Borrowers looking to increase leverage by transferring collateral to subsidiaries may find that strategy closed to them, as lenders appear to have had enough of such tactics and have sought to prevent them by tightening terms, according to Fitch Ratings.
A long list of companies has pursued the tactic over the last few years, including Claire’s, PetSmart, Toys “R” US, Hilton, and iHeartMedia. Signs of lender unrest emerged last year when J.Crew sent a proposal for a distressed debt exchange to its payment-in-kind lenders and later transferred intellectual property (IP) to a subsidiary that was not a part of its loan agreement, intending to use the secured debt of that entity as part of the exchange. However, the transfer would result in the $1.5 billion term-loan creditors losing most of their collateral should J.Crew file for bankruptcy (See iTreasurer, “Canny Collateral Move Comes Under Fire”).
The lenders, represented by Wilmington Savings Fund Society, took the issue to the New York State Supreme Court, arguing the transfer was not in compliance with the terms of its documentation. On April 26, 2018, a New York judge threw out certain claims against the J.Crew and absolved Wilmington for signing off on the debt swap with support from lenders holding 88% of J.Crew’s top-ranking debt obligations, according to the Wall Street Journal.
Fitch Ratings notes in a recent report that lenders are starting to respond by pressing for tighter controls over the use of unrestricted subsidiaries, and also the amount and nature of assets that may be transferred. The report points to McDermott International’s credit agreement, which aims to prevent the transfer of IP collateral.
“The definition of Unrestricted Subsidiaries stipulates that such subsidiaries may not own IP. Additionally, the affirmative covenants require that IP be owned by loan parties only,” the Fitch report says, adding, “Of note is that the credit agreement is drafted in a way that is aimed to ensure no IP is transferred outside the credit agreement system.”
Lenders to global beauty company Coty took another approach to fence in their collateral. Fitch notes that when pursuing collateral transfers, issuers use a basket allowing them to transfer assets from restricted loan party subsidiaries to restricted non-loan party subsidiaries. Then, issuers utilize a basket that permits restricted non-loan party subsidiaries to make investments in the unrestricted subsidiaries, effectively moving the collateral out of reach of secured lenders.
Coty approached the capital markets in late March for a broad cross-border refinancing effort that included refinancing all of its institutional term loan. Fitch notes that instead of singling out IP, the lenders amended and restated the credit agreement to remove entirely the basket permitting investments by restricted non-loan parties, restricting the company’s ability to stream away assets.
“Coty and McDermott’s credit agreements present two different approaches lenders take to tightening the security package,” the Fitch report says. “Fitch expects to see more changes to documentation aimed at preserving value, given recent examples of collateral leakage and some signs of late credit cycle trends.”