Tue 09/22/2020 07:30 AM
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On June 8, Serta Simmons announced that it had entered into a transaction support agreement with a majority of its first lien and second lien term loan lenders pursuant to which the company expects to reduce outstanding debt by $400 million and increase liquidity by $200 million. Continue reading for the Covenants by Reorg team's covenant analysis, and request a trial to access our covenant analysis for thousands of other credits. 

Under the terms of the proposed transactions, Serta Simmons amended its existing debt documents to permit it to incur (i) $200 million of new-money superpriority “first out” debt and (ii) $875 million of superpriority “second out” debt that will be used to exchange for a portion of the company’s outstanding first lien term loans (at an expected exchange rate of $74 for every $100) and a portion of the company’s outstanding second lien term loans (at an expected exchange rate of $39 for every $100). The company’s debt documents were also amended to add an additional basket for superpriority “third out” debt that could be used for additional exchanges.

On June 11, entities affiliated with certain of Serta Simmons’ lenders, including Apollo, Angelo Gordon and Gamut Capital, filed a complaint in the New York Supreme Court seeking an injunction prohibiting Serta from consummating its announced refinancing transactions and “any change in the pro rata distribution provisions of Sections 2.18(b) and 2.18(c) of the Credit Agreement without the approval of all affected Lenders.”

On June 20 the judge overseeing the litigation denied Apollo’s request for a preliminary injunction, and on June 22 Serta announced the closing of the transaction. Despite the closing, lenders have continued to try to have the transaction voided.

Following suit, Boardriders on Aug. 31 announced a recapitalization transaction comprising $467 million of priming loans that was negotiated among certain of the company’s term lenders including Brigade Capital and Canyon Partners, the French government and sponsor Oaktree Capital, according to sources. The transaction provides $135 million of new money alongside the rollup of $332 million of existing debt; in connection with the transactions, Boardriders also amended its existing credit agreement to eliminate substantially all of the covenants.

On Sept. 18 King & Spalding, as counsel to an ad hoc group of minority term lenders under Boardriders’ term loan, sent a demand letter to the company demanding that no later than Sept. 24, the company repays all of the existing term loans in full in cash, purchase, or cause an affiliate or third party to purchase, the existing term loans held by the lender group at par, or exchange the existing term loans held by the lender group for superpriority term loans.

King & Spalding specifies in the letter that if the request is not met by the Sept. 24 deadline or the borrower does not otherwise take action satisfactory to the lender group by such time, the group intends to “immediately pursue legal action” against the parties involved in the priming transaction that challenges the legality of the priming transaction and to seek appropriate remedies, including but not limited to repayment of the existing term loans.

Both transactions were structured similarly into two distinct parts: (i) the companies, having already agreed with a majority of its lenders, amended their credit agreements to provide superpriority debt capacity and (ii) both companies issued new superpriority debt, which through open market purchases was used in a cashless exchange with those majority lenders to repay their term loans and roll them up into the new superpriority debt. Serta purchased its first and second lien debt at already agreed-to below par prices, while Boardriders purchased its first lien term loans at par.

According to Americas Core Credit by Reorg, Centerbridge Partners-owned TriMark has also recently consummated a similar non-pro-rata recapitalization executed with a group of majority first lien term lenders including Oaktree Capital. According to sources, the transaction amends certain existing loan documents to permit a $120 million new-money superpriority “first out” term loan that ranks ahead of the existing first lien term loan and a $307 million superpriority “second out” term loan that ranks ahead of the existing first lien term loan. Proceeds from the second-out tranche will be used to purchase $307 million of the existing first lien term loan at par.

Collateralized loan obligation sources assert that the Serta Simmons, Boardriders and TriMark transactions, and similar transactions in the making, are a negative development for the loan market that needs to be addressed. Specifically, the sources say, non-pro-rata transactions have the potential to reduce recovery rates for leveraged loans, trigger widespread repricing and downgrades by rating agencies, and increase the perception of risk in the asset class. They add that consequently, CLOs will become increasingly stressed and lose flexibility as their lower-rating buckets are inflated, making it difficult to obtain financing.

