Global A&T Electronics Ltd. (GATE) is currently embroiled in an intercreditor battle that is shaping competing restructuring proposals from two separate ad hoc committees of noteholders. With the company in an interest payment grace period and—barring a forbearance—a 1 September Chapter 11 filing looming, the Debtwire legal analyst team follows its previous report on the GATE restructuring to shine a spotlight on the intercreditor disagreements that the parties are attempting to settle right this very moment, as reported by Debtwire.
From “add-ons” to “pile-ons”
GATE, an outsourced semiconductor assembly and test services company, was acquired in a 2007 LBO by sponsors TPG Capital and Affinity Equity Partners. The current noteholder dispute stems from a controversial September 2013 debt exchange in which GATE swapped USD 543m of existing second lien term loans into an approximately USD 502m add-on offering to the Company’s USD 625m of 10% first lien notes, which were only just issued a mere seven and a half months earlier in February 2013. The exchange surprised the initial noteholders because they did not believe that the second lien debt could be refinanced with pari debt in compliance with their indenture and intercreditor agreement and because, if effective, the exchange would significantly dilute their collateral to a much greater degree than expected (along with diluting their voting rights and destroying their credit cushion), due to a subtle drafting loophole in a Permitted Lien carveout.
Unsurprisingly, announcement of the exchange drove down the trading price of the initial notes ~20 points, from 89% to 69.5%. Notably, Costa Esmeralda Investments Limited, an affiliate of sponsor Affinity, owned ~35% of the second lien terms loans that were exchanged into add-on notes, and the add-on notes were exchanged at 92.5% of the principal amount of existing second lien term loans, plus, interestingly, an issuance fee of 3.25% of the principal amount of add-on notes, plus a consent fee of 2.0% of the exchanged amount of term loans—both paid to exchanging term loan lenders for an aggregate consideration of ~97.5%.
Opportunities in drafting exploitations
Two agreements are at the center of the dispute: the company’s February 2013 indenture under which the initial notes were issued and the February 2013 intercreditor agreement, which governs the lien priorities between GATE’s first and second lien obligations.  Copies of the indenture and intercreditor agreement are available here:
Between these agreements, the company attempted to justify the September 2013 exchange by exploiting the interplay of three separate drafting concepts: (1) a unique intercreditor problem we label the “simultaneity problem;” (2) the unilateral amendments GATE executed to effectuate the debt exchange; and (3) a Permitted Lien loophole that purported to make securing the add-on notes possible.
The Simultaneity Problem: Under the initial intercreditor, the initial notes constitute first lien obligations and the initial indenture constitutes a first lien agreement, including amendments thereto, and the (refinanced) second lien term loans constitute second lien obligations under second lien agreements. While these mechanics are typical, they present an unusual and problematic issue in the context of the September 2013 exchange, as the add-on notes could simultaneously constitute both a first and a second lien obligation.
Specifically, the intercreditor’s lien subordination provisions, per the definition for second lien agreement (the “Second Priority Agreement” definition), require any agreement governing debt that refinances the second lien term loans (e.g., the add-on notes) to likewise constitute a second lien agreement and be subordinated to the liens of any first lien agreement. But, as noted above, the initial indenture, including amendments thereto (e.g., a supplemental indenture issuing additional notes), constitutes a first lien agreement. Thus, confusingly, under the intercreditor, the add-on notes—which refinanced a second lien obligation—can simultaneously constitute both a first and a second lien obligation because they were (1) issued under an amendment to the first lien indenture and (2) are a refinancing of second lien debt.
So, in order to accomplish the exchange, the company needed to ensure that the Add-On Notes would be entirely first lien debt. To do so, it amended the intercreditor agreement’s definition of the second lien agreement to exclude the add-on notes. Such an amendment, if effective, would resolve the simultaneity problem in favor of the company, but at the expense of the initial noteholders.
The Amendments: In connection with the September 2013 exchange and without consent from the initial noteholders, GATE unilaterally amended: (1) the intercreditor’s definition of second lien agreement to exclude any agreement that expressly states that it is not and is not intended to be a second lien agreement; (2) the initial indenture to expressly state that the add-on notes would not constitute second lien obligations; and (3) the initial intercreditor to designate the indenture and any notes issued under it to be a first lien agreement/obligation, including any add-on notes.
In the add-on notes’ offering memorandum, the Company characterized these unilateral changes as “clarifying” amendments, and, for obvious reasons, the amendments did not sit well with the initial noteholders. Such amendments, if effective, would gut the protections provided to the initial noteholders by the initial intercreditor’s subordination provisions, as the initial noteholders could be diluted by an unlimited amount of add-on notes up to a 2.0x fixed charge coverage ratio, due to a subtle drafting loophole in a Permitted Lien carveout, which we tackle next.
