Market Intelligence Briefing
February 12, 2026
Context: 2026 TMA Distressed Investing Conference & SFNet Asset-Based Capital Conference — Encore at Wynn, Las Vegas, NV
Subject: The Mechanics, Evolution, and Current Legal Status of “Creditor-on-Creditor Violence”
1. Executive Summary
The fundamental assumption of distressed debt investing — that pari passu lenders will be treated equally in a restructuring — is dead.
Over the last decade, the leveraged finance market has been fundamentally reshaped. What was once a bilateral negotiation between Borrower and Lender has become a multilateral conflict of Lender vs. Lender. This phenomenon — known in the trade as “Creditor-on-Creditor Violence” and formally classified as a Liability Management Exercise (LME) — is driven by private equity sponsors exploiting contract arbitrage to pit lender groups against one another.
Through loose covenants in Credit Agreements, sponsors can strip assets, subordinate existing liens, and dilute voting power, all without the consent of minority lenders.
State of Play: February 2026
The legal landscape is split. The Fifth Circuit (Texas) struck down the “Open Market” loophole on December 31, 2024, effectively reversing Serta. Meanwhile, the New York Appellate Division, First Department, upheld a structurally similar priming exchange in Mitel on the same day — reaching the opposite conclusion based on more permissive contract language (a broad “purchase by assignment… at any time” right, without an “open market” qualifier). And in December 2025, the District Court for the Southern District of Texas reversed the Bankruptcy Court in Incora/Wesco, holding that the vote-manufacturing transaction was “proper, appropriate, lawful, and consistent” with the indentures.
This divergence has created a venue-shopping dynamic where the jurisdiction of a potential filing is now as critical as the credit documents themselves.
This briefing details the three generations of LME structures, the specific covenant loopholes that enable them, and the litigation risks investors face today.
2. Evolution of Violence (2016–2026)
The tactics used to expropriate value from lenders have evolved in three distinct “generations,” each more aggressive than the last. For practitioners who have spent careers negotiating indentures and credit agreements, the progression is both familiar and alarming: each generation of exploit arises precisely because the prior generation’s loophole was partially closed, forcing sponsors and their counsel to find the next contractual gap.
Generation 1: Asset Stripping — The “Drop-Down” and the “Designation”
Generation 1, defined by J. Crew (2016) and Neiman Marcus (2018), focused on moving collateral out of lenders’ reach.
The Borrower moves valuable assets — typically intellectual property — out of the “Restricted Group” (where lenders hold a lien) and into an “Unrestricted Subsidiary” (where they do not). Once unshackled, the Unrestricted Subsidiary borrows new debt secured by those assets. The original lenders lose their collateral coverage; the new lenders acquire a contractually senior claim on the transferred IP.
J. Crew executed this through the now-infamous “Trap Door” investment mechanism — a two-step transfer routing IP through a Cayman Restricted Subsidiary to circumvent the direct Investment basket cap. But Envision introduced a more dangerous variant. Rather than transferring assets, the Borrower used Available Amount (Builder Basket) capacity to redesignate a Restricted Subsidiary as “Unrestricted.” The assets never moved; the subsidiary’s status changed. This sidesteps both the “Asset Sale” covenant and the “Investments in Non-Loan Parties” basket entirely. The Available Amount basket is the nuclear provision: if it is not tightly capped and subject to conditions, it enables massive value leakage through designation rather than transfer.
PetSmart/Chewy (2018) was technically different from both, and the distinction matters. PetSmart used restricted payment and investment basket capacity to distribute 20% of Chewy’s equity to the sponsor consortium and transfer 16.5% to a newly formed Unrestricted Subsidiary. Once Chewy ceased to be “Wholly Owned,” its guarantee of PetSmart’s secured term loan fell away automatically under the loan documents’ release provisions. This was not a classic “drop-down” of IP. It was a guarantee release mechanic exploiting the “Automatic Release” clause. The economic result (stripping a $14 billion subsidiary out of the lender collateral package) was identical in spirit but operationally distinct in execution.
The permissiveness of the Restricted Payments, Investments, and Available Amount baskets — and the interaction between designation rights and automatic guarantee release provisions — is precisely what made all three variants possible.
