Liability Management Exercises In Europe: What Do They Mean For Lenders?

Synopsis

Liability management exercises (‘LMEs’), originally a phenomenon of the bond world, have spilled over to the senior secured leveraged finance market in the US for a number of years as a result of the prevalence of covlite, among other factors. Drop downs, uptiers, double dip and pari plus transactions – all forms of LMEs – are now starting to be seen in Europe.

In the US, creditors’ response to the recent round of LMEs has been described as a ‘whack a mole’ approach – each type of LME generates a specific documentary response, which is often only included in the post-LME documentation. Creditors’ search for an omni-blocker is continuing.

This Part One covers what LMEs are, documentary provisions and responses and their use in the US. Part Two, which will be published in the next edition, covers the use of LMEs in Europe and potential legal issues to be considered.

1. What are LMEs and types of LMEs

LMEs, also now being referred to somewhat misleadingly as creditor-on-creditor violence, have been around for years in the bond world. What is relatively new is that these techniques are now appearing in the senior secured leveraged finance market, where investors seem to have expected to be uniformly pari passu or senior to other creditors and discover that this is not always the case.

Most of the LMEs in the news over the past few years have been executed by groups seeking liquidity when their ability to borrow is tapped out for whatever reason – be it covenants or the credit.

Others are driven by the need to achieve a minirestructuring without the greater expense of a formal restructuring via US Chapter 11 – reducing leverage and interest expense and getting in liquidity to keep the business operating.

Finally, a few seem to have been driven in part by a desire of shareholders to retain exposure to a valuable asset that otherwise might be dragged into a deterioration of the overall business.

Broadly speaking, the LMEs that have been getting all the attention fall into several distinct categories, and sometimes a combination of them:

1. Drop downs and/or structurally senior financings, often achieved within the covenant permissions of the pre-existing debt – some of these are referred to as a J. Crew (drop down of intellectual property into an unrestricted subsidiary that borrows new debt), Envision (designation of a subsidiary with intellectual property as an unrestricted subsidiary that borrows new debt) or Nieman Marcus (drop down into an unrestricted subsidiary and dividending the unrestricted subsidiary out of the group).

2. New financings coupled with super seniority for the new financing and potentially for pre-existing debt held by the lenders participating in the new financing – with those participating lenders voting through the necessary amendments to preexisting debt documentation. These are usually referred to as ‘Serta’ style ‘uptiering’ or ‘priming’ after Serta Simmons Bedding implemented this kind of uptiering – first withstanding litigation scrutiny and more recently with some setbacks. Most uptier transactions involve the exchange of old debt for new, more senior debt (usually at a discount) coupled with an amendment of the terms of the old debt to the disadvantage of the creditors not participating in the uptier transaction.

3. New financings where the financing is effectively pari passu with the pre-existing senior secured debt, but which also has additional credit support that does not need to be shared with the other pari passu creditors. These new financings typically require a special purpose vehicle (‘SPV’) to act as borrower from the third-party financiers, with the borrower on-lending into the group on a pari passu senior secured basis. The extra credit support varies according to what is possible at the time – sometimes significant assets are dropped into the SPV, sometimes the group guarantees the third-party debt using basket capacity and so on. Similar to drop downs, these are often achieved within the covenant permissions of the pre-existing debt.

4. Releases of guarantees and security over key assets by creating minority holdings in relevant subsidiaries, taking advantage of contractual provisions allowing the releases when the subsidiary is not wholly owned.

2. Documentary provisions/enhanced flexibility

The recent relative popularity of LMEs in the senior secured debt market is driven in part by a convergence over the past 15 years or so in many loan leveraged finance and private credit documents on the flexibility of bond covenants, particularly in the large cap space but also to a degree in the mid-market.

Before that convergence took place, typical LMA market standard facility agreements contained maintenance covenants whose starting point was that actions could only be taken by the borrower and its subsidiaries if expressly permitted by a series of negotiated baskets, ideally (from the creditors’ viewpoint) but not always set on the basis of fixed amounts rather than ratios. The convergence was driven by a number of factors, including the low interest rates and available liquidity seeking return driven by post ‘global financial crisis’ and post COVID-19 quantitative easing as well as technical factors such as were recently a relative dearth of M&Adriven financings after events such as the Russian invasion of Ukraine.

