Liability management transactions: While US bankruptcy courts send mixed messages to markets, lenders prepare for the next wave

Introduction

What’s en vogue today might be passé tomorrow. Some trends are “out” before they’re ever really “in,” some stick around until a new one comes along, and others still come-and-go with the seasons. Liability-management transactions, or LMTs, might have seemed like another restructuring fad to some, but they’re more popular than ever. 

Why do LMTs seem to have such “staying power” across industries and sectors? For one thing, LMTs—or the risk of one—can provide cash-strapped companies with valuable leverage, particularly those with flexible credit documents (e.g., covenant-lite and covenant-loose loans). Borrowers and their sponsors can use that leverage to partner with new and existing stakeholders to “redesign” capital structures, tapping new liquidity, refinancing legacy debt, and re-allocating value among stakeholders in the process. The flexibility of LMT-driven strategies is especially valuable in this economy, where domestic and global markets remain awash in uncertainty and upheaval. For lenders, LMTs are now an ever-present risk that could affect any number of credits throughout a portfolio.

In a previous article, we explored the emergence (or rather, re-emergence) of LMTs as a legitimate alternative for companies and their sponsors looking to address short-term liquidity challenges, lay the groundwork for a comprehensive restructuring, or accomplish other strategic objectives. We also provided an introduction to the most-common LMTs—“uptier” and “drop-down” transactions—and the typical LMT “playbook” to explain how these transactions exploit loopholes in credit documents to “unlock value” for some lenders at the expense of those that either declined—or weren’t permitted—to participate. Since then, the appetite for LMTs has only grown, and with it, so have LMT-related lawsuits. 

By choice or by circumstance, some borrowers land in chapter 11 after executing an LMT, often dragging with them a raft of complex litigation. In this article, we briefly review certain holdings in two recent decisions issued by Houston bankruptcy judges sitting in Houston, Texas in the US Bankruptcy Court for the Southern District of Texas regarding the Robertshaw and Wesco Aircraft “uptier” transactions and related disputes. We then examine two potential alternative LMTs certain borrowers might prefer to more-aggressive “uptier” and “drop-down” transactions that still dominate industry headlines. Lastly, we highlight key takeaways for market participants from the latest liability-management developments.

Litigation developments: Robertshaw and Wesco Aircraft provide some guidance, raise more questions

In the past couple of years, certain market participants have explored using the extraordinary relief available under the US Bankruptcy Code to short-circuit what would have otherwise been years of time-consuming, costly LMT litigation. chapter 11, in theory, provides borrowers and participating creditors an opportunity to quickly resolve their disputes with non-participating creditors and implement a comprehensive restructuring based on that resolution. As noted in our previous article, the Serta Simmons chapter 11 cases filed in the US Bankruptcy Court for the Southern District of Texas could have been viewed, at the time, as a template for resolving post-LMT disputes.

In Serta, after a prepetition uptier transaction and mixed litigation results, the borrower negotiated a restructuring support agreement and a chapter 11 plan before filing for bankruptcy relief, and immediately teed up its LMT-related disputes for rapid resolution by the bankruptcy court. Just two months after filing, the Serta court ruled in favor of the borrower and participating lenders, finding that the uptier transaction “clearly” fell within the unambiguous terms of the “open market purchase” provisions in the credit agreement. The non-participating lenders then contested the confirmation of the borrower’s chapter 11 plan but lost again as the bankruptcy court found that all parties knew the borrower had built “flexibility” into the credit agreements and, as a result, non-participating lenders had to live with their bargain. The bankruptcy court’s Serta decisions are currently on appeal to the US Court of Appeals for the Fifth Circuit, which heard oral argument and took the appeals under advisement on July 10, 2024.

On the heels of the borrower’s and participating creditors’ triumph in Serta, two more post-LMT borrowers turned to the Houston bankruptcy court for relief. In June 2023, just days after Serta’s plan-confirmation trial concluded, Wesco Aircraft and its affiliates filed for chapter 11 relief and their cases were assigned to then Chief Judge David R. Jones, who also presided over Serta’s chapter 11 cases. Months later, in February 2024, Robertshaw and its affiliates filed for chapter 11 cases and their cases were assigned to Judge Christopher M. Lopez. 

