Nothing's Serta-in

Non-pro rata uptier debt exchanges a la Serta: certain considerations for capital structures including New York law-governed European high yield bonds 

The investor community has been understandably focused on the non-pro rata uptier debt exchanges effected by Serta Simmons, Boardriders and TriMark in the United States in recent months. In short, the borrowers in these transactions obtained consent from a simple majority of lenders to create or increase super senior debt capacity under their existing credit agreements, and then used the open market repurchases language in those credit agreements to offer to consenting lenders (but not to all lenders) the opportunity to "roll-up" or exchange their existing debt for super senior debt, thus priming the lenders who were not invited to participate. In some cases, this was accompanied by the injection of super senior new money debt, super senior hollow tranche layering and covenant stripping of the existing debt, all without any prior notice to non-participating lenders.

All three transactions are currently subject to ongoing litigation in the United States. Should the outcome of such litigation confirm the validity of the non-pro rata uptier debt exchanges, this could have a significant impact on future debt restructurings. This is because it is expected that the vast majority of existing New York law-governed credit agreements (and bond indentures as well) contain open market purchases language similar to that which was used to effect the Serta Simmons, Boardriders and TriMark transactions, which, at least in theory, would leave the door wide open for similar non-pro rata uptier debt exchanges to become a standard tool in the restructuring playbook.

Each of the Serta Simmons, Boardriders and TriMark transactions involved debt under credit agreements only. In this piece, in light of the capital structures frequently encountered in the European market, we outline a number of considerations which might impact the ability of borrowers/issuers to structure a "Serta-like" non-pro rata uptier debt exchange where there is a New York law-governed European high yield bond component. In short, these issues add structuring complexities, none of which may be insurmountable on its own, but each of which nevertheless warrants early consideration.

Covenants and Requisite Consent Levels to Amend the Covenants

There are several considerations which might impact the ability of bondholders representing the requisite majority of outstanding debt to effect amendments to an indenture necessary to pave the way for a Serta-like transaction. In particular:

• "Covenant stripping". US case law establishes that bond exit consents are not valid in scenarios where those whose rights are affected by the exit consents are not given the option to participate. In this case, a transaction may be unwound. This means that if, as part of a Serta-like transaction, the borrower proposes to strip the covenants of the minority bondholders who have not been invited to participate in the uptiering debt exchange (as opposed to solely amending the indenture to allow for a super senior tranche of debt in order to facilitate that exchange), they may not be able to achieve this without launching a consent solicitation to all bondholders.¹ However, if the borrower has already secured support for stripping the covenants by the requisite majority of bondholders, it may be that this is merely a formality, with the votes of the minority bondholders not being sufficient to alter the outcome (albeit it would serve as notice to those minority bondholders that a transaction from which they have been excluded is about to happen).²

• Sweeper fundamental rights protective covenant. While most European high yield bond indentures do not have to be qualified under the US Trust Indenture Act, many of them nonetheless contain language taken verbatim from that Act which requires the consent of each bondholder to any amendment if its ability to receive payment on the bonds is in any way affected by such amendment. There is some precedent (albeit not universally accepted) for interpreting "ability to receive payment" broadly and thus requiring all bondholder consent for certain major amendments, including amendments that collectively rise to the level of "covenant stripping". This language, if present, undercuts the 90% supermajority consent threshold common in European high yield bond indentures and would make any restructuring more challenging.

• Payments for consent. Bond indentures typically do not contain a pro rata sharing provision; however, many of those issued in the European market do contain a "payment for consent" covenant (which is rare in US bond indentures). The payment for consent covenant, when worded broadly, would require all bondholders to be offered the same consideration for consent. Therefore, to the extent that a consent solicitation is required to obtain amendments to the indenture necessary to enable a Serta-like transaction to be implemented, it may be necessary for the transaction to be structured such that any consideration offered to bondholders supporting the transaction (such as the invitation to participate in a uptier debt exchange) would not be caught by the payment for consent covenant, otherwise such consideration would need to be offered to all bondholders.³

Securities-Related Considerations

There is an additional layer of securities laws and regulations applicable to bond transactions, which does not come into play in a loan context. In addition, bonds are typically very liquid and are traded on regulated securities exchanges, which necessitates the involvement of additional parties such as bond trustees and the clearing systems. 

