Dynegy Dives as Enron Won't Go Quietly

Not everything a rogue says is false. Bear that in mind in gauging who will win the escalating legal battle between Enron (ENE Quote - Cramer on ENE - Stock Picks) and Dynegy (DYN Quote - Cramer on DYN - Stock Picks) over the disintegration of the companies' merger plans last week.

Dynegy's planned acquisition of Enron amounted to a rescue effort, so the death of the deal on Nov. 28 all but guaranteed Enron's demise. The final blow came Sunday, when the once-dominant energy trader filed for bankruptcy protection in a New York court and simultaneously sued Dynegy for at least $10 billion in damages.

Familiar Slope Deterioration at Dynegy

Enron's suit appears to be unnerving Dynegy investors. Extending a bruising series of down days, its stock plunged 11% Monday on fears it could be a long, hard and expensive struggle to defeat the Enron complaint, which charges Dynegy with a "wrongful termination" of the Nov. 9 merger agreement. Dynegy on Monday described Enron's lawsuit as "frivolous and disingenuous." Dynegy didn't comment on the dispute beyond its statements in Monday's conference call; Enron wouldn't comment.

So why believe Enron? Recent accounting controversies at the company, its poor disclosure and the low credibility of its management all make it hard to believe anything Enron now says, even in a legal document. But it's fair to say that the court will care little about Enron's past sins and will focus narrowly on whether Dynegy wrongfully broke off the agreement to combine. When viewed that way, it appears that Dynegy still has something of a fight on its hands.

In a nutshell, Enron claims that certain deeply negative developments that came after the merger agreement was struck were caused by Dynegy, or were nonmaterial. So what are the merits?

IOU?

Dynegy is making a lot of fuss about a surprise disclosure in an Enron 10-Q filing of quarterly results with the Securities and Exchange Commission on Nov. 19.

That document revealed that a downgrade of Enron debt had triggered the early repayment of a $690 million obligation. That revelation added to the view that Enron's management was woefully ignorant of its true liabilities, or, even worse, was hiding them. And the acceleration of the repayment would've eaten into Enron's cash position, which was dwindling quickly at the time. "The accelerated obligation was absolutely material," says Carol Coale, energy analyst at Prudential Securities. (She rates Dynegy hold, and Pru doesn't do underwriting.)

Upon seeing the nasty disclosures, Dynegy began to feel aggrieved, and it started to let that show -- albeit subtly. On Nov. 21, after a 20%-plus plunge in Enron's stock, Dynegy issued a press release that said it was "encouraged" to hear that Enron had "received a commitment from its lead bank to extend the $690 million note payable obligation described in Enron's recent 10-Q filing." However, instead of stating that it was unequivocally committed to the deal, Dynegy's language became more circumspect. In the statement, Dynegy CEO Chuck Watson merely said: "We are continuing our confirmatory due diligence and working to accelerate the regulatory approvals required to complete the merger in accordance with the previously announced agreement."

Dynegy's Watson also appears to be saying that Enron's cash burn took it by surprise. On a conference call Monday, he said that he had expected to see more than $3 billion of cash in hand in the 10-Q, instead of the $1.2 billion actually stated. This implied that Enron had consumed the $1.5 billion cash infusion that Dynegy had made as part of the original merger agreement. "Neither the treasurer nor the CFO could explain where the cash went," Watson said. "The [10-]Q destroyed any remaining confidence and credibility."

When terminating the deal, Dynegy cited "Enron's breaches of representations, warranties, covenants and agreements in the merger agreement, including the material adverse change provision." Merger agreements' "material adverse change provisions" are designed to give parties a basis on which to exit a deal in event of certain, usually extraordinary, developments.

So what is Enron's response? On the $690 million obligation triggered by the ratings downgrade, Enron's argument is far from robust. The company argues: "The rating event itself did not constitute a material adverse event." The suit implies that is so because the downgrade came after the merger agreement was signed. But surely one of the main points of the material adverse effect clause is to address events that happen after the agreement. Conspicuously, Enron makes no comment on the failure to notify Dynegy about the early repayment clause. That looks like nothing short of negligence.

Lukewarm

However, the second prong of Enron's suit is stronger. It alleges that Dynegy publicly vacillated on the deal "to maximize the uncertainty in the market among Enron's counterparties, and thus undermine the safety net the merger was supposed to provide to Enron." In essence, Enron claims that Dynegy allegedly went lukewarm to kill the deal.

In making this argument, Enron pointedly targets the Nov. 21 Dynegy press release that speaks of continuing due diligence. It rightly contends that was misleading because due diligence is supposed to be done before the merger agreement. Damagingly for Dynegy, Enron quotes Dynegy President Stephen Bergstrom saying the company performed "considerable due diligence." Typically, corporate law holds that a buyer can't pull out of a deal simply because it failed to do its homework.

Enron goes too far in saying Dynegy wanted to scuttle the deal to finish off Enron as a competitor. But it's certainly possible that Dynegy did move to undermine the merger once it realized it was buying a dud. More detail on the negotiations is needed to determine who will win this case. But Dynegy's stock has reached the correct interim verdict: Enron hasn't lost yet.