The sources note that the trend is likely to continue as long as sponsors are enabled by arrangers and underwriters. They agree that the emerging trend should make market participants more defensive about protections in credit agreements, similar to the market’s response to the proliferation of loose asset transfer capacity, even in strong markets when liquidity increases and covenant quality tends to deteriorate as portfolio managers focus on putting money to work at the expense of credit terms.

In this article, we discuss the exact mechanics that Serta, Boardriders and TriMark have relied on to consummate these superpriority uptier exchanges and analyze the merits of Apollo’s and King & Spalding’s arguments seeking to void them. We also provide various provisions that lenders could include in new credit facility documentation to ensure that these transactions cannot happen in the future.

We conclude that although most existing private sponsored credit facilities would allow the borrowers to conduct similar superpriority uptier exchanges through the steps illustrated below, if lenders insist either that amendments that result in lenders’ liens being subordinated require the consent of all lenders or that clear procedures detail the process by which borrowers can purchase term loans in the open market, they could ensure that these transactions would be prohibited in the future.
Serta Simmons covenant analysis super-priority uptier exchange from Covenants by Reorg

Credit Agreement Amendments

Lien Subordination

Although King & Spalding’s demand letter did not call into question the validity of the amendment that provided Boardriders with superpriority debt capacity, Apollo’s complaint reasoned that Serta’s superpriority amendment was invalid as it required consent from each lender, rather than a simple majority.

Specifically, Apollo argued that:
“[T]he Proposed Transaction would have the effect of effectively releasing all or substantially all of the First Lien collateral from the current first-priority ranking lien that benefits the First Lien Lenders by modifying the ranking of the loans. It would further have the effect of releasing all or substantially all of the value of the guarantees that protect the First Lien Lenders, because the guarantees of the existing loans, which would now be subordinated, would be worthless. In each case, this violates Sections 9.02(b)(B)(2) and 9.02(b)(B)(3) because the consent of the Plaintiffs have not been provided (or requested). An agreement to release all or substantially all of the Collateral (except under limited circumstances that do not apply in this context) requires the prior written consent of each Lender, as does an agreement to release all or substantially of the value of the guarantees of the borrower’s obligations under the Credit Agreement under Section 9.02(b)(B)(3)” (emphasis added).

The amendment section in almost every credit agreement provides that all amendments to the loan documents require consent from a majority of lenders, other than amendments to so-called sacred rights, which require consent from all or all affected lenders (many ABL facilities also require consent from 66.66% of lenders for amendments related to the borrowing base).

These sacred rights include (i) increases to lenders’ commitments, (ii) reductions of the principal amount of debt owed to lenders, (iii) extension of the maturity, (iv) decreases to interest rates and (v) other similar fundamental aspects of the debt.

Amendment sections also almost always require all lenders to consent to amendments that result in the “release [of] all or substantially all of the Collateral from the Lien granted pursuant to the Loan Documents” and “release all or substantially all of the value of the Guarantees under the Loan Guaranty.”

Under Serta’s terms loans and, we assume, Boardriders’ credit agreement, amendments that result in lenders’ liens being subordinated were not included in the list of sacred rights amendments.

Although Serta’s and Boardriders’ amendments subordinated lenders’ liens on the collateral to the newly issued superpriority debt (and as a result the guarantees provided under Serta’s term loans), the amendments did not result in the release of any collateral.

