It's Okay That Chesapeake Forgot To Call Some Bonds

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Well this isn't great:

The story behind that - more fully described here - is that Chesapeake issued $1.3 billion of seven-year bonds in February 2012, and those bonds were freely callable from November 2012 to March 2013, and thereafter not callable (except with a T+50 makewhole) until maturity. And in March Chesapeake tried to call them, and their trustee - BoNY Mellon - said, well, no, you needed to give notice of a call a month in advance, everyone knows that, so you're outta luck and can't call them except at the makewhole price (~129). And Chesapeake disagreed and so they sued. The dispute turned on some ambiguous language - some places the bond documents said you need to provide notice a month before you call, other places they say that the early call works as long as you provide notice before March 2013 - but I wasn't particularly sympathetic to Chesapeake, based mostly on market-practice-y reasons, and gave them about 25% odds of winning.

I was wrong!1 Today Chesapeake won its lawsuit and so will be redeeming those bonds at par. To be fair The Market was wrong too, as the bonds were trading at 108ish (5.25%-ish), wider than Chesapeake's non-callable bonds but still well north of the 100 that you're now going to get for them.

The opinion is an astonishing 92 pages long and like half of it is boring what-is-the-meaning-of-is stuff that we can skip. (Oddly the judge concludes that the disputed language is clear, which is somewhat refuted by the 92-page-ness of the opinion.) But the other half is a description of how this provision came about and is perhaps an edifying tale. So here it is:

As of the start of 2012, Chesapeake was in search of additional sources of short-term liquidity, after an unusually warm winter had caused a significant decline in the price of natural gas. On or around February 8, 2012, [Chesapeake CFO Domenic] Dell’Osso was approached by [BAML debt capital markets managing director Lex] Maultsby and Scott Van Bergh, both of BAML, with a proposal for a public debt offering. Maultsby and Van Bergh proposed that this offering contain an unusual feature: It would provide Chesapeake with the option to call the notes at par early in their lifetime. Such a feature would give Chesapeake the liquidity it needed in the short term. However, it would also allow Chesapeake to repay the notes after certain planned asset sales—then in the works—had occurred, without paying a premium, unlike in the case of typical high-yield bonds. Dell’Osso expressed interest in the proposal. His assessment was that “BAML had done an excellent job of reading Chesapeake’s financial situation.” ...

BAML proposed that Chesapeake issue five-year notes that could be called at par during a period that spanned the last six weeks of 2012. ... Dell’Osso expressed a desire to extend the “early-call-at-par” period to 12 months. Such a period would have given Chesapeake a year in which to decide whether to call the bonds early, flexibility that served Chesapeake’s business needs because its planned asset sales were at that time not “close to completion.”

BAML, however, responded that a 12-month period would be too long. ... Dell’Osso told [his lawyer Michael] Telle that he wanted as long a period as possible to redeem. ... Telle recognized that, with a March 15, 2013 redemption deadline, Chesapeake would have to give notice by February 13, 2013—30 days earlier. At that point, Telle developed the idea on which this lawsuit turns: to make the period of November 15, 2012, through March 15, 2013 the time frame within which Chesapeake merely had to give notice that it planned to exercise its call option, as opposed to the time frame within which redemptions would have to be completed.

They discussed with the bankers, conclusively enough that Maultsby, the BAML DCM MD, "'understood the final language to mean that Chesapeake could issue a notice to redeem the notes at par' until March 15, 2013," and, in a final pre-launch call:

Dell’Osso asked “something along the lines of "I can redeem by giving notice up to March 15th, right?” “[O]ne of the banks respond[ed] affirmatively,” saying “‘That’s right, that’s the deal.’”

So it was clear to everyone and off they went, selling the deal to 166 investors. Given that this intent was clear to Chesapeake and the bankers, and that they were the ones actually negotiating the bonds, the judge was surely right to conclude that Chesapeake should have until March 15 to give its notice of redemption.

But do you think it was clear to the investors? I don't know?2 I mean, I found the language confusing, and so did the trustee, though the judge says he didn't. One thing you can say with reasonable precision is that it wasn't clear to the people buying them since March in the hope that Chesapeake had missed its call window. On paper, since yesterday, those people have lost around $95 million.3

Should they be pissed? At whom? It doesn't really seem like Chesapeake's fault, does it? Bank of America won this business - and about $4.75mm in underwriting fees - by doing "an excellent job of reading Chesapeake’s financial situation" and creating a structure that fit that situation. But once they won the business their job, as underwriters, was really to negotiate with Chesapeake on behalf of the bond investors who weren't there. And they did maybe a so-so job of communicating that structure to the market, with the result that a lot of owners of these bonds seem to have been rather unprofitably surprised by how they actually work. That seems like a bit of a failure by BAML.

Chesapeake v. BoNY Mellon opinion [S.D.N.Y.]
Chesapeake wins bond dispute with Bank of NY Mellon [Reuters]
Earlier: Chesapeake Forgot To Call Some Bonds

1.The moral is, of course, NOTHING HERE IS INVESTMENT ADVICE. Though I will console myself with beingright about the AIG/Countrywide/NY Fed lawsuit, in which AIG deservedly won a round on Monday.

2.I suppose one way to find out would be to look at, like, option valuation - like, did the market price this like a call expiring in February 2013 or March 2013? - but hahahahaha no. I once asked a high-yield banker how to think about pricing issuer call options and he said "it's 25bps." Note that this deal priced at a 7.00% (T+562) yield on February 13, 2012, when Chesapeake's 6.625% of November 2019 was trading at around 6.96% (per Bloomberg). Figure that extra 8 months of maturity is worth ~15-20bps and, yeah, the call option was worth around 20-25bps. I'm sure no one priced what the extra month was worth.

3.That is, $1.3bn of bonds trading at ~108 yesterday and at ~100.5 today. That may be the wrong way to count; one plausible alternative is to look only at bonds bought since Chesapeake arguably missed its notice deadline on February 13, 2013. By that count I get around $343mm of bonds that changed hands, or around $25mm in paper losses by those buyers:

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