Description

Scully Royalty had a ruling against it in the Grand Court of the Cayman Islands which was delivered on July 7, 2020 but has not been disclosed by the company.

This has long been my favorite investment as a LONG. I wrote it up on VIC here.  At its core, the investment revolves around a royalty on an iron mine in Canada. 

I found this company while the royalty earned nothing but news that a private company acquired the mine and raised the funds to get it going again was out.

I could not have asked for better iron ore prices in the interim. Especially given circumstances. 

But this judgment against the company changed everything. 

Summary: worldwide asset freeze, claims coming, can lose key assets

The company has been hit by a worldwide asset freeze, will likely face claims against it tallying up to ~$125 million and the Cayman Grand Court believes there are good arguable cases to be made against the company. This could result in assets including the merchant bank and iron ore royalty to get clawed back outside the company. The integrity of management is a real question mark. The key asset remains very valuable and attractive in my opinion but it could come under threat of a potential claimant. 

It seems like a short now. I don’t think it is a fantastic short because there remains uncertainty around the ultimate reach of creditors to former subsidiaries and the iron ore mine is a fantastic asset imho. But everything taken together it looks like a terrible risk/reward here and like a trainwreck in the short term. Maybe it is not the best short but because I’ve previously argued the long case and the undisclosed judgment completely changed my disposition towards this company I’d like to show why.

The judgment

Raiffeisen Bank International AG is an Austrian bank headquartered in Vienna and it is Austria's second-largest bank. It is listed on the Vienna stock exchange. RBI claims that LTC Pharma, a guarantor of RBI under a guarantee from 2017 was asset-stripped by Scully Royalty and other subsidiaries of Scully Royalty at an undervalue. Raiffeisen Bank claims this was done to put LTC Pharma’s assets (including the royalty on the iron ore mine) out of RBI’s reach to avoid enforcement of a claim against those assets.

From my understanding, this lawsuit is a necessary first step before Raiffeisen can pursue claims in under jurisdictions like Austria and the Marshall Islands to try and claw back assets or get paid owed monies. Freezing assets of debtors also tend to get them to the table rather quickly and it secures potentially valuable assets. 

If creditors can convince the court that the stripped assets need to be returned to the company they were stripped from that would mean they are pulled out of the Scully Royalty group. It doesn’t seem likely to me that Raiffeisen, a cooperative, will pursue the assets aggressively but instead is exerting pressure to get its money back. 

From the judgment I’ve learned the following: 

On 30 September 2019: the court granted an injunction ex parte against Scully Royalty which prohibited the disposal of certain assets worldwide and made an order for service out of the jurisdiction 1178936 B.C  and others. 1178936 B.C is the company that likely holds the Scully Royalty.

On 4 November 2019: the court refused an application that the injunction is stayed pending an application to discharge it and made ancillary orders as to compliance and the listing of the inter partes hearing and the provision of evidence.

I can't find any disclosure related to these injunctions preventing the disposal of certain assets worldwide in the 12-31-2019 financial results H1 2019 by Scully Royalty.

The company does highlight its plan to restructure the group into three segments. A restructuring I interpreted as an indication of the first step towards a spin-off or simplification of the corporate structure to unlock the value present.

The company does make reference to the case, that results in the judgment discussed here, in its financial results:

3 February 2020: Freezing Order Expanded

RBI was granted continuation application in respect of the worldwide freezing order against Scully Royalty. The judge also rejected a Scully subsidiary's application to set aside the freezing order. The judge also granted RBI's WFO application against MFC II and granted RBI's application to amend to join four other subsidiaries. Permission was also granted to serve the amended claim outside of the jurisdictions of these subsidiaries.

April 30 2020: Scully Royalty announces it has issued its annual report on 20-F for 2019

I have not been able to locate any mention of a worldwide freezing order or injunction against the company or a subsidiary in this report.