Standard baskets include:

— Financial indebtedness: new indebtedness is not permitted to be incurred except debt that does not meet the technical definition of indebtedness and any debt that is permitted to be incurred under the relevant baskets. The specific size and characteristics of the baskets (e.g. is it a fixed amount, based on a multiple of EBITDA or based on senior secured or total leverage or fixed charge cover) vary by deal, industry and what kind of debt it is, but fixed amount baskets have got rare. However, a set of baskets has become relatively standard, including: credit facilities or freebie basket (not limited by leverage), incremental facilities limited by leverage and/or fixed charge cover (as the case may be), capitalised lease obligations, ratio debt, general debt and contribution debt, as well as industryspecific baskets.

— Permitted collateral liens and permitted liens: most, but not necessarily all, of the financial indebtedness baskets may be permitted to be secured by the existing senior secured collateral (permitted collateral liens) or other collateral (permitted liens), either in full or in part, with the most restrictions on what can be secured applying to the existing senior secured collateral. Senior secured ratio debt, general debt, and the debt in the credit facilities baskets can typically be secured by existing collateral. Capitalised lease obligations and, occasionally, the general debt basket can be partly and/ or fully secured by new security. In the European market contribution debt can now commonly be secured by existing collateral or new security. 

— Restricted investments: other than pursuant to a predetermined basket as negotiated, investments are generally not permitted save, typically, investments in other members of the restricted group, investments in cash and investments in assets or entities that become assets or members of the restricted group as well as transactions that technically fall within the definition of investments but that need to be permitted to allow the smooth running of daily operations. In addition, other investments are often permitted in the amounts that otherwise could be dividended out of the group.

— Restricted payments: restricting dividends and other forms of distributions to shareholders/sponsors and restricted payments on subordinated debt (noting that second lien is not invariably treated as subordinated debt in some formulations because of the seniority of the second lien unsecured claim), so that payments are subject to limits during the life of the debt and (sometimes) conditional on there being no default outstanding and (where applicable) additional capacity under the ratio debt basket. The restricted payments basket typically has the capacity to grow depending on distributions from, and other transactions with, unrestricted subsidiaries.

Not only have maintenance covenants given way to incurrence covenants, but the incurrence covenants have also become increasingly borrower-friendly, starting with a generous basket size that grows with adjusted EBITDA (adjusted for synergies and certain other reorganisation/cost savings and other steps – as negotiated – on a pro forma basis). This results in significant basket capacities that, if earlier unused and/or annual, gives a debtor significant leeway to combine more than one basket for use in one LME.

3. Documentary responses

As the recent round of US LMEs kicked off, there were market reactions with each LME-type generating its specific documentary ask, rather than creditors adopting a holistic approach.

— The J Crew/Envision blocker: has become fairly standard, blocking the transfer of material intellectual property outside the restricted group (by transfer or, as was the case in Envision, by designating a subsidiary as unrestricted that already had the asset in question) as well as at times limiting the amounts that can be invested in unrestricted subsidiaries. This is sometimes extended to capture other material assets that can be used for a structurally senior financing.

— The Chewy blocker: limits the ability of a restricted subsidiary to trigger contractual provisions entitling it to the release of guarantees and security over its assets by issuing or transferring some of its shares outside the restricted group.

— The Serta blocker: limits any change to the 100% or super-majority amendment provisions in the senior facilities or intercreditor agreements in relation to any subordination and – importantly as some miss it – any change in the proceeds waterfall. Note that the requirement for super-majority or all-lender consent can be overridden by a courtsupervised process that requires lower consent levels, such as an English scheme of arrangement (75% of value and a majority in number in each class of those voting in person or by proxy), an English restructuring plan (75% of value of each class of those voting in person or by proxy) or the Dutch WHOA (66²⁄³% per class). 

There has been some focus by lenders on limiting the use of exclusionary exchange offers to achieve uptierings, and a focus by some borrowers on ensuring this flexibility remains. Where this will settle in the market is unclear at the moment.

