Opinion Analysis: Sacred Rights in Spotlight After American Tire DIP Dispute

Relevant Documents:
Minority Lender DIP Objection
Debtors’ Reply
Ad Hoc Group Reply

Recently, American Tire Distributors sought bankruptcy approval for debtor-in-possession financing that included a non-pro-rata rollup of a prepetition term loan, sparking an objection from a group of minority lenders that wanted to be included in the DIP. Delaware Bankruptcy Judge Craig T. Goldblatt told the parties he would approve the DIP but only without prejudice to the minority lenders’ ability to bring a suit alleging the non-pro-rata rollup breached sacred rights provisions in the prepetition credit agreement, a suit that the judge said the minority lenders would win. In response, the DIP (and majority) lenders abandoned the rollup provision.

Most disputes about violations of sacred rights in non-pro-rata uptier transactions are not litigated and there are far fewer disputes involving sacred rights violations in the context of DIP rollups in bankruptcy. As a result, Judge Goldblatt’s comments about the interplay between the rollup and the prepetition credit agreement are an important preview of how such disputes could be treated in future scenarios.

As discussed below, the American Tire credit agreement included a DIP carve-out to certain “Serta blocker” lien subordination protections, but this carve-out did not clearly extend to pro rata payment and sharing protections. In addition, the credit agreement was not explicit regarding whether rollups implicate payment and sharing protection provisions. We also review similar disputes in other cases and conclude that drafters of financing documents should ensure DIP carve-outs – if desired – to sacred right protections are clearly incorporated to all relevant provisions and that any such DIP carve-outs expressly address the potential for a rollup.

American Tire Distributors’ DIP Financing Dispute

American Tire Distributors filed for bankruptcy on Oct. 22 under a restructuring support agreement with an ad hoc group of lenders holding 88.6% of the debtors’ prepetition first lien term loans and 100% of 2024 delayed-draw first-in, Iast-out, or FILO, loans.

The ad hoc lender group agreed to provide the debtors with DIP financing, consisting of $250 million in new money and a rollup of $750 million of the ad hoc group’s prepetition loans into DIP term loans (a 3-to-1 ratio). The DIP term facility would also contain a rollup of 100% of the 2024 FILO loan, which was provided by the same group of prepetition lenders forming the ad hoc group. The DIP financing was approved on an interim basis.

An ad hoc group of minority lenders representing 7.2% of the prepetition term loan objected to the rollup of the prepetition term loan on a non-pro-rata basis, arguing that it improperly primed their interests in the prepetition loan collateral by moving “approximately $1.123.3 billion of debt ahead (in both lien and payment priority)” in violation of the prepetition term loan credit agreement. The minority lenders requested that the court condition final approval of the DIP term loan on them being allowed to participate in the DIP generally, including the rollup. According to the objection, the debtors repeatedly requested the DIP being expanded to the dissenting group, but the majority lenders refused.

The debtors and majority lenders countered the objection by noting that the prepetition loan agreement did not require that all prepetition term lenders be offered the opportunity to participate in DIP financing. The debtors also stressed that the DIP facility was the “the best – and only – financing available,” and the rollup was an integral component.

The majority lenders further noted that they had “generously” offered the minority lenders the opportunity to participate in the final draw under the DIP facility on a pro rata basis and that one minority lender left the group and signed the RSA after this offer.

What the Court Said and Minority Lenders’ Pyrrhic Victory

At the contested hearing on final DIP approval, Judge Goldblatt told the parties that he was “inclined” to approve the DIP financing, but only if it did not prejudice the minority lenders’ rights to sue for breach of the prepetition credit agreement on which he believed they would prevail.

In Judge Goldblatt’s initial view, the proposed DIP rollup violated the pro rata paydown requirement in the prepetition credit agreement. During oral arguments, Judge Goldblatt stated that the prepetition credit agreement did not permit uptier or priming transactions without allowing all lenders to participate, but with an exception for DIP financing. So, in the judge’s view, the DIP financing without the rollup could exclude some of the lenders. However, he continued, if the rollup is a draw on the DIP that pays off the prepetition debt, the credit agreement’s prohibitions against a payment that only pays some lenders and is not pro rata would apply. Reading the agreement as providing a pro rata payment or sharing exception, as proposed by the majority lenders, was “a preposterous overreach” that would become “a game of Russian roulette,” according to the judge.