May 21, 2020: Court ruling delivered in MFC Resources vs Homann

This ruling awards Homann $7.6 million and MFC Industrial is responsible. MFC Industrial is the company that originally acquired Scully Royalty’s current merchant bank and later changed its name to MFC Bancorp.The CEO and CFO of the defendant go by the same name as executives of Scully Royalty. Currently, MFC Bancorp seems to be an independent entity (per Orbis) but it would not surprise me if this judgment is the responsibility of Scully Royalty. I didn’t see this lawsuit disclosed in the latest annual report. 

7 July 2020: Court ruling delivered (discussion of the judgment) 

To this day I have not seen any disclosure of this court ruling by the company while I interpret it as a significant issue. I'll go over some of the key parts of the judgment:

RBI argues Scully Royalty asset-stripped LTC Pharma which gave RBI a guarantee. RBI believes the shareholdings of LTC Pharma or “the value of the same” should be restored to LTC Pharma.  " because they were disposed of for no value or at an undervalue as part of a conspiracy in bad faith and with the intent to defraud.  that the estimated value of assets stripped from LTC Pharma was between C$216m and C$437m. 

The guarantee amounted to some EUR 40 million. But I fear that this judgment impairs my assessment of the value of Scully Royalty by a multiple of the guarantee. 

RBI has filed evidence supporting the claim that LTC Pharma owes its creditors EUR 105.3m. That includes a further EUR 45m which RBI says it is owed under other guarantees not yet brought into these proceedings. From the judgment, it is clear those are likely to be brought during follow-up litigation. 

RBI argues that the estimated value of assets stripped from LTC Pharma was between C$216m and C$437m. The plaintiff argues that those transactions should be set aside and "that the shareholdings in question, or the value of the same, should be restored to LTC Pharma because they were disposed of for no value or at an undervalue as part of a conspiracy in bad faith and with the intent to defraud. The intent to defeat the obligations owed by LTC pharma to Raiffeisen Bank."

Worryingly, the judgment states:

In Xie Zhikun v Xio [2018 (2) CILR 508] the CICA confirmed the decision in Peak Hotels [2015] EWCHC 3048 per Birss J and Maroil [2017] EWHC 45 per Teare J that providing there was a sufficiently arguable case (to survive a strike out application) mandatory injunctions were available as a remedy with respect to the tort of conspiracy. Therefore an injunction to prevent and restore loss was available in response to claims including the tort of unlawful means conspiracy. On this basis there is a good arguable case that D1 and D3 - D7 should be required to transfer back and restore, or in the case of D1 and D5 to procure the transfer back by wholly-owned subsidiaries the assets that they have received wrongfully, to D2.

To me the above indicates there is a good arguable case that Scully Royalty should give back the assets it has taken out of LTC Pharma which is now a separate company. 

The Guarantee is governed by Austrian law and contains an arbitration clause. It is my layman’s understanding that an arbitration clause also requires contracts, under Austrian law, to be signed through a qualified electronic process if not in wet ink. Scully’s lawyer has argued the guarantee isn’t a valid contract because it hasn’t been signed in a valid way. The judge reviewed their evidence and arguments and concluded that RBI had another “good arguable case that is valid.” But left it to be potentially ruled on in an Austrian court proceeding.

The relationship between RBI and the MFC group dates back to around 2001 and in the court’s eyes appears to have been built on trust with little reliance on documented security. Perhaps there’s some hope for Scully Royalty that Raiffeisen’s claims won’t hold up down the line. 

The worldwide asset freeze order only applies to certain specified assets and not all the MFC group's assets. The way I understand the ruling the parent company Scully Royalty and the subsidiary MFC II are not covered by the freeze.

The court also takes the view that MFC group's accounts were opaque and there were breaches of accounting standards within them.

What does it all mean?

A global asset freeze is an unusual tool. In theory, a company that has its asset frozen can continue business as usual. For a merchant bank, this may be more difficult than for most other companies. I'm not sure. I'd think the goal is for the company to be able to conduct its normal business. My understanding is that the company won’t be able to sell assets. This is relevant because selling some of its currently valuable assets could go a long way towards satisfying claims against it, while realizing that value within Scully Royalty.