Generation 2: Priority Stripping — The Priming Exchange
Generation 2 emerged in 2020 with Serta Simmons Bedding, Boardriders, and TriMark (the last of which was settled and partially unwound in January 2022 — the rare lender victory).
A majority group of lenders (typically >50.1%) agrees to amend the Credit Agreement to allow the Borrower to issue a new tranche of “Super-Priority” debt. The majority lenders exchange their old debt for the new priming tranche. The minority lenders — excluded from the deal — are pushed down the waterfall, effectively watching their First Lien claims transform into Third Lien paper without their consent.
This generation exploits the amendment provisions themselves — the very sections lawyers on both sides fight hardest over. When the amendment threshold is a simple majority, the sponsor only needs to recruit 50.1% of the lender group, creating an incentive that fractures lender solidarity by design.
TriMark deserves special mention. It is the one major uptier case where the minority lenders sued successfully, securing a January 2022 settlement that resulted in a dollar-for-dollar exchange of all outstanding first lien term debt into Tranche B Loans under the Super Senior Credit Agreement. The participating lenders’ Tranche A Loans retained their senior position, so the “unwind” was partial — but it was a real cost imposed on the transaction. The New York State court’s refusal to dismiss the breach of contract claims (on sacred rights grounds) left precedent on the books that has influenced every subsequent negotiation.
Generation 3: Dilution & Vote Manufacturing — The “Double Dip” and the “Vote Rig”
Generation 3, exemplified by Incora/Wesco (2022), Sabre (2023), and At Home (2023), abandoned any pretense of bilateral negotiation.
Instead of merely stripping assets or priority, the Borrower manufactures artificial voting majorities or creates “phantom” claims to dilute the recovery of existing lenders.
Double Dip (also “Pari Plus”): A new lender receives two claims for every dollar lent — one against the parent, one against a subsidiary via an intercompany loan receivable. The desk shorthand is “Pari Plus”: pari on the guarantee, senior on the intercompany loan. In a liquidation, recovery on both claims dilutes existing lenders by 50% or more.
Vote Manufacturing: Issuing new notes to the majority group — notes with voting rights but limited or no independent economic substance at inception — purely to accrete the majority’s holdings past a supermajority consent threshold (e.g., two-thirds). Once the threshold is breached, the enlarged majority strips liens or releases collateral. The economic substance of the new issuance is secondary; the consequence for minority holders is brutal.
3. Mechanics & Covenant Architecture
Understanding how these transactions are executed requires understanding the specific vulnerabilities embedded in standard credit documentation. These are not drafting errors. They are the product of years of negotiation where issuers fought for flexibility and lenders, in liquid cov-lite markets, conceded more than they should have. (Section numbers below reference typical LSTA-form Credit Agreement provisions; specific agreements may vary.)
A. The “J. Crew” Mechanics: Two-Step Asset Transfer
The primary governor here is Section 9.04 (Investments), which typically caps investments in Unrestricted Subsidiaries. But a separate basket for “Investments in Non-Loan Parties” (e.g., Restricted Foreign Subsidiaries) is often substantially larger, sized for global operations, not domestic asset parking. And the “Permitted Investments” definition frequently allows Non-Loan Parties to make unlimited investments in other subsidiaries.
The Two-Step: Parent transfers IP to a Cayman Restricted Subsidiary (a Non-Loan Party). The Cayman Sub then transfers the IP to the Unrestricted Subsidiary. The strict cap on the Parent is bypassed because the transfer technically originated from the Cayman Sub.
The Designation Variant (Envision): Rather than a physical asset transfer, the Borrower redesignates a Restricted Subsidiary as Unrestricted using Available Amount capacity. The assets remain in place; the lien evaporates. No “Asset Sale” covenant is triggered, and the specific “Investments in Non-Loan Parties” basket is bypassed entirely — the only capacity consumed is the general Available Amount, reducing covenant friction significantly depending on the drafting.
B. The “Serta” Open Market Loophole
Section 2.18 (Pro Rata Treatment) requires that any payment or purchase of debt be shared equally among all lenders. But the true structural protection lives in Section 9.02 (Amendments), which designates Pro Rata Treatment as a protected provision — an all-affected-lender consent trigger. The violence happens when sponsors argue that Section 9.02(b) does not apply to Open Market Purchases, severing the link between the pro rata right and its protective amendment threshold.
