Lenders Lock Horns Amid Tightening Credit Environment
Liability management exercises, sometimes called “position enhancing transactions” or, more colorfully, “lender-on-lender violence” is a relatively recent restructuring phenomenon in the U.S. The trend presents itself in different restructurings, each with a slightly different flavor. The overall theme, however, is the same. These transactions involve groups of lenders coordinating with the company to modify the company’s debt structure and provide new money. These transactions benefit those lenders which decide to participate, while excluding certain other investors from the benefits of the transaction. Litigation often ensues.
In this article, we discuss some of the specific ways in which the participating lenders of a company are able to take advantage of covenants or provisions of loan documents to benefit from transactions over the objections of non-participating lenders. We also explain the ways in which we expect these transactions will have an impact on the market, and how this U.S. trend will see repercussions in Europe and the UK.
‘Up-Tier’ and ‘Drop-Down’ Transactions
‘Up-tier’ and ‘drop-down’ transactions are two examples of transactions where lenders that hold pari-passu debt, and share recoveries on a pro-rata basis, can be prejudiced by agreements between the borrower and a subset of the lenders in the same class. The borrower in such cases works alongside a subset of the lenders to amend the underlying credit documentation, permitting preferential treatment of this subset of lenders to the prejudice of lenders who are not a part of the participating group. This trend was initially well publicized in the restructuring of Serta Simmons1, as well as Boardriders2 and more recently in Envision and Wesco Incora.
Some of the main questions we have relate to the specific ways in which the participating lenders of a company are able to take advantage of covenants or provisions of loan documents that allow them to do this over the objections of non-participating lenders. How are companies able to issue new debt and prime existing lenders, or take collateral that was attached to existing debt to use as part of a new transaction?
This could happen in the form of ‘up-tier’ transactions, which require amendments to existing credit documentation, and often lead to litigation. Typically, in exchange for the agreement between the subset of lenders and the borrower – which allows the company to amend the documentation and provide it with greater flexibility – the lenders that agree to the amendments are allowed to provide additional super-senior financing. In addition, a portion of such lenders’ existing loans are typically rolled up into this super-senior tranche. As minority lenders are ‘primed’ without their consent, this creates two classes of creditors from the single group of lenders that were originally ranked pari-passu. Often those lenders left outside of these agreements are faced with the prospect of diminished recovery and, in certain situations, little to no recovery.
A second form of “lender on lender violence” are ‘drop-down’ transactions, whereby the company, working within the confines of its existing debt documentation (using permissive investment and asset sale baskets), contributes certain assets to entities outside the credit support group such as an unrestricted subsidiary. This enables that subsidiary to incur financing that is structurally senior to the other debt, allowing the company to extend its runway while also benefiting from a liquidity injection. Majority creditors have recourse to the ‘dropped down’ assets, thus eliminating the risk that their recoveries are diluted by minority creditors. This type of drop-down financing was most notably seen in the restructuring of J. Crew.
Bankruptcy Courts Begin to Weigh In
It should come as no surprise that these transactions give rise to litigation, including in bankruptcy courts when borrowers are not able to stave off financial distress. In recent years, The Southern District of Texas has become a bankruptcy filing hotspot. 2023 is no exception, with the district seeing the highest number of corporate Chapter 11 filings in the country.
It is particularly noteworthy then, that the Bankruptcy Court for the Southern District of Texas issued a decision in the Serta Simmons bankruptcy upholding Serta’s liability management transaction, holding that the transaction was permitted by the terms of the relevant debt and not conducted in bad faith. The decision appeared to be motivated by a view that sophisticated investors should bear responsibility for assessing what creative transactions might be permissible under governing documents, and that companies should have latitude to take advantage of perceived “gaps” in covenants. Notably, the Bankruptcy Court’s decision reached an opposite conclusion from a U.S. District Court judge in New York, who refused to dismiss a complaint filed by non-participating creditors prior to Serta’s bankruptcy. The Court’s decision will not be the last word; non-participating creditors in the Serta case have appealed.
