The Background

The last decade has seen a substantive loosening of covenants in debt instruments on both sides of the Atlantic. Oneconsequence of enhanced document flexibility in the US has been the proliferation of liability management exercises (LMEs). These transactions offer novel (if divisive) mechanisms to address liquidity or debt maturity concerns, where a company isunable to raise capital on terms acceptable to it via more traditional means. On the one hand, LMEs can provide companies with creative routes to restructure debt and potentially avoid bankruptcy. However, LMEs can also engender lender-on-lender violence by dividing creditors into opposing groups, with one classfavoured at the expense of the other (an issue exacerbated by the shift in lender composition over the past several years,with institutional investors often more willing to take aggressive steps to recover value). Per table one below, LMEs can be roughly classified into three groups: drop-downs, uptiering, and double-dip transactions.

Table One

Market Response to Hostile LMEs

While LMEs remain largely untested in the European courts, they have left a trail of litigation in their wake in the US, primarilydue to their tendency to pit lender groups against one another. The market has responded by adopting a series of protective documentary measures, or “blockers”, with the apparent goal of preventing LMEs that could be unfavourable to minority lender groups. We have previously reported on the most common of these blockers, and what they seek to do¹.

While LME blockers originated in the US as a response to specific, landmark cases, they are also being seen with increasing frequency in the European debt markets. “J Crew blockers” and, to an extent, “Chewy blockers”, have been around on thisside of the Atlantic for years, and are only growing more prolific: in 2024, we recorded some form of J Crew blocker in overtwo thirds of the European loan deals we reviewed, and Chewy blockers in around 40%².

In the last few months, we have also witnessed the emergence of anti-Serta provisions, Envision blockers and (most recently) double-dip blockers in European term sheets, senior facilities agreements and bond offering memoranda.

The Blockers: Pitfalls and Weaknesses

Investors might be tempted to take comfort from buzz-word references in term sheets to blockers for “J Crew”, “Chewy”,“Serta” and “Envision”, and assume they will be protected from the haunting spectre of non-consensual LMEs. But, as withso many supposed covenant protections in the current market, the devil is very much in the detail. In reality, these blockers are often drafted so that, at best, they offer incomplete protection and, at worst, they are almost entirely useless.

In table two, we examine some common caveats and loopholes we have seen in the European loans market that can hamstring the applicable blocker’s functionality.

Table Two

The “Gold Standard” Solution

So, if the current generation of LME blockers offers flawed protection at best, how else can creditors seek to arm themselves against LME-related risk?

First and foremost (and as is always the case), through tighter covenants:

1. Drop-down transactions: concerns raised by cases such as J-Crew and Envision can be addressed through a combination of the following:

• Controlling the designation of Unrestricted Subsidiaries via conditions that e.g. require no default and compliance with a minimum financial condition and that impose caps on Unrestricted Subsidiary EBITDA and asset value;
• Including a robust limit on investments and RPs that can be made into, or assets that can be contributed to, Unrestricted Subsidiaries for the entire tenor of the financing (rather than just at the time the Unrestricted Subsidiary is designated);
• Prohibiting leakage of critical material assets (whether IP or otherwise) out of the Restricted Group generally via any covenant;
• Blocking any ability to reclassify or contribute capacity from other baskets to the designated Unrestricted Subsidiary basket; and
• Considering any appropriate controls on leakage from Guarantors to non-Guarantor Restricted Subsidiaries.

2. Chewy: concerns around the release of subsidiary Guarantors can be addressed by:

• Allowing non-wholly owned companies to be Guarantors or prohibiting entities from becoming non-wholly owned once they have become Guarantors; and/or
• Rejecting auto-release requirements where subsidiaries become non-wholly owned (unless entire sharecapital is sold).

3. Serta-style uptiering: concerns can be addressed by:

• Ensuring that the incurrence of super senior debt, the subordination of liens, changes to the ICA order of priority/distribution of enforcement proceeds and the pro rata sharing provisions are expressly included as all-lender consent items;
• Tightening the definition of “Refinancing Debt” to prevent the replacement of existing debt with priority ranking debt; and

Blockers to protect against double-dip structures are new to the European market, so their robustness (or otherwise) has not yet been analysed. The same rule will likely apply, however. In addition to any specific “blocker” clause, creditors wishing topreclude non-consensual double-dip LMEs would be best served by ensuring their covenants are drafted sufficiently tightly to prevent parties exploiting flexibilities and large or open-ended baskets. Pertinent provisions will likely include (i) capacity for the Restricted Group to guarantee or provide security for the debt of Unrestricted Subsidiaries, (ii) capacity for Unrestricted Subsidiaries to own the debt of members of the Restricted Group, (iii) subordination requirements in respect ofany inter-company loans and (iv) conditions for designating Unrestricted Subsidiaries.

Cooperation Agreements

In addition to documentary blockers, the proliferation of LMEs has been met with a rise in cooperation agreements or “coops”. Here, creditors agree between themselves to abide by certain rules including, for example, not consenting to LMEs without the approval of the other parties to the co-op, thereby reducing the risk of creditor-on-creditor violence.

As with all things, this solution is unlikely to offer infallible protection. Companies who are unhappy with the limitations coops impose on their ability to explore flexible LME options might seek to include anti-cooperation clauses in their debt documents. While it was ultimately dropped, we have seen at least one attempt in Europe to incorporate provisions to prohibit lenders from entering co-ops without company consent. Further, in the US at least, there has been some debate around whether borrowers can challenge co-ops on the grounds they constitute anti-competitive behaviour.

The Upshot

As LME activity continues unabated, “LME blockers” seem likely to become a recurrent feature of European debt documents. Unfortunately, the protection offered by the current generation of blockers is often incomplete. Investors anxious to avoidfinding themselves on the wrong side of a hostile LME should be mindful of the exclusions and limitations described abovewhen considering any purported “blocker” language in their term sheets, facilities agreements and offering memoranda, and push for more comprehensive documentary defences.

¹ “Newsflash”: LME Blocker Frenzy in Europe – Don’t Believe the Hype!

² Our cohort of European leveraged loan documentation reviewed includes, in some cases, syndication term sheets or draft senior facilities agreements where we have not received or reviewed the final version/executed document. We expect there may be some deviations to the terms in the final documentation which may impact these statistics.

Julia is an English qualified lawyer with over 13 years’ experience specialising in European leveraged loans andacquisition finance. She previously practised at DLA Piper.

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