Considerations for U.S. Boards when Contemplating a Liability Management Transaction

As liability management transactions (LMEs) become increasingly prevalent, directors are frequently called upon to evaluate these complex transactions.

We outline key considerations for boards contemplating these transactions under Delaware law.

LMEs are strategic transactions implemented by borrowers, often at the request of a key group of lenders, to take advantage of flexibility in current loan documentation. Typically, LMEs take the form of one of the following three transaction structures:

1. Drop-Down Financing: A borrower transfers material assets (often material intellectual property or a valuable business unit) to an unrestricted subsidiary (which is excluded from the loan agreement covenants) or a non-guarantor subsidiary, in each case resulting in the liens on the underlying assets being released. Structurally senior debt is subsequently incurred at the unrestricted subsidiary/non-guarantor subsidiary from existing lenders, private equity sponsor, or third parties, with proceeds on-lent to the borrower to fund cash flow shortfalls and bolster liquidity. Participating lenders end up with structurally senior debt and non-participating lenders are left with subordinated debt.
2. Uptier Transaction: A borrower incurs new money “super-priority” loans provided by a group of existing lenders that is senior to the company’s existing debt, with existing debt of participating lenders exchanged for or “rolled up” into (typically a lesser amount of) “second” priority loans, while existing loans of non-participating lenders are effectively subordinated to a “third” priority position.
3. Double-dip: A borrower creates a new subsidiary that is not a guarantor of the company’s existing debt (NewCo) which incurs new debt from participating lenders. The transaction creates two separate claims against the same source of credit support whereby: (1) the existing borrower and guarantors under the company’s existing secured debt guarantee NewCo’s debt, and (2) NewCo on-lends the proceeds of the new debt to borrower/guarantors and pledges that receivable to its lenders. In a “pari plus” transaction (a variation of the Double-dip), the new debt receives the benefit of additional guarantees and collateral that the lenders to the existing borrower do not receive, in addition to pari passu credit support from the existing credit group.

Companies and sponsors pursue LMEs to, among other things, extend maturities, raise liquidity and/or de-lever (at times by capturing debt discount). Existing creditors often push companies to pursue such transactions to enhance credit protections, improve their rate return through new money financings, exchange or extend debt at favorable prices, and position themselves better for a potential Chapter 11 restructuring. Recent studies have shown that about half of LMEs undertaken since 2016 do not prevent a future default or bankruptcy filing.

LMEs have become prevalent in the market since the J. Crew transaction in 2016 (which is generally regarded as the first high-profile drop-down transaction). LMEs have been described as forms of “lender on lender violence” or “tranche warfare” as participating lenders receive enhanced priority and economics to the exclusion of non-participating lenders. As a result, many lenders in the market have responded by demanding certain minority lender protections in loan agreements, frequently dubbed as “LME blockers.”[1]

Given the strategic importance of and potential creditor litigation inherent in LMEs, boards should carefully navigate their fiduciary obligations throughout the decision-making process. Under Delaware law, boards of directors owe fiduciary duties to represent the best interests of the corporation and its stakeholders. Generally speaking, the duty does not extend to creditor unless the company is insolvent. The two core fiduciary duties are the duty of care and the duty of loyalty and good faith.

With respect to the duty of care, Delaware law provides significant protection through the Business Judgement Rule under which directors are protected from being second-guessed on the merits of individual business decisions, meaning directors cannot be penalized for making what turns out to be a bad business decision, so long as the decision was made in good faith and on an informed basis.

Before embarking on LME discussions, boards should develop a sufficient record that they have considered alternative avenues (i.e., solicited proposals from existing and third-party lenders and evaluated other transactions such as equity raises or asset dispositions) and have obtained the advice of qualitied professionals, which may include lawyers, financial advisors (which advise on operational improvements to improve margins and liquidity) and investment bankers (which advise on balance sheet transactions and lender negotiation dynamics). Board should also analyze their directors’ and officers’ (D&O) insurance policies. Ensuring adequate coverage is in place before entering into potentially contentious negotiations is a prudent risk management step. A number of insurance companies now offer policies solely to cover potential exposure (particularly litigation) arising out of LMEs.

LMEs can involve complex conflicts of interest that trigger heightened scrutiny. Many LMEs involve a sponsor or related parties investing additional capital to facilitate the broader transaction, creating a situation where a controlling stockholder or other interested party may be on both sides of the transaction. In such circumstances, board actions may be examined under an “entire fairness” standard rather than the deferential Business Judgement Rule. This higher bar requires demonstrating both fair dealing (process) and fair price, with the defendant bearing the burden of proving “entire fairness” at trial.

To address these potential conflicts and shift the burden of proving entire fairness, boards typically establish a special committee process involving the appointment of independent directors to the board and a newly formed special committee. The special committee can establish procedures and timetables, retain professionals, negotiate the transaction, analyze the economic fairness of the offer(s), and either present recommendations to the full board or have fully delegated authority to approve the transaction.

Over the past decade, an entire industry of independent directors specializing in the analysis of LMEs has emerged. Such directors are often appointed to boards by sponsors when a company faces an impending catalyst for a liability management transaction (i.e., an impending maturity, projected covenant breach, liquidity shortfall or the company’s existing debt is trading at a discount). These directors provide comfort to board members and lenders alike as they have credibility with stakeholders and experience in evaluating similar transactions.

From a legal review and board oversight perspective, close scrutiny should be paid to existing documentation to ensure that the proposed LME is permitted and that requisite consent from existing creditors is obtained. Boards should receive briefings on the terms and process to ensure risks are appropriately considered. Lenders, particularly minority lender groups, have been known to try to block an LME through an injunction otherwise seek damages following consummation of the LME. Particular attention should be paid to:

• Indebtedness, lien, investment and restricted payment covenants
• Amendment provisions (if the LME requires amendments to existing documentation)
• Affiliate transaction covenants (if implicated by the underlying transaction)

Furthermore, boards should pay close attention to the material terms of the proposed LME as documentation often requires enhanced reporting, tighter covenants, more limited baskets (i.e., exceptions to the debt, lien, investment and restricted payment covenants) and other lender protections, including potentially LME blockers. Particular care should be taken to ensure that the company can continue normal operations post-LME closing despite the tighter debt documents.

LMEs present both opportunities and risks for distressed companies. They can present a path forward to a forbearance, restructuring and financing. But they can also result in litigation and might not save the company from a formal proceeding. Directors are called upon to navigate complex fiduciary duties, potential conflicts of interest and intricate documentation requirements. By establishing robust processes—including special committees where appropriate, thorough documentation review, and careful consideration of all strategic alternatives—boards can fulfil their fiduciary obligations and protect themselves from liability.

[1] For additional information on LME blockers, see our October alert memo available here.