By now, many lenders have heard of the steps taken by J. Crew to remove its valuable intellectual property from the collateral securing its term loans and asset-based credit facilities through a clever (although disputed) use of the transactions permitted under the negative covenants included in the credit agreements governing such credit facilities (the “baskets”).

The transfer of the intellectual property through a series of maneuvers using “unrestricted subsidiaries” and “permitted investments,” which J. Crew argues are allowed under the applicable credit agreement, has led to ongoing litigation between a certain group of the term loan lenders and the company in Eaton Vance Management, et al, v. Wilmington Savings Fund Society, et al, Case. No. 654397/2017, in the Supreme Court of the State of New York.

Meanwhile, litigation has also begun in connection with the financing led by Citibank that was provided to PetSmart, Inc. for its acquisition of Chewy.com.  On June 26, 2018, PetSmart filed a complaint in the United States District Court for the Southern District of New York against Citibank, the former administrative agent under its $4.16 billion term loan facility.  The complaint in Argos Holdings Inc. and PetSmart, Inc. v. Citibank, N.A., Case No. 18-cv-5773, charges that Citibank failed to fulfill its contractual obligations under the credit agreement to release certain collateral.

How did matters get to the point where this borrower is suing its lenders?  And, more importantly, what can we learn from the dispute between PetSmart and its lenders about how the covenants in credit agreements may need to be done differently to prevent the unpleasant surprises for lenders that occurred in J. Crew and now in the PetSmart financing—notwithstanding this hyper-competitive, borrower/issuer friendly environment?

A brief history to set the stage.  PetSmart, like J. Crew, is owned by a private equity firm.  In PetSmart’s case, the private equity firm is BC Partners, which acquired PetSmart from Longview Asset Management in 2015 in a leveraged buyout for $8.7 billion.  Two years later, in May 2017, PetSmart acquired the online pet product retailer, Chewy.com.  The $3 billion acquisition was financed with $1.35 billion in first lien notes, $650 million in unsecured notes and $1 billion in equity from BC Partners.  PetSmart already had a $205 million asset-based facility, a $4.16 billion term loan facility and $1.9 billion in senior unsecured notes.

After the Chewy.com transaction, PetSmart debt was subject to the following agreements:

• an asset-based credit agreement for $955 million;
• a term loan credit agreement for approximately $4.2 billion of secured term loan debt; and
• three indentures for different senior notes, including 7.125% Senior Notes due 2023, 8.875% Senior Notes due 2025 and 5.875% Senior First Lien Notes due 2025.

While the Chewy.com acquisition left the company with around $8 billion in debt overall, the move to expand from just a brick-and-mortar retailer into e-commerce through the acquisition of Chewy.com was seen by lenders and investors as a smart move at the time.  However - despite the acquisition, EBITDA, revenues and same store sales at PetSmart all declined in its 2017 fiscal year.

On June 1, 2018, PetSmart executed two transactions according to the complaint in the Citibank action “as part of its ongoing efforts to manage its capital structure…”.

• First, the “distribution”--PetSmart made a distribution to its parent, Argos Holdings, of 20% of the outstanding common stock of Chewy.com, followed on the same day by a distribution of such common stock by Argos to its parent company.
• Second, the “investment”--PetSmart made an “investment” of 16.5% of the outstanding common stock of Chewy.com in the form of a capital contribution to a newly formed wholly owned subsidiary of PetSmart created on May 30, 2018 and designated as an “Unrestricted Subsidiary” under the ABL credit agreement, the term loan credit agreement and each of the three indentures.

The effect of the distribution of the 20% of the shares to the parent holding company and the investment of 16.5% of the shares was that the senior secured lenders to PetSmart lost the value of those shares as part of the collateral that supported the credit that they had provided to PetSmart. The parent holding company that received the 20% of the shares was not a guarantor and its assets were not part of the collateral and the “Unrestricted Subsidiary” that received 16.5% of the shares also did not guarantee any of the applicable debt or grant liens on its assets to secure any such debt (and being an “Unrestricted Subsidiary” was also not subject to any of the covenants or other terms of any of the applicable credit facilities or indentures, allowing it to obtain other financing should it so elect without restriction).

But, that was not all! The basis for the litigation brought by PetSmart against Citibank is that Citibank would not deliver the lien release documents for Chewy.com, as PetSmart argued it was required to do under Section 9.15 of the term loan credit agreement, which says:

“A Loan Party shall automatically be released from its obligations under the Loan Documents, and all security interests created by the Security Documents in Collateral owned by such Subsidiary Loan shall be automatically released…in connection with a transaction permitted under this Agreement, as a result of which such Subsidiary Loan Party ceases to be a wholly-owned Subsidiary.”   

Boom!
So now not only had the senior secured lenders lost the benefit of 36.5% of the stock of Chewy.com, but, in fact, had lost all of its assets as part of the collateral to support the lenders’ credit exposure, including the loans made to finance the acquisition of Chewy.com. Given that loans were made and notes issued in reliance on the acquisition of Chewy.com, it seems the lenders may have been surprised to learn that those assets were no longer collateral for their loans and notes.

In order to see how we got to this predicament and perhaps more importantly to see how it might be avoided in the future, we have to break down the covenant package that the sponsors and their lawyers negotiated for in the credit documents.

First, let’s look at the distribution of the 20% of Chewy.com stock to the parent holding company, a transfer that falls within the commonly used concept of a “Restricted Payment.”  While the term loan credit agreement includes the customary negative covenant prohibiting Restricted Payments, there are also a series of carve outs from the general prohibition (that is the “baskets”). According to PetSmart’s complaint, Section 6.08(a)(viii) of the term loan credit agreement allowed PetSmart to make Restricted Payments up to the sum of:

• $200 million, plus
• the “Available Equity Amount”.

