Publication
Overview
Goldberg Kohn's Knowledge Management Department has been focused on development of tools that enable our firm to analyze and summarize trends in deal terms that are relevant to middle market ABL and cash flow financing transactions. With these tools, Goldberg Kohn is able to provide our clients with valuable insights into documentation trends in the middle market lending space as well as the broader leveraged lending market. Summarized below are a few key topics of interest:
2022 Credit Agreement Trends
Select Middle Market Covenants[1]
While covenant erosion has occurred in all parts of the leveraged lending market over the last several years, one noteworthy difference in the small to core middle market lending space is that certain covenant features found in larger transactions have not yet fully permeated this part of the market. Notably, based on Goldberg Kohn deal data from 2022 cash flow transactions compared to the broader leveraged lending market:
Incremental loans: Only about half of deals have an incremental facility. Of the deals that have an incremental facility, slightly less than half of those have a true free and clear basket. Rather than a true free and clear basket, most deals with an incremental facility have a basket tied to a leverage governor that is set at a turn below the applicable covenant leverage level, or set at a static leverage requirement that is below the covenant level that applies for most of the term of the deal. In the market more broadly, nearly all deals have an incremental facility, and most of those with an incremental also have a free and clear tranche.
Synergies addbacks: While somewhat more common than the incremental feature, a synergies addback is not a given in credit agreements in this part of the market, appearing in about 60 percent of deals Goldberg Kohn documented in 2022. In nearly all deals there is some type of cap on addbacks, either as a percentage of EBITDA or a fixed dollar amount. In the broader middle market, nearly all deals have a synergies addback to EBITDA. Lining up with our firm's observations, the vast majority in the broader market do have some cap on the amount that can be added back.
Builder baskets: While builder baskets have become very common in larger leveraged loan deals, they are still not the norm in the small to core middle market, appearing in about 30 percent of deals in 2022. When they are included, they are nearly always tied to a leverage requirement, with the average leverage governor set at just over 4x. Again differing from Goldberg Kohn's observations, broader middle market data shows builder baskets appearing in the vast majority of transactions, though nearly all of them require deleveraging from closing date leverage to use the basket.
Unrestricted subsidiaries: A great deal of analysis has been published by various sources on how to protect against liability management transactions involving unrestricted subsidiaries, and as noted below, one of the most common responses has been to include an IP blocker or other limitations on investments in unrestricted subsidiaries. While using an IP blocker has certainly cropped up in small to core middle market deals, it is notable that the majority of these deals (more than 80 percent) still do not allow for unrestricted subsidiaries at all.
LIBOR Transition
As expected, there was a significant shift away from LIBOR in 2022, as federal bank regulators required banks to cease from entering into new contracts that use LIBOR as of December 31, 2021. While the regulatory requirements do not apply to non-bank lenders, most non-banks have chosen to transition on much of the same timeline in order to line up with the market and prepare for full LIBOR cessation in 2023.
Goldberg Kohn's data for middle market lenders generally shows a fairly abrupt switch – while nearly 60 percent of deals in the second half of 2021 were tied to LIBOR, this number changed to just over 10 percent in the first half of 2022, and was down to less than 10 percent in the second half of 2022. While Term SOFR has emerged as the clear frontrunner in LIBOR alternatives (our firm has seen only a handful of loans tied to other alternative rates), consternation remains over how to account for the different characteristics of SOFR versus LIBOR.
Based on our firm's observations (as well as observations from various other sources), no true market standard has emerged around the use of credit spread adjustments. For all of 2022, Goldberg Kohn's deals showed that the most common spread adjustment was 10/15/25 bps, in a little over 40 percent of deals. About 30 percent of deals had no spread adjustment, and the remainder were split between deals with a flat spread adjustment and deals using the ARRC recommendations. As more lenders incorporate the additional risk associated with Term SOFR into their pricing models, the difference may be reflected in higher margins and will become even more difficult to track.
