CALDERWOOD & HARKNESS LLP PRIVILEGED AND CONFIDENTIAL ATTORNEY WORK PRODUCT
MEMORANDUM
CONFIDENTIALITY LEGEND: This memorandum is prepared in connection with the rendering of legal advice to Harrowgate Private Equity Fund IV, L.P. and Veldran Industries Holdings, Inc. and is protected by the attorney-client privilege and/or the work product doctrine. This memorandum reflects preliminary analysis based on information available as of the date hereof and is subject to revision upon receipt of additional diligence materials, including the final executed Indenture and all supplements thereto. Do not distribute without prior approval of Leonard Cross.
I. Executive Summary
The purpose of this memorandum is to analyze the provisions of the indenture (the "Indenture") governing Veldran Industries Holdings, Inc.'s ("Veldran" or the "Company") 6.250% Senior Unsecured Notes due 2027 (the "Notes") that may be implicated by the proposed pro rata distribution by Veldran of 100% of the common stock of Meridian Flow Technologies, Inc. ("Meridian" or "SpinCo") to Veldran's shareholders (the "Distribution"). The Notes have an aggregate principal amount outstanding of $450,000,000 and were issued under an indenture with Colton Trust Company, 10 South LaSalle Street, Chicago, IL 60603, as trustee (the "Trustee").
As set forth in greater detail below, our preliminary analysis indicates that the Indenture does not contain an explicit spin-off blocker provision — that is, no provision expressly prohibits the Company from effecting a spin-off or tax-free distribution of a subsidiary's equity interests. However, the absence of an explicit blocker does not mean that the Distribution may proceed without restriction. To the contrary, the Distribution could trigger the Indenture's asset-sale covenant and potentially the restricted-payment covenant, either of which would impose substantive conditions on the consummation of the transaction. In addition, the successor-company provisions may be relevant to the extent that the internal restructuring steps preceding the Distribution involve a transfer of a material portion of Veldran's consolidated assets.
Given the estimated fair market value of the Meridian stock to be distributed ($1.4 billion to $1.7 billion), it is highly likely that the available basket capacity under either the asset-sale covenant or the restricted-payment covenant would be insufficient to accommodate the Distribution without consent from the requisite noteholders. Accordingly, a consent solicitation from holders of a majority in principal amount of the Notes outstanding, or, in limited circumstances, the Trustee alone, will likely be required to permit the Distribution to proceed.
In connection with any such consent solicitation or waiver process, noteholders or the Trustee may condition their consent on the receipt of a tax opinion confirming that the Distribution qualifies as a tax-free transaction under Sections 355 and 368(a)(1)(D) of the Internal Revenue Code of 1986, as amended (the "Code"). Calderwood & Harkness LLP has been engaged to deliver a "should" level tax opinion in connection with the transaction — that is, an opinion that the Spin-Off "should" qualify under the applicable provisions of the Code. This represents the second-highest level of tax opinion comfort, below a "will" opinion but above a "more likely than not" standard.
Based on the analysis set forth herein, we recommend the following course of action: (i) the spin-off transaction should be structured to minimize Indenture triggers to the extent practicable; (ii) Veldran should prepare for a formal consent solicitation process under the Indenture, to run in parallel with the lender consent negotiations under the First Lien Term Loan B credit agreement; and (iii) coordination with corporate counsel at Whitfield & Gage LLP (counsel to Harrowgate Private Equity Fund IV, L.P.) and Thornapple McCord LLP (counsel to Veldran) is recommended to ensure alignment of the Indenture consent workstream with the broader transaction timeline. This memorandum should be updated and finalized once the executed Indenture and all supplements thereto are confirmed in final form and the outstanding diligence items identified in Section VIII have been resolved.
II. Background
A. The Proposed Transaction
Veldran Industries Holdings, Inc. is a Delaware corporation (EIN 86-1920347) headquartered at 2400 Commerce Park Drive, Suite 500, Charlotte, NC 28217. Veldran operates through two principal business segments: (i) the Engineered Coatings Division, which generated approximately $1.52 billion in revenue and approximately $285 million in EBITDA for fiscal year 2021, and (ii) the Precision Flow Solutions Division, which generated approximately $820 million in revenue and approximately $133 million in EBITDA for fiscal year 2021. On a consolidated basis, Veldran reported aggregate revenue of approximately $2.34 billion and aggregate EBITDA of approximately $418 million for fiscal year 2021.
