Corinne Ball
Corinne Ball ()

The recent decision by the U.S. Court of Appeals for the Second Circuit in Chesapeake Energy v. Bank of New York Mellon Trust, No. 15-2366-CV, 2016 WL 4895581 (2d Cir. Sept. 15, 2016) reaffirms the prudence of requiring a final order and rewards the appellant for persevering despite its adversary’s determination to act upon a declaratory judgment subject to appeal. In an era of robust review of indenture provisions and the Trust Indenture Act, as well as accordion and similar basket provisions in credit agreements in the wake of Marblegate, Caesars, iHeartMedia and Arch Coal, the role of the courts in formulating strategies designed to provide optionality and additional time, even additional borrowed cash, to highly leveraged companies facing liquidity or other restrictions arising from the documents governing their funded indebtedness cannot be underestimated. Debtholders are sophisticated, comfortable in court, and often well funded. Companies are subject to complex capital structures, often including first and second lien debt, as well as publicly traded bond debt. Companies are often the beneficiaries of so-called “covenant lite” debt terms and baskets for investment and additional debt (including secured debt) which at times may be implemented with asset transfers or designation of “unrestricted” subsidiary affiliates. The amounts involved in any given liability management tactic can run into the hundreds of millions of dollars. Generally the debt documents are governed by New York law. Often, companies and their debtholders disagree on the extent of permitted activities. Hence, resort to the courts for a determination of the permissibility of a contemplated action may be a condition to executing on a disputed strategy. Chesapeake involved a dispute between bondholders and the issuing company regarding whether a “make whole” or pre-payment premium was required when the bond issue was refinanced. While the issue was discreet, the efficacy of a resort to the court for a speedy determination is now subject to question if there is an appeal pending—even one without a stay pending appeal.

Background

In February 2012, Chesapeake Energy, a publicly-traded Oklahoma corporation which produces oil and natural gas, issued $1.3 billion in senior notes due in 2019 (the Notes). One of the two indentures governing the Notes established two types of early redemption rights, exercisable at Chesapeake’s option—an early redemption at a lower “At-Par” price (equal to 100 percent of the principal amount plus accrued and unpaid interest), exercisable at “any time from and including Nov. 15, 2012 to and including March 15, 2013,” and redemption at a higher “Make-Whole” price (equal to the sum of the present value of the principal of the Notes and remaining interest payments) exercisable at any time after March 15, 2013. The early redemption option required that Chesapeake provide notice of the redemption at least 30 days, but not more than 60 days before the date of redemption.

On Feb. 20, 2013, Chesapeake announced that it planned to exercise its right of redemption at the At-Par price. However, shortly after the announcement, Bank of New York Mellon Trust Company (BNY Mellon), the indenture trustee of the Notes, notified Chesapeake of its belief that the notice deadline for the At-Par price had already passed. As a result, BNY Mellon informed Chesapeake that if it proceeded with the redemption, the noteholders would be entitled to the Make-Whole price, which exceeded the At-Par price by approximately $400 million.

Chesapeake’s position was that the notice period ran until March 15, 2013, and, therefore, redemption at At-Par could occur as late as May 14, 2013 (i.e., 60 days after the March 15 deadline). To resolve the dispute, on March 8, 2013, Chesapeake brought an action in the District Court for the Southern District of New York, seeking a declaratory judgment on two counts, that: (1) if the proposed notice of redemption (the Notice) was mailed by March 15, 2013, and effective on May 13, 2013, the Notice would constitute a timely exercise of the At-Par redemption; and (2) in the event that the Notice was found untimely, it would be considered null and void. After an expedited trial, on May 8, 2013, the District Court rendered a decision in Chesapeake’s favor on the first count, and ruled that the second count was moot. Despite BNY Mellon’s filing a notice of appeal almost immediately after the decision was rendered, Chesapeake proceeded to redeem the Notes on May 13, 2013.

