Key Takeaway: In the wake of several contested transactions that have occurred in recent years, borrowers and lenders (together with their respective legal counsel) must understand the implications stemming from certain provisions included in many loan agreements. The “Double Dip” transaction is among the newer concepts that have surfaced. Parties to existing credit facilities and those entering into new facilities should carefully review their loan documentation to determine what is and is not permissible. 

As in many other industries, legal and finance professionals package complex concepts into a familiar phrase or term. Those who negotiate, document and interpret sophisticated leveraged loan transactions are no different. Terms like the ‘Double Dip’ and ‘Nieman Two-Step’ may sound like viral dance moves to the uninitiated; ‘Chewy’ and ‘J. Crew’ could refer to items on a to-do list. Instead, those terms relate to concepts that have surfaced in certain commercial loan transactions in recent years. 

These concepts, often referred to as “liability management transactions”, are utilized by borrowers to provide flexibility to restructure their existing liabilities and free up liquidity that, on the surface, are restricted by the covenants contained in their existing credit facilities. Liability management transactions are possible only if the underlying loan documentation is drafted in a way that permits such transactions (or at least does not block them). When first utilized, many of the existing lenders in liability management transactions did not (a) appreciate that the transactions were permissible under the terms of their loan documentation or (b) support them because, from their perspective, liability management transactions could have a material adverse impact on the value of the collateral supporting the loans they agreed to fund. Depending on the type of liability management transaction implemented, lenders viewed them as (i) removing valuable collateral supporting their loans (a concept sometimes referred to as ‘leakage’), (ii) diluting the collateral supporting the loans by allowing other lenders to either share the collateral on a pari passu basis, or usurping the existing lenders’ first lien priority over the collateral. 

The lenders’ concern is that in the event a borrower files for bankruptcy, the collateral supporting such borrower’s obligation to repay the loans will not be sufficient to make the lenders whole. In each case, new or existing lenders constituting a voting bloc obtain a superior or pari passu security interest in the collateral that was, until the liability management transaction took place, solely supporting the loans provided by the existing lenders. Although this process is often referred to as ‘creditor on creditor’ violence, courts have been reluctant to support the argument that the borrower and the majority bloc of lenders violated New York’s implied covenant of good faith and fair dealing. However, that does not mean courts will not take that position in the future if different facts are presented. 

Historically, two types of liability management transactions have been utilized by borrowers: (i) drop-down transactions and (ii) uptiering transactions. In drop-down transactions (such as J.Crew), valuable assets supporting existing lenders’ loans are transferred (or dropped-down) to an unrestricted subsidiary of the borrower (an entity that neither provides credit support for existing loan obligations nor is subject to the covenants in the existing loan documentation). Once freed from these restrictions, this collateral can be used to secure additional debt that would have otherwise not been permitted to exist.

In uptiering transactions (such as Serta Simmons), a majority block of lenders that are party to an existing credit facility (typically referred to as “required lenders”) agrees to provide additional funding to a borrower. In exchange for this additional funding (which usually refinances the old debt on terms more favorable to the borrower) the new debt is supported by liens on the collateral that are contractually superior to or pari passu with the existing liens on the collateral. The minority creditors are usually left with a dilemma of resisting and retaining an inferior collateral position and eviscerated covenants or accepting the new deal with less favorable terms. It is effectively a coercive debt exchange. 

In both drop-down and uptiering transactions, existing lenders who do not participate in the new financings face the result of having their existing collateral removed from their reach entirely, having to share it ratably with the new lenders or even or losing their status as the first lien creditors. The existing lenders did not anticipate these possibilities when they agreed to provide the loans, and viewed their liens on the collateral as airtight. 

A third type of liability management transaction, known as a “Double-Dip”, has recently gained notoriety. It has existed in other forms in the past, but usually for a bona fide business purpose unrelated to securing additional funding otherwise considered impermissible in the loan documentation. A Double-Dip transaction may adhere to variations on the following structure:

1. A company (“Company”) identifies or creates a subsidiary entity that has no assets to be the borrower (“SPV Borrower”) under a new credit facility (“SPV Facility”).
• This new entity will likely be an unrestricted subsidiary of the Company because it is neither a guarantor of, nor subject to the restrictions in, the existing credit facility.
2. The Company or another entity that is subject to the covenants and restrictions in the existing credit facility (“SPV Guarantor”) provides a guarantee of payment to the creditor(s) providing the SPV Debt (“SPV Lender”).
• This is considered the first ‘Dip’, because the SPV Lender has recourse to the guarantee of payment provided by the SPV Guarantor.
3. The proceeds of the SPV Debt are used to make an intercompany loan from the SPV Borrower to the Company.
4. The receivable created by the intercompany loan becomes the only asset of the SPV Borrower, and is pledged as security for the SPV Facility.
• This is the second ‘Dip’, because the SPV Lender will have a first lien on the intercompany receivable.

A Double-Dip, like every other liability management transaction, can only occur if the provisions of the loan documentation are flexible enough to permit it. At each of the four stages above, the loan documentation requires considerable flexibility. The terms of some credit facilities are much tighter than others, and since liability management transactions began coming to light, provisions have been included in loan documentation to prevent or ‘block’ liability management transactions from taking place. As of this writing, the Sabre, At Home Group and Trinseo transactions are the only intentional Double-Dips known to the authors and no courts have yet been tasked with assessing their merits; but that does not mean they will not face judicial scrutiny in the future. 

Liability management transactions have been in the market for several years now and the provisions in loan documentation permitting them (or that do not expressly prohibit them) are usually heavily negotiated. However, since Double-Dip transactions are a relatively recent phenomenon, there are likely many existing debt facilities that have not been properly scrutinized to address the potential use of this concept by borrowers. In today’s environment, borrowers may press to find funding solutions through such liability management transactions with required majority lender consent, rather than via formal restructurings. It is thus critical that borrowers and lenders understand what kind of future liability management transactions are and are not possible when negotiating a new credit facility, or even assessing an existing credit facility to which they are a party.

Should you wish to assess whether any of your credit facilities are ripe for a liability management transaction, please do not hesitate to contact a member of Dentons’ Banking and Finance Group.