KEY POINTS Feature – The liquidity issues suffered by US businesses as a result of COVID-19 have, in some cases, caused them to implement increasingly creative liability management techniques. – These have typically involved either the transfer of assets outside of the value perimeter of secured or the incurrence of new super-priority priming debt. – Many of these transactions have been challenged while creditors on new transactions are seeking documentary protections to mitigate the risk of these transactions occurring in the future.

Authors Lee Federman, Lewis Grimm, Kay Morley, Michael Schneidereit and Ewen Scott Jumping the line: priming transactions during the COVID-19 crisis

Over the past year, the COVID-19 crisis has caused liquidity issues for many US businesses, subsidiaries); and (iii) an unlimited basket which has forced some borrowers to resort to increasingly creative restructuring options. for investments by non-guarantor restricted These have generally fallen within two categories – “dropdown” transactions and “uptiering” subsidiaries, to the extent that such investment exchange transactions, both of which have seen borrowers take steps under their credit was financed with the proceeds received from agreements to prioritise one set of lenders over another. This article tracks the key cases in a guarantor-restricted subsidiary. the US market and offers a flavour of what may be arriving soon on European shores. Once the intellectual property was transferred to the unrestricted subsidiary through this “trap door”, it was used as Under a drop-down transaction, notably single unifying feature – the creative use of collateral for an exchange offer for certain ndeployed in the J.Crew and Neiman unrestricted subsidiaries. Unlike restricted holdco PIK notes in the J.Crew capital Marcus transactions, the borrower transfers subsidiaries, unrestricted subsidiaries are structure. More recently, documentation assets into entities that are not (or designates not bound by the covenants imposed by the for certain leveraged loan and high-yield entities holding such assets as no longer being) credit documents upon the restricted group transactions have included the so-called “black part of the restricted group and the secured and as such can incur debt, grant , sell hole” where the transfer at stage 1 of J.Crew creditors value perimeter and then uses those assets, pay dividends and make investments (above) is uncapped, thereby allowing for a black assets to raise indebtedness or extend maturities without limitation. They are also not required hole of value extraction. In J.Crew, a group of as part of its liability management strategy. to provide guarantees or collateral in respect ad hoc lenders brought proceedings; however, The second category of transactions of the borrowers’ obligations. Borrowers can certain holdco PIK noteholders were able to buy emerging last year in Serta Simmons, usually create or designate an existing restricted the majority of the secured debt and approve the Boardriders and similar cases, are “uptiering” subsidiary as an unrestricted subsidiary fairly transactions, which rendered the litigation moot. JUMPING THE LINE: PRIMING RESTRUCTURING TRANSACTIONS DURING THE COVID-19 CRISIS RESTRUCTURING TRANSACTIONS PRIMING THE COVID-19 THE LINE: DURING JUMPING exchange transactions where, rather than easily provided they have appropriate capacity moving assets outside of the value perimeter of under their investments covenants. NEIMAN MARCUS the secured creditors, existing term loans are The examples below highlight the Neiman Marcus, an American chain of luxury exchanged for new term loans with super- permissive exceptions available under certain department stores, was similarly able to utilise priority ranked liens leapfrogging ahead of US leveraged loan documentation. the exceptions under its covenants to spin off a unexchanged term loans and other debt. Often division of its business to shareholders through lenders participating in these transactions J.CREW what has been coined a “two-step” dividend. As are also given the opportunity to provide new J.Crew, the American specialty retailer, utilised in the case of J.Crew, the valuable collateral sat money super-priority debt. Whilst historically a series of baskets in its credit documents to with one of the guarantor-restricted subsidiaries. this was more common in a Chapter 11 scenario create a so-called “trap door”, purportedly Using available investment capacity in the with super-priority -in-possession enabling it to move approximately $250m restricted group, Neiman Marcus was able financings and related debt roll ups, uptiering of valuable intellectual property from a to redesignate the relevant guarantor as an exchanges now appear more regularly in guarantor-restricted subsidiary into an unrestricted subsidiary, with such redesignation pre-Chapter 11 liquidity . It is this unrestricted subsidiary (via a non-guarantor- being treated as an investment equal to the new sub-set of transactions in particular that restricted subsidiary) and thereby outside of fair-market value of the net assets of the newly has captured the eyes of the European market the creditors’ collateral pool and covenant designated unrestricted subsidiary. With the and has raised the question as to whether similar regime. The three relevant baskets used were: value now held by an unrestricted subsidiary, transactions will occur in Europe. (i) a $150m fixed-cap investment basket for Neiman Marcus was able to make use of a investments by guarantor-restricted subsidiaries permission under its restricted payment regime DROPDOWN TRANSACTIONS into non-guarantor restricted subsidiaries; which allowed for the distribution as a dividend (ii) a general basket equal to the greater of of the capital stock of an unrestricted subsidiary. Unrestricted Subsidiaries and Non- $100m and 3.25% of total assets for investments Guarantor Restricted Subsidiaries by guarantor-restricted subsidiaries into TRAVELPORT Dropdown transactions often have a anything (including non-guarantor-restricted In one of the more recent cases, Travelport, the