• US securities laws:US securities laws may be applicable to exchange offers even in the European bond market, unless such offers are structured to exclude US bondholders (this is permitted in certain instances, e.g. where the US nexus is de minimis, although, as a practical matter, it may be very difficult to confirm whether this is the case until an actual event is likely or has occurred). Key US securities laws considerations include:

• Rule 10b-5 of the US Securities and Exchange Act of 1934 imposes liability under US securities laws for any fraudulent, deceptive or manipulative acts or practices in connection with the purchase or sale of any securities. Because this rule extends potential liability to all parties providing information in connection with the relevant transaction (i.e. both the issuer and the underwriters and their respective advisors), it tends to promote heightened caution and extensive due diligence by all parties involved and has a potentially chilling effect on the execution of more aggressive structures. Standard remedies in 10b-5 cases are expectation or benefit of the bargain damages, plus legal fees and expenses, or rescission of the transaction. The outcome of the ongoing litigation in respect of the Serta Simmons, Boardriders and TriMark transactions, and in particular the allegations of breach of an implied covenant of good faith and fair dealing, will likely impact the possibility of 10b-5 causes of action being brought in connection with future Serta-like transactions involving a bond component.
• Tender offer rules may be implicated, thus requiring that any exchange offer: (1) remain open for a minimum of 20 US business days (with 10 business day extensions each time a material amendment to the offer terms is made) unless the tender offer fits within the terms of the Abbreviated Tender or Exchange Offers for Non-Convertible Debt No-Action Letter, (2) provide a significant amount of disclosure (i.e. some form of a disclosure memorandum), and (3) in the case of an offer with any equity and/or convertible bonds component, be open to all holders of securities of the same class. Depending on the specifics of the issuer's capital structure and the composition of the bondholder group at any given point in time, there may be ways to tailor the transaction such that the tender offer rules do not apply, or do not apply in such a way that prevents the desired transaction, but this may not be straightforward. For example, if only a few large bondholders collectively represent the requisite majority of outstanding debt, the transaction could be structured as two separate steps: (1) a simple majority consent solicitation to amend debt covenants to permit or increase super senior debt capacity and (2) a private exchange offer to enable only those large bondholders to benefit from an uptier debt exchange.⁴

• EU Directive 2004/25/EC: The directive provides that all securities holders must be treated equally and must have sufficient time and information to enable them to reach an informed decision. If applicable, the directive would limit the ability of an issuer to make a non-pro rata exchange offer to bondholders. Note that this directive applies to a company that is incorporated in an EU Member State or that has securities listed on a regulated securities exchange located within an EU Member State (e.g. the Luxembourg Stock Exchange or Irish Stock Exchange). Therefore, this directive may not apply, for example, (after December 31, 2020) to a UK-incorporated issuer whose equity securities are privately held and whose debt securities are listed on an exchange outside the EU (e.g. The International Stock Exchange in the Channel Islands). It is, however, worth noting that the listing rules of non-EU regulated securities exchanges may contain equal treatment of holders language that is similar to that in EU Directive 2004/25/EC. Most of the time, the sole remedy for violation of such rules is the delisting of the securities from the exchange, but while it is possible to re-list the securities on a different exchange (that does not have the equal treatment of holders language), such delisting and relisting may raise some reputational concerns.
• Clearing systems: To the extent that it is not possible for the desired transaction to be negotiated and effected pursuant to direct, bilateral communications with identified bondholders, any communications with bondholders would need to take place via clearing systems (in Europe, typically Euroclear or Clearstream). The clearing systems are not set up to distinguish between different categories of bondholders, so all information and any exchange offer would be sent to all bondholders who could then participate in the exchange offer. However, it may still be possible to structure the exchange offer to give (but not guarantee) in-the-know bondholders an advantage, e.g. acceptance on a first-come first-serve basis in the case of a partial tender, or to be open only to bondholders who meet a narrow set of criteria.
• Trustee: To implement any amendments to a bond indenture, a trustee for the bondholders must sign all necessary documentation on behalf of the bondholders. Although a typical indenture provides the trustee with robust indemnities, market practice reveals that trustees are often reluctant to effect a transaction structure that has not been fully tested in the market and/or the courts without clear instructions from requisite bondholders, independent legal advice and additional indemnity comfort.

Intercreditor Agreement

In Europe, it is common to have a comprehensive English law-governed intercreditor agreement in place, which governs relations between stakeholders across a borrower's capital structure, including term loan and bond debt, as well as subordinated sponsor and intercreditor liabilities (even if some of these tranches of liabilities do not exist at the time the initial transaction is being negotiated; the provisions are inbuilt as "hollow tranches" for future flexibility, should such tranches be created at a later time). In the United States, unless there is existing first lien and second lien debt, it is common not to have an intercreditor agreement which governs relations between stakeholders across a borrower's capital structure, nor with "hollow tranches" in place, as the U.S. Bankruptcy Code generally sufficiently governs relations between various layers of debt in the absence of a contractual arrangement.

While top-tier large-cap sponsor transactions tend to have fairly permissive (from the borrower's perspective) intercreditor agreements, which generally allow for and regulate any debt that is permitted by the underlying debt documents (as they may be amended in accordance with their terms)⁵, the intercreditor agreement is a bespoke document, and the level of permissiveness varies from transaction to transaction. For example, certain intercreditor agreements may impose additional anti-layering restrictions and pro rata requirements that might offer protection against a Serta-like transaction. It is worth noting that European intercreditor agreements often specifically disapply pro rata provisions in respect of permitted debt repurchase transactions; however, the basis on which such transactions may be effected by a borrower tend to be more restrictive (for example, requiring a Dutch auction or some other form of pro rata solicitation to be conducted prior to the consummation of bilateral repurchases from individual lenders; there may also be restrictions on sources of funding that may be used to make the purchases). In addition, the amendment of payment waterfalls under an intercreditor agreement may require all lender consent, and where multiple classes of debt rank pro rata (which is likely to be the case in a typical European pari bank/bond structure), this will likely create additional complexity, as consent from (and therefore incentivisation of) potentially two or more groups of lenders may be required in order to effect the amendments necessary to allow a Serta like transaction.

