Market Advisory
July 24, 2023
“Liability Management Transaction: Drafting Fixes”
In the recent past, lenders have been caught unaware by certain liability management transactions
(“LMTs”) that have taken place and been permitted under credit agreements. In 4Q20, the LSTA hosted
two webinars on this topic; replays of those presentations are available to our members on our website.
In our continuing effort to educate our members about LMTs, we offer this Market Advisory.
The Advisory summarises the key features of the two main types of LMTs that have been prevalent in our
market -- the drop-down financing and the uptiering transaction – matches them to the relevant credit
agreement provisions; sets out “documentation fixes” (i.e., broadly drafted “riders” which can be included
in credit agreements to limit the ability to effect .a particular LMT.); and provides lenders with a useful
credit agreement “Documentation Checklist”.
We plan to continue to provide educational resources to our members so that they may confidently
negotiate and enter into credit agreements based on a clearer understanding of what could transpire
amongst the parties.
Types of Liability Management Transactions
1. Drop-Down Financings: Structural Subordination
In a drop-down financing, a borrower identifies assets that may be readily separated from the rest of
the business (such as a separate business line or discrete intellectual property) and transfers these
assets to either an unrestricted subsidiary or a non-guarantor (excluded) restricted subsidiary
(“NewCo”). Upon such transfer, the lien on these assets securing the borrower’s obligations to
existing creditors is automatically released and such (newly) unencumbered assets are available to
secure newly incurred indebtedness of NewCo provided by new creditors. The claims of the new
creditors against NewCo – and the transferred assets – are, thus, structurally senior to the claims of
the existing lenders. The quintessential drop-down financing was the 2017 J. Crew transaction, but
more recent examples include Travelport (2020), Cirque de Soliel (2020), Revlon (2020), and
Envision (2021).
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1
The following chart summarizes the structural features of such financings as well as the credit agreement
provisions, they implicate:
Typical Structure Applicable Credit Agreement Provision
• Definition of “unrestricted subsidiary” and
Formation or identification of NewCo unrestricted sub “designation” provisions
• Collateral and guarantee requirements /
excluded subsidiary provisions
• Investments covenant
Transfer of assets to NewCo (often accompanied by • Asset sale covenant
a license of the transferred asset back to borrower) • Collateral release provisions
• Sale leaseback covenant
• Limitations on release of all or substantially
all of the collateral (if applicable)
Incurrence of new indebtedness by NewCo (the • If applicable, restrictions on unrestricted
“New Structurally Senior Debt”), which will either subsidiaries guaranteeing, or being
be: guaranteed by, credit parties
• unlimited (if NewCo is an unrestricted • If incurred at or guaranteed by an excluded
subsidiary); or restricted subsidiary, debt and lien capacity
• subject to the existing credit facility covenants (subject to any “non-guarantor” caps or sub-
(if NewCo is an excluded restricted subsidiary). limits)
• Pro rata sharing provisions
Where applicable, exchange or “roll-up” all or a • Borrower buybacks, including provisions
portion of any existing loans of the new creditors for “open market purchases” and/or
for or into the New Structurally Senior Loans Dutch auction provisions
• Limits on prepayments of “junior” debt (if
applicable)
2. Uptiering Transactions: Contractual Subordination
In an uptiering transaction, rather than transferring assets outside of the credit group, the borrower
offers new lenders a claim against the existing credit parties that is contractually senior -- through
either collateral priority or in the form of waterfall/payment priority -- to the claims of existing
lenders. An uptiering transaction will typically be offered to existing (majority) lenders, who will
provide all or a portion of the new financing, including by exchanging (or refinancing) all or a portion
of their existing loans into such contractually senior debt. Such exchanges are typically made at a
(significant) discount to par and, to facilitate the transaction, the participating existing majority
lenders will effect any necessary amendments to the existing credit facility (sometimes referred to as
an “exit consent”). The result for the borrower is new money loans (the “New Superpriority Debt”),
reduced overall debt burden (on account of the below-par exchange of existing loans) and often
additional covenant flexibility. One of the earliest examples of an uptiering transaction was the 2017
NYDJ transaction, but more recent examples include Murray Energy (2018), Serta Simmons (2020),
Trimark (2020), Boardriders (2020), Incora (2022) and Mitel (2022).