On appeal the first time around, the Second Circuit reversed, holding that the redemption was not timely, and remanded the case to the District Court for consideration of the second count. On remand, the District Court determined that the second count remained moot in so far as it sought the nullification of the Notice, but not as to the redemption itself. The District Court then considered the amount of damages to which the noteholders would be entitled. Chesapeake argued that the damages should be set at a “restitution” amount because it had relied on the District Court’s decision when redeeming the Notes. But for the District Court’s initial ruling approving the notes repurchase, the company argued, it would not have proceeded with the redemption. As such, the noteholders would only be entitled to the difference between the At Par price and the present value of the company’s payouts on the Notes to maturity.

The District Court disagreed and awarded contract damages based on the difference between the At-Par amount and the higher Make-Whole amount because the redemption had occurred after the close of the At-Par period. Chesapeake appealed again, stressing that it had relied on the District Court’s earlier decision when moving forward with the redemption. Specifically, the company argued that, under federal law, “the remedy for actions taken in reliance on a judgment that is later reversed is restitution putting the note holders back in the same economic position they occupied before the redemption, not a claim for breach of contract.” Chesapeake, 2016 WL 4895581, at *3.

Second Circuit’s Decision

On appeal, the Second Circuit rejected Chesapeake’s restitution argument, holding that the indenture controlled the award of damages. The Second Circuit observed that the indenture “dictates the Noteholders’ recovery arising from Chesapeake’s underpayment for its May 13, 2013 redemption.” Chesapeake, 2016 WL 4895581, at *11. Accordingly, the court reasoned that a failure to pay that amount constituted a breach of contract by the company. The court explained that holding otherwise “would frustrate the Noteholders’ legitimate expectations regarding their rights under the [indenture]” and that Chesapeake was “ on notice at all relevant times that the District Court could require it to pay the Make-Whole Price for its [redemption],” given the unambiguous indenture language and the fact that “this had been [the indenture trustee's] litigation position since the outset.” Chesapeake, 2016 WL 4895581, at *4. The crux of the Second Circuit’s decision was that the indenture, as a valid and enforceable contract, dictated the noteholders’ recovery, rather than a court relying upon equitable principles to fashion a damages award. Chesapeake has filed a pending motion for rehearing en banc by the Second Circuit.

Implications of the Ruling

Chesapeake is important because it supports a rule that if a company takes an action in reliance on a District Court decision, the indenture and “the Noteholders legitimate expectations” may nevertheless trump any order that is not “final.” Hence, if there is a dispute that is resolved in the company’s favor, the losing debtholders (or their representative) not only have every incentive to appeal, but can do so without the burden of obtaining a stay pending appeal. Chesapeake underscores the need to anticipate the timing and cost of a court process which results in a “final” order. Indeed, if a company were to consider acting prior to that final determination, it must take into account the risk of reversal and the resulting costs. It may be that the risk means the company must be willing to commence a bankruptcy case if the initial court determination is reversed. That consequence may be acceptable, but post-Chesapeake must be considered. Moreover, the impact of a subsequent bankruptcy on the disputing debtholder must also be considered. Given the complexity of capital structures, there may be a strategy that addresses one debt issue, but causes a dispute with a different debtholder who may argue that the planned action in respect of the debt issue that is the subject of the liability management tactic causes a default under the documents governing the company’s obligations to a complaining debtholder. For example, if the action involves a debt exchange, should the parties consider what would happen in a subsequent bankruptcy? Will the newly exchanged notes be recognized? Will the safe harbors of the bankruptcy code protect the exchange? There is a lack of clarity on that question. Yet, if the tactic involved a “cash tender” offer, bankruptcy may pose a risk that is acceptable because the “safe harbors” afforded to a debtor company under the Bankruptcy Code will likely protect a cash payment on a publicly traded bond from recapture. While from inception liability management strategies are designed to avoid bankruptcy, the court’s decision in Chesapeake suggests that an in depth bankruptcy review is necessary if circumstances do not permit a company to undertake a complete court process and obtain a final, unappealable order prior to executing on a strategy.

