Talen Energy Corp.
Unrestricted Subsidiary Transfers Threaten to Split Lenders Into Haves and Have-Nots Potentially Deprived of Secured Status in Chapter 11, Often Lead to Acrimonious Litigation
Fri 09/24/2021 08:00 AM
Things are heating up in Talen Energy as creditors organize in anticipation of a potential restructuring built around a transfer of its Susquehanna nuclear facility to an unrestricted subsidiary that would secure new financing for the company’s new data center and crypto-mining initiatives. Talen has said these initiatives could require up to $800 million of new capital and move the company toward “a sustainable, ESG-focused future” after year-over-year deterioration in first-quarter EBITDA and weaker-than-forecast results as of June.
Talen Energy recently announced that its wholly owned subsidiary Cumulus Digital has secured a new six-year, up to $175 million strategic capital partnership with Orion Energy Partners. The new funds would be secured by substantially all assets of Cumulus Digital Holdings, the parent of Cumulus Digital, and its subsidiaries. At the same time, subsidiaries of Talen Energy Supply LLC sold their equity interests in certain clean energy development entities to Cumulus Growth Holdings in exchange for voting convertible preferred equity interests in subsidiaries of Cumulus Growth.
Talen would not be the first company to pursue the unrestricted subsidiary transfer financing tactic. When faced with a need to enhance liquidity or pivot to higher growth opportunities, companies often pursue value-maximizing strategies using the collateral of existing lenders. As seen in other unrestricted subsidiary transfers in cases such as Revlon and J.Crew and superpriority uptier exchanges in Serta Simmons, Boardriders and TriMark, such transactions create haves and have-nots among lenders, often followed by litigation between the two groups and against the company.
In this article, Reorg considers the impact that unrestricted subsidiary transfers have on existing creditors’ claims to those assets should the company file for chapter 11 in the context of a hypothetical Talen filing, taking into account the specific terms of Talen’s loan documents. We also provide a summary of similar transactions and related litigation.
Restricted vs. Unrestricted Subsidiaries Under Debt Documents
Under most U.S. debt documents, Talen’s included, the borrower (under credit agreements) or the issuer (under notes) is the debtor, and its material wholly owned domestic restricted subsidiaries guarantee their debt; creditors under secured debt typically have a security interest in the equity of the subsidiary guarantors, substantially all of their tangible and intangible assets and a 65% pledge in the voting equity of foreign subsidiaries (and 100% of the non-voting equity).
However, the negative covenants under most U.S. debt documents restrict the borrower or issuer and its “restricted subsidiaries” from incurring new debt and liens, paying dividends, making investments and prepaying certain outstanding debt.
Restricted subsidiaries typically include the subsidiary guarantors as well as all of the company’s other subsidiaries, other than unrestricted subsidiaries. Generally, a company’s nonguarantor restricted subsidiaries are its foreign subsidiaries and immaterial U.S. subsidiaries.
Why do borrowers and issuers want as large of a restricted group as possible? Net leverage ratios and baskets based on a percentage of EBITDA or total assets include cash, EBITDA and total assets of the entire restricted group. As a result, companies forgo the added flexibility of having foreign subsidiaries not being subject to their debt documents’ negative covenants for the benefit of their cash, EBITDA and total asset contribution.
Unrestricted subsidiaries, on the other hand, sit outside of the restricted group and are not subject to the negative covenants included in the company’s debt documents. To the extent assets are transferred to unrestricted subsidiaries, those subsidiaries can incur as much debt as the market will allow and treat the transferred assets as they wish.
Importantly, to the extent collateral assets are transferred to unrestricted subsidiaries, the liens on those assets typically are automatically released. In addition, although the borrower’s or issuer’s equity interest in an unrestricted subsidiary is an asset, it is almost always carved out of the assets which must be pledged to creditors under secured debt tranches.
Although liens on collateral assets that are transferred to nonguarantor restricted subsidiaries are also automatically terminated, those nonguarantor restricted subsidiaries are subject to the company’s negative covenants, so the nonguarantor restricted subsidiaries, unlike unrestricted subsidiaries, will not have unfettered flexibility to do what they want with the transferred assets.
Consequences of Transfers to Unrestricted Subsidiaries for Pre-Existing Lenders
Secured Status
Although a lender may be treated as a secured creditor outside of bankruptcy notwithstanding the value of its collateral, when a company files for chapter 11 protection, that secured claim is limited to the value of its collateral not encumbered by higher-priority liens. This creates a serious problem for lenders whose collateral has been diminished by unrestricted subsidiary transfers.