As noted above, the judge did not rule on these issues but indicated that he would preserve the minority lenders’ litigation rights.

The majority lenders argued that the rollup was a conversion of the prepetition loan into a DIP loan on a cashless basis as consideration for providing the DIP loan, and so did not amount to a payment of the prepetition term loan and could be done on a non-pro-rata basis. Judge Goldblatt stated that while he did not know if that interpretation was correct or “too cute by half,” he was not going to let the majority lenders “off the hook on the litigation one iota.”

Judge Goldblatt emphasized repeatedly that it was not his role “to tilt the leverage.” He stressed, however, that “life would be easier” if the minority lenders were “dealt in.” Nonetheless, the judge concluded, it was not appropriate to condition DIP approval on the parties reaching a commercial understanding and, at most, he would condition DIP approval on not prejudicing the minority lenders’ right to sue.

Judge Goldblatt adjourned the hearing, allowing the majority lender group to decide if they wanted to move forward with the DIP loan absent findings that would protect them from a suit by the minority lenders or just let the minority lenders participate in the DIP.

Instead of letting the minority lenders into the facility, the majority lenders abandoned the rollup of the prepetition debt entirely and retroactively, so the prepetition term debt rolled up under the interim DIP order would be reinstated. The revised DIP order did not, however, affect the rollup of the approximately $90 million FILO loan.

At the continued DIP hearing, Judge Goldblatt again emphasized that his intent was not to alter the economics but to avoid entering an order that jeopardized minority lenders’ rights. “I meant what I said in TPC,” he added, referencing another one of his cases in which he approved an uptier over dissenting challenges and observed that parties can be held to the terms of an agreement “with a hole” in it that allows a majority to take advantage of a minority group. However, Judge Goldblatt continued, the “actual language” of the prepetition credit agreement was “what separated this case from that.” Ultimately, he concluded that these determinations are based on the underlying agreements, and “the documents say what they say.”

Brief Background on Sacred Rights, Serta Blockers

Credit agreements contain operational and administrative sections that govern how and when borrowings and payments will be made, how and when the debt can be purchased and how the credit agreement can be amended.

Within the rules governing amendments, credit agreements usually contain “sacred rights,” or certain fundamental lender rights – such as the right to receive scheduled payments of principal and interest – that cannot be modified without the consent of each affected lender.

In response to Serta’s 2020 uptiering transaction, expanded sacred rights provisions (so-called Serta blockers) that explicitly prohibit lien subordination amendments without the consent of each affected lender are now common in some form in most credit agreements. New protections in response to Serta and its progeny also include strengthened provisions imposing pro rata payment and sharing obligations. A credit agreement should contain both lien subordination and pro rata payment and sharing protections to protect lenders against uptiering transactions.

Sacred Rights Provisions at Play in American Tire Distributors

The American Tire DIP rollup raised two issues that implicated “sacred rights” provisions in the prepetition credit agreement.

First, did a carve-out for “any ‘debtor-in-possession’ facility” encompass both lien subordination and pro rata payment provisions?

Sections 10.01 (d) and (h) of the prepetition credit agreement provides that “no such amendment, waiver or consent” shall:
 

Section 10.01(h)(ii) provides a form of Serta blocker, and requires the consent of each affected lender to pass an amendment that subordinates senior liens to super senior liens, except if the opportunity is offered to all lenders on a pro rata basis.

Section 10.01(h)(i) and section 10.01(d) are pro rata payment and sharing protections that require the consent of each affected lender to pass an amendment that alters certain pro rata payment and sharing provisions, except if the opportunity is offered to all lenders on a pro rata basis.

Here, we discuss our reading of the American Tire sacred rights provisions and Judge Goldblatt’s commentary.

All parties agreed that the DIP carve-out in section 10.01 applied to the Serta blocker in section 10.01(h)(ii). The parties disagreed, however, about whether the DIP carve-out extended to the pro rata payment and sharing protections in section 10.01(h)(i) and section 10.01(d). The debtors and majority lenders argued that the DIP carve-out applied to both of these provisions, a position rejected by the minority lenders.

