Moving the Collateral Somewhere the Lenders Cannot Reach

Restructuring Without a Courtroom

A leveraged company facing a maturity it cannot meet has traditionally had two options: negotiate a consensual amendment with its lenders or file for bankruptcy protection and restructure under court supervision

A third route was developed over the last decade.a responsibility management exercise uses the flexibility of the borrower's own loan documents to improve their position without the need to submit an application and importantly without needing the agreement of all their lenders

The techniques are based on simple observation. Credit agreements allow for many things and permissions written for ordinary business purposes can be combined in ways that no one contemplated when writing them

The Drop Down

The first technique puts assets out of reach. Most credit agreements distinguish restricted subsidiaries who are bound by the covenants and whose assets back the loans so unrestricted subsidiaries which they are not

Arrangement investment baskets allow the borrower to transfer a limited amount of assets to unrestricted subsidiaries. By combining multiple baskets a borrower can move valuable assets often intellectual property or a valuable line of business to an unrestricted subsidiary against which existing lenders have no claims

That affiliate can then borrow new money secured by those assets from lenders that are structurally superior to the originals with respect to the collateral that was moved

The original lenders still have your loan. What they no longer have is a claim on the assets they believed secured them

The Uptier

The second technique reorders priority among existing lenders. Loan agreements generally require unanimous consent to change payment terms or release all collateral and allow many other modifications by majority vote

Therefore a borrower can bring together a majority of lenders amend the agreement with their consent to allow new super-senior debt and then swap that majority into the new senior tranche. The minority that was not invited remains on the original loan now subordinated to a facility created with its nominal consent to the amendment mechanisms

A Worked Example: Counting the Value That Moves

Both techniques are often described qualitatively making them seem like technicalities. Put numbers on them and the size of the transfer becomes apparent

Set up the company. A borrower has $1 billion in outstanding term loans. The company is worth $700 million of which $400 million is intellectual property and $300 million is everything else including inventory accounts receivable facilities and operating business

Before anything happens the lenders share 700 million in value against 1,000 million of claims. The recovery is 70 cents on the dollar for everyone equally

Now the dropdown menu. The borrower combines investment baskets to transfer the intellectual property to an unrestricted affiliate which then raises $300 million of new money collateralized on it

The original lenders now have a claim against a restricted group holding 300 million assets against the same billion in debt. Recovery falls from 70 cents to 30 cents. No payments were missed no payments were missed and 40 cents on every dollar left the building by written permission from the lenders

Now the top level run it on the same company before any dropdown menu. The borrower brings together lenders holding 51 percent of the loans or $510 million in credit and exchanges them for a new super-priority facility that is ahead of everything else

Against 700 million of enterprise value the super priority tranche of 510 million is fully covered and recovers 100 cents. What is left for the excluded minority is 700 minus 510 or 190 million dollars compared to its 490 million subordinated credits. That is a recovery of around 39 cents

Count the transfer. The minority previously had credits worth $343 million at a rate of 70 cents out of $490 million. They then own about 190 million. Approximately $153 million passed from one group of lenders to another between parties who had signed the same document and until the previous week had identical credits

That's the only reason these transactions lead to litigation instead of shrugs. The top takes value from the lenders and gives it to the company and its new financiers who at least finance something. The top takes value from some lenders and gives it to other lenders in the same class and the only thing that distinguishes the winners is which ones the borrower called first

These are illustrative figures with a clean capital structure. The real ones are much more complicated and the direction and approximate scale of the transfers are not sensitive to that

How the Documentation Allowed It

These structures were made possible by a decade-long erosion in loan documentation standards driven by a market in which borrowers had influence

Covenant packages became more flexible investment baskets grew and multiplied unrestricted subsidiary definitions expanded and sacred rights requiring unanimous consent were reduced to a shorter list than lenders assumed

Investors accepted these terms during a period of abundant credit and low defaults when the provisions seemed theoretical. They stopped being theoretical when defaults arrived

Case Study: J.Crew and Serta Simmons

Each technique has a transaction that names it and both are now shorthand in all credit negotiations

J. Crew 2016. The retailer was struggling under a heavy debt load from leveraged buyouts. Its most valuable asset was its brand and associated intellectual property. Using a combination of investment baskets in its credit agreement the company transferred a substantial interest in that intellectual property to an unrestricted subsidiary outside the reach of term loan lenders and then used it to support a debt exchange on terms favorable to the company and its backers

Lenders were furious and largely failed because the agreement allowed for the actions taken. The maneuver entered the vocabulary as the J.Crew trapdoor and the provisions written to prevent it restricting transfers of material intellectual property to unrestricted subsidiaries are now standard and are literally called J.Crew blockers. A single transaction from 2016 is the reason a clause appears in thousands of credit agreements today

