In this Ropes & Gray podcast, finance partner Leonard Klingbaum is joined by Colin Adams, a managing director and senior professional at the investment and advisory firm M-III Partners, to discuss one of the most critical issues for clients in the stressed and distressed space: attention to documentation, or the lack thereof. From both a legal and business perspective, this podcast explores the prevalent concerns lenders and borrowers have faced regarding (1) voting provisions, (2) pro rata provisions and (3) EBITDA, as well as the opportunities that arise when these areas are reviewed competently.
Leonard Klingbaum: Sure, thanks Colin for the question. That actually is the primary reason why I joined Ropes & Gray – I'm a fairly new partner here. What this firm has put together is a platform that addresses needs in the event-driven financing space, or the capital solutions or credit opportunity space. And we are a platform now comprised of professionals across the spectrum of where we see clients are in need in the times of those circumstances or event-driven opportunities. So we've got now dedicated finance partners, myself and several others at the firm. We've got credit-side restructuring professionals, and we've got corporate partners who focus exclusively on those same types of transactions. Again, it's the event-driven credit opportunities-side of transactions.
Colin Adams: So Leonard, as you're going around the city and the world meeting with clients, what are they telling you?
Leonard Klingbaum: There are three principle things that most clients have repeated to me as being critical: documentation, documentation, documentation.
Colin Adams: Okay, so clearly the documents are an issue. What's underneath that? What are the driving issues where people are saying to you, "Leonard, I've got an issue with my documents?”
Leonard Klingbaum: So I think a good portion of the market at this point is well aware of things like what has been called the “J. Crew trap door.” But what people are starting to see, and I as a professional who has been dealing in this space now for more than 20 years, is that the issues in documentation go well beyond what people have been talking about nowadays. For instance, voting provisions, pro rata payment provisions, and EBITDA adjustments – those are three of the most important things, or perhaps the most critical things that are deficient in many documents that some credit funds that we're talking to are starting to realize and see as real problems as we get into a little bit of a softer market.
Colin Adams: So let me ask, and this may be a little bit of a novice question, but how did we end up here where there are issues in preexisting documents that lenders, potentially borrowers, maybe it's mainly lenders, are unhappy about?
Leonard Klingbaum: Essentially what has happened in the last many years is that there's been a tremendous pressure, and in some areas it continues to be applied on deploying capital. And it just has meant that sponsors and borrowers have had, for the most part, all the leverage. And that has played out not just in the area of rates and covenant light provisions, again, two things that people often talk about, but it's also played out in maybe as big, if not a bigger way, in the documentation. Documentation have become far less rigorous than they were perhaps ten years ago. And that has allowed things like a J. Crew trap door, things that might have been intended by those who drafted the documents to provide maximum flexibility to the borrower clients, but it's also permitted a lot of other things, like I mentioned before, for example in voting provisions.
Colin Adams: So fair to say that at new issue or at issuance, there's a leverage dynamic between the issuer and the capital providers. Are you finding now, given where the credit markets are, is there an opportunity to revisit these documents because there's been a shift there? Tell me a little bit about how that happens – how do you have the opportunity to be having these conversations?
Leonard Klingbaum: So there are a couple of different ways in which we can approach that. If the documents are already out there, there's one approach that we have, and I think your question was more specific to what if this is a new issuance? So if it's a new issuance what we do, what I have done in the last several years, is focus very hard on a lot of these types of provisions that I've seen play out in the last cycle and I've seen start to be playing out again as the market might be softening, to a degree. And that is to tighten up provisions, for example, on voting. It's also to call to the attention of the business people how structure matters. So whether we're doing a specialty finance deal and we're driving our clients to really do those deals in the context of a special purpose vehicle away from the risk of other creditors, or if we're talking to our clients about building in safety valves for the lenders when it comes time to vote on either a plan or pre-bankruptcy within the context of a credit document where there's more than one lender and how to protect the lender from things that people might think are sacrosanct that can't be affected, can't be touched absent that lenders vote, building in those protections ahead of time as we're doing the documentations to protect the lender.
Colin Adams: Okay, so with that as context, you've identified in effect three key areas within documentation that you're getting asked questions about over and over, over the last several months, and those are the voting provisions, the pro rata provisions, and EBITDA, or I assume sort of the definition of EBITDA on adjustments. Could you explain a little bit what those three topic areas are, and in a sense what people are asking you? Why the questions on these three in particular?