100 February 2021 Butterworths Journal of International Banking and Financial Law JUMPING DURING LINE: THE COVID-19 THE PRIMING TRANSACTIONS RESTRUCTURING CRISIS Biog box Lee Federman and Ewen Scott are both partners in the London office of Jones Day and are Feature members of the firm’s Financial Markets Group. Email: [email protected] and [email protected] Lewis Grimm is a partner in the New York office of Jones Day and a member of the firm’s Financial Markets Group. Email: [email protected]

UK based travel booking platform, transferred (J.Crew); (ii) dividends and distributions which was issued in exchange for a portion $1.15bn of intellectual property assets of non-cash assets (Neiman Marcus); of outstanding first and second lien outside of its restricted group to unrestricted (iii) release of guarantees if equity is transferred term loans at a discount; and (iii) additional subsidiaries. Travelport had received an to an affiliate (PetSmart/Chewy); and amounts of super-priority third-out debt that independent valuation on the transferred (iv) the subordination of liens and obligations could be used for future debt exchanges. intellectual property and determined that, under the credit agreement and open market Importantly, the proposed indebtedness using multiple baskets under its credit debt buybacks using debt or other non-cash referred to above was all to rank ahead of Serta’s agreement, it had available basket capacity of consideration (Serta Simmons). existing facilities. As such, certain minority $1.27bn to execute the transaction. There are a variety of versions of J.Crew existing lenders that were not offered the An ad hoc group of first lien lenders blockers, most of which have included provisions opportunity to participate in the debt for debt challenged the transaction asserting an event of that restrict the designation of a restricted exchange found themselves subordinated to on the basis that the valuation was flawed subsidiary into an unrestricted subsidiary where new super-priority facilities and quickly filed and unsound and that Travelport had incorrectly it owns a core asset and restrict the transfer for injunctive relief in the New York state court. calculated basket capacity. Specifically, the (whether by investment, asset sale or otherwise) After the New York state court declined to lenders argued that the $238m “similar business” of core assets to unrestricted subsidiaries (and grant injunctive relief, a separate proceeding basket was not available to Travelport given the sometimes non-guarantor restricted subsidiaries). was commenced by a separate minority lender unrestricted subsidiary receiving the intellectual Whilst blockers can be helpful in seeking in the Federal District Court for the Southern property assets did not have any operating to minimise the risk of well-known liability District of New York. A number of key issues business and hence was not a similar business. management techniques, blockers do not (and were explored in the course of the litigation Travelport has since reached agreement with likely cannot) cover all possible ways that assets which are discussed below. its creditors which included an unwind of can be transferred out of the restricted group, the intellectual property transfer in question nor do they prevent similar transactions being LIEN SUBORDINATION together with an out-of-court recapitalisation. implemented without the use of unrestricted The plaintiffs in the litigation argued that the subsidiaries. In addition, given the nature modification of the ranking of the term loans PETSMART/CHEWY of these kinds of covenants, the market and had the effect of releasing substantially all of In PetSmart, the company was able to transfer what is often at stake in these transactions for the collateral and the value of the guarantees 36.5% of its equity in its recently acquired companies and their creditors, one might expect thereby rendering the term loans unsecured, an subsidiary, Chewy, to its private equity sponsor that there will likely be an increase in controversy action which would otherwise require the prior (20%) and to an unrestricted subsidiary regarding these types of transactions. written consent of each lender. (16.5%). It was able to do this using two Serta asserted that the credit agreement relatively standard baskets under its restricted UPTIERING TRANSACTIONS could have included sacred rights (requiring payments and permitted investments covenants. unanimous lender consent) in respect of the PetSmart’s credit documentation further stated Serta Simmons subordination of collateral or debt obligations that to the extent any subsidiary of PetSmart The most recent evolution of priming debt (as is the case in some market documents) but no ceased to be a wholly owned subsidiary, any restructurings through uptiering transactions such anti-subordination provision was included. collateral or guarantees in respect of that began with Serta Simmons Bedding, LLC As such the state court found that, although subsidiary would be automatically released. (Serta), a private equity backed US mattress Serta’s amendments had the economic effect of a While it is usual to exclude non-wholly owned manufacturer. The liquidity position of Serta release, the lack of an anti-subordination provision subsidiaries from the guarantee and collateral was severely impacted by the COVID-19 meant that the transaction was not prohibited. pool, the creditors had not contemplated this pandemic and it entered into discussions with result, and litigation quickly ensued. While certain senior secured lenders to discuss its OPEN MARKET PURCHASE EXCEPTION PetSmart did not use unrestricted subsidiaries financing options. Serta had an existing capital TO PRO RATA REQUIREMENTS to effect this transaction, the impact of the structure comprised of a $225m asset-based The plaintiffs in Serta also argued that the guarantee and collateral release was still loan due November 2021, a $1.95bn first lien incurrence of the super-priority term loans strongly felt by the existing group. term loan due November 2023 and a $450m violated the pro rata sharing provisions of second lien term loan due November 2024. the credit agreement and any amendment to Blockers and related issues In June 2020, Serta negotiated a the pro-rata sharing provisions required the Following widespread coverage of these cases, transaction support agreement with a group consent of all lenders. in recent times, creditors both in the US and representing a majority of its existing term Typically, US credit agreements provide Europe have focused closely on “blocker” lenders that permitted it to incur: (i) $200m that mandatory and voluntary prepayments provisions, specifically to counteract: (i) transfers of super-priority first-out debt (new money); together with repayments from the proceeds of of key assets to unrestricted subsidiaries (ii) $875m of super-priority second-out debt, enforcement of collateral are paid to lenders on

