Liability Management in Canada

In the context of corporate debt, 'liability management' refers to a company taking steps to manage its existing debt obligations. This often involves a combination of one or more open market repurchases, redemptions/repayments, consent solicitations, tender offers or exchange offers, and may involve other transactions. A repurchase of debt from a holder is one of the most straight-forward examples of liability management.

Liability Management Transactions

Increasingly in the last several years, the term 'liability management transaction' (LMT) has referred more specifically to creative management of debt liabilities, often by distressed companies. These commonly involve or facilitate a change in the priority of creditors (whether structurally, in lien priority or in right of payment) and/or a transfer of value from entities subject to covenant restrictions to entities with fewer restrictions. Such transactions are generally completed in compliance with the terms of the company's existing debt, after giving effect to any obtained waivers, amendments or consents, but are rarely expressly contemplated by the original governing documents. 

LMTs can be used by a company to, among other things, facilitate the incurrence of new debt, reduce the company's overall debt burden (e.g., by refinancing junior debt at a discount), improve the company's maturity schedule and/or address restrictions that prevent other transactions desirable to the company. 

The feasibility of a particular LMT, and the steps involved in its structuring, will depend on the terms of the company's existing debt instruments, who holds them and the laws of the applicable jurisdictions.

Named LMTs and Related Blockers

The most well-known LMTs are informally named after the companies that brought them to prominence. J. Crew ('drop-down' of assets into an unrestricted subsidiary), Mitel and Serta (non-pro rata 'uptier' of certain creditors),^[1] Petsmart/Chewy (release of subsidiary guarantees) and Incora (issuance of additional debt to reach a consent threshold), among others, are household names not just for their customers but also for liability management practitioners. 'Double-dips' and related LMTs have also gained popularity: these usually involve pledging an intercompany loan in support of a new debt instrument with the intention of giving holders of the new instrument more than one claim against the available collateral. 

In response to the development of LMTs, corresponding 'blocker' provisions, which are designed to restrict known types of LMT (and, in some cases, LMTs more generally), have become part of the discussion in negotiating debt documents.

Application to Canadian Debt Instruments

The overwhelming majority of debt raised by Canadian companies falls under one of three categories:^[2]

1. Domestic market debt governed by Canadian law, including credit facilities with Canadian banks but excluding marketed high yield notes and instruments based on US precedent.^[3]
   1. Instruments in this category often contain significantly more restrictive covenants than are found in marketed high yield notes, covenant-lite loans or similar instruments in the US market, thereby limiting the potential for LMTs.
   2. The relatively small size of the domestic Canadian bank lending market fosters cooperative relationships among syndicate members, reducing the likelihood of 'creditor-on-creditor violence' and increasing the reputational risk associated with upsetting one or more bank lenders.
2. Debt governed by US law, including US dollar-denominated high yield notes and credit facilities with US lenders ("Type 2" debt).
   1. The well-known categories of LMT that are possible under some US law-governed instruments, including many high yield notes and covenant-lite loans, are also available to, and have been used by, Canadian issuers of such instruments.
   2. Non-convertible debt securities are not subject to Canada's issuer bid rules (there is no Canadian equivalent of US debt tender offer rules) and debt securities are not subject to the Canadian proxy solicitation rules that apply to solicitations of common shares and other voting securities. As a result, Canadian securities law generally permits LMTs that are permissible under US securities law, and Canadian law may even provide greater flexibility in cases where US securities law is inapplicable.^[4]
3. Debt governed by Canadian law but based on US precedent ("Type 3" debt).
   1. Many Canadian issuers switch between Canadian and US law-governed debt instruments depending on whether they wish to raise money in Canadian or US currency. The covenant packages among these instruments tend to be consistent and based on US precedent, regardless of the governing law. For example, an issuance of Canadian dollar-denominated high yield notes will generally be governed by Canadian law, but its covenants will often match those in the company's US-market indenture.
   2. Even for issuers that have only Canadian dollar-denominated debt, Canadian high yield covenants are generally consistent with those found in the US market. As a result, they provide similar scope for LMTs.

Due in part to the smaller size of the Canadian market, there have been far fewer LMTs in Canada than in the United States. Nevertheless, Canadian companies have in recent years completed publicized drop-down and uptiering transactions under their US law-governed (Type 2) debt instruments. There are a significant number of debt instruments with similar covenants outstanding in Canada (both Type 2 and Type 3) that could potentially allow more Canadian companies to avail themselves of LMTs should they have reason to do so.

As Canadian companies increasingly adopt US-style covenant packages–even in Canadian dollar-denominated instruments governed by Canadian law–the scope for LMTs in Canada is expanding. This highlights the importance of understanding the evolving toolkit of liability management in Canada, including blocker provisions designed to restrict LMT structures and the legal nuances that may constrain or enable such transactions.

For more information about LMTs, or if you have any questions about liability management in Canada, please contact one of the authors. 

Articling student James Atkinson assisted in the preparation of this article.

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[1] An 'uptier' transaction is one in which a group of creditors receive higher priority debt of the company, thereby subordinating any remaining holders of the original debt. The 'uptiered' creditors may be new money investors or existing investors who exchange into the new senior priority indebtedness.

[2] There is a fourth, much smaller, category of debt instruments governed by the laws of countries outside North America, which is not discussed in this publication.

[3] We draw a distinction between this category and Type 3 debt below ('Debt governed by Canadian law but based on US precedent'). There is a growing trend among certain Canadian issuers and borrowers, particularly those who have experience with raising debt in the US market, to carry over to their domestic debt capital raising activities governed by Canadian law (whether bank financings or broader debt capital markets activities) the terms they are accustomed to seeing or receiving on their US financings. While there is this growing convergence with practice on the US side of the border, there nonetheless remains robust domestic banking and debt capital markets that continue to follow the Canadian covenant conventions noted in category 1.

[4] There are common law remedies potentially available to aggrieved creditors in certain cases, which a company contemplating an LMT should discuss with its Canadian legal counsel. The 'oppression remedy' is particularly noteworthy in the context of potential LMTs involving Canadian companies.