Contrary to the minority lenders’ arguments, we believe the better reading of section 10.01(h) is that the DIP carve-out in section 10.01(h)(y) applies both to the Serta blocker in Section 10.01(h)(ii), as well as to the pro rata payment and sharing protections in section 10.01(h)(i). The language that precedes the two carve-outs in section 10.01(x) and (y) says “in each case of the foregoing, except.” “Each case” implies more than one. In addition, the language “in each case” also appears after 10.01(y), after the parenthetical is closed, stating in full: “in each case without the written consent of each Lender directly and adversely affected thereby.”

This must apply to both section 10.01(h)(i) and (ii) for the entire clause to make sense; otherwise, the pro rata payment and sharing protections could not be amended at all. There is no reason to read the second instance of “in each case” differently than the first.

However, there is nothing in the prepetition credit agreement’s language that extends section 10.01(h)(y) to section 10.01(d). Absent explicit language otherwise, a proviso is not usually interpreted as applying beyond the clause that it modifies. Moreover, as Judge Goldblatt held in approving TPC’s uptier transaction, courts expect that “[t]o the extent such holders want to be protected against self-interested actions by borrowers and other holders, they must include such protections in the terms of their agreements.” At best, the extent of the DIP carve-out is ambiguous, which would require parol evidence to resolve.

If – as we believe and Judge Goldblatt appears to believe – the DIP carve-out does not apply to the pro rata payment and sharing provisions, then a second issue is whether the non-pro-rata DIP rollup actually implicates the pro rata payment and sharing provisions protected in section 10.01(d) and (possibly) section 10.01(h). The provisions that the minority lenders allege the rollup violated concern “payments” and “purchases.” For example:
 

• Section 2.12(a) of the prepetition credit agreement requires the agent to distribute to each lender its “Applicable Percentage” (that is, its ratable share) of any “payment” received by the agent.
   
• Section 2.13 requires that if a lender obtains “any payment … in excess of its ratable share,” the lender must immediately “purchase from the other Lenders such participations in the Loans made by them as shall be necessary to cause such purchasing Lender to share the excess payment in respect of such Loans or such participations, as the case may be, pro rata with each of them.”
   
• Section 8.04 requires that, on acceleration, funds need to be applied, “[t]hird, to payment” of “accrued and unpaid interest … ratably among the Lenders,” and “[f]ourth, to payment” of “unpaid principal … ratably among the Secured Parties.”
   
• Section 10.07(b)(ii)(H) provides that: “a Parent and its Subsidiaries may not purchase any Loans or Term Commitments so long as any Event of Default has occurred and is continuing” (emphasis added).
   

Judge Golblatt stated his initial view during oral argument that the credit agreement allows for DIP financing that primes the credit agreement even if the DIP financing is only open to certain lenders. However, he reasoned, if the rollup is a draw on the DIP that pays off the prepetition debt, then the credit agreement’s protections against non-pro-rata payments and sharing would apply. The majority lenders argued that these provisions do not implicate the rollup. The merits of that argument – that is, that the rollup was not a “payment” or a “purchase” – are unclear, but Judge Goldblatt conceded that the issue may be “more nuanced” than he originally thought. The RSA DIP term sheet did describe the DIP term loan’s purpose as being “to repay the equivalent principal amount of the Term Loan Obligations outstanding under the Term Loan Credit Agreement” (which the majority lenders addressed in a footnote).

Notably, the majority lenders did not make a Serta-style “open market purchase” argument, despite the prepetition credit facility permitting “open market purchase[s] on a non-pro rata basis … including pursuant to any privately negotiated open-market transactions.” We suspect this is because of section 10.01(b)(ii)(H) (quoted above), which provides that a parent and its subsidiaries cannot purchase loans during an event of default. All parties agreed that filing the chapter 11 petition caused an immediate event of default under the prepetition credit agreement. Non-pro-rata open-market purchases likely would have been blocked by the default purchase blocker. While the majority argued that the rollup was not a “purchase,” we suspect that they did not believe that was a strong argument.