Butterworths Journal of International Banking and Financial Law February 2021 101 Biog box Feature Kay Morley is a partner in the London office of Jones Day and a member of the firm’s Business Restructuring and Reorganization Group. Email: [email protected] Michael Schneidereit is a partner in the New York office of Jones Day and a member of the firm’s Business Restructuring and Reorganization Group. Email: [email protected] The views and opinions set forth herein are the personal views or opinions of the authors; they do not necessarily reflect views or opinions of the law firm with which they are associated.

a pro rata basis. An exception to this rule is a imply into their respective contract laws to of uptiering cases has received, lenders have repayment via an open market purchase (buying ensure that parties to a contract do not act to focused more on the risks involved and are back debt on the open market) which is usually destroy the other party’s rights to receive the fighting back. Although it is not obvious that permitted (as was permitted in the Serta credit benefits of the relevant contract. these cases are moving the market on new money agreement) to be made on a non pro rata basis. In rejecting the plaintiff’s injunction transactions, lenders would be well advised to Credit agreements that have this feature include motion, the state court found that the plaintiffs take steps at the outset of deals to mitigate the little to no detail as to how the open market could not establish a likelihood of success on risk of future uptiering exchange transactions. purchase is intended to work in practice. their claim for breach of the implied covenant Simple changes such as the inclusion of Although the state court found that the credit because: (i) the covenant cannot nullify express appropriate blockers or anti-subordination agreement “seems to permit the debt-to-debt terms of a contract or create independent provisions, will go a long way to achieving this. exchange on a non pro rata basis as part of an open contractual rights; and (ii) a good faith claim As the carnage piles up in the US, market transaction”, the plaintiffs in the federal cannot arise from the same facts and seek the European lenders are becoming more wary of action argued that the transaction executed by same damages as a breach of contract claim. these scenarios playing out in the European Serta was not an “open market purchase” at all market outside of any formal restructuring because it was not offered to all lenders, and was a BOARDRIDERS implemented by way of an English scheme or cashless roll-up that did not reflect the prevailing On 31 August 2020, Boardriders, the California- pursuant to the new restructuring plan. trading value of the debt. However, Serta argued based surfing and skateboarding apparel company, European leveraged loan transactions that the term “open market purchase” was not announced a restructuring transaction which bore on the whole provide stronger protections defined in the credit agreement and there was no many of the features of Serta. The restructuring for the pro rata treatment of lenders in debt other requirement in the credit agreement for the involved $110m of new money super-priority repurchase transactions. These will typically purchase to be offered to all lenders or cash paid, loans together with a $332m uptiering require, in the first instance, a solicitation nor any guidance as to pricing benchmarks. debt exchange using the same “open market process whereby the borrower invites every purchase” exception to the pro rata payments lender to participate in the debt repurchase. WATERFALL PROVISIONS regime in its credit agreement. Both of these The repurchase process outlined in the credit The next issue was