Breaking the Chain: District Court’s Wesco Opinion Limits ‘Effect of’ Sacred Rights Protections, a Boon for Vote-Rigging and Other Multi-Step LMEs

Relevant Documents:
Opinion
 

 

• In a memorandum order released this week, District Court Judge Randy Crane ruled that the March 2022 amendments enabling Wesco’s two-step uptier of its 2026 secured notes did not violate the relevant indenture.
   
• The ruling reverses Bankruptcy Court Judge Marvin Isgur’s finding that the initial amendment issuing $250 million of additional secured notes to the Pimco- and Silver Point-led majority group (and which granted the incremental voting power needed to pass a subsequent lien-stripping amendment) had the “effect of” releasing all or substantially all collateral without the requisite supermajority consent.
   
• Pending a likely appeal to the Fifth Circuit, the district court’s decision could have important implications for how “effect of” language, which is generally understood to broaden the scope of lenders’ sacred rights, will be interpreted across the leveraged loan and high-yield bond markets, including in the ongoing STG Logistics liability management exercise litigation before the New York Supreme court.

 

The Wesco dispute has spanned several years and multiple proceedings. Octus has covered this dispute from the outset. More fulsome background on the transaction can be found HERE, and on the dispute more broadly HERE.

As part of Wesco’s 2022 uptier exchange (the “2022 Transaction”), a group holding a majority of the company’s 2026 secured notes led by Pimco and Silver Point (the “Majority Group”) implemented two amendments to the 2026 secured notes indenture that enabled the majority group to exchange its holdings into priming debt while stripping the liens and covenants of the excluded minority. The crux of the dispute at issue in Judge Randy Crane’s opinion is whether the majority group had the requisite consents for the amendments that implemented the transaction.

Under the 2026 secured notes indenture, Wesco needed the consent of 66-2/3% to make an “amendment, supplement or waiver” that “may … have the effect of releasing all or substantially all of the Collateral from the Liens created pursuant to the Security Documents…”

The Majority Group lacked a supermajority position in the 2026 notes. To meet the supermajority threshold, Wesco and the Majority Group amended the 2026 notes (through the execution of a third supplemental indenture) to issue the Majority Group additional 2026 notes (“Amendment No. 1”). With the requisite supermajority, Wesco and the Majority Group entered into a fourth supplemental indenture (“Amendment No. 2”) under which liens securing the 2026 notes were removed, certain negative covenants stripped, and the notes’ exchange authorized.

All documents necessary to consummate the uptier exchange were executed and consummated over seven hours on a single day (March 28, 2022) in a prenegotiated and preplanned process. That process involved the sequential release of the agreements from escrow under agreed-upon closing mechanics.

Throughout the litigation, the Majority Group’s position was that Amendment No. 1 required only majority noteholder consent, which the Majority Group held at the time it entered into Amendment No. 1.

A group of minority lenders (the “Minority Group”) raised several objections to the 2022 Transaction, including that Amendment No. 1 had the “effect of” releasing all of the collateral backing the 2026 notes because it was the predicate for Amendment No. 2, and the entire structure of the 2022 Transaction was pre-ordained. Thus, according to the Minority Group, Amendment No. 1 was invalid because the Majority Group lacked the required supermajority at the time it was passed.

In its Report and Recommendation issued on Jan. 17, 2025, the Bankruptcy Court sided with Minority Group on its “effect of” argument.

The Bankruptcy Court in its review of the process surrounding the 2022 Transaction found that the collateral release under Amendment No. 2 was effectively baked into the 2022 Transaction at the time all of the documents were executed and delivered into escrow, finding that the “moment the Third Supplemental Indentures were executed, the rest of the documents (having already been delivered in executed form subject to release) were released and effective automatically and instantaneously.” As illustrated below, according to Bankruptcy Court Judge Marvin Isgur, the entire transaction was a “domino agreement” – once the first domino toppled, the rest would necessarily fall.
 

 

The district court flatly rejected the Bankruptcy Court’s Report and Recommendation and took specific issue with the bankruptcy court’s characterization of the 2022 Transaction.

The decision rests largely on: (1) the court’s view of the plain language of the indentures and the “sophisticated entities” that were parties to them, and (2) in stark contrast to the bankruptcy court, the court’s finding that the serial steps of the 2022 Transaction were not automatic or irreversibly preordained.

