Priming Transactions Update: Don’t Sleep on Serta

While priming transactions are not a new phenomenon, they have recently become more frequent and more onerous from the perspective of the lenders who have their liens subordinated in the process.  In some recent transactions, majority lender groups have modified existing credits to not only permit the new priming debt, but to remove most of the covenants, defaults, and other customary lender protections from the surviving debt.  Taking the extra step of stripping covenants further ensures that the new priming debt is in the driver’s seat for any further restructurings of the borrower’s balance sheet.

While the priming/stripping “two-step” is understandable from the view of the priming lenders, it leaves minority lenders holding what is essentially a bare promissory note secured by a structurally or direct junior lien—an investment far from the one they originally made.

For many borrowers, these transactions are a last resort to stave off bankruptcy.  To that end, borrowers will enter into direct priming transactions or drop-down structurally senior financings (as detailed in our prior client alerts COVID 19: Prime Time for Priming and Predatory Priming: How Can Investors Protect Their Priority?) to keep the business running by increasing liquidity, extending maturities, restructuring covenants, or taking other steps to preserve equity and seek a bridge to normalized operations.  For the lenders participating in these transactions, the goal is to provide a financial fix while protecting the return on investment by lending at a senior position to existing debt.  For lenders already in the debt, exchanging, refinancing, or otherwise abandoning their existing positions to move up the capital structure helps increase their blended return on their exposure to a borrower and also has the advantage of preventing other investors from grabbing the “high ground” above them.  Unfortunately for the lenders not participating in the transaction, whether due to limits on their investment criteria (such as CLOs, as detailed in our prior client alert CLO Issues In Workouts and Debt Restructurings), dissatisfaction with the credit terms, or the transaction not being offered to all lenders, the result is their original investment is devalued as it is pushed down the capital structure.

While legal challenges by minority lenders to some of these transactions are ongoing, it is helpful to understand how these transactions work and to consider what steps, outside of litigation, investors can take to protect their loans.

Trimark USA and Boardriders Inc.—a King Size Serta

In a prior client alert (COVID 19: Prime Time for Priming), we detailed how debtors such as the Murray Energy Holdings (“Murray”) and Serta Simmons Bedding, LLC (“Serta”) have used a combination of trap-doors, loopholes, and exceptions in covenants and/or majority lender votes to prime existing debt.  In some transactions, such as Revlon, some lenders increased their revolving commitments to create a technical majority to achieve the priming position without ever funding the increased commitment.  Other lenders have called these “sham revolvers” and have legally challenged this technique.  While the challenge is ongoing, there is usually nothing in the express terms of standard credit documentation that would disqualify an increased—though undrawn—revolver commitment otherwise permitted by the credit agreement (either through an incremental provision or basket) from being included in the majority vote.  Such vote is customarily calculated, including both outstanding loans and undrawn commitments.

Recently, transactions such as TriMark USA and Boardriders Inc. followed the priming playbook and took things one step further.  In addition to using majority vote to roll up into new priming debt, the lenders modified the credit facility they were exiting to remove most of the covenants, defaults, and other lender protections.  While these transactions have drawn legal challenges from the excluded lenders, the assertion by the borrower and the priming lenders is that the amendments did not directly impact any of the “sacred rights” and the issuance of the priming debt and the stripping of covenants were permitted under the express terms of the existing credit documents.

General Trends in Credit Documentation

Credit agreements typically have a list of items, commonly referred to as “sacred rights,” which can only be modified by the vote of all lenders or all affected lenders.  The purpose of the sacred rights is to protect minority lenders from having their critical rights or investment fundamentally altered by the majority.  Sacred rights are typically limited to changes that extend the maturity, delay scheduled payments, reduce interest margins, change pro rata sharing of distributions and payments, release all or substantially all of the collateral or guarantors, or adversely affect the sacred rights.  But for those limited items, all other credit agreement provisions can be amended with just the consent of lenders holding a majority of the loans and commitments.

Generally, the trend in credit documentation has been to relax terms and make modifications more flexible.  The sacred rights have not been immune from this trend, and many exceptions and loopholes exist to minority protections.  For instance, incremental debt provisions, open market debt purchases, and other transactions permitted by the credit agreement are usually exceptions to the sacred rights requirements.  The sacred right on release of collateral has been read by courts as not applying to subordination of liens, even if such subordination might render the liens worthless.  Further, the pro rata sharing provisions of the credit agreement only apply to payments under the agreement and do not impact debt issued under a separate agreement, as is the case in many pre-approved incremental debt provisions, which allow the debt to be separately documented (commonly called “incremental equivalent debt”).

Priming transactions illustrate that if a matter is not expressly covered by a sacred rights provision, it is not a term that minority lenders can rely on for protection, particularly in distressed situations.