Specifically, section 506 of the Bankruptcy Code provides that a creditor’s allowed claim that is secured by a lien on property in which the bankruptcy estate has an interest is secured only “to the extent of the value of such creditor’s interest in the estate’s interest in such property” and “is an unsecured claim to the extent that the value of such creditor’s interest … is less than the amount of such claim” (emphasis added). If the estate’s interest in certain assets has been reduced because of the company’s transfers of assets to unrestricted subsidiaries, a creditor’s secured claim with respect to the assets (as security) is similarly reduced.
If the value of a lenders’ collateral is diminished because of the company’s transfers to unrestricted subsidiaries, the lender’s secured claim could be rendered partially or even entirely unsecured, depending on the extent of the diminution. The lender would then be left with an unsecured deficiency claim.
The following chart illustrates the effect of an unrestricted subsidiary asset transfer on the pre-existing collateral base:
If the company and the subsidiary both file for bankruptcy protection, the same result would occur: Secured claims of the subsidiary debtor would also be secured to the extent of the value of the collateral base held by the subsidiary.
Not only do lenders face a shrinking collateral base as unrestricted subsidiary transfers occur, they also face a corresponding loss of certain rights, due to the diminution of the value of their collateral, under the Bankruptcy Code.
Under the Bankruptcy Code, existing secured lenders are entitled to adequate protection to safeguard the collateral value of their liens on property of the estate, particularly when a debtor takes out a DIP that is secured by a priming lien or equal lien on the same property. Adequate protection may come in the form of additional or replacement liens and cash payments, but only up to the secured value of the lenders’ claim. This means that as the collateral base diminishes because of unrestricted transfers, so too does the value of the lenders’ secured claim on property of the estate and attendant rights to adequate protection.
Similarly, the right to credit bid would be negatively impacted by unrestricted subsidiary transfers. Under section 363(k) of the Bankruptcy Code, an existing lender is permitted to offset the value of its secured claim against the purchase price in a bankruptcy sale of assets unless the court for cause orders otherwise. The right to credit bid, however, is directly tied to the underlying value of the lender’s interest in the assets being sold.
Lenders would also have to contend with lesser claim treatment rights under any plan of reorganization by the company. The Bankruptcy Code’s “best interests” test requires that each creditor receive under a plan at least as much as it would receive in a chapter 7 liquidation of the company, and secured creditors must be paid the full amount of their secured claims under a chapter 11 plan. In a liquidation scenario, a secured lender whose collateral base has declined because of unrestricted transfers would face a lower theoretical recovery on its claim, with any deficiency left as a general unsecured claim.
The loss of rights as a secured lender turned undersecured, or even wholly unsecured, becomes even starker if, prior to an unrestricted transfer, the secured lender was oversecured. Under the Bankruptcy Code, oversecured lenders would be entitled to postpetition interest and “reasonable fees, costs or charges” as provided under the credit agreement, including adequate protection in the full amount of their claim and costs, fees and expenses. Newly undersecured lenders would find themselves no longer entitled to insist on payment of these amounts once the value of their collateral base is reduced to an amount that is equal to or less than their claim.
The extent of the deterioration of secured lenders’ rights under the Bankruptcy Code would depend on the value of the remaining assets of the company that still serve as the lender’s collateral after an unrestricted subsidiary transfer.
Fraudulent Conveyance Litigation
One way for lenders to attack unrestricted subsidiary transfers would be through fraudulent conveyance litigation. Under state law fraudulent conveyance statutes and their Bankruptcy Code equivalents, which largely mirror state law provisions, lenders may seek avoidance of the transfer as an actual fraudulent transfer or a constructively fraudulent transfer.
Generally under section 548(a)(1)(A) of the Bankruptcy Code, a claim for actual fraudulent transfer requires the plaintiff to show, by a preponderance of the evidence, that the transfer was made with “actual intent to hinder, delay or defraud” existing creditors. Direct evidence that a transfer was intentionally fraudulent is rare, which is why plaintiffs and courts alike typically rely on circumstantial evidence, known as “badges of fraud,” to infer fraudulent intent. Badges of fraud include the relationship between the borrower or issuer and the transferee; the consideration paid, if any, for the transfer; the insolvency or indebtedness of the borrower/issuer; how much property was transferred; any reservation of benefits, control or dominion by the borrower/issuer; and any secrecy or concealment of the transaction.
A claim for constructive fraudulent transfer under section 548(1)(B) of the Bankruptcy Code, on the other hand, requires the plaintiff to show, by a preponderance of the evidence, that the transfer occurred without “reasonably equivalent value” in exchange for the borrower/issuer’s transfer of assets, and the company was undercapitalized or became insolvent as a result of the transfer. Any transfer of assets to an unrestricted subsidiary without any value in return would be subject to attack as a constructively fraudulent transfer, but only if the borrower/issuer was insolvent at the time or rendered insolvent by the transfer. If value was given in exchange for the transfer, a fact-intensive inquiry focused on whether the value was “reasonably equivalent” would be required.
