Hedge Funds Fight ‘Un-Canadian’ Debt Exchange as Defaults Loom

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When Mudrick Capital Management LP’s David Kirsch asked the Alberta oil company he’d lent millions to if it was about to cut a deal with other creditors and leave him out, he says management told him such a thing would be “un-Canadian.”

Calgary-based Lightstream Resources Ltd. did just that, according to the anecdote recounted by Kirsch in a lawsuit his firm filed against the company last month, the second from a U.S. hedge fund since the July 2 debt exchange. Lightstream’s moves allowed it to reduce its debt load by handing its two biggest bondholders better terms, while leaving all the ones who were left out, such as Kirsch’s, with significant losses.

With plunging oil prices once again raising the prospect that more Canadian energy companies will have trouble keeping up with interest payments on their debt, Mudrick’s lawsuit and another filed by FrontFour Capital Group LLC, are being closely watched to see how far firms can go to stay solvent, and whether lenders left in the lurch can do anything to fight back.

“If you see companies that are struggling, they may well see this as a good test if they run any risks in restructuring some of their debt,” said Alan Gardner, chair of the securities litigation group at Bennett Jones LLP in Toronto. “You may see more and more companies going out and restructuring their debt.”

Defaults Loom

In its statement of defense to the July 14 lawsuit from FrontFour Capital, Lightstream said the debt exchange was allowed under the terms of its old bonds and investors’ reasonable expectations of fair treatment by the company don’t extend beyond what’s specifically laid out in that contract.

“In our view, both claims, FrontFour and Mudrick, have no merit and we will defend them vigorously,” Annie Belecki, Lightstream’s general counsel, said in a phone interview Tuesday. “The second-lien transaction involved extensive legal review and advice.”

Jason Mudrick, president and founder of New York-based Mudrick Capital, declined to comment on the suit beyond the documents that have been filed.

Renewed declines in oil prices, which this week touched a six-month low as they fell below $50 per barrel, are already being felt in the part of the debt markets that Canada’s neediest companies depend on for cash. Borrowing costs for junk-rated Canadian firms in the U.S. climbed this week to 723 basis points more than ultra-safe government debt, the highest since February, according to Bank of America Merrill Lynch data.

Refinancing Hurdles

That could make it harder for cash-strapped resource firms to re-finance their debt as it comes due and avoid default.

Amid the leg down in oil, Lightstream last month negotiated a private debt exchange with the two largest holders of its $800 million of 8.625 percent notes, swapping more than $465 million of the securities for $395 million of new securities that rank higher in the company’s capital structure.

Moody’s Investors Service labeled the deal a “distressed debt exchange,” which the company did to avoid defaulting on its bonds.

It allowed the two unidentified investors to swap their portion of the old notes for new ones with a higher claim on the company’s assets, and gave them the exclusive opportunity to buy even more of the new debt so Lightstream could pay off other, more expensive obligations.

Case Watch

“It’s just a restructuring where you get screwed,” said Mark Wisniewski, a bond manager in Toronto at Sprott Asset Management LP who doesn’t hold Lightstream’s debt, but is following the case. “You got completely subordinated by a deal by a bunch of bondholders.”

The lawsuits from Mudrick, and Greenwich, Connecticut-based FrontFour Capital, rest on a provision in Canadian corporate law that allows security holders, including bondholders, to seek damages if a company treats them unfairly or prejudicially.

The line of argument, called “the oppression remedy,” is often used by investors in Canada during a proxy contest for control of a board of directors, hostile takeovers, or other major corporate transactions, said Eliot Kolers, a partner in the litigation group at Toronto-based Stikeman Elliott LLP.

Both hedge funds assert they were in regular contact with the company in the period before the debt exchange was announced, and the company’s failure to tell them about a deal that would benefit other investors at their expense, and then the refusal to cut them in after the fact, constitutes the court’s definition of ‘oppression.’

“It’s going to be an important case,” said Paul Steep, an expert in securities litigation at McCarthy Tetrault LLP in Toronto. He said he expects the case will be decided on whether a creditor’s expectation of fairness goes beyond what is specifically laid out in the terms of a bond indenture, or if the company’s adherence to the letter of the contract was enough.

“That’ll have a big impact not just on the law, but on the market,” he said.

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