Lead Article: Liability Management Exercises: What They Are and What They Mean for Market Participants
Sign Up for PublicationsI. What Are Liability Management Exercises?
In an environment with looser restrictions and more flexible conventions for borrowers in the credit markets, the last several years have provided interesting examples of opportunistic borrowing and debt restructuring. These transactions have left both a wake of litigation and a desire to implement new and improved terms in loan documents, designed to inhibit similar transactions with the benefit of hindsight. Liability management transactions or exercises (LMEs) offer creative, albeit controversial, mechanisms for companies to raise debt capital where they may otherwise be facing a liquidity crunch and have no unencumbered assets to offer. These out-of-court restructurings are designed to avoid bankruptcy by, among other things, amending limitations on additional debt and delaying the maturity on existing debts (amending and extending). Still, the results are mixed in their ability actually to avoid Chapter 11.
Although an LME could in theory be offered pro-rata to all noteholders, the economics of such a capital raise would be more expensive for borrowers and less lucrative for the lenders who participate. LMEs therefore typically divide creditors into two classes – participating lenders (the haves) and non-participating lenders (the have nots). This division not only has generated litigation risk from lenders who were excluded from the transaction but also has created practical hurdles for borrowers, as lenders are increasingly seeking to block an unfavorable transaction by signing a co-operation agreement among them that expressly prohibits each signatory from engaging with the borrower unless a majority of the signatories are on board.
Moreover, although they continue to take new shades and permutations, LMEs tend to fall into one of two key categories:
Dropdowns. Dropdown transactions involve a borrower transferring certain collateral, often intellectual property, from restricted subsidiaries (i.e., entities that are subject to the loan agreement) into an unrestricted subsidiary (i.e., an entity that is not considered part of the borrower-lender relationship), rendering the collateral unencumbered. The unrestricted subsidiary can then pledge this liberated collateral in support of new debt. The preexisting debt is no longer secured by the “dropped down” collateral, and the issuer gets the benefit of additional capital without having to provide new or additional assets as security. Rather than involving a transfer of assets, the economic equivalent of dropdowns may sometimes be obtained by simply re-designating a “restricted” subsidiary as an “unrestricted” subsidiary, provided the designation complies with rules set forth in the loan agreement.
Uptiers. In contrast, uptier transactions do not require moving collateral. Instead, the issuer typically acquires the necessary consents from participating lenders in order to amend the governing debt documents to permit the issuance of new notes with a superior claim on the collateral. Creditors who provide the fresh capital are also invited to exchange their existing debt for more of the new preferred debt, rendering the non-participating holders of preexisting debt subordinated and providing the issuer with the needed capital at the lowest possible cost. These transactions may involve lien-stripping in addition to, or instead of, the subordination of the preexisting debt.
This piece will first examine how LMEs have fared in litigation, discussing landmark cases as well as recent LMEs and ongoing litigation. Then it will consider how the syndicated loan, high-yield, and private credit markets have addressed these risks in next-generation loan documents, highlighting LME “blocking” technology and considering the competing incentives for deploying (or omitting) such protections. Finally, it will examine certain risks that these transactions may carry for third-party equity sponsors in some cases.
II. How Have LMEs Been Addressed by Courts?
As long as LMEs continue to evolve in the leveraged finance market, they will likely continue to be tested in the judicial system. Such litigation risk is often a consideration in employing LMEs, sometimes prompting issuers to initiate declaratory judgment actions after closing to bless the steps taken in the restructuring transaction. This risk, though, is not limited to breach of contract claims. Nor is the litigation risk limited to attacks directed at the borrower or the participating lenders. Third parties, such as private equity sponsors, board members, and even collateral agents or indenture trustees, may be held to account for their roles in effectuating a transaction. The claims could include aiding and abetting fraudulent transfer by the borrower (depending on the jurisdiction), breach of fiduciary duty, self-dealing, and/or tortious interference with contract. The claims against the borrower and the participating lenders may include breach of contract, breach of the implied covenant of good faith and fair dealing, constructive or intentional fraudulent transfer, equitable subordination (particularly in a bankruptcy context), unjust enrichment, and tortious interference with contract. As courts have continued to address the claims that arise from these transactions (with mixed results), certain cases stand out as flags in the sand for market participants considering an LME.
A. Landmark LME Cases
In the last several years, there have been a number of significant cases where LMEs were challenged in the courts, with mixed outcomes for those involved. See generally Abigail Arndt & Kevin Eckhardt, Liability Management Exercise Litigation & Bankruptcy Tracker, Octus (Nov. 18, 2024), https://app.reorg.com/v3#/items/intel/13755?item_id=291542.