Section 548 of the Bankruptcy Code has a two-year lookback period to recover fraudulent conveyances. However, the Bankruptcy Code incorporates state law fraudulent conveyance statutes at section 544(b), which in turn effectively extends the lookback period to four or more years depending on state law provisions.
Outside of bankruptcy, creditors have the right to sue to avoid fraudulent transfers on their own behalf - subject, of course, to no-action provisions in the relevant credit documents. The Bankruptcy Code authorizes a chapter 11 debtor, as a debtor-in-possession, to pursue fraudulent transfer claims for the benefit of the bankruptcy estate and its creditors. Of course, a debtor would be reluctant to bring such a claim with respect to a prepetition unrestricted subsidiary transfer. In the event a debtor fails to prosecute such claims, a creditor may seek derivative standing to do so as Oaktree Capital Management did in Claire’s Stores chapter 11 cases.
Examples of Unrestricted Subsidiary Transfers
The following are brief summaries of private recapitalization transactions undertaken by Revlon and J.Crew as well as “uptier exchanges” by Serta Simmons, Boardriders and TriMark, including related litigation. The summaries illustrate that whether through sale-leaseback, unrestricted subsidiary transfers or debt-for-debt uptier exchanges, companies in need of capital will find strategies to value-maximize with willing new and pre-existing lenders. Non-participating lenders have shown that they will aggressively litigate over the transaction.
Revlon
Disclosure: Funds associated with Warburg Pincus hold a majority interest in the parent company of Reorg Research Inc.
Talen Energy recently announced that its wholly owned subsidiary Cumulus Digital has secured a new six-year, up to $175 million strategic capital partnership with Orion Energy Partners. The new funds would be secured by substantially all assets of Cumulus Digital Holdings, the parent of Cumulus Digital, and its subsidiaries. At the same time, subsidiaries of Talen Energy Supply LLC sold their equity interests in certain clean energy development entities to Cumulus Growth Holdings in exchange for voting convertible preferred equity interests in subsidiaries of Cumulus Growth.
Talen would not be the first company to pursue the unrestricted subsidiary transfer financing tactic. When faced with a need to enhance liquidity or pivot to higher growth opportunities, companies often pursue value-maximizing strategies using the collateral of existing lenders. As seen in other unrestricted subsidiary transfers in cases such as Revlon and J.Crew and superpriority uptier exchanges in Serta Simmons, Boardriders and TriMark, such transactions create haves and have-nots among lenders, often followed by litigation between the two groups and against the company.
In this article, Reorg considers the impact that unrestricted subsidiary transfers have on existing creditors’ claims to those assets should the company file for chapter 11 in the context of a hypothetical Talen filing, taking into account the specific terms of Talen’s loan documents. We also provide a summary of similar transactions and related litigation.
Restricted vs. Unrestricted Subsidiaries Under Debt Documents
Under most U.S. debt documents, Talen’s included, the borrower (under credit agreements) or the issuer (under notes) is the debtor, and its material wholly owned domestic restricted subsidiaries guarantee their debt; creditors under secured debt typically have a security interest in the equity of the subsidiary guarantors, substantially all of their tangible and intangible assets and a 65% pledge in the voting equity of foreign subsidiaries (and 100% of the non-voting equity).
However, the negative covenants under most U.S. debt documents restrict the borrower or issuer and its “restricted subsidiaries” from incurring new debt and liens, paying dividends, making investments and prepaying certain outstanding debt.
Restricted subsidiaries typically include the subsidiary guarantors as well as all of the company’s other subsidiaries, other than unrestricted subsidiaries. Generally, a company’s nonguarantor restricted subsidiaries are its foreign subsidiaries and immaterial U.S. subsidiaries.
Why do borrowers and issuers want as large of a restricted group as possible? Net leverage ratios and baskets based on a percentage of EBITDA or total assets include cash, EBITDA and total assets of the entire restricted group. As a result, companies forgo the added flexibility of having foreign subsidiaries not being subject to their debt documents’ negative covenants for the benefit of their cash, EBITDA and total asset contribution.
Unrestricted subsidiaries, on the other hand, sit outside of the restricted group and are not subject to the negative covenants included in the company’s debt documents. To the extent assets are transferred to unrestricted subsidiaries, those subsidiaries can incur as much debt as the market will allow and treat the transferred assets as they wish.