Notable Bankruptcy and Secured Lending Cases
Focus on Liability Management
Preliminary court decisions related to liability management litigation, particularly in the last quarter of 2022, have made it increasingly clear that these types of endeavors will likely face protracted litigation. Though there has been no final resolution on the merits that are instructive to future transactions, non-participating lenders can look to the claims that have survived motions to dismiss in Serta, NYDJ (where Goldberg Kohn represented a minority lender), TriMark and Boardriders[1] as a roadmap for challenges that may be likely to succeed in the future.
The main issues raised that are sure to garner additional attention in the future are: (1) the permissibility of "vote rigging" by borrowers and cooperating lenders by providing additional debt through an incremental facility or other methods, solely to obtain the votes necessary to engage in amendments to transfer collateral or make other changes to the credit structure (an issue raised in Revlon and Incora[2]); (2) whether actions by borrowers and cooperating lenders to roll a portion of the debt into a more senior tranche and/or consent to transfers of collateral constitute a breach of express provisions in the credit agreements on pro rata sharing of payment, releases of collateral, or other covenants (an issue raised in Revlon, TPC Group[3], Serta and TriMark); and (3) the standards applicable to show a breach of the implied covenant of good faith and fair dealing, which implies a duty to refrain from destroying the essence of a contract (an issue raised in Serta, NYDJ, TriMark, and Boardriders, so far with differing results).
Goldberg Kohn Bankruptcy and Creditors' Rights attorney Randall L. Klein has previously discussed how such actions may be subject to attack as a fraudulent transfer (see article here), and has also discussed in detail the restoration of the good faith doctrine as a response to these transactions (see article here). The market has responded to increased liability management activity by including language in credit agreements intended to limit the ability of borrowers to engage in these endeavors, including IP blockers, leverage tests for transfers of assets to unrestricted subsidiaries, unanimous lender consent for debt/lien subordination, and conditions on open market debt repurchases. Any of these solutions are of limited efficacy, however, if they are not appropriate for the borrower's business and/or if they are not drafted carefully.
Make Whole Premiums
The Fifth Circuit's long awaited decision in the Ultra Petroleum[1] case held both good and bad news for lenders. The decision addressed (1) whether a make-whole premium constitutes liquidated damages, or whether it constitutes unmatured interest that should be disallowed under section 502(b)(2) of the Bankruptcy Code; (2) whether the solvent-debtor exception survived the enactment of the Bankruptcy Code in 1978 and allows payment of post-petition interest to unimpaired unsecured creditors; and (3) if the solvent-debtor exception does allow payment of post-petition interest, whether unimpaired creditors are entitled to post-petition interest at the rate specified in the contract or only at the lower federal judgment rate.
The bad news for lenders is that the Fifth Circuit held that the make-whole premium in this case was the economic equivalent of unmatured interest, and thus should be disallowed under section 502(b)(2). However, because the debtor was solvent and the make-whole did not constitute an unenforceable penalty, the creditors were nonetheless entitled to payment of the make-whole premium.
The court additionally held that the solvent-debtor exception required payment of post-petition interest at the contractual rate (rather than the federal judgment rate). The solvent-debtor exception is a historic common law doctrine that pre-dates the Bankruptcy Code and allows interest to continue to accrue after a bankruptcy filing if the debtor has sufficient assets to pay it. The court reasoned that because there was no clear abrogation of the solvent-debtor exception when the Bankruptcy Code was enacted, it still applies and creditors of a solvent debtor are entitled to post-petition interest and make-whole premiums at the rate specified in the contract.
With this ruling, the Fifth Circuit has joined the Ninth Circuit in finding that the solvent-debtor exception survived the enactment of the Bankruptcy Code and allows payment of post-petition interest at the rate specified in the contract. Similar litigation in the Hertz[2] case will likely be appealed next year, determining whether the Third Circuit will follow suit. In addition to the solvent-debtor exception underscored by Ultra Petroleum, it is also important for secured lenders to note that in cases where they are oversecured, a prepayment premium may be enforceable under 506(b) of the Bankruptcy Code regardless of whether the premium constitutes unmatured interest and/or the debtor is solvent.