Audio from the hearing where Judge Goldblatt discussed his reviews on the rollup and the credit agreement is available HERE.

Prior Disputes Involving Sacred Rights, Non-Pro-Rata DIP Rollups

There have been several disputes in recent years concerning violations of sacred rights in non-pro-rata uptier transactions, most of which have been settled. A few others, such as Mitel and the recently filed Hunkemoller, are winding their way through the courts. Major substantive decisions concerning such transactions include TPC and Incora. Meanwhile, Serta is awaiting a decision from the Fifth Circuit.

Fewer disputes, however, have implicated sacred rights violations in the context of non-pro-rata DIP rollups. While fewer and farther between, American Tire continues a string of cases where minority lenders raised sacred rights violations after being angled out of a lucrative DIP.

Aleris

In Aleris’ 2009 chapter 11, the debtors sought DIP financing that included a dollar-for-dollar rollup of a $540 million portion of outstanding prepetition term loans. Two hedging counterparties argued the rollup violated an intercreditor agreement that required each counterparty’s consent if “all or substantially all” of the liens changed a lienholder’s priority “in relation to the priority of the Liens securing the other Secured Obligations.”

The debtors countered that this provision was not triggered because the DIP only rolled up $540 million out of approximately $1.2 billion of prepetition debt (roughly 45% of the liens). The hedging counterparties argued that the rollup was benefiting from all of the collateral and that triggered their consent rights.

Deutsche Bank, the agent under the credit agreement, also argued that the hedging counterparties’ consent was only required for priming in relation to the liens that secured the prepetition term loans, but not to priming by new facilities.

The bankruptcy court approved the final DIP order with the rollup, overruling the objections and finding that the DIP did not change the priority of the objector’s lien in “relationship to the priority of the lien securing the other secured obligations.” Notably, however, the court continued that “the spirit of the inter-creditor agreement would require that [the objectors] be afforded the opportunity on commercially reasonable and substantially similar terms to participate in [the rollup] and I would so require.”

Appvion

Appvion concerned an alleged violation of sacred rights in a DIP facility that provided it could not be modified “in a manner that would alter the pro rata sharing of payments required thereby” without the consent of each lender.

After the DIP was approved, the debtors sought approval of a two-step transaction that included a sale transaction and a new $100 million DIP loan. About $85 million of the new DIP loan rolled up the new-money loans under the original DIP with priming liens superior to those that secured the original DIP. The new priming DIP loans would be assumed by the buyer and the original rollup loans credit bid and converted to equity in the buyer. The court approved the new DIP but preserved the minority’s right to assert a breach of the original DIP.

As part of the new DIP, the required lenders under the original DIP executed waivers and consents that waived certain rights, permitted priming of the original DIP liens and partially waived the mandatory prepayment provisions in the original DIP loan so that they only applied to the loans being rolled up under the new DIP. Two of the original DIP lenders filed suit. One suit settled, but the other went to a decision on a motion to dismiss. Judge Michael E. Wiles characterized the breach of contract claims as “elusive” but denied the motion to dismiss the alleged pro rata sharing breach. The case subsequently settled.

JC Penney

In J.C. Penney’s 2020 bankruptcy, the debtors sought approval of a DIP loan consisting of $450 million in new money and a $450 million rollup. An ad hoc group of excluded lenders objected to the DIP because the rollup violated the ratable sharing provisions in the prepetition credit agreement and first lien intercreditor agreement.

The credit agreement required that any lender who received a payment, “whether by voluntary payment … or otherwise,” in a greater proportion than other lenders must share that payment so that recoveries are proportionate. The intercreditor required that if the “DIP Financing and/or cash collateral is applied to repay any of the” term loans, such an amount must be applied “to the payment in full of the Term Loan/Notes Secured Obligations of each Series on a ratable basis in accordance with the terms of the applicable Term Loan/Notes Documents.”

Similar to American Tire, the excluded group argued that the rollup violated these provisions because it was “a repayment of a preexisting obligation, whether new dollars are provided to the company for the selective repayment or whether the prepetition debt is simply elevated to DIP financing by way of legal fiction.”

