A unitholder of Linn Energy LLC launched a derivative suit Friday in Texas court, alleging executives and board members at the energy giant hid hundreds of millions in investment expenses, prompting a federal investigation that caused the company’s artificially inflated value to crash.
In his suit against Linn Energy’s top execs and board members, the unitholder claims a series of newspaper articles revealed the company’s unusual practice of excluding from its income calculations costs related to financial derivatives purchased as a long-term hedge against volatile energy prices, causing the U.S. Securities Exchange Commission to investigate and Linn Energy’s value to crater.
The unitholder claims that Linn Energy, which is structured as the eighth-largest master limited partnership in the U.S., has steadily increased dividend distributions to unitholders since 2006, despite being free cash flow negative since 2010. According to the suit, the company has been able to sustain its impressive track record through the adoption of a non-generally accepted accounting principles practice designed to mask Linn Energy’s true financial health.
Styling itself a “different kind of oil-and-natural-gas company,” Linn Energy aims to maximize its revenue by hedging the output from its energy assets years in advance with financial derivatives, the unitholder says. As a part of that strategy, Linn Energy prefers to use expensive “put options” which enable it to sell its securities to a specified buyer at a set price for a period of time.
For much of the first four years of its existence, strong cash flow allowed Linn Energy to absorb the higher cost of the put options and pay increasing dividends, the complaint alleges. But in 2010, the company found itself struggling to cover the cost of the options and faced the specter of cutting dividend payments.
The complaint says that Linn Energy execs wanted to avoid that possibility, given that their “gaudy” compensation incentives were tied in part to the ability to make unitholder distributions.
“Rather than disclose Linn’s true financial health and risk limiting dividend distributions (and their own incentive-based compensation), the individual defendants devised a scheme to conceal Linn’s cash flow problems from investors by artificially inflating the company’s adjusted net income on its published balance sheets,” the suit said.
According to the suit, sometime in 2011, Linn Energy began recognizing gains from the sales of its financial derivatives on its balance sheet, but ignored the cost of the put options, “wildly overstating the company’s actual cash flows” in filings with the SEC and investors statements.
The alleged scheme began to crumble in February, when Barron’s ran the first of a series of articles scrutinizing Linn Energy’s accounting practices and describing the energy company as overvalued by as much as 50 percent, the suit says. Market analysts and investors took notice and by the time Barron’s published its third piece on Linn Energy in June, the company’s stock price had begun its descent.
But the biggest blow to unit holders came July 1, when the company announced that it was cooperating with an informal SEC inquiry into its proposed merger with Berry Petroleum Co. and Linn Energy’s accounting methods relating to its hedging strategy. In 48 hours, the company’s unit price lost 31.5 percent, falling from $33.29 to $22.79, the lawsuit claims.
The suit says that the damage to Linn Energy is not just limited to the outcome of the SEC investigation: On July 9, a separate securities fraud class action suit was filed against the company in Texas federal court.
The complaint alleges breach of fiduciary duty, unjust enrichment and waste. It is seeking actual damages and disgorgement, among other things.
The case is Peters et. al. v. Ellis et. al., case number 2013-40929, in the 152nd Judicial District Court of Harris County, Texas.