While royalty income from the iron ore mine should continue unabated, the income alone together with liquidity within Scully Royalty may not suffice to satisfy all claims that could be brought against the company.

This increases the odds that assets need to be returned to LTC Pharma to satisfy claims. In my opinion, that’s one of the worst-case outcomes for Scully shareholders because it would potentially mean that the iron ore royalty is transferred outside the group. Scully shareholders have recourse to the other assets but in my opinion, the crown jewels are the assets that will need to go back to LTC Pharma. 

It also seems likely it will be impossible to spin-off assets to unlock the value within the company. That’s bad because shareholders were counting on that process to unlock the value embedded in Scully Royalty. 

Effect on the financial statements

The company states in its reports that it doesn’t recognize contingent liabilities. It considers the legal liabilities contingent. This compounds uncertainty as it appears likely that the company does not disclose every legal liability against itself, its subsidiaries or former subsidiaries. In its legal proceedings section, it recognizes $67 million of possible legal liabilities but I don't think these are (fully) reflected in the financials.

Note 27

My interpretation here is that the company disclosed a $50 million liability which it reduced to ~$5 million through creative accountancy. The amount is in line with a loan payable on the balance sheet in the 20-F. But most of its liabilities are tax liabilities as well as bonds payable. I can’t find a major reserve in case this or other lawsuits went against the company.

There’s still another $25 million of potential liabilities revealed in this case that I don’t see reflected in the filings. Possibly, because management believes there won’t be a material adverse effect on its financial condition or results of operations.

It seems wise to me, given the surfaced court rulings and increased uncertainty surrounding the company’s disclosures and the accuracy of its accountants, to adjust the liabilities to reflect at least another $130 million.

Integrity

The court proceedings, facts revealed and arguments brought forward also reflect badly on management's integrity. It is hard to put a price on it but it's definitely a negative. Especially, as they are hard to get rid off. 

The assets are valuable 

RBI's argued the value of the assets that were moved out of LTC Pharma exceeds C$500m. That’s approximately $380 million. The current market cap of Scully Royalty is $88 million. Given my work on the value of the iron ore royalty that estimate does not seem out of order. At current iron ore prices of $125 per ton, I expect the royalty, with the mine fully ramped, to produce annualized EBITDA of approximately $40 - $50 million. I consider a 6-8x multiple on a royalty stream conservative. But because iron ore prices are high, a lower multiple is to be expected. .

Red and orange flags

If you invest in deep value companies there are often issues. Liabilities to lawsuits, tax disputes, self-dealing, overpaid management, etc. Many of you are familiar with these drawbacks. Sometimes part of the thesis is to clean up the company which creates value in itself. Sometimes the value in the assets is so large compared to the share price you can get paid sufficiently that a lot of challenges can be overcome. 

This court case had me reviewing some of the red and orange flags with fresh eyes. This is a list of some of the things that were never great but now seem much more problematic and new orange and red flags I’ve come across:

In the 2018 annual report the company revealed that during 2017, "two subsidiaries of the Group entered into agreements with third party employee incentive corporations. These companies were granted the right to buy up to 10% of the share capital of the subsidiaries on a diluted basis at a price to be no less or more than the then-existing net.  In the 2019 annual report, this section expanded "and upon the occurrence of a change in control event rights to purchase shares in the entities with pre-determined prices were issued." I believe this is a poison pill type structure to fend off activists and acquirers. 

In his ruling, the judge stated that:

It is arguable in this case that:

a) the defendants were responsible for obscuring the true state of affairs and the true financial position;

b) the defendants have given incomplete and misleading evidence; and

c) the defendants failed to comply properly with asset disclosure requirements.

As a shareholder that’s not what you want to hear about your management. Another statement by the judge that bothered me 

I am also not persuaded that Scully Royalty has complied fully and openly with disclosure orders. The evidence that has been provided by the represented defendants is in places inconsistent and in many respects simply not credible. The court expects that the parties can work together to make sure that the ordinary course of business matters may proceed with the requisite disclosure, transparency, and collaboration.