Wesco Aircraft and Robertshaw followed the Serta “playbook”: after executing prepetition uptier transactions, they sought to negotiate restructuring support agreements and related transactions with the participating creditors, later filed for bankruptcy relief, and ultimately made the timely resolution of uptier-related litigation the “centerpiece” of their chapter 11 cases. Both cases appeared to be headed down the path Serta had just cleared, but so far, only the Robertshaw debtors made it to the end.

Robertshaw court finds that minority creditors must live with their bargain

Robertshaw, an engineering and manufacturing firm, was acquired by an its sponsor company in 2018. At some point, Robertshaw’s lender group organized into two factions: an ad hoc group of lenders and an individual lender. In 2023, Robertshaw and certain of its lenders executed multiple related transactions that set the stage for a contentious chapter 11 case.

First, in May 2023, Robertshaw negotiated an uptier transaction with both factions (i.e., the ad hoc group and the individual lender) that included a new-money first-lien financing and the exchange of participating lenders’ existing holdings for higher-priority debt, and also conferred on the participating lenders, as a combined voting bloc, “required-lender status” under the new credit agreement. 

Sometime in July 2023, however, the individual lender increased its holdings and became the sole “required lender” without the ad hoc group’s knowledge. Then, in the fall of 2023, Robertshaw faced another liquidity crunch and attempted to negotiate a refinancing transaction with a third party. The individual lender did not support the third-party transaction and, over a number of weeks, entered into various credit-agreement amendments typical in a potential workout scenario (e.g., certain waivers and forbearances, key financial accommodations, bankruptcy-filing milestones, and the like). The ad hoc group learned about the amendments only later from another source, and then began negotiating an alternative transaction with Robertshaw and its sponsor. 

Ultimately, Robertshaw’s board approved the ad hoc group’s alternative transaction. In December 2023, Robertshaw and the ad hoc group implemented a multi-step proposal, which included financing a debt repayment that allowed the ad hoc group to become the “required lenders” under the existing credit agreements, further authorized Robertshaw to issue new first-out and second-out loans, and simultaneously eliminated the individual lender’s status as “required lender under the same credit agreements.” The individual lender then sued in New York state court to nullify the transactions and regain control under the credit agreements, but those disputes were ultimately argued before the Houston bankruptcy court after Robertshaw’s chapter 11 filing. 

In June 2024, the bankruptcy court denied the individual lender’s request to unwind the transaction, and largely ruled in favor of Robertshaw, its sponsor, and the ad hoc group. The rulings were firmly rooted in the interpretation of the first-lien credit agreement. With respect to breach-of-contract claims, the bankruptcy court found that the only breach committed by Robertshaw was its failure to comply with mandatory-prepayment provisions. The bankruptcy court further found that, under the “four corners” of the agreement, the individual lender’s sole remedy was a claim for monetary damages. Thus, the bankruptcy court expressly declined to use its equitable powers to unwind the transaction and re-allocate control among the lenders. With respect to other equitable and tort claims, the bankruptcy court observed that the May 2023 uptier-exchange transaction “established a baseline of conduct” among the lenders, and that the individual lender then “engaged in acts it now calls bad faith.” Consequently, neither Robertshaw nor the ad hoc group breached the “implied covenant of good faith and fair dealing” under New York law, and Robertshaw’s sponsor did not tortiously procure any breach of the credit agreements.

Wesco Aircraft court partially invalidates prepetition uptier-exchange

Like the Robertshaw borrower, Wesco Aircraft Holdings, a supply-chain management-services provider, operating as “Incora,” was the product of a leveraged buyout financed through secured notes maturing in 2024 and 2026, and unsecured notes maturing in 2027. 

In March 2022, Wesco and certain participating lenders executed an uptier-exchange transaction. Before the transaction, the participating lenders held a supermajority voting position (i.e., two-thirds of the outstanding notes) under the 2024 indenture, but only a simple majority under the 2026 indenture. The default rule under both indentures was that indenture amendments were prohibited unless a supermajority of noteholders consented. Wesco and the participating lenders sought to circumvent the supermajority-consent requirement by implementing the transaction through two indenture amendments. 

The first amendment was structured under an exception to the above “default rule” that permitted Wesco to issue the “additional notes” with only a simple majority of consenting noteholders. Relying on this exception, the participating lenders consented to an indenture amendment that allowed Wesco to issue “additional notes” under the 2026 indenture, the participating lenders then purchased the newly issued “additional” 2026 secured notes and, as a result, gained a supermajority position under both the 2024 and 2026 indentures. The participating lenders then used their newly acquired voting power to approve the second indenture amendment, which authorized the exchange of their existing 2024/2026 notes for new 2026 secured notes and stripped non-participating 2024/2026 noteholders’ liens. 