The proposed transaction contemplates a two-step process designed to separate the Precision Flow Solutions Division from Veldran's remaining operations:
Step 1 — Contribution. Veldran would contribute to Meridian Flow Technologies, Inc. ("Meridian" or "SpinCo"), a newly formed Delaware corporation, all assets and liabilities associated with the Precision Flow Solutions Division, in exchange for 100% of the outstanding common stock of Meridian and Meridian's assumption of certain allocated liabilities (the "Contribution"). Upon completion of the Contribution, Meridian would be a direct, wholly owned subsidiary of Veldran, holding all of the assets and liabilities historically attributable to the Precision Flow Solutions Division.
Step 2 — Distribution. Immediately following the Contribution, Veldran would distribute 100% of the outstanding Meridian common stock pro rata to all holders of Veldran common stock on a 1:1 basis — that is, each holder of Veldran common stock would receive one share of Meridian common stock for each share of Veldran common stock held as of the record date (the "Distribution"). As of the date of this memorandum, there are 74,500,000 shares of Veldran common stock outstanding. Following the Distribution, Meridian would be an independent, publicly traded company, and Veldran would retain the Engineered Coatings Division as its sole operating business.
The Contribution and Distribution together (collectively, the "Spin-Off") are intended to qualify as a tax-free reorganization under Section 368(a)(1)(D) of the Code and a tax-free distribution under Section 355 of the Code. Separate memoranda addressing the business purpose requirement (dated July 18, 2022) and the Section 355(e) plan analysis (dated June 28, 2022) have been prepared in connection with the tax opinion workstream and are incorporated by reference herein to the extent relevant.
The estimated fair market value of Meridian (SpinCo) at the time of the Distribution is in the range of $1.4 billion to $1.7 billion, based on a preliminary valuation analysis prepared by Brackenridge & Co. This preliminary valuation applies an enterprise value-to-EBITDA multiple range of 10.5× to 12.8× to Meridian's fiscal year 2021 EBITDA of approximately $133 million, with adjustments for estimated net debt and working capital at the time of separation. The final valuation will depend on the terms of the separation agreement, including the allocation of debt between Veldran and Meridian, and is expected to be refined as the transaction timeline progresses.
The Spin-Off was originally targeted for completion in Q4 2022, although, as discussed below, the Indenture consent process and related workstreams may affect the timeline. The transaction is being led by Harrowgate Private Equity Fund IV, L.P. ("Harrowgate"), the Company's controlling stockholder, in coordination with Veldran management.
B. Veldran's Capital Structure
Veldran's authorized capital stock consists of 100,000,000 shares of common stock, par value $0.01 per share. As of the date of this memorandum, 74,500,000 shares of common stock are issued and outstanding. There is no preferred stock currently authorized or outstanding.
The ownership of Veldran's outstanding common stock is as follows:
Harrowgate, through its wholly owned subsidiary Harrowgate Veldran Holdings LLC, is the controlling stockholder of Veldran. Prescott Capital Management LP is a significant minority holder that acquired its position through a series of open-market purchases and a negotiated block trade in 2020. The management stockholders include current and former officers and directors of Veldran who hold shares subject to various vesting, lock-up, and transfer restrictions.
In addition to equity, Veldran's capital structure includes the following material debt instruments:
First Lien Term Loan B. Veldran is the borrower under a first lien term loan B facility in an aggregate principal amount of $1.1 billion. The administrative agent for the facility is Ashfield National Bank, N.A. The Term Loan B is secured by substantially all assets of Veldran and its material domestic subsidiaries and is guaranteed by such subsidiaries. The covenant implications of the Spin-Off under the First Lien Term Loan B credit agreement are analyzed separately in a companion memorandum dated August 2, 2022, prepared by Garrett Simmons and reviewed by Leonard Cross, and are summarized in Section VII of this memorandum.
6.250% Senior Unsecured Notes due 2027. The Notes, which are the subject of this memorandum, were issued in an aggregate principal amount of $450,000,000. The Notes are senior unsecured obligations of Veldran, ranking pari passu in right of payment with all other existing and future senior unsecured indebtedness of the Company and senior in right of payment to any future subordinated indebtedness. The Notes are effectively subordinated to all secured indebtedness of Veldran, including the First Lien Term Loan B, to the extent of the value of the collateral securing such indebtedness, and are structurally subordinated to all existing and future indebtedness and other obligations of Veldran's subsidiaries (to the extent such subsidiaries are not guarantors of the Notes).
