Chesapeake Ruling Shocks With $117 Million Loss: Credit Markets

Last week’s court ruling against a group of Chesapeake Energy Corp. bondholders exposes another risk for investors seeking gains in a market where securities valuations are already at record highs.

Prices on the second-biggest U.S. natural gas producer’s notes have fallen by as much as 9 cents on the dollar, erasing $117 million, after a judge ruled May 8 that Chesapeake could redeem the securities at par. Investors including the hedge-fund firm run by former Lehman Brothers Holdings Inc. President Bart McDade were betting the Oklahoma City-based company had missed a deadline and would have to pay as much as $400 million to retire the debt early.

A search for returns has highlighted the dangers implicit in wagering on disputes in which borrowers traditionally had the upper hand after yields on junk debt dropped to a record 5.98 percent and prices soared to an unprecedented 107.2 cents on the dollar on May 9. Pacific Investment Management Co.’s Bill Gross called a top to the bond market in a May 10 Twitter post, saying a “30-year bull market in bonds likely ended” on April 29.

“In a difficult environment, people are looking for almost any way to get an edge,” Philip Adams, an analyst at Gimme Credit LLC, who wrote the court would likely rule for the company in a March 12 note, said in a telephone interview. “It was an opportunistic situation where someone said ‘Ah, I think we got ’em’ and tried to make a buck off of it.”

Bondholder Risks

The quality of investor protections built into high-yield bond sales is deteriorating to record lows as buyers funnel into riskier assets for a reprieve from a fifth year of Federal Reserve stimulus, according to Moody’s Investors Service. The lowest-rated tier of high-yield bonds has returned 8.9 percent this year, more than any other slice of corporate debt, Bank of America Merrill Lynch index data show, even as the default rate rises.

Any company that drafts ambiguous deal documents may receive similar legal treatment to the “get out of jail free card” that U.S. District Judge Paul Engelmayer in Manhattan handed to Chesapeake, according to Brian Gibbons Jr., an analyst at debt researcher CreditSights Inc. in New York.

“The assumption now will be that indenture readers need to be on the lookout for sections of documents where they might need ‘time to apply thoughtfully the canons of contractual interpretations,’” Gibbons wrote in a May 8 report. “The risks are to be laid on the bondholder for bad drafting.”

‘Clumsy’ Indenture

Chesapeake sold $2.3 billion of bonds on March 18 to pay back the outstanding debt before the dispute was resolved, demonstrating their confidence that they’d prevail even after being denied an emergency court ruling on March 14. They joined borrowers in issuing $158.5 billion of speculative-grade notes in the U.S. this year, on pace to beat last year’s record $359 billion of issuance.

“The court clearly upheld the issuer’s ability to be innovative in crafting an indenture that serves its legitimate business purposes, even when that innovation departed from customary business practices and was phrased in a way that was a little bit on the clumsy side,” Richard Ziegler, the lead attorney for Chesapeake at the trial, said in a telephone interview.

Market participants and their lawyers expect commercial law will follow actual practices and the decision “turns those expectations on their head,” Jeff Ross, a commercial litigator with Ross and Orenstein LLC in Minneapolis, said in a telephone interview last week.

‘Flamingly Inconsistent’

“Certain ramifications of the decision are flamingly inconsistent with credit market usage of terms, practices and expectations,” he said.

Elsewhere in credit markets, the cost of protecting corporate debt from default in the U.S. rose for a fourth day. The Markit CDX North American Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, increased 1.9 basis points to a mid-price of 74 basis points as of 11:22 a.m. in New York, according to prices compiled by Bloomberg.

The index, which ended May 7 at the lowest level since November 2007, typically rises as investor confidence deteriorates and falls as it improves. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

Rate Swaps

The U.S. two-year interest-rate swap spread, a measure of debt market stress, increased 0.6 basis point to 13.8 basis points as of 11:23 a.m. in New York. The gauge widens when investors seek the perceived safety of government securities and narrows when they favor assets such as company debentures.

Bonds of Cupertino, California-based Apple Inc. are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 4.8 percent of the volume of dealer trades of $1 million or more as of 11:23 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. The iPhone maker sold $17 billion of bonds on April 30 in the biggest corporate offering on record.

Chesapeake sued Bank of New York Mellon Corp. March 8 after the bank challenged its bid for an early redemption of $1.3 billion of 6.775 percent notes due in 2019. Bond investors wagered that the company had run out of time to repurchase the debt at par. That would have forced the company to pay about $400 million in a so-called make-whole premium, or the present value of all future interest payments, in addition to the principal amount of the bonds.

