May 10, 2023 - On May 9th, the LSTA hosted a webinar, “Liability Management Transactions: What is an Open Market Purchase Anyway?”, presented by Alston & Bird partners, Paul W. Hespel, Brett D. Jaffe, Ken Rothenberg, and J. Eric Wise. In recent years, the distressed loan market has trended away from in-court proceedings toward antagonistic transactions to effect balance sheet restructurings, commonly referred to as liability management transactions (“LMTs”). Our expert panelists provided an overview of one type of LMT, the uptiering transaction, and a case study of the Serta litigation.
Relaxed credit terms have created opportunities for priming financing outside Chapter 11. In today’s market, drafting holes in sponsor-friendly credit agreements are exploited to avoid the cost and dislocation of a Chapter 11 process. The current trend is an evolution from one type of LMT, the drop-downs of collateral, toward the other type of LMT, senior new money and non-ratable uptier exchanges. In an uptiering transaction, rather than transferring assets outside the credit group, the borrower offers new lenders a claim against the existing credit parties that is contractually senior to the claims of existing lenders. An uptiering transaction will typically be offered to existing (majority) lenders, who will provide all or a portion of the new financing, including by exchanging all or a portion of their existing loans into such contractually senior debt. Such exchanges are typically made at a discount to par and, to facilitate the transaction, the participating existing majority lenders will effect any necessary amendments to the existing credit facility. Notably, in these uptiering transactions, the borrower is not paying cash; rather the lenders are exchanging their debt to the borrower (it is not a cancellation of indebtedness). The result for the borrower is new money loans, reduced overall debt burden (on account of the below-par exchange of existing loans) and often additional covenant flexibility.
LMTs during the global financial crisis led to increased flexibility to provide for additional liquidity and for borrowers to take advantage of depressed prices in the secondary market. As an exception to the pro rata provisions, express provisions of credit agreements became commonplace for loan buybacks by borrowers and/or sponsors, modified Dutch auctions and open market purchases, and because maturity walls were more relevant, partial refinancings and additional financings through “incremental equivalent debt” also became more common. Under the open market purchase provision,a borrower is allowed to purchase loans from individual lenders at discounted prices. When doing this, there cannot be a default or an event of default under the credit agreement, and the borrower must typically cancel the debt upon acquisition. Generally, the pro rata sharing obligation carves out open market purchases so that if the seller sells its debt via an open market purchase, they need not share the proceeds with all the other lenders. The pro rata treatment provisions have traditionally been protected as a “sacred right,” but subject to exceptions to permit for negotiated non-pro rata repurchases.
The panelists explained that typically it has been their experience that when an open market purchase is effected and not in the context of a LMT, a borrower or sponsor reaches out to a trading desk and lets them know that they want to buy back the debt. The sellers are then found and the trade is documented. Because it is not entirely clear what an open market purchase is, credit agreements have tried to clarify the term and may provide, on the one hand, that the consideration paid for repurchases in an open market purchase must solely be in cash or, on the other hand, they may provide that an open market purchase would include privately negotiated purchases to contemplate a Serta situation.
A LMT begins with creditors holding common positions and having common interests in the capital structure identifying each other and forming an ad hoc group. Then that ad hoc group will coordinate with the borrower under an NDA, with a view toward entering into a restructuring support agreement and locking in support for a specific restructuring. The ad hoc group may not even be open to other members of the same tranche. The ad hoc group may choose not to invite others even if they are in the same class or even if aligned to the same purposes because if the group providing the bridge financing is smaller they may be able to capture a larger share of the economics for themselves. This is the backstory of the restructuring of Serta Simmons Bedding and its LMT which resulted in extensive litigation. The lenders that were left out in Serta commenced litigation which ultimately triggered the Serta bankruptcy.
The Serta credit agreement permitted a lender to sell on a non prota basis its loans in a Dutch auction or an open market purchase; the credit agreement made it clear this was an exception to the pro rata sharing provision. Under the Serta credit agreement, the non-ratable uptiering of the pre-LMT First and Second Lien Term Loans relied on the term “Open Market Purchase” as an exception to the ratable sharing rule, which was protected by a 100% vote requirement, to effect unequal treatment of pre-LMT First and Second Lien Term Loans which was at the heart of the litigation.
The panelists reviewed both the state and federal court cases in Serta both of which are stayed as a result of Serta’s Chapter 11 filing. They noted that in the federal court litigation, Serta argued that open market means an arm’s length exchange at fair value. The plaintiffs, who did not know of the LMT, argued that open market means open and thus for a transaction to truly be open it must be open to all lenders — all lenders needed an opportunity to participate in the transaction. While Serta maintained that “open market” can only mean an arm’s-length exchange for fair market value, the court found this is not “the only susceptible meaning of this phrase”. The court maintained that “open market purchase” may also reasonably be construed to exclude transactions “negotiated in private” as part of a “structured debt exchange that was not open to everyone” and continued that “[on] a plain reading of the term, the Transaction depicted in the Complaint did not take place in what is conventionally understood as an open market.” The Court downplayed Serta’s contention that “open market” loan transactions are fundamentally different from conventional “open market” transactions in publicly traded securities.
The court stated that “[it] admits of the possibility” that “the open-market provision may contemplate loan-repurchase transactions that involve fewer than all lenders in any given class of debt.” Finally, the court noted that the defendant had not proffered the “definite and precise meaning” of the term “open market purchase” about “which there is no reasonable basis for a difference of opinion”.
The Serta Confirmation hearing is set for May 15th. As a matter of process, it is possible that on that day Serta’s plan will be confirmed, new debt and equity issued, and for Serta all this litigation will be in the rear-view mirror.
LSTA Market Advisory: Drafting Fixes
As members consider whether and how to address these issues in their deals, they should refer to the LSTA Market Advisory on point. One of the drafting fixes which we have provided in the Advisory sets out the following language for inclusion in credit agreements to address this and protect lenders:
[No amendment, waiver or consent shall] without the prior written consent of each Lender directly affected thereby, (i) subordinate, or have the effect of subordinating, the Obligations hereunder to any other Indebtedness, (ii) subordinate, or have the effect of subordinating, the Liens securing the Obligations to Liens securing any other Indebtedness, or (iii) modify Section [include pro rata sharing, pro rata treatment, post default waterfall an borrower/affiliate buyback mechanics if appropriate] or any other provision hereof in a manner that would have the effect of altering the ratable reduction of Commitments or the pro rata sharing of payments otherwise required hereunder.
A particularly powerful tool for minimizing these LMTs that include a rollup feature would be either to require all borrower buybacks to be pro rata (and specify that for amendment purposes this is a “sacred right” requiring 100% lender consent) or define open market purchase in a way that limits its availability for transactions of this type (by, for example, requiring the repurchase to be brokered or through a trading platform and set at a quoted market price). When you are considering whether to acquire a loan, we urge our members to read the Advisory and review the list of questions set out in the Liability Management Checklist in Annex A to the Advisory. For example, ask yourselves, does the credit agreement permit “open market” repurchases and, if so, how is that defined (if at all)? Will there be a market test or opportunity for all lenders to participate? Is there an aggregate cap?
The panelists left the audience with the question – will credit agreements evolve to provide clarity around the meaning of open market purchases or will the market prefer the ambiguity so that there is flexibility around structuring such transactions? The answer is up to you.
Click here for the slides and replay.