The agreement contains an exception for “Open Market Purchases,” a term typically left undefined. The Borrower and Majority Lenders argue that their private, cashless debt exchange qualifies under this exception.
This leaves the Majority’s old debt retired and replaced with new Super-Priority paper — without extending the same offer to the Minority. Whether a negotiated, private exchange constitutes an “open market” transaction is now the central legal battleground.
C. The “Pari Plus” Structure (Double Dip)
The goal is straightforward: create a bankruptcy claim with priority superior to existing pari passu debt.
The New Lender extends funds to a “Bankruptcy Remote” Financing Subsidiary, not the operating Borrower. The Financing Sub on-lends those funds to the Borrower via a Secured Intercompany Loan.
This leaves the New Lender with two distinct claims: a Guarantee from the Borrower (pari passu with existing lenders) and a Lien on the Intercompany Loan Receivable (structurally senior). Pari on the guarantee, senior on the intercompany loan — hence “Pari Plus.” In a liquidation, they recover on both, diluting existing lenders’ recovery by structurally subordinating their deficiency claims.
4. Current Legal Landscape
Litigation outcomes have diverged sharply by jurisdiction, creating significant venue risk that must be underwritten alongside traditional credit risk.
Serta Simmons Bedding — The “Uptier” Reversal
5th Circuit Court of Appeals (Texas) | December 31, 2024 (as revised Feb. 14, 2025) | Reversed & Remanded
The Fifth Circuit, in a unanimous three-judge panel, held that the 2020 uptier did not qualify as an “open market purchase” under the 2016 Credit Agreement. The Court defined “open market” as a term of art, referring to the specific secondary market for syndicated loans: a designated market that is “generally open to participation by various buyers and sellers.” A private, negotiated, cashless exchange between a borrower and a select group does not meet this standard.
The Court also reasoned that “open market purchase” and “Dutch Auction” must be mutually exclusive constructs to avoid surplusage under New York contract interpretation. If any private competitive exchange qualified as “open market,” the Dutch Auction exception would do no work.
The Fifth Circuit went further: it excised the participating lenders’ indemnification provision from Serta’s confirmed Chapter 11 plan, calling it “an impermissible end-run around” the Bankruptcy Code’s disallowance of contingent reimbursement claims. That excision leaves participating lenders exposed to direct liability claims with no company-funded backstop. The Court also rejected equitable mootness arguments, noting that the doctrine “cannot be a shield for sharp or unauthorized practices.”
Implication: The “Classic Uptier” relying on an undefined “open market purchase” exception faces serious challenge for companies filing in Texas, with breach claims remanded and trial looming in early 2026. The Fifth Circuit cautioned that, while “every contract should be taken on its own,” open market purchase exceptions “will often not justify an uptier.”
It is worth noting that Texas is not the only jurisdiction where uptiers face resistance. In New York, Boardriders (NY State Supreme Court, Justice Masley) and TriMark both survived motions to dismiss on breach of contract and good faith grounds — suggesting that even where the contract language is broader, New York courts may scrutinize the circumstances of the exchange where bad faith is alleged. The Fifth Circuit’s textualism and New York’s occasional willingness to look behind the text create overlapping but distinct risks for sponsors.
Incora / Wesco — Vote Manufacturing Survives
S.D. Texas (District Court, Judge Crane) | December 8, 2025 | Reversed Bankruptcy Court, Upheld Transaction
This one surprised the market. Judge Isgur at the Bankruptcy Court had invalidated the 2022 priming exchange in a January 2025 opinion, adopting a “falling dominos” framework — viewing the sequenced amendments as a single integrated transaction that violated the unanimous consent protections. Judge Crane reversed.
The District Court held that each individual amendment complied with the express terms of the applicable indentures at the time it was executed. The Third Supplemental Indenture’s immediate legal effect was to authorize additional pari passu notes — subject to only majority consent. Once the majority group accumulated two-thirds of outstanding notes (including the newly issued paper), they had the contractual right to release liens. The Court refused to find “implied sacred rights” and pointed out that the minority noteholders were sophisticated parties who could have bargained for all-holder consent thresholds on the issuance of additional notes — and chose not to.
