By Michael Friedman, Simone Tatsch, and Nicholas Whitney (Chapman and Cutler LLP)
As more Companies face liquidity issues and near term debt maturities, they are looking closely to exceptions contained within their indenture/credit agreement covenants in order to achieve an overall or partial restructuring of their capital structure. Investments in “Unrestricted Subsidiaries” are an exception to investment covenants, which have been used in an attempt to provide flexibility in restructuring a Company’s capital structure. Before purchasing debt, distressed investors need to be mindful of what Unrestricted Subsidiaries are and how they impact the overall credit of a Company or debt recovery.
Companies may use Unrestricted Subsidiaries in order to transfer a valuable asset outside of the purview of a Financing Agreement’s covenants. A Company can use the Unrestricted Subsidiary to exchange near term maturing debt junior in the Company’s capital structure for debt issued by the Unrestricted Subsidiary – an exchange that would otherwise not be permitted by the covenants. The exchanged indebtedness could then be supported by the asset which has been transferred to the Unrestricted Subsidiary.
Two recent and well publicized examples of moving value into an Unrestricted Subsidiary are iHeartCommunications (“iHeart”) and J.Crew Group, Inc. (“J.Crew”). In iHeart, the stock of an iHeart subsidiary was moved to an Unrestricted Subsidiary in order to effect a debt exchange, while in J.Crew valuable intellectual property was moved into an Unrestricted Subsidiary for likely the same purpose. Investors must be prepared to determine if there is a way for a Company to utilize its covenants to transfer value to an Unrestricted Subsidiary.
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