C. The Notes and the Indenture
The Notes were issued under an indenture dated as of the original issue date (the "Indenture") between Veldran Industries Holdings, Inc., as issuer, and Colton Trust Company, as trustee. The precise date of the Indenture is to be confirmed from the diligence materials; we have requested the final executed copy of the Indenture and all supplements and amendments thereto from Philip Crundell, General Counsel of Veldran, and from Priya Chandrasekar of Whitfield & Gage LLP, as set forth in the Initial Tax Diligence Information Request List dated April 25, 2022. The analysis in this memorandum is based on our review of what we understand to be a substantially final but unexecuted draft of the Indenture; all conclusions are subject to confirmation upon receipt of the executed instrument.
The material terms of the Notes are as follows:
• Aggregate Principal Amount: $450,000,000
• Coupon: 6.250% per annum, payable semi-annually in cash in arrears
• Maturity: 2027
• Ranking: Senior unsecured obligations of the Company
• Trustee: Colton Trust Company, 10 South LaSalle Street, Chicago, IL 60603
The Indenture contains covenants that are customary for high-yield senior unsecured notes issued in the U.S. capital markets. These covenants include, among others:
• A restricted payments covenant (limiting dividends, distributions, stock repurchases, and certain other payments);
• An asset-sale covenant (limiting sales, transfers, and dispositions of assets outside the ordinary course of business);
• A limitation on the incurrence of additional indebtedness;
• A limitation on liens;
• A limitation on transactions with affiliates;
• A successor-company/merger covenant (restricting mergers, consolidations, and transfers of all or substantially all assets); and
• Various reporting and compliance covenants.
This memorandum focuses on the three covenant categories most directly implicated by the proposed Spin-Off: (1) the asset-sale covenant (Section III), (2) the restricted-payment covenant (Section IV), and (3) the successor-company/merger covenant (Section V). Additional covenants, including the limitation on indebtedness and limitation on liens, may also be relevant to the extent that the separation agreement allocates debt or encumbered assets between Veldran and Meridian; however, analysis of those covenants is deferred to a subsequent memorandum or to corporate counsel, as appropriate.
III. Asset-Sale Covenant Analysis
A. Summary of the Asset-Sale Covenant
The Indenture restricts Veldran and its Restricted Subsidiaries from consummating an "Asset Sale" unless certain conditions are satisfied. This covenant is designed to prevent the Company from disposing of material assets without providing adequate protection to the noteholders, either by ensuring that the Company receives fair value for its assets or by channeling disposition proceeds to the benefit of noteholders through a mandatory repurchase offer mechanism.
The term "Asset Sale" is defined broadly in the Indenture to include any sale, lease, transfer, conveyance, or other disposition (including by way of merger, consolidation, or similar transaction) of assets or properties of Veldran or any Restricted Subsidiary, in each case outside the ordinary course of business. Critically, the definition of "Asset Sale" is not limited to transactions involving the receipt of cash consideration; any "disposition" of assets, regardless of the form of consideration received (or even the absence of consideration), may fall within the scope of the definition.
The definition of "Asset Sale" also typically extends to dispositions of equity interests of a Restricted Subsidiary, which is directly relevant to the analysis of the Distribution. In typical high-yield indentures of this type, a transfer or distribution of equity interests of a subsidiary is treated no differently than a transfer of the underlying assets held by that subsidiary — a structural feature that is intended to prevent the Company from circumventing the asset-sale restrictions by packaging assets into a subsidiary entity and then disposing of the subsidiary's equity rather than the assets themselves.
The Indenture provides certain customary carve-outs from the definition of "Asset Sale," which typically include:
(a) dispositions of inventory, equipment, and other assets that are obsolete, damaged, or no longer useful in the ordinary course of business;
(b) dispositions of assets (or series of related dispositions) with a fair market value below a specified de minimis dollar threshold (commonly in the range of $10 million to $25 million);
(c) dispositions of assets between Veldran and any wholly owned Restricted Subsidiary, or between wholly owned Restricted Subsidiaries — the so-called intercompany carve-out;
(d) transactions that constitute "Restricted Payments" permitted under the restricted-payment covenant (discussed further in Section IV.D below, addressing the interplay between the two covenants); and
(e) certain other specific carve-outs that may vary from indenture to indenture, such as dispositions of receivables in connection with factoring arrangements, casualty events, and certain permitted investments.
