Debt workouts and liability management transactions

Relaxed credit terms have created opportunities for priming financing outside Chapter 11.  In today’s market, drafting holes in sponsor-friendly credit agreements are exploited to avoid the cost and dislocation of a Chapter 11 process.  The current trend is an evolution from one type of Liability Management Transaction (LMT), the dropdowns of collateral, toward the other type of LMT, senior new money and non-ratable up tier exchanges.  

A LMT begins with creditors holding common positions and having common interests in the capital structure identifying each other and forming an ad hoc group. Then that ad hoc group will coordinate with the borrower under an NDA, with a view toward entering into a restructuring support agreement and locking in support for a specific restructuring.   The ad hoc group may not even be open to other members of the same tranche.  The ad hoc group may choose not to invite others even if they are in the same class or even if aligned to the same purposes because if the group providing the bridge financing is smaller, they may be able to capture a larger share of the economics for themselves.   This is the backstory of the restructuring of Serta Simmons Bedding and its LMT which resulted in extensive litigation.  The lenders that were left out in Serta commenced litigation which ultimately triggered the Serta bankruptcy.

The Serta credit agreement permitted a lender to sell on a non pro rata basis its loans in a Dutch auction or an open market purchase; the credit agreement made it clear this was an exception to the pro rata sharing provision.  Under the Serta credit agreement, the non-ratable up tiering of the pre-LMT First and Second Lien Term Loans relied on the term “Open Market Purchase” as an exception to the ratable sharing rule, which was protected by a 100% vote requirement, to effect unequal treatment of pre-LMT First and Second Lien Term Loans which was at the heart of the litigation.

LMT created with all balance sheet changes and the dynamics amongst creditors. The reason for these transactions become popular is due to main macro reasons:

1. Change in the structure of creditors - Over the last 15 years, the distressed debt has steadily migrated from banks to funds of one nature or another, who are more active and more creative than banks. 

2. Macro finance environments – we had for the last decade or more a low-rate financial environment and many covenants’ favor’s deals that no longer exist. 

So, when a business runs into trouble, these days, where there is less flexibility and a higher interest rate environment, people will investigate the creative value of this tough situation the business ran into. LMT typically involves a borrower that uses its existing financing documents to unlock value and secure new-money financing while circumventing unanimous creditor voting requirements and other negotiated protections. LMTs often lead to litigation between the borrower and participating creditors, on the one hand, and non-participating creditors on the other hand. This litigation, however, can motivate borrowers to consider a more comprehensive restructuring, which might see the borrower and supporting parties pursue a pre-negotiated chapter 11 plan , as in the Serta Simmons case,  that could lock out non-participating creditors and impact their recoveries.

There are 2 broad categories that cover these types of transactions:

1. Drop down transactions – taking assets that are within an existing collateral package and moving them out of that collateral package and using them to secure new/replacement  debt that can be granted to a favored credited group. 

2. Up tier –insert new debt above the existing senior secured debt.  

Drop Down - Credit agreements include various baskets of permitted transfers which will include general baskets and permitted investments baskets. So, to exercise the drop-down transaction, you should look at the baskets’ capacity and determine which assets are able to migrate into a different entity with the consent of the majority lenders.

Up tier – In an up-tiering transaction, rather than transferring assets outside the credit group, the borrower offers new lenders a claim against the existing credit parties that are contractually senior to the claims of existing lenders. An up-tiering transaction will typically be offered to existing (majority) lenders, who will provide all or a portion of the new financing, including by exchanging all or a portion of their existing loans into such contractually senior debt.  Such exchanges are typically made at a discount to par and, to facilitate the transaction, the participating existing majority lenders will affect any necessary amendments to the existing credit facility.  Notably, in these up-tiering transactions, the borrower is not paying cash; rather the lenders are exchanging their debt to the borrower (it is not a cancellation of indebtedness). The result for the borrower is new money loans, reduced overall debt burden (on account of the below-par exchange of existing loans) and often additional covenant flexibility. These types of transactions are fundamentally about the majority of the creditor group extracting value from a minority of the same creditor group. It is possible for the majority of the existing lenders to agree to one or more layers of new financing coming in senior to the existing debt with priority and there is a direction issued to the administrative agent and the collateral agent to sign on a new intercreditor agreement. 