J. Crew. Perhaps the most familiar LME was the dropdown transaction done by J. Crew in 2017 with the hope of averting Chapter 11. In that transaction, the issuer moved its valuable IP to an unrestricted subsidiary in order to issue additional debt backed by that IP. Following the transaction, the company preemptively filed a declaratory judgment action defending the transaction. Ultimately, however, the dropdown was never tested in the courts, as (against the backdrop of the company’s preemptive litigation and using a portion of the cash raised) the company successfully incentivized noteholders to accept a deal. Several years later, when J. Crew filed for Chapter 11 bankruptcy, an independent director with independent counsel conducted an investigation and determined the dropdown did not constitute a fraudulent transfer. See In re Chinos Holdings, Inc., No. 20-32191 (KLP) (ECF 414 at 13) (Bankr. E.D.Va. May 5, 2020).
Revlon. A similar dropdown executed by Revlon was examined by a court when a group of creditors challenged the LME in an adversary proceeding after Revlon had entered Chapter 11. The court, however, determined that the plaintiffs no longer had standing to pursue these claims against the company and participating lenders because their claims asserted the type of non-particularized injuries that, upon Revlon’s bankruptcy filing, became property of the estate. See In re Revlon, Inc., 2023 WL 2229352, at *16 (Bankr. S.D.N.Y. Feb. 24, 2023). The court also cast doubt on a plaintiff’s ability to unwind a transaction of this nature, noting that it concurred with the defendants’ assertion that the equitable relief requested would be impracticable because the “egg” could not be “unscrambled” in light of the “many events that have ensued since [the transactions] in reliance on those transactions.” Id. at *17.
Serta. Turning to uptiers, this landmark LME case once represented a “successful” transaction after holding up against litigation—but the Fifth Circuit’s recent reversal has upended the lower court’s decision and ruled in favor of excluded lenders. After a first-of-its-kind test of an uptier transaction at trial, the Southern District of Texas Bankruptcy Court had held in favor of Serta and its participating lenders that the transaction did not violate the company’s credit agreement because the company used “open market purchases” (an undefined term) to facilitate non pro-rata debt exchanges. See In re Serta Simmons Bedding, LLC, 2023 WL 3855820, at *13 (Bankr. S.D. Tex. June 6, 2023). The trial court had also rejected the excluded lenders’ argument that the transaction violated the implied covenant of good faith and fair dealing, noting that lenders were aware of the flexibility that the credit agreement granted Serta. Id. at *13-14 (“And this litigation ends with each party receiving the bargain they struck –not the one they hoped to get. … The parties were keenly aware that the 2016 Credit Agreement was a ‘loose document’ and understood the implications of that looseness.”). On appeal, the Fifth Circuit reversed the bankruptcy court’s decision, finding that the 2016 uptier was not an “open market purchase” in light of the plain meaning of “market” and the context of the agreement, and thus Serta and participating lenders could not take advantage of that exception to end-run the agreement’s provisions that otherwise required pro-rata sharing and unanimous consent among lenders. See In re Serta Simmons Bedding, LLC, 23-20181 (ECF 233-1, at 29-38) (5th Cir. Dec. 31, 2024). Rather than decide the breach of contract questions, the court remanded the case but noted that “the Excluded Lenders have a strong case that [the defendants] breached the 2016 Agreement.” Id. at 38. The Fifth Circuit also rejected an equitable mootness argument from the participating lenders with respect to certain indemnities included in the plan confirmed by the bankruptcy court, noting that “excision [of an unlawful provision of a reorganization plan] does not toll doom for the Plan.” Id. at 44. While equitable mootness has for years been asserted by bankruptcy plan supporters with a respectable degree of success, the court flatly rejected the participating lenders’ “aggressive position” that it is “unfair for this court to excise the indemnity now without letting them go back to the drawing board” on other aspects of the plan. The Fifth Circuit held that those fairness considerations are not at play given the participating lenders did not offer concessions to objecting creditors in the plan, and “to the extent equitable mootness exists at all, … it cannot be a shield for sharp or unauthorized practices.” Id. at 44-45 (internal quotations omitted).
