September 16, 2014

Explainer: why the James Hardie asbestos victim compensation fund is running out of money

By Lee Moerman, University of Wollongong and Sandra van der Laan, University of Sydney

After a week of media speculation on the issue, building materials company James Hardie yesterday confirmed the fund for compensating asbestos victims could run short of money as soon as 2017.

Generally, when investigating corporate affairs the golden rule is to “follow the money”. However, in the saga of James Hardie’s involvement with asbestos victims, it may be wiser to follow the numbers.

Since the company’s highly public and controversial corporate restructure in 2001, the guarantee of payments to sufferers from asbestos-related disease has been under constant scrutiny from analysts, journalists and asbestos disease advocacy groups.

The directors of the Asbestos Injuries Compensation Fund (ACIF) are now seeking discussions with James Hardie and the NSW government about the establishment of a payment scheme, to avoid paying lump sums, from July next year.

This is not the first time a payment scheme has been mooted. In the aftermath of the global financial crisis, the NSW government (in agreement with the federal government) established a cash advance facility to stop the need to go to “trickle” payments for claimants and their families through a payment scheme. Media reports at the time highlighted the inability of a financially distressed James Hardie to ensure peace of mind for asbestos victims.

A complicated history

The current arrangement is a result of an extended period of “to-ing and fro-ing” over asbestos compensation funding beginning with the restructure and re-domiciling of the parent company in the Netherlands (and later Ireland). The potential insolvency of the Medical Research and Compensation Fund led to the establishment of a more independent arrangement through the AICF.

The AICF is a separate legal entity that is responsible for asbestos-related claims in the past and into the future. The separation of legal responsibility and the arrangements to fund asbestos claims from current operations is covered by the Amended Final Funding Agreement (AFFA) which spells out the terms of the fiduciary relationship.

In this agreement James Hardie is required to contribute to the AICF annually through an “Annual Payment” that is the lesser of actuarial estimates of claims payments and fund running costs known as the “Annual Contribution Amount” (ACA), and a complex bespoke accounting-based formulation of “free cash flows”. This ensures that James Hardie is never required to contribute more than the estimate of future claims.

Will James Hardie do the right thing?

The current concerns focus on James Hardie’s moral obligation, rather than mere compliance with the funding agreement. Some have asked why James Hardie was able to pay out US$556 million to investors via dividends during the last two years and millions of dollars in staff pay rises, with the risk of a compensation fund shortfall looming.

Compliance with the funding agreement allows for the payment of ordinary dividends (albeit capped at 75% of net income) as these do not form part of the calculation of free cash flow. The free cash flow amount consists of operating cash flows plus or minus such transactions as those relating to interest (normally a financing cash flow) and payments made to the compensation fund during the year (not a component of operations).

The primary reason for the projected shortfall is that the annual contribution amount and the 35% of free cash flows are independent calculations based on different criteria.

The contribution amount is basically an accounting provision or balance sheet item for the compensation fund, whereas the free cash flow relates to the income statement or profitable operations of James Hardie and relies on its ability to generate cash flows from operations. The further into the future cash flows are expected, the less they become in present value terms.

Therefore, in essence the estimates of the annual contribution amount will only affect James Hardie’s annual payment to the AICF at such a time as the projection of future claims diminishes or James Hardie operations generate extraordinary cash flows.

The drafting of the funding agreement was complicated by the long-tail nature of asbestos-related diseases and the need to project so far into the future. The need to provide funding without compromising the viability of James Hardie required a model that controlled and limited the way payments were made resulting in a mismatch between payments to the fund and asbestos claims.

As it stands, claims in recent years have been higher than expected, with a spike in expensive mesothelioma-related claims.

Should the NSW government step in?

James Hardie is not required to “catch up” or top up the fund next year when the annual contribution amount - the amount required to appropriately fund future asbestos claims - outstrips the free cash flow calculation. While the disconnect between the numbers and the money creates uncertainty for the AICF, which is responsible for compensation payouts, and a PR nightmare for James Hardie, spare a thought for the victims and their families who justifiably feel outraged and confused.

Given this scenario, Monday’s media release from the AICF is a cry for help to the government for further assistance due to the restrictive conditions of the funding agreement, albeit potentially at the expense of asbestos victims.

Bearing in mind that the forward projections of compensation payments from the AICF are just that – estimates – what does the change from a lump sum to an instalment payment scheme achieve?

It will likely only achieve some comfort with numbers reported for directors attenuating the risks around the fund trading while insolvent. However, it will not affect the money that changes hands. That is, it will not change the annual payment amount required from James Hardie, nor the availability of a government-sponsored loan facility, nor the amount of compensation awarded to asbestos victims.

While there are a plethora of potential solutions to increasing asbestos compensation claims, such as removing asbestos from the environment, statutory limits on payouts and disease prevention and cure initiatives, resolving the shortfall of the compensation fund under current arrangements will require James Hardie to accept responsibilities beyond the scope of the funding agreement by paying the fund amounts that more closely match asbestos claims.

This article was originally published on The Conversation. Read the original article.