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The following chart summarizes the characteristics of such transactions as well as the credit agreement
provisions they implicate:
Typical Structure Applicable Credit Agreement Provision
Incurrence of new debt by the borrower that is • Debt and liens covenants
senior to existing loans. • Limits on subordination of existing debt
• Agent’s authorization to execute intercreditor
Exchange/rollup of all or a portion of existing • Pro rata sharing provisions
loans into senior debt that is pari with or junior to • Borrower buybacks, including provisions
the New Superpriority Debt (but senior to the for “open market purchases” and/or
existing loans) (“Rolled Up Superpriority Debt”). Dutch auction provisions
• Limits on prepayment of junior debt (if
applicable)
The New Superpriority Debt and the Rolled Up • Pro rata sharing/waterfall provisions
Superpriority Debt may take the form of: (including related amendment requirements)
• a new tranche of loans within the loan • Subordination/release of all or substantially
document, with priority governed by a all collateral
payment “waterfall”; or • Intercreditor restrictions
• new loans under a separate credit facility,
with priority governed by an intercreditor
agreement.
3. Potential Documentation “Fixes”1
Credit agreements will require careful review in order to identify and address flexibility that would
allow the liability management transactions described above to proceed. To assist in that review, we
developed the Documentation Checklist on Annex A hereto. Set forth below are suggested riders
designed to address key issues raised by recent liability management transactions.
1. Drop-Down Financing Rider: Notwithstanding anything herein to the contrary, in no event shall
[(i) any Loan Party contribute, or otherwise invest, any [Material Asset] in, or Dispose of any
[Material Asset] to, any Subsidiary that is not a Loan Party,] 2 (ii) any Restricted Subsidiary
contribute, or otherwise invest, any [Material Asset] in, or Dispose of any [Material Asset] to, any
Unrestricted Subsidiary or (iii) any Subsidiary be designated as an Unrestricted Subsidiary if such
subsidiary owns any [Material Asset].
“Material Asset” means any [asset] owned by any Loan Party that is, [in the reasonable
determination of the Borrower], material to the operation of the business of the Borrower and its
Restricted Subsidiaries, taken as a whole. 3
2. Uptiering Transaction Rider. Most credit agreements require the consent of 100% of lenders to
release all or substantially all of the collateral, but do not expressly require the same consent for
a subordination of the existing loans to one or more new classes of (super-priority) loans or a
new (super-priority) credit facility (whether via payment or lien subordination). To address this
consider the adding the following to the amendment section:
1
Reference is made to the separate “Documentation Checklist” that serves as a more comprehensive guide to
reviewing credit agreements for flexibility to engage in liability management transactions.
2
Borrowers will often seek to limit the restrictions on investments in or dispositions to unrestricted subsidiaries (vs.
any non-credit party) covered by (ii).
3
The scope of these assets is often limited to “Material Intellectual Property”.
3
[No amendment, waiver or consent shall] without the prior written consent of each Lender
directly affected thereby, (i) subordinate, or have the effect of subordinating, the Obligations
hereunder to any other Indebtedness, (ii) subordinate, or have the effect of subordinating, the
Liens securing the Obligations to Liens securing any other Indebtedness, or (iii) modify
Section [include pro rata sharing, pro rata treatment, post default waterfall an
borrower/affiliate buyback mechanics if appropriate] or any other provision hereof in a
manner that would have the effect of altering the ratable reduction of Commitments or the pro
rata sharing of payments otherwise required hereunder.