Serta Simmons 2020. The mattress maker under pressure early in the pandemic executed the uptier that defined the technique. A majority group of lenders provided roughly $200 million of new money and swapped their existing holdings into new first- and second-lead super-priority tranches preempting lenders that had not been included. The excluded lenders which had proposed a transaction of their own sued

The litigation lasted for years and centered on strict wording. The credit agreement allowed the borrower to buy back loans through a open market purchase without offering the prorated opportunity to all lenders and the participating group argued that the exchange fell within that permission. In December 2024 the Fifth Circuit Court of Appeals disagreed holding that a privately negotiated exchange with a carefully chosen majority was not an open market purchase in the ordinary meaning of that phrase

Note what that decision did and did not do. It did not find the uptiers inappropriate. It held that this particular provision did not authorize this particular transaction. A credit agreement drafted with broader permission would produce a different response which is exactly the pattern described in the next section

What the Courts Have Said

Litigation has produced a genuinely mixed record which is an honest summary

Some transactions have been confirmed based on the reasoning that the agreement clearly permitted what was done and that the sophisticated parties are bound by the documents they signed. Others have been successfully challenged or settled on terms favorable to excluded lenders particularly where courts determined that the actions taken were not permissible upon careful reading or where the implied covenant of good faith and fair dealing was compromised

The pattern that emerges is that the results depend on specific wording rather than a general principle. There is no doctrine that these maneuvers are inappropriate and there is no guarantee that any particular one will survive

Where the Outrage Overreaches

These transactions are often described as predatory and on the other hand there is one serious case that receives very little publicity

The lenders drafted the documents and charged for them. Every basket every unrestricted subsidiary definition and every majority amendment provision was negotiated by institutions with legal teams and flexible terms were accepted in exchange for performance. A lender that priced a Covenant Lite loan at a Covenant Lite spread and then objected to the Covenant Lite results has received exactly what it bought

Flexibility is not free. Unrestricted investment baskets and subsidiaries exist so that healthy companies can make acquisitions form joint ventures and operate without seeking consent for ordinary decisions. Closing every loophole that a drop-down menu allows also eliminates the operational freedom that makes leveraged loans viable for the borrower

The counterfactual is often bankruptcy. A liability management exercise usually occurs because the company cannot meet a maturity. The realistic alternative is a Chapter 11 filing which entails professional fees in the tens or hundreds of millions customer and supplier flight and a smaller estate for everyone. A transaction that leaves the minority with 39 cents is bad for them and may still leave the entire group of lenders better off than a filing

New money really deserves priority. Lenders who financed $200 million to a distressed borrower took on a real risk that the excluded group refused to take. The priority for new money is an old and defensible principle and it is also present in bankruptcy financing. The objectionable part of an uptier is usually the treatment of existing debt exchanged rather than the priority given to fresh cash

My own opinion is that dropdown is harder to defend than top because it removes value from the lender pool entirely while a top at least keeps you in class and ties you to someone willing to finance

The Market Response

Lenders adapted in two ways

Adjusted documentation. Provisions specifically addressing these techniques have become standard requests including restrictions on the transfer of material intellectual property to unrestricted subsidiaries requirements that any new super-senior debt be offered pro rata to all lenders and expanded rights requiring unanimous consent

Cooperation agreements emerged. Lenders now frequently sign agreements with each other at the first sign of trouble pledging not to engage in a transaction that harms other members of the group. These agreements exist entirely to defeat the divide-and-conquer dynamic that makes an uptier possible since the borrower needs a majority willing to be favored at the expense of the rest

Why It Matters Beyond Credit Markets

The broader lesson concerns what a contract actually protects. Lenders in this market believed they had secured claims on collateral identified in priority to each other. What they had was a set of permissions that could be recombined by a counterparty with strong incentives and good advisors

This is not unique to loan contracts. It is a general property of long complex contracts negotiated under benign conditions and tested under adverse conditions and the answer here tightening the wording and coordination between counterparties is also the general answer

The Bottom Line

Liability management exercises allow a distressed borrower to move assets out of the reach of its lenders or subordinate some of them with the consent of others using the flexibility that the lenders themselves granted

The transfers are large and countable. In a company with a billion dollars in loans against a value of 700 million moving 400 million of intellectual property to an unrestricted subsidiary reduces the lender's recovery from 70 cents to 30. An uptier that elevates a majority of $510 million to super priority leaves the excluded 490 million with about 190 million of residual value a recovery close to 39 cents which moves approximately153 million dollars between the lenders who signed the same document

J.Crew named the uptier in 2016 and produced the blocking clauses that are now standard everywhere. Serta Simmons named the uptier in 2020 and the Fifth Circuit held in December 2024 that its particular trade was not an open market purchase resolving that transaction without resolving the strategy. Whether a specific transaction survives depends on precise wording rather than principle and courts have gone both ways. The lasting consequence is that theCredit documentation is rewritten and lenders organize in advance which is what happens when a market discovers that its protections were tighter than it assumed