Importantly, to the extent collateral assets are transferred to unrestricted subsidiaries, the liens on those assets typically are automatically released. In addition, although the borrower’s or issuer’s equity interest in an unrestricted subsidiary is an asset, it is almost always carved out of the assets which must be pledged to creditors under secured debt tranches.
Although liens on collateral assets that are transferred to nonguarantor restricted subsidiaries are also automatically terminated, those nonguarantor restricted subsidiaries are subject to the company’s negative covenants, so the nonguarantor restricted subsidiaries, unlike unrestricted subsidiaries, will not have unfettered flexibility to do what they want with the transferred assets.
Consequences of Transfers to Unrestricted Subsidiaries for Pre-Existing Lenders
Secured Status
Although a lender may be treated as a secured creditor outside of bankruptcy notwithstanding the value of its collateral, when a company files for chapter 11 protection, that secured claim is limited to the value of its collateral not encumbered by higher-priority liens. This creates a serious problem for lenders whose collateral has been diminished by unrestricted subsidiary transfers.
Specifically, section 506 of the Bankruptcy Code provides that a creditor’s allowed claim that is secured by a lien on property in which the bankruptcy estate has an interest is secured only “to the extent of the value of such creditor’s interest in the estate’s interest in such property” and “is an unsecured claim to the extent that the value of such creditor’s interest … is less than the amount of such claim” (emphasis added). If the estate’s interest in certain assets has been reduced because of the company’s transfers of assets to unrestricted subsidiaries, a creditor’s secured claim with respect to the assets (as security) is similarly reduced.
If the value of a lenders’ collateral is diminished because of the company’s transfers to unrestricted subsidiaries, the lender’s secured claim could be rendered partially or even entirely unsecured, depending on the extent of the diminution. The lender would then be left with an unsecured deficiency claim.
The following chart illustrates the effect of an unrestricted subsidiary asset transfer on the pre-existing collateral base:
If the company and the subsidiary both file for bankruptcy protection, the same result would occur: Secured claims of the subsidiary debtor would also be secured to the extent of the value of the collateral base held by the subsidiary.
Not only do lenders face a shrinking collateral base as unrestricted subsidiary transfers occur, they also face a corresponding loss of certain rights, due to the diminution of the value of their collateral, under the Bankruptcy Code.
Under the Bankruptcy Code, existing secured lenders are entitled to adequate protection to safeguard the collateral value of their liens on property of the estate, particularly when a debtor takes out a DIP that is secured by a priming lien or equal lien on the same property. Adequate protection may come in the form of additional or replacement liens and cash payments, but only up to the secured value of the lenders’ claim. This means that as the collateral base diminishes because of unrestricted transfers, so too does the value of the lenders’ secured claim on property of the estate and attendant rights to adequate protection.
Similarly, the right to credit bid would be negatively impacted by unrestricted subsidiary transfers. Under section 363(k) of the Bankruptcy Code, an existing lender is permitted to offset the value of its secured claim against the purchase price in a bankruptcy sale of assets unless the court for cause orders otherwise. The right to credit bid, however, is directly tied to the underlying value of the lender’s interest in the assets being sold.
Lenders would also have to contend with lesser claim treatment rights under any plan of reorganization by the company. The Bankruptcy Code’s “best interests” test requires that each creditor receive under a plan at least as much as it would receive in a chapter 7 liquidation of the company, and secured creditors must be paid the full amount of their secured claims under a chapter 11 plan. In a liquidation scenario, a secured lender whose collateral base has declined because of unrestricted transfers would face a lower theoretical recovery on its claim, with any deficiency left as a general unsecured claim.
The loss of rights as a secured lender turned undersecured, or even wholly unsecured, becomes even starker if, prior to an unrestricted transfer, the secured lender was oversecured. Under the Bankruptcy Code, oversecured lenders would be entitled to postpetition interest and “reasonable fees, costs or charges” as provided under the credit agreement, including adequate protection in the full amount of their claim and costs, fees and expenses. Newly undersecured lenders would find themselves no longer entitled to insist on payment of these amounts once the value of their collateral base is reduced to an amount that is equal to or less than their claim.
The extent of the deterioration of secured lenders’ rights under the Bankruptcy Code would depend on the value of the remaining assets of the company that still serve as the lender’s collateral after an unrestricted subsidiary transfer.
Fraudulent Conveyance Litigation
One way for lenders to attack unrestricted subsidiary transfers would be through fraudulent conveyance litigation. Under state law fraudulent conveyance statutes and their Bankruptcy Code equivalents, which largely mirror state law provisions, lenders may seek avoidance of the transfer as an actual fraudulent transfer or a constructively fraudulent transfer.
