporate recovery.

44 The Bank of England took considerable steps to ensure that the London Approach was seen as informal

recommendations, and not seen as government-mandated rules


74

Appendix:

The Restructuring Of Stolt Offshore

Following on from the initial crisis stabilization at Stolt Offshore, there were two elements to the

strategy to restructuring the company. The first was to solve the strategic uncertainty problem as

previously described, and reformulate the capital structure, which involved securing an

agreement between creditors and the company over the terms for continued financing, and an

injection of new equity capital. This case shows how difficult it is for lenders that start with badly

designed debt contracts to wrest power back from an entrenched shareholder-management. The

second was to reset the strategic direction of the company. These two strategies were interrelated,

as the refocusing of the company entailed selling non-core assets and businesses, a

condition also demanded by the creditors to reduce debt.

The financial restructuring of Stolt Offshore is an example of the successful management of

external stakeholders. Creating the conditions to successfully implement a corporate turnaround

strategy depends on managing both the rights and the expectations of all the stakeholders. This

includes all the people that have an interest in the company, including creditors, shareholders,

customers and employees. An otherwise recoverable situation can be lost if key staff leave;

customers seek alternative suppliers, or creditors decide to cut their losses and liquidate. The

positive opinions of Stolt Offshore expressed by some of the major oil companies that used its

services was a critical factor in the banks decision to support the restructuring rather than

liquidate the company.

An example of the necessary conditions for a successful recovery or turnaround situation were 45

laid out by Pelham Allen, a highly experienced UK turnaround professional, in the Financial

Times:

1. There is an underlying viable business in all or part of the debtor group of companies

where repayment and/or servicing of debt have become difficult or impossible.

2. The original equity in the debtor group has significantly reduced in value so that the

shareholders face the prospect of losing almost everything

3. The main financial creditors in the debtor group, faced with the prospect of significant

short term losses have agreed to convert all or part of the debt to equity in a new entity

which is formed to takeover the original business in the hope of obtaining a better recovery in

the longer term 46 .

Other turnaround professionals interviewed for this project add the existence of a credible

management team, or its replacement by a CRO and other professionals as an additional critical

factor 47 .

45 Financial Times, June 2005

46 Successful outcomes are by no means guaranteed Slatter (1984) analyzed 2100 firms over a 16 year period ending

1976, finding that about 1 in 5 needed some help, and that only 1 in 4 of these were successfully restructured – the

remainder were either closed or bought out. While his choice of period may have exaggerated the effect because it

ends just after one of the worst bear markets in UK stock market history, the point is well made.

47 Private correspondence with Alan Tilley, Chairman, Turnaround Management Association, UK


75

Operational Restructuring

A survey of preferred turnaround techniques among turnaround professionals working in the UK

was reported in Venkatesh (2005), and the results are shown in Table 17 below. The table shows

a clear focus across the restructuring profession of the need to take control of cash flow, after

which management changes, financial structure changes and critical process improvements rank

highest. These techniques divide into two main groups – fixing the finance (the primary subject

of the third paper), and fixing the business. A number of the techniques that appear in the table

were used in the restructuring of Stolt Offshore.

Table 17: Preferred Turnaround Techniques in the UK

Source: survey data from Venkatesh (2005)

The recovery plan formulated by Ehret and Jackson was designed to give the company a new

business strategy, deal with the cost structure and improve profitability, but required a

restructuring of the capital structure of the company. Figure 4 illustrated the problem, showing

that EBITDA had ceased to cover even interest costs.

Crisis Stabilization

In the early stages of a crisis, a source of liquidity is vital to keep the company functioning, and

the cheapest available source of such cash is often internally generated funds. The first action of a

CRO is to take control of the cash position, and then negotiate with the funding sources to ensure

that the company maintains enough cash to survive. Stolt Offshore demonstrated one way to

implement such a strategy - the company drew down on all of its available credit facilities and

liquidated all the foreign exchange and interest rate hedges that had a positive mark-to-market

value. Slightly longer-term, the company proved remarkably competent at squeezing working

capital out of the business to pay down debt.

If the immediate problem is a covenant breach, extensions or waivers need to be negotiated also

In order to be able to proceed with the turnaround, it was essential to regain the confidence of the

external stakeholders - in particular, the financial institutions. Understanding their concerns and

their requirements before supporting a restructuring was critical to achieving a successful

outcome.. Four covenant waivers were needed – and granted - as mounting problems with the

legacy contracts drove debt/ebitda ratios through each agreed covenant limit.

Longer-Term Strategic Changes

Beyond the short-term stabilization of the company, a strategy for restructuring the business has

to take into account the capabilities and the competencies of the organization, and then

implement business processes that support them. The role of the Chief Restructuring Officer is

critical to this. Almost any process of change management in a crisis situation will involve the

managers of this change in constructing a vision of the new company and an implementation plan


76

of sufficient credibility to prevent the defection of key customers to the competition and of staff

to new employers.