It appears from the court case that, for a brief time, the royalty on the Scully iron ore mine had been transferred out of the MFC Group for very little consideration. I’m not aware of any disclosure regarding that sale or transaction. In addition on October 4 2018, the company agreed to split the interest in the mine 99%/1% with a third party. This later appears to have been reversed. But if it happens once, can it happen again? This is the company’s key asset! 

Various tax matters and litigation are outstanding

It is not unusual for companies to have tax disputes, litigation, or matters outstanding. But given the fact that I’ve been surprised by the extent of potential liabilities uncovered in court, it becomes another threat. 

Tax audits or disputes, or changes in the tax laws applicable to us, could materially increase our tax payments.

We exercise significant judgment in calculating our provision for income taxes and other tax liabilities. Although we believe our tax estimates are reasonable, many factors may affect their accuracy. Applicable tax authorities may disagree with our tax treatment of certain material items potentially causing an increase in tax liabilities. Due to the size, complexity and nature of our operations, various tax matters and litigation are outstanding from time to time, including relating to our former affiliates. Currently, based upon information available to us, we do not believe any such matters would have a material adverse effect on our financial condition or results of operations. However, due to the inherent uncertainty, we cannot provide certainty as to their outcome. If our current assessments are materially incorrect or if we are unable to resolve any of these matters favourably, there may be a material adverse impact on our financial performance, cash flows or results of operations.

In the 12/5/2019 proxy, there’s this awkward paragraph on tax services. This is especially awkward because the company is already involved in fiscal disputes with various tax authorities. The amounts involved seem inconsequential but increasingly I’m less sanguine about low numbers.

The Audit Committee believes that the independent auditor can provide Tax services to the Company such as tax compliance, tax planning and tax advice without impairing the auditor’s independence. However, the Audit Committee will not permit the retention of the independent auditor in connection with a transaction initially recommended by the independent auditor, the purpose of which may be tax avoidance and the tax treatment of which may not be supported in the Internal Revenue Code and related regulations. 

Material weakness 

The company disclosed it found a material weakness in the latest annual report. This happens but it is a bad disclosure combined with all this other stuff.

Auditor revolving door

November 2017 PricewaterhouseCoopers resigned as auditors. In the 2019 annual report Moore Stephens LLP is being replaced by BDO and in its opinion basically reveals it does not agree with the adjustments described in Note 2. The incoming auditor BDO is responsible for those. The change in note 2 doesn’t have a lot of effect on the value of the company but the revolving door of accountants is disconcerting. Especially, given the disclosure around controls AND because the judgment shows management seems to be trying to conceal bad news.

Executives are quite well paid given the profitability of the firm. Board members are extremely well paid given the size of the business. Members of the audit committee are among the highest-paid directors.

Letter from the SEC

On 7/9/2020 the company received a letter from the SEC asking for additional disclosures. Initially, I liked the letter expecting increased disclosures would be an improvement. I still think they are going to be an improvement but I’m less certain additional disclosures will result in an improving share price. 

Merkanti Bank gave a credit facility of $40 million to Scully Royalty. Per the Merkanti bond prospectus Scully had drawn ~$5 million. This facility will mature at the end of 2020. I’m not certain how agreements like that interact with asset freeze orders. But if Merkanti can’t loan to Scully that certainly does not help to manage group liquidity. Merkanti holds a bank license. If Merkanti becomes capital constrained all kinds of EU bank regulation like CRD IV and CRR CRD IV, CRR and BRRD could start becoming problematic. One of the reasons for the bond issue was to loan $5 million to Merkanti Bank from the real estate companies. One example of what regulators can do under BRRD:

The powers provided to resolution authorities under the BRRD include write-down powers to ensure relevant capital instruments absorb losses upon, amongst other events, the occurrence of the non-viability of the relevant institution or its parent company, as well as a bail-in tool comprising a more general power for resolution authorities to write down the claims of unsecured creditors of a failing institution and to convert unsecured debt claims to equity.

