Liability management transactions ("LMTs") are gaining traction in the world of debt financing. Where borrowers and debt issuers are experiencing financial difficulties to meet their obligations with respect to existing credit facilities, bonds and other debt obligations, they use LMTs to restructure their existing liabilities to obtain additional liquidity without unanimous consent of existing creditors.
What are Liability Management Transactions?
There are two common approaches to LMTs. Drop-down transactions occur where a borrower utilizes the available capacity in one or more "baskets" under the restrictive covenants contained in its existing credit agreement to transfer certain of its assets to an affiliated entity with the goal of using such transferred assets as collateral to obtain new secured debt from a third party financing source, all without the need to obtain consent of its existing creditors. For instance, in 2016, J. Crew transferred its "crown jewel" intellectual property that constituted collateral securing J. Crew's existing term loan to an unrestricted subsidiary by utilizing a combination of three separate baskets available in its credit agreement. Because the unrestricted subsidiary was not subject to the restrictions under the credit agreement, J. Crew, through the unrestricted subsidiary, was then able to use the transferred intellectual property as collateral to secure an additional financing in an effort to de-lever its balance sheet. From an existing creditor's perspective, this type of LMTs effectively removes valuable collateral supporting their loans.
Uptiering transactions are LMTs where a borrower amends certain terms of its existing loan that may not require unanimous lender approval (such as the pro rata sharing provisions or the waterfall provisions) with support of a group of "participating" majority lenders in a manner that benefits the borrower and those participating lenders at the expense of the remaining "non-participating" lenders. Under such arrangement, the participating majority lenders would agree to provide additional, new "priming" loans at a discount to the borrower in exchange for their existing loans. Such new "priming" loans would be structured to have lien and/or payment priority over the loans held by the non-participating minority lenders. This type of LMTs has the effect of diluting the value of the collateral supporting the loans held by the remaining minority lenders and/or the minority lenders actually losing their priority as a result of their loans becoming subordinate to not only the new "super-priority" loans but also the "rolled-up" second priority loans of participating lenders. For example, Serta Simmons Bedding LLC entered into an uptiering transaction in 2020 that resulted the minority lenders in a subordinate position to over $1 billion of new super priority and rolled-up second priority loans. This type of LMT can result in high profile litigation and the LMT being challenged by the excluded, non-participating creditor groups.
A "double-dip" is another, more recent type of LMTs. In a "double-dip" LMT, a newly formed unrestricted "shell" subsidiary becomes a borrower for a new credit facility guaranteed by the parent company that is a party to an existing credit agreement. This guarantee provided by the parent gives rise to the "first dip" of claim by the new lender. The "second dip" is created where the subsidiary uses the proceeds of the new credit facility to fund an intercompany loan to the parent and the intercompany receivable is pledged as security for the new credit facility.
How does the Oppression Remedy help existing Creditors?
Existing creditors, however, are not without defence against LMTs that attempt to circumvent their rights under existing credit agreements and debt arrangements. While historically more commonly known as a remedy for minority shareholders, the oppression remedy potentially offers some leverage for existing creditors.
In BCE Inc. v. 1976 Debentureholders, the Supreme Court of Canada emphasized that the oppression is an "equitable remedy", which look at not only what is legal but also what is fair. The reasonable expectations of the parties underpin the assessment of what is "just and equitable".1 For a claim under the oppression remedy to succeed, a claimant must satisfy a two-part test: (1) whether there was a reasonable expectation, and (2) whether such reasonable expectation was breached in a manner that amounts to "oppression", "unfair prejudice" or "unfair disregard" of relevant interests.2 Although neither the Canada Business Corporations Act3 nor the Ontario Business Corporations Act4 expressly include a creditor or lender as part of the definition of "complainant" for the purpose of oppression and other remedies, the courts have recognized creditors as "proper persons" for oppression remedy claims.5 As an equitable remedy, the oppression remedy allows a court to make any order they see fit, including overriding contractual provisions and setting aside transactions.
In the context of LMTs in a financing transaction and the use of the oppression remedy, the central question is whether the LMT proposed by the debtor would be "unfairly prejudicial to" or have "unfair disregard" for the interests of the existing creditors with respect to their reasonable expectations under the existing debt arrangements. Of particular relevance, the Supreme Court of Canada in BCE identified preventive steps as a consideration in the assessment of reasonable expectations and stated that "it may be relevant to inquire whether a secured creditor claiming oppressive conduct could have negotiated protections against the prejudice suffered".6 Therefore, while the oppression remedy is potentially available to creditors that are unfairly prejudiced as a result of LMTs, creditors should also ensure the provisions and covenants in the credit agreements and indentures sufficiently address any vulnerabilities they can reasonably foresee.
Conclusion
At a time of increased financial difficulties for many borrowers, lenders can protect themselves from unexpected LMTs by strengthening their credit agreements, such as (i) limiting the categories of assets that can be transferred or disposed into unrestricted subsidiaries, or the investment basket a loan party can utilize for investments into unrestricted subsidiaries, (ii) removing the concept of, or ability to designate new subsidiaries as, unrestricted subsidiaries, (iii) ensuring that the priority of liens and payment can be modified only with unanimous or supermajority lender consent, and (iv) prohibiting the borrower's ability to repurchase debt on non-pro-rata basis. If a borrower manages to get past some or all these defensive provisions and employs a LMT that is unfairly prejudicial to the existing lenders or unfairly disregards their relevant interests in a manner that breach their reasonable expectations under the credit agreement, the oppression remedy provides another recourse for a lender under the respective governing legislation.
Footnotes
1. BCE Inc. v. 1976 Debentureholders, 2008 SCC 69 at para 58 [BCE].
2. Ibid at paras 56, 67-68.
3. Canada Business Corporations Act, R.S.C., 1985, c. C-44, s. 238.
4. Business Corporations Act, R.S.O. 1990, c. B.16, s. 245.
5. See e.g.: Canadian Opera Co. v. 670800 Ontario Inc., [1990] O.J. No. 2270 (Gen. Div.); Downtown Eatery (1993) Ltd. v. Ontario, [2001] O.J. No. 1879 (ON CA), Hayat v Raja, 2016 ONSC 6805 [Hayat].
6. BCE Inc. v. 1976 Debentureholders, 2008 SCC 69 at para 78.
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