There are several borrower-friendly variations of this language in the market:
• Exclude DIP facilities or use of cash collateral in a bankruptcy proceeding of the borrower
• Limit application to “debt for borrowed money”
• Exclude indebtedness “otherwise permitted” by the credit agreement (if agreed, should be
limited to “otherwise permitted on the Closing Date”)
• Exclude subordination to indebtedness issued in exchange for existing debt
(including this provision would effectively limit .an uptiering transaction to “new
money”)
• Exclude subordination to senior indebtedness if the subordinated lender was given an
opportunity to participate in that senior indebtedness [on the same terms as other
similarly situated lenders].
The last option in particular has become more common recently. The idea is that if an affected
creditor is given an equal opportunity to participate in the proposed super-senior tranche and
refuses the opportunity, it effectively forfeits the right to object. The concern with this
formulation is that it puts minority lenders in a difficult position vis-à-vis the majority lenders
proposing the uptiering transaction, as they must either accept terms offered (without any
differentiated fees that the majority may be receiving for “backstopping” the super-senior
tranche) or have their claim subordinated.
3. Supermajority Vote. Rather than being an “all affected” lender vote, there are formulations that
require supermajority (66 2/3% or 75%) consent to amend a credit agreement to permit lien or
payment subordination. This solution has been less common, but sample language for this
follows:
[No amendment, waiver or consent shall] (i) subordinate, or have the effect of subordinating, the
Obligations hereunder to any other Indebtedness, or (ii) subordinate, or have the effect of
subordinating, the Liens securing the Obligations to Liens securing any other Indebtedness, in
each case without the prior written consent of (x) the Supermajority Lenders and (y) each Lender
directly affected thereby that has not been offered a bona fide opportunity to participate in the
senior Indebtedness giving rise to such subordination on a pro rata basis.
4. Open Market Purchases. An effective but uncommon tool for restricting or prohibiting liability
management transactions that include – and are, as noted above, often motivated by – a “rollup
feature” would be to either (a) require all borrower buybacks to be pro rata or at least offered to
all lenders on a pro rata basis (and specify that for amendment purposes this is a “sacred right”
requiring 100% lender consent) or (ii) defining open market purchase in a way that limits its
availability for transactions of this type (by, e.g., requiring the repurchase to be brokered or
through a trading platform, be conducted at arms-length and set at quoted market price or other
measure of fair market value). There seem to be only limited cases in which that approach has
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been used. To the contrary, there are examples where borrowers seek to clarify and expand this
language specifically to permit “privately negotiated exchanges” as part of the “open market
purchase” exception to pro rata treatment.
5. Envision Protection. We have seen some lenders insist on an aggregate cap on the value of assets
that can be contributed to or restricted group investments in an unrestricted subsidiary. Rather than
being able to aggregate various investments (and often restricted payments) baskets, the borrower
is forced to either use the unrestricted subsidiary basket exclusively, or live within an overriding
aggregate cap. Some lenders can go further and prohibit netting of debt or returns on such assets
from the utilization of the applicable investment basket.
6. Entry Consents. In some recent liability management transactions, the requisite consent to the
uptiering and related covenant stripping has been achieved after giving effect to incremental
indebtedness, which is sometimes undrawn. Some lenders will seek to prohibit the voting of
incremental undrawn facilities, at least unless the conditions to drawing are satisfied.
7. Conditions to designating (and maintaining) unrestricted subsidiaries. In general, an unrestricted
subsidiary should not be permitted to receive credit support (guarantees, etc.) from the loan party
group (or such credit support should be capped, e.g., by being expressly treated as an investment
and permitted only pursuant to agreed baskets). However, even where this restriction is included,
there are recent reports of liability management transactions being structured so that a non-
guarantor restricted subsidiary or an unrestricted subsidiary may take credit support indirectly, by
making a loan to the loan party group in exchange for a secured intercompany note which is then
pledged to the participating lenders. This should be explicitly prohibited (e.g., by prohibiting
ownership by an unrestricted subsidiary of equity or debt of any loan party and/or prohibiting the
unrestricted subsidiary from incurring indebtedness that is directly or indirectly secured by the
assets of the loan party group). Ensuring that the conditions for designating an unrestricted
subsidiary apply to each unrestricted subsidiary (so that, for example, a subsidiary cannot become
an unrestricted subsidiary just because it is a subsidiary of another unrestricted subsidiary), and
that those conditions continue to apply post-designation, is critical.