The Deficient Permitted Lien Carveout: Permitted Lien carveout (17) of the indenture permits “Liens securing the Notes and the Note Guarantees,” with “Notes” atypically defined to include not only the initial notes but also “any additional Notes that may be issued under a supplemental indenture.” Therefore, from an indenture perspective, GATE can incur an unlimited amount of add-on notes up to the limits set forth by the Debt covenant, which includes a Ratio Debt basket subject to a 2.0x fixed charge coverage ratio.
Notably, this same Permitted Lien loophole existed in GATE’s November 2012 preliminary offering memorandum that marketed the Company’s first lien notes due 2018; that deal was pulled and relaunched as the initial notes. In the offering memorandum for the initial notes, the deficiency was less than clear, as it lacked any risk disclosures directly on point and confusingly included multiple definitions of “Notes.”
In an unsecured offering these mechanics wouldn’t matter, but in a secured offering they create an unbounded Permitted Lien permission. And, if combined with a permission to amend an intercreditor agreement to allow exchanges of second lien debt into first lien debt, the perfect storm is created for diluting first lien debtholders.
A survey by our friends at Xtract Research of the ~90 high yield issues it reviewed in 2Q13 found that the Permitted Lien loophole existed in only one other deal that came to market during that period. More typically, if the carveout permits liens securing add-on notes, it will contain an additional restriction such as a fixed dollar or secured leverage limitation.
Initial noteholders run to court
Following the September 2013 exchange, the initial noteholders formed an ad hoc committee and in November 2013 delivered a notice of default supported by the requisite percentage of holders, and in early 2014 the initial noteholders sued the company in New York state court, characterizing the initial notes as a USD 625m “bait and switch,” alleging multiple covenant breaches, and seeking to unwind the exchange or, alternatively, subordinate the liens of the add-on notes to the liens of the initial notes. GATE moved to dismiss the case on the grounds that the claims lacked legal merit, and the trial court, siding with the company, dismissed the case in July of 2015.
Of particular note, the court analyzed the unilateral amendment provisions of the intercreditor, which permit the company to, without noteholder consent, amend the intercreditor to permit additional first lien obligations if incurred in compliance with the indenture and permitted by the indenture to be subject to the intercreditor.  Therefore, the court turned to Section 4.16 of the indenture, titled “Additional Intercreditor Agreements or Amendments to Intercreditor Agreements,” which sets forth the circumstances in which GATE can amend the intercreditor either unilaterally or with majority consent of the notes’ balance. As would be expected, the general rule is that majority consent is required. The provisions allowing for unilateral amendments exist to fix unobjectionable items such as scrivener’s errors and other situations not adverse to the rights of noteholders. For example, the unilateral amendment provisions of Section 4.16 permit amendments to:
(1) cure an ambiguity, defect, or inconsistency in the intercreditor;
(2) increase the amount of secured debt or types of secured debt covered by the intercreditor that GATE may incur in compliance with the indenture and subject to the intercreditor;
(3) “make provision for the security securing additional Notes to rank pari passu with the security securing the Notes on the Collateral;” or
(4) “make any other such change to [the intercreditor] that does not adversely affect the rights of the [Noteholders] in any material respect.”
The trial court held that the amendment to the intercreditor was proper under any of the first three provisions above, emphasizing how the amendment removed the inconsistency presented by the simultaneity problem.
On appeal, the Appellate Division unsurprisingly reversed the trial court and, in an opinion that was sparse on analysis, reinstated the initial noteholders’ breach of contract claims for further proceedings. The court made three important points:
First, the appellate court held that the initial noteholders stated a claim for a breach of Section 4.16 of the indenture, the provisions specifying the circumstances in which the company could amend the intercreditor without noteholder consent. Of note, the court stated that “GATE lacked the authority” to execute the amended intercreditor because the amendment was subject to the provisions of the initial intercreditor and did not conform with but rather sought to circumvent the agreement’s priority scheme. The court rejected any notion that the amendments could be effectuated under the unilateral amendment provisions, thereby requiring consent of the initial noteholders.
Second, the appellate court also held that the initial noteholders stated a claim for breach of the indenture’s Lien covenant, because, in the court’s view, the lien securing the add-on notes could not have been incurred under the deficient Permitted Lien carveout as “any new liens are subject to the priority scheme set forth in the [initial intercreditor].” 
