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NEW YORK, June 15 (LPC) – Investors are taking the fight against an assault on leveraged loan documentation to the courts as more private equity-backed companies, such as troubled retailer PetSmart, seek flexibility that could lead to raising new debt.

Private equity firms have been able to exploit red-hot investor demand for floating rate US leveraged loans and weaken loan documentation as demand continues to outstrip supply, but this has already produced at least two court cases as investors fight back.

Legal conflicts have erupted among lenders to US retailers such as Not Your Daughters Jeans (NYDJ) and J Crew in the last 12 months, as issuers added extra debt by exploiting loopholes in their credit documents.

PetSmart’s owners took steps on June 4 to potentially create additional flexibility by creating a new unrestricted subsidiary and transferring 16.5% of its online company Chewy into the new facility.

Investment firm Octagon Credit Investors sued NYDJ and a group of lenders last November after a majority group of lenders led by Mudrick Capital provided a US$20m loan in May 2017 that ranked senior to an existing US$144m loan in the company’s capital structure.

The lenders that issued the US$20m loan owned most of the existing US$144m loan and simply informed the minority group of their decision without obtaining their consent or inviting them to participate.

The US$20m loan was problematic for the minority group as the majority group essentially created a new class of senior term loans, subordinating the class of term loans for the minority group. Senior bank loans hold legal claim to borrowers’ assets above all other debt obligations and are repaid first in a bankruptcy, before other creditors, preferred stockholders or common stockholders are paid.

The New York Supreme Court was critical of the move during arguments in February, saying that the group of lenders did not have the right to simply approve a new tranche, and affirmed the minority lenders’ right to participate in the new debt. The majority group then amended the agreement in April to allow the minority group the same rights.

“I think it is a warning shot to companies and sponsors to not get cute with credit agreements,” said Geoff Dorment, general counsel of Octagon.

The NYDJ case follows a lawsuit filed last year by J Crew’s lenders which tried to block the company from transferring intellectual property assets, including its name brand, to an unrestricted subsidiary and raising new debt secured on those assets.

J Crew, which is owned by TPG Capital and Leonard Green Partners, offered to buy US$150m of debt back at par if lenders’ dropped their litigation. The loans were trading at 30 cents on the dollar at the time, according to
Breakingviews.

PetSmart’s lenders’ are organizing, according to press reports, and may follow a similar legal route. S&P cut PetSmart’s corporate rating to CCC from CCC+, citing the firm’s unsustainable capital structure and the increased risk of a distressed debt exchange after the Chewy transfer. PetSmart has more than US$8bn of outstanding debt.
UNFIT LOANS

NYDJ was seeking to raise new loans in 2016 after the company’s performance weakened in line with the broader retail sector. The Mudrick Capital-led group, which owned slightly more than half of the company’s debt, provided the new US$20m loan in May 2017.

Mudrick alerted Octagon of its plans in August 2016 before the US$20m loan was added, but Octagon declined to participate due to concerns over whether this was permitted under the credit agreement and the ethics of the situation, Dorment said. The firm said after it declined initially that it did not hear more from Mudrick until the minority lenders were notified that the move had been made.

Octagon, which owned US$15.6m of the existing US$144m loan, fought the move in court. Although the loan size was small in the context of the leveraged loan market, Octagon said that it had litigated due to the principle.

“We thought this transaction was really precedent-setting, and we didn’t want to see this continue,” said Lauren
Basmadjian, a portfolio manager at Octagon.

Covenant Review, a credit research firm, warned that the significant loosening of covenants remains a risk and that lenders need to make sure they have proper voting standards in the credit agreements.

“While it is encouraging to see that at least one judge reads the commercial reasonableness standard to potentially preclude NYDJ-style attacks, it would be ill-advised for investors to view that as the takeaway in this case,” Covenant Review said in a note.

NYDJ is a warning to lenders to make sure that loan documentation is tight enough to avoid similar situations in the future, the research firm said.

“I think overall the trend will continue to see documents become looser,” Basmadjian said. “This is a warning to aggressive companies and lenders if they are going to try to use documents in a way that is outside of the spirit of the credit agreement.”

NYDJ and Mudrick did not return a request for comment.