The leveraged-loan restructurings known as liability management exercises (LMEs) climbed to record levels as troubled borrowers sought to avoid bankruptcy. But the contentious out-of-court transactions have been somewhat tempered by legal rulings as senior lenders continue to defend their interests.
The restructurings, enabled by weak lender protections in loan documentation, generally seek to extend loan maturities, lower interest rates, or otherwise provide relief to debtors. When debt trades below par but the borrower urgently needs cash, aggressive LMEs can be an enticing option. They can result in a transaction’s value shifting in favor of a bare majority of lenders and against the minority.
According to Pitchbook | LCD’s trailing 12-month calculation, distressed LMEs resulting in non-pro rata outcomes for groups of lenders reached a record high of 38 last December. That compared with 21 in December 2023 and nine a year before that.
LMEs this year fell off slightly through March before increasing in April.
“We’re likely to see more of those transactions” because of market and economic uncertainties, said Jared Muroff, stressed/distressed research manager at credit analysis firm Octus. “LMEs save time and money compared to bankruptcy, and they provide less of a reputational hit.”
LMEs were particularly aggressive in 2023 when multiple borrowers pursued non-pro rata up-tier exchanges. In up-tiers, currently the most common form of LMEs, new debt is issued that holds priority over senior debt held by lenders outside the LME. Many of the LMEs transferred more than 50% of company value to the steering lender groups. In the cases of Wesco Aircraft Holdings (doing business as Incora) and Mitel Networks, 100% of value was transferred, according to Octus.
Such LMEs have resulted in litigation. However, numerous up-tier exchanges’ transaction-value transfers fell to low double-digit and even single-digit percentages last year, Octus says. The trend began when U.S. Bankruptcy Judge Marvin Isgur in the Southern District of Texas in January 2024 permitted a challenge by minority lenders to an Incora multi-step up-tiering transaction to continue.
Shai Schmidt of Glenn Agre Bergman & Fuentes
A subsequent ruling by the same judge in the Incora case invalidated the strategy in which the company issued new bonds to provide a subset of bondholders with the two-thirds consent necessary to release liens. The lenders then exchanged their unsecured bonds for newly issued secured bonds, which rendered other formerly secured borrowers unsecured.
“One of the rationales behind Judge Isgur’s ruling was that an issuer may not circumvent a contractual prohibition by breaking a transaction into multiple self-executing steps that achieve the same impermissible outcome,” said Glenn Agre Bergman & Fuentes partner Shai Schmidt.
He added that the Incora decision and prior New York court denials of motions to dismiss LME-related lawsuits may have given excluded lenders additional leverage in restructuring negotiations.
Out-of-court LMEs that followed in 2024 resulted in value transfers of less than 15%, including those for Eyecare Partners, City Brewing, Valcour, and Empire Today, according to Octus. Minority lenders that are less disadvantaged may choose not to litigate.
“If a lender is losing 10% of its value, that may feel more like a loan backstop fee, and it might not be worth taking up arms to litigate,” Muroff explained.
While some LMEs have provided minority lenders with better terms, borrowers have continued to pursue significant value transfers via up-tier LMEs as well as drop-downs. In the latter, the borrower transfers collateral to a subsidiary that is unrestricted by the loan documentation. The subsidiary then proceeds to issue new debt secured by the transferred collateral to a new, typically majority lender group.
Octus noted that AMC Entertainment and Del Monte pursued transactions combining drop-downs and up-tiers that created sufficiently disparate outcomes to prompt litigation.
A November 2024 Moody’s Investors Service report, “Investors are winning name-brand protections even as newer risks grow,” said that after two years of elevated defaults punctuated by aggressive LMEs, lenders had succeeded in incorporating some version of protections, or blockers, against common LMEs named after their precedents. Those name-brand blockers include Serta, J. Crew and Chewy. Moody’s found 89% of credit agreements it sampled with some form of “Serta protection.”
Such blocker language, however, may give lenders a false sense of security, Moody’s said, as the protections “are limited in scope and rife with loopholes.”
Court rulings may also provide only limited protection. At the end of 2024, the U.S. Court of Appeals for the Fifth Circuit in New Orleans ruled in favor of minority lenders in the long-running Serta Simmons Bedding case. It overturned a bankruptcy-court decision that said the private sale of senior notes to the steering lenders in the up-tier LME constituted an open market purchase. An open market purchase is an exception to the pro rata sharing sacred right in credit agreements that requires all lenders of similar positions be treated equally.
Steve Wilkinson, managing director at S&P Global Ratings, said the Serta and earlier decisions increase litigation risk and the probability of an adverse outcome for borrowers and the steering lender group. That may be pushing them to pursue more consensual LME restructurings that involve most if not all lenders.
Nevertheless, he said, borrowers and their sponsors are discussing ways to insert more flexible language into documents.
“On a go-forward basis, the restrictions from this court ruling don’t preclude them from using tactics similar to those that have been so dominant over the last year or so,” Wilkinson said.
As 2024 drew to a close, an up-tier LME for Better Health, which Octus described as transferring 63% of its value to the majority lender group, was about to make use of the open-market-purchase exemption established by Serta. When the Fifth Circuit’s Serta decision arrived on December 31, the borrower and the steering group of lenders, advised by Davis Polk and Houlihan Lokey, quickly changed course to an “extend and exchange” strategy. It created a new class of debt by extending the maturity date of the loans held by the majority group.
“If you create a new class, then arguably you’re not subject to the pro rata sharing provision,” said an attorney familiar with the transaction who was not authorized to comment publicly.
Oregon Tool followed suit with the same approach in February, and while the LME was less aggressive, it still disadvantaged minority lenders.