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Annex A
Liability Management Checklist
1. Investment Covenant
✓ What is the aggregate capacity for a drop-down financings? For this analysis, it is critical to take
into account all relevant baskets as a whole, including ratio-based baskets, cumulative credit
(including capacity that may have been built by earlier capital contributions) and other baskets
that can be reallocated from the restricted payments or other covenant.
✓ Is there a cap on [non ordinary course] investments by credit parties in non-credit party
restricted subsidiaries? Would such a cap be appropriate given the operations of this
borrower?
✓ Does the document contain the “J. Crew” loophole (allowing restricted subsidiaries to make
investments (including in unrestricted subsidiaries) from investments made in such restricted
subsidiary by a loan party)?4
✓ Are there limitations on moving certain categories of assets outside the credit group (e.g.,
intellectual property or distinct lines of business)?
✓ Are there specific provisions permitting the movement of intellectual property within the corporate
group that would permit drop-down financing (this has become more common in recent
transactions)?
✓ Consider requiring a leveraged-based or interest coverage ratio test on the use of cumulative credit
for investments.
✓ When investing assets, how is the value of the assets to be determined? By the borrower in good
faith? Subject to a third-party verification if over a threshold (this would be unusual in loan
agreements)?
2. Unrestricted Subsidiaries
✓ Are there any unrestricted subsidiaries at closing that may be used to consummate a drop-down
financing in future without complying with the applicable “designation” requirements?
✓ Is there a leveraged-based or interest coverage ratio test that must be satisfied as a condition to
designating unrestricted subsidiaries?
✓ What limits, if any, exist on unrestricted subsidiaries guaranteeing obligations of, or being
guaranteed by, credit parties?
✓ Are there any significant – and meaningful – exclusions from the requirements that the borrower
and its subsidiaries provide guarantees and collateral?
✓ Is the exclusion of foreign subsidiaries appropriate given the transaction structure and tax
regulations?
3. Release of all or Substantially All Collateral; Subordination.
✓ Does the credit agreement require a 100% lender vote for subordination of existing loans?
✓ Do amendments to “pro rata” sharing provisions apply broadly to amendments that “by their
terms” or “have the effect” of impacting “pro rata” sharing?
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4. Pro Rata Sharing and Buybacks
✓ If there is no cap on investments by credit parties in non-credit party restricted subsidiaries,
the “J. Crew” provision creates unlimited capacity to invest in unrestricted subsidiaries are
“pro rata” sharing provisions subject to 100% or all affected lender vote?
✓ Which specific “pro rata” provisions are referenced? Pro rata sharing generally? Pro rata
treatment of payments? Default waterfall?4
✓ What are the exceptions to the pro rata provisions?5
✓ Do the pro rata sharing provisions protect all lenders or only lenders within a class (so that
the borrower may create a new class and then offer that new class non-pro rata treatment)?
✓ Does the credit agreement permit “open market” repurchases and, if so, how is that defined (if at
all)? Will there be a market test or opportunity for all lenders to participate? Is there an aggregate
cap?
✓ Does the credit agreement permit “Dutch auctions” and how is that defined? Is there an aggregate
cap?
✓ What vote is required to modify the open market repurchase or Dutch auction exceptions to the
pro rata sharing?
5. Other Protections
✓ Consider imposing caps on non-credit party debt incurrence in light of potential future
liability management transactions.
✓ Do refinancing provisions (and related definitions) permit “uptiering” of lien or payment
priority?
✓ Review remedy limitation provisions to determine individual or minority lender rights to
bring independent causes of action.
✓ Review provisions referencing intercreditor arrangements (including defined terms and
provisions authorizing agents to enter into intercreditor agreements consented to by majority
lenders).
4
There is considerable variation in the market as to which pro rata provisions require 100% lender consent.
5
As a baseline matter, these provisions will expressly cross reference borrower buybacks.
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