Priming transactions – potential tax consequences

Executive summary

In the newly evolving area of priming (or uptiering) transactions – unexpected tax consequences may result from such transactions. In the event that a priming transaction results in a significant modification, the debtor would likely recognize cancellation of debt income as a tax consequence, if the debt is publicly traded.

Priming transactions – potential tax consequences

In recent years, cash-strapped borrowers have begun using a new technique to increase liquidity, which is known as a “priming transaction”.^[1] In a priming transaction, the borrower negotiates with the majority debt holders to amend the existing debt/loan agreement to issue new senior debt.^[2] In these transactions, the majority debt holders usually fund the new senior debt with cash or exchange their existing debt with new senior debt. These transactions are performed without the participation and consent of the minority creditors, resulting in the minority creditors’ debt becoming subordinated to the new debt. As a result, some minority debt holders brought suits claiming breach of contract and “breach of the implied duty of good faith and fair dealing”.^[3]

In a few of these cases, the court sided the majority debt holders. In 2018, Murray Energy Holdings (“Murray”), through a modified Dutch auction, replaced its existing debt issued under its 2015 agreement with a new superior debt.^[4] The agent representing the minority lenders brought suit challenging the 2018 agreement’s validity as “a modified Dutch auction”,^[5] and as such, the debt subordination required the consent of all the lenders.^[6] With regard to the violation of the modified Dutch auction, the court stated that issue needed to be resolved at trial and not under a summary judgement motion.^[7] However, the court concluded that the debt subordination was not equivalent to a collateral release that would require the consent of all the lenders, and that the parties did not specify such a requirement in the credit agreement.^[8] As such, the “priming” was upheld.

In a similar case, In re TPC Grp. Inc. (TPC), the debtor issued a senior note, “the 10.875% Notes” which took priority to the lien securing TPC`s existing notes, “the 10.5% Notes.^[9] Some of the minority noteholders of the 10.5% Notes challenged the uptiering transaction arguing that any changes to the existing debt required the vote or consent of all the 10.5% noteholders, because the change adversely affected them. The Delaware Bankruptcy Court, however, found that the issuance of the new senior note did not require the vote of 100% of the existing noteholders. The court in that case found that a “sacred rights” provision within the 10.5% Note agreements protected the rights among the 10.5% Note holders and did not rise to the level of an anti-subordination clause.  

In contrast, the New York Supreme Court and the United States District Court for the Southern District of New York denied motions to dismiss objections to the uptiering transaction in the Not Your Daughter`s Jeans (NYDJ)`s case. In 2017, the minority lenders sued the majority lenders in the case, arguing that the majority lenders conspired to prioritize their own debt in bad faith and without the knowledge and assent of the minority lenders.^[10] The court declined the majority lender’s motion to dismiss, as they preliminarily found the uptiering arrangement to be unreasonable and unfair.^[11]

Trimark^[12], Serta^[13], and Boardriders^[14] also engaged in similar priming transactions where the minority lenders, among others, brought arguments of bad faith, violation of sacred rights, and most importantly, breach of contract claims. The courts in all three cases denied the motions to dismiss by the majority and mainly allowed the breach of contract claims to go forward.^[15]’[16]

Debt Modifications

As discussed above, due to current economic or other challenges, debtors may negotiate with their lenders to amend existing debt agreements or to exchange the existing debt with a new debt. To the extent that the debt amendment or the exchange leads to a significant modification, the debtor may incur Cancellation of Debt Income (CODI), as described below.^[17]

Under Section 1.1001-3(c) of the Treasury Regulations (“Treas. Reg.”), modifications could include deferral of payments of interest and extension of maturity, interest holidays, changes in interest rate, subordination of debt, reduced collateral on debt, and change from recourse to nonrecourse.^[18] Treas. Reg § 1.1001-3(b) states that a “modification is significant only if, based on all facts and circumstances, the legal rights or obligations that are altered and the degree to which they are altered are economically significant.”^[19]

Significant modifications, among others, includes change in obligor or security.^[20] Treas. Reg § 1.1001-3(e)(4) defines significant modifications for both recourse and non-recourse debt instruments. Based on Treas. Reg § 1.1001-3(e)(4)(iv)(A), a modification is significant when it “releases, substitutes, adds or otherwise alters the collateral for, a guarantee on, or other form of credit enhancement for a recourse ” and it results in a change in payment expectations.^[21]

