In a recent series of well-publicized cases, several companies have taken advantage of covenant exceptions in their credit documentation to move valuable assets beyond their senior creditors’ reach, in an effort to raise additional capital. J. Crew and Claire’s each relied upon a combination of investment baskets to transfer valuable intellectual property to an unrestricted subsidiary. iHeart transferred a portion of the equity interests in a profitable subsidiary to an unrestricted subsidiary. A recent case involving PetSmart’s partial transfer of equity in its profitable subsidiary, Chewy.com, and the corresponding release of Chewy’s guarantee, is particularly troubling to lenders due to its implication of the guarantor-release provisions.
In June 2018, PetSmart announced that it had transferred 36.5% of the equity interests in Chewy.com to a consortium of investors led by its private-equity sponsor (20%) and to an unrestricted subsidiary (16.5%), which resulted in Chewy ceasing to be a wholly owned subsidiary.
PetSmart’s credit agreement provides that, when a subsidiary ceases to be wholly owned, that subsidiary is automatically released from its guarantee obligations, and any liens that subsidiary may have granted on its assets are terminated. While it is customary to exclude non-wholly owned subsidiaries from the guarantor pool, a lender that underwrote a deal via an entire corporate family may see the unexpected loss of a guarantor and its collateral as an unexpected result. On the other hand, borrowers desire the ability to release a subsidiary from its guarantee obligations and liens upon the transfer of that subsidiary in a permitted transaction.
Parties have arrived at several ways of balancing these competing interests—for example, treating the release of a subsidiary that becomes an excluded subsidiary (by designation or otherwise) as an investment, requiring the borrower to have investments capacity equal to the fair market value of the subsidiary that is no longer providing credit support for the lender group.
The Chewy case (and other cases involving restricted subsidiary transactions) highlights the importance of analyzing the guarantee-release provisions in credit documentation, particularly the exclusion of non-wholly owned subsidiaries, to avoid undesirable outcomes.