— Pluralsight blocker: in Pluralsight, intellectual property was moved to a non-guarantor restricted subsidiary that issued preference shares to a shareholder affiliate, rather than the intellectual property being moved to an unrestricted subsidiary as was the case in J. Crew. The Pluralsight blocker is usually a restriction on the issuance of minority stakes outside the restricted group by a restricted non-guarantor subsidiary that owns an important asset.

— Vote rigging blockers: to be able to implement LMEs, some debtors have made use of the incremental debt provisions to issue additional debt to supportive creditors just before a vote on a proposed LME. The debt issuance is designed to be sufficient so that the supportive creditors constitute the necessary majorities to implement the planned LME against the objections of a sizeable minority. Vote rigging blockers therefore seek to block the votes of debt issued at substantially the same time as the LME transaction in question.

— Double dip blockers: these are relatively rare and seek to block credit support for debt of unrestricted subsidiaries or, at times, for non-guarantor restricted subsidiaries, to the extent done to enable multiple claims into the group. This can include limiting restricted group credit support for debt of unrestricted subsidiaries, the so-called ‘At Home’ blocker.

— General LME blocker: the market became excited about the RR Donelly (and its limited number of progeny to-date) use of a general LME blocker. However, the ones seen so far have included a ‘bona fide business purpose’ or similar exception that may make it ineffective against the categories of LME whose purpose includes raising new funds for the restricted group. The search by creditors for an effective omni-blocker continues.

This lack of a holistic approach means that troubled borrowers and their financiers will inevitably continue to pore over their documentation to find ways of raising finance and find ways of delivering it.

New LME structures are also still being thought about, such as a hypothetical new LME structure termed ‘inside out’ by some by which a third-party lender or minority lender ‘dethrones’ a majority lender group and acquires requisite lender status by funding a refinancing loan to help the company prepay existing loans on a pro rata basis.

The majority of LMEs to date, and any associated litigation, have been in the US. There has been much speculation about whether we will see similar LMEs here in Europe. There has already been a number of LMEs used by European debtors, at times driven by US principles. These include the negotiations that took place in relation to Altice France, the Ardagh pari plus and the recent Hunkemöller uptier, followed by a super senior security enforcement, now in litigation in the US. All those cases involved New York law debt documentation. While there are clear differences between New York law and, for instance, English law, and the duties and potential liabilities of directors are generally broader under European laws than US laws, there is clearly scope for these transactions to be proposed in the UK and Europe depending on the circumstances.

4. Cooperation agreements

One way that creditors have taken back some control in light of aggressive LMEs is the use of cooperation agreements. Even though cooperation agreements cannot stop borrowers from taking actions permitted under the debt documents, e.g. a drop down of material assets or a double dip transaction, they have been used successfully, not only in the US but recently also in Europe, to restrict a debtor’s actions in relation to a proposed LME.

Nevertheless, cooperation agreements can only assist in certain circumstances and come with notable drawbacks so that creditors and their advisors will want to carefully weigh their limitations against their potential advantages.

As already mentioned, one significant drawback is that a cooperation agreement cannot prevent a transaction which is already permitted under the debt documents, even though it can exclude the cooperation agreement members from participating in that transaction. Similarly, it cannot prevent the debtor diluting voting power of existing holders by issuing permitted incremental debt to non-cooperation group members. In addition, a cooperation agreement involves significant coordination costs and adds an extra layer in addition to the costs of negotiating a restructuring agreement. As two practical points, cooperation agreements also disproportionately favour weaker creditors and therefore there will need to be sufficient incentives for stronger creditors to join the cooperation agreement, and as cooperation agreements require the creditor parties and their successors to be bound, i.e. transferors require their successors to become bound, this may affect pricing in the secondary market.

In the latest development, sponsors/debtors have been trying to contractually exclude creditors’ ability to enter cooperation agreements by inserting anticooperation clauses. At the time of writing, we are not aware of any anti-cooperation language expressly excluding cooperation agreements which has been accepted by creditors in Europe or the US. Given the flurry of LMEs in the recent years and the change in market conditions, it is unclear whether creditors will be willing to give up one of their most effective defences against the effects of loose documents.

Finally, there are potential competition issues that must be considered if the effect of the cooperation agreement is to make certain types of financing unavailable (or change the available terms).

Part Two of this article will analyse the differences between LMEs in Europe and the US and will look at recent trends of European debtor LMEs.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.