Moreover, Treas. Reg § 1.1001-3(e)(4)(v) further specifies that a “change in the priority of a relative to other debt of the  is a significant  if it  in a change in payment expectations”.^[22] Change in payment expectations occurs if the obligor`s capacity to satisfy the obligations that was speculative prior to the modification is substantially enhanced.<sup>[23]</sup> The change in payment expectations could also happen when there is substantial impairment in the obligor`s capacity to pay the debt obligation and the capacity is speculative while it was adequate before the modification.^[24] Thus, a change to one debt instrument outstanding may impact the payment expectations of others, as could be the case if a majority lender enhances its priority.

The reason why it is important whether a debt modification is significant or not relates to the tax consequence of the modification. As mentioned above, if it is determined that a modification in a debt agreement is significant, it results in CODI. Note that if a modification is considered to be significant, it could result in CODI on all debt, even debt that is not modified.

Cancellation of debt income concerns^[25]

When a debt-for-debt exchange occurs, the old debt is treated as satisfied for an amount equal to the issue price of the new debt.^[26] For debt that is not traded on an established market (i.e., is not publicly traded), the regulations provide a favorable rule to determine the issue price, which generally results in little or no CODI. When debt that is not publicly traded is modified, resulting in a debt-for-debt exchange, the issue price is generally equal to its principal amount, provided it bears adequate stated interest.^[27] This generally results in debt being satisfied for the face amount even if the value is significantly less.

However, where the debt exceeds $100 million and is publicly traded, the potential for a CODI event increases significantly. The definition of publicly traded debt is much broader than some may think.^[28] To the extent the debt is publicly traded, the debt is treated as satisfied for its fair market value, which if less than the face amount, will result in CODI. Assuming that the debtor is a solvent company that is not in a bankruptcy proceeding, this CODI is generally taxable income and not eligible for exclusion.

Application to priming transaction

It is unclear whether priming transactions could result in a significant modification of subordinated debt under the Treas. Reg. § 1.1001-3(e)(4). Based on the above analysis, a significant modification may occur in priming transaction, because, as stated under Treas. Reg. § 1.1001-3(e)(4)(iv)(A), the same collateral is used to secure the new debt results in subordinating the existing debt. As such, based on Treas. Reg. § 1.1001-3(e)(4)(v), the new debt in a priming transaction is given priority over the existing debt by giving the majority debt holders the right to a claim on the collateral before the existing or minority debt holders. Note that debtors may be variously (i) secured, (ii) partially secured or (iii) unsecured, based on the FMV of the underlying collateral, which can shift in value over time.

In accordance with Treas. Reg. §§ 1.1001-3(e)(4)(vi)(A)(1) & (2), a priming transaction can also result in changing the expectations of the debt holders to be paid in full or in part. For the majority debt holders, as the holders of the new debt, the capacity of the issuer may be enhanced. However, for the minority debt holder(s), the capacity of the issuer is usually impaired as they will not be paid until the majority debt holder are paid. Though not a specific modification to the minority holders’ debt instruments, arguably their payment expectations have changed. The substantial impairment of the debtor`s capacity relating to changes in payment expectations can be even more apparent in bankruptcy cases, two of which are discussed above: Murray and TPC. In such cases, the minority debt holders may not even be paid in part or in whole if the collateral is not sufficient to satisfy more senior claims.

In the event that a priming transaction results in a significant modification, the debtor likely recognizes CODI as a tax consequence if the debt is publicly traded.

For example, assume the adjusted issue price is $120M and the FMV on the transaction date is $20M. If the debt is publicly traded, and the debtor is not insolvent (or in bankruptcy), the debtor would recognize $100M of CODI and the creditor would likely receive a correlative bad debt deduction.

However, please note that this analysis is highly dependent on the facts and circumstances relating to a particular debt instrument and whether a debt is recourse or nonrecourse. Debt agreements are negotiated in arms-length transactions and the fact that a modification is significant or not depends on the terms and conditions of each agreement.

