Liability management transactions: providing new capital and laying the groundwork to cramdown of those left behind

Introduction

Liability management is having a moment. Once a disfavored strategy, liability-management transactions, or LMTs, are now viewed as a legitimate alternative for private companies and their sponsors working to navigate near-term financial headwinds (e.g., a challenging liquidity position or upcoming maturity wall) and, potentially, lay the groundwork for a comprehensive, long-term financial restructuring. Although the phrase "liability management" could cover the full range of potential restructuring transactions, in this context, it concerns a borrower's efforts to "re-align" its capital structure by working with select creditors and stakeholders to issue new senior-secured indebtedness within the confines of the borrower's existing financing documents.

For years, low interest rates and other factors combined to foster fierce competition among financial creditors, vest borrowers with real bargaining power, and, over time, dilute market-standard creditor protections. Borrowers used that leverage to roll back restrictive loan provisions that creditors used to prevent borrowers from moving collateral around the enterprise and away from the credit group (i.e., a borrower and its affiliate guarantors and pledgors under a secured-financing arrangement). However, things have changed. Today's market is defined by higher interest rates, stubborn inflation, and the lingering consequences from years of global turmoil. More private companies now find themselves managing through untold operational and financial challenges in a complex post-pandemic environment with a much tighter credit market. With few attractive refinancing or restructuring options, many borrowers have tried to make good use of their legacy covenant flexibility, turning to LMTs to extend their runway and avoid an imminent bankruptcy filing or, in some cases, set the foundation for a lasting financial reorganization.

The LMT "playbook" typically calls for a struggling borrower to, first, identify how it can exploit its existing financing documents to "unlock" value to eventually secure new-money financing without tripping unanimous creditor voting requirements, pro rata sharing provisions, and other creditor protections and, second, build a coalition of supporting creditors and stakeholders willing to provide fresh capital, refinance with discounted paper, or otherwise offer better credit terms in exchange for a superior position in the borrower's capital structure and enhanced recovery expectations. In most cases, LMTs are executed over the objection of creditors that either chose not to support the transaction, or were not invited to participate at all. LMTs often sort syndicates and creditor groups into "winners and losers," as non-participating creditors are forced to watch their collateral base or lien priority—not to mention their potential recoveries—erode almost overnight.

LMTs, predictably, spawn litigation between the borrower and participating creditors on the one hand, and non-participating creditors on the other. That litigation, with its attendant cost and risk, motivates an increasingly popular notion that an LMT is the beginning of potential restructuring, not the end. Some borrowers take advantage of their revised capital structures to negotiate a more comprehensive reorganization supported by their "new" senior-secured creditors that, if circumstances require, can be implemented through a confirmed chapter 11 plan that could extinguish or haircut the non-participating and now "junior" creditors' LMT-related claims.

In this article, we identify the most common types of LMTs and various ways that the market has responded to bolster creditor protections. We then examine the Serta Simmons "uptier" exchange and related chapter 11 case, which could serve as a model that others try to emulate. Finally, we highlight key takeaways for market participants from Serta and other recent liability-management developments.

The "go-to" LMTs: Drop-downs and uptier transactions

There are two species of transactions that tend to dominate the LMT landscape: "drop-down" and "uptier" transactions. These transactions, through different means, effectively enhance the participating new money creditors' exposure to the borrower and frustrate the economic expectations of other creditors (usually the non-participating creditors). Although the details always matter, and are different in every case, these kinds of transactions share certain general characteristics.

"Uptier" transactions

In a typical uptier transaction, a borrower partners with a coalition of creditors sufficient to approve an amendment to the existing financing documents (e.g., "majority" lenders or holders). Those creditors then vote to amend the financing documents to allow the borrower to issue new, senior-secured debt that, in substance, primes the existing secured debt held by creditors that did not participate in the LMT (e.g., "minority" lenders or holders). To help ensure majority creditor participation, such creditors are often allowed to exchange their portion of the existing (and now subordinated) debt for new, discounted debt that is junior to any new money, but senior to the old debt and minority creditors—so-called "1.5" lien debt.

Uptier transactions, in effect, contractually subordinate minority creditors through a flurry of amended and new financing documents voted through by the majority. Uptiering has been used by borrowers as early as 2017 (e.g., Not Your Daughters Jeans) and has been a popular alternative since (e.g., Serta, TriMark USA, Boardriders, and TPC Group).