Trimark. Turning to another landmark uptier, in the wake of the global pandemic, a New York state court was tasked with addressing the propriety of a restaurant service provider’s deliberate sequencing of transaction steps to obtain needed liquidity without (it asserted) violating the credit agreement. In suing over TriMark’s transaction in 2021, excluded lenders “denounce[d] [the issuer and participating lenders’] conduct as a ‘cannibalistic assault,’ ‘lender-on-lender violence,’ and outright ‘theft’” because the series of transactions resulted in $300 million of incremental liquidity for the company, super-senior liens for participating lenders, and a subordinated position for excluded lenders. Audax Credit Opportunities Offshore Ltd. v. TMK Hawk Parent, Corp., 150 N.Y.S.3d 894 (N.Y. Sup. Ct. 2021). In spite of these harsh characterizations of the Trimark uptier, the court granted several defendants’ motion to dismiss claims for breach of the implied covenant of good faith and fair dealing (finding that New York law will not rewrite sophisticated agreements), tortious interference (finding that New York’s economic interest defense applied), and fraudulent transfer. Id. Still, the court denied defendants’ motion to dismiss with respect to the technical breach of contract issues based on perceived ambiguity in how a phrase should be interpreted in the context of the whole agreement. The Trimark parties settled before proceeding to summary judgment or trial on the remaining contract issues.
Wesco Aircraft (Incora). Only a year after the Southern District of Texas ruled in favor of the debtor in Serta, the same trial court (with a different judge) came to a markedly different conclusion in the Wesco/Incora adversary proceeding over another uptier transaction, albeit on entirely different grounds. See In re Wesco Aircraft Holdings, Inc., No. 23-90611 (Bankr. S.D. Tex.) (only oral ruling issued as of January 2025). There, the court held in favor of non-participating lenders to determine that the uptier transaction “had the effect” of stripping liens without the necessary two-thirds consent to do so. The court rejected the idea that a sequence of transactional steps should be evaluated for compliance with the indenture at each relevant step because an earlier step (to issue new notes) “had the effect” of the subsequent ones (which relied on the new notes for voting purposes). The Wesco court announced that the issuance of the new notes created a “domino” effect that “had the result of” releasing liens, even though that amendment (in isolation from the subsequent amendments that made up the larger transaction) did not release liens in and of itself. See Octus, Court Finds Wesco/Incora Uptier Exchange Breached Indenture, Restores Liens Securing All 2026 Wesco/Incora Notes (Aug. 2, 2024) (reporting the court’s oral ruling), https://octus.com/resources/articles/wesco-incora-uptier-exchange-breached-indenture/. With Wesco’s plan now confirmed, the participating lenders await the court’s written decision and intend to appeal following Wesco’s emergence from Chapter 11.
B. Other Recent Examples of LMEs
AMC Entertainment Holdings. In July 2024, AMC completed a comprehensive dropdown transaction by transferring valuable collateral to an unrestricted subsidiary and allowing participating noteholders to exchange their debt for new, first-lien debt backed by that subsidiary. Meanwhile the existing notes lost their liens on the desired collateral. Non-participating lenders brought breach of contract claims against AMC and the participating lenders in New York state court, and motions to dismiss from both defendants are currently pending. See A Holdings – B LLC, et al. v. GLAS Trust Co., et al., No. 24-654878 (NMB) (N.Y. Sup. Ct. Sep. 19, 2024) (ECF 15, 36). As the claims center around the alleged breach of a pre-existing intercreditor agreement, the dismissal arguments assert that the terms of the intercreditor agreement are unenforceable against the new notes, which were governed by an entirely separate agreement.
American Tire Distributors. In another quasi-uptier transaction, American Tire, already in Chapter 11, proposed debtor-in-possession (DIP) financing that would include a non-pro-rata “roll-up” of a prepetition term loan. A “roll-up” is a long-standing practice when existing loans are exchanged into super-senior loans as part of a larger DIP financing, subject to approval of a bankruptcy court. Minority lenders opposed the financing (see In re American Tire Distributors, Inc., No. 24-12391 (CTG) (ECF 186) (Bankr. D. Del. Nov. 12, 2024), and the court noted that he would approve the DIP loan but would not deprive the minority lenders their right to sue the majority for breach of the prepetition credit agreement. The court then added that, if they did sue, the minority lenders would likely win. In light of the court’s preemptive commentary, the debtor and the DIP lenders withdrew the controversial roll-up provision. Melissa Kelley & Blanka Wolfe, Opinion Analysis: Sacred Rights in Spotlight After American Tire DIP Dispute, Octus (Dec. 5, 2024), https://app.reorg.com/file/1195366/Octus_Intel_-_2024-12-05_10_49_29-84780-0.pdf. This move by the Delaware bankruptcy court may reflect judicial skepticism toward non-pro-rata exchanges—at least after a bankruptcy has been filed—given bankruptcy’s fundamental policy of ratable treatment for similarly situated creditors.