Where a transaction constitutes an "Asset Sale" and does not fall within any of the available carve-outs, the Indenture generally requires Veldran to satisfy the following conditions:
(i) Veldran must receive consideration for the disposed assets equal to at least the fair market value of such assets (as determined in good faith by the Company's board of directors);
(ii) at least 75% of the consideration received must be in the form of cash or cash equivalents (or certain specified non-cash consideration treated as cash equivalents, such as assumption of liabilities or receivables); and
(iii) the net proceeds of the Asset Sale must be applied within a specified period (typically 365 or 450 days) in accordance with the Indenture's asset-sale proceeds waterfall — generally, first, to repay secured indebtedness (including the First Lien Term Loan B), and then, with respect to any remaining "Excess Proceeds," to make a mandatory offer to repurchase the Notes at a price equal to 100% of the principal amount thereof, plus accrued and unpaid interest, or to reinvest such proceeds in replacement assets used or useful in the Company's business.
B. Application to the Distribution
The application of the asset-sale covenant to the proposed Spin-Off requires separate analysis of the Contribution step and the Distribution step.
The Contribution Step. The Contribution involves the transfer by Veldran of all assets and liabilities of the Precision Flow Solutions Division to Meridian, a newly formed, wholly owned subsidiary of Veldran. Following the Contribution, but prior to the Distribution, Meridian would be a wholly owned Restricted Subsidiary of Veldran. The Contribution step, standing alone, would likely fall within the intercompany carve-out described above — namely, the carve-out for dispositions of assets between Veldran and a wholly owned Restricted Subsidiary. This carve-out is specifically designed to permit internal restructuring transactions, and the Contribution is a classic example of such a transaction. Accordingly, the Contribution step, in isolation, would not be expected to trigger the asset-sale covenant.
However, it is important to note that this analysis depends on the characterization of Meridian as a "Restricted Subsidiary" at the time of the Contribution. If, for any reason, Meridian were designated as an "Unrestricted Subsidiary" prior to or concurrently with the Contribution, the intercompany carve-out would not be available, and the Contribution itself could constitute an Asset Sale. We do not expect Meridian to be designated as an Unrestricted Subsidiary prior to the Distribution, but this point should be confirmed with corporate counsel.
The Distribution Step. The Distribution involves the pro rata distribution of 100% of the outstanding Meridian common stock to all holders of Veldran common stock. This step constitutes a disposition by Veldran of 100% of the equity interests of a subsidiary — Meridian — that holds a material portion of Veldran's consolidated assets. Specifically, the Precision Flow Solutions Division, which would be held by Meridian at the time of the Distribution, represents approximately $820 million of Veldran's consolidated fiscal year 2021 revenue (or approximately 35% of the total) and approximately $133 million of Veldran's consolidated fiscal year 2021 EBITDA (or approximately 32% of the total). By any measure, this is not a de minimis disposition.
The Distribution is not a sale for cash consideration; it is a pro rata distribution to shareholders for no purchase price. Veldran would receive nothing in exchange for the Meridian stock distributed to its shareholders. Nonetheless, the definition of "Asset Sale" in typical high-yield indentures broadly encompasses "dispositions" and is not limited to sales for cash or to any other form of exchange transaction. The term "disposition" is generally understood to include any transfer, conveyance, or distribution of assets or equity interests, regardless of whether consideration is received. This interpretation is consistent with the protective purpose of the asset-sale covenant — noteholders are concerned with the departure of assets from the credit group, irrespective of the form of transaction by which those assets depart.
Conclusion. Based on the foregoing analysis, the Distribution would likely constitute an "Asset Sale" under the Indenture because it involves the disposition of equity interests in a subsidiary (Meridian) to persons other than Veldran or a wholly owned Restricted Subsidiary, and the value of the disposition (estimated at $1.4 billion to $1.7 billion) far exceeds any applicable de minimis threshold. If the Distribution is classified as an Asset Sale, the Indenture would require Veldran to:
(i) receive fair market value consideration for the disposed assets — a requirement that is fundamentally problematic in the context of a pro rata spin-off, where Veldran receives no cash or other consideration from any party;
(ii) apply the net proceeds of the Asset Sale in compliance with the Indenture's asset-sale proceeds waterfall, including making an offer to repurchase the Notes at par — again, problematic where there are no "proceeds" in the traditional sense; and
(iii) satisfy any other conditions specified in the Indenture, including minimum cash/cash-equivalent consideration requirements.
