A liability management exercise, often shortened to LME, is a set of out-of-court transactions a company uses to restructure its outstanding debt by exploiting flexibility built into its existing loan documents. Liability management exercises typically create new borrowing capacity, extend maturities, or reduce the debt load, and they often do so at the direct expense of some of the company’s own lenders. The technique rose to prominence after high-profile transactions at J.Crew and Serta Simmons, and it has since generated intense litigation and rapid changes in how credit agreements are drafted.
Where the Flexibility Comes From
Every LME starts with a close reading of the borrower’s credit agreement or bond indenture. Counsel hunts for room the original lenders may not have expected would be used this way. Three features carry most of the weight.
A basket is a dollar-amount carve-out from an otherwise restrictive covenant. A credit agreement may broadly bar the borrower from taking on additional debt yet include a basket permitting a specified amount of new borrowing for a defined purpose. Others allow investments in subsidiaries or asset transfers up to a set value. The borrower’s team inventories every basket to calculate how much room exists for restructuring.
Negative covenants restrict what the borrower can do with its assets, liens, and debt capacity, but the exceptions inside those covenants are where the action happens. A covenant might prohibit transfers of collateral to subsidiaries while carving out transfers to “unrestricted subsidiaries” that sit outside the agreement’s reach. The gap between the broad prohibition and the narrow exception is the corridor through which most LMEs travel.
Sacred rights are the provisions that require unanimous lender consent to change. They usually protect each lender’s right to receive principal, interest, and payment by maturity. If a proposed transaction does not directly alter those specific economic terms, the borrower may need only a simple majority to amend the agreement. For bonds governed by the Trust Indenture Act, Section 316(b) provides a statutory backstop: no bondholder’s right to receive principal and interest on the due dates can be impaired without that holder’s individual consent, regardless of what the indenture says.1Office of the Law Revision Counsel. 15 U.S. Code 77ppp – Directions and Waivers by Bondholders The practical consequence is that LMEs work around payment rights rather than through them.
The Main Types of LME
The core logic is always the same. The borrower finds a group of lenders willing to cooperate, offers them improved terms, and in doing so weakens the position of the lenders left behind. The variants differ in whether the borrower is moving collateral, reordering priority, layering claims, or repurchasing debt at a discount.
Drop-Down Transactions
In a drop-down, the borrower transfers valuable assets into a subsidiary that the credit agreement classifies as unrestricted. Because the original lenders’ liens and covenants do not extend to unrestricted subsidiaries, the transfer effectively strips the collateral away from the existing loan. The borrower then pledges those same assets to secure new debt, generating fresh borrowing capacity from collateral that used to back the old loans.2New York University School of Law. The Loan Market Response to Dropdown and Uptier Transactions J.Crew’s 2017 transfer of its intellectual property to an unrestricted subsidiary became the defining example. Existing lenders lost their claim on the brand’s most valuable asset and were left holding loans secured by a diminished collateral pool.
Uptier Transactions
An uptier works differently. Instead of moving collateral out, the borrower reshuffles the priority of claims against the same collateral. The borrower approaches a majority group of existing lenders and offers to exchange their current loans for new debt carrying a superior lien, often called super-priority or first-out debt. In return for consenting to amend the credit agreement to permit this new senior layer, participating lenders receive better protection and sometimes additional compensation. Lenders who decline or are not invited find their formerly first-lien debt effectively subordinated.3Harvard Law School Bankruptcy Roundtable. The Loan Market Response to Dropdown and Uptier Transactions The Serta Simmons uptier in 2020 became the most litigated example, and the phrase “lender-on-lender violence” entered the restructuring lexicon soon after.
Double-Dip Structures
A double-dip takes the drop-down concept a step further. The borrower routes new financing through a non-guarantor subsidiary, which issues the new debt and then lends the proceeds back to the parent through an intercompany loan. The new creditors end up with two paths to recovery: a direct guarantee from the parent and operating subsidiaries, and an indirect secured claim through the subsidiary’s intercompany receivable. In a bankruptcy, this structure can give the new creditors a disproportionate share of the collateral because they effectively hold two claims against the same asset pool. Recovery is still capped at par plus accrued interest, but the double-dip meaningfully increases the new creditors’ pro rata share relative to other secured lenders holding single claims.
Open Market Purchases
Not every LME requires subsidiary structures or lender amendments. When a company’s debt trades at a significant discount to face value, the borrower can buy it back. Open market purchases let the borrower retire debt on a one-off basis without offering the same deal to every lender. Credit agreements typically condition these buybacks on the absence of a payment default and sometimes prohibit using revolving credit funds. For bonds, the borrower must comply with securities law anti-fraud provisions and cannot repurchase while holding material non-public information.
Exit Consents
Exit consents are a coercive tool paired with an exchange offer. As a condition of tendering, each participating lender must vote to strip protective covenants from the old debt. If enough lenders tender to reach the amendment threshold, departing lenders receive new bonds with better terms and holdouts are stuck with old bonds whose meaningful protections are gone. The threat pushes reluctant lenders toward participating even when the exchange terms are unfavorable. If the borrower does not hit the required majority, neither the exchange nor the covenant strip goes through.
Securities Law Constraints
Debt exchanges implicate federal securities law even when they involve only existing lenders. The borrower must either register the new securities or find an exemption. Most LMEs rely on Section 3(a)(9) of the Securities Act, which exempts any security exchanged by the issuer with its existing holders as long as no commission or remuneration is paid to anyone for soliciting the exchange.4Office of the Law Revision Counsel. 15 U.S. Code 77c – Classes of Securities Under This Subchapter That last requirement is why the borrower, not an investment bank, technically makes the offer in many LME structures. If a dealer manager solicits the exchange, the exemption is lost and registration becomes necessary.
