Nevertheless, it is crucial to recognize that restructuring endeavors must carefully account for the interests of diverse stakeholders who possess varying levels of risk tolerance. Achieving successful renegotiations and adept deal management necessitates the involvement of experienced lenders equipped with astute decision-making capabilities and a knack for generating innovative solutions. This includes a willingness by private credit managers to readily consider swapping debt for equity when they possess confidence in the borrower’s long-term value proposition.

In our Q3-2020 President’s Letter, we discussed the Companies’ Creditors Arrangement Act (the “CCAA”), Canada’s main statute for restructuring insolvent corporations. Crucial to the proper functioning of the CCAA is the court-appointed monitor, a trustee and insolvency professional that functions as the court’s independent advisor on the fairness and soundness of any proposal or plan. The monitor’s primary duty is to act in the best interests of all stakeholders, striving to maximize value for each party involved, irrespective of whether this entails facilitating a restructuring plan or overseeing an asset liquidation. A chronic issue in the use of the CCAA to authorize sales of substantially all of a debtor’s assets is undervaluation. Despite the objective to generate prices equal to fair market value, our experience is that sales processes conducted in insolvency proceedings produce below market prices, especially when they occur during a recession or financial crisis.

There are several reasons for the systematic undervaluation of assets during insolvency driven sales processes (“IDSPs”). The absence of so many features that buyers in normal, negotiated sales process have come to expect virtually ensures that below-market prices will prevail. The flaws pervade the process. IDSPs are forced sales and when they occur during economic downturns can become fire sales. In normal, voluntary sales processes, a financial advisor or investment banker will prepare a detailed information package about the business and assets for distribution to prospective buyers. The package will include detailed background and performance information about the business and assets, market and competitive data, customer and supplier disclosure, and forward-looking information about asset potential and plans. Bidders normally can visit the business, inspect the condition of the assets, and perform other customary due diligence. None of these features are present in IDSPs.

Unlike normal sales processes, IDSPs receive little publicity and the responsible monitors, who want to minimize costs, will usually provide only the legally required notice. The purchase agreement entered into by the buyer will not be tailored to the buyer’s specific needs and will not contain any representations or warranties about the assets’ condition or performance. The buyer will have no recourse to the debtor or monitor. IDSPs are typically conducted with strict and hurried timelines and completed within weeks rather than months for normal sales processes. All of this reduces the number of buyers and lowers the sales price.

Perhaps the biggest barrier to attracting multiple attractive bids in IDPSs is the secured lender’s asymmetric funding advantage due to its ability to “credit bid” for the assets that comprise its collateral. Third-party bidders must pay in cash. Credit bidding is a powerful tool granted to secured lenders under bankruptcy and insolvency regimes, enabling them to utilize their secured claim as a form of currency during auctions of the debtor’s collateral. In the U.S. and Canada, the secured lender has the ability to offset their claim’s full-face amount against the purchase price of the collateral. This mechanism empowers the secured lender to acquire the debtor’s assets, which are subject to their lien, in exchange for a complete or partial cancellation of the debt, effectively allowing them to secure the assets without making any direct cash payments.

Credit bidding serves as a crucial defensive mechanism for lenders, effectively safeguarding the value of their collateral amidst the backdrop of deteriorating asset prices. By utilizing credit bidding, secured lenders can protect their interests and ensure the preservation of asset value during the sale process. Without the ability to credit bid, there is a risk that the collateral securing a lender’s claim may be undervalued and sold at a discounted price, either intentionally or unintentionally. Debtors are incentivized to sell collateral at reduced prices to insiders, “white knights”, or other third parties if they believe such sales will result in favorable treatment from these buyers in the future. If the collateral is undervalued and sold below its fair market value, secured lenders may find a significant portion of their secured claim treated as unsecured, potentially yielding only a fraction of its value in the bankruptcy estate.

Credit bidding ensures that the secured lender receives the fundamental benefits of its credit agreement. By allowing the secured lender to bid up to the total amount of its secured obligation in the sale of collateral, credit bidding enables the lender to compete with cash bids from third parties. This mechanism upholds the secured lender’s essential right, both inside and outside of the CCAA, to obtain either the money owed or the assets securing the debt. Furthermore, credit bidding safeguards the secured lender from the sale of collateral at a value lower than its full worth.

