Drop It Like It’s Debt: A Canadian Guide To Liability Management Exercises – Part I

Background

In recent years, liability management exercises (“LMEs“), including high-profile transactions conducted by J. Crew Group, Inc. (“J. Crew”) and Serta Simmons Bedding, LLC (“Serta”), have reshaped the U.S. leveraged lending landscape. As discussed further below, an LME involves a borrower taking advantage of flexible loan documentation to restructure its outstanding debt obligations outside of formal insolvency or bankruptcy proceedings. While LMEs may generally provide an attractive option for borrowers facing maturity concerns to generate additional liquidity without seeking amendments to existing credit facilities, they are typically achieved at the expense of the rights of some or all of their existing creditors.

For some time, LMEs have been a foreign concept for Canadian market participants, as Canada’s conservative lending culture and tighter covenant packages limited their relevance. However, that may be changing. As Canadian borrowers increasingly access U.S. and international debt markets that employ more permissive U.S.-style documentation, they may acquire the contractual flexibility necessary to execute LMEs.

This bulletin explains what LMEs are, how the main forms of LME transactions operate, and why the features that have historically limited their occurrence in Canada may be changing.

What Are Liability Management Exercises?

An LME is a transaction undertaken by a borrower to restructure its outstanding debt obligations and improve its financial position, often avoiding a formal insolvency proceeding, at least in the short term, while offering several key advantages over such processes, including:

• avoiding the cost and disruption of formal insolvency proceedings;
• obtaining additional liquidity;
• extending debt maturities; and
• capturing deleveraging opportunities.

While an LME may bring much needed short-term relief to a debtor’s business, a lender that does not or is not invited to participate in the transaction may find itself subordinated in payment priority behind new or existing majority lenders, deprived of valuable collateral, diluted in voting power, or left with materially weakened credit protections. Critically, many LMEs do not breach the borrower’s existing loan documents. Rather, they exploit exceptions or permissive covenants in the documents that were negotiated before financial distress arose.¹

The Three Main Types of LMEs

LME structures are often complex and tailored to the specific loan documentation at issue, and market practices continue to evolve significantly. Three structures have become particularly prevalent:

1. Drop-down;
2. Uptiering; and
3. Double-dip.

This list is not exhaustive and the development of new LME structures has been described as a game of ‘whack-a-mole,’ with novel transaction types continuing to emerge as borrowers and their advisors identify and exploit additional sources of documentary flexibility.

Drop-Down

In a drop-down transaction, a borrower transfers material assets to an unrestricted subsidiary, removing these assets from the collateral pool supporting its existing debt so that they can be pledged in support of new financing, leaving existing lenders with a materially diminished collateral package.

The classic example of a drop-down financing was completed by J. Crew in 2016. In that transaction, the borrower used basket capacity in its loan documents to transfer its intellectual property, widely considered its “crown jewel”, to a newly created unrestricted subsidiary. Those assets were then pledged to secure new financing from a different group of lenders, effectively stripping the existing lender group of their most valuable collateral. Alternative forms of a drop-down may also involve the release of a subsidiary guarantor from its guarantee and security obligations rather than an asset transfer, which was the case in the widely reported PetSmart/Chewy transaction in 2017.

Uptiering

An uptier transaction reorganizes existing syndicated debt in a non-pro rata way, so that a favoured majority of existing lenders end up with higher priority over the borrower’s collateral than the minority lenders who are left behind. The borrower allows the majority lenders to exchange their debt for new super-priority obligations, while non-participating lenders find their existing loans subordinated without their consent through amendment mechanics requiring only majority approval. While the pro rata payment provision is typically included in the “sacred rights” for U.S.-style loan agreements,² certain amendments that incidentally affect those rights may only require majority approval, leaving room for uptiering transactions that effectively circumvent pro rata treatment.

The 2020 Serta transaction is a seminal example. A narrow majority of Serta’s existing first-lien term lenders exchanged a portion of their loans for new super-priority instruments, relying on an “open market purchase” exception to the pro rata sharing provision in the loan documentation. The exchange effectively subordinated the remaining first-lien lenders, who were excluded from the transaction. While the use of uptier transactions proliferated after the Serta transaction, the U.S. Court of Appeals for the Fifth Circuit held that Serta’s private engagement of individual lenders did not qualify as an “open market purchase,” and that the pro rata sharing provision had been breached.³ Recently, the participating lenders were found liable for $260 million in damages and $142 million in prejudgment interest.⁴

Double-Dip

A double-dip transaction gives a favoured group of lenders multiple recovery claims against a set of collateral based on the same underlying financial claim, thereby improving their pro rata recovery outlook. Typically, a borrower with existing financing creates a new subsidiary to which new-money lenders provide financing, supported by a secured guarantee from the borrower (the first dip). The new debt proceeds are then used to fund a secured intercompany loan from the new subsidiary to the borrower, creating a secured intercompany loan receivable that is pledged to the new-money lenders as additional security (the second dip). Unlike drop-down or uptiering transactions, a double-dip does not involve the transfer of assets out of the existing lenders’ collateral package or the structuring of new debt to explicitly prime existing obligations. However, because the new-money lenders hold multiple claims against the same pool of collateral, existing creditors’ recoveries in an ultimate insolvency situation could be significantly impacted.

