Fri 05/15/2020 04:00 AM
Unrestricted subsidiaries have hit the headlines more than once since 2015 when a number of U.S. groups, most notably iHeartCommunications, J.Crew, Claire’s, Neiman Marcus and, more recently, PetSmart, used the flexibility available to them in their debt documents to move valuable assets beyond the reach of their lenders. While the mechanics and motivation for these transactions vary, the unifying factor is that they all involved transfers of assets to companies not subject to the credit agreement restrictions. Although the “J.Crew trapdoor” may have caught lenders’ attention, our analysis shows that many credit agreements provide substantial capacity for assets to be transferred to these “unrestricted subsidiaries” even in the absence of that particular loophole.

We have not yet seen similar exploitation of unrestricted subsidiaries in Europe, however, unrestricted subsidiaries offer an additional route to raise priming debt and current market circumstances may result in borrower groups and sponsors considering creative ways to address unsustainable capital structures or to extract value.

In this latest article in our Navigating Uncertainty series, we discuss certain provisions relating to unrestricted subsidiaries in the European leveraged loan market, highlight some of the main areas of concern for lenders and explore some of the less obvious advantages and disadvantages of designating a subsidiary as unrestricted. Of paramount concern:
  • Absence of “no default”/“no event of default” stoppers in the URS designation provision and/or related restricted payment/investment covenants may allow significant cash leakage at the time funds need to be retained in the restricted group;
  • Multiple baskets in the restricted payment/investment covenant, over and above the dedicated URS/similar business baskets, may permit significant investments to be made in URS;
  • The value in an URS (based on investments and assets, for example) may be used in a variety of ways to increase restricted payment capacity and enable cash/assets to be returned to sponsors/shareholders.
The data referred to in this article has been drawn from our representative loan terms, or RLT, database and refers to deals reviewed by Debt Explained during the period from Jan. 1, 2017, to May 5, 2020, (the “relevant period”) which are governed by the laws of England and Wales or the laws of another European jurisdiction (“deals reviewed”). If you have any specific queries on capacity for value transfer to unrestricted subsidiaries, or any other provision, in a document or deal in your portfolio please email To access the RLT database click HERE.

One of the most controversial uses of URS has been in the context of restructurings, including to facilitate debt exchanges or additional debt raising within financially stressed businesses. This has taken a variety of forms including:
  • Transfer of valuable assets (in J.Crew’s case, IP) to URS to support raising structurally senior debt within the URS, either as a standalone transaction or, more egregiously, with the proceeds of such debt being used to buy back structurally junior debt or facilitate a debt exchange which improved the position of structurally junior creditors;
  • Transfer of operating subsidiary shares to URS so that dividends received on those shares could be used to buy back senior debt at a discount;
  • Transfer of an entire business division to a URS, the equity in which was then dividended to the parent company, effectively handing the business to the equityholders through the resulting change in the corporate structure; and
  • Using a URS investment basket on top of available dividend capacity to increase the amount of equity in a recently acquired subsidiary which could be transferred out of the restricted group, resulting in the release of guarantees and security originally granted by that subsidiary, and thus creating a non-guarantor restricted subsidiary with substantial capacity to incur structurally and effectively senior debt.
Restricted Versus Unrestricted Subsidiaries

Covenants apply to whole group

Traditionally, the covenant package and other restrictions in European law credit agreements applied to all companies within the group, usually defined as the “parent” or “company” and its subsidiaries (generally those more than 50% owned). There would usually be some differences in the way the borrowers and guarantors (often called “obligors” or “loan parties”) were treated compared to non-obligors, dictated by the lenders’ desire to restrict leakage of value from the obligors against whom lenders have a secured debt claim to non-obligors whose creditors would be structurally senior to the syndicate.
Covenants only apply to the “restricted group”

As for many other provisions, the U.S. leveraged loan and high-yield bond markets have influenced how European loans are structured and it is now common to find an additional distinction between group members; while the starting position for most deals is that all subsidiaries (whether or not obligors) are bound by the covenant package and other credit agreement provisions and thus are “restricted subsidiaries” (“RS”) and members of the “restricted group”, this status can be changed by designating certain RS as “unrestricted subsidiaries” (“URS”).