Generally under section 548(a)(1)(A) of the Bankruptcy Code, a claim for actual fraudulent transfer requires the plaintiff to show, by a preponderance of the evidence, that the transfer was made with “actual intent to hinder, delay or defraud” existing creditors. Direct evidence that a transfer was intentionally fraudulent is rare, which is why plaintiffs and courts alike typically rely on circumstantial evidence, known as “badges of fraud,” to infer fraudulent intent. Badges of fraud include the relationship between the borrower or issuer and the transferee; the consideration paid, if any, for the transfer; the insolvency or indebtedness of the borrower/issuer; how much property was transferred; any reservation of benefits, control or dominion by the borrower/issuer; and any secrecy or concealment of the transaction.
A claim for constructive fraudulent transfer under section 548(1)(B) of the Bankruptcy Code, on the other hand, requires the plaintiff to show, by a preponderance of the evidence, that the transfer occurred without “reasonably equivalent value” in exchange for the borrower/issuer’s transfer of assets, and the company was undercapitalized or became insolvent as a result of the transfer. Any transfer of assets to an unrestricted subsidiary without any value in return would be subject to attack as a constructively fraudulent transfer, but only if the borrower/issuer was insolvent at the time or rendered insolvent by the transfer. If value was given in exchange for the transfer, a fact-intensive inquiry focused on whether the value was “reasonably equivalent” would be required.
Section 548 of the Bankruptcy Code has a two-year lookback period to recover fraudulent conveyances. However, the Bankruptcy Code incorporates state law fraudulent conveyance statutes at section 544(b), which in turn effectively extends the lookback period to four or more years depending on state law provisions.
Outside of bankruptcy, creditors have the right to sue to avoid fraudulent transfers on their own behalf - subject, of course, to no-action provisions in the relevant credit documents. The Bankruptcy Code authorizes a chapter 11 debtor, as a debtor-in-possession, to pursue fraudulent transfer claims for the benefit of the bankruptcy estate and its creditors. Of course, a debtor would be reluctant to bring such a claim with respect to a prepetition unrestricted subsidiary transfer. In the event a debtor fails to prosecute such claims, a creditor may seek derivative standing to do so as Oaktree Capital Management did in Claire’s Stores chapter 11 cases.
Examples of Unrestricted Subsidiary Transfers
The following are brief summaries of private recapitalization transactions undertaken by Revlon and J.Crew as well as “uptier exchanges” by Serta Simmons, Boardriders and TriMark, including related litigation. The summaries illustrate that whether through sale-leaseback, unrestricted subsidiary transfers or debt-for-debt uptier exchanges, companies in need of capital will find strategies to value-maximize with willing new and pre-existing lenders. Non-participating lenders have shown that they will aggressively litigate over the transaction.
Revlon
- Transaction: 2019-2020 multi-step, sale-leaseback recapitalization, consisting of new money and a rollup of old debt.
- $880 million in new debt issued to Ares and consenting 2016 term lenders secured by a first-priority lien on BrandCo IP.
- A portion of the proceeds retired a $200 million term loan that was issued to Ares under a 2019 credit agreement.
- Included a rollup of approximately $953 million of 2016 term loan facility into “new” loan facilities - the 2020 rollup facility and the 2020 junior rollup facility - with second and third liens on the BrandCo IP.
- A portion of the proceeds retired a $200 million term loan that was issued to Ares under a 2019 credit agreement.
- BrandCo IP, which secured the 2016 term loan, was transferred to subsidiaries then leased back.
- Issuance of $200 million in new, unfunded revolver commitments under the 2016 credit agreement to term lenders who would be participating in the 2020 new credit facility and agreed to an amendment of the 2016 credit agreement.
- $880 million in new debt issued to Ares and consenting 2016 term lenders secured by a first-priority lien on BrandCo IP.
- Litigation:
- A New York federal court lawsuit was filed on Aug. 12, 2020, by UMB Bank, as administrative agent to 2016 term loan and as assignee to certain dissenting term lenders, saying the issuance of $200 million of unfunded revolving loans was a “sham” to manufacture lender consent to transaction involving IP transfers and otherwise breached the 20216 credit agreement’s sale-leaseback limitations. The complaint outlined how the unlawful sale-leaseback recapitalizations “ripped away” the IP collateral securing the 2016 term, which is “no longer a fully secured, first-priority obligation” of the company but rather subordinate to $2 billion in loan obligations “(approximately 50% of which simply rolled up existing Term Loans and provided no new money).” Defendants sued were Revlon, former administrative agent Citibank, Jefferies, Ares and the lenders to the 2020 BrandCo facility.