In practical terms, the Distribution cannot comply with the substantive conditions of the asset-sale covenant because the covenant presupposes the receipt of consideration by the Company. A spin-off is structurally incompatible with a covenant framework designed for arm's-length asset sales. This structural mismatch underscores the need for a consent or waiver from the noteholders, or, alternatively, a determination that the Distribution is more properly analyzed under the restricted-payment covenant rather than the asset-sale covenant (discussed in Section IV.D below).
C. Potential Exceptions and Mitigation
We have reviewed the available draft of the Indenture to determine whether any express exception or carve-out would permit the Distribution without triggering the asset-sale covenant. Our preliminary review indicates the following:
No Express Spin-Off Exception. The Indenture does not contain an express exception for "spin-offs," "distributions of equity interests of subsidiaries," "tax-free reorganizations," or any similar category of transactions. While certain more recent high-yield indentures have begun to include explicit spin-off carve-outs (particularly in the leveraged finance context, where sponsor-backed issuers seek maximum flexibility for future restructurings), the Indenture governing the Notes does not appear to include any such provision. In this respect, the Indenture neither explicitly blocks the Spin-Off nor explicitly permits it — a gap that creates ambiguity and, in our view, weighs in favor of seeking consent rather than proceeding unilaterally.
Fair Market Value Argument. One potential argument is that the "fair market value" requirement of the asset-sale covenant can be satisfied by treating the Distribution as a return of capital to shareholders — that is, that the consideration for the disposition of Meridian stock runs to Veldran's equity holders (in the form of Meridian shares received) rather than to Veldran itself. Under this theory, the "fair market value" requirement is met because Veldran's shareholders collectively receive Meridian stock worth $1.4 billion to $1.7 billion in exchange for the equity interests disposed of by Veldran. We believe this argument is likely insufficient. The asset-sale covenant is designed to protect noteholders by ensuring that the Company receives adequate value for assets that leave the credit group. The fact that shareholders (who rank junior to noteholders in a liquidation) receive value does not satisfy the covenant's purpose. Moreover, the covenant typically requires that the Company (not its shareholders) receive fair market value consideration, and a distribution to shareholders is the opposite of a receipt by the Company.
Classification as a Restricted Payment. The most promising alternative theory is that the Distribution should be classified as a "Restricted Payment" rather than an "Asset Sale." Many high-yield indentures, including the Indenture, define "Asset Sale" to exclude transactions that constitute "Restricted Payments" (or vice versa), in order to avoid double-counting and to channel each category of transaction into the appropriate covenant regime. If the Distribution is properly characterized as a "Restricted Payment" — that is, a dividend or distribution on equity interests — then it would fall outside the definition of "Asset Sale" and would instead be analyzed under the restricted-payment covenant. This alternative theory is discussed in detail in Section IV below.
Consent Solicitation. If the Distribution triggers the asset-sale covenant and no exception is available, a consent solicitation to the requisite noteholders will be required. Under the Indenture, the consent threshold for an amendment or waiver of the asset-sale covenant is typically set at holders of a majority in principal amount of the Notes then outstanding (i.e., holders of Notes representing more than $225 million in aggregate principal amount). A consent solicitation would involve the preparation of a consent solicitation statement, the solicitation of consents from registered and beneficial holders, and the payment of a consent fee to consenting holders. The consent solicitation process is governed by the Trust Indenture Act of 1939, as amended, and the terms of the Indenture, and would need to be coordinated with corporate counsel and the Trustee.
Alternatively, the Indenture may permit the Trustee to grant a waiver without a noteholder vote in certain limited circumstances — for example, where the Trustee determines that the transaction does not materially prejudice the interests of the noteholders. However, we expect that the Trustee would be reluctant to exercise such authority unilaterally in connection with a transaction of this magnitude and would instead require noteholder direction. This point will need to be discussed with the Trustee's counsel.
IV. Restricted-Payment Covenant Analysis
A. Summary of the Restricted-Payment Covenant
The Indenture restricts Veldran from making "Restricted Payments," which are broadly defined to include the following categories of transactions:
(a) the declaration or payment of any dividend or distribution on, or in respect of, equity interests of the Company