Economics

The company’s latest disclosed unaudited balance sheet looks strong and it's been a key reason for me to be here. Note that I know think this should probably reflect another $125 - $130 million additional liabilities.

But why did the company issue bonds at 4% through the Merkanti Holding subsidiary in August 19 to raise ~$25 million with a balance sheet like this? Then get hit shortly after by an asset freeze. 

Here are the latest results from operations. The large profits in 18’ are because the company revalued the Scully Iron Ore mine by $188 million CAD. 

Broken down by segment things look as follows:

Or done differently it looks like this:

The breakdown of costs of sales and services looks like this:

At least on a gross basis, the merchant banking/trade finance is profitable. Revenue from Merkanti Holding should decline given the real estate has been encumbered by 4% bonds since the last quarter of 2019. 

Meanwhile, the Scully iron ore mine continues to ramp up. It is running at a quarterly rate of 800k tons per quarter per Q2 2020. In Q1 2020 it did 400k tons.

There’s some uncertainty around the exact ramping schedule as I derive the production figures from 3rd party figures about published tons shipped. Because a train can easily fall just in a certain quarter or just outside of a certain quarter this may not accurately reflect the ramping rate.

If we assume the run-rate is at 800k tons per quarter the mine is doing 3.2 million tons per year. That’s about half of its fully ramped rate. That should result in approximately $20 million in revenue for the year. I’ve assumed iron ore prices of $110 per ton for the year, given the premium quality of Scully’s product as well as high prices, and factored in Canadian royalty taxes. $10 million may have accrued to the balance sheet already. Potentially the royalty could do even better in H2. Fully ramped up (6-6.5 million tonnes) at great iron ore prices the royalty can produce $40 - $50 million per year. 

Conclusion

My take here is that even though Scully Royalty owns an amazing asset in the iron ore mine it is basically uninvestable given the uncertainty around the potential claims against this and other assets. 

This is further exacerbated by the company’s disclosures that are limited (as evidenced by the SEC letter) and sometimes late or absent. Add to that the juggling of subsidiaries around and even moving THE key asset outside of the group without disclosure. 

I expect legal expenses will continue to run high for the foreseeable future as the company fights with creditors, former business partners, and (former) shareholders. 

Purely on a valuation basis, Scully Royalty is attractive. In my prior write-up, I laid out the upside for the shares to between $15 and $31. It did go over $15 for a time. If I adjust for previously unknown liabilities and judgments against it, that comes down to between $5 and $21. That’s still great given it is now at $6.5. And I think the framework I used for valuation is still valid.

But that’s based on its assets being unencumbered by undisclosed claims or lengthy worldwide asset freezes. This case has deteriorated to where it is necessary to underwrite the odds of losing key assets, to a point where I’m not confident the actual numbers of the company are in the same galaxy as the disclosed financials, where banking regulation can come into play that I’m not familiar with. 

In my opinion, and I believe many (former) shareholders will see it similarly, given the enormous uncertainty the company is now facing, the company will need to improve its disclosures and communication immensely before it can become a long again, at a certain price. Both the board and management should be removed or remove itself even though that’s likely not going to happen. 

I’m not arguing this is a fraud to zero types short. Or a great short because there’s a terrible underlying business. I think it is a sell or short because of 1) the dirt this judgment has surfaced 2) The follow-up actions that Raiffeissen is likely to take. 3) With the SEC telling the company to up its disclosures and reminding executives they are responsible for these in public letters, it just seems extremely likely the company will need to make some very ugly disclosures. 4) The income from the royalty is great and growing but unlikely to offset reported losses and with the asset freeze, it should be impossible to sell assets.   

Previous the low for the company was around $4. I think it can trade below official cash per share and only buyers at these levels that make sense to me would be quants. I think it can now go through that to $3 in the next three months. I really hope at some point the company turns it around but I don't see it anymore in the near future.

Catalyst

Negative catalysts could be company disclosing claims against it, additional liabilities, a worldwide asset freeze, banking regulatory stepping in or it becoming clear that Raiffeisen can go after the royalty and/or merchant bank.