As shown by the graph below, the use of a “restricted group” concept in deals reviewed has increased over the relevant period. 59% of deals from 2017 included the concept of a “restricted group”. As discussed further below, nearly all contain a provision which would enable the borrower group to designate group members as URS.

Following designation, those companies will no longer be caught by the covenants and other limitations imposed on the restricted group by the credit agreement. In a handful of deals, URS are already in existence at closing. As you would expect, the lenders will have no recourse to any assets of URS as they will not be obliged to provide any credit support (whether in the form of guarantees or collateral/security) and it would also be very unusual for the shares in any URS to be pledged in favor of the lenders under the credit agreement. Clearly, given the absence of control over, or recourse to, URS, it is vital for lenders that the restricted group’s relationship with URS and, in particular, the ability of the restricted group to transfer value to URS, is adequately addressed in the loan documentation.
Conditions for Designating URS

While the most famous (or infamous) uses of URS have been as part of a restructuring toolkit, flexibility for borrower groups to have entities that sit outside of the restricted group and can incur debt, grant security and otherwise operate unconstrained by the credit agreement may be useful for a number of other reasons, for example to test, or grow, new businesses, project finance or participating in joint ventures.

It is typical for a credit agreement to contain a mechanic whereby:
(i) New entities can be incorporated in the group structure as URS; and
(ii) An existing RS can be designated as an URS. Uncontroversially, given it would expand the restricted group and be to the benefit of the lenders, credit agreements also usually contain a mechanic for an URS to be redesignated as an RS (although the limited conditions which may be found in this provision will not be covered by this article). Of interest, we have also seen (albeit very rarely) credit agreements contain a provision stating that any RS that has previously been an URS cannot subsequently be redesignated as an URS - this would prevent borrowers chopping and changing the status of their subsidiaries.

Of the deals reviewed in the relevant period, we are aware of at least one that did not allow for the post-closing designation of any RS as URS. While this would appear to make it incredibly lender-friendly, the fact that there were URS at closing means this is not really the case and we presume that the absence of the usually standard mechanic for designation of further URS in this deal was down to the fact that the lenders were not willing to take the risk that the restricted group would be shrunk further, resulting in additional assets being put outside of their reach.
The “standard” designation conditions

We have seen a fair amount of variation in the conditions for the designation of RS as URS in the remaining deals reviewed in the relevant period (referred to hereafter as the “relevant deals”), which suggests either that these provisions are negotiated in great detail and tailored to the deal in question (which is no bad thing given the overwhelming use of precedent documents in the sponsor market) or that the European market has not yet settled on a set of acceptable precedent conditions. However, and largely in line with what we would expect to see in a high-yield bond indenture, the following conditions emerge as the most “standard”:

Ability to make the investment under the restricted payments covenant:
  • The vast majority of relevant deals contain an express requirement in the URS designation provision that the restricted group has the ability to make an investment in the URS and/or that the limitation on restricted payments covenant would be complied with - meaning that there must be capacity under that covenant to make an investment equal to the value of the deemed investment in the URS at the time of designation. This requirement may be set out as a specific condition in the URS designation provision (which may or may not include specific limits on the amount that may be invested in URS at any one time/in any financial year) or may be incorporated by way of a cross-reference. The terms of the credit agreement will set out how, and when, the investment will be valued but it is usual for it to be valued at fair market value or net book value of the net assets of the subsidiary at the time of designation.
  • Capacity under any available restricted payment or permitted investment baskets can be used but borrowers will have to comply with any further conditions applicable to the use of the selected basket(s) - for example, specific limits on the amount that can be invested in URS at any time are included in certain relevant deals. Clearly, the more valuable the assets/business owned by the proposed URS, the more challenging it will be to meet all relevant conditions and the more restricted payment capacity will be used up.
  • By far the most aggressive condition we have seen to date in relation to the URS designation provision, which has thankfully only been seen in one relevant deal, allows a RS to be designated as an URS even when there is NO restricted payment/investment capacity and the restricted payment covenant cannot be complied with subject only to there being no payment or bankruptcy-related event of default. Once designated as an URS, assets may be able to leak from the restricted group to the URS as discussed further below.
Default/event of default stopper:
  • No default (found in 28% of relevant deals) or event of default (found in 36% of relevant deals) would occur as a result of the designation as URS.
  • Aggressively, a further 3% of relevant deals included a narrower construct, making the designation conditional upon there being no payment or bankruptcy event of default, details of which, together with the other conditions which would apply when designating an URS in these deals, can be found HERE.
  • For those deals which do not expressly contain this condition, compliance with a no default/no event of default stopper may still apply if contained in another covenant which must be complied with (such as the restricted payments/investments covenant discussed below). However, if this is not the case, the borrower/sponsor may be able to designate an RS as a URS when they are in default and, given the potential leakage issues discussed below, this is arguably the worst possible time for such designation to take place from the perspective of a lender.
De-linkage requirements: To ensure they are as delinked from the rest of the restricted group as possible, the URS must not hold any shares in any restricted group member (found in 24% of relevant deals) or must not hold any shares in, debt of, lien on the assets of, investment in, or other property in any restricted group member (found in 38% of relevant deals).

