How Can Lenders Proactively Defend against Value Leakage to Unrestricted Subsidiaries? ▴ Question

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The Unseen Erosion of Collateral

In the realm of secured lending, the integrity of a collateral package is paramount. Lenders extend credit based on the assurance that a specific pool of assets is available to them in a default scenario. However, a subtle yet significant threat to this security exists in the form of value leakage to unrestricted subsidiaries. This phenomenon occurs when a borrower transfers valuable assets, such as intellectual property or profitable business units, from the restricted group of companies that guarantee a loan to an unrestricted subsidiary.

These unrestricted subsidiaries are not bound by the covenants of the credit agreement and, therefore, can incur additional debt, grant liens to other creditors, or dispose of assets without the original lenders’ consent. This effectively removes the transferred assets from the reach of the original lenders, diminishing the value of their collateral and increasing their risk exposure.

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The Mechanics of Value Diversion

The process of value leakage often begins with the designation of a subsidiary as “unrestricted.” This designation is typically permitted under the terms of the credit agreement, provided certain conditions are met. Once a subsidiary is designated as unrestricted, the borrower can then transfer assets to it, often through a series of complex transactions designed to obscure the ultimate destination of the value. These transfers can take many forms, including:

Asset sales ▴ The borrower may sell valuable assets to an unrestricted subsidiary at a price below their fair market value.
Intellectual property licensing ▴ The borrower may grant an exclusive, royalty-free license to an unrestricted subsidiary to use valuable intellectual property, such as trademarks or patents.
Intercompany loans ▴ The borrower may make loans to an unrestricted subsidiary on terms that are not commercially reasonable.

These transactions, while seemingly innocuous on their own, can have a devastating cumulative effect on the value of the lenders’ collateral. The infamous J. Crew case serves as a stark reminder of this risk. In that case, the company transferred its valuable intellectual property to an unrestricted subsidiary, which then used those assets to secure new financing from a different group of lenders. This left the original lenders with a significantly diminished collateral package and a much higher risk of loss.

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The Evolving Landscape of Lender Protections

In the wake of the J. Crew case and other similar instances of value leakage, lenders have become increasingly focused on protecting themselves from this risk. As a result, credit agreements have evolved to include a variety of provisions designed to prevent or mitigate value leakage to unrestricted subsidiaries. These provisions, often referred to as “J. Crew blockers,” typically include:

Restrictions on the transfer of material intellectual property ▴ These provisions prohibit the borrower from transferring or exclusively licensing material intellectual property to unrestricted subsidiaries.
Limitations on investments in unrestricted subsidiaries ▴ These provisions limit the amount of money that the borrower can invest in unrestricted subsidiaries.
“Chewy” protections ▴ These provisions restrict unrestricted subsidiaries from owning equity in, or holding debt of, the borrower or its restricted subsidiaries.

While these protections have become more common in recent years, they are not foolproof. Borrowers and their legal advisors are constantly developing new and creative ways to circumvent these provisions and extract value from the restricted group. As a result, lenders must remain vigilant and proactive in their efforts to defend against value leakage.

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Strategy

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A Proactive Defense against Value Leakage

A reactive approach to value leakage is often too little, too late. By the time a lender discovers that valuable assets have been transferred to an unrestricted subsidiary, the damage has already been done. Therefore, a proactive defense is essential. This involves a multi-pronged strategy that begins with a thorough understanding of the borrower’s business and capital structure.

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Due Diligence the First Line of Defense

The first step in any proactive defense is to conduct thorough due diligence on the borrower and its subsidiaries. This should include a detailed review of the borrower’s organizational structure, financial statements, and material contracts. The goal of this due diligence is to identify any potential red flags that could indicate an increased risk of value leakage. Some of the key things to look for include:

Complex organizational structures ▴ Borrowers with a large number of subsidiaries, particularly those located in offshore jurisdictions, may be more likely to engage in value leakage.
A history of aggressive financial engineering ▴ Borrowers that have a history of using creative accounting or complex financial instruments may be more likely to engage in value leakage.
Weak corporate governance ▴ Borrowers with weak corporate governance, such as a lack of independent directors or a dominant CEO, may be more susceptible to value leakage.