In the case of Stolt Offshore, it was the lack of appropriate processes in particular that seemed to

be a large part of the problem. Barney (1991) divides the resource-based sources of competitive

advantage into a combination of three groups: assets, people, and processes. The component

strategies of the turnaround of Stolt Offshore included the divestiture of assets, changes in

management and a reduction in headcount, and significant investment in new processes. These

included improvements in working capital management, organizational improvements, new

critical processes, development of a marketing strategy; risk control measures and improvements

in corporate governance.

The need for some of these changes had already been recognized by Jacob Stolt-Nielson, who

had initially attempted to pull the company around without attracting the attention of the external

stakeholders – a common first reaction to trouble. Among the more public measures undertaken,

Jacob Stolt-Nielson appointed one of his sons as an interim CEO, and then replaced other board

members. Changes to the management team continued into the following year. In February 2003,

the company appointed Tom Ehret as CEO. A Frenchman, he had considerable experience in the

oil sector, having previously been Vice-Chairman of Technip. He did not become a member of

the Board until November 2003 because of resistance by the Stolt-Nielson family.

Despite steps such as these, Stolt Offshore’s share price resumed its fall, reaching a new intra-day

low of US$1.11 on March 4 th 2003 48 . The fall was exacerbated by concerns over a delay in

releasing results due to a change in auditors and changes to reporting requirements that developed

in the USA after the Enron debacle. A new CFO – Stuart Jackson was appointed in the following

month, although again, not a board level appointment. Given the scale of the external stakeholder

relationship problem, there was a split of responsibilities between Tom Ehret, who was

responsible for handling the internal situations and the customers, and the CRO who handled the

external stakeholders.

Strategic Refocusing

Noting a trend towards increasing offshore oil production, the management decided to refocus on

what it called ‘SURF’ (Subsea construction, Umbilicals, Risers and Flowlines). This typically

included conventional fixed platform work adjacent to deepwater areas, and worldwide

inspection maintenance and repair work. Discussions with oil industry professionals for this

project suggests that this strategy was well received, as it focuses on a likely key part of coming

oil exploration activities, particularly in the North Sea. Despite the fact that failures within large g

were a major contribution to the company’s earlier crisis, the company’s recovery has been

assisted by its successful involvement in two very large projects – Greater Plutonio, in West

Africa, and Langeled in the North Sea.

48 Also at this time, the company was able to negotiate an amnesty in an anti-trust investigation in the US. The US

government later attempted to rescind the amnesty after the company had complied with the terms, but a court in

Philadelphia threw this out. However, concerns about cartel actions in Europe continued to have an impact on the

company share price for some time after, according to brokerage reports.


77

The impact of the asset sales and divestitures can be seen now that the restructuring of Stolt

Offshore is complete. The asset sales included some of the more marketable ships that the

company owned. As a result of these sales, in late 2005, Stolt Offshore was reported to have the

oldest shipping fleet in the sector. The fleet now needs upgrading, raising the forward investment

costs of the company. The costs of financial distress do not necessarily end when the

restructuring does.

Organizational Changes & Critical Process Improvements

Given that the Stolt-Nielson’s had run the company as an extension of the family’s shipping

business, it was clear that the corporate culture would have to change to one more appropriate for

a public company. There was no union presence in the corporate part of the business, so

management was able to focus directly on staff relationships, and particularly on how the

different divisions worked together.

One of Ehret’s first actions was a big shift to centralized decision making, removing the

autonomy of the local and overseas divisional managers (but increasing the overall level of

consultation, and cross-company communication), and imposing limits on contracts and decisionmaking

that could be done without his personal oversight. This was already a signal of a cultural

shift, given the very decentralized processes of the past. The changes in the management team

were also very important in changing the culture - 75% of the team being replaced.

Prior to the restructuring, the company had been organized along individual product lines but this

was changed to a focus on individual projects within geographic regions, allowing much better

integration of decisions across all the product lines involved in a specific project. In the new plan,

six regional VP’s reported to a COO, and then to the CEO. Corporate functions such as finance,

strategy and marketing each have a VP who reports direct to the CEO.

The company set out to improve its critical processes. In particular, there was a complete

overhaul of its tendering and risk management systems. Following on from the organizational

changes described above, the company centralized the tender review process for larger contracts.

However, it also gave other managerial levels more responsibility within a more controlled

process for smaller contracts. Given the new focus on projects, new project management skills

were brought into the company. Risk analysis became a major part of the business evaluation

process, with new process to analyze and control for weather risk, strikes, supplier delays and

other cost problems. A change in decision-making processes was implemented that allowed

projects to be vetoed by senior management that considered them to be either too risky or

unlikely to be profitable. A currency and interest rate risk hedging facility was implemented,

although during the financial restructuring process, most of the companies existing hedges were

liquidated

There was also a change of emphasis in performance monitoring. For example, while

transportation companies such as SNSA may focus on maximizing the utilization rates of ships,

this is not necessarily the case for more complex project management companies such as Stolt

Offshore, where ship utilization measures remain important, but not the determining factor for

project acceptance.