Implication: While Serta constrains the “open market purchase” path, Incora confirms that vote manufacturing — accreting a supermajority through new issuance to strip liens — remains viable where the indenture does not expressly protect against dilution of consent thresholds. The analysis turns on whether the immediate legal effect of each amendment triggers the higher consent requirement, not the aggregate effect of the sequenced transaction.
Mitel Networks — The New York View
NY Appellate Division, First Department | December 31, 2024 | Dismissed Claims Against Participating Lenders
Decided the same day as Serta, with the opposite result. The First Department upheld Mitel’s 2022 priming exchange because the credit agreement expressly allowed the borrower to “purchase by way of assignment” loans “at any time” — no “open market” qualifier. The Court found that “purchase” is not mutually exclusive with a “refinancing” or “exchange,” and that the effect on non-participating lenders was “indirect” and therefore did not trigger the all-affected-lender consent provisions.
Mitel subsequently filed a pre-packaged Chapter 11 in March 2025 in the Southern District of Texas, and its largely consensual plan was confirmed in April 2025. The parties had reached a settlement before filing, mooting the remaining litigation risk.
Implication: New York courts remain reluctant to read implied protections into sophisticated commercial contracts. Where the document language is permissive (plain “purchase” rather than “open market purchase”), the First Department has signaled that textual strictness will prevail.
The bottom line on venue: for any credit position in a potentially distressed issuer, investors must now assess not only the covenant package but the likely filing jurisdiction. Texas and New York can produce diametrically opposite outcomes on the same transaction structure. The specific contract language — particularly around buyback provisions, protected consent thresholds, and incremental issuance capacity — is now the dominant variable.
Texas itself is no longer a monolith. The Fifth Circuit has killed the classic open-market uptier, but the District Court has preserved vote manufacturing in Incora. Venue selection now demands scrutinizing specific Blocker language against these two opposing precedents — Texas filings carry asymmetric risks depending on the LME flavor.
5. Protective Covenants: The “Blocker” Toolkit
Sophisticated investors are now demanding specific “Blocker” language in new issuances to close these loopholes. The presence or absence of these provisions should be part of any credit underwriting.
Worth emphasizing: the “Chewy Blocker” addresses a particularly elegant exploit. PetSmart released Chewy’s guarantee by diluting ownership — distributing equity to make Chewy no longer “Wholly Owned,” which triggered an Automatic Release clause in the loan documents. The mechanic is guarantee release through ownership dilution, not asset stripping. That distinction matters in litigation and in drafting.
J. Crew Blocker — Prevents transfer of material IP to Unrestricted Subsidiaries. Look for: “No Intellectual Property material to the business may be transferred to, or owned by, an Unrestricted Subsidiary.”
Serta Blocker — Prevents non-pro rata priming exchanges. Look for: “Any subordination of the Liens... requires the written consent of each Lender directly and adversely affected thereby.”
Chewy Blocker — Prevents “Automatic Release” of a Guarantor solely due to ceasing to be Wholly Owned. Look for: “No Guarantor shall be released from its Guarantee... unless such disposition is to a Person that is not an Affiliate.” The critical fix is tying guarantee release to exit from the Restricted Group entirely, not merely to cessation of wholly-owned status.
Open Market Definition — Prevents private exchanges disguised as market transactions. Look for: “Open Market Purchases shall mean purchases for cash consideration... at a price determined by a market clearing process.” Post-Serta, some agreements are adding explicit definitions that reference the secondary market for syndicated loans.
Anti-Dilution / Incremental Issuance Blocker — Post-Incora, the newest addition to the toolkit. Requires all-holder (or supermajority) consent for the issuance of additional notes that could accrete voting power past a protected consent threshold. Without this, the Incora playbook remains open.
6. Lender Cooperation Strategies: The “Co-Op”
In response to Sponsor aggression, lenders have deployed the Cooperation Agreement — a binding contract among lenders holding a blocking position (typically >50% of outstanding debt), signed before the Borrower approaches them.