Reversal Sought

Noteholders involved in the lawsuit include McDade’s River Birch Capital LLC, Archer Capital Management LP, Ares Management LLC, Aurelius Capital Management LP, Carlson Capital LP, Cetus Capital LLC, Latigo Partners LLP, Monarch Alternative Capital LP, P. Schoenfeld Asset Management LP and Taconic Capital Advisors LP, according to a March 12 court filing.

The notes due March 2019 climbed to 109.5 cents April 30 when Judge Engelmayer said the company “had any number of ways” it could have improved the language to clarify a deadline for early redemption. The securities last traded at 101.25 cents on May 10, after falling as low as 100.5 on May 9, Trace data show.

“The judge carefully explained why the contract allows a par redemption, and then also why even if the contract was ambiguous, Chesapeake would still win,” Adam Cohen, an analyst and founder of New York-based Covenant Review, said in an e-mail. “This makes it tough for bondholders to prevail if they appeal.”

A notice of appeal was filed May 11 in federal court in Manhattan, with BNY Mellon seeking reversal of the ruling.

Market Peak

Paul Caminiti, a spokesman for Chesapeake, said the company is confident in the legal basis of the ruling, expects to prevail on appeal and that the notes’ redemption is expected to go forward today as planned.

The dispute came at a time of plunging yields as the Fed expands its balance sheet to $3.32 trillion through bond purchases intended to fuel economic growth and reduce unemployment. After four years of annualized returns of 11.3 percent on corporate bonds globally, Pimco’s Gross, who earned the nickname “The Bond King” in media outlets, said the debt’s best years of gains have probably ended in a May 10 Twitter post.

“You need to look at an amalgamation of Treasuries, mortgages and corporates, and not just Treasuries,” Gross, co-founder and co-chief investment officer of Newport Beach, California-based Pimco, said in an e-mailed statement. “Measured on that basis, 4/29/13 has been the price high and yield low, to this point.”

Record Issuance

Chesapeake sold $2.3 billion of senior bonds in three parts to redeem debt including the 6.775 percent notes even with the lawsuit against noteholders pending. The bonds are rated Ba3 by Moody’s and BB- by Standard & Poor’s and Fitch Ratings, Bloomberg data show. The offering wasn’t conditioned on the outcome of the legal dispute.

“They’re saying, ‘We’re so confident that the 2019s are going to be redeemed at par that we’re going to issue these bonds and start paying interest on them,” said Covenant Review’s Cohen at the time.

Companies worldwide from the neediest to the most-flush with cash have sold $1.54 trillion of debt this year, exceeding the $1.5 trillion in the same period last year when issuance reached a record $3.97 trillion, Bloomberg data show.

Demand Cycles

Investor protections on North American high-yield debt averaged over three months deteriorated to a record low, Moody’s said last month. The average covenant score, in which 1 represents the highest quality and 5 the weakest, worsened for a third period to 3.97 in March.

“We go through these cycles of extreme demand and liquidity,” said Scott Colyer, who manages $10.5 billion as chief investment officer at Advisors Asset Management in Monument, Colorado. “We’re closer to that top. It does show it’s worthwhile for companies to do anything they possibly can to refinance and call in early their debt.”

Chesapeake issued the contested bonds in February 2012, just before it was disclosed that former Chief Executive Officer Aubrey McClendon had been using his personal 2.5 percent stakes in some Chesapeake Energy wells as collateral for loans that weren’t fully disclosed to shareholders.

The energy provider included a novel provision in the note’s contract that would allow the company to redeem the securities at an early date after it had completed planned asset sales. Chesapeake said it would save about $100 million in interest payments by refinancing the bonds before they matured.

‘Perfect Clarity’

Judge Engelmayer ruled in favor of Chesapeake even as he wrote in his opinion that the company failed to draft the contract with “perfect clarity” and said other company documents describing the provision were “imprecise” and reflected “inattention” and “sloppiness.”

“This shows that sloppy drafting can have enormous consequences,” Richard Farley, a New York-based attorney with Paul Hastings LLP, said in a telephone interview. “This should be a case study for every junior bond lawyer coming into the business.”

The case is Chesapeake Energy Corp. v. Bank of New York Mellon Trust Co., 13-cv-01582, U.S. District Court, Southern District of New York (Manhattan).

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