Like the individual lender in Robertshaw, the non-participating noteholders sued in New York state court to, among other things, unwind the transactions, but those disputes were later removed and brought before Judge David R. Jones in the Houston bankruptcy court (who presided over the Serta chapter 11 cases). At that point, Wesco Aircraft seemed on its way to being the next Serta. But in October 2023, with summary-judgment motions pending, Judge Jones resigned from the bench and Wesco Aircraft was re-assigned to Judge Marvin Isgur. Judge Isgur then ruled that a number of claims and disputes survived summary judgement, and the parties proceeded to a 30-day trial on the remaining issues.

On July 10, 2024, the Wesco Aircraft court issued an oral ruling that partially invalidated the uptier-exchange transaction. The court viewed the transaction as “dominos”: after the first amendment was executed, the result (i.e., stripping non-participating 2026 noteholders’ liens) was “inevitable.” Thus, the court found that the first amendment “had the effect” of releasing the non-participating 2026 noteholders’ liens and, as a result, the amendment could not have been executed without supermajority consent under the then-existing indenture’s terms. The participating creditors were only able to reach the supermajority-voting threshold through the subsequent issuance of the additional 2026 secured notes. Unlike the outcome in Robertshaw, the bankruptcy court determined that, under the circumstances, the transaction, at least in part, had to be unwound. 

The ruling restored all of the 2026 secured noteholders’ rights and liens as if the uptier-exchange never occurred, whereas the 2024 noteholders’ liens were not restored because the court found that the requisite two-thirds majority of 2024 noteholders consented to the lien-stripping amendments in the uptier-exchange. Finally, the Wesco Aircraft court indicated that its oral ruling would later be replaced and superseded by a full written opinion (which had not been issued before this article was published). 

Lessons learned?

In liability management, where every transaction is tailored to the facts and circumstances, every LMT stands alone. The same is true for the LMTs at issue in Robertshaw and Wesco Aircraft. Still, these cases reflect certain common themes and issues (e.g., shifting or “manipulation” of lender voting power, transaction sequencing) that are often implicated in some way in most LMTs and related litigation. For that reason, both commentators and litigants have argued that Robertshaw and Wesco Aircraft are contradictory decisions, leaving the market without clear guidance. There is, at minimum, “tension” in aspects of the analysis and divergence in the results. 

Both cases included facts that, arguably, involved some degree of “voting manipulation,” as rival lender groups vied for supermajority or “required lender” control under credit documents, and both cases involved requests by non-participating or excluded lenders to avoid or unwind the resulting transactions. In Robertshaw, “vote rigging” allegations didn’t factor into the analysis, but similar allegations in Wesco Aircraft were “front and center.” In Robertshaw, the court’s remedy selection was defined by the credit agreement’s negotiated terms rather than a broad equitable inquiry, but in Wesco Aircraft the court felt compelled to undo portions of the transaction, clearly troubled by the notion that management and their supporters could take “someone’s property rights” away while purportedly acting in the borrower’s best interest. These holdings are difficult to reconcile, but provide some high-level guidance: “words still matter,” precise drafting should remain front of mind, but one should pause before elevating “form over substance,” and bankruptcy courts will take care to ensure that stakeholders cannot “structure away” good faith and fair play.

While early signs indicate that the market may be moving toward less-aggressive transactions, it’s too soon to tell how far it will move and what’s motivating that movement. It may be wise to reserve judgment until the full written Wesco Aircraft opinion is issued. For now, it is clear that the Robertshaw and Wesco Aircraft cases, as well as the Serta appeals and developments in the Houston bankruptcy court, need to be closely watched by players and professionals in the LMT market for the foreseeable future. 

Market outlook: Recent litigation results might influence pending and future transactions

“Uptier” and “drop-down” transactions still dominate the LMT landscape because of their demonstrated ability to bolster participating creditors’ recoveries and deliver at least some balance-sheet relief to distressed borrowers. These transactions will likely remain the market’s “go to” LMTs in the near future. After accounting for litigation risk and differing decisions like those in the Serta, Robertshaw, and Wesco Aircraft chapter 11 cases, some borrowers and lenders may choose another path. For some, particularly those exploring less-aggressive options, that path could lead them to consider another increasingly popular type of LMT: the “double dip.” Like other LMTs, the term “double dip” encompasses an array of transactions; however, double dips generally come in two flavors: either a basic double-dip, or a “pari-plus” double-dip transaction. 

