The parties have found several ways to balance these competing interests – for example. B, treat as an investment a subsidiary that becomes an excluded subsidiary (by designation or otherwise) and require the borrower to have an investment capacity equal to the fair value of the subsidiary that no longer provides credit support to the lender group. PetSmart continued to experience financial difficulties, allowing its senior debt and unsecured debt to trade at reported levels of 80 cents and 50 cents per dollar, respectively. Nevertheless, the Chewy guarantee and its assets have provided lenders with a sense of comfort given their ever-increasing market share, revenue growth and the valuation of their business. However, due to a series of transactions related to Chewy`s holdings, which PetSmart said were allowed under the terms of PetSmart`s debt agreements, lenders quickly found that the comfort level was significantly eroded. In 2017, in its fixed-term loan agreement, J.Crew relied on its investment capacity and limited ability to pay to transfer at least $250 million in intellectual property that secured its term loans to an unrestricted subsidiary, and then borrowed on the transferred assets to repay its parent company`s structurally subordinated debts. Although “J.Crew blockers” are not widely used, several loan agreements contain provisions that attempt to prevent borrowers from engaging in a J.Crew-type transaction, and there are a variety of J.Crew blockers on the market. The most protective J.Crew blocker aims to prevent the transfer of tangible intellectual property or other guarantees of value outside the credit group (for example.B. “No tangible intellectual property belonging to a third party of credit may be brought by a creditor party as an investment to a non-creditor party”). However, sponsors have generally managed to crack down on these blockers.
Chewy, meanwhile, continued to grow rapidly, and PetSmart and its equity investors sought an IPO of Chewy to monetize that growth. In order to clarify an IPO, the legal dispute between PetSmart and its creditors had to be settled. After an unsuccessful attempt to amend the capital transfers, PetSmart managed to convince lenders to accept such approval, but only after softening the terms of a second change, including higher interest rates, approval fees, and improved repayment terms. After a major key investor agreed, lenders rushed to make sure they weren`t left without a proverbial “bone.” A general review of large leveraged credit facilities guaranteed by promoters shows that it is common for restricted payment and investment baskets to be used to deceive a subsidiary so that it is no longer a wholly-owned subsidiary by distributing shares of the lending party structure or by contributing minority interests to subsidiaries without restriction. Consequently, such a subsidiary would no longer be `wholly owned` by the borrower under the loan agreement. Some law firms and leveraged finance review sites have proposed revisions to credit documents to protect creditors from another Chewy incident. While such proposals are well-intentioned (and may be necessary in some cases), we believe that proposals such as banning dividend and distribution baskets used to distribute assets create complications for borrowers and promoters and are ultimately not accepted by developers and their portfolio company borrowers. In June 2018, PetSmart transferred 36.5% of its interest to Chewy through the use of restricted payment and investment baskets available under its secured credit facilities. PetSmart transferred 20% through a distribution to a holding company owned by its equity investors (none of which supported PetSmart`s credit facilities) and contributed 16.5% as an investment in a new wholly-owned subsidiary of PetSmart, which was designated as an unrestricted subsidiary. It is important to note that PetSmart relied on an “available amount” basket to complete the distribution, which means that PetSmart was able to distribute up to the approximately $1 billion in cash contributions it received from PetSmart shareholders in the period following the initial closing of the PetSmart credit facilities. An external consultant hired by PetSmart determined the value of the distribution of the stakes in Chewy at $908.5 million. Thus, PetSmart considered that the distribution was eligible under its debt agreements, since the value of Chewy`s assets thus distributed fell into the basket of available amounts.
In a recent series of high-profile cases, several companies have used restrictive covenant exceptions in their credit documents to remove valuable assets from the reach of their senior creditors in order to raise additional capital. J. Crew and Claire`s each relied on a combination of investment baskets to transfer valuable intellectual property to an unrestricted subsidiary. iHeart transferred a portion of the shares of a profitable subsidiary to an unrestricted subsidiary. A recent case involving the partial transfer of equity to its profitable subsidiary Chewy.com petSmart and the corresponding release of Chewy`s collateral is particularly troubling for lenders due to the impact of the provisions on the release of guarantors. PetSmart relied on its ability to invest in a “similar business” to transfer its equity in Chewy to a newly formed shell subsidiary. The current trend in limited partnership activities is to extend the definition of “like business” to unrestricted subsidiaries, the issuer`s parent company and limited liability subsidiaries. This gives holding companies a greater opportunity to rely on their investment baskets to get guarantees on loan support. In contrast, a small number of recent agreements have included provisions to prevent the release of loan support where there is a partial transfer of equity from a guarantor to an affiliate.
The Chewy case (and other cases with limited subsidiaries) underscore the importance of analysing collateral release provisions in credit documentation, in particular the exclusion of non-exclusively owned subsidiaries, in order to avoid undesirable outcomes. Nieman Marcus Group Inc. divested its subsidiary MyTheresa (which allegedly held approximately $1 billion of Nieman`s valuable intellectual property) to its ultimate sponsor owners by (1) using investment capacity to avoid restricting MyTheresa and (2) using an exception to a dividend payment restriction that allowed share capital dividends to subsidiaries without restriction. We expect this exception, which allows borrowers to distribute shares of subsidiaries without restriction, to be slightly more common in leveraged loan agreements. .