June 25, 2020 - This week saw the closing of a transaction by Serta Simmons that was the subject of much attention and concern in the market. Interestingly, it is one of the types of transactions that Covenant Review foreshadowed in their prescient report “Priming Debt and Inside Maturity Debt Allowed Under US Credit Agreements”. (To request a copy, click here). Covenant Review explained that priming debt can take the form of (1) new debt that is contractually senior in right of payment and/or security to the relevant credit facility (as in Serta), (2) structurally senior debt at non-guarantor subsidiaries (think Travelport and Cirque du Soleil), and/or (3) debt that is secured by structurally senior liens on non-collateral assets (Revlon). Notably, they also report that their CS Lev Loan Index analysis suggests that only 6% of the related credit agreements require affected/all lender approval to effect such subordination. Following is a brief summary of the Serta transaction, the hotly contested litigation surrounding it and the possible implications of priming debt generally for the market.
Background. In late 2016 Serta entered into credit facilities that included a $1.95 billion first lien loan, a $450 million second lien, and a $225 million ABL. Serta had been struggling well before the outbreak of the coronavirus and the pandemic only exacerbated the company’s troubles. In early June 2020, the company announced a proposed transaction under which it would create $200 million of super priority first-out debt, $875 million of super priority second lien debt and the capacity to incur an unspecified amount of super priority third lien debt. The first-out new debt consisted of new money and the second-out debt was offered in exchange for about $1.3 billion in existing loans. Importantly, the offer to fund the new money and exchange the existing debt was extended only to the holders of a bare majority of the first lien and second lien debt; the remaining lenders would be subordinated to the holders of the priority loans.
Litigation. A number of the minority lenders who were not offered the opportunity to participate sued in New York State Supreme Court to block the transaction, arguing that it violated the terms of the credit agreement. (Notably, some of the plaintiffs in this case had earlier proposed their own priming transaction, offering to provide additional debt in a “J-Crew” transaction” secured by some of the company’s intellectual property that would have moved the assets beyond the reach of the other first lien lenders). The plaintiffs alleged that the company and the majority lenders breached the credit agreement by entering into a transaction support agreement that would effectively release all or substantially all the collateral and alter the pro rata distribution provisions of the “waterfall” without obtaining the consents of all of the affected lenders. The defendants countered that the proposed transaction needed only a majority vote rather than the vote of all affected lenders because there was no “anti-subordination clause” in the credit agreement and subordination could be accomplished with a simple majority vote. They further argued that the remaining elements of the proposed transaction, including the creation of the priority loans, could also be done with credit agreement amendments approved by only a majority lenders. After a hearing, the court denied the plaintiff’s motion for a TRO and preliminary injunction. For a preliminary injunction to be granted a plaintiff must establish the likelihood of success on the merits, the danger of irreparable harm in the absence of a preliminary injunction, and the balance of the equities in its favor. The court found that none of the elements applied here. While an analysis of the court proceedings is beyond the scope of this article, Covenant Review has recently published a thorough and thoughtful analysis.
Takeaways. “Given today’s environment and the desperation of so many increasingly stressed loan issuers planning on doing something similar”, Covenant Review sees the Serta court case as very pivotal, possibly leading to more so-called priming “out-of-court roll-ups” without requiring the consent of affected lenders. This may surprise regular-way lenders who assumed that pro rata provisions requiring affected lender consent protected them from having similarly situated lenders jump ahead of them. On the other hand, it is no secret that credit agreement terms have gotten looser over the past few years and market participants may be experiencing the implications in some stressed transactions.