COVID-19: Prime Time for Priming
July 15, 2020
It is nothing new for distressed companies to search for liquidity and creative ways of incurring or refinancing debt, sometimes at the expense of existing lenders. Different routes are taken with the same end goal in mind—freeing up balance sheet room to support additional debt or extend maturities to avoid default. While this exercise can create a lifeline for the debtor, it can result in existing lenders seeing their debt directly or indirectly subordinated to new tranches of debt. As companies take new approaches during the pandemic to achieve their desired goals, a familiar pattern emerges: a company will utilize a new method to incur or refinance existing debt and other lenders in the market will react by trying to close those corresponding loopholes in their credit documentation. While lenders attempt to stay ahead of the curve, as liquidity and refinancing options become even more important to pandemic-challenged borrowers, new trap doors keep opening.
Priming Through “Trap Doors”
In 2017, J.Crew finalized a transaction that has now entered the lexicon of investors and lenders and has them asking whether a new investment exposes them to being “J.Crewed.” In December 2016, J.Crew Group, which initially owned its domestic trademarks (the “IP”) through a restricted subsidiary, used permitted investment covenants and baskets to transfer approximately US$250 million in value in those trademarks to a foreign restricted subsidiary, which subsequently transferred the IP interests to an unrestricted subsidiary (an entity that is not subject to the covenants and restrictions of the credit documentation for primary debt). The IP was initially part of the lenders’ collateral package because it was owned by a restricted subsidiary. But the transfer from a guarantor to an unrestricted subsidiary resulted in the IP’s release from the collateral package. The unrestricted subsidiary then used those unencumbered assets to issue new debt to refinance existing PIK debt that was at the holdco level and structurally subordinated to J.Crew’s primary lenders. When the dust settled, the roles of senior and subordinated debt were reversed, and the primary lenders had become structurally subordinated to the new debt issued by the unrestricted subsidiary.
The reaction to the J.Crew transaction was generally one of disbelief, followed by lenders trying to close the J.Crew loophole by changing documentation for future deals. The changes took various forms, including imposing limits on the transfer of core intellectual property and other valuable assets outside the ring fence of the credit group.
Even with these modifications, debtors are still finding ways to “J.Crew” their lenders. For instance, the lenders for Travelport are currently litigating the propriety of the company’s transfer of US$1.15 billion in intellectual property assets away from the first lien lenders to unrestricted subsidiaries. By using a combination of investment and restricted payment baskets, Travelport was able to circumvent limitations on unrestricted subsidiary investments and designated its restricted subsidiaries that held the intellectual property assets as unrestricted subsidiaries. The lenders are claiming the transaction breached the credit agreement and is also a fraudulent conveyance to an insider affiliate. The court has not yet ruled. In the meantime, J.Crew-type priming will likely continue.
Priming by Majority Lenders
While the J.Crew transaction was accomplished without the consent of any lenders, the approach taken in two recent deals, Murray Energy Holdings (Murray) and Serta Simmons Bedding, LLC (Serta), subordinated existing lenders to new debt provided by the majority lenders. In each deal, the company was able to make the necessary amendments to the credit documents without implicating any lender “sacred rights,” which would have required the consent of all lenders or all affected lenders. In most credit documents, the “sacred rights” are limited to changes extending maturity, delaying scheduled payments, reducing interest margins, changing pro rata payments, releasing all or substantially all of the collateral, and changing amendment provisions related to sacred rights. Outside of these limited restrictions, the majority lenders can make amendments and modifications to the debt documents that can adversely affect the rights and payment priority of non-consenting lenders.
In June 2018, with the majority of lenders’ consent, Murray amended its US$2 billion credit facility to remove all negative covenants (including limitations on incurring debt and granting liens) and to permit the majority of lenders to sell their existing loans (the “2015 Loans”) to Murray in exchange for new loans issued under a new credit agreement (the “2018 Loans”). As part of the amendment, the 2018 Loans were granted a first-out position in front of the 2015 Loans, which were now held by the minority lenders who did not consent to the amendments.
Murray subsequently filed for bankruptcy, and the agent, on behalf of certain of the minority lenders, filed an adversary proceeding to rescind the transaction. The plaintiffs made two arguments. First, that the lenders who purchased the 2018 Loans and consented to the amendment should not have been counted for purposes of determining majority-of-lenders consent because they had already committed before the amendment to selling the 2015 Loans back to Murray. Second, that the subordination of liens required the consent of all affected lenders because it implicated a “sacred right,” i.e., essentially a release of all or substantially all of the collateral. While the plaintiffs conceded that the amendment subordinated but did not release their liens in the collateral, they asserted that the resulting change in priority rendered the liens worthless.