Still, some secured lenders refuse to credit bid because they cannot or do not want to own the business or collateral assets, even for a short period of time, due to policy restrictions, the additional costs of restoring or maintaining the assets, or the lack of a viable strategy to operate and eventually monetize the business or assets. This was the case for lenders to the distressed Canadian e-grocer that we recently helped rescue. In another recent CCAA case involving a private credit fund as the primary secured lender, the IDSP resulted in only one third-party bid, which was a fraction of the fund’s debt, and the fund’s manager decided not to exercise its right to credit bid. The private credit manager lacked the internal capabilities to manage the debtor’s business as a going concern, which would have most certainly resulted in a superior recovery.

While credit bidding is recognized as a vital aspect of the secured creditor’s rights, some argue that it can hinder bidding activity or impede the debtor’s ability to maximize asset value. Substantial litigation has taken place in U.S. bankruptcy cases over the years to determine the merits of credit bidding in general. The efficacy of the credit bid mechanism, which typically serves to protect secured lenders against undervaluation during IDSPs, can be compromised in situations where a third party acquires secured debt with the intent of pursuing a loan-to-own strategy to gain control of the target company. In such cases, the secured party may intentionally suppress the market value instead of enhancing it. Credit bidding can be utilized to deter or restrict bidding activities before or during an auction, discouraging prospective bidders from participating in the sales process.

The third-party debt buyer’s inclination to assume ownership of the debtor’s business, rather than seeking repayment of the loan, can disrupt the sales process. Instead of maximizing the value of the assets, the secured party has sought to diminish the sales price of the debtor’s assets. This approach would primarily benefit the third-party debt buyer while placing the estate’s other creditors at a disadvantage. The implementation of the third-party debt buyer’s loan-to-own strategy would very likely dampen market interest for the bankruptcy sale.

Overall, credit bidding provides experienced secured lenders and astute distressed investors with a powerful shield to protect their interests, acquire assets, and navigate the complexities of the bankruptcy process. Credit bidding can result in a permanent transfer of wealth from the bankruptcy estate to the secured lender equal to the difference between the fair market value of the collateral and the credit bid plus the value of any deficiency claim against the bankruptcy estate. It enables them to strategically utilize their secured claims, ensuring the preservation of asset value and facilitating acquisitions in a manner that may not require significant cash outlays.

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In some cases, these measures may prove insufficient to address the cash flow challenges faced by some companies. As a result, owners and lenders are actively seeking strategies to inject much-needed liquidity into distressed situations with the aim of supporting the implementation of turnaround plans. The need to address exigent liquidity issues can develop suddenly, so lenders must structure to accommodate such extenuating circumstances. The challenge lies in the fact that the eventual state of the business on the other side of the turnaround remains unknown. This uncertainty instills fear and avoidance on the part of most lenders when it should be recognized and embraced as the origin of a lucrative possibility.

Most strategic liquidity transactions that occur in the private credit market do not make media headlines and rarely make their way into courtrooms. Nonetheless, we have over the past few months participated in or witnessed several notable situations that shed light on the opportunities (or perils, depending on which side you’re on) afforded by weak credit documentation and inexperienced lenders. Many of these instances involve either the interpretation of provisions in syndicated credit agreements made among multiple lenders or uninitiated private credit managers inadequately prepared to handle the challenges associated with loan defaults and distress.

During periods of financial distress, borrowers will resort to radical measures to raise critical new liquidity even if it means negatively impacting certain existing lenders in the capital stack. When this occurs between a group of lenders in the same syndicate, it becomes what some affected lenders have termed a “cannibalistic assault!”¹ By leveraging the authority granted to majority lenders within the framework of their credit agreements, minority lenders can be effectively strong-armed into relinquishing their first-lien rights without their consent or even the requirement of seeking it. Investors of ours know that we emphatically emphasize the importance of private credit managers controlling the terms, amendments, waivers and exercise of remedies in their credit agreements. In an uncertain macroeconomic climate, borrowers will be increasingly tempted to use gaps and ambiguities in their lenders’ rights to unlock additional liquidity and uncover leverage against such lenders. Strong, experienced lenders will feast; weaker ones will be devoured.