"Drop-down" transactions

A borrower can structurally subordinate non-participating creditors by transferring valuable assets outside of the borrower's credit group. In a drop-down transaction, the borrower uses "basket capacity" under its existing covenants to transfer collateral out of the credit group to an "unrestricted subsidiary," that is, a subsidiary that is not an obligor or pledgor under the borrower's existing financing documents. As a result, the existing creditors' liens on the transferred assets are automatically released and the unrestricted subsidiary is then free to use those now-unencumbered assets to secure the new senior indebtedness.

Unlike an uptier transaction, a drop-down may not require majority creditor consent or support because these transactions can be executed without amending existing financing documents. A borrower might have more flexibility in a drop-down transaction to partner with other stakeholders, including its sponsor or a new slate of lenders and investors, to provide new-money financing at the unrestricted sub.

The best-known drop-down transaction, J. Crew, was executed in 2016 when the company transferred valuable IP assets to an unrestricted subsidiary, which subsidiary then guaranteed and pledged those assets to secure the issuance of new secured notes. Such transactions have remained a popular option in the years since (e.g., Neiman Marcus, Revlon, Cirque de Solie!, Travelport, and Envision).

Addressing LMT risk in debt documents

In either case, it's unclear what, if anything, non-participating creditors can do to improve their position or potential recoveries after the transaction is executed. Given that an LMT's size and shape are a function of the existing financing documents' covenants and conditions, negotiated protections at the outset are crucial to limiting creditors' exposure to these transactions. Under most financing documents, sacred rights (e.g., maturity extensions, changes to payment schedules or pro rata sharing arrangements, commitment increases, and releases of collateral) cannot be changed unless each creditor votes to approve the amendment. LMTs arguably do not implicate sacred rights despite the severe economic consequences they have for non-participating creditors. There is no "one size fits all" approach to addressing drop-down or uptiering risks, but in recent years creditors have focused on improving the market standard for certain creditor protections in financing documents.

In a drop-down, for example, the collateral transfer and lien release is a permitted transaction so an amendment or creditor approval of any kind is rarely required. After J. Crew, creditors began tightening covenants by requesting investment "blockers" (colloquially called Envision blockers) that limit a borrower's investments in unrestricted subsidiaries, often by confining such investments to an "unrestricted subsidiary basket" and limiting the borrower's ability to use its return on investments to replenish basket capacity. Creditors also routinely request additional asset-transfer limitations designed to prevent investments and transfers that might move too much collateral value or the borrower's "crown-jewel" assets outside of the credit group.

As for uptiering, decisions rendered in LMT litigation show that creditors should pay close attention not only to a borrower's covenant flexibility, but to voting mechanics and pro rata sharing provisions (i.e., terms that require any payments or recoveries under a financing be shared pro rata by all creditors). Courts have held that the contractual subordination is not tantamount to a collateral release and, therefore, does not implicate sacred rights or require a unanimous creditor vote. Consequently, creditors now request provisions that prohibit both debt and lien subordination absent the consent of adversely affected creditors.

Uptiering transactions and other LMTs also often rely on exceptions to pro rata sharing provisions to offer majority creditors opportunities to exchange (or "roll up") their existing exposure for new, 1.5-priority debt at a discount to par. To implement these exchanges, borrowers frequently use "open-market-purchase" exceptions, which allow them to repurchase debt through private transactions with participating majority creditors without extending the offer to others. In response, some creditors devote more attention to defining what does, or does not, constitute an "open market purchase" to, if nothing else, create more certainty concerning their potential exposure.

Developments in LMT litigation and restructuring strategies

Minority creditors often rush to challenge LMTs in state and federal courts. So far, overall litigation results have been mixed (and occasionally contradictory). These post-transaction litigations provide market participants (both borrowers and creditors) with useful guidance for either implementing an LMT-based restructuring or dealing with LMT exposures. Increasingly, however, borrowers, with the support of their sponsors and participating creditors, are dragging their LMT-based disputes into chapter 11. Such borrowers often file for bankruptcy relief with a prepackaged or prenegotiated plan of reorganization with the senior debt in hand (e.g., Envision Healthcare and Diamond Sports) and put lingering LMT challenges before the bankruptcy court and push for a rapid resolution.

Serta Simmons: A potential model for liability management through chapter 11

Serta's chapter 11 case filed in the wake of its LMT is instructive on the use of LMTs. In late 2019, Serta faced economic challenges stemming from the restructuring of its largest retail partner and increased competition from direct-to-consumer businesses. In 2020, Serta needed new capital to, among other things, weather the COVID-19 pandemic and started working with some of its lenders to explore alternatives. Some lenders had favored a drop-down transaction, but Serta opted for an uptiering transaction supported by its majority lenders.

