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May 02, 2016

Halliburton's canceled merger with Baker Hughes raises board oversight questions

Setting breakup fee at twice the average for strategic deals with apparent disregard for regulatory hurdles and extended drop in oil price suggests inadequate due diligence

Should Halliburton shareholders have to swallow a $3.5 billion breakup fee that the oilfield services company has to pay Baker Hughes after the two companies canceled their merger on Sunday?

Given widespread doubts and warnings from the start about whether the proposed deal would pass regulatory muster, the idea that the possibility of an extended drop in energy prices – and consequently in strategic buyers’ appetite for the assets each company was trying to sell off to assuage antitrust concerns – wasn’t anticipated in the board’s oversight efforts around the merger calls for further inquiry.

In the civil antitrust lawsuit it filed in early April, the Department of Justice said the merger would eliminate head-to-head competition in as many as 23 product lines, which would lead to higher prices and less innovation, as reported by the Wall Street Journal on Monday.

The average breakup fee for mergers involving strategic buyers such as Halliburton’s rose to 5.1 percent of deal equity value in 2015 from 4.3 percent in 2014, according to ‘M&A at a glance: 2015 year-end roundup’, a report by Paul Weiss Rifkind Wharton & Garrison. The $3.5 billion breakup fee amounts to 10 percent of the original deal value of $35 billion – twice the average – and a whopping 12.5 percent of the more recent estimated value of $28 billion based on current share prices.     

The high fee was required to prevent the deal from fizzling after the two companies’ initial struggle during the fall of 2014 to agree on a suitable price and breakup fee, as reported by the New York Times’ DealBook blog on Monday.

But what could members of Halliburton’s board have been thinking? Even after five years of stable oil prices at elevated levels and during a bull market in energy prices with full confidence in continued demand from industrial expansion, especially in key foreign markets such as China and India, how could Halliburton’s board not have taken full account of major changes in the world market, including the sheer volume of oil and natural gas coming to market as US hydro-fracturing went wild?

In its 2014 short-term energy outlook, the US Energy Information Administration projected that global crude oil production would increase by 1.4 million barrels a day in 2014 and by roughly 1.5 million barrels a day in 2015 versus projected increases in liquid fuels consumption of 1.2 million barrels a day in 2014 and 1.4 million barrels a day in 2015. To be fair, world oil prices didn’t approach $70 a barrel until the start of the fourth quarter of 2014 – shortly before Halliburton and Baker Hughes entered into their merger agreement in November – and didn’t initially breach the alarming $50 threshold until the first quarter of 2015. By November 2014, however, oil prices had already been in precipitous decline for five months and had fallen 38 percent from $115 a barrel in June.

And it wasn’t until November 27, 2014 – 10 days after the merger was announced – that the Organization of Petroleum Exporting Countries, which controls nearly 40 percent of the world market, failed to agree on production curbs, which accelerated the drop in prices, as The Economist explained in a blog post in December 2014. 

But many of the factors responsible for the extended drop had been in evidence for years before the merger was announced, including diminishing demand resulting from weak economic activity, more efficient industrial operations, an expanding transition to alternate fuels and the US becoming the world’s largest oil producer and substantially cutting its imports.

Halliburton’s executive pay plan for 2015 at least reflects the extended market downturn. In its 2016 proxy statement, the company said it had changed its long-term incentive mix in its plan to weight it more heavily toward performance units, which now comprise 50 percent of total long-term incentives for the company’s named executive officers (NEOs). In the proxy statement, Halliburton writes: ‘In an effort to help manage fixed costs during the downturn, all our NEOs took a voluntary reduction in base salary on April 1, 2015’. This included a 6.9 percent cut in CEO Dave Lesar’s base salary and a 3 percent reduction for all other NEOs. These changes, however, aren’t reflected in the ‘2015 salary’ column in the compensation discussion & analysis section of the proxy, Halliburton says.

To read more on the canceled merger, click here.   

David Bogoslaw

Associate Editor and Online features producer for Corporate Secretary