- The suit was dismissed voluntarily on Nov. 6, 2020, by UMB Bank, after the court denied UMB’s request for an extension to serve the complaint on Revlon because UMB wanted a stay of the proceedings pending resolution of Citibank’s clawback action for $500 million in mistaken transfers it made to term lenders. That action is currently on appeal before the Second Circuit, after U.S. District Judge Jesse Furman issued a Feb. 16 ruling allowing the lenders to retain the mistaken transfers.
- A New York federal court lawsuit was filed on Aug. 12, 2020, by UMB Bank, as administrative agent to 2016 term loan and as assignee to certain dissenting term lenders, saying the issuance of $200 million of unfunded revolving loans was a “sham” to manufacture lender consent to transaction involving IP transfers and otherwise breached the 20216 credit agreement’s sale-leaseback limitations. The complaint outlined how the unlawful sale-leaseback recapitalizations “ripped away” the IP collateral securing the 2016 term, which is “no longer a fully secured, first-priority obligation” of the company but rather subordinate to $2 billion in loan obligations “(approximately 50% of which simply rolled up existing Term Loans and provided no new money).” Defendants sued were Revlon, former administrative agent Citibank, Jefferies, Ares and the lenders to the 2020 BrandCo facility.
- Transaction: 2016-’17 multistep, refinancing transaction consisting of transfers of IP collateral to unrestricted subsidiaries.
- Steps in IP transaction resulting in IP transfers to unrestricted subsidiaries:
- J.Crew International, a wholly owned subsidiary of J.Crew OpCo, contributed and assigned “an undivided 72.04% interest in certain of its U.S. trademarks with a value of $250 million to J.Crew Cayman,” which is “a non-Loan Party Restricted Subsidiary.”
- Cayman immediately transferred the IP assets to J.Crew Brand Holdings, an unrestricted subsidiary.
- Brand Holdings then contributed the IP assets “through certain remaining Brand Entities to Domestic Brand, all Unrestricted Subsidiaries.”
- According to J.Crew, the multistep IP transaction was a permitted investment, a permitted disposition and a permitted affiliate transaction under the loan agreement, and the contribution of IP assets among J.Crew’s unrestricted subsidiaries was outside the scope of the loan agreement.
- J.Crew International, a wholly owned subsidiary of J.Crew OpCo, contributed and assigned “an undivided 72.04% interest in certain of its U.S. trademarks with a value of $250 million to J.Crew Cayman,” which is “a non-Loan Party Restricted Subsidiary.”
- Included a July 2017 loan amendment, with consent of lenders holding approximately 88% of the $1.57 billion secured term loan.
- Steps in IP transaction resulting in IP transfers to unrestricted subsidiaries:
- Litigation: Two Lawsuits
- A New York state court lawsuit was initiated on Feb. 1, 2017, by J.Crew against Wilmington Savings Fund Society, as term loan agent, to determine - in response to “improper pressure” by dissenting lenders - that no default occurred in connection with the company’s transfers of IP to an unrestricted subsidiary to enable J.Crew to “consider potential value-maximizing strategic transactions … that will benefit all stakeholders, including the Lenders.”
- A separate New York state court lawsuit was commenced on June 22, 2017 (amended on Sept. 8, 2017), by term loan lenders Eaton Vance and Highland Capital Management against J.Crew and Wilmington Savings Fund Society as term loan agent.
- Certain claims were dismissed with prejudice on April 25, 2018, by Judge Shirley Werner Kornreich (affirmed by the New York Supreme Appellate Division on April 25, 2019), which left intact the plaintiffs’ claim that “all or substantially all” of the lenders’ collateral was transferred in the transaction in violation of the term loan credit agreement, particularly provisions that require unanimous consent from lenders for “any transaction or series of related transactions” involving “all or substantially all” of the collateral or guaranty.
- Highland’s claims were dismissed on Oct. 10, 2018, for failure to retain new counsel.
- Certain claims were dismissed with prejudice on April 25, 2018, by Judge Shirley Werner Kornreich (affirmed by the New York Supreme Appellate Division on April 25, 2019), which left intact the plaintiffs’ claim that “all or substantially all” of the lenders’ collateral was transferred in the transaction in violation of the term loan credit agreement, particularly provisions that require unanimous consent from lenders for “any transaction or series of related transactions” involving “all or substantially all” of the collateral or guaranty.
- Bankruptcy: J.Crew filed for chapter 11 protection on May 4, 2020, with its second amended plan confirmed on Aug. 26, 2020, and effectuated on Sept. 10, 2020. The disclosure statement to the plan indicates the debtors believed that the Eaton Vance litigation would be resolved in connection with the transaction support agreement and that any claims relating to the litigation would be classified as other general unsecured claims under the plan.
