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Protective clauses are on the uptick in New Zealand institutional and leveraged loan documents as lenders seek to mitigate the risk of borrowers taking advantage of loopholes in loan agreements to raise more debt. We explain why they are used, where they originate from and what they mean for borrowers.
Why use a protective clause?
The reason is on the tin, to provide protection.
Protective clauses can protect lenders from liability management transactions. Borrowers tend to undertake those transactions to restructure their balance sheets (particularly in times of distress) in order to increase liquidity, reduce leverage and extend the maturity of existing debt. Two common methods borrowers use to achieve these goals are uptiering and asset drop-downs.
- Uptiering involves creating a new class of debt that takes priority over existing secured debt and allows borrowers to raise additional secured debt capacity.
- Asset drop-downs involve transferring assets to a subsidiary that isn't bound by the loan agreement who can then borrow against those assets. This can improve liquidity or facilitate debt exchanges without breaching financial covenants.
Where do protective clauses come from?
The push for protective clauses can be traced back to some high-profile cases (and ensuing litigation) that highlighted the need for greater protection for lenders.
Uptier cases
- Serta: Serta undertook a recapitalisation transaction that created a new class of super-priority debt, effectively subordinating existing loans. This was approved by the majority lenders who also funded the new loans. Minority lenders weren't given the chance to participate, leading to significant controversy.
This case was notable for the willingness of some lenders to act contrary to the interests of other lenders and has been described as “lender on lender violence”.
The response to this has been provisions requiring the consent of each affected lender before altering the ranking or subordination of loans, granting minority lenders veto power over such decisions. Other provisions can impose more rigorous tests and conditions for incurring additional debt.
Asset drop-down cases
- J. Crew: J. Crew used its disposal rights to move its trademarks to non-guaranteeing subsidiaries, removing it from the security provided to senior lenders. J. Crew then raised new debt secured against those trademarks.
The new provision is an express prohibition on transferring material intellectual property (or other assets) to non-guarantor subsidiaries, ensuring that key assets remain within the credit support framework.
- PetSmart/Chewy: PetSmart transferred a large portion of its equity in Chewy, using provisions in its credit agreements that automatically released subsidiaries from guaranteeing obligations when they ceased to be wholly owned.
We are now seeing clauses preventing this from happening unless specific conditions are met, such as ensuring the transaction that results in an entity ceasing to be a wholly owned subsidiary is for a bona fide business purpose and not primarily to release the subsidiary from its guarantee.
Considerations for borrowers
Liability management transactions of this nature are less likely in New Zealand for a variety of reasons. The small size of our market makes it less likely that lenders will agree to deal with other lenders so aggressively, and borrowers may struggle to find alternative lenders if they are known for this behaviour. Often our loan documents will prevent these transactions anyway.
However, we are starting to see New Zealand and Australian banks require protective clauses in any event.
Key considerations from a borrower’s perspective are:
- lack of flexibility: some of these clauses expand the list of things needing unanimous lender consent, which cuts across the principle that as many decisions as possible should be majority lender decisions and, where they give individual lenders more power in a syndicate context, can lead to inflexibility in debt arrangements
- unintended consequences: a borrower’s usual permitted disposal or indebtedness rights may be inadvertently constrained, in particular through tighter restrictions on removing subsidiaries as guarantors or because incurring further debt can cause issues, particularly when borrowers are under stress. Borrowers shouldn’t assume that these clauses are ‘standard’ and therefore overlook them in negotiation.
Take-outs
It is crucial for borrowers to assess the relevance of these clauses to their business operations and negotiate terms that prevent undue limitations on their financial strategies. It’s important that these provisions be considered in context with the rest of the document, and that they are tailored to provide appropriate levels of certainty and flexibility.
It remains essential for borrowers to have good relationships with their lenders. This can facilitate more favourable negotiations and foster a collaborative approach to addressing financial challenges.