Status of the subsidiary to be designated as an URS:
  • Almost a quarter of relevant deals explicitly state that an obligor/material subsidiary/holding company of an obligor or a material subsidiary cannot be designated as an URS.
  • A condition stating that the only entities that can be designated as URS are newly incorporated, shelf or special purpose companies was only found in 5% of relevant deals.
A Possible Rationale for the Lack of Express Designation Conditions

To avoid triggering a default, the restricted group will need to ensure that they are in compliance with all applicable covenants in the credit agreement at the moment a URS is so designated. There is therefore an argument that the designation of URS provision does not actually need to expressly state that certain covenants are/will be satisfied. It could be said that the URS designation provision only needs to include additional conditions that need to be satisfied at the time an RS is to be designated as a URS. This argument may go some way to explaining why a small proportion of relevant deals do not expressly include the ability to make an investment in the URS/comply with the restricted payment covenant as a specific condition in the URS designation provision. In addition, it may explain why there is significant variation in the conditions seen throughout the relevant deals. For example, very few of the relevant deals include a condition in the designation provisions stating that a URS may have no debt other than debt that is non-recourse to the restricted group or include a condition stating that the restricted group is not permitted to provide guarantees/credit support for debt of a URS but, unless the credit agreement permits otherwise, this would not usually be permitted under the terms of the debt and liens covenants anyway. Similarly, any intercompany loans from an RS to the entity being designated as a URS would need to be unwound or be able to fall within an applicable permitted debt basket in order to comply with the debt covenant. In addition, any ongoing or future transactions and other arrangements between the restricted group and a URS would need to comply with the limitation on affiliate transactions covenant (if applicable).

However, as always with complex leverage finance documents, the specific URS designation provisions (which may be set out in the definition of “Unrestricted Subsidiary” itself and/or in a specific designation covenant) must always be reviewed alongside the other covenants in the credit agreement to ensure that there are no loopholes that can be exploited by the borrower/sponsor.

Investors should be aware that a handful of relevant deals include a carve out in the URS designation provision which allows an RS with total consolidated assets below a de minimis threshold (£1,000 or less, for example) to be designated as a URS without satisfying the designation conditions. The inclusion of any such carve out potentially gives sponsors/borrowers additional flexibility - for example, the borrower could designate an immaterial subsidiary as a URS when it was unable to satisfy the conditions (say, because it was in default or had no capacity in its investment baskets) and it could be kept outside the restricted group “just in case” there was scope for assets to be leaked to it.
Potential Leakage to/via URS

As noted above, once cash or any other assets are in the hands of a URS, lenders lose all control over what happens next. Consequently, lenders need to ensure that their credit agreements restrict the amount of, and circumstances in which, leakage from the restricted group to URS can occur. Traditional English law credit agreements typically include separate covenants limiting acquisitions, loans, guarantees and the like by the group and also frequently impose restrictions on transactions between obligors and non-obligors, to protect value within the guarantors. However, credit agreements with high-yield bond-style covenants tend to subsume these transactions into the wider concept of “investments” and do not distinguish between obligors and non-obligors when addressing restricted intra-group transactions. In addition to understanding the overall potential for leakage, if there are any particularly important assets which lenders are concerned should remain within the restricted group or, better still, the obligor group, lenders should ensure that this is comprehensively (and explicitly) covered in the credit agreement.
Investments in URS

It almost goes without saying that URS should not get the benefit of any basket or carve-out permitting intragroup investments under the credit agreement; with the exception of restrictions on affiliate transactions, URS should be treated as third parties.