Adopting a literal approach that, in our view, is divorced from the context and purpose of the 2022 Transaction, the court specifically focused on the express terms of Amendment No. 1 and found that Amendment No. 1 complied with the terms of the indentures. Amendment No. 1 simply authorized the issuance of the additional notes for which only majority consent was required and did not have the “effect of” releasing any collateral. The court found that each other component of the 2022 Transaction complied with the express noteholder voting thresholds. According to the court, it simply refused to read any “implied sacred rights” into the indentures.

The court cites as support for its conclusions the Fifth Circuit’s Serta decision and the need to adhere to the precise language in the agreement at issue, stating that: “Unlike the loan agreement in Serta, the 2026 Indenture does not include any provision requiring Wesco to obtain unanimous consent from its existing noteholders in order to engage in an uptier transaction” (emphasis added). That is a curious (and perhaps imprecise) citation, given that the credit agreement in Serta in fact lacked any provision requiring unanimous consent to subordinate the lenders’ lien or payment priority (hence the eponymous Serta blocker). Perhaps the court’s reference to Serta was to the pro rata sharing provision, but regardless we will leave it to the Fifth Circuit to address the propriety of the court’s reliance on the Serta decision in this context.

The court’s conclusions are in part guided by its view of the sophistication of the parties involved. The parties were well aware of the terms of the indentures and that they permitted issuing additional notes with only majority consent. The court reiterated a well-worn admonition that had minority holders wished to include a more expansive set of sacred rights that would have precluded the 2022 Transaction, they could have done so, but they did not.

On the basis of this analysis, the court summarily rejected the Minority Group’s argument that Amendment No. 1 is invalid because it had the effect of releasing all or substantially all of the collateral. The court looked at the meaning of “effect” in the context of a legal instrument, relying on Black Law’s definition that “effect” in this context means “[t]he result that an instrument between parties will produce on their relative rights.” In the context of the 2022 Transaction, this meant that Amendment No. 1 “itself” must have the effect of releasing the collateral and “not just to initiate a chain of events, including subsequent amendments, that may eventually lead to releasing the collateral.” Here “the only ‘result’ that the Third Supplemental Indentures themselves ‘produce[d] on [the parties’] relative rights’ was to enable Wesco to issue additional 2026 Notes – an effect that did not require supermajority consent under the express terms of the 2026 Indenture” (emphasis added). We imagine that this interpretation, which is squarely at odds with the Bankruptcy Court’s views, will provide ample fodder on appeal.

The court was equally dismissive of the related argument that Amendment No. 1 had the effect of releasing all of the collateral because the resulting steps under the 2022 Transaction were “automatic” and “inevitable.” The court acknowledged that the parties to the 2022 Transaction had agreed on the closing mechanics and a closing sequence during a pre-closing call on the morning of the closing. After the call, the serial closing took place over the next seven hours. Despite the factual record, in the court’s view, after the closing of Amendment No. 1, at any time before the release of the liens, any party could have withdrawn its consent to the balance of the 2022 Transactions. While the court acknowledged that this might have triggered litigation, “it would also unquestionably have prevented the release of the liens” (emphasis added).

The court seemed to pose a hypothetical and improbable situation that defies all reasonable commercial expectations. Parties which the court acknowledged are experienced and sophisticated negotiated a multi-step transaction to effectuate a lien-stripping uptier. In our view, the notion that anyone would pull the plug mid-closing on a carefully orchestrated transaction designed to provide significant economic benefits to both sides, despite the enormous litigation risks involved, strains credulity.
 

What Effect Does “Effect of” Actually Have?

We expect that the decision will be appealed to the Fifth Circuit Court of Appeals, which will take several months at least. As we have seen in Serta, predicting the appeal’s outcome would be the proverbial fool’s errand. In the interim, Wesco has important implications for market participants and litigants. In the decision’s aftermath, we see three primary issues.

First, the district court’s decision arguably raises more questions about what “effect of” means than it resolves. The inclusion of “effect of” type language in the sacred rights provisions is not a given in the broadly syndicated or high-yield markets but a highly negotiated creditor protection that is relatively uncommon outside of the post-LME context. Those credit agreements and indentures that did include this language were thought to offer lenders greater protection than those that did not.

Whether that is the case now remains an open question. The court’s focus was on the propriety of Amendment No. 1 as step one in a multi-step process. It did not meaningfully address the impact of “effects of” sacred rights language outside of this context. Arguably, the decision can be limited to a holding that “effect of” language will not protect lenders in a step transaction, where previous steps lay the groundwork to permit subsequent steps. That said, “effect of” language may still broaden the reach of a sacred right within the document itself. For example, a sacred right that requires unanimous consent for amendments that have the “effect of” altering the pro rata sharing provision may still cover changes to other parts of the agreement, not just the pro rata provision itself.

