Developed in the US since 2016 and now a relatively common phenomenon in the US, liability management exercises (LMEs) are making their way into European debt structures. LMEs allow borrowers to access liquidity and reduce their debt burden through contractual permissions rather than in-court or extrajudicial restructuring processes. While these exercises can help companies attract new financing, they also may have implications for creditors and lead to "creditor-on-creditor violence", where different creditor groups act strategically to protect their interests, often at the expense of others.

Despite their controversial nature, US courts, particularly in New York, have generally sanctioned LMEs, considering it primarily a contractual matter. As a result, LMEs are becoming institutionalised and an expected feature in US debt structures. Adding nuance to this expectation, however, a recent US court ruling overturned a USD 200 million uptier transaction.

What is liability management and what types of structures are available?

Liability management refers to financial actions employed by borrowers to restructure their debt obligations and improve liquidity. Factors driving this trend, the first few of which were established in debt documents years ago, include:

• a surge in leveraged buy-outs with increasing leverage
• a shift toward direct lending in the US (and subsequently the UK)
• direct lenders preferring a mix of tranches and returns rather than single-class senior loans
• increasing debt stacks negotiated by sponsors, allowing for borrower-friendly structures with loose covenants and few restrictions
• high-restructuring costs in the US

LMEs can take various forms, all aimed at helping the borrower prime their debt or generate cash to attract new funding. Common structures include drop-down financing, non-pro rata uptiering, and double-dip transactions.

Drop-down financing: In this structure, a borrower transfers specific assets, such as a separate business unit or intellectual property, to an unrestricted subsidiary or a non-guarantor restricted subsidiary (NewCo). This transfer effectively releases the lien securing the existing credit facility, thereby freeing the assets to serve as collateral for new indebtedness provided by new creditors. The new debt, secured by these unencumbered assets, is structurally senior to the claims of existing lenders. Alternatively, existing lenders may participate by providing new loans to NewCo and exchanging their existing debt for new debt of NewCo, thus rolling up their subordinated exposures into a structurally senior position. Notable examples of drop-down financing in the US include J. Crew (2017), Travelport (2020), Cirque de Soleil (2020), and Revlon (2020).

Non-pro rata uptier transactions: In these types of transactions a borrower, rather than transferring assets outside of the credit group, amends its existing loan documents to permit the incurrence of new "super priority" debt, secured by liens that have priority over the existing secured debt. This process typically involves offering some but not all existing lenders (often majority lenders) a senior claim against the borrower's assets and collateral, either through collateral priority or payment priority by amending the waterfall structure. Participating lenders may also exchange their existing debt for new super priority debt, thereby elevating their position in the capital structure. Examples include NYDJ (2017), Murray Energy (2018, litigated in 2020) and Serta Simmons (2020), though the latter was recently overturned on appeal.

Double-dip transactions: Following this strategy, a borrower raises new financing through a non-obligor subsidiary, which is then guaranteed by the parent and other obligors. The proceeds from this new financing are on-lent to the parent company, creating a dual claim structure. The new financing is secured by the subsidiary's assets and guaranteed by the parent and other obligors (first dip). Additionally, the intercompany loan from the subsidiary to the parent is guaranteed by the other obligors and pledged to the new lenders (second dip). This effectively allows the new lenders to have two points of entry for their claims on the same set of assets, thereby diluting the collateral available to existing creditors.

While these strategies provide opportunities for borrowers to raise capital, they pose significant implications for existing lenders, who may find their claims subordinated if they do not participate in the new financing. This means that these LMES introduce complexities and risks that must be carefully managed to maintain financial stability and creditor confidence.

Impact of LMEs on the European, specifically the Dutch, debt market

LMEs are gradually entering the European debt market, but their impact is expected to be smaller compared to the US for several reasons:

• The European market is of a size and nature less familiar with aggressive debt stacking.

• European (particularly Dutch) courts are more likely to consider non-contractual factors in creditor disputes, raising the bar for justifying LMEs towards those impaired.

• In-court restructurings in Europe, such as pursuant to the Dutch WHOA, offer flexible frameworks and lower costs compared to their US counterparts so there is less need for LMEs.

• The LMA-style intercreditor model in Europe often requires unanimous lender consent for changes to collateral ranking, making implementation of LMEs impossible or at least much more difficult.

• Directors in Europe may face personal liability if transactions are pursued when insolvency may be imminent, making them more cautious than their US counterparts. US directors are typically protected by the "business judgment rule" which, in essence, provides that courts will defer to board decisions unless these lack a rational business purpose.

Nevertheless, US-sponsored structures are pushing for a more favourable approach to liability management in Europe. In the Netherlands, there has been a rise in private credit since 2017, with examples of LMEs in US-funded structures, often involving Dutch companies with US shareholders.

Although LMEs are not yet common in the Netherlands, there is growing demand for flexible capital structures, mostly driven by private equity funds that have been growing their share of the Dutch loan market for years now. Factors such as high inflation, supply chain challenges, and changes in consumer demand have created greater uncertainty in the Dutch debt market. As a result, auditor scrutiny has increased materially and borrowers are now starting to build their refinancing strategy well ahead of maturity.

Ten recommendations for Dutch borrowers when conducting LMEs

For Dutch companies considering LMEs, we recommend that directors carefully consider their fiduciary duties, as these may prevent the board from pursuing liability management to the exclusion of a consensual deal with all creditors. Failing to do so could lead to liability in bankruptcy scenarios. Below are ten recommendations for Dutch borrowers considering LMEs:

1. Define a clear end goal: LMEs should be geared towards achieving a capital structure and getting access to liquidity that meets the company's need. Engage financial and legal advisors early on to develop a roadmap towards that end goal, while ensuring the stakeholders are aligned and on board throughout the process.
2. Evaluate new money priority: consider increased pricing for new pari passu debt instead of super senior debt to avoid subordinating others.
3. Consider egalitarian structures: if any new capital through pari passu debt is not available, consider offering all existing lenders an opportunity to participate in the LME.
4. Ensure compliance with loan documentation: carefully review existing loan documentation to ensure that the intended transaction is permissible. This includes understanding any limitations and conditions related to asset transfers, debt incurrence and lien subordination.
5. Evaluate the impact on existing lenders: assess how the LME will affect existing creditors' positions, collateral, and recovery prospects to prevent prejudice.
6. Incentivise participation: encourage all lenders to participate in the LME by reserving a significant portion of the new money opportunity for the negotiating lender group and compensating them for providing backstop commitments. Offering this to all lenders can help mitigate disagreements, but the specific circumstances will determine whether there is a realistic opportunity for broader participation and sufficient time to involve everyone.
7. Conduct fair market valuation: ensure that any assets being transferred or used as collateral in exchange for a fair consideration and in good faith.
8. Maintain transparency and communication: communicate openly with all stakeholders, especially existing lenders, about the planned LME and the rationale behind it to minimise concerns and disputes.
9. Consider long-term implications: evaluate the long-term implications of the transaction on the company's capital structure and financial health. Consider how the LME will affect the company's ability to raise future financing and manage its debt obligations.
10. Document decision-making process: keep thorough records of the decision-making process, including the rationale for the LME, the advice received from (legal and financial) advisers, and the steps taken to ensure compliance and fairness. Keeping detailed documentation of what was considered at the time will provide the best defence against hindsight bias, should the process ultimately prove unsuccessful.