As already discussed, the initial designation of a URS will constitute an investment by the restricted group. In the future, any contribution of assets or loans to, acquisitions of shares or other equity contributions in, or guarantees or grants of security for the benefit of, a URS by a member of the restricted group will also be an investment and will either need to be a “permitted investment” under the credit agreement or otherwise be permitted as a carve-out to the restricted payments.

Many relevant deals have specific annual or per financial year baskets for making investments in URS and, as with most baskets in the current market, these are usually capped at the greater of a hard amount and a specified percentage of EBITDA; with EBITDA calculated on a rolling 12-month basis. Borrowers will want to maximize their EBITDA-based basket capacity before their first set of coronavirus-affected financial statements becomes available. Dedicated URS investment baskets are typically sized at 30% to 40% of EBITDA in the current market and many relevant deals also include a further grower basket for investments in joint ventures or similar businesses, often with a comparable cap; absent any drafting to the contrary, these could also potentially be used for URS investments. Unless expressly prohibited, any general permitted investment basket and any general restricted payment basket, including build-up, leverage-based and annual/lifetime baskets, will be available for making investments in URS in addition to the dedicated URS/similar business baskets.

Permitted investment baskets are often replenished by returns of/on investments originally made from the applicable basket and ideally this replenishment should be limited to the amount originally invested so that there is no overall (and unquantifiable) increase in URS investment capacity over time. It is also worth noting that “no Default”/“no EoD” stoppers are less common in the context of permitted investment baskets compared to restricted payment baskets, so these may remain available at a point where cash leakage is even less desirable from the lenders’ point of view.
Restricted Payments

As noted above, in the absence of preventative language to the contrary, general restricted payment baskets can also be used to make investments in URS. However, there are other ways in which URS value might be used to increase restricted payment capacity.

Restricted payments using URS equity: Although URS are not part of the restricted group and lenders do not have direct recourse to their assets, the shares in URS will still be owned by the restricted group at the time of URS designation and thus are of value to the restricted group and, potentially, its lenders. However, many high-yield bond-style deals include a carve-out to the restricted payments covenant for dividends made using URS equity (“URS spin-off”). Therefore, in circumstances where liquidity is tight and a restricted group is not in a position to pay a cash dividend it could still transfer value to shareholders by distributing the equity in a URS.

Creation of restricted payment capacity from asset sales: It should be borne in mind that both the restricted group and RS/URS concepts are documentary constructs and, although not bound by the credit agreement, URS remain part of the operating group for practical purposes. As with the other covenants, URS will not be bound by the asset sales covenant and so disposals by URS to third parties will not be restricted. Going one step further, many high-yield bond-style credit agreements carve out disposals of URS shares from the “asset sale” definition meaning that, even though shares held in URS by RS are assets of the restricted group, proceeds received by the restricted group from a sale of these assets will fall outside the purview of the asset sale covenant and the proceeds of any such sale will not need to be applied in accordance with the asset sale proceeds waterfall. Further inverting the traditional principle that asset sale proceeds should be used to pay down debt, amounts received from sales of URS are frequently included in the builder elements of restricted payment buildup baskets and so increase the group’s dividend and other restricted payment capacity. Likewise, revenue generated by URS may ultimately end up within the restricted group, whether by way of dividends to RS or otherwise, and this can also contribute to the restricted payment buildup basket. Lenders should take care that any possibility of double counting amounts received from, or in respect of, the restricted group’s investments in URS is excluded.
Aggressive Document Terms

“J.Crew” trapdoor: In addition to a capped basket for investments in URS, J.Crew’s credit agreement contained language which permitted the value of investments made in RS under a separate RS investment basket to be transferred by the recipient RS to URS, effectively converting that specific RS investment basket to an additional URS investment basket and allowing that value to fall out of the restricted group. This is one of the few examples of a covenant loophole that lenders have consistently and successfully resisted in recent times and, as a consequence, J.Crew-like trapdoor provisions remain rare.