- A New York state court lawsuit was initiated on Feb. 1, 2017, by J.Crew against Wilmington Savings Fund Society, as term loan agent, to determine - in response to “improper pressure” by dissenting lenders - that no default occurred in connection with the company’s transfers of IP to an unrestricted subsidiary to enable J.Crew to “consider potential value-maximizing strategic transactions … that will benefit all stakeholders, including the Lenders.”
- Transaction: June 22, 2020, non-pro-rata private recapitalization of new money and loan-for-loan exchange.
- $200 million of new money as a priority term loan.
- Exchange of approximately $1 billion in first lien debt and $300 million in second lien debt, at already agreed-to below par prices.
- Reduced company’s debt held by participating lenders by over $400 million.
- Increased liquidity; accelerated the company’s “business transformation plan.”
- Included amendments to first and second lien term loans.
- According to litigation filed by nonparticipating funds, the transaction converted existing first lien lenders into four tranches that, in effect, subordinated nonparticipating lenders to “first out,” “second out,” and “third out” tranches.
- $200 million of new money as a priority term loan.
- Litigation: Two Lawsuits
- Overview: Two lawsuits were filed by separate minority lenders in response to the transaction, first in New York state court, then about a month later in New York federal court. Plaintiffs alleged breach of the first lien credit agreement’s pro rata sharing provisions and that unanimous consent is required for any adverse action, challenging the “open market purchase” characterization of the transaction when it was private. The defendants were Serta; lenders Eaton Vance Management, Invesco Senior Secured Management, Credit Suisse Asset Management and Boston Management and Research; Advent International; and Barings.
- The first lawsuit, filed in New York state court on June 11, 2020, by excluded funds affiliated with Apollo, Angelo Gordon and Gamut Capital, sought to block the transaction, calling it “tantamount” to transforming nonparticipating first lien lenders into unsecured lenders while enabling participating lenders to “leap-frong” into a new superpriority position. The complaint centered on the transaction as a breach of the first lien credit agreement’s waterfall provisions and the covenant of good faith and fair dealing. On June 22, 2020, New York State Supreme Court Judge Andrea Masley denied the plaintiffs’ preliminary injunction request, finding that the “debt-to-debt exchange on a non-pro rata basis” appears permissible “as part of an open market transaction” exception to the waterfall provisions under the credit agreement (emphasis added). This litigation was discontinued on Nov. 30, 2020, as requested by the plaintiffs over defendants’ objection, but without prejudice to refiling.
- The second lawsuit, filed in New York federal court on July 13, 2020 (after Judge Masley in the state court suit preliminary found that the transaction may constitute an open market transaction), alleged that Serta unlawfully deprived excluded first lien lenders of their “first-lien, priority pro rata rights” in favor of a “handpicked group” of lenders. The complaint challenged whether the transaction fit within “open market transaction” provisions, asserting that open-market deals “are offered to market participants generally” rather than being negotiated in private on terms “not available to or even derived from the market” and that the amendments pursuant to which the transaction was effected are null and void because unanimous lender consent is required for any adverse changes to first lien lenders’ pro rata rights. This case was dismissed on March 10 by U.S. District Court Judge George Daniels on the basis of procedural grounds that the court lacked subject-matter jurisdiction.
- Overview: Two lawsuits were filed by separate minority lenders in response to the transaction, first in New York state court, then about a month later in New York federal court. Plaintiffs alleged breach of the first lien credit agreement’s pro rata sharing provisions and that unanimous consent is required for any adverse action, challenging the “open market purchase” characterization of the transaction when it was private. The defendants were Serta; lenders Eaton Vance Management, Invesco Senior Secured Management, Credit Suisse Asset Management and Boston Management and Research; Advent International; and Barings.
- Transaction: August 2020 non-pro-rata private recapitalization, consisting of new lending and “open market” purchases of term loans.
- Up to $110 ($135 as announced) million of new money.
- Rolled up more than $321 ($332 as announced) million of existing term loan debt held by participating lenders at par rather than at market value of 50 to 60.
- Included amendments to the credit agreement, a new intercreditor agreement, a new superpriority lending agreement.
- Up to $110 ($135 as announced) million of new money.
- Litigation: A New York state court lawsuit was filed on Oct. 12, 2020, by an ad hoc group of minority term lenders, saying the transaction “unfairly” favored controlling and conflicted equity sponsor Oaktree and certain of the company’s original first lien lenders “handpicked” by Oaktree. The defendants are Boardriders, equity sponsor Oaktree Capital, Canyon Capital, Marathon Asset Management, Brigade Capital Management, AustralianSuper, MidOcean Credit Fund Management, Corbin Capital Partners, Pontus Holdings, and Redwood Capital Management.