Bombardier. In a series of transactions across years, Bombardier disposed of business lines accounting for more than two-thirds of its earnings, prompting lenders to assert that these transactions unlawfully disposed of substantially all of the company’s assets in violation of the governing indentures. The company then attempted to solicit consents from noteholders to waive any resulting event of default and issued an additional $260 million in notes allegedly “for the purpose of trying to divest the Plaintiffs of their ability to cause the Trustee to bring suit,” and therefore “entirely disenfranchise all other [n]oteholders.” Antara Capital Master Fund LP v. Bombardier Inc., 184 N.Y.S.3d 591 (N.Y. Sup. Ct. 2023). In a written ruling, the New York court dismissed only a single declaratory judgment claim, allowing all other claims (including breach of contract and tortious interference) against the company and the trustee to survive, noting that plaintiffs had more than sufficiently alleged negligence and bad faith on the part of the trustee. Antara Capital Master Fund LP v. Bombardier Inc., No. 650477/2022, 2023 WL 8869650, at *9 (N.Y. Sup. Ct. Dec. 22, 2023). In the wake of the court’s decision on the motions to dismiss, the company settled with the lenders in July 2024. See Bombarier Announces Settlement of New York Bondholder Lawsuit (July 1, 2024), https://bombardier.com/en/media/news/bombardier-announces-settlement-new-york-bondholder-lawsuit#:~:text=About%20Bombardier,the%20United%20States%20and%20Mexico.
Empire Today. Though not in litigation, Empire Today’s pending transaction is notable as it represents a possible move toward somewhat less aggressive (and, thus, potentially less likely to be litigated) LMEs by allowing all lenders to participate in an exchange in some respect, though not necessarily on equal terms. Empire Today’s transaction involves an ad hoc group representing more than 80% of the outstanding debt receiving more favorable, first-out loans, with those remaining lenders invited to participate in an exchange for second-out loans at a price below par. See Harvard Zhang, Empire Today’s LME Favors AHG Lenders, Uses Springing Maturity to Limit Holdouts, Octus (Nov. 20, 2024), https://app.reorg.com/v3#/items/intel/2117?item_id=292745. Transactions of this nature may have reduced litigation risk and see fewer practical barriers with reduced lender opposition. This appears to be the case even though it may be alleged the transaction “coerced” excluded lenders into participating in a deal that is less favorable to those lenders that were not members of the ad hoc group. The benefits of this “friendlier” uptier transaction will be tested as the market waits to see whether Empire Today (or others like it) successfully avoids litigation.
Mitel. In another non-pro-rata exchange, Mitel conducted an uptier in October 2022, prompting litigation brought by non-participating lenders in New York state courts. In the exchange, Mitel received about $156 million in new money as a super-priority loan from participating lenders, who also uptiered their holdings into new second-out and third-out loans. Non-participating lenders were consequently subordinated to more than $850 million of new debt. See Octus, Mitel Executes Non-Pro-Rata Priming Exchange With $857M of New Debt Ahead of Existing Loans (Oct. 20, 2022), https://app.reorg.com/v3#/items/intel/13755?item_id=193946. The trial court dismissed the non-participating lenders’ implied covenant and tortious interference claims, along with cross-claims brought by a participating lender—but allowed non-participating lenders’ contract claims (asserting that their sacred rights were violated) to survive. Harvard Zhang & Adelene Lee, Litigation Coverage: Mitel Uptier Challengers’ Breach of Contract Claims, Request to Unwind Transaction Survive Dismissal; Implied Covenant, Fraudulent Transfer, Tortious Interference Claims Thrown Out, Octus (Dec. 5, 2023), https://www.stg.reorg.com/articles/litigation-coverage-mitel-uptier-challengers-breach-of-contract-claims-request-to-unwind-transaction-survive-dismissal-implied-covenant-fraudulent-transfer-tortious-interference-claims-t//. In a decision handed down on December 31 (the same day as the Fifth Circuit’s Serta decision), a five-judge panel of the First Department Appellate Division unanimously reversed the trial court, holding that the contract claims should be dismissed as the uptier did not violate the applicable credit agreement. See Ocean Trails CLO VII v. MLPTopco LTD. et al., No. 2004-00169 (ECF 37) (N.Y. App. Div. Dec. 31, 2024). In its reversal, the appellate court determined that the consent of non-participating lenders was not required to conduct the transaction because (i) the language of the agreement required only consent from those “directly adversely affected,” while the impact of the transaction was indirect, and (ii) the transaction did not actually amend a provision that would have required consent, even if the transaction did impact its application. See id. at 2-3.