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Covenant Structuring a Critical Tool

Once the due diligence is complete, the next step is to structure the credit agreement in a way that minimizes the risk of value leakage. This involves negotiating a set of covenants that are specifically designed to prevent the borrower from transferring valuable assets to unrestricted subsidiaries. Some of the key covenants to consider include:

Covenant	Description
Limitation on Restricted Payments	This covenant limits the ability of the borrower and its restricted subsidiaries to make payments, such as dividends or investments, to unrestricted subsidiaries or other third parties.
Limitation on Asset Sales	This covenant restricts the ability of the borrower and its restricted subsidiaries to sell assets, particularly to unrestricted subsidiaries, without the lenders’ consent.
Limitation on Affiliate Transactions	This covenant requires that all transactions between the borrower and its affiliates, including unrestricted subsidiaries, be conducted on an arm’s-length basis.

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Monitoring and Enforcement an Ongoing Process

A proactive defense against value leakage does not end with the closing of the credit agreement. It is an ongoing process that requires constant monitoring and enforcement. Lenders should regularly review the borrower’s financial statements and other reports to ensure that they are in compliance with the covenants of the credit agreement. They should also be prepared to take swift and decisive action if they discover any evidence of value leakage.

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Execution

From Theory to Practice a Step-By-Step Guide

The successful execution of a proactive defense against value leakage requires a disciplined and systematic approach. The following is a step-by-step guide that lenders can use to implement the strategies discussed in the previous section.

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Step 1 Conduct a Comprehensive Risk Assessment

The first step is to conduct a comprehensive risk assessment of the borrower and its subsidiaries. This should involve a detailed review of the borrower’s business, financial condition, and corporate structure. The goal of this assessment is to identify the specific risks of value leakage that are present in the transaction. Some of the key factors to consider include:

The nature of the borrower’s business ▴ Businesses with a high proportion of intangible assets, such as intellectual property, may be more susceptible to value leakage.
The borrower’s capital structure ▴ Borrowers with a high level of unsecured debt may be more motivated to transfer assets to unrestricted subsidiaries.
The legal and regulatory environment ▴ The laws and regulations of the jurisdictions in which the borrower and its subsidiaries operate can have a significant impact on the risk of value leakage.

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Step 2 Develop a Customized Covenant Package

Based on the results of the risk assessment, the next step is to develop a customized covenant package that is specifically designed to address the identified risks. This may involve negotiating for stronger-than-market covenants in certain areas, such as the transfer of intellectual property or the making of investments in unrestricted subsidiaries. It is important to remember that there is no one-size-fits-all solution when it comes to covenant structuring. The optimal covenant package will vary depending on the specific facts and circumstances of each transaction.

Covenant	Key Considerations
Definition of “Unrestricted Subsidiary”	The definition of “unrestricted subsidiary” should be narrowly tailored to limit the borrower’s ability to designate subsidiaries as unrestricted.
“J. Crew” Blocker	The “J. Crew” blocker should be drafted to prohibit the transfer of any material intellectual property to an unrestricted subsidiary.
“Chewy” Protections	“Chewy” protections should be included to prevent unrestricted subsidiaries from owning equity in, or holding debt of, the borrower or its restricted subsidiaries.

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Step 3 Implement a Robust Monitoring Program

The final step is to implement a robust monitoring program to ensure that the borrower is in compliance with the covenants of the credit agreement. This should involve regular reviews of the borrower’s financial statements, compliance certificates, and other reports. It is also important to have a clear plan in place for responding to any potential breaches of the covenants. This may include conducting a more detailed investigation, demanding additional collateral, or even declaring a default.

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References

Proskauer Rose LLP. “Private Credit Explained ▴ Plug The Gap – Minimizing Value Leakage.” 2024.
“The J. Crew Legacy in Secured Lending ▴ Consider a ‘Tailored’ Approach.” 2024.
Simpson Thacher & Bartlett LLP. “Leveraged Finance 101 – A Covenant Handbook.”
Proskauer. “Lending & Secured Finance – 2023.” 2023.
McDermott Will & Emery. “CLOs ▴ Adding Flexibility to Engage in Liability Management Transactions.” 2022.

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A Paradigm Shift in Lender Vigilance

The threat of value leakage to unrestricted subsidiaries has forced a paradigm shift in the way that lenders approach secured lending. No longer can they rely on a boilerplate set of covenants to protect their interests. Instead, they must adopt a more proactive and customized approach that is tailored to the specific risks of each transaction.

This requires a deep understanding of the borrower’s business, a willingness to negotiate for strong covenant protections, and a commitment to ongoing monitoring and enforcement. By embracing this new paradigm, lenders can significantly reduce their risk of loss and ensure that their collateral remains intact.