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Linn Energy, LinnCo, Berry Petroleum and the SEC

By David Dittman on July 8, 2013

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When the deal was first announced, on Feb. 21, 2013, Linn Energy LLC (NSDQ: LINE) and affiliate LinnCo (NSDQ: LNCO) expected their billion acquisition of Berry Petroleum Co (NYSE: BRY) to close by July 1, 2013.

The Linn entities offered 1.25 shares of LinnCo for every one Berry share; the day before the deal’s announcement, Feb. 20, 2013, LinnCo closed at $36.99, putting a preliminary value on the deal, including assumed debt, of $4.4 billion, or $46.2375 per Berry share.

LinnCo’s sole assets are the Linn Energy units it owns; it was created to boost Linn Energy’s ability to raise equity capital for use in acquisitions to further Linn Energy’s growth strategy. LinnCo’s finances and results of operations depend entirely upon Linn Energy.

Following completion of the transaction LinnCo was to contribute Berry to Linn Energy in exchange for newly issued Linn Energy units, after which Berry would be an indirect wholly owned subsidiary of Linn Energy.

Up until July 2, 2013, we expected the oil-heavy Berry assets to materially boost Linn’s production profile and to provide the basis for distribution sustainability and growth.

On July 1, however, after the market close, Linn Energy and LinnCo announced that the Securities and Exchange Commission (SEC) has commenced an inquiry into the entities’ accounting practices with regard to their hedge program as well as their proposed merger with Berry.

On July 2 we issued a Flash Alert to readers of Personal Finance, where we held Linn Energy in the Income Portfolio, advising them to sell their units.

But the Income Report published at www.PFNewsletter.com and dated July 5, 2013, submitted for publication on June 26, 2013, in time for inclusion in the July 10, 2013, print edition of Personal Finance, included the concluding statement, “We continue to rate Linn Energy a buy under 40.”

The facts about Linn Energy, LinnCo, Berry and the SEC changed subsequent to June 26, when we submitted the July 5/July 10 Income Report. In light of the SEC investigation and its potential implications for the Berry deal we issued a Flash Alert on July 2 advising subscribers to sell Linn Energy.

When I spoke to members of the Investing Daily Wealth Society at the recent Wealth Summit in Scottsdale, Arizona, I noted my concern about Linn Energy, its deteriorating production profile, the complexity of its accounting and the fact that I liked straightforward stories that are easy to describe to everyday, retail investors.

In recent weeks the story at first began to get a little less complicated, as the MLP had discontinued its prior hedging strategy, no longer buying puts in favor of a program built around costless swaps.

But the SEC’s informal, non-public inquiry into the entities’ proposed merger with Berry, Linn Energy’s and LinnCo’s use of non-GAAP accounting standards and the hedging strategy employed by Linn could be a deal-breaker. And that would put Linn in a difficult position with regard to finding new ways to grow production and support its distribution.

This follows a series of articles published in Barron’s that questioned Linn’s financials and also raised questions about potential tax liabilities for LinnCo shareholders potentially accruing due to the Berry Petroleum transaction.

Linn’s unit price and LinnCo’s share price both suffered steep declines on Tuesday, July 2, after the release of the statement. The MLP slid from its July 1 close of $33.29 to $27.05, while LinnCo, a corporation the only asset of which is its ownership of Linn Energy units, fell from $37.07 to $30.90.

Linn Energy has recovered a bit today but is now down 33.6 percent from its 2013 high of $39.33, set Jan. 29, while LinnCo is off 32.6 percent from its April 25 high of $42.84.

Linn Energy LLC 8.625 Percent Note of 04/15/20 (CUSIP: 536022AC0), which we hold in the UF Income Portfolio Conservative Holdings, also took a steep dive. The note last traded at $100 as of this writing, well off the all-time high of $115.66 established May 8, 2013.

In its announcement Linn/LinnCo noted, “The SEC has stated that the fact of the inquiry should not be construed as an indication that the SEC or its staff has a negative view of any entity, individual or security.” The Linn companies “are cooperating fully with the SEC in this matter.”

No timeframe for resolution of the inquiry was forecast. It will likely take at least a month but could drag out for quarters.

There may be deal sweeteners being discussed, as LinnCo’s share price is 22 percent below the Feb. 20 close that set the preliminary deal value of $4.4 billion, including assumed debt. And a breakup fee of $83.7 million will also give pause to Berry. But that can be negotiated too.

Berry may also consider the sale of its long-life California assets to Linn; but it could spin out assets as an MLP. At any rate, the Linn-Berry merger is uncertain at this point, and this uncertainty, in addition to the SEC investigation, will hang over Linn.