It remains to be seen how other courts will interpret these issues, but companies will likely continue to seek out favorable benches. The facts will be different in each case, and perhaps by showing bad-faith arrangements a decision will be different. As a general rule, however, bankruptcy judges may be more inclined to make a decision that would allow for a debtor’s restructuring, as opposed to a non-bankruptcy judge who may take a less flexible or reorganization-minded approach.
Bankruptcy Courts Begin to Weigh In
It should come as no surprise that these transactions give rise to litigation, including in bankruptcy courts when borrowers are not able to stave off financial distress. In recent years, The Southern District of Texas has become a bankruptcy filing hotspot. 2023 is no exception, with the district seeing the highest number of corporate Chapter 11 filings in the country.
It is particularly noteworthy then, that the Bankruptcy Court for the Southern District of Texas issued a decision in the Serta Simmons bankruptcy upholding Serta’s liability management transaction, holding that the transaction was permitted by the terms of the relevant debt and not conducted in bad faith. The decision appeared to be motivated by a view that sophisticated investors should bear responsibility for assessing what creative transactions might be permissible under governing documents, and that companies should have latitude to take advantage of perceived “gaps” in covenants. Notably, the Bankruptcy Court’s decision reached an opposite conclusion from a U.S. District Court judge in New York, who refused to dismiss a complaint filed by non-participating creditors prior to Serta’s bankruptcy. The Court’s decision will not be the last word; non-participating creditors in the Serta case have appealed.
It remains to be seen how other courts will interpret these issues, but companies will likely continue to seek out favorable benches. The facts will be different in each case, and perhaps by showing bad-faith arrangements a decision will be different. As a general rule, however, bankruptcy judges may be more inclined to make a decision that would allow for a debtor’s restructuring, as opposed to a non-bankruptcy judge who may take a less flexible or reorganization-minded approach.
Migration to Europe and the UK
This is an evolving area of the law, with many decisions that are still pending. And while lender-on-lender violence has not been as pervasive in the UK and Europe yet, there is an expectation that it will become a more common trend – not least because many of the private equity companies involved in U.S. restructurings are also involved in situations in these other jurisdictions.
Already, some of these issues are playing out in Europe. Greek gaming company Intralot, for example3, restructured in 2021 and saw some of the same tactics used by lenders discussed above.
However, there are certain restraining factors from a European perspective including:
If the existing financing arrangements involve an intercreditor agreement, an amendment to the intercreditor ranking with respect to collateral which was not otherwise contemplated in the original financing would require all lender consent (thereby requiring an English scheme of arrangement or restructuring plan); and
Exit consents are commonly used in exchange offers; but where the relevant debt is English law governed, market participants have been careful to limit to the scope of the exit consent terms in light of a past English court decision that admonished against aggressive tactics used in that regard.
So how does this emerging trend fit into the bigger restructuring picture? In light of higher interest rates and higher borrowing rates amid a tighter credit environment, issuers are going to look for more creative solutions to buy themselves time. Companies are going to continue to scrutinize opportunities to take advantage of existing covenant packages and raise additional financing.
At the same time, we have also witnessed a tightening of covenants and an increase in thresholds for various actions. For example, the ability for borrowers to issue new notes under an existing indenture is becoming more limited, as are opportunities related to lien stripping. Because consent rates are increasing in bond and loan documents, investors will likely need to exercise greater caution with respect to having a strong relationship with a super-majority of lenders, in order to minimize the risk of minority lenders having hold-out value over the majority.
In light of the recent credit environment, we expect companies will continue to face difficulties in terms of restructuring their existing debt obligations. Creative solutions such as ‘up-tier’ and ‘drop-down’ transactions, and the spill-over effects of these approaches, will likely continue to engender litigation between lenders, though it remains to be seen how insolvencies across the pond will differ from those in the U.S.
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