The court recently dismissed these claims (In Re Murray Energy Holdings Co., No. 19-56885 (Bankr. S.D. Ohio, May 4, 2020)). In rejecting the plaintiff’s first basis for invalidating the amendment, the court found that while the lenders holding the 2015 Loans had committed before entering the 2018 amendment to selling the 2015 Loans to Murray, they remained “lenders” under the agreement at the time of their consent, and thus the amendment was effective. The court likewise rejected the lien subordination argument, holding that consent to subordination was not required by all lenders “merely because the actual impact of a subordination on a particular creditor is the same as a release of collateral.” The court declined to treat “release” and “subordination” as interchangeable because if the parties had intended the amendment provision to cover subordination, they would have used that term in addition to “release.”
Serta was able to push existing secured debt to a lower priority by using the incremental equivalent debt provisions to issue a new super senior debt facility. With the consent of the majority lenders, Serta incurred the following New Debt (1) US$200 million of new money first out debt (the “First Out Debt”) and (2) US$875 million of second out exchange debt (the “Second Out Debt”), each to the detriment of certain minority lenders. Serta incurred the First Out Debt as incremental equivalent debt. It incurred the Second Out Debt in exchange for existing first and second lien loans on a “non pro rata basis as part of an open market transaction” because the credit agreement permitted non pro rata purchases of term loans. The amendment modified credit agreement provisions that prohibited senior liens and required that incremental equivalent debt not be senior to the existing debt.
The minority lenders sought to enjoin the amendment in a lawsuit filed in New York Supreme Court. The court denied their motion for a preliminary injunction, however, based on failure to show likelihood of success on the merits because the court did not believe that the proposed transaction required the consent of all lenders under the credit agreement. (North Star Debt Holdings, L.P. v. Serta Simmons Bedding, LLC, No. 652243/2020 (N.Y. June 19, 2020)) Serta consummated the transaction that same day.
In Serta, the plaintiffs asserted three arguments. First, plaintiffs argued, similar to the plaintiffs’ argument in Murray Energy, that the change in priority of their existing liens was essentially a release of collateral requiring the consent of all affected lenders. The court did not find a likelihood of success to this argument because the amendment did not implicate any of the sacred rights in the credit agreement. Second, plaintiffs asserted that the credit agreement’s pro rata provisions and post default waterfall provisions required amendments for Serta to incur super-priority debt and that those amendments would necessitate all lender consent. The court rejected this argument because Serta incurred the New Debt outside of the credit agreement as incremental equivalent debt and, as a separately documented transaction, the New Debt was not subject to the credit agreement’s pro rata or waterfall provisions. Finally, the plaintiffs asserted that the actions of the majority breached the implied covenant of good faith and fair dealing. The court viewed this claim as essentially the same as the breach of contract claims on which the court determined the plaintiffs were unlikely to succeed.
Investors and their counsel should be on the lookout for potential credit agreement loopholes that would permit the borrower to prime their existing positions in both their existing deal portfolios and any new transactions or investments. While J.Crew was able to accomplish their transaction without any lender consent, the outcome in both the Murray and Serta transactions demonstrates that minority lenders can be at the mercy of the majority in certain circumstances. The primary message of Murray and Serta is that if it is not a sacred right clearly requiring all lenders (or all affected lenders) to modify, then it is a right an existing lender can’t count on in distress.
Potential changes to address these trap doors could include modifying (i) the sacred right on release of collateral to encompass any subordination of the underlying lien priority and (ii) the amendment section to render lenders that are exiting the credit facility through an exchange ineligible to consent to any credit documentation amendments necessary to consummate the exchange. The subordination bar would be consistent with many first lien bond issuances, which commonly require the consent of all affected holders to lower the priority of the bonds. The exit consent point, however, is inconsistent with bond documentation, as many indentures expressly permit exchange offers and exit consents. Other changes that could further limit loopholes include capping the aggregate value of non-guarantors and unrestricted subsidiaries. Any of these revisions, however, would go against general trends in credit documentation that have prevailed most of this century. Further, trap doors, while a headache for lenders, are extremely valuable to debtors trying to keep their business afloat. They can also help lenders if the resulting transaction equates to the difference between performance and bankruptcy.
The trend in credit documentation over the years has been to loosen the terms of credits (including the amendment provisions), so it is doubtful that the trap-door genie can be put back in the bottle. Even if documentation changes are made going forward, the bulk of deals already in the marketplace have terms that make priming through existing loopholes or amendments by the majority possible. Investors, therefore, need to understand how they may be affected by priming loopholes and by majority lenders modifying credit agreement terms. Having the full picture is fundamental to assessing risk, particularly when investing at the distressed stage of a credit.
This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Jeff Norton, an O’Melveny partner licensed to practice law in New York, Sung Pak, an O’Melveny partner licensed to practice law in New York, John J. Rapisardi, an O’Melveny partner licensed to practice law in New York, Jonathan Rosenberg, an O’Melveny partner licensed to practice law in New York, Daniel S. Shamah, an O’Melveny partner licensed to practice law in New York, and Adam J. Longenbach, an O’Melveny counsel licensed to practice law in New York, New Jersey, and Pennsylvania, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.
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