Leonard Klingbaum: Sure. So EBITDA is a great metric for financial covenant testing, but has, in my experience, and from speaking with credit fund lenders, taken on a proxy of performance of business. And given the fact that most EBITDA definitions are really adjusted EBITDA definitions, and given some of the dynamic that we've discussed earlier around availability of capital in the market, causing a deterioration of the quality of the documents, these adjusted EBITDA numbers have grown exponentially. So, again, great for covenant testing because you can set up a covenant level based upon what you think the adjustments are going to be, but it's become, in some respects, a proxy for the performance of the business. What I've heard from several credit fund clients recently is that companies are in compliance with their credit documents because again, they've got great adjusted EBITDA numbers, but are running very low on cash, have not been able to adhere to capex needed in businesses, again, depending on the type of business, and are, accordingly, much closer to the downward spiral than you would've hoped, given that if you've had an EBITDA or a leveraged covenant, you would've hoped to have an earlier warning sign. But a lot of times we're seeing borrowers that haven't given up those warning signs early, but are actually in dire straits on an unexpected basis, making it harder to finance, putting more pressure on lenders to put more capital in, putting more pressure on sponsors to put in more capital. The second area is pro rata payment provisions, which ties into voting to some degree. So I think the general prevailing view among credit professionals is there are sacrosanct or sacred rights in credit documents.
Colin Adams: Yes, we used to call them the “holy trinity,” back when I was practicing law.
Leonard Klingbaum: There you go, the holy trinity. And so most people go into these discussions looking at the voting provisions very quickly, and lawyers who focus on the frontend-side of the deals may look for the standard language that you can't amend or affect the pro rata payment provisions by example without the vote of every lender affected by the change.
Colin Adams: Yes, generally speaking that it's sort of maturity, interest rate, and changes in the collateral would be the three big ones that you can't… the lenders are entitled to recover on their collateral, the lenders are entitled to share that among themselves equally, and you can't monkey with how much they're getting paid or when the final principle amount is due. Usually if somebody asked me, I would say, "You're out of luck. You're not going to be able to effectively do an amendment without every affected lender, basically 100%, agreeing to that."
Leonard Klingbaum: Correct.
Colin Adams: And so you're saying that maybe there's some technology out there that could alter that?
Leonard Klingbaum: There is technology out there. There is pending litigation around some of this right now. There is also my own personal experience in representing either a lender or a borrower where we've gone out with amendments that really deviate from what people think is the rule, which is again, every lender has to vote for it. And part of this is driven by the words on the page because they say you can't amend Section, let's call it 213, which is oftentimes the pro rata payment provision in the credit agreement, without the vote of every lender. Great. But under the rules of strict construction of a credit document, you can amend another section or add another section that may have the effect of changing the rule that you thought was sacrosanct in Section 213. Now, it doesn't work every time and there are ways in which you can thread the needle to make it work, more often than not. Prior to joining Ropes, we represented an ad hoc group of first lien lenders in a particular situation. Those documents were done – they were in the market and we had to deal with what was in there. And we came up with a methodology that the clients themselves, the credit funds who were secondary buyers of the paper, hadn't realized that because that indirect language was not in the document, that they could do something indirectly, what every credit professional would say there's no way you could do directly. And we did it – we did it successfully. We did an uptiering exchange of debt for debt, leaving the nonconsenting lenders behind, but putting them in a junior position. And as a result of doing that, we were able to change the economics for the consenting lenders versus the nonconsenting lenders. Colin, from the perspective of an advisor to distressed companies, what have you been seeing?
Colin Adams: So great question, and I would say we've been seeing a couple things. The first is there's no question that especially in what I would describe as the private credit market, so not the broadly syndicated capital markets, although we're beginning to see a little bit there, but definitely in the private credit markets, we're starting to see some cracks around middle market and upper middle market names. I think a lot of that actually does go to what you were talking about earlier, which is a reliance on, in particular, adjusted EBITDA to speak to the health of the company. And in that context, what we've been seeing with specific credits is that adjustments are provided, in effect, early on. “Hey, we're going to do a merger. We've done the merger. We believe there's $10 million of synergy from that merger, cost savings.” So the credit documents allow you to add $10 million to EBITDA today in the expectation that there's $10 million of cost savings that will boost your EBITDA in the future. Those provisions are not freebies, they often have periods of time over which that adjustment begins to burn away because the idea would be you get the benefit of the adjustment. As you begin to make those synergies and get to cost savings, your EBITDA is improving. And so when you get to the end of the burn off period, your EBITDA is on an actual basis, where it would've been on an adjusted basis. That's how it's supposed to work in theory. As you've pointed out, Leonard, what's begun to happen is that expectations have been higher than reality. And as things begin to burn off, you have companies that have leverage levels and interest coverage levels that, on an adjusted basis, look okay, and on an actual basis, look very poor. And so what that has meant for us, as professionals that do work in the fiduciary, financial advisory and interim management space, is that we're spending a lot of time with clients trying to understand where can we find liquidity? Is there anything in the system that allows us to get more cash into the company? Because ultimately, what all of this plays out as, it's a deterioration in operating performance, and where the rubber really begins to hit the road is in a lack of cash liquidity. And it's really a lack of cash liquidity that begins to cause issues as between borrowers and their lenders. So Leonard, when you're out speaking with clients and potential clients, and they are approaching you with issues and questions about documents, how are you in a position to help them if they've got credit documents that have already been finalized in the marketplace on syndicated credits or private credits where the deal has been done – how do you help them there?
Leonard Klingbaum: So if the documents have already been done, primarily we focus on how a sponsor or borrower can utilize collateral exclusions to create a space for leverageable assets. We will typically carefully consider the voting provisions to explore where and how lenders can be harmed or how they may be able to proactively offer greater protections to consenting lenders, including through modifying the waterfall, despite what might appear in documentations to be a block on doing so in the absence of full lender consent. We also focus a lot on lien perfection issues, something that we'll discuss in a little bit more detail. But if we are doing the documents, we focus first and foremost on structure. So, for example, in our specialty lending deals, and some of the other deals that aren't specialty lending, but also are direct lending in more of a event-driven opportunity, we'll look at key enforcement points, bankruptcy consolidation risk, and potential for priming opportunities by others that aren't our lenders. If we are representing a minority holder of the debt, we'll focus very much so on the voting provisions, and as I've discussed earlier, the ability for folks to do indirectly what everyone thought they couldn't do directly. And we have technology that we've used in a couple of example credit agreements, where we've represented minority lenders that have effectively prevented the majority from doing harm to that minority lender. Colin, how have you seen it play out, where the documents purport, for example, to have all of the assets, but yet a company needs liquidity?
Colin Adams: So at M-III, we take pretty much in every engagement that we work on, we take a five-pronged approach to the beginning of that engagement. We start with liquidity. Then we are looking at how liquidity plays into prong number two, which is the operating plan for the business – in other words, where's liquidity today? What does the operating plan tell us about how much liquidity may be necessary to make the business function? If we are able to find that liquidity, what's the business going to ultimately generate in the future – what does that look like? And then the third prong of our approach is working on issues with management, which usually takes the form of a spans and layers analysis, which is looking at do we have the right people in the right seats to be able to execute? The fourth prong is really dealing with stakeholders. Where are lenders, creditors, other important stakeholders around the table? What's in their documents? What are their rights, obligations, entitlements? How does that fit in with prongs one, two and three? And then, of course, the fifth thing that we're trying to do is create consensus around the table so that we can take liquidity, operating performance, a management team that's been stood up in the right way, and put all that together to get to an end of the transaction.
To your question specifically, which really deals with prongs number one and number two, we work with competent counsel like yourself to try and identify, in the documents, and in the assets that are actually on the ground at the company, what is available to us in order to generate that liquidity. It can be as simple as liquidity that can be found through documentation. For example, in our Sears engagement, where we acted as CRO and then ultimately CEO of the company, one of the primary gating issues was the ability to generate more liquidity under an ABL facility, which meant really understanding the borrowing base and the practical implications there. There were goods where we were getting different levels of credit and liquidity from our lenders, depending on where the goods were within the supply chain. We identified that while the documents were perfectly legitimate in terms of if the goods are on the dock in Asia, you're getting a 20% advance. When they're on the boat, it's 50%. When they get to the port in LA, it's 60%. And then when they get to your distribution center, you're getting up to almost 80%-85% credit. Nothing wrong with the document, but the company itself was having difficulty tracking the goods. And so we had goods that were already in the port in Los Angeles for which we were only getting 25%-30% credit. If you're able to accurately identify where your assets are, that can generate liquidity. In addition, another example from Sears, we found that there were a series of intercompany notes running between the various subsidiaries in the parent holding company that had a tremendous amount of value. And there were no liens attached to those notes, so we were able to go into the marketplace. There was a demand for them. We were able to sell those notes and generated almost $90 million of cash for Sears, which provided incremental liquidity on which to run the process by which we ultimately got to consensus among all the parties and a confirmed Chapter 11 plan.
Leonard Klingbaum: So Colin, you mentioned liens and the absence of liens on certain assets that, as a result of the absence of those liens, generated liquidity, much needed liquidity for Sears. That reminds me of in my practice area, one of the things that I do when I first get engaged by a client that either is looking to buy some debt in the market or already owns some debt in the market, but a company is sliding in terms of performance or creditworthiness, is we look at the liens and we look at lien perfection. And there are many people who will do a fairly rote exam of liens and lien perfection. You look at your security agreement, you run down the list of what's been pledged, and then you check your UCC filings or you check your possessory collateral, and you either check the box that liens are perfected or you check that liens haven't been perfected.
Colin Adams: Now, let me just ask, the focus on having a lien versus perfection, I think a lot of people who might be listening to this, especially if they're new to the credit markets, what's the distinction? Why is it so important not just to have a lien, but to have a perfected lien? Why does that matter?
Leonard Klingbaum: It matters in two ways. The first is out of court, so a company's not in Chapter 11. If it's not a perfected lien, which is essentially for most categories of assets, a state law filing and essential registry that becomes in the public domain, a second person or a third party that wants to do a loan or provide some sort of consideration to that same company, may want those same assets and get a lien on them. And if they search the registry and there's nothing there, in their mind they are able to get a lien, a first lien, a first priority lien on those assets. And if they in fact file with a central registry, a UCC-1, before the original creditor files, that second creditor actually gets the first lien. The second area where this is important and probably easier to explain is if your lien is not perfected and the company enters into an insolvency proceeding, it's as if you don't have a lien, plain and simple. You’re an unsecured creditor.
Colin Adams: So people obviously are aware of the penalty for not being perfected, so my assumption is that these liens get perfected right away and that it might not be very fertile ground for investigation. But let me ask you, Leonard, you've been doing this for the better part of 20 years, have you ever been involved in a situation where lien perfection became an issue and resulted in a material difference in outcome?
Leonard Klingbaum: Several. And I think the biggest situation that I was involved in related to an aircraft manufacturing company. And it actually all starts back with what we've talked about earlier, Colin, and that is the rigorousness or lack thereof of documentation. And this airplane manufacturing company had a set of documentation—it was a broadly syndicated deal by a large banking institution, by a large group of banking institutions, in the billions—and when you have an aircraft and you want to perfect your lien in an aircraft, you have to file evidence of your lien with the FAA in Oklahoma City. But as part of the dynamic of negotiating the original credit documents between the sponsors there and the lenders, and given the vast amount of capital available in the market, the final negotiated documents provided that no filing with the FAA would be required for a period of 180 days after the manufacturing process of that plane was completed. The theory was times were good, people were buying these planes, even before they were finished being built, so there was no need to put a mortgage on them at the FAA, and only then to quickly release that mortgage or that lien with the FAA. So the documents provided 180-day period. Well, the problem became that the company started to be unable to sell their aircraft. And if you put it in more laymen's terms, how I think about it is you now had a new car lot, or a new plane lot, filled with unsold planes. All within that 180-day period, none of which planes had a perfected lien or mortgage filed at the FAA on those aircraft. There's more nuance to the explanation, in the sense that it's not just a completed plane, but it's even at some stage during the manufacturing process, when it becomes an airplane, as it's defined in the relevant statutes, you have to put a mortgage on it. So it was more than just those planes sitting on the new plane lot. But it was a bunch of planes still in the manufacturing process, all of which had effectively no lien. The company was teetering on filing for Chapter 11 and the lenders had assumed that they had liens on all the assets across the board, and there was no opportunity for the company to go raise any additional liquidity. The net effect was the lenders were dictating the terms of debtor in possession financing and the outcome of a plan of reorganization. Well, we did that lien perfection analysis, but again, not just that rote analysis. But we did, Colin, one of your prongs as you've articulated. We actually looked at what's happening on the ground – what do the documents say and how do you perfect in every different type of collateral of asset that's out there? And lo and behold, what we discovered was in excess of $800 million of value that had no lien filed against it and the company was still in compliance with its credit documentation. That was a game-changer in that particular situation because when we rolled that out to our lenders, we actually rolled it out together with committed financing that we had obtained from a third-party bank against those assets. And that third-party bank financing would've been our debtor in possession financing had we then filed for Chapter 11. That was a complete shift in leverage and something that the lender-side had not picked up in their lien analysis because, again, their lien analysis was pure documentation driven, as opposed to looking at the documents, looking at the world around them, looking at the assets on the ground and thinking through a variety of different permutations.
Colin Adams: So I think in summary, what we both seem to be saying on the legal and business side, is that a lack of attention to documentation may well lead to a situation where lenders believe they're protected, but as in your example, they're not, to the tune of almost $800 million of value. And borrowers believe they're constrained, whether constrained in the ability to get that debtor in possession financing or in the other example you've used, constrained in the ability to negotiate a creative financing midstream, if there are issues that have arisen. And in reality, it seems like there are risks and opportunities that are available to both lenders and borrowers in stressed and distressed situations, if they've got somebody who's in there looking at the documents, looking at what's happening on the ground, paying attention to business operations and assets.
Leonard Klingbaum: I couldn't agree more, Colin. And we're seeing more and more of these sorts of questions and issues come up with our clients. Colin, thanks so much for joining me here today. And thank you to our listeners. For more information on the topics that we discussed or other topics of interest to the credit funds and finance communities, please visit our website at www.ropesgray.com. And of course, we can help you navigate any of the topics we discussed – please don't hesitate to get in touch. You can also subscribe and listen to this series wherever you regularly listen to podcasts, including on Apple, Google, and Spotify. Thanks again for listening.
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