Therefore, because of the structure of amendment sections - unless specifically included in the list of amendments requiring all lender consent, all amendments require consent from a simple majority of lenders - in order to have effectuated the lien subordination amendments, Serta and Boardriders needed to obtain only the consent of a majority of its lenders.
Blocking Future Lien Subordination Amendments

Ensuring that borrowers cannot subordinate lenders’ liens without obtaining consent from all lenders is simple. Adding any of the following types of amendments, or similar provisions, to the list of sacred right amendments would immediately prohibit a Serta or Boardriders transaction from happening:
"[S]ubordination of any of the Secured Obligations of the Loan Parties under the Loan Documents to any other Indebtedness, without the written consent of each Lender";

"[S]ubordinate[s] the Obligations hereunder or the Liens granted hereunder or under the other Loan Documents, to any other Indebtedness or Lien, as the case may be without the written consent of each Lender”; or

"[M]odify … Section 6.01 to permit additional Indebtedness not otherwise permitted hereunder that is secured on a pari passu basis with (or a basis senior to, including as a result of the seniority or the priority of any Liens) the Indebtedness incurred under this Agreement and the other Loan Documents, or that is senior in right of payment to the Indebtedness incurred under this Agreement and the other Loan Documents, in each case without the written consent of each Lender.”

Nevertheless, although lenders could have the ability to push for this addition in new loan facilities, many lenders under existing facilities run the risk of having their liens subordinated. Of over 200 private sponsored credit agreements Reorg Covenants Prime has reviewed for this analysis from 2017, 2018 and 2019, only five require consent from all lenders to amend lien priorities.

Interestingly, of the handful of draft credit agreements Reorg Covenants Prime has reviewed since the Serta transactions, not a single one has required more than majority consent to subordinated lenders’ liens.

Regardless of what has happened and what terms have become market standards, it is hard to see a valid reason why borrowers and sponsors would need the ability to subordinate lenders’ liens with only a majority of lenders consenting.
Amendments to Increase Debt, Liens Capacity, Eliminate Restrictions

Neither Apollo’s complaint nor King & Spalding’s demand letter challenged the amendments’ validity in respect of providing the companies with additional debt and liens capacity.

This is not surprising given that amendments to negative covenant capacities are rarely, if ever, included as a sacred right. As such, both Serta and Boardriders were well within their rights to seek majority consent to increase their ability to incur new-money debt and liens.

Similarly, unless included as a sacred right, any term or provision in a credit agreement can be eliminated with majority lender consent. Though controversial because of its consequences, Boardriders’ ability to have “eliminated substantially all of the covenants” with its majority lender was almost certainly permitted by its credit agreement.
Pro Rata Sharing Provisions, Open-Market Purchases

The main thrust of both Apollo’s and King & Spalding’s arguments was that the uptier transactions violated the credit agreements’ pro rata sharing provisions. Implicit in Apollo’s argument and explicit in King & Spalding’s argument is that the debt-for-debt exchanges into superpriority term loans did not constitute open-market purchases.
Pro Rata Sharing Provisions

Credit agreements include pro rata sharing provisions that typically require that mandatory and voluntary prepayments of principal and interest on term loans be allocated pro rata among all lenders, and to the extent a lender receives payments of principal and interest in excess of their pro rata share, such lenders must share such excess payments with other lenders. Credit agreements also include, whether in the pro rata sharing provisions or elsewhere, that upon an acceleration of the debt, lenders will be repaid on a pro rata basis from proceeds from collateral sales.

Many times, the pro rata sharing provisions will exclude certain payments from having to comply with pro rata distribution of payments to lenders, including payments to lenders as a result of Dutch auctions and open-market purchases. The pro rata sharing provisions in Serta’s credit agreements also carved out transactions permitted by the intercreditor agreement.

Apollo’s complaint and King & Spalding’s demand letter acknowledge that the pro rata sharing provisions in Serta’s and Boardriders’ credit agreements exclude open-market purchases from the pro rata sharing provisions.