III. How Is the Market Responding to LMEs?
Some market participants have taken note of the particulars of each of these transactions, modifying debt documents in a prophylactic attempt to dissuade (or entirely prohibit) creditor-on-creditor violence. Many bond issuances in 2024 evidence these new “blocking” provisions that retrofit protections against these creative transactions. With tighter documents, creditors may gain comfort that their investments are safe from certain types of transactions. Still, the efficacy of many of these blocking provisions has generally not yet been proven in litigation.
A. Examples of LME “Blocking” Provisions in Next-Generation Loan Documents
- Anti-Dropdown Provisions
J. Crew Blockers are designed to restrict the movement of material assets, including IP, from restricted subsidiaries to unrestricted subsidiaries. To achieve the maximum protection against these transactions, debt documents must apply to both transfers of assets between subsidiaries and designations of restricted or unrestricted subsidiaries. An example of a J. Crew Blocker includes:
“[I]n no event shall this Section 6.03(b) permit the Borrower or any Restricted Subsidiary to Dispose of any Material Intellectual Property to an Unrestricted Subsidiary …”. Square, Inc., Revolving Credit Agreement § 6.03(b) (May 1, 2020).
A J. Crew Blocker may go further, however, to prohibit an issuer from changing the designation of a subsidiary:
“Notwithstanding anything else set forth in this covenant or in the definition of Permitted Investment, no Restricted Payment or Investment in an Unrestricted Subsidiary of Material Intellectual Property (or designation of any Restricted Subsidiary holding such Material Intellectual Property as an Unrestricted Subsidiary) will be permitted under the Indenture.” Eolo Offering Memorandum for Senior Secured Notes due 2028, at 233.
PetSmart/Chewy Blockers restrict the issuer’s ability to release subsidiary guarantors from their guarantees. Specifically, these protections are designed to prevent an issuer from transferring the equity of a wholly-owned subsidiary to an affiliate, such that it becomes a non-wholly-owned subsidiary, which may then be excluded from the definition of guarantor subsidiaries and used as collateral for securing additional financing. An example of this language includes:
“[A] Guarantor shall not be released from the Guarantee solely as a result of becoming a non-wholly owned Restricted Subsidiary in connection with a de minimis transfer of Capital Stock in such Guarantor if there is no bona fide business purpose for such transfer of Capital Stock and such transfer of Capital Stock is intended solely to obtain a release of the Guarantee, in each case as determined in good faith by the Borrower.” Snap One Holdings Corp., Credit Agreement § 1.17(a) (Dec. 8, 2021).
Here, drafters rely on the “bona fide business purpose” to prohibit the nominal transfer of ownership of a guarantor subsidiary to avoid its guarantee obligations.
- Anti-Uptier Provisions
Serta Blockers require unanimous consent to subordinate lenders’ existing liens to new, super senior liens. To guard against a Serta-like uptier transaction, debt documents would require unanimous consent from affected lenders in order to subordinate lenders in right of payment or lien priority. Still, there are weaker versions of these protections that may create exceptions if the priming debt is being offered pro-rata to all lenders. Stronger protections extend this protection to amendments that have the effect of subordinating existing lenders in right of payment or in priority of liens. An example of Serta-blocking language includes:
“[N]o [] amendment, waiver or consent shall … subordinate, or have the effect of subordinating, the Obligations hereunder to any other Indebtedness, or subordinate, or have the effect of subordinating, the Liens securing the Obligations to Liens securing any other Indebtedness without the prior written consent of each Lender directly and adversely affected thereby.” Viad Corp., Indenture § 10.01(l) (July 30, 2021).
“No such agreement shall: (x) effect, directly or indirectly, any waiver, amendment or modification that contractually subordinates, or has the effect of subordinating, (1) the Liens on any Collateral … or (2) the Loan Obligations …”. Rackspace Finance LLC, Incremental Assumption and Amendment Agreement No. 1, Annex A First Lien Credit Agreement (Mar. 12, 2024).
