Some UnSub Spinoff Baskets May Provide Illusory Protection to Noteholders Against Use of Investment Capacity for Dividends Through Cash Spinoffs

Under many debt documents, the restricted payments covenant includes a basket permitting the borrower or issuer to pay dividends in the form of unrestricted subsidiary stock or debt (referred to herein as an “UnSub spinoff basket”). Continue reading for our Americas Covenants team's analysis of the UnSub spinoff baskets and Request a Trial for access to the linked debt documents, tear sheets, and summaries as well as our coverage of thousands of other stressed/distressed debt situations.

UnSub spinoff baskets are most often drafted in one of two ways. In one version, the “No Carve-Out” version, the basket permits all such dividends, as in this basket from Bausch Health’s senior secured notes due 2028, which permitted:

In another version, the “Full Carve-Out” version, the basket specifically disallows the distribution of equity of an unrestricted subsidiary if the “primary assets” of that subsidiary consist of cash and cash equivalents. For example, in Booz Allen Hamilton’s senior notes due 2029, the spinoff basket permitted:

In this article we discuss the operation of these baskets and how some formulations could present risks for creditors.

The Full Carve-Out version protects noteholders against a “cash spinoff” dividend in which the issuer uses the UnSub spinoff basket to pay what is effectively a cash dividend, by using the unrestricted subsidiary as a container for cash. In such a transaction, the issuer first moves cash into an unrestricted subsidiary, then transfers ownership of that subsidiary to the parent through a dividend of 100% of the subsidiary’s stock. The No Carve-Out version of the basket does not expressly prohibit such a transaction.

The cash spinoff dividend effectively converts investment capacity into dividend capacity, since the issuer must use investment capacity to transfer cash to the unrestricted subsidiary, but the subsequent distribution of that subsidiary’s equity to the issuer’s equityholders does not utilize any capped dividend capacity, since the UnSub spinoff basket permits any dividend if it is structured as a distribution of UnSub equity.

In a third, less common, version of this basket (the “Investments Carve-Out” version), the carve-out applies only if the cash investment in the unrestricted subsidiary was made using specified baskets - the restricted payments basket for investments in unrestricted subsidiaries or any “Permitted investments” basket. For example, CEC Entertainment’s senior secured notes due 2026 permitted:

The Investments Carve-Out version does not bar all cash spinoff transactions (like the Full Carve-Out version) but will usually prevent an issuer from using the UnSub spinoff basket to convert investment capacity into dividend capacity. Under the Investments Carve-Out version, the carved-out baskets, under most notes, represent all capacity that can be used to transfer value to unrestricted subsidiaries but cannot be used to pay dividends (typically, in high-yield notes, “Restricted Payments” capacity can be used for dividends or investments). While the Investments Carve-Out version would not prevent the spinoff of a subsidiary funded using capacity under the general restricted payments basket, for example, such a transaction is less problematic because the capacity could alternatively be used to pay a dividend directly. Therefore, a cash spinoff of a subsidiary funded using general restricted payments basket capacity would not allow the issuer to pay dividends in excess of its otherwise available restricted payments capacity.

In some limited circumstances, however, the Investments Carve-Out version could still be used to pay an effective cash dividend in excess of available dividend capacity. Under some notes, use of the restricted payments “builder basket” capacity for dividends is subject to more restrictive conditions than use of the basket for investments. For example, in some cases, use of the builder basket for investments is not subject to the ability to satisfy ratio debt tests or a no-default condition, though these conditions apply to other types or restricted payments. The Investments Carve-Out version would not prohibit a cash spinoff of a subsidiary funded using builder basket capacity at a time when the issuer could not use such capacity to pay a dividend directly. The conditions under which this could occur will likely be rare, however.

At least one issuance this year has included a fourth variation on the UnSub spinoff basket. In Univision Communications’ senior secured notes due 2029, launched in May 2021, the basket included a carve-out that applied only to subsidiaries that had received a cash contribution by way of an investment using the restricted payments basket for investments in unrestricted subsidiaries:

This variation (the “Univision version”) is also included in other Univision notes, including its 9.5% senior secured notes due 2025 issued in April 2020 and 6.625% senior secured notes due 2027, issued in June 2020.

The Univision version operates as a watered-down version of the Investments Carve-Out. Like the Investments Carve-Out version, the Univision version carves out spinoffs of subsidiaries funded using the restricted payments basket for investments in unrestricted subsidiaries. However, the Univision carve-out does not apply to subsidiaries funded using Permitted Investments capacity under the notes. Therefore, the Univision version permits all capacity under Permitted Investment baskets that can be used for investments in unrestricted subsidiaries to be effectively converted to dividend capacity using the UnSub spinoff basket, as discussed above.

Under Univision’s 2029 notes, the restricted payments basket for investments in unrestricted subsidiaries is sized at the greater of $450 million and 24.75% of EBITDA. Therefore, the Univision version carve-out prevents at least $450 million of cash spinoff dividends that could be made absent the carve-out. However, the Univision carve-out does nothing to prevent more than $1.25 billion of spinoff dividends that can still be made using Permitted Investments capacity under baskets summarized below:

Therefore, while the Univision version prevents about $450 million of spinoff dividends, it nevertheless allows the issuer to use more than $1.25 billion of Permitted Investments capacity to pay cash spinoff dividends using the UnSub spinoff basket.

At a minimum, the Univision version would appear to be more protective to noteholders than the No Carve-Out version, since it prevents at least a portion of the otherwise available investment capacity from being used for dividends, while the No Carve-Out version does not expressly prohibit any cash spinoff dividend.

In one way, however, the Univision variation might be more problematic for noteholders than the No Carve-Out basket. Under the No Carve-Out version, a noteholder that seeks to challenge a cash spinoff transaction (as a violation of the implied covenant of good faith and fair dealing, for example) could argue that the parties never contemplated using the basket in this way and that doing so would circumvent the parties’ intent with respect to limits on dividend capacity under the notes. Under the Univision variation, that argument would have no traction, since the nature of the carve-out makes clear that the parties did contemplate that the basket would be applied to a subsidiary holding primarily cash assets and intended to disallow only such spinoffs when the cash was invested in reliance on a particular basket.

At this point, the Univision variation of the UnSub spinoff basket appears to be limited to Univision’s debt documents. It remains to be seen whether other issuers will adopt this version or another version that similarly chips away at the protections against cash spinoff dividends provided under the more common carve-outs to this basket.

--Mitch Oates