The “Available Equity Amount” includes capital contributions in cash or Permitted Investments received by the company after the closing of the term loan credit agreement.  The complaint says that the company received $1.0 billion in capital contributions from indirect equity owners in connection with the acquisition of Chewy.com, so it is permitted to make Restricted Payments of up to $1.2 billion.

Note that the distribution was of 20% of the Chewy.com stock, not all of it.  Do you see where this is going? What was the Chewy.com stock worth?  According to PetSmart, based on the mid-point value range determined by its financial advisor, the value of the distribution was $908.5 million—less than the amount it could have distributed under the basket, according to PetSmart.  Of course, we can easily see this sort of calculation leading to a “battle of the experts” on the valuation of Chewy.com.  

But more importantly, from a lender’s perspective, the question is whether the lenders ever focused on the fact that a distribution or dividend could be paid in property other than cash.  Generally, when lenders think of a company paying a dividend or making a distribution in respect of its equity, a lender thinks of a cash payment to equity owners for them to recover some of their investment when a company is performing well.  Lenders do not think that an income-producing asset, like a subsidiary, could be transferred in the form of a dividend or distribution. And they certainly do not think that a company with declining sales and increasing losses should be able to dispose of such assets, at least not without the consent of the lenders.

Another lesson that lenders might learn here is the connection (or in this case the lack of connection) between the timing of a company receiving equity investments or cash in some other form relative to when it is paying dividends or making other distributions for purposes of the basket amount.  While it is certainly a positive development from the lenders’ perspective for the company to receive such investments, a lot can occur in 3, 6 or 12 months with respect to a company’s financial performance that means a company should not necessarily be able to pay out dividends at such later date just because a year earlier it had received funds into the company.

Second, let’s look at the “investment” in the form of a contribution of 16.5% of the outstanding stock of Chewy.com to the newly formed “Unrestricted Subsidiary.”  “Unrestricted Subsidiaries,” which by definition are not included in the credit facility such that their assets are not collateral and they are not subject to the covenants or other terms of a credit facility, are common in larger transactions, but have become a way for borrowers to move assets that were collateral to assets that are not collateral—usually at the time when the lenders are looking for more protection, rather than less.

Interestingly, the complaint does not discuss whether the company was permitted to form the new subsidiary and designate it as an “Unrestricted Subsidiary” and therefore outside of the credit facilities.  Lenders may want to be quite careful in establishing the conditions which must be satisfied for a company to form or designate an Unrestricted Subsidiary, given how they may be used.  But, ultimately, in this case the issue really is the conditions that must be satisfied to permit investment in an Unrestricted Subsidiary.  

Here again, the complaint looks at the sum of two elements of the baskets under Section 6.04 of the term loan credit agreement, which permits “other Investments and other acquisitions” of:

• up to $375 million, plus
• the “Available Amount”. 

The Available Amount includes the “starter basket” of $200 million plus 50% of “Consolidated Net Income” for the period from the closing of the facility to the end of the applicable test period.  Consolidated Net Income for the period the company says in the complaint was approximately $1.2 billion.  Therefore, according to the company, taking 50% of the Consolidated Net Income plus $200 million, it is permitted to make investments of up to approximately $820 million.

Based on the mid-point of the value range determined by PetSmart’s financial advisor, the value of the 16.5% of the stock that was given as a contribution to the Unrestricted Subsidiary was $749.5 million—so the contribution was permitted.

What about other covenants in the credit agreement?  Is there no place for the lenders to turn for protection?  The complaint reviews other provisions of the term loan credit agreement, including the negative covenants on asset dispositions and transactions with affiliates. Not surprisingly, given that generally the credit agreements are structured to be consistent so that a transaction permitted under one provision of the agreement is not prohibited by another, the complaint concludes that these other covenants did not prohibit either transaction.  The complaint also argues that the indentures for the three sets of notes issued by PetSmart permitted the transactions.

As the discussion of these other provisions in the complaint reflect, it is important for lenders to understand the various negative covenants with respect to Restricted Payments, investments (and not only in the form of capital contributions, but intercompany loans as well), asset dispositions and transactions with affiliates—each as mechanism for a company to have assets of all types or character moved beyond the reach of the lenders.  

While the disputes about the ability of PetSmart to take the steps that it has is just beginning, lenders should consider ways to avoid these issues coming up in the first place.

• First, lenders should consider limiting dividends and other distributions on equity, as well as investments for general baskets to the use of cash or cash equivalents, rather than such assets as intellectual property or equity interests.
• Second, given the way negotiations evolve and the approach commonly taken by borrowers and their counsel, it is too easy to get distracted by the extensive number of baskets which often overlap and are duplicative so as to allow for transactions that were never contemplated. Lenders need to look at the aggregate value of permitted transactions and try to resist overlapping baskets.
• As part of this exercise, the covenant baskets need to be viewed in their totality rather than looking at them separately in order to keep track of how assets may be moved away from the lenders.  The analysis for a lender when going into a deal does not stop with restricted payments or permitted investments, but must consider asset dispositions, designation of unrestricted subsidiaries, and transactions with affiliates. 
• The timing of when cash comes into a company relative to when cash or other assets may be disposed of by a company (whether in the form of dividends, investments, or asset dispositions) need to be connected. 

The lenders to PetSmart filed their responses to the action brought by PetSmart against them on September 6, 2018. Stay tuned for how the lenders are pushing back against the company’s efforts to shift assets away from them.