How It Works
No lender will negotiate a separate deal with the Borrower. Because the group holds a majority, they can block any amendment the Borrower proposes. The Borrower is forced to negotiate with the entire group, neutralizing “divide and conquer” tactics. In recent years, cooperation agreements have become standard practice among institutional lenders who recognize that their individual leverage evaporates the moment the sponsor picks them off one by one.
The Counter-Attack
The legal risks of cooperating are escalating on two fronts. In Incora, Judge Isgur denied summary judgment on the excluded lenders’ tortious interference claims against Platinum Equity — the furthest such a claim has proceeded against a sponsor. The equity sponsor’s economic interest defense, which had been sufficient for other courts to dismiss at the pleadings stage, did not carry the day at summary judgment.
But the bigger development is the antitrust front. In late 2025, two federal lawsuits attacked cooperation agreements directly under the Sherman Act. In Optimum Communications v. Apollo et al. (S.D.N.Y., November 2025), the borrower itself sued its lender co-op — including Apollo, Ares, BlackRock, GoldenTree, JPM, Loomis, Oaktree, and PGIM — alleging the cooperation agreement constitutes an illegal group boycott and price-fixing conspiracy. Optimum claims the co-op controls 88% of the leveraged finance market and 99% of its outstanding debt, and that the agreement has inflated its borrowing costs by roughly 200 basis points. Separately, in Deltroit v. Selecta Group (S.D.N.Y., October 2025), excluded lenders brought per se restraint-of-trade claims against a majority co-op under both federal and New York antitrust law. Cleary Gottlieb published a defense of cooperation agreements in December 2025, arguing they should survive rule-of-reason analysis — but neither case has been dismissed.
This front — lenders being sued for the act of cooperating, under both tort and antitrust theories — represents perhaps the most striking development in this evolving conflict, and was the hottest topic of discussion at the Encore this week.
7. Key Players & Market Leaders
Legal Counsel (The Architects)
Davis Polk frequently represents the “Ad Hoc Groups” of lenders executing Co-Op strategies and has been at the center of the consent-rights jurisprudence. Gibson Dunn, Latham & Watkins, and Kirkland & Ellis often represent Sponsors or the Borrower, designing the aggressive LME structures. Cleary Gottlieb has produced some of the most granular covenant analysis in the space.
Financial Advisors (The Strategists)
PJT Partners, Houlihan Lokey, and Evercore structure the economic terms of the debt exchanges and advise on restructuring alternatives. These firms are increasingly involved earlier in the process, helping lender groups model recovery scenarios before deciding whether to cooperate or participate.
8. The Co-Op Imperative
For sophisticated investors, the credit market in 2026 has moved beyond a Prisoner’s Dilemma. It is now “Co-Op or Die.”
If you participate in the LME, you protect your own recovery — at the expense of the minority. If you refuse to participate on moral, legal, or fiduciary grounds, you risk being primed and watching your recovery approach zero. But if you organize early enough and hold the blocking position, you can force the Borrower to the table on your terms.
The overarching theme from the Encore this week is that contract arbitrage is not a bug — it is a feature of the current documentation regime. Until a uniform ruling from the Supreme Court or a fundamental shift in standard documentation occurs, Creditor-on-Creditor Violence remains the dominant risk factor in distressed debt.
RECOMMENDATION
Assume every document has a trap door. If a Blocker is not explicitly present, assume the Sponsor can and will move the assets, strip the liens, or manufacture a majority. In 2026, you are not just underwriting the credit risk of the company — you are underwriting the structural risk of the covenant package and the behavioral risk of your fellow lenders. Read the amendment provisions. Count the protected covenants. Check the incremental issuance capacity. And get into the Co-Op before the Borrower calls.
DISCLAIMER
This note is provided for informational and discussion purposes only. It does not constitute legal advice, investment advice, a recommendation, or a solicitation to buy or sell any security or credit instrument. The author and Elm Tree Partners may hold positions in securities or credit instruments mentioned. All data is sourced from publicly available information including court opinions, law firm client alerts, conference proceedings, and industry commentary as of February 12, 2026. Past performance is not indicative of future results. Distressed debt, leveraged credit, and liability management exercises involve substantial risk of loss. © 2026 Elm Tree Partners.