78

Cash Management Improvements

While the initial improvements in working capital management and in customer relations can also

help generate cash in various ways. Stolt Offshore was able to make significant improvements in

its receivables management quite quickly. A focus on improved external communications led to

an improvement in customer relations as a result of which the company was able to renegotiate

upwards the prices of some of the legacy contracts.

Poor working capital management is one of the factors identified by Lovett and Slatter (1999) as

often being present in cases of financial distress, and improvements in cash and working capital

management can quickly realize cash that can be used more effectively, either to support

operations or to pay down debt. However, this is not a universal position – for example, French

law allows banks to sell current assets to pay down debts without any other preferential creditors

being able to claim against them.

The primary area where the situation could be improved at Stolt Offshore was in the trade

receivables 49 , although the accounts payable was further extended into 2003, although it had been

growing since 2000. The nature of the companies business meant that there was little realizable

value in work-in-progress.

Centralized financial controls were lacking at Stolt Offshore as the company had delegated most

of its financial controls to the divisional level. There was no central financial policy setting, and

as a result, each division seems to have had its own practices. Consequently, following the

appointment of external advisors and a new Chief Financial Officer that implemented new

controls, it was possible to make significant improvements to the situation. Figure 25 below

shows the development of the accounts receivables over time, using both the two-year average

and a 1-year figure for comparison 50 .

It is noticeable that significant improvements had already occurred up to 2000 before the

situation worsened again. The company had used the previous improvements in its receivables

management to retire debt, hence the better debt position than its competitors shown in the

comparison of capital structure, and improvements in the accounts receivables position back to

the level seen in 2000 would release considerable funds to cover debt repayment. In fact, by

November 2004, account receivables were down by US$169 million – or nearly 51% of the

outstanding debt in 2002. However, not all this might have been available for bank debt

repayment, as accounts payable had expanded by even more than the increase in bank debt in the

previous three years, and which was partially repaid in 2004.

49 Accounts Receivable Days is an indicator of the amount of time taken for debtors to pay, normalized by the sales

figures. Where possible, this should be by Credit Sales, but in many cases this is not reported. The formula is given

by:

AverageAccounts Re ceivable*365

Accounts ReceivableDays

=

Sales

where the Average Accounts Receivable is the average of the current and previous accounting year closing position.

50 This formula produces slightly different figures from those quoted in some Stolt Offshore Annual Reports. For

example, in 2003, Stolt Offshore reported 99 Accounts Receivables Days down from 114 in 2002. The current chart

shows 97 days in 2003, down from 109 in 2002.


79

Figure 25: Evolution of Accounts Receivables Days

140

130

120

Account Receivables in Days

110

100

90

80

70

1996 1997 1998 1999 2000 2001 2002 2003 2004

Accounts Receivables Days (2 Year Average)

Source: Authors calculations from Stolt Offshore quarterly reports

(Accounts Receivables - Instant)

Final Outcomes

Despite the complexity, the organizational restructuring was largely successful. Figure 26 below

illustrates the evolution of the market capitalization of Stolt Offshore, on the dates for which

quarterly results are prepared, through the period from November 1999 to November 2005 51 .

Both the destruction of value that occurred as a result of the unsuccessful attempt to diversify the

company and expand the business, and the recovery that began when new management took over

in early 2003 are very clear.

51 Capitalization was calculated from NASDAQ market share prices and an “equivalent” number of common shares

to the actual shareholding structure as published by Stolt Offshore in their quarterly performance reports over the

period. Data for November 2005 assumes that the number of shares has remained unchanged since August and used

the price on the day of completion of this project.


80

Figure 26: Market Capitalization of Stolt Offshore

$2,600

$2,350

$2,100

$1,850

Millions of $US

$1,600

$1,350

$1,100

$850

$600

$350

$100

Feb-00

May-00

Aug-00

Nov-00

Feb-01

May-01

Aug-01

Nov-01

Feb-02

May-02

Aug-02

Nov-02

Feb-03

May-03

Aug-03

Nov-03

Feb-04

May-04

Aug-04

Nov-04

Feb-05

May-05

Aug-05

Nov-05

Sources: Stolt Offshore, finance.yahoo.com

From an intra-day low at $1.05 in mid November 2002, the share price has traded as high as

$13.28 in August 2005, by when the number of shares had more than doubled. This price

recovery illustrates the success of the turnaround, including the improvements in operating

margins, and improvements in the contract backlog.


81

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