Emerging Issues
The Uniform Commercial Code Catches Up With Technology
On November 17, 2022, the Uniform Law Commission posted the final recommended text for the 2022 amendments to the Uniform Commercial Code, along with comments. These amendments represent comprehensive changes to the UCC (including to Article 9 on Secured Transactions) to address emerging technology and provide new rules for commercial transactions involving virtual currencies, distributed ledger technology, blockchain technology and artificial intelligence. The amendments will be considered by each state, and are expected to be enacted in largely the form recommended over the next few years. Of particular note for secured lenders are the following changes:
- Controllable Electronic Records: The amendments adopt a new Article 12, which governs transactions in a subset of assets called "controllable electronic records" (CERs), defined as records "in an electronic medium that can be subjected to 'control'" (which is further defined in Article 12).
- Security Interests in CERs: Amendments to Article 9 provide that a secured party may perfect a security interest in a CER by either filing or by control, and a security interest perfected by control has priority over one perfected by filing.
- Electronic Money: Amendments to Article 9 also create the concept of electronic money, which includes central bank digital currencies, but not non-government virtual currencies. A security interest in electronic money can be perfected only by control (unless it is credited to a deposit account, then existing rules regarding deposit account perfection apply).
- Definitions: The definitions of various terms, including "sign" and "writing," have been revised to reflect digital transactions as well.
Knowledge Management Spotlight
Data Driven Deals
To provide maximum value for our clients, Goldberg Kohn's Knowledge Management Department is working with different technology platforms and using AI tools that provide us greater insight into the highly negotiated deal points in credit documentation and transactions. While considerable large market data exists, it can be difficult to find meaningful data related to the middle market lending space. Goldberg Kohn's internal data tools, coupled with new legal tech platforms allow our attorneys to more effectively negotiate and review contracts, as well as to develop valuable lending market insights.
This newsletter is provided by Goldberg Kohn's Commercial Finance and Bankruptcy & Creditors' Rights practices. The attorneys in these practices collaborate to represent a diverse group of banks, commercial finance companies, providers of mezzanine loans and other institutional lenders engaged principally in middle market lending operations. Goldberg Kohn is known for the depth of its practice, providing practical legal guidance, efficient staffing, and ability to facilitate smooth closings.
If you have any questions about this newsletter, please contact our Knowledge Management Attorney, Laura Jakubowski, or the Goldberg Kohn attorney with whom you normally consult. The information contained herein is provided for general information purposes only, and for review and use only by the direct recipient of this newsletter. The information contained in this newsletter is not intended to be and should not be relied upon as legal advice.
[1] Certain market comparative data was sourced from third party sources, including products of Fitch Solutions, Inc.
[2] See LCM XXII Ltd. v. Serta Simmons Bedding, LLC, No. 21-cv-3987, 2022 WL 953109 (S.D.N.Y. Mar. 29, 2022); Octagon Credit Inv., LLC v. NYDJ Apparel, LLC, No. 656677/2017, Hr'g Tr (N.Y. Sup. Ct. Jan. 9, 2018); Audax Credit Opportunities Offshore Ltd. v. TMK Hawk Parent, Corp., No. 565123/2020, 2021 WL 3671541 (N.Y. Sup. Ct. Aug. 16, 2021); ICG Global Loan Fund 1 DAC v. Boardriders, Inc., No. 655175/2020, 2022 WL 10085886 (N.Y. Sup. Ct. Oct. 17, 2022).
[3] See AIMCO CLO 10 Ltd. v. Revlon, Inc. (In re: Revlon, Inc.)., No. 22-01167 (Bankr. S.D.N.Y.), filed Oct. 31, 2022; SSD Invs. Ltd. v. Wilmington Sav. Fund Soc'y, FSB, No. 654068/2022 (N.Y. Sup. Ct.), filed Oct. 28, 2022.
[4] Bayside Cap., Inc. v. TPC Grp. Inc. (In re TPC Grp. Inc.), No. 22-50371 (Bankr. D. Del, July 6, 2022).
[5] In re Ultra Petroleum Corp., 51 F.4th 138 (5th Cir. 2022).
[6] Wells Fargo Bank, N.A. v. Hertz Corp. (In re Hertz Corp.), 637 B.R. 781 (Bankr. D. Del.2021).
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