Chesapeake Energy has had lots of scandals over the last year or so, but now they’re embroiled in a new one that is perhaps their most damaging yet. No, I’m kidding, it’s totally trivial, but in my capital-markets-dork mind it’s kind of funny, so now I’m going to talk about it and you’re not going to listen, probably, if you know what’s good for you.
Basically: Chesapeake has some bonds that they wanted to call, and they forgot to call them, and now it’s probably but not certainly too late, and they’re suing to make sure. This is a difficulty of corporate personhood: when I do something dumb, I just get real quiet and hope no one notices, but when a company does something dumb, the particular human who did the dumb thing gets fired or yelled at or whatever, while other particular humans go around demanding a do-over.
The bonds are Chesapeake’s $1.3 billion of 6.775% notes due 2019, issued in February 2012. According to the prospectus, the bonds are:
- Not callable from February 2012 to November 2012, then
- callable at par from November 15, 2012 to March 15, 2013, then
- callable at a make-whole price from March 15, 2013 until maturity on March 15, 2019.
The make-whole price is the present value of future payments discounted at T+50bps, so the call price goes sort of like this:1
So the very worst time to call these bonds is next week, because then you have to pay ~129 points, whereas this week you have to pay 100 points. Waiting that extra week costs you $380 million.
And Chesapeake maybe missed its chance to call them this week? That’s the dispute: the indenture provides that Chesapeake has to give notice of a call at least 30 days before the call date. It has not given any notice. The question is: does it have to get the notice in by 30 days before March 15, 2013 (the last par call date), or does it just have to get the notice in by March 15, 2013, and can then actually redeem the bonds 30 days later? Cheseapeake thinks the notice is due by March 15; the indenture trustee at BoNY Mellon, and the bondholders, think it’s due by February 13. Bloomberg seems to side with Chesapeake though it’s hard to tell.2 I’m with the bondholders though I don’t think it’s 100% clear. It’s like 75% clear.3
In any case it’s dumb: Chesapeake had a four-month window to call the bonds, and could have avoided any problem by just issuing the call notice in November, or December, or January
, or at any rate by February 13.3A Their complaint says that they called up BoNY Mellon on February 20 to have a pleasant chat about when they were going to issue the call notice, and got an an unpleasant surprise.
There’s no larger message here, really. It’s just dumb. If you have to pick a message it’s that valuing optionality in securities is hard, because companies don’t always do the thing that looks “rational” to the market. Sometimes they choose not to do NPV-positive things for various sorts of plausible reasons. And every so often they just forget.
Rationally, Chesapeake was certainly going to call these bonds. Chesapeake’s 6-year cost of debt is not 6.775%; it’s probably more like 5%.4 Even if it’s 5.25%, calling these bonds at par and re-funding them with a new 6-year at 5.25% would save Chesapeake $20 million a year in just free money. So the market assumed that would happen, and as of two months ago these bonds were trading at a smidge over par, for a yield-to-maturity in the mid-6s. If they were getting called at par in a month – and of course they would be – selling them at 101 was pure profit, and buying them at 101 was dumb. Then Chesapeake forgot to call them, and anyone who bought at 101 got a windfall – the bonds are at ~106.5 now:5
Sometimes there is free money. Err, free-ish. Chesapeake still has, by my count, three days to win its lawsuit and redeem these bonds at par. The market doesn’t seem to think they will, but the market has been wrong about these bonds before.
1. This is just using one constant Treasury rate, and not at all right especially in later years; it’ll move around. Good enough for our purposes though.
Incidentally: the obvious question “why did they do it this way?” is unanswered both in the prospectus and in Chesapeake’s complaint filed last week.
2. This is not a thing to believe but sometimes people believe it:
At least 30 days but not more than 60 days before a redemption date, the Company shall mail a notice of redemption by first-class mail to each Holder of Securities to be redeemed at such Holder’s registered address.
The supplemental indenture says (section 1.7):
At any time from and including November 15, 2012 to and including March 15, 2013 (the “Special Early Redemption Period”), the Company, at its option, may redeem the Notes in whole or from time to time in part for a price equal to 100% of the principal amount of the Notes to be redeemed, plus accrued and unpaid interest on the Notes to be redeemed to the date of redemption; provided, however, that, immediately following any redemption of the Notes in part (and not in whole) pursuant to this Section 1.7(b), at least $250 million aggregate principal amount of the Notes remains outstanding. The Company shall be permitted to exercise its option to redeem the Notes pursuant to this Section 1.7 so long as it gives the notice of redemption pursuant to Section 3.04 of the Base Indenture during the Special Early Redemption Period. Any redemption pursuant to this Section 1.7(b) shall be conducted, to the extent applicable, pursuant to the provisions of Sections 3.02 through 3.07 of the Base Indenture.
The question is basically, does that “so long as it gives notice … during the Special Early Redemption Period” sentence mean what it says? (If it does, of course, then the first sentence – “At any time from and including” etc. – does not mean what it says, since the company can redeem the notes at par outside of the Special Early Redemption Period. The description of the notes in the prospectus is not especially clarifying. My personal sense is that market practice is “we can call between Date X and Date Y on Z days’ notice” means you gotta get the notice in at least Z days before Date Y, regardless of what weird sentences you add way in the back of your indenture, but that’s just me.
[Update: A further concern for Chesapeake is section 3.02 of the indenture, which requires 45 days' notice to the trustee before the call (though that is waivable by the trustee). That doesn't really matter - if Chesapeake is right, it can still issue the notice today, give holders 60 days' notice, and give the trustee its formal notice in 15 days. But it doesn't help. In any case, yes, bad drafting.]
3A. [Update: Per section 3.02, you really need 45 days' notice, so cutting it close wouldn't work. The point remains: cutting it close, not a good idea.]
4. I see 5-year CDS at ~375-380, 5-year swaps at ~1.02%, suggesting a 5-year rate of ~4.8%. Chesapeake has $1.3bn of 6.625% bonds due August 2020 trading at around 109 (5.1% YTM).
5. Here’s yield, graphed against those 6.625s of 2020, which are not freely callable: