Distressed Debt Legal Insights: Xerox and the “Non-Subsidiary” Drop-Down

Welcome to Distressed Debt Legal Insights, Ropes & Gray’s periodic source of timely insights for professionals navigating the complex world of liability management and special situations finance. In this issue we analyze Xerox Corporation’s recent IP drop-down and explain why this structure may continue to be utilized by distressed issuers, particularly in the “software as a service” space — and the related potential risk areas for creditors.

Xerox’s liability management transaction garnered attention for using a joint venture (i.e., an entity that falls outside the definition of “subsidiary” within the credit documents) to avoid restrictions in its debt documents that apply to “subsidiaries.” Xerox is not the first company to creatively use a non-subsidiary in a liability management transaction; Trinseo’s double dip in September 2023 utilized a “sister” entity to avoid certain restrictions on subsidiaries, as one example. Still, the current attention on Xerox, combined with the ongoing downturn in the software as a service sector, suggests this approach may gain traction in the near term, particularly among borrowers whose balance sheets are anchored by valuable IP.

Xerox’s IP Drop-Down

On February 17, Xerox Corporation announced that it entered into a new joint venture with various investors. Xerox contributed certain IP assets to the joint venture (“IPCo”), including the trademarks for Xerox, in exchange for Class B units. The transferred IP is subject to a shared services and license agreement in favor of Xerox. IPCo then raised $450 million – comprising $405 million of senior secured term loans and $45 million of Class A preferred equity issued to the investors – and distributed the proceeds back to Xerox.

Xerox indicated that the proceeds will be used for general corporate purposes, including addressing its capital structure (potentially by purchasing unsecured notes in the open market). None of Xerox’s existing debt documents were amended, underscoring that the structure was engineered to fit within the existing covenant framework.

Avoiding Restrictions on “Subsidiaries”

In a traditional drop-down, the transferee of the assets is either a non-guarantor restricted subsidiary or an unrestricted subsidiary. The former often provides greater capacity to receive investments and asset transfers but limited ability to incur new debt, while the latter permits debt incurrence but typically faces tighter limits on the value of investments that can be made, as well as, to the extent of any applicable J. Crew protections, the nature of investments or assets that can be so transferred.

While majority creditors can sometimes mitigate, waive or amend these restrictions, obtaining such waivers or amendments is difficult when, as in Xerox’s case, the capital structure includes multiple secured and unsecured tranches, each with its own set of creditors to coordinate.

Certain of Xerox’s existing debt documents limit capacity to incur debt at non-guarantor restricted subsidiaries and include J. Crew protections that prohibit the transfer of material IP to an unrestricted subsidiary. How, then, can it execute an IP drop-down, with negative covenants constraining restricted subsidiaries and the J. Crew blocker applying to unrestricted subsidiaries? By creating an entity that is not a “subsidiary” at all. This structural solution exploits the technical definition of “subsidiary” in debt documents, thereby stepping outside the traditional restricted/unrestricted framework entirely.

The precise mechanisms of Xerox’s transaction have not been fully disclosed, but across its debt documents, “subsidiary” is defined as an entity in which the parent owns more than 50% of the voting power. Under that definition, an entity would not be a “subsidiary” if, for example, Xerox owns 49% of such entity and the new investors own the other 51%, with voting interests that correspond to ownership interests. Alternatively, the structure could separate voting and economic power – for instance, Xerox could hold common and preferred equity entitling it to all of the underlying economic interest (capturing all or substantially all of the upside) while the new investors could hold voting preferred stock entitling them to 50.1% or more of the aggregate voting power of the capital stock of such entity. This would allow Xerox to retain the economic benefit of the IP while ensuring that the entity does not qualify as a “subsidiary” under its debt documents.

Distressed Software Companies May Benefit from the Non-Subsidiary Playbook

For companies weathering the widespread downturn in enterprise software valuations, Xerox’s J. Crew blocker workaround may have arrived at an opportune moment. Many software companies raised significant debt during the 2020-2021 low-rate environment and are now confronting tighter liquidity, declining equity valuations (linked to the threat of AI, among others), and looming maturities.

Software companies tend to have significant IP, which is a particularly well-suited asset for a drop-down transaction for several reasons: it can be transferred without material operational disruption; royalty and licensing streams provide predictable cash flow to service new debt; and IP valuations are inherently subjective, thereby giving parties flexibility in structuring the economics. While many creditors negotiated J. Crew blockers to prevent transfers of material IP to unrestricted subsidiaries, Xerox’s structure demonstrates that those protections may not address transfers to non-subsidiary affiliates — a distinction that is likely to receive heightened scrutiny in both new-issue documentation and amendment negotiations.

Why This Matters

The non-subsidiary drop-down may become the latest trend in liability management. Covenant protection against structural subordination is less common than protection against lien and payment subordination, which makes drop-downs appealing, and the ability to simultaneously bypass negative covenants and J. Crew protections makes the non-subsidiary approach especially compelling.

The non-subsidiary approach does carry meaningful tradeoffs, including ceding majority voting control over the entity holding the IP; rating agency downgrades or negative watches impacting trading prices of the existing debt and complicating ordinary course refinancing efforts; and potential tax and accounting friction, including de-consolidation of the entity from the borrower’s consolidated financial statements and consolidated tax returns, transfer pricing considerations, and GAAP variable interest entity considerations, among others. Another omnipresent risk with any liability management transaction is the risk of creditor challenges and litigation. In a non-subsidiary drop-down transaction, we anticipate that claims (if any) will be based, among other things, on provisions in the non-subsidiary governing documents (i.e., whether, despite the “non-subsidiary” designation, the combination of call options, put rights, minority equity-holder protections (including any retained governance or veto rights for the borrower’s parent), or other mechanisms in the documentation result in the designation being perfunctory) and the breach of the implied covenant of good faith and fair dealing, or fraudulent transfer claims.

Nevertheless, borrowers facing near-term liquidity pressure or looming maturities may view those costs as acceptable in exchange for immediate balance sheet relief.

The high-profile nature of Xerox’s transaction may prompt creditors and their counsel to develop a “Xerox blocker” in future debt documentation. Such a blocker could take multiple forms: it could widen the J. Crew blocker to apply to all non-guarantor entities (not just “unrestricted” subsidiaries) or expand the definition of “subsidiary” to include entities over whom the company has de facto control even without a majority of voting power. We expect future debt documents to address this structure directly, either by broadening affiliate transfer restrictions, adopting control-based subsidiary definitions (for example, by further aligning the definition with GAAP consolidation requirements, which consider elements of de facto control and the intended primary beneficiary of the arrangements), or both, with the goal of capturing joint venture arrangements designed to achieve a similar result.