Double-dip structures, both of the basic (e.g., At Home and Wheel Pros) and pari-plus (e.g., Sabre, Trinseo, and Rayonier) variety, have become popular alternatives in the last year or so. A key difference between the double-dip structure and other LMTs is that, in a double dip, new-money creditors attempt to maximize their recoveries by creating “new claims” throughout the borrower’s corporate family and capital structure. 

Basic and “pari-plus” double-dip transactions

A “double dip” is a multi-part, but still straightforward, set of financing transactions. At a high level, double dips are implemented in two phases:

• First, one of the borrower’s subsidiaries, a “financing sub,” will incur a new-money secured loan. That new-money loan will typically be guaranteed and secured by entities and assets already within the borrower’s existing credit group (i.e., the guarantors and collateral that support the borrower’s existing debt).
• Second, the financing sub then on-lends the proceeds of the new secured facility to the borrower through an intercompany loan and, in turn, pledges that intercompany loan to the double-dip lender. In this case, the “first dip” is the double-dip lender’s claim against existing guarantors or collateral, and the “second dip” is the pledged intercompany claim against the borrower. 

A basic double dip gives a new-money lender multiple direct and indirect claims at strategic points in the borrower’s existing credit group. In theory, long-standing bankruptcy principles and caselaw would allow the double-dip lender to pursue US$2.00 in claims against different credit-group entities for every US$1.00 advanced to the financing sub through the new-money loan.

A “pari-plus” transaction is a subset of the double-dip genre. In a pari-plus transaction, the “first dip” in the basic double-dip structure is enhanced by having entities that are outside the existing credit group incur or guarantee the new-money secured facility. Consequently, the double-dip lender in this transaction is “pari” in respect of the intercompany claims provided through the “second dip” above, “plus” benefits from structurally senior claims on any assets of the obligors that are outside of the borrower’s existing credit group. 

More double-dip transactions on the way?

Double-dip structures seem poised for another big year. Like other LMTs, double-dip proceeds can be used to plug liquidity holes, refinance legacy debt, or fund strategic initiatives in a challenging operational and financial environment. Moreover, a double-dip facility can be implemented as a standalone LMT or in conjunction with another LMT (e.g., an uptier, drop-down, or other combination of transactions) to provide participating lenders with additional credit support. 

These LMTs may also prove more attractive to some borrowers and creditors looking for a “cleaner” or facially “less aggressive” structure in the wake of Wesco Aircraft (not to mention lingering uncertainty regarding the fate of Serta’s bankruptcy strategy at the Fifth Circuit). The “mere dilution” of existing lenders’ claims in a double dip may seem less “violent” than the lien-stripping, asset-shuffling, “overnight” subordination, and disenfranchisement that characterize other LMTs. In addition, double-dip transactions (in most cases) rely entirely on exploiting covenant capacity and basket availability in the borrower’s existing credit documents (e.g., a borrower must have sufficient debt-and-lien-covenant capacity for the financing sub to incur the new-money secured facility), which allow borrowers to negotiate and implement double-dip transactions on a tight timeline and with minimal process or interference from non-participating or excluded lenders.

Still, this strategy is not without risk. Although challenges to uptiers and drop-downs in bankruptcy have led to mixed results, double-dip financings have not been tested in bankruptcy court. Double-dip transactions rely on the creation of a collection of direct and indirect claims to bolster lender recoveries; if any one claim, or class of them, were to fall away through the chapter 11 process, a double-dip lender’s exposure could dramatically change.

Takeaways

Under current market conditions, LMTs aren’t going away. They are, at least for now, a fact of life and lenders will need to fully assess and track LMT-related risks and developments throughout their portfolios. Results like Robertshaw and Wesco Aircraft in many ways seem to reinforce the need for lenders to negotiate unambiguous credit documents that incorporate the latest protective “technology” whenever possible. But in the absence of clearer signals from federal and state courts, lenders should prepare for a new wave of “creativity” in the LMT space, including comparatively novel structures (e.g., double dips), and bolster their “early-warning systems” to ensure that they aren’t caught flat-footed when distressed borrowers start looking to other sources for financial solutions.