Wesco-Incora Blockers seek to prohibit the dilution of voting power through the issuance of additional notes if used to obtain the necessary consent thresholds to effectuate an uptier transaction. A Wesco-Incora Blocker may read like the following examples:
Increasing the vote needed to issue additional notes: “In addition, without the consent of the Holders of at least 80% in aggregate principal amount of the Notes then outstanding … no amendment, supplement or waiver may … (4) permit the incurrence of more than $25 million of Additional Notes (including by amending the covenants under Sections 4.09 and 4.13)…”. Cooper-Standard Automotive, Inc., Indenture 8.02(c) (Jan. 27, 2023).
Disregarding votes from notes issued concurrently with amendment: “Subject to the Noteholder Participation Rights, without the consent of the Issuers and the holders of at least 66 2/3% in principal amount of the Notes then outstanding, make any change to this Indenture and the other Note Documents (A) to permit the issuance of notes under this Indenture other than the Initial Notes or permit the Incurrence of any Indebtedness secured by any Liens on the First Lien Collateral ranking pari passu with the Liens securing the First Priority Note Obligations and (B) include appropriately the holders of such notes in the relevant provisions of this Indenture; provided, that any such notes shall be disregarded for purposes of determining compliance with any specified voting threshold if incurred substantially concurrently with any such determination or for the purpose of achieving a specified voting threshold …” .Mallinckrodt Plc., Indenture § 9.02 (Nov. 14, 2023).
- Omni-Blocker Provisions:
Most recently, creditors have also tried to implement a streamlined, all-in-one “Omni-Blocker” that expressly prohibits issuers from entering into “liability management transactions” that are not offered pro-rata. This language is included in the term sheet for the exit notes contemplated in Spirit Airlines’ Chapter 11 plan are contemplated to include this language (along with provisions that prohibit modification of the omni-blocker without unanimous consent). See In re Spirit Airlines, Inc., No. 24-11988-SHL (ECF 114 at 257-58) (Bankr. S.D.N.Y. Dec. 26, 2024) (“[T]he negative covenants in the Definitive Exit Secured Notes Documentation shall include a Liability Management Transaction … covenant that does not permit the Issuer to, and shall not permit any of the Subsidiaries to, enter into any Liability Management Transaction.”). However, it remains to be seen how effective these Omni-Blockers could be in the market, and commenters have already identified their likely shortcomings, particularly noting the difficulty defining LMEs to prohibit any such transactions in a “bulletproof” manner that cannot be contracted around by creative investors. See Julia Bulaon & Mellissa Kelley, ‘Omni-Blocker’ in Spirit Airlines’ Exit Notes Not a Cure-All for Lender LME Woes, Raises Questions About How to Define ‘Liability Management Transaction’, Octus (Dec. 20, 2024), https://app.reorg.com/v3#/items/intel/20676?item_id=297453.
B. Market Adoption of Anti-LME Provisions
Researchers have empirically examined the market response to LMEs by evaluating the frequency of these updated, anti-LME provisions in loan agreements. See Vincent S.J. Buccola & Gregory Nini, The Loan Market Response to Dropdown and Uptier Transactions, 53 J. L. Studies 2, 5-6 (updated January 2024), https://ssrn.com/abstract=4143928. While analyzing the bond market’s response to uptiers, these researchers have concluded that, whereas only 40% of loans blocked uptiers before the Serta transaction, that number climbed to 85% after Serta. Id. at 6. Additionally, the imposition of a sacred right (i.e., requiring each affected lender’s consent) to subordinate a loan climbed from 10% pre-Serta to 70% post-Serta. Id. at 6-7. The widespread adoption of Serta Blockers demonstrates that, when incentivized, the bond market can move quickly toward eliminating the prospect of an undesired result (here, nonconsensual lien subordination).
Yet, the bond market demonstrates relative stickiness in responding to at least certain types of LMEs. These researchers concluded that contracts have failed to respond swiftly and aggressively to inhibit borrowers’ ability to conduct dropdown transactions altogether, or by eliminating the designation of “unrestricted” subsidiaries altogether, though they did point out an increase in IP blockers which, though less broad, would at least have blocked J. Crew’s transfer of IP collateral. Buccola and Nini, at 35 (“Contracts could adjust to prevent dropdowns but did not.”).