Similar issues are now before the New York Supreme Court in the STG Logistics motions to dismiss, where a decision is pending. There, the pro rata sharing provision required the consent of all lenders “directly and adversely affected” for amendments that “could change or have the effect of changing the priority or pro rata treatment of any payments (including voluntary and mandatory prepayments) … .” Defendants’ principal argument is that the transaction did not amend the pro rata sharing and payments waterfall provisions. Minority lenders counter that the sacred right encompasses amendments that can affect priority or pro rata sharing treatment even if not made directly to the express pro rata sharing provision.

The relevance of Judge Crane’s Wesco decision was not lost on STG’s counsel. On Tuesday, Kirkland & Ellis filed a notice of supplemental authority highlighting the reversal of Judge Isgur’s Wesco decision (which plaintiffs relied on in their briefing) as “directly relevant to the issues raised” in the motion-to-dismiss briefing. Arguably, a decision by a New York court addressing a document governed by New York law about the meaning of “effect of” language could have more market importance than one by the Southern District of Texas. That said, the court in STG may not have the chance to decide this issue. Octus recently reported that STG Logistics is contemplating a chapter 11 filing. Following the typical playbook (which Wesco itself followed), absent some type of global settlement, the litigation now pending before the New York Supreme Court would end up before the bankruptcy court in which STG Logistics’ case is commenced.

Multi-Step Transactions

Second, construed broadly, Judge Crane’s approach to analyzing each step of a multi-step transaction in a vacuum from other steps could also affect a court’s approach to other LMEs (even absent “effect of” language in the sacred rights).

Multi-step transactions, such as Wesco’s and those seen in Robertshaw, Better Health, Oregon Tool and, more recently, Optimum Communications, have long been a favored tool of borrowers and majority groups for circumventing lender protections in connection with an LME. The proponents of similar transactions will take comfort in Judge Crane’s view that expanding step-one in a multi-step transaction creates “difficult line-drawing problems … [o]nce the inquiry moves beyond the immediate effect of an amendment there is no logical stopping point” (emphasis added). That is, it creates an open question as at what point in time, if any, can it be said that step one no longer has any “effect” on any subsequent transaction.

Although multi-step transactions are often structured so that all steps occur substantially simultaneously, some spread the steps over a longer time span. For instance, unlike the Wesco transaction steps, which were effectuated over several hours, Hunkemöller’s multi-step liability management exercise spanned several months. The payments-for-consent clause at issue in the Hunkemöller New York litigation was stripped in April 2024, but the rest of the LME was not effectuated until June 2024.

A License to Vote-Rig?

Third, borrower and majority groups could, on one reading, interpret Wesco as providing an unfettered right to gerrymander votes to obtain the voting thresholds necessary for a given action, even where “effect of” language is present in sacred rights.

The District Court’s Wesco decision does not offer much room for interpretation in this context. The court acknowledges that the transaction from the outset was intended to achieve a desired result (i.e., a capital raise, non-pro-rata uptier and lien strip) and was deliberately structured to achieve the requisite voting thresholds. Despite the clear factual record, the court relied on a literal reading of the indenture, and without even a hint of reservation, sanctioned the vote-rigging accomplished in Wesco. If the end results of the 2022 Transaction were not, as determined by the District Court, inevitable, it is hard to imagine what type of transaction would be.

This approach also differs markedly from that of the New York State Supreme Court in Bombardier, where Justice Andrew Borrok refused to count the new notes issued by Bombardier to meet the requisite voting thresholds to obtain a waiver of its covenant default.

For now, majority investors (particularly in the high-yield market, where the 66-2/3 % voting threshold for lien-stripping amendments is common) may feel emboldened by the Wesco decision to engage in vote-rigging. However, all is not lost for minority groups. The decision is not binding outside of the Southern District of Texas, and while the decision is persuasive, there is nothing to prevent a reviewing court from siding with the Bankruptcy Court’s opposing view.
 

The inevitable Wesco appeal and the pending litigation in STG Logistics leave matters in a state of flux. It remains to be seen how the market will respond and whether borrowers, sponsors, and majority lenders will view Wesco as a green light to continue indirect attacks on sacred rights or engage in aggressive vote-rigging.

To prevent majority groups from manipulating voting schemes, credit agreements and indentures ideally should include appropriate vote-rigging blockers (i.e., Wesco protection) that (ideally in the sacred rights) restrict the company from manipulating voting thresholds, including by issuing additional voting debt. For real world examples of Wesco protection and other liability management blockers that have appeared in high-yield bond and leveraged loan documentation, see our LME Jargon Buster.