Liability Management Exercises and Creditor-on-Creditor Violence
When a stressed borrower can't pay its debts outright, it often restructures them through negotiated exchanges instead of bankruptcy — and increasingly, it does so by favoring one group of lenders over another using loopholes in the original loan documents.
Prerequisites: Structural Subordination and Guarantees, Maintenance vs Incurrence Covenants
A company doesn't have to file for bankruptcy the moment it can't comfortably pay its debts. Long before that, it can pursue a liability management exercise (LME) — a negotiated transaction that changes the terms, ranking, or ownership of its existing debt without going to court. Classic examples include buying back bonds at a discount, exchanging old debt for new debt with easier terms, or extending maturities. Done cooperatively, these transactions can genuinely help both sides avoid the cost and disruption of formal bankruptcy.
A liability management exercise restructures debt outside of court by negotiating directly with lenders. Increasingly, sponsors use loopholes in loan documents to reward one subset of lenders at the direct expense of another — a tactic creditors have started calling "creditor-on-creditor violence."
How the aggressive version works
Many loan agreements allow a borrower to designate certain subsidiaries as "unrestricted," pulling their assets outside the reach of existing lenders' covenants, or to issue new debt that structurally or contractually jumps ahead of existing lenders in priority. An aggressive LME exploits exactly this: the company moves valuable collateral into an unrestricted subsidiary, then uses that subsidiary to raise new, priming debt from a cooperating subset of its existing lenders — offered better terms in exchange for participating — while the lenders left out are stuck holding claims against a shell that no longer owns the valuable assets.
Worked example
A company with $500 million of loans and $300 million of collateral value proposes a transaction: 70% of lenders, by agreeing to extend $100 million of new priority financing, get moved ahead of the entire existing debt stack and gain access to collateral relocated into a new subsidiary structure. The other 30% of lenders, who don't participate, are left with their original claim — now effectively junior to both the new money and the moved assets. Before the transaction, all lenders shared pro rata in the same $300 million of collateral; afterward, non-participants might realistically expect to recover only a fraction of what they'd have recovered under the original structure, purely because of a maneuver permitted by loose loan document language they didn't anticipate being used this way.
What this means in practice
These transactions have become common enough in leveraged loan and high-yield markets that "documentation quality" — how tightly a loan agreement closes off these loopholes — is now a first-order factor lenders and rating agencies weigh, sometimes as important as the borrower's leverage itself. Lenders who once assumed pro rata treatment among a single credit facility now negotiate explicitly for protections against exactly this kind of asset-stripping and priming.
Two lenders holding what looks like the identical loan, in the identical facility, can end up with very different recoveries if one group agrees to a liability management transaction and the other doesn't. Always check whether a document permits unrestricted-subsidiary designations or uncapped priority debt before assuming pro rata treatment is guaranteed in a distress scenario.
Further reading
- Moody's, 'Liability Management: A Growing Source of Credit Losses'
- Fabozzi, Bond Markets, Analysis, and Strategies (ch. on distressed restructuring)