It’s likely that the Barron’s series touched off the SEC investigation. That it’s characterized as “informal” at this stage is of no moment; all such investigations begin “informally.” Here’s how the process works from here.

At this stage SEC staff has no formal subpoena power, relying instead on the cooperation of the parties subject to the investigation for relevant information. Following the conclusion of the informal phase staff may recommend that the SEC undertake an enforcement action with sanctions at the other end, seek a formal order of investigation or conclude the investigation without recommending an enforcement action.

When the SEC staff request and receive a formal order, the next stage is a formal investigation. The SEC approves requests for formal orders when it finds that it’s likely that a violation of securities law has occurred. The formal order grants designated SEC staff the ability to issue subpoenas and to administer oaths.

The formal investigation can lead to the recommendation of no charges or sanctions. On the other hand, subject parties may receive what’s called a “Wells notice,” which signals the commencement of an enforcement proceeding.

The recipient of a Wells notice has a period of time, usually a month, to provide the staff with a Wells submission, essentially a brief arguing why an enforcement proceeding isn’t merited. Upon reviewing the Wells submission, the staff may elect to modify or reverse its recommendation to the SEC.

Upon the staff’s recommendation to bring an enforcement action, the SEC has several options. It may authorize a civil action in federal court, an administrative proceeding before an administrative law judge, or no enforcement proceeding at all.

Whether the SEC authorizes a civil action in federal court or an administrative proceeding depends on several factors, including the severity of the allegations, the nature of the conduct alleged, tactical considerations and the type of sanctions sought.

The most important immediate question from a Linn Energy investor’s perspective is what becomes of the Berry Petroleum merger. Linn management acknowledged in its July 1 statement that it is “committed to the completion of the transaction.”

Linn and Berry had been setting up for a third-quarter close. The timing, and the consummation itself, is very much in question.

Berry Petroleum, as of this writing, has issued no statement on the SEC inquiry of Linn or on its feelings about the completion of the merger. CNBC, without identifying sources, reported that Berry remains committed to the deal.

It is the longstanding policy of Utility Forecaster to not buy bonds issued by a company the stock of which we would not purchase.

We have downgraded Linn Energy’s common units to “sell” in Utility Forecaster’s sister publications Personal Finance, where we held the MLP in the Income Portfolio, MLP Profits and The Energy Strategist. But this isn’t a “new purchase” decision; we held the bond before the downgrade.

Only a bankruptcy can interrupt interest payments, and, despite serious questions about its accounting and the importance of the Berry transaction to boosting long-term production trends, no one is suggesting Linn is headed for a Chapter 11 filing.

And this bond’s claim is junior only to Linn Energy’s $4 billion credit line, on which $1.3 billion is currently drawn. At these levels the yield-to-call on the bond is approaching 8 percent. The first call is April 15, 2015, at $104.13.

Barron’s raised questions about Linn Energy that, it could be argued, were based on information and views sourced from analysts who were very publicly shorting the stock. We had been comforted by the fact that Berry’s public positions backed up its proposed merger partner and by the defense offered by Leon Cooperman of Omega Advisors via a letter to the editor published in the June 24, 2013, Barron’s.

We’re downgrading Linn Energy to “sell” in the PF Income Portfolio due to the uncertainty of the Berry Petroleum merger. But we should also acknowledge the merit of the very simple question Hedgeye Risk Management has raised.

According to the statement of cash flows filed along with its Form 10-K for 2012, Linn generated $1.14 billion in operating cash flow from 2010 to 2012. During this same period Linn spent $1.90 billion on capital expenditures, excluding acquisitions.

As Hedgeye Risk Management Director of Research Daryl Jones, as reflected in a July 1, 2013, response to Mr. Cooperman in Barron’s, notes “By the most direct definition, Linn’s free cash flow was a deficit of $757 million for the period.”

In the July 10, 2013, Personal Finance Income Report I concluded:

The complexity of Linn Energy’s hedge accounting has been resolved with management’s commitment to using only swaps going forward. Along with the significant production increase that will come with the Berry acquisition, not only is the present distribution rate secure but growth seems inevitable as well.

The accounting question is now renewed with the SEC inquiry. The Berry Petroleum merger is, at best, likely delayed. The present distribution and future growth are also very questionable.

From an operating perspective Linn Energy’s production profile, absent Berry, is deteriorating. Its financial position has come under legitimate scrutiny. And now its regulatory and legal situation has grown more complex.

We made our decision to sell Linn Energy from the PF Income Portfolio and the April 2020 8.625 percent note from the UF Income Portfolio Conservative Holdings because these collections of stocks and bonds should be about, first, preserving capital and, second, generating income.

These model Portfolios are no place for securities subject to such volatility.

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