Things to consider on LMT’s:

1. Is it an opportunistic or a distressed transaction - Choosing the right liability management alternative to restructure or retire outstanding debt securities or to manage risk and reduce funding costs depends on a few factors. Often, market participants assume that only issuers facing financial distress or that are highly leveraged will engage in a liability management transaction. The type of transaction and the terms will depend on the issuer’s business objectives, whether the issuer has sufficient cash on hand, and on market conditions. The transaction may be motivated by an accounting, regulatory, or tax objective or may simply allow the issuer to refinance its outstanding indebtedness at attractive rates, extend its debt maturities, address its exposure to LIBOR-based indebtedness, or repurchase outstanding securities trading at a discount. 

2. Evaluate whether the issuer’s contractual agreements prohibit repurchases, tenders, or exchanges of its outstanding securities. An issuer’s existing commitments may prevent the repurchase, tender, or exchange of an outstanding security or trigger repayment obligations or requirements to use proceeds from a new issuance for other purposes. Therefore, the issuer’s existing financing arrangements and other material agreements must be carefully reviewed. For example, an existing credit facility may prohibit prepayment or redemption of the issuer’s outstanding debt securities or the debt security itself may have call protection features (preventing or limiting a redemption) that should be analyzed. Moreover, debt securities may be redeemable by the issuer only after a certain period has elapsed or a certain market return has been achieved. Additionally, an indenture may contain financial covenants that restrict the issuer’s ability to use available cash to pay down or retire other classes of outstanding debt securities. The indenture governing the securities to be redeemed will specify the redemption price and mechanics and typically requires notice of not less than 30 days nor more than 60 days be provided to holders. Often, the redemption price equals the face amount plus the present value of future interest payments. In certain situations, to permit a desired liability management transaction, an issuer may need to first or concurrently conduct a consent solicitation to amend or waive restrictive financial covenants or event of default provisions under an existing indenture that otherwise would limit its ability to engage in the liability management transaction. In connection with providing notice of redemption, a company typically issues a press release to announce its decision to redeem outstanding debt securities. This public disclosure should occur before contacting the company’s debt holders if the broader impact of the transaction on the company’s financial condition is viewed as material.

3. Assess whether the tender offer rules apply - An issuer repurchasing its securities, whether in privately negotiated transactions or in open market purchases, runs the risk that it may inadvertently trigger the tender offer rules. 

4. Assess whether the issuer has (or wants to use its) available cash to affect the transaction. - An issuer may not have sufficient cash to affect a redemption, repurchase, or tender offer, or the issuer’s management may view using cash to affect such a transaction as an inappropriate use of resources given market uncertainty. In that event, an issuer might instead consider a noncash transaction, such as an exchange offer or a consent solicitation (likely to require payment of a modest cash fee). In an exchange offer, the issuer offers to exchange a new debt or equity security for its outstanding debt or equity securities. An exchange offer can be an especially useful mechanism for an issuer to reduce its interest payments or cash interest expense, reduce the principal amount of its outstanding debt, manage its maturity dates, and reduce or eliminate onerous financial covenants. Coupled with a consent solicitation, an exchange offer may be an attractive option for an issuer seeking to significantly amend or waive restrictive indenture provisions. Conversely, issuers with sufficient cash may consider conducting privately negotiated repurchases, open market repurchases, or a cash tender offer. Repurchasing debt allows the issuer to obtain pricing based upon the current market price of securities that are likely trading at a discount. The issuer will often engage a financial intermediary to negotiate and affect the repurchase or to repurchase the debt securities on a principal basis. 

5. Assess the composition of the holders of the issuer’s securities - The issuer should consider whether the securities that are the subject of the liability management transaction are widely held, as well as the status and location of the holders of such securities. For example, privately negotiated repurchases are usually most effective if the issuer is seeking to repurchase a small percentage of an outstanding series of debt securities held by a limited number of holders. A tender offer may be more appropriate if the security is widely held, and the issuer would like to retire all or a significant portion of the outstanding securities. Tender offers are the most common type of transaction and may be for “any and all” of the outstanding securities of one or more series or for a maximum principal or purchase amount. 

6. Tax implications - An issuer engaging in a liability management transaction must be aware of applicable tax consequences relating to cancellation-of-indebtedness (COD) income. Issuers with outstanding debt may be subject to tax on COD income when all or a portion of such debt has been effectively canceled. COD income can arise in several circumstances, including forgiveness of debt by the debt holder, repurchase of debt by the issuer at a discount, exchange of one debt instrument of the issuer for another, modification of debt, and exchange of debt for the issuer’s equity. Additionally, repurchases or exchanges by persons related to the issuer may inadvertently result in COD income.