Tender offers for debt are also subject to Rule 14e-1 under the Exchange Act, which ordinarily requires offers to remain open for at least twenty business days.5eCFR. 17 CFR 240.14e-1 – Unlawful Tender Offer Practices A 2015 SEC no-action letter allows abbreviated tender offers for non-convertible debt to run as short as five business days, provided the offer meets specific conditions including immediate widespread dissemination of the terms.6Securities and Exchange Commission. No-Action Letter: Abbreviated Tender or Exchange Offers for Non-Convertible Debt Securities The shorter timeline has become standard for many private debt exchanges.
Tax Consequences
When a company retires debt for less than face value, the difference is generally cancellation of debt (COD) income and taxed as ordinary income in the year of the cancellation.7Internal Revenue Service. Canceled Debt – Is It Taxable or Not? In an LME where lenders exchange $100 million in old debt for $70 million in new super-priority debt, the borrower has $30 million of potential COD income. The tax hit can be large enough to influence whether the deal makes economic sense.
Two exclusions under the Internal Revenue Code matter most for distressed borrowers. In a Title 11 bankruptcy case, all COD income is excluded from gross income. If the borrower is insolvent outside of bankruptcy, COD income is excluded up to the amount by which its liabilities exceed the fair market value of its assets immediately before the discharge.8Office of the Law Revision Counsel. 26 U.S. Code 108 – Income From Discharge of Indebtedness Neither exclusion is free. The borrower must reduce favorable tax attributes like net operating losses and credit carryforwards as a trade-off. Companies executing LMEs outside of bankruptcy that are not yet technically insolvent may face the full COD bill, which is one reason many LMEs are structured as exchanges at par rather than at a discount.
Litigation Risk
LMEs have generated an extraordinary volume of litigation, most of it brought by excluded lenders whose positions were subordinated or whose collateral was depleted. Two landmark decisions issued on the same New Year’s Eve in 2024 reached opposite conclusions on essentially the same legal question.
Serta Simmons
The Fifth Circuit reversed the bankruptcy court and held that Serta Simmons’s 2020 uptier transaction violated the credit agreement’s pro rata sharing provisions. The agreement allowed the borrower to repurchase loans on a non-pro-rata basis through Dutch auctions open to all lenders or through open market purchases. The Fifth Circuit read “open market” to mean the established secondary market for syndicated loans, where various buyers and sellers can participate. Because Serta had privately approached a select group of lenders outside that market, it could not claim the open market exception. The court also found that the borrower’s reading would render the Dutch auction exception meaningless, since any private deal could then qualify as an open market purchase.9Fifth Circuit Court of Appeals. In re Serta Simmons Bedding, LLC
Mitel Networks
The same day, a New York appellate court reached the opposite result in Mitel Networks. The Mitel credit agreement authorized the borrower to “purchase by way of assignment and become an Assignee with respect to Term Loans at any time.” The court found that a refinancing or exchange could constitute a purchase and that nothing in the agreement required cash payment or prohibited non-pro-rata treatment. On sacred rights, the court held that subordination only “indirectly” affected the excluded lenders and therefore did not trigger the provision requiring consent from each “directly adversely affected” lender. Together, Serta and Mitel show that the outcome of LME litigation depends heavily on the precise wording of the credit agreement.
Claims Excluded Lenders Bring
Breach of contract is the most straightforward theory: the transaction violated pro rata sharing, sacred rights, or other protective provisions. Lenders also allege breach of the implied covenant of good faith and fair dealing, arguing that even where the borrower stayed within the letter of the agreement, the deal destroyed the benefit of their bargain. Other claims include fraudulent transfer, equitable subordination, and tortious interference with contract against participating lenders who facilitated the deal.
How Lenders Push Back
The wave of litigation has changed how credit agreements are drafted. Lenders who watched J.Crew and Serta unfold have pushed for stronger contractual protections, and borrowers seeking favorable terms now negotiate over these provisions.
J.Crew Blockers
Named after the transaction that exposed the vulnerability, a J.Crew blocker prevents the borrower from transferring material intellectual property or other high-value assets to unrestricted subsidiaries. A well-drafted blocker also bars the borrower from redesignating any subsidiary that already holds material intellectual property as unrestricted. Without it, the borrower can drain the collateral pool by moving its most valuable assets beyond the lenders’ reach.
Anti-Uptier Provisions
Lenders have responded to uptier transactions by expanding the list of sacred rights to include lien subordination. Explicit anti-subordination language means no amendment permitting new super-priority debt can take effect without the consent of every affected lender, not just a majority. Some agreements go further and require that any debt repurchases or exchanges be offered pro rata to all lenders, eliminating the selective dealing that makes uptiers possible. These provisions are increasingly common in new deals but are not universal in the existing stock of leveraged loans.
Cooperation Agreements
When lenders suspect an LME is coming, they can band together through a cooperation agreement. Each participating lender commits not to enter into any deal with the borrower without offering the same terms to the rest of the group. The agreement typically becomes effective once the cooperating lenders hold a majority of the outstanding debt, giving them enough voting power to block unfavorable amendments. Cooperation agreements have become a powerful defensive tool because they prevent the borrower from picking off individual lenders one by one to build a consenting majority.
The practical effect is a drafting arms race. Each new LME technique exposes a contractual gap, lenders respond with tighter language, and borrower-side counsel begins looking for the next overlooked exception. Whether a given credit agreement is vulnerable often comes down to when it was drafted and how aggressively the lenders negotiated at the time.