Take the recent example of our rescue financing for a Canadian online grocery and wholesale distributor of fresh, local, organic produce and groceries. Existing lenders, including a government credit agency, a now defunct U.S. bank, and several small Canadian private credit funds, lacked the skill and will to provide the liquidity that was prudent and necessary to ensure the company’s survival and protect their investments. Our new superpriority loans secured against all existing loan collateral became a triumph for us but a disastrous woe for the existing lenders – all of them were completely wiped out. This outcome could have been prevented with creativity, additional investment, and more rigorous enforcement.

Perhaps, owing to the regulations governing risk weighting and asset treatment, or the desire to raise more capital, the lenders that backed the company were inherently inclined to delay acknowledging the distress and avert harm to their balance sheets. The lenders found themselves in a state of uncertainty, unsure of the appropriate course of action, and consequently lacked the motivation to actively enhance asset value or invest in initiatives that would improve future monetization prospects for their existing loans. We, on the other hand, are driven by our relentless pursuit of maximizing returns and capitalizing on mispriced risk. Banks are bound by a structural and regulatory framework that restricts their flexibility in deviating from narrow pricing parameters. Newer private credit managers that have not engaged in extensive loan workouts and corporate restructurings are ill-equipped to navigate through turbulent, volatile, and adversarial lender negotiations. In stark contrast, we thrive on the inherent possibility of transforming a secured debt instrument into an ownership instrument, thereby opening the door to unlimited upside potential.

Debt restructurings are going to increase in frequency and complexity. We believe this will lead distressed borrowers to engage in aggressive tactics to access new capital by finding loopholes in or amending their existing credit agreements, to permit new, and sometimes “superpriority”, secured debt. Such tactics are not new and increase in prominence during periods of economic crisis. In 2016, for instance, when deflation fears and a slowing Chinese economy caused oil prices and stock markets to plunge, many companies struggled to raise new capital. J. Crew, an apparel company, was facing the impending maturity of over US$500 Million in unsecured notes but had no new assets to pledge as collateral. The company exploited a loophole in its secured credit agreement to remove intellectual-property collateral from its lenders’ reach to help refinance the other maturing but unsecured debt. With the help of sophisticated distressed lenders, J. Crew found a “trap door” provision that facilitated the transfer of collateral and new secured loans. A closer look at this provision reveals that it was intended to permit J. Crew to invest in overseas subsidiaries and minimize taxes, not to permit the transfer of the lenders’ collateral.² After the fact, it is obvious that J. Crew’s existing lenders could have stopped this specific maneuver with a simple change to the contract.

One way we protect collateral leakage is by restricting transfers of assets and ensuring that the most precious “crown jewel” assets are held in entities that are firewalled from business risks and over which we have effective control through sole liens, share pledges, and lockbox arrangements. Borrowers’ tactics to exploit contractual weaknesses will become the norm and lenders must exercise caution to avoid falling victim to the pitfalls in their credit agreements lest they become “J. Crewed.”

Within syndicated credit facilities, a natural inequality or imbalance exists between lenders holding the majority of the debt and the other lenders. As a general rule, waivers, amendments and other modifications to the terms of a credit agreement must be approved by the “required lenders”, which is typically defined as those lenders holding a simple majority (i.e., over 50%) of the aggregate principal amount of the relevant credit exposures (including undrawn revolving commitments and outstanding term and revolving loans). Exceptions to this general rule are generally provided for amendments to so-called “sacred rights”, which represent lenders’ critical rights or core economic terms and which will require the consent of all lenders or every affected lender to be amended. These “sacred rights” typically include: (i) increases to lender’s commitments; (ii) reductions of principal amount; (iii) extensions to the payments dates; (iv) reductions of interest margins or fees payable; (v) amendments to the pro rata provisions; (vi) releases of all or substantially all of the collateral and (vii) other fundamental aspects of the credit agreement terms, such as voting rights.