The recent decision by the U.S. Court of Appeals for the Second Circuit in Chesapeake Energy v. Bank of New York Mellon Trust, No. 15-2366-CV, 2016 WL 4895581 (2d Cir. Sept. 15, 2016) reaffirms the prudence of requiring a final order and rewards the appellant for persevering despite its adversary’s determination to act upon a declaratory judgment subject to appeal. In an era of robust review of indenture provisions and the Trust Indenture Act, as well as accordion and similar basket provisions in credit agreements in the wake of Marblegate, Caesars, iHeartMedia and Arch Coal, the role of the courts in formulating strategies designed to provide optionality and additional time, even additional borrowed cash, to highly leveraged companies facing liquidity or other restrictions arising from the documents governing their funded indebtedness cannot be underestimated. Debtholders are sophisticated, comfortable in court, and often well funded. Companies are subject to complex capital structures, often including first and second lien debt, as well as publicly traded bond debt. Companies are often the beneficiaries of so-called “covenant lite” debt terms and baskets for investment and additional debt (including secured debt) which at times may be implemented with asset transfers or designation of “unrestricted” subsidiary affiliates. The amounts involved in any given liability management tactic can run into the hundreds of millions of dollars. Generally the debt documents are governed by New York law. Often, companies and their debtholders disagree on the extent of permitted activities. Hence, resort to the courts for a determination of the permissibility of a contemplated action may be a condition to executing on a disputed strategy. Chesapeake involved a dispute between bondholders and the issuing company regarding whether a “make whole” or pre-payment premium was required when the bond issue was refinanced. While the issue was discreet, the efficacy of a resort to the court for a speedy determination is now subject to question if there is an appeal pending—even one without a stay pending appeal.

Background

In February 2012, Chesapeake Energy, a publicly-traded Oklahoma corporation which produces oil and natural gas, issued $1.3 billion in senior notes due in 2019 (the Notes). One of the two indentures governing the Notes established two types of early redemption rights, exercisable at Chesapeake’s option—an early redemption at a lower “At-Par” price (equal to 100 percent of the principal amount plus accrued and unpaid interest), exercisable at “any time from and including Nov. 15, 2012 to and including March 15, 2013,” and redemption at a higher “Make-Whole” price (equal to the sum of the present value of the principal of the Notes and remaining interest payments) exercisable at any time after March 15, 2013. The early redemption option required that Chesapeake provide notice of the redemption at least 30 days, but not more than 60 days before the date of redemption.

On Feb. 20, 2013, Chesapeake announced that it planned to exercise its right of redemption at the At-Par price. However, shortly after the announcement, Bank of New York Mellon Trust Company (BNY Mellon), the indenture trustee of the Notes, notified Chesapeake of its belief that the notice deadline for the At-Par price had already passed. As a result, BNY Mellon informed Chesapeake that if it proceeded with the redemption, the noteholders would be entitled to the Make-Whole price, which exceeded the At-Par price by approximately $400 million.

Chesapeake’s position was that the notice period ran until March 15, 2013, and, therefore, redemption at At-Par could occur as late as May 14, 2013 (i.e., 60 days after the March 15 deadline). To resolve the dispute, on March 8, 2013, Chesapeake brought an action in the District Court for the Southern District of New York , seeking a declaratory judgment on two counts, that: (1) if the proposed notice of redemption (the Notice) was mailed by March 15, 2013, and effective on May 13, 2013, the Notice would constitute a timely exercise of the At-Par redemption; and (2) in the event that the Notice was found untimely, it would be considered null and void. After an expedited trial, on May 8, 2013, the District Court rendered a decision in Chesapeake’s favor on the first count, and ruled that the second count was moot. Despite BNY Mellon’s filing a notice of appeal almost immediately after the decision was rendered, Chesapeake proceeded to redeem the Notes on May 13, 2013.