Importantly, under Serta’s and Boardriders’ credit agreements, amendments to the pro rata sharing provisions required the consent of all lenders.
Prepayments, Repayments, Purchases of Term Loans

There are typically two broad methods borrowers can use to repay their term loans:

  • Voluntary and mandatory prepayments - Borrowers can usually voluntarily prepay outstanding term loans at any time (first lien facilities usually include a six-to-12-month 1% call protection for certain voluntary prepayments, and second lien facilities usually include a two-to-three-year call protection, with 2% in the first year and 1% in the second, for all voluntary prepayments and certain mandatory prepayments) and will be required to prepay outstanding term loans with proceeds from asset sales and excess cash.

    Almost always, voluntary prepayments must be made at par and must be offered to all lenders. Borrowers can also refinance outstanding term loans and can extend their maturity. While refinancings are not required to be made at par, because they are repayments of principal, the pro rata sharing provisions usually require that the proceeds of refinancing debt be offered to all lenders. Similarly, extension offers are typically required to be made to all lenders.

  • Dutch auctions and open-market purchases - Dutch auctions and open-market purchases provide borrowers with their easiest methods to purchase outstanding term loans at below-par prices (although there is no requirement that such purchases are made for below par).

    The most significant difference between Dutch auctions and open-market purchases is that while Dutch auctions require borrowers to make offers to all lenders to purchase their term loans on a pro rata basis (although borrowers must make an offer to all lenders, they can consummate Dutch auctions on a non-pro-rata basis based on which lenders have submitted the lowest prices at which they would sell their term loans), open-market purchases can be made on a non-pro-rata basis without having to purchase term loans of all term loan lenders.

    Crucially, whereas credit agreements typically include a detailed schedule of how Dutch auctions should be conducted, they almost never include processes or requirements governing how open-market purchases should be.

King & Spalding’s Argument

King & Spalding’s argument can be summarized by the following paragraph in their demand letter:
“Section 12.06 of the Existing Term Loan Credit Agreement prohibits any non-pro rata repayment of Existing Term Loans or distributions other than via ‘open market’ purchases of Existing Term Loans as set forth under Section 2.15 of the Existing Credit Agreement … Here, the ‘roll-up’ of Existing Term Loans for Superpriority Term Loans was a repayment of the Existing Term Loans at par via a cashless exchange of the new Superpriority Term Loans. It was not an ‘open market purchase’, as the Existing Term Loans held by the Consenting Lenders were not ‘purchased’ and such purported purchase was not on the ‘open market’. To the contrary, the ‘roll-up’ was not a purchase at all, but a private debt exchange that did not reflect the then current trading value of the exchanged debt. Therefore, the roll-up of the Existing Term Loans held by the Consenting Lenders into Superpriority Term Loans violated the pro rata sharing provisions of the Existing Credit Agreement, which cannot be amended without the consent of all affected lenders” (emphasis added).

King & Spalding reasons that because the loans were not purchased for cash but were exchanged through a cashless rollup and because they were purchased above their trading value, the term loans were not purchased through open-market purchases and, therefore, because they were not purchased on a pro rata basis, they violated Boardriders’ credit agreement’s pro rata sharing provisions.

Many credit agreements, including Serta’s credit agreements, include cashless rollover provisions similar to the following provision in Serta’s first lien credit agreement that provides that lenders that exchange their term loans with loans under a separate credit facility will be deemed to have complied with any cash consideration requirements required to effectuate such exchange:
“Notwithstanding anything to the contrary contained in this Agreement or in any other Loan Document, to the extent that any Lender … replaces, renews or refinances, any of its then-existing Loans with … loans incurred under a new credit facility, … to the extent such … replacement, renewal or refinancing is effected by means of a ‘cashless roll’ by such Lender, such … replacement, renewal or refinancing shall be deemed to comply with any requirement hereunder or any other Loan Document that such payment be made ‘in Dollars’, ‘in immediately available funds’, ‘in Cash’ or any other similar requirement.”

Assuming Boardriders’ credit agreement includes a similar cashless rollover provision, the fact that the exchange was made through a private debt exchange, rather than for cash, should not disqualify the transaction from being deemed an open-market purchase given that cashless rolls are considered to be cash consideration for purposes of debt-for-debt exchanges.