However, cash-strapped borrowers in desperate times will resort to desperate measures. Rather than removing collateral from the reach of existing creditors, a borrower could obtain consent from required lenders to create new superpriority debt capacity under its existing credit agreement. In order to avoid running afoul of lenders’ sacred rights, the borrower crafts its amendment so as not to alter the credit agreement’s pro rata sharing provisions. Courts have rejected the argument that the sacred right protecting against releases of collateral is implicated by amendments causing (even deep) lien subordination.³ Pro rata sharing provisions, a key aspect of lenders’ sacred rights, ensure that lenders receive their proportional share of collateral proceeds based on the face value of their loan ownership. Typically, amending these provisions or other sacred rights requires the unanimous consent of all lenders or all affected lenders. Sacred rights serve to safeguard minority lenders from changes that could alter the fundamental aspects of their investment. Conversely, apart from sacred rights, most other provisions in the credit agreement can usually be amended with the consent of the required lenders alone. Increasingly, however, even the sacred rights are no longer truly sacred.

The Serta Simmons Bedding (“Serta”) restructuring in 2020 is an example of a crafty maneuver by which the borrower collaborated with the required lenders to amend the credit agreement to permit the borrower to incur incremental superpriority debt. The lenders in the majority group funded a new tranche of first-out superpriority debt and then exchanged their existing senior loans for a new tranche of second-out superpriority debt. The remaining minority lenders (who were not afforded the opportunity to participate in the new money financing or the exchange) found themselves effectively subordinated to these two new superpriority tranches. Serta circumvented the pro rata sharing provisions of the credit agreement by using undefined “open market purchase” language in their credit agreements. An open market purchase is a transaction in which a borrower purchases its own debt from lenders under a credit agreement’s terms. The open market purchases between Serta and the required lenders drew the ire of the minority lenders because the purchases were not offered to all lenders and were conducted via debt exchanges, not as purchases for cash.

The minority lenders appealed the transactions but in April 2023 the U.S. Bankruptcy Court ruled against them. The success of such so-called “uptier transactions” has revealed that minority lenders may not be able to rely on any contractual protection not expressly covered by a sacred-rights provision, particularly in distressed situations. Future majority lenders will be empowered to make aggressive amendments upending the rights and payment priorities of nonconsenting lenders. A lot of unsuspecting private credit managers are minority participants in syndicated loans governed by credit agreements that could suddenly render them unprotected or worse, unsecured. As a general rule, TEC does not participate in credit agreements where it does have majority control and administrative and collateral agent status.

The optimal solution to a borrower’s short-term liquidity crisis that threatens lender recovery may be the infusion of cash pursuant to debt restructuring transactions that involve a superpriority tranche of debt from existing lenders or otherwise. These transactions have the potential to serve as a lifeline to distressed businesses by allowing them to acquire much-needed new capital. They also benefit participating lenders, who receive enhanced priority and premiums on new or exchanged loans, while strengthening their position in any future financing or restructuring decisions. In our rescue financing for a Canadian e-grocer, for example, the existing lenders would have vastly enhanced their prospects of recovery had they joined TEC in its superpriority financing. The unfortunate reality is that many debt restructuring transactions present a zero-sum game.

Given these circumstances, it becomes paramount for investors exposed to direct lending strategies to carefully assess the track record and expertise of their managers in this dynamic economic environment. In Canada, a scarce number of private credit managers possess the requisite skills and experience to deliver innovative solutions that bridge the liquidity gap and adeptly steer companies through challenging periods of transformation. So many lenders unfamiliar with dealing with distressed borrowers will be disappointed by the willing bargain they made under their credit agreements. Recent debt restructuring transactions in the market illustrate the lengths to which borrowers and certain lenders will go to stay afloat (and recoup their investment) when under duress. Restructurings have become lender-vs-lender contests with competitors angling to push the losses of default onto others.

With the rise in defaults today being inevitable, private credit managers need to be prepared to consider extreme options when loans in their portfolio show signs of stress or distress, including foreclosing on assets or “taking the keys” of the business of their borrowers. Failing to do so will result in these managers being eaten alive by their own peers.

[1] From complaints in litigation of Audax Credit Opportunities Offshore Ltd. v. TMK Hawk Parent, Corp., No. 565123/2020, 2021 WL 3671541.
[2] King & Spalding Private Credit and Special Situations Investing Group. “J. Crew and the Original Trap Door”
[3] Moore and Van Allen Special Situations Client Bulletin. “The Tyranny of the Majority”

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