The transaction by At Home Group Inc. (“At Home”) is a well-known example of a double-dip. At Home issued new senior notes through a newly created Cayman subsidiary, guaranteed on a secured basis by the existing borrowers, including At Home and certain of its restricted subsidiaries. The Cayman subsidiary then loaned the note proceeds to the existing borrowers in a secured intercompany loan and pledged this receivable to the lenders of the new senior notes. This structure gave the new noteholders both a direct claim via the guarantees and an indirect claim through the intercompany loan receivable against the existing borrowers, improving their recovery prospects in the event of bankruptcy.

LMEs in Canada

Why LMEs Are Rarer in Canada

Two structural features of the Canadian market have historically limited LME activity:

• Tighter covenant packages. Canadian loan agreements have traditionally employed more restrictive covenants than broadly syndicated U.S. facilities, including maintenance financial covenants and more limited baskets for asset transfers, debt incurrence and structural changes. Canadian syndicated loans also typically employ higher approval thresholds than a simple majority of lenders, which are key to many U.S. LME transactions. This gives Canadian borrowers less documentary flexibility to execute LMEs.
• Common law and statutory remedies. Canadian courts are often considered more willing than their U.S. counterparts to consider fairness and reasonableness in commercial disputes. Canadian common law contract interpretation necessarily considers the surrounding circumstances in which an agreement was reached when assessing its meaning,⁵ which departs from the approach in U.S. jurisdictions that stick to the “four corners of the contract” in the absence of an ambiguity.⁶ Beyond the rules of contract interpretation, two legal tools could be invoked by non-participating lenders to contest an LME in Canada: (i) the common law duty to exercise contractual discretion in good faith⁷, which may have broader application in Canada than its U.S. equivalent; and (ii) the oppression remedy under the Canada Business Corporations Act and its provincial equivalents, which provides a broad suite of remedies where a corporate stakeholder’s reasonable expectations are oppressed. However, neither basis has been tested in the LME context and they should not be relied upon as primary protections. Notably, the Supreme Court of Canada has held that a creditor’s ability to negotiate contractual protections is relevant to assessing reasonable expectations that ground any relief under the oppression remedy,⁸ reinforcing the importance of careful documentation for sophisticated lenders.

Evolving Canadian Developments

As Canadian borrowers have increasingly accessed U.S. and international debt markets governed by U.S.-style covenant packages, several Canadian companies have already engaged in LME transactions. Once a borrower has negotiated that flexibility in an international facility, it frequently becomes the starting point for subsequent domestic transactions.

LMEs in Canada are no longer anomalous, prompting a greater need for Canadian loan documentation to evolve and meet the expectations of both borrowers and lenders.

Takeaways

LMEs enable borrowers to restructure their debt outside of formal insolvency proceedings, but often to the detriment of existing lenders. The most common structures, as outlined above, exploit permissive covenant flexibility to subordinate, dilute or strip collateral from non-participating creditors. While these transactions have historically been rare in Canada, the growing adoption of U.S.-style documentation is eroding the structural barriers that have historically limited their occurrence. In Part II of this series, we will examine the practical steps creditors can take to protect themselves against LME risk in their loan documentation.

Footnotes

1 See Stephen Brown-Okruhlik’s previous updates: “Unbearable Lite-ness: Lenders’ Remedies in the Age of Missing Covenants”.

2 The term “Sacred Rights” is a U.S. construct. In Canada, such lender protections may be found in provisions governing Rate, Amortization, Term or Security (“RATS” clauses) with different structure.

3 In re Serta Simmons Bedding, L.L.C., 2024 WL 5250365 (5th Cir. Dec. 31, 2024)

4 Serta Simmons Bedding LLC v. AG Centre St. P’ship (In re Serta Simmons Bedding, LLC), No. 23-90020, Adv. No. 23-09001, 2026 WL 1968535 (Bankr. S.D. Tex. July 7, 2026).

5 Creston Moly Corp v Sattva Capital Corp, 2014 SCC 53 at paras 46-47, 55.

6 See, for example Greenfield v. Philles Records, Inc., 98 N.Y.2d 562, 750 N.Y.S.2d 565, 780 N.E.2d 166, 170–71 (2002).

7 Wastech Services Ltd v Greater Vancouver Sewerage and Drainage District, 2021 SCC 7 at para 63. Note that the Province of Quebec is not a common law jurisdiction. There are separate relevant contract and good faith requirements in Quebec that are not discussed in this update.

8 BCE Inc v 1976 Debentureholders, 2008 SCC 69 (CanLII) at para 78.