Another review of first-lien credit agreements that were publicly-filed and entered into between 2021 and 2022 concluded that, of those that included anti-dropdown language, none required more than a majority of lenders to consent to eliminate the anti-dropdown provisions (e.g., the prohibitions against transferring material IP or re-designating restricted subsidiaries as unrestricted; or the prohibitions against transferring the equity of a subsidiary guarantor in order to render that guarantor non-wholly-owned and, as a result, excluded from guarantor subsidiaries). See Octus, Elimination of Material IP Transfer Prohibitions, Anti-PetSmart Guarantor Protections Could Be Next Frontier in Lender-on-Lender Violence (Oct. 3, 2022), https://app.reorg.com/file/1191938/Octus_Intel_-_2022-10-03_08_46_36-84780-0.pdf.
This evidence demonstrates conflicting results with respect to the market responses to these transactions. In other words, although anti-LME blocking language exists in some more recent governing documents (especially uptier blockers), many agreements still appear to omit (or meaningfully dilute) blocking technology, at least as it relates to certain types of LMEs, especially dropdown blockers. This leaves lenders exposed and preserves greater flexibility/optionality for borrowers seeking to restructure their debt or facing a solvency crisis. One could read the disparity between the response to Serta and the response to J. Crew to indicate that, although lenders will not tolerate the risk of lien subordination, they may be more willing to accept the risk of a transfer of collateral to an unrestricted subsidiary. See LSTA, Loan Market Covenant Trends 2Q24 (July 16, 2024) (identifying the frequency of dropdown blockers at 8.9% of loans versus the frequency of uptier blockers at 70.9% of loans), https://www.lsta.org/news-resources/loan-market-covenant-trends-2q24/#APPENDIX.
Additionally, governing documents may adjust the applicable voting thresholds to require unanimous consent, creating a sacred right. In fact, these consent thresholds may be the most effective lever that negotiating parties can pull in adjusting the protectiveness of an agreement for lenders. However, the handful of examples of blocking provisions above reflect that, even where bondholders seek to incorporate LME-blocking provisions, they may not do so on a unanimous basis. That is, they may prohibit the issuance of additional notes to affect voting thresholds (a Wesco-Incora Blocker) but bake-in an exception where the borrower has support from a supermajority of noteholders. See supra Cooper-Standard Automotive, Inc., Indenture § 8.02(c) (Jan. 27, 2023). This may be attributable to multiple things, such as a desire to avoid the tyranny of the few, holdout bondholders, or the negotiated-for middle ground for lenders and borrowers. It may also indicate some willingness to bake in flexibility on the part of lenders.
Further, not all blocking provisions are created equal. This “protective” technology can be materially weakened when it is accompanied by carveouts or exceptions that give borrowers the flexibility to contract around the anti-LME provisions, or when it is paired with an ineffective voting threshold. On one hand, this may invite an interesting litigation landscape, where lenders can argue that the transaction violates the spirit of the contract or the implied covenant of good faith when it circumnavigates a blocking provision, while borrowers assert that their transaction was permissible as it was carved out of the limited blocking provision.
On the other hand, the inclusion of watered-down protections and (in some cases) no protection at all against these known risks may simply reveal that lenders are willing to accept some LME-related risk. After all, repeat players (i.e., high-yield bond investors) are familiar with the rules of the game, even though those rules may still be in flux. Perhaps there is something to the idea that a lender can “win one, lose one,” as it may not be permitted to participate in one LME, but it may still desire some flexibility to participate in another. The mixed empirical evidence suggests that the bond market is still grappling with this cost-benefit analysis.
IV. What Third Party Liability Can an LME Carry?
While the debt markets grapple with these transactions and the consequences for companies trying to access capital, LME litigation reveals that third parties may also have exposure. In other words, it is not the case that only lenders and borrowers may be impacted by an LME. Third parties, like an issuer’s private equity sponsor—and, in particular, an equity sponsor who participates in its own debt investments in a priming transaction—may also face litigation in the wake of an LME. That is, an equity sponsor or controlling shareholder may itself be sued, even though it is not the borrower and, as a result, not the (allegedly) breaching party. An equity sponsor, as well as individual members of the borrowers’ board of directors, may face allegations of self-dealing and breach of fiduciary duty to the company. Non-participating lenders may also argue that a sponsor tortiously interfered with their contractual rights in causing the borrower to undertake the LME by, for example, exercising their control over the borrower’s board of directors. Although equity sponsors have long been able to defend against these claims by arguing they were simply acting in their economic best interest without malice or fraud (especially when a restructuring is designed to stave off the borrower’s impending default), recent developments indicate that courts may no longer be deferential to sponsors’ economic interests amid aggressive restructuring transactions. This is particularly salient in circumstances where the equity owner exercises control over the borrower as its owner and benefits from the transaction as a debtholder.