However, even without the cashless rollover provisions, King & Spalding’s argument is likely not dispositive for the same reason that their argument that because the term loans were exchanged at a price above their current trading levels, the exchange could not have been an open-market purchase is not dispositive.

While Serta’s credit agreements and, based on language in King & Spalding’s demand letter, Boardriders’ credit agreement explicitly allow the companies to conduct open-market purchases on a non-pro-rata basis, they include no other rules, procedures or guidelines that govern what is and what is not an open-market purchase.

Different sections of credit agreements are structured differently.

Affirmative covenant sections require borrowers to take certain actions and provide the borrowers with a framework within which those actions must be taken; borrowers have to deliver quarterly and annual financials within a prescribed period of time and must include specific information set forth in the credit agreements. If an action is not included in the affirmative covenant section, borrowers are not required to take those actions.

Conversely, negative covenant sections prohibit borrowers from taking certain actions, subject to a host of exceptions that themselves include certain conditions; borrowers cannot pay dividends, other than a specific amount of dividends and only then if it can meet a specific leverage test. If an action is not included in the negative covenant section, borrowers are not restricted from taking those actions.

The section that typically permits borrowers to conduct open-market purchases (or, by omission, would not allow borrowers to conduct open-market purchases), the successors and assigns section, restricts lenders from assigning their term loans but, like the negative covenants section, includes certain exceptions to the rule as long as certain conditions can be met.

The assignment section in Serta’s first lien credit agreement provides that:
“Notwithstanding anything to the contrary contained herein, any Lender may, at any time, assign all or a portion of its rights and obligations under this Agreement in respect of its Term Loans to any Affiliated Lender [defined to include Serta] on a non-pro rata basis (A) through Dutch Auctions open to all Lenders holding the relevant Term Loans on a pro rata basis or (B) through open market purchases … without the consent of the Administrative Agent; provided that” (emphasis added).

The conditions that must be met in order to conduct a valid Dutch auction or an open-market purchase under Serta’s first lien term loan include (i) a restriction on such purchases being funded with revolving borrowings, (ii) a requirement that any term loans purchased by Serta be automatically canceled and (iii) a cap of 30% on term loans purchased by Advent, Serta’s owner.

As is common, there is no explicit requirement that open-market purchases must be made with cash, that the term loans are purchased at or around current trading prices or that they are done between Serta and individual lenders (rather than a group of lenders).

Taken together, given the absence of specific guidelines for conducting open-market purchases, it may be hard for King & Spalding to argue that Serta’s and Boardriders’ debt-for-debt exchanges are not valid open-market purchases.
Apollo’s Argument

In addition to its argument that because Serta’s transaction had the effect of releasing the collateral and the guarantees, the company had to obtain consent from all lenders, Apollo also argued that the transaction violated the credit agreements’ pro rata sharing provisions and that in order to amend those provisions, Serta would also have needed to obtain consent from all affected lenders:
“The Proposed Transaction plainly violates the Plaintiffs’ sacred rights under the pro rata sharing and amendment provisions of the Credit Agreement. While the Company has not disclosed the precise mechanics of the Proposed Transaction, this much is clear: if consummated, the proposed transaction would have the effect of amending Section 2.18(b)’s waterfall provision in a way that alters the pro rata sharing of payments it requires. If the Proposed Transaction closes, then under Section 2.18(b), the proceeds of any liquidation of collateral would go first to pay certain administrative expenses, then to holders of the Super-Priority Loans, and only then to holders of the ‘First Lien’ Term Loans.”

Because the proposed transactions would create a new group of lenders who would be higher in the payment waterfall, Apollo argued that the proposed transactions would require an amendment to the pro rata sharing provisions.

However, the pro rata sharing provisions only govern the allocation of payments to lenders solely under the first lien or the second lien credit agreement. They do not govern how payments should be allocated within Serta Simmons’ entire capital structure.