There are many existing trap-doors, loopholes, and exceptions in most credit documents that permit a majority to amend an existing credit to both issue new priming debt and also strip covenants and other protections from the minority lenders they are leaving behind.  This priming/stripping two-step is likely to become more common for distressed credits, as it helps ensure the priming lenders can better control any future restructuring of the debt.  The old credit agreement is not only lien subordinated, but it is also stripped of terms that would otherwise have the old lenders at the table if the new priming debt stumbles.

It is worth noting that stripping covenants in connection with bond exchange offers is nothing new.  But bondholders have the Trust Indenture Act requirement that any exchange has to be offered to all holders on an equal basis.  As credit loans are private transactions, what can and can’t be done as far as priming, covenant stripping, and other modifications depends on the terms of each credit agreement.  Consequently, as has happened in recent transactions, the “inside” participating majority lenders did not offer the deal to the “outside” minority lenders, leaving the latter stranded with lien subordinated and covenant-stripped debt.  Even where offered, some creditors such as CLOs may not be able to participate in the new debt.

The priming/stripping two-step changes the playing field for investors in distressed credits trying to assess risks to their positions.

Takeaways

While there is not one silver bullet to protect against all possible priming scenarios, we have outlined several possible solutions to increase priority protection for investors in one of our prior client alerts (Predatory Priming: How Can Investors Protect Their Priority?).

Priming. For investors looking to protect against priming, there are a couple of approaches.  After the seminal J.Crew drop down priming transaction, lenders attempted to close various loopholes in credit documentation to specifically address the transfer of value outside of the core credit group.  These “surgical” efforts were largely unsuccessful because of the complex matrix of definitions and other terms that create the covenant scheme, which borrowers and lenders can easily work around.  A better approach is a “blanket” covenant overriding other terms of the credit to cap the aggregate value of assets that can be sold, invested, or otherwise transferred to parties that are not guarantors or pledgors.

While a stop-gap covenant will help in limiting priming, it won’t work if majority lenders participate in amendments to permit the priming.  To that end, the sacred right on the release of collateral could be expanded to require all affected lenders to consent to any subordination of the debt or its lien priority.  Another helpful approach would be to expand the typical sacred right pro rata sharing provisions to apply to open market purchases by the borrower or its affiliates or any transaction in which lenders gain a lien priority recovery on shared collateral that is not offered equally to all lenders.

These steps, however, could prove problematic for borrowers needing to reset their balance sheet for the benefit of all lenders and could grant significant “hold-up” value to minority lenders at the expense of the whole credit.

A fix for this problem would be to not make these revisions sacred rights, but matters that a super-majority of lenders, such as 66-2/3% or 85%, could approve.  This would limit the hold-up value of a handful of lenders from preventing execution of a transaction that makes credit sense to the overwhelming majority of lenders.  Requiring a supermajority also makes the “sham revolver” technique more difficult.  Supermajority voting is a common concept in asset-based lending where it is used to limit changes to key borrowing base concepts such as advance rates.  Adding it to cash-flow deals—similarly for the purpose of preserving core collateral and credit group value for all secured lenders—could be a more flexible compromise on these issues, preferable to expanding 100% sacred right lender issues.

Stripping.  Changes to limit the stripping of covenants by majority lenders looking to move up the capital structure is problematic for a broad-brush approach.  It would not be helpful to the markets to over-cure the problem and create new ones for amendments and modifications that are necessary for the borrower businesses to perform.  There are changes that could be sought to the calculation of majority lenders and prohibiting exit consents by up-tiering lenders, but these changes run the risk of causing unintended consequences in the ability to amend or modify a credit in the ordinary course.  It is important to note that priming is the core intent of these transactions, and stripping is secondary to moving up the capital structure on the new debt.  Further, these transactions only take place in times of distress if participating lenders see room for a priming position to have value.  Therefore, while changes that would limit stripping are certainly possible, closing the priming door is likely the best protection for minority lenders in all of these scenarios.

Any of these changes go against the general trend in credit documentation to be more borrower-friendly, which includes greater majority control and easier amendments.  Given the competition for deals, it is also unlikely there will be widespread changes in credit documentation to address these issues.  This is good news for borrowers and sponsors looking to preserve wiggle room in distressed situations and priming lenders looking to preserve value and return on their investment.  For minority lenders on the outside, however, it means they will have to pick their battles as to where they can change the terms of credits they are investing in, particularly if the credit is already or likely to become distressed.

All of this proves the adage that the terms of any credit, no matter how tight, cannot replace good old-fashioned diligence and credit analysis.  Priming and stripping only happen when a credit is distressed and other options are limited.  As always, in the debt marketplace, buyer beware.

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, Peter Friedman, an O’Melveny Partner license to practice law in New York, the District of Columbia, and Illinois, Daniel Shamah, an O’Melveny Partner licensed to practice law in New York, Jennifer Taylor, an O’Melveny partner licensed to practice law in California, Evan Jones, an O’Melveny partner licensed to practice law in California and the District of Columbia, David Johnson Jr., an O’Melveny partner licensed to practice law in California, the District of Columbia, Hong Kong, and New York, and Adam Longenbach, an O’Melveny Counsel licensed to practice law in New York, 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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