Clausi on Arcan Resources: My Debt trumps your Equity
Imagine going to your bank and saying, “My mortgage is almost due but I can’t pay it, so here’s a 27% discount on what I owe you, and I’m going to keep the rest because I feel like it.” Arcan Resources Ltd. tried doing that.
Arcan produces light, sweet oil from the Swan Hills area of the Western Canadian Sedimentary Basin. In 2011, the company was of a decent size with decent prospects. To help exploit those prospects, in 2011 Arcan raised over $160M by way of convertible debenture ($75M at par in Feb/11 and a further $85M at par in Sept/11).
The prospectuses for that debt stated, “in the event of the … reorganization … the Corporation’s assets will be available to pay its obligations with respect to the Debentures only after it has paid all of its secured creditors and all holders of Senior Indebtedness.” This common concept means THIS DEBT RANKS BEHIND OTHER DEBT AND AHEAD OF THE EQUITY. Indirectly, I bought debentures and common shares cleared in those prospectuses. The debentures have paid out interest on schedule and have traded publicly.
Management’s access to cash became tight, with adjusted quarterly revenue of $14M and expenses exceeding $22M (Q1 ended March 31/14), for a net loss of 7 cents a share. The cupboard was bare, and the exploration program gave little cause for optimism. As Arcan’s CEO Terry McCoy said, “There is a lot of upside but you need capital to develop them. Arcan is severely capital constrained to within cash flow” (Financial Post). It takes money to make money, and Arcan had none.
Operating losses plus a depleting asset base plus a large working capital deficiency plus $86M of debt coming due in 2016 equalled a debt crisis. The debs traded down in the 60 cent range. But the debenture holders (including me) took comfort in that the common shares still had value. Since the debs ranked ahead of those shares, the debt would eventually be paid out in the normal course or re-financed, right?
Uh, only a little bit, was Arcan’s response. How about a 27% discount instead?
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The strategists (ScotiaBank was the lead financial advisor) came up with a plan in the spring of 2014 that would see the debentures be retired for only 82.5 cents on the dollar, plus warrants in a new SpinCo. No debt holder ever likes to take a haircut, but that’s one of the accepted risks I take when lending against a depleting resource like oil. At least you get paid ahead of the common share holders …. but hang on … Arcan also proposed returning capital to the common share holders with new equity in SpinCo, ahead of the debenture holders being made whole.
The proposal was not well received. Scott Reid of Stornoway Portfolio Management, a firm that owned the debentures, referred to the proposal as “deeply flawed” and an attempt “to induce the debenture holders to abandon their rights in favour of Arcan’s shareholders.” (Financial Post).
Mr. McCoy’s explanation for the debt haircut was, “And the debenture holders, who were trading in the 60 cent range are now trading at 82 cents, are getting a 25%-33% return immediately.” That’s a tough argument to swallow. I and the other debenture holders paid 100 cents on the dollar in 2011, only to see them trade down to the 60 cent range in 2014. It’s hardly a win to get 82 cents for something you paid 100 cents for three years ago.
At the meeting held on Aug 20, Arcan needed two-thirds of each class of debenture holders and the common share holders to vote yes. Negativity permeated the lead-up to the meeting. As one punter on the bulletin boards wrote, “Can’t think of a compelling reason to vote yes for this”. Arcan’s plan was soundly rejected. (I voted against.) The process cost Arcan roughly $1M.
There are several nasty questions that come out of this. First, Mr. McCoy has been, “President of Burlington Resources Canada Ltd., Vice President of Exploration and Land at Poco Petroleums Ltd. and Murphy Oil Company. He has served on the boards of directors of both public and private corporations.” (from the company’s press releases). The auditors are KPMG LLP, the legal counsel is national powerhouse Blake Cassels & Graydon LLP, and the board is populated with well-regarded individuals having diverse and appropriate skillsets. How did a seasoned leadership team so badly misread market sentiment? (We’re going to assume that change of control payments aggregating $2,000,000 team did not factor into the decision.)
Second, Arcan’s two largest shareholders are Crescent Point Energy Corp. and Lightstream Resources Ltd., together owning 36% of the voting shares. How could Arcan go ahead without ensuring that they were locked down?
Third, and most fundamentally, who forgot that debt ranks ahead of equity? It was there in the prospectus. It’s there in everyday life (just ask your bank about only paying off 83% of your mortgage). But somehow, the debt holders were taken for granted. They have spoken, loudly, angrily, so now Arcan has to do something to regain the market’s trust. It will be interesting to see if Arcan is in play, if a white knight rides to the rescue or if the company will be wound up. Whatever happens, debt ranks ahead of equity, so there might be a good reward in assuming the risk that follows the debentures.
(Note: the author indirectly owns both the debentures and the common shares, and voted against the plan.)
Mr. Clausi is an experienced investment banker, executive and director. A graduate of Osgoode Hall Law School called to Ontario's bar in 1990, Mr. Clausi ... <Read more about Peter Clausi>