Generally, Serta's LMT provided a new super-priority term loan facility with two tranches: a US$200 million new-money tranche and a debt-for-debt exchange tranche pursuant to which US$850 million of priority terms loans were issued and exchanged by participating lenders for US$1 billion of their exposure under the existing credit facility.

Serta's non-participating lenders challenged the transaction in New York state and federal courts, asserting a variety of claims, including for breach of the credit agreement and the implied covenant of good faith and fair dealing. The lenders argued that the transaction did not qualify as an "open market purchase" and otherwise trampled on their sacred rights (e.g., their right to receive a pro rata share of payments and recoveries, and their senior lien priority and position in Serta's capital structure). After a series of apparent setbacks and seemingly inconsistent results in different courts, in January 2023, Serta and its affiliates filed for chapter 11 protection in the US Bankruptcy Court for the Southern District of Texas and the cases were assigned to Judge David R. Jones, who sits on the court's Complex Case Panel.

Serta filed with a restructuring support agreement and a chapter 11 plan prenegotiated with its majority lenders (i.e., the lenders participating in the prepetition LMT) and others already in hand. The proposed plan provided for 73.7% to 100% recoveries for lenders that supported Serta's LMT and chapter 11 plan, and just .6% to 2.4% recoveries for the non-participating group and other unsecureds, but also included a "participating-lender" indemnity that covers certain losses of participating lenders related to litigation in Serta's bankruptcy case and the prepetition uptier transaction and related matters. Within a day of Serta's bankruptcy filing, it removed LMT litigation pending in New York federal district court (where participating lenders received some adverse rulings) to the Texas bankruptcy court and filed a related adversary proceeding there that immediately teed up for Judge Jones the LMT-related claims and defenses that had been pending for years. Judge Jones agreed with Serta that the LMT disputes needed a rapid resolution and were integral to Serta's bankruptcy and proposed chapter 11 plan. On March 28, 2023, just two months after filing, Judge Jones granted summary judgment in favor of Serta and the participating lenders, ruling that the uptier transaction "clearly" fell within the unambiguous terms of the "open market purchase" provisions in the credit agreement. That decision paved the way to a quick (albeit contentious) confirmation trial where the remainder of the non-participating lenders' claims would be addressed. The nonparticipating lenders lost again. Judge Jones confirmed Serta's chapter 11 plan—including the participating-lender indemnity provisions—disposed of certain claims challenging the uptier transaction, and found that all parties knew Serta had flexibility built into the credit agreement and would have to live by the bargain they struck.

The non-participating lenders are appealing Judge Jones's decisions, including the confirmation of Serta's chapter 11 plan. Still, Serta's path from its LMT through chapter 11 stands as a notable test case for borrowers and their supporting stakeholders, and yet another cautionary tale for the rest of the creditor body.

Takeaway

LMTs are not going anywhere. Borrowers with covenant-lite financings or other generous terms are wise to explore all of their options. Creditors, for their part, should continue to carefully craft documents that help manage exposure and mitigate risk. Despite their growing popularity, LMTs are not without risk to borrowers. An LMT can extend a borrower's runway, but it cannot guaranty that a comprehensive, long-term restructuring will ever truly get off the ground. Borrowers may find themselves struggling to recover, weighed down by years of expensive litigation and unavoidable uncertainty. Indeed, many market participants question the reasoning and efficacy of LMTs and point to data that show the transactions rarely help avoid a default or bankruptcy filing and often do not improve a borrower's credit profile.

In some situations, however, avoiding bankruptcy may not be the point. In light of outcomes like those achieved in Serta and other chapter 11 cases, some borrowers might come to see LMTs as part of a program of transactions that culminates with a confirmed chapter 11 plan; trading years of expensive and contentious litigation and consensus building for an accelerated (but still expensive) trip through a specialized federal court that can deliver real finality and the kind of comprehensive relief only available through chapter 11. The court's decision demonstrates that an LMT can withstand judicial scrutiny where the borrower operates within the unambiguous terms of its financing documents and adheres to corporate-governance best practices in planning and executing on its strategy.

Given the number of LMT-related cases currently working their way through the bankruptcy system—and with several more on the cusp of filing—borrowers and creditors alike will need to pay close attention to keep up with the latest liability-management trends and, as always, make sure their next deal documents reflect a "state of the art" covenant package suited to their particular interests.