On appeal the first time around, the Second Circuit reversed, holding that the redemption was not timely, and remanded the case to the District Court for consideration of the second count. On remand, the District Court determined that the second count remained moot in so far as it sought the nullification of the Notice, but not as to the redemption itself. The District Court then considered the amount of damages to which the noteholders would be entitled. Chesapeake argued that the damages should be set at a “restitution” amount because it had relied on the District Court’s decision when redeeming the Notes. But for the District Court’s initial ruling approving the notes repurchase, the company argued, it would not have proceeded with the redemption. As such, the noteholders would only be entitled to the difference between the At Par price and the present value of the company’s payouts on the Notes to maturity.

The District Court disagreed and awarded contract damages based on the difference between the At-Par amount and the higher Make-Whole amount because the redemption had occurred after the close of the At-Par period. Chesapeake appealed again, stressing that it had relied on the District Court’s earlier decision when moving forward with the redemption. Specifically, the company argued that, under federal law, “the remedy for actions taken in reliance on a judgment that is later reversed is restitution putting the note holders back in the same economic position they occupied before the redemption, not a claim for breach of contract.” Chesapeake, 2016 WL 4895581, at *3.

Second Circuit’s Decision

On appeal, the Second Circuit rejected Chesapeake’s restitution argument, holding that the indenture controlled the award of damages. The Second Circuit observed that the indenture “dictates the Noteholders’ recovery arising from Chesapeake’s underpayment for its May 13, 2013 redemption.” Chesapeake, 2016 WL 4895581, at *11. Accordingly, the court reasoned that a failure to pay that amount constituted a breach of contract by the company. The court explained that holding otherwise “would frustrate the Noteholders’ legitimate expectations regarding their rights under the [indenture]” and that Chesapeake was “ on notice at all relevant times that the District Court could require it to pay the Make-Whole Price for its [redemption],” given the unambiguous indenture language and the fact that “this had been [the indenture trustee's] litigation position since the outset.” Chesapeake, 2016 WL 4895581, at *4. The crux of the Second Circuit’s decision was that the indenture, as a valid and enforceable contract, dictated the noteholders’ recovery, rather than a court relying upon equitable principles to fashion a damages award. Chesapeake has filed a pending motion for rehearing en banc by the Second Circuit.

Implications of the Ruling

Chesapeake is important because it supports a rule that if a company takes an action in reliance on a District Court decision, the indenture and “the Noteholders legitimate expectations” may nevertheless trump any order that is not “final.” Hence, if there is a dispute that is resolved in the company’s favor, the losing debtholders (or their representative) not only have every incentive to appeal, but can do so without the burden of obtaining a stay pending appeal. Chesapeake underscores the need to anticipate the timing and cost of a court process which results in a “final” order. Indeed, if a company were to consider acting prior to that final determination, it must take into account the risk of reversal and the resulting costs. It may be that the risk means the company must be willing to commence a bankruptcy case if the initial court determination is reversed. That consequence may be acceptable, but post-Chesapeake must be considered. Moreover, the impact of a subsequent bankruptcy on the disputing debtholder must also be considered. Given the complexity of capital structures, there may be a strategy that addresses one debt issue, but causes a dispute with a different debtholder who may argue that the planned action in respect of the debt issue that is the subject of the liability management tactic causes a default under the documents governing the company’s obligations to a complaining debtholder. For example, if the action involves a debt exchange, should the parties consider what would happen in a subsequent bankruptcy? Will the newly exchanged notes be recognized? Will the safe harbors of the bankruptcy code protect the exchange? There is a lack of clarity on that question. Yet, if the tactic involved a “cash tender” offer, bankruptcy may pose a risk that is acceptable because the “safe harbors” afforded to a debtor company under the Bankruptcy Code will likely protect a cash payment on a publicly traded bond from recapture. While from inception liability management strategies are designed to avoid bankruptcy, the court’s decision in Chesapeake suggests that an in depth bankruptcy review is necessary if circumstances do not permit a company to undertake a complete court process and obtain a final, unappealable order prior to executing on a strategy.