Secured lenders are troubled at the recent news that a New York state court judge denied a preliminary injunction request filed in the Supreme Court of New York by a group of dissenting first-lien lenders, seeking to prevent a borrower, Serta Simmons, and certain first-lien consenting lenders from entering into a recapitalization transaction. In exchange for the purchase of the consenting lenders’ debt at a discount, the consenting lenders received new super-priority debt ranking ahead of the non-consenting lenders’ debt. The dissenting lenders argued in their complaint and related request for a temporary restraining order (TRO) and preliminary injunction that the recapitalization transaction, among other things, violated certain sacred rights provisions of the first-lien credit agreement—including the “pro rata” sharing provisions of Section 2.18 of the credit agreement that could not be amended without the consent of each affected lender—and that the transaction violated the implied covenant of good faith and fair dealing as an “unlawful scheme to rob certain of Serta’s lenders of their bargained-for rights to security for their loans under a credit agreement while protecting and providing special benefits to a group of favoured lenders who agreed to participate in the scheme.” After initially entering a TRO to allow argument on the request for injunctive relief, Judge Masley declined to grant the further request for a preliminary injunction, finding that the dissenting lenders had failed to establish a likelihood of success on the merits of their contractual claims. In addition, Judge Masley concluded that the dissenting lenders had failed to establish irreparable harm even if they were to prevail; in particular, the court noted that “money damages are available to plaintiffs here” which, under applicable case law, rendered them incapable of demonstrating irreparable harm for purposes of preliminary injunctive relief.1
In the Serta case, the dissenting lenders held approximately 30 percent of Serta’s outstanding $2 billion first-lien term loan with the consenting lenders holding more than 50.1 percent of the first-lien term loan; as such, the consenting lenders constituted “Required Lenders” under the Credit Agreement. The dissenting lender’s complaint alleged that all affected lenders—not just “Required Lenders”—must approve any amendment that “amends or modifies the provisions of Sections 2.18(b) or (c) of [the Credit] Agreement in a manner that would by its terms alter the pro rata sharing of payments required thereby.” The essential thrust of the dissenting lender argument is that by granting the consenting lenders a super-priority position in the waterfall, the transaction violated the agreement’s restriction on amending the pro rata sharing provision without each affected lender’s consent being violated. Ultimately, the judge, in her opinion denying preliminary injunctive relief noted that the credit agreement seems to permit debt-to-debt exchange on a non-pro rata basis as part of an open market transaction. Section 9.05(g) provides: “any Lender may, at any time assign all or a portion of its rights and obligations under this Agreement in respect of its Term Loans to any Affiliated Lender…on a non-pro rata basis...through open market purchases...without the consent of the Administrative Agent.” The court also noted that the “proposal does not require the release of or guarantee by any collateral that is subject to [Serta’s] existing First Lien Term Loans.” Because the court concluded that the amendments “do not affect plaintiffs’ so-called ‘sacred rights’ under the Credit Agreement, plaintiffs’ consent does not appear to be required.”
While it appears that several “large-market” credit agreement provisions such as “open market” Dutch auction flexibility permitted Serta to effectuate the recapitalization, at its heart the judge’s decision calls into question the notion of the inviolability of the “sacred rights” pro rata sharing clause in many credit agreements. While the notion of creative uptiering restructuring transactions is by no means new, this case further underscores the need for lenders to understand the exact nature of their “sacred rights” under their governing agreements and the ways in which they could be circumvented by sponsors, borrowers and creative lenders.
So, what can individual lenders do to protect themselves? Certainly, in any transaction where a lender does not either comprise “Required Lenders” acting alone, or at the very least have a voting share which would be required to comprise “Required Lenders,”2 discussion at a credit committee level should include whether to request, in addition to the standard pro rata sharing restrictions, that the amendment section include a provision prohibiting any subordination of the claims or liens granted to the lenders without the consent of each lender, or a super-majority (66 2/3 percent), of lenders. For larger syndicated transactions, the addition of a new “sacred” right and 100-percent threshold may be a difficult sell with both lead arrangers and borrowers, and the less restrictive but nonetheless protective super-majority lender standard might be all that a lender is able to achieve. In smaller club transactions where lenders are more likely to have a preexisting relationship to one another and a shared alignment on approach to remedies the 100-percent lender standard for subordination of obligations may be more achievable. Amendment provisions should also be revisited to confirm that prohibitions on amending pro rata sharing provisions include any action which directly or indirectly has the effect of altering pro rata sharing (including by way of permitting priming indebtedness inside or outside the existing credit agreement). While addition of any new provisions to an amendment section will undoubtedly be cause for much debate with sponsors and borrowers as well as arrangers, lenders should at least consider whether the provisions of a given credit agreement and the parties involved warrant such additional protections.
1 Following the ruling, a number of the dissenting lenders indicated that, notwithstanding the judge’s preliminary injunction ruling, they intend to “vigorously pursue” claims for damages through final judgment.
2 Note that given the increased flexibility through incremental and similar provisions, a lender’s percentage of a facility can change over time, and consideration should be given to this fact when analyzing whether the lender indeed has a blocking vote or alone comprises “Required Lenders.”