Third, the court held that the initial noteholders stated a claim for breach of the indenture’s Affiliate Transactions covenant, which, as is typical, requires that transactions with affiliates in excess of a de minimis amount be approved by a majority of disinterested directors and on terms no less favorable than can be obtained in an arm’s-length transaction. Affiliate transactions in excess of USD 25m also require a fairness opinion.
Though not mentioned by the court, but presumably on its mind, exchanging term loan lenders were paid an aggregate consideration of ~97.5%, accounting for the fees referenced above. The court did, however, in rejecting an economic interest defense to the initial noteholders claim for tortious interference with contract, state that “in bringing about the debt exchange, [the sponsors] were not acting to protect their legal or financial stake in GATE” but rather “were acting to protect the interests of defendant Costa,” the affiliate which owned ~35% of the second lien terms loans.
Following the ruling, the Appellate Division denied the Company leave for an interlocutory appeal.
Shaping the Chapter 11 waterfall
Having moved past the motion to dismiss phase, the initial noteholders now have a motion for summary judgment pending before the trial court, with a status conference scheduled for 29 August and a decision expected by the end of September. The company, the initial noteholders, and the add-on noteholders all have proposed restructuring plans, as detailed in our 18 August report, with the initial noteholders asking for a 96% recovery. Considering the strength with which the Appellate Division reversed the trial court and invalidated the amendments, it’s no wonder why the 28 June 2017 restructuring proposal of the initial noteholders contains such a high ask. In comparison, the company proposed that the initial noteholders receive new notes representing an ~72% recovery, plus a 6.4% stake in the restructured organization. The sponsors would retain a 90% equity stake under that plan.
In any event, the company missed a USD 56m interest payment due on the notes on 1 August 2017 and is currently in a 30-day grace period. As reported by Debtwire on Friday, the company had called a last-minute negotiation with both creditor factions in order to avoid a free fall Chapter 11. If no one budges and the noteholders don’t, at the very least, agree to forbear an event of default in order to continue those talks, expect an early battle in the bankruptcy over whether to permit the court overseeing the intercreditor dispute to continue with the pending litigation. Due to the automatic stay, a party would have to ask for the bankruptcy court’s permission to permit the pending intercreditor battle to proceed any further. Alternatively, this prepetition fight could find new life as an adversary proceeding brought in the bankruptcy court, and the choice between the two courts could be an early Chapter 11 dispute. Regardless, if noteholder consensus remains elusive, this fight will be fought—in one court or another.
 See Intercreditor Agreement § 2.1 Subordination of Liens, subsection (a) (“Any and all Liens now existing or hereafter created or arising in favor of any Second Priority Secured Party securing the Second Priority Obligations, regardless of how acquired, whether by grant, statute, operation of law, subrogation or otherwise are expressly junior in priority, operation and effect to any and all Liens now existing or hereafter created or arising in favor of the First Priority Secured Parties securing the First Priority Obligations”); see also § 3.2 Standstill and Waivers (“The Second Priority Representative, on behalf of itself and the other Second Priority Secured Parties, agrees that, until the First Priority Obligations Payment Date has occurred, subject to the proviso set forth in Section 5.1: (a) they will not take or cause to be taken any action, the purpose or effect of which is to make any Lien in respect of any Second Priority Obligation pari passu with or senior to, or to give any Second Priority Secured Party any preference or priority relative to, the Liens with respect to the First Priority Obligations or the First Priority Secured Parties with respect to any of the Common Collateral;”).
 See Intercreditor Agreement § 9.3 Amendments; Waivers, subsection (b) (“It is understood that the First Priority Representative and the Second Priority Representative, without the consent of any other First Priority Secured Party or Second Priority Secured Party, may in their discretion determine that a supplemental agreement (which may take the form of an amendment and restatement of this Agreement) is necessary or appropriate to facilitate having additional indebtedness or other obligations (“Additional Debt”) of any of the Loan Parties become First Priority Obligations or Second Priority Obligations, as the case may be, under this Agreement, which supplemental agreement shall specify whether such Additional Debt constitutes First Priority Obligations or Second Priority Obligations, provided, that such Additional Debt is permitted to be incurred under the First Priority Agreement and any Second Priority Agreement then extant, and is permitted by said Agreements to be subject to the provisions of this Agreement as First Priority Obligations or Second Priority Obligations, as applicable.”).
 See Intercreditor Agreement § 9.1 Conflicts (“In the event of any conflict between the provisions of this Agreement and the provisions of any First Priority Document or any Second Priority Document, the provisions of this Agreement shall govern.”).
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