Again similar to American Tire, the debtors argued that the rollup was not a repayment but, at best, a refinancing. The “debt that is being ‘rolled up’ remains outstanding as a debt obligation until satisfied pursuant to a plan of reorganization, a section 363 sale, or further order of the Court.”

The majority similarly argued that the rollup was consideration for new value and not a payment under the prepetition credit agreement. Even if the rollup was a payment, the prepetition credit agreement expressly excepted from the ratable sharing requirement “any payment obtained by any Lender as consideration for the assignment or sale of a participation in any of its Loans or other Obligations owed to it.”

The majority also alleged that they held more than 75% of prepetition term loans and had the authority to amend the pro rata sharing provisions to permit the DIP rollup.

The parties settled and permitted the minority to participate in the rollup on the same terms, except that (a) the minority group was not permitted to exercise any voting rights over the rollup, but (b) were granted consent rights over the pro rata treatment provision in the DIP credit agreement.

Ascena

Also in 2020, Ascena Retail sought to fund its chapter 11 case through a $311.8 million DIP consisting of two $75 million new-money tranches where participating lenders would roll up their prepetition debt. The first tranche would be syndicated to all term lenders while the second would be reserved solely for term lenders that signed an RSA. The minority lenders mobilized and then settled on terms allowing them to join the RSA and participate in both tranches.

Lessons Learned From American Tire Distributors and Its Predecessors

To paraphrase Judge Goldblatt, disputes over non-pro-rata DIP rollups turn on whether primed credit documents say what their drafters intended them to say. Clear drafting at the outset can help lenders determine whether a non-pro-rata DIP rollup is permitted under the relevant document.
 

As discussed above, one of the issues in American Tire was whether the DIP carve-out extended to the pro rata payment and sharing protections in both section 10.01(h)(i) and section 10.01(d).

We believe that the better reading of the agreement is that the DIP carve-out in section 10.01(y) applied to both sections 10.01(h)(i) and (ii). If that is the case, that could have been made clear by stating “except in each case of (h)(i) and (h)(ii),” rather than by “in each case of the foregoing.” Further, if the DIP carve-out was also intended to apply to section 10.01(d), that also should have been stated explicitly in section 10.01(d).

In our experience, it is common for a Serta blocker to have a DIP exclusion, but pro rata payment and sharing provisions do not usually have a DIP carve-out.

An example of a Serta blocker with a clear DIP carve-out is NortonLifeLock’s 2022 restated credit agreement, which required all lender consent to:
 

The DIP carve-out clearly applies to the entirety of the clause (“it being understood that this clause (h)”). It does not, however, explicitly prohibit a DIP rollup.

An example of a DIP carve-out that prohibits a rollup is Dave & Busters’ 2022 credit facility, which contained a Serta blocker that excluded payment or lien subordination “in connection with a debtor-in-possession financing approved by the Required Lenders that does not provide for the ‘roll up’ of any existing obligations in any proceeding under any Debtor Relief Law.”
 

The extent of the DIP carve-out in American Tire also was muddy because both sections 10.01(d) and 10.01(h)(i) addressed amendments “that would alter the pro rata sharing of payments,” including section 8.04. Ideally, only one sacred rights provision should have addressed pro rata payment and sharing obligations.
 

In J.C. Penny and American Tire, the debtors and/or majority lenders raised arguments that the DIP rollup did not constitute a “payment,” “repayment,” “prepayment” or “purchase” that implicated pro rata payment and sharing provisions. Credit agreements should state clearly whether pro rata payment and sharing provisions encompass a DIP rollup, even though cash does not flow through clearing systems. That can be stated in the pro rata payment and sharing provisions themselves, in the related sacred rights, or in a stand-alone section.
 

In Aleris, Deutsche Bank argued that the lien subordination protection did not apply to priming by new facilities because the relevant provision provided for lien subordination protection “in relation to the priority of the Liens securing the other Secured Obligations.” To protect against an uptiering transaction, lien subordination protection should extend to other indebtedness (which should be defined as including a DIP rollup).

Octus previously covered other suggested edits to Serta blockers.