Sabrina Fox is founder of Fox Legal Training.
Altice’s latest quarterly conference call could come to be seen as a major turning point for European lenders: the continent’s first adoption of J Crew’s creditor playbook.
Management’s glib reference to its lenders taking a debt haircut if they want to see proceeds from billions’ worth of asset sales proved that reputational risk is not, in fact, a robust deterrent against aggressive debt-management moves. Further, the vast scale of Altice’s debt complex and its need to frequently access capital markets was not incentive enough for the company to play nice, as many lenders had expected.
With these conventions off the table, lenders are left with only the four corners of their debt contracts as protection against similar manoeuvres. They are no doubt scouring their agreements for terms that could allow other corporate management teams to follow in Altice’s footsteps.
But where to start?
In J. Crew’s case, the infamous “trap door” was a contract loophole that allowed intellectual property to be funnelled out of the group into unrestricted subsidiaries, the place within Altice’s capital structure where its assets currently sit. While the trapdoor was subsequently shut — well, mostly — lenders learned a valuable lesson about the risks when borrowers can shift assets to unrestricted subsidiaries.
“Unrestricted”, in this case, means they are not subject to the restrictions of the covenant package. Once assets are transferred to such a subsidiary, they are outside of lenders’ reach — even if they once constituted part of the collateral package. Management is free to do with them as they please, whether that means spinning them off to shareholders or selling them and distributing the proceeds to equity or other junior stakeholders.
In the carrot-and-stick game of debt negotiations, that’s a very big stick.
It will come as no surprise that Altice’s ability to transfer assets at this scale arose from its loose debt documents. However, the precise source — a single reference date — might raise some eyebrows.
Like the J. Crew scenario, the borrower’s ability to do this is surprising because that’s not how the provision is supposed to work. However, it falls short of being a drafting error because it worked exactly as Altice intended.
The restriction on a borrower sending assets outside of the “restricted group” is not a blanket prohibition — there are standard permissions, called baskets, that will allow the borrower to take certain actions, including making investments in unrestricted subsidiaries as Altice did here, so long as certain conditions are met.
The largest potential source of such ability is called the “builder basket” because investment capacity accrues, or builds, over time. The parties agree that the borrower will be permitted to make restricted payments (including investments in unrestricted subsidiaries) in an amount that approximates a proportion of its profitability during the life of the bonds. The thinking here: If management generate profits, they should be able to take some of them off of the proverbial table. There are different versions of this provision, and Altice used one that builds capacity the fastest.
Because it is the largest single source of restricted payments capacity, the basket’s use is subject to additional protective conditions — traditionally, that at the time of the transfer of value no default or event of default is outstanding, and the borrower can meet a debt-ratio test, which serves as a proxy for its financial health.
However, the last decade of covenant erosion has poked countless holes in these protections, and in Altice’s case the ratio test condition did not apply to management’s decision to send these assets out of the restricted group. This is a shame for lenders, because this would have prevented them from accessing the estimated €17 billion present in the builder basket.
The scale of that figure no doubt strikes fear into the hearts of lenders. How did the basket get that big?
Here is where the reference date comes in. Typically, as noted above, the basket builds from around the time the bonds are issued. If a new bond is issued whilst the first is outstanding, many deals refer back to the original issue date, which is what Altice did. The problem for lenders is that they continued to do it, many years after the original bond was long refinanced.
As a result, the reference date for builder basket capacity accrual for Altice was a full decade in the past — April 1, 2014.
Ten years later, like a beast lying in wait, that one reference date afforded this borrower the ability to leverage asset sale proceeds for discounted debt repurchases.
If borrowers are indeed willing to use this type of covenant flexibility regardless of reputational risk and despite the need for repeat visits to the capital markets, we can hope that, like with J. Crew, lenders seek to slam this trapdoor shut, too.