USA Trends and Developments Contributed by: Meyer C. Dworkin, James A. Florack, Vanessa L. Jackson and Kenneth J. Steinberg, Davis Polk & Wardwell LLP
Protecting a lender’s position in the capital structure Liability management transactions often result in the claims of existing lenders becoming contractually or structurally subordinated to – or benefiting from a weaker credit support package than – claims of oth- er creditors, without, in many cases, these lenders even being offered an opportunity to participate. This outcome fundamentally conflicts with long-stand- ing assumptions as to the general priority of senior secured creditors in the capital structure and equal treatment across lenders in a single facility. Borrowers, in contrast, view liability management transactions as an indispensable tool in providing flexibility to manage capital structures, especially in times of distress. Such flexibility should, at least in theory, also ultimately ben- efit lenders in the long run, since these transactions are meant to stabilise the underlying business and avoid a value-destructive bankruptcy filing. To reconcile these competing interests, loan mar- ket transactions include negotiated provisions that impose limitations on borrowers’ ability to subordi- nate existing obligations and provide varying levels of protection against potential drop-down transactions. With each new variation of liability management trans- action introduced to the market, lenders respond by reconsidering the effectiveness of existing protections and evaluating the scope and structure of new ones. To engage in these discussions, it is critical to under- stand the loan documentation provisions implicated by liability management transactions. The covenants subject to the most detailed negotiation of appropriate protections include the following. Investment limitations The investments covenant is most relevant in drop- down financings as the basis on which a borrower’s assets are transferred to – “invested” in – an unrestrict- ed subsidiary or non-guarantor restricted subsidiary to support the new structurally senior debt. Lenders have broadly eliminated certain of the more aggressive investments baskets, including the “trapdoor” provi- sion permitting a non-loan party restricted subsidiary to invest, on an unlimited basis, investments received from a loan party. Lenders have more recently focused on aggregate investment capacity, ensuring both
that there is a cap on investments by loan parties in non-loan parties and/or requiring that investments in unrestricted subsidiaries be made solely pursuant to a dedicated (and capped) investments basket. More tai- lored provisions seek to prohibit the movement of key assets, often material intellectual property or specific corporate “crown jewels”, outside of the restricted party (or, more recently, loan party) group, whether through investments, the designation of unrestricted subsidiaries or any other disposition or transfer. To the extent a borrower has multinational interests or aspi- rations that could be limited by these restrictions, the negotiations may require significant effort to restrict liability management exercises without curtailing the borrower’s ability to engage in important commercial activity, in a way that acknowledges the multi-year commitment by the parties. Other limitations on unrestricted subsidiaries Unrestricted subsidiaries provide borrowers with sig- nificant operating flexibility, as they are not subject to the covenants, events of default and other limita- tions included in loan documentation. As a result, the loan covenants generally restrict borrowers’ ability to capitalise or otherwise invest in such entities, sub- ject to the agreed baskets. Borrowers may typically designate unrestricted subsidiaries subject solely to an event of default “blocker” and, increasingly rarely, a ratio test (though designation will typically be a deemed investment subject to available invest- ment capacity). Rather than focus on the conditions to designating a subsidiary as an unrestricted sub- sidiary, loan participant focus has instead been on the amount and types of assets that can be contributed to, or owned by, the unrestricted subsidiary, and, more recently, the relationship of unrestricted subsidiaries with the restricted group. In particular, certain facilities prohibit an unrestricted subsidiary and its creditors from receiving a guarantee from, lien on assets of or other direct credit support from loan parties. Others limit the ability of an unrestricted subsidiary from hold- ing debt issued by or to otherwise benefit from indirect
credit support of the loan party group. Sharing provisions and lien subordination
Secured loan documentation generally restricts modi- fications to pro rata sharing and payment waterfalls and the release of all or substantially all guarantees
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