Apollo appears to also make an argument similar to King & Spalding’s that because the transaction was not conducted through open-market purchases, it violated the credit agreements’ pro rata sharing provisions:
The Credit Agreement recognizes that four types of [exceptions to the pro rata sharing provisions] are permissible without unanimous consent, and expressly carves these amendments out of the sacred rights provisions … Finally, Section 9.05(g) allows a First Lien Lender to assign its loans on a non-pro rata basis in certain limited circumstances through either a Dutch Auction or an open market purchase. None of these provisions permits an amendment that provides for a loan with a priority superior to that of the First Lien Lenders” (emphasis added).

While Apollo acknowledges that open-market purchases are carved out of the pro rata sharing requirements, it concludes - without any discussion - that Serta’s exchange did not involve open-market purchases.

As has already been discussed, it could be difficult to show that Serta’s and Boardriders’ exchanges did not meet the requirements for open-market purchases under the credit agreements.
Documentary Changes to Clarify Open-Market Purchases

Adding more specific rules and regulations regarding what does and what does not constitute an open-market purchase could provide lenders with more certainty that borrowers could not incur superpriority debt to be used in an exchange for existing debt.

However, whereas it would be difficult for borrowers and sponsors to argue that there is a valid business reason why lenders should provide them with the ability to subordinate lenders’ liens with a simple majority of lenders, lenders could face more resistance to the extent they wanted to include limitations concerning companies’ ability to purchase their debt in the open market.
Liens Subordination Without Open-Market Purchases

If a credit agreement would allow a borrower to subordinate lenders’ liens with consent from a majority of lenders but the credit agreement does not allow for open-market purchases, a borrower could nevertheless consummate a superpriority uptier exchange to the extent it is permitted to amend the pro rata sharing provisions with consent from a majority of lenders.

In this scenario, the pro rata sharing provisions could be amended to allow the borrower to exchange the newly incurred superpriority debt for the existing term loans of the consenting lenders and a new section could be added to the prepayment covenant, with the majority consent, allowing for such exchange at par or, if agreed, below par.
Are Superpriority Uptier Changes Better Than the Alternative?

In its complaint, Apollo discussed the consequences of Serta’s transaction on remaining first lien and second lien term loan lenders, noting that:
“If the Proposed Transaction were permitted to be consummated, there would be a minimum of $1.075 billion of Super-Priority Loans … that would be given priority liens on the collateral that secures the Credit Agreement, ahead of the $814 million remaining First Lien Term Loans owned by the Plaintiffs and others. The remaining (former) ‘First Lien’ Lenders will be left out in the cold. They will effectively become third lien, or potentially even fourth lien, lenders. Given the condition of Serta’s business, this is tantamount to transforming these First Lien Lenders into unsecured lenders, while allowing other lenders - including current Second Lien Lenders - to leap-frog into a new super-priority position” (emphasis added).

In Serta’s answer to Apollo’s complaint, the company disclosed that prior to announcing the exchange, Apollo had proposed a different financing transaction that would have included transferring between $465 million and $590 million of collateral consisting of intellectual property and royalty streams to unrestricted subsidiaries and “stripping approximately $465-$590 million in first lien collateral from the existing, non-participating lenders.”

Although as a result of Serta’s exchange, the claims of the initial first lien term loan lenders on the collateral became subordinated to at least $1.075 billion of superpriority debt, the value of that collateral remained the same and outstanding debt was reduced.

Alternatively, had the company pursued an unrestricted subsidiary transfer, although first lien lenders would have remained at the top of Serta’s capital structure, the value of the collateral securing the debt could have been significantly reduced and it is not clear whether total outstanding debt would be lower.

As illustrated below, under Serta’s first lien credit agreement, the company is likely permitted to transfer at least $675 million of assets to unrestricted subsidiaries.
Serta Simmons covenant analysis credit agreement from Covenants by Reorg
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