- The complaint alleges that the defendants “exploited” the company’s liquidity need to “enhance their yield on investment” by “improperly diverting” value” in “secret” from nonparticipating lenders and “improperly added new onerous ‘no action’ provisions in the credit agreement” to make it “impractical and financially difficult” for nonparticipating lenders to challenge the misconduct in court. The complaint focuses on the transaction as a violation of the credit agreement’s pro rata provisions, arguing that the debt-for-debt exchanges did not constitute “open market” purchases, but instead were voluntary prepayments that were required to be made on a pro rata basis to all lenders at par, and that such adverse action required consent by all lenders. Prior to filing the complaint, the ad hoc group sent the company a demand letter stating that the company repay all of the existing term loans in full or exchange them for the superpriority term loans.
- The complaint explains that nonparticipating lenders were subordinated in lien priority by up to $431 million of superpriority secured debt, of which $321 was pari passu to the existing term loans held by nonparticipating lenders prior to the transaction. After the transaction became public, the ad hoc group said the trading value of their term loan debt dropped almost 50%, and as of Jan. 28, the loans trade at an approximate 55% discount to the newly created superpriority debt now held by the rollup lenders.
- The complaint alleges that the defendants “exploited” the company’s liquidity need to “enhance their yield on investment” by “improperly diverting” value” in “secret” from nonparticipating lenders and “improperly added new onerous ‘no action’ provisions in the credit agreement” to make it “impractical and financially difficult” for nonparticipating lenders to challenge the misconduct in court. The complaint focuses on the transaction as a violation of the credit agreement’s pro rata provisions, arguing that the debt-for-debt exchanges did not constitute “open market” purchases, but instead were voluntary prepayments that were required to be made on a pro rata basis to all lenders at par, and that such adverse action required consent by all lenders. Prior to filing the complaint, the ad hoc group sent the company a demand letter stating that the company repay all of the existing term loans in full or exchange them for the superpriority term loans.
- The defendants have filed motions to dismiss the complaint on the basis of a no-action clause in the credit agreement requiring that plaintiffs pursue claims through the agent, which were heard on Sept. 10 and 20 and taken under advisement.
- Transaction: September 2020 non-pro-rata private recapitalization, consisting of new lending and “open market” purchases of term loans.
- $120 million of new first-out super senior debt, secured by the same collateral securing the existing first lien debt.
- $307.5 million of new second-out super senior debt issued to participating lenders in a dollar-for-dollar exchange for their existing $307.5 million face amount of first lien debt, which was trading at about 78 cents on the dollar representing a total market value of $239.8 million, or a profit of $67.6 million in immediate profit; secured by the same collateral securing the existing first lien debt, but with a higher priority.
- Included amendments to the credit agreement, a new super senior credit agreement and a new intercreditor agreement.
- $120 million of new first-out super senior debt, secured by the same collateral securing the existing first lien debt.
- Litigation: A New York state court lawsuit was filed on Nov. 9, 2020, by an ad hoc group of minority term lenders, calling the transaction a “cannibalistic assault by one group of lenders in a syndicate against the other,” while the company, a distributor of food service equipment to restaurants, is “hobbled by the pandemic and vulnerable to bankruptcy.” The defendants are TriMark; equity sponsors Centerbridge Partners (which owns 59.8% of TriMark equity) and Blackstone (which owns 26.8% of TriMark equity); and lenders Oaktree Capital, Ares Management, Blackstone, Sculptor and BlackRock. Centerbridge Partners acquired TriMark from Warburg Pincus in 2017.
- The complaint centers on the transaction as a breach of explicit contractual terms protecting pro rata rights as well as “established industry precedent and norms.” If the transaction is allowed to stand, the ad hoc group says it could trigger “the devolution of the leveraged loan market into violence among lenders” with “drastic consequences for the broader financial markets.”
- Some claims (tortious interference, fraudulent transfer and good faith and fair dealing) were dismissed on Aug. 16 by New York Supreme Court Justice Joel Cohen, leaving intact claims for declaratory judgment that the transaction is void and for breach of the original credit agreement. Judge Cohen found the “liquidity transaction” represented a single transaction for the purposes of analyzing the impact on the plaintiff creditors’ “sacred rights” under the original credit agreement and that the plaintiffs therefore “have a plausible argument” that the uptier exchange required their consent, because it “alter[ed] the order of application of proceeds” by subordinating their interest to the new superpriority intercreditor agreement.
Disclosure: Funds associated with Warburg Pincus hold a majority interest in the parent company of Reorg Research Inc.
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