whether the transactions debt issuances effectively subordinated a group agreement will also likely include restrictions violated the waterfall and pro rata sharing of minority existing lenders who were not given on the sources of funding any buybacks, which provisions of the credit agreement on the an opportunity to participate in the exchange. may not allow for a debt for debt exchange. basis that the super-priority debt was only This transaction also involved the Unlike Serta and Boardriders, European JUMPING THE LINE: PRIMING RESTRUCTURING TRANSACTIONS DURING THE COVID-19 CRISIS RESTRUCTURING TRANSACTIONS PRIMING THE COVID-19 THE LINE: DURING JUMPING offered to certain lenders. amendment to the existing credit agreement credit agreements also usually include very The plaintiffs relied on the provision that to remove substantially all affirmative and prescriptive ranking provisions and any stated that any amendment that “by its terms negative covenants by the use of exit consents purported cramdown of existing debt to alters the pro rata sharing of payments” requires notwithstanding that almost all of these permit the incurrence of super-priority debt unanimous lender consent. The plaintiffs argued were included in the new credit agreement would likely require an amendment to the that the transaction violated their sacred rights governing the super-priority debt. This was a intercreditor agreement, which typically under the pro rata sharing and amendment fairly novel step in the US leveraged loan market requires more than a mere majority lender provisions because it had the effect of amending notwithstanding the prevalence of covenant consent. In addition, there may be possibilities the waterfall provision in a way that altered stripping in the high yield bond world. for minority creditors who are not invited to the pro rata sharing of payments, because the The minority lenders filed suit in the New participate in any uptiering to challenge the existing term loan lenders would get paid only York state court to void the transaction and the transaction under English law on the basis after the new super-priority debt. accompanying credit agreement amendments, that there has been an improper exercise of However, the state court held that, because as well as seek damages for breach of contract voting power against the minority. the transaction did not actually amend and voidable transfer on similar grounds to This is of course not to say that European any part of the pro rata sharing provisions Serta, namely: (i) the violation of the pro rata borrowers will not still be seeking to find ways, themselves and the new super-priority debt sacred rights provision; (ii) the inapplicability whether through the structural adjustment or was to be incurred in a separately documented of the “open market” purchase provisions; permitted refinancing debt provisions in credit transaction, no sacred right had been violated. and (iii) a breach of the implied duty of good agreements or hollow tranches in intercreditor faith particularly with regard to the punitive agreements to incur new super-priority debt. IMPLIED COVENANT OF GOOD FAITH covenant stripping. A motion to dismiss has We haven’t seen examples of this yet but as AND FAIR DEALING been filed, and the litigation remains pending. the COVID-19 fallout continues, we expect Finally, the plaintiffs further alleged that the borrowers to continue to consider their transaction violated the implied covenant of THE EUROPEAN PERSPECTIVE options, keeping a close eye on developments good faith and fair dealing which all US states Given the attention that this most recent round and innovations across the pond. n

102 February 2021 Butterworths Journal of International Banking and Financial Law