Conclusion

Priming / uptiering transactions are a new and evolving area of law. No cases have yet reached ultimate disposition relating to priming transactions – nor by inference is there meaningful guidance relating to the tax consequences if a plaintiff were to prevail in such a case. However, it is logical to assume that if a creditor prevails in such a case – there may be a significant modification to the underlying debt instrument – with resulting tax consequences to both debtor and creditor. The tax consequences would be very dependent on the facts and circumstances relating to a particular debt instrument. As such, consulting with experienced tax advisors and legal professionals would be critical in determining the tax consequences of significant modification relating to a priming transaction.

^{[1] See, e.g., Mannal, Douglas; Zide, Stephen; and Stevens, Isaac. “Liability Management Transactions (Part I): Uptier Transactions.” Dechert LLP, November 2022.}

^{[2] Shamah, Daniel S. and Taylor, Jennifer. “Priming Transactions Update: Boardriders.” O’Melveny,}

^{Oct. 25, 2022. Priming Transactions Update: Boardriders - O'Melveny .}

^{[3] Id(can you spell out this abbreviation). at 1.}

^{[4] Jacobson, Seth E.; Meisler, Ron E.; Dressel, Christopher M.; Halcomb, Darrin R.; Ritchie, Rebecca L., “Unhappy Lenders Challenge Aggressive Debt Exchanges.” Skadden, Jan. 19, 2022. Unhappy Lenders Challenge Aggressive Debt Exchanges | Insights | Skadden, Arps, Slate, Meagher & Flom LLP.}

^{[5] See, e.g., , for a discussion regarding the mechanics of a modified Dutch auction.}

^{[6] Mintz, Douglas S.; Schodek, Ned S.; Amend, Peter J. “Recent Challenges to Uptiering Transactions,”}

^{American Banckrupcy Institute Journal.}

^{[7] Id. at 5.}

^{[8] Id. at 5.}

^{[9] Jarashow, Kizzy;  Lathrop, James;  Cheng, Andrew W. ; Goldstein, Michael H. “TPC Bankruptcy and}

^{District Court Opinions Uphold Uptiering Transaction and Teach an Important Lesson on the Need for}

^{Express Lender Protections in Debt Documents,” Goodwin, Aug. 17, 2022. TPC Bankruptcy and District Court Opinions Uphold Uptiering Transaction and Teach an Important Lesson on the Need for Express Lender Protections in Debt Documents | Insights & Resources | Goodwin Procter .}

^{[10] Octagon Credit Inv., LLC v. NYDJ Apparel, LLC., et al., No. 656677/17 (N.Y. Sup. Ct. 2018).}

^{[11] Id. at 9.}

^{[12] Audax Credit Opportunities Offshore Ltd., et al. v. TMK Hawk Parent, Corp., et al., 150 N.Y.S. 3d 894 (N.Y. Sup. Ct. 2021).}

^{[13] LCM XXII Ltd., et al. v. Serta Simmons Bedding, LLC, No. 21-cv-3987, 2022 WL 953109 (S.D.N.Y. March 29, 2022).}

^{[14] ICG Global Loan Fund 1 DAC, et al. v. Boardriders, Inc., et al., No. 655175/20 (N.Y. Sup. Ct. 2018).}

^{[15] Id. at 1.}

^{[16] To read more about these four cases, please refer to the excellent article written by Douglas Mannal and Stephen Zide, “Liability Management Transactions”, contained in the AIRA Journal, published in the second quarter of 2023.  Mannal, Douglas and Zide, Stephen. “39th Annual Bankruptcy & Restructuring Conference (“AC23”),” AIRA Journal, June 7-10, 2023.}

^{[17] Id. at 12.}

^{[18] Reg. section 1.1001-3(c).}

^{[19] Reg. section 1.1001-3(b).}

^{[20] Reg. section 1.1001-3(e)}

^{[21] Reg. section 1.1001-3(e)(4)(iv)(A).}

^{[22]  Reg. section 1.1001-3(e)(4)(v).}

^{[23] Reg. section 1.1001-3(e)(4)(vi)(A)(1).}

^{[24] Reg. section 1.1001-3(e)(4)(vi)(A)(2).}

^{[25] Adapted from the following article}

^{[26] Section 108(e)(10).}

^{[27] Sections 1273(b)(4) and 1274.}

^{[28] For a more detailed discussion on this issue, refer to the following article regarding modifying debt over $100 million}