In Boardriders, non-participating lenders pursued a tortious interference claim against the issuer’s equity sponsor alongside their breach of contract claims against the company itself. ICG Global Loan Fund 1 DAC v. Boardriders, Inc., 2022 WL 10085886, at *5 (N.Y. Sup. Ct. 2022). The equity sponsor relied on the “economic interest defense” to successfully argue for dismissal of the claim, based on the idea that it was acting to protect its own legal or financial stake in the (allegedly) breaching party’s (i.e., the issuer’s) business. Id. at *9-10. Plaintiffs had not shown the necessary malice, fraud, or illegality to overcome this defense from the equity sponsor. Id. In Boardriders, however, the primary legal arguments did not invoke questions about the equity sponsor being permitted to participate its own debt in the uptier. Rather, the parties focused on the issue of whether they had exercised control over the issuer to cause the alleged breach of the loan agreements.
Other cases have put more emphasis on the dual role of an equity sponsor participating in an LME as a debtholder. The Robertshaw court addressed an uptier where a participating lender “through some of its managed funds, indirectly [held] a majority equity interest in Robertshaw.” In re Robertshaw US Holding Corp., 662 B.R. 146, 164 (Bankr. S.D. Tex. 2024). There, however, the equity owner did not sit on the company’s board of directors, and “did not structure the [] Transactions or influence the [participating lenders] or Robertshaw to do it.” Id. at 165. As a result, the court quickly decided the issue in favor of the equity owner, relying on these facts and noting that the economic interest defense would also protect the equity owner as there was “no meaningful evidence that [it] acted for any reason other than to protect its economic interest.” Id. at 166.
However, a case decided around the same time in the same district demonstrates some courts’ hesitancy to allow equity sponsors to rely on the economic interest defense. In In re Wesco Aircraft, the equity sponsor that participated its unsecured debt in the portfolio company’s uptier was required to go to trial on a tortious interference claim after the court denied requests to apply the defense in pre-trial dispositive motion practice. The equity sponsor’s alleged role in the transaction was one of the key areas of inquiry in the trial before Judge Isgur. After the court ruled in favor of the plaintiffs/non-participating lenders on the breach of contract issue, the equity sponsor continues to face exposure on the yet-undecided tortious interference claim. Even if this issue is decided in favor of the sponsor, the survival of this tortious interference claim through trial alone represents a sharp contrast from the precedent that sponsors have relied on in cases like TriMark and Boardriders and the (seemingly) durable economic interest defense.
In re Wesco Aircraft is not the only evidence of challenges faced by equity sponsors in litigation of this type. A New York state court in Surterra Holdings Inc. also declined to dismiss both tortious interference claims and breach of fiduciary duty claims against an equity sponsor and an individual who allegedly controlled both the sponsor and the borrower. See Morgan v. Surterra Holdings Inc., 2022 WL 4117319, at *2-4 (N.Y. Sup. Ct. 2022). With respect to the tortious interference claim, the court noted that the company’s financial distress was not dispositive of the economic interest defense in light of “the circumstances alleged by the plaintiffs, including [the sponsor’s] control of the company before the [] transaction occurred.” Id. at *4. The Surterra Holdings court also cited the “personal involvement” of the individual alleged to have breached his fiduciary duty in terms of apparently controlling the private equity sponsor as well as the borrower.
In light of litigation risks, equity sponsors should carefully consider their roles in any contemplated LMEs, including their involvement in structuring or approving a transaction, as well as their participation to the extent they or their affiliates own any of the company’s debt. The acceptance of the economic interest defense in a pre-trial dispositive motion may be particularly inhibited where a transaction is viewed by the judge as aggressive towards creditors (e.g., because it involves subordinating and lien-stripping, for example). That is, a court may be less willing to accept the idea that an equity sponsor was simply acting in its economic best interest where it allegedly causes a borrower to undertake a transaction that not only preserves the equity value but also addresses the equity sponsor’s debt in the restructuring, while simultaneously altering third-party lenders’ rights. Of course, a sponsor should always take care to ensure its indisputable right to control a portfolio company is exercised in a manner that minimizes legal risks in times of the company’s distress. For example, equity sponsors increasingly appoint independent board members with experience in restructurings (including LMEs) who will weigh competing lender proposals and evaluate their benefits to the company without any alleged conflicting interests.