English Case Law Protecting Minority Creditors

If there is a relevant UK connection, it may be possible for minority creditors who are not invited to participate in an uptier debt exchange a la Serta to challenge the transaction on grounds that the English case law principle which protects the minority of a class of stakeholders from the improper exercise of majority voting powers has not been respected.⁶ This principle provides that a majority voting power must be exercised in a bona fide manner for the purposes of benefitting the best interests of the relevant class of stakeholders as a whole. While the mere fact that a minority of lenders affected by a transaction have been relatively disadvantaged does not automatically mean that a majority voting power has been exercised improperly, and the English courts do recognise that economic rights (particularly where these have been negotiated between sophisticated investors advised by legal professionals) must be protected, if there is evidence to suggest that a majority voting power has been exercised for a collateral purpose, the transaction may well find itself subject to close scrutiny by the English court.

This piece highlights just some of the considerations that might be relevant in structuring a Serta-like transaction in a New York law-governed European high yield bond context; it is not intended to be a comprehensive list. While none of the above issues may be insurmountable individually, all or some of these considerations taken collectively will likely make structuring any transaction more complex. 

With the litigation in respect of the Serta Simmons, Boardriders and TriMark transactions ongoing, non-pro rata uptier debt exchanges are being closely scrutinised, and this area is fast developing. We have not (yet) observed a change in the drafting of documentation governing new European loan and bond issuances in response to these cases, but it will be interesting to see if the outcome of the ongoing litigation begins to create pressure towards tighter documentation or impacts other aspects of European financing deals, particularly as lenders and bondholders excluded from a Serta-like transaction on one case may well be the lenders and bondholders anchoring a Serta-like transaction on another.

Watch this space. Nothing's yet Serta-in!

Authors: Natalia Sokolova, Anna-Marie Slot, Doug Murning and Ru-Woei Foong.

1. We understand that in the case of Boardriders and TriMark, the existing credit facilities were "covenant stripped" by consent from the requisite majority of lenders, and in the case of Boardriders this was done without any prior notice to non-participating lenders.
   
2. "Covenant stripping" also can implicate consideration of whether the scope of the amendments rise to the level of creating a new security and whether or not that is being offered to all holders. While there is general consensus around certain covenants being removed with a simple majority consent, detailed review of the terms of the covenant  strip and the applicable indenture is required in each instance. The "new securities" doctrine is a complicated matter under US securities laws and is beyond the scope of this briefing.
3. The next question is whether this covenant could be deleted or amended with a simple majority consent (in most cases, it is not specifically listed as one of the "sacred rights" amendments requiring supermajority consent, but it could be interpreted as an amendment of one of the money terms that do require supermajority consent). It is worth noting that the more narrowly worded payment for consent covenant may be interpreted as not requiring the offer to be made to all holders, but rather requiring all holders to whom the offer is made to be offered the same consideration for consent. A careful analysis of the specific wording of the covenant would be required.
4.  Alternatively, a small number of private exchange offers could be effected as open market repurchases; however, the issuer would need to be wary of these constituting a "creeping tender offer" whereby open market repurchases completed over a period of time add up to actions which amount to a tender offer, based on a facts and circumstances analysis of what are referred to as the "Wellman" factors established by US case law. In this scenario, and the scenario outlined above, the steps might be vulnerable to an argument that they constitute part of the same wider transaction to which the tender offer rules are applicable.
5. With regard to new tranches of debt, it may be that these are either specifically regulated for pursuant to the day 1 terms of the intercreditor agreement or, if they are not, the intercreditor agreement may permit the security agent to make facilitation amendments to the intercreditor agreement to enable such new debt financing to be structured in.
6. The leading case on this principle is Redwood Master Fund Limited and Others v TD Bank Europe Limited and Others [2006] 1 BCLC 149. Azevedo v IMCOPA - Importacao, Exportaacao e Industria de Oleos Ltda [2012] EWHC 1849 (Comm) and Assenagon Asset Management SA v Irish Bank Resolution Corp Ltd (formerly Anglo Irish Bank Corp Ltd) [2012] EWHC 2090 (Ch) confirmed that the principles identified in Redwood in the context of loan syndicates also applied to bondholders. The Azevedo case determined that consent fees on their own would not normally constitute a fraud on the minority. Briggs J in Assenagon also suggested that clearly worded contractual provisions might exclude the application of minority protection principles.