Indirect dividends: Standard high-yield bond-style drafting in the restricted payments covenant prohibits the making of direct and indirect restricted payments. This is intended to prevent disguised dividends being made via restricted payment and permitted investment baskets which cannot be used “directly” for that purpose. To avoid cash extraction via investments in URS being caught by the prohibition on indirect dividends, some sponsors have sought to include language specifically stating that any payment out by a URS using amounts received from the restricted group in compliance with the covenants will not constitute an “indirect dividend.” This is considered aggressive but it is perhaps worth bearing in mind that, as a practical matter, even with the indirect dividend prohibition, it is likely to be difficult for lenders to accurately track URS use of invested amounts as time passes and, if a URS spin-off carve-out is available, the borrower group could dividend the value invested in the URS to its shareholders in any event.

Looser conditions for making restricted investments: Standard conditions in the current market for use of the 50% CNI build-up basket for making restricted payments (including restricted investments) are that the group would still have capacity to incur an additional £/$/€1 under its ratio debt basket and that no event of default (weakened from the traditional “no default”) is outstanding or would result from the payment/investment. However, in more aggressive deals these conditions have been eroded in relation to restricted investments, potentially allowing value transfer to URS to be made when the group’s financial position has deteriorated to such an extent that it cannot meet its ratio debt test and/or is in default under the credit agreement.
Other Documentary Issues

Ratios and basket capacity: Once transferred to an URS, the assets owned by and the EBITDA generated by them, will no longer be included in the consolidated assets nor, other than through cash distributions to the restricted group which are included in CNI, the EBITDA of the restricted group for ratio purposes. As a result, borrowers will need to be aware of the potential impact on their ability to meet financial covenants (if tested), to use ratio-based-incurrence covenants and their capacity under total asset or EBITDA-based grower baskets.

Reporting: For accounting purposes, URS will still be part of the consolidated group. However, under the terms of the credit agreement, borrower groups may be required to prepare additional financial statements stripping out URS so that lenders can assess the performance of the restricted group.

Debt buybacks: As highlighted in Part 1 of the Debt Buybacks articles in the Navigating Uncertainty Series, lenders should check that URS are covered by either the group or sponsor affiliate buy back controls, absent which they would be able to undertake unrestricted buybacks.

Guarantor coverage tests: Borrowers will need to check that they will remain in compliance with any guarantor coverage test following the designation of any URS, taking into account any relevant exclusions from the numerator and or denominator. If coverage would fall below the required threshold, arrangements will need to be made for additional group members to accede as guarantors, which may be time and cost intensive. Lenders should be aware of coverage requirements based on the restricted group only, as there will be limited visibility on the value of URS and other excluded entities.
Other Considerations

Documentary capacity is not the only consideration when evaluating the potential benefits of designating an URS and other, more practical considerations will need to be taken into account including the following:
  • Availability of suitable assets: Some assets are easier to transfer than others - J.Crew involved the transfer of IP and iHeart of shares - and a borrower group may not have sufficient value in assets which can be simply (and cheaply) transferred.
  • Ongoing operations: If there is a transfer of substantial assets, the borrower group will almost certainly need to have an ongoing day to day business relationship with the URS to ensure it will still be able to use the contributed assets. Borrowers/sponsors will need to consider how easily this can be facilitated once the restricted group can no longer take advantage of intragroup flexibilities in its credit agreement. Additional operational complexity is unlikely to be helpful, particularly if the business environment is already challenging.
  • Litigation/reputational risk: Some of the better known URS transactions have been challenged by lenders and it is likely that others have at least contributed to a less harmonious relationship between the borrower and its lending syndicate. Sponsors, of course, may feel entitled to use the flexibility provided to them by loose covenant packages but they also need to consider the potential consequences should they need amendments and/or waivers under their credit agreements further down the line.
  • Directors’ duties: Almost all jurisdictions impose fiduciary duties on company directors and these come into sharper focus when a company is financially distressed. Directors will need to be confident that dividends and value transfers are not subject to challenge and that, where applicable, adequate consideration is received by the restricted group.

Although aggressive loopholes such as J.Crew trapdoors garner attention, they are rare. However, lenders should be aware that many credit agreements provide substantial capacity for value leakage to URS even where the covenant package appears to be relatively standard. Some sponsors have been prepared to exploit available flexibility in the past, despite controversy, and it is more than possible that history will be repeated if the potential benefit to a financially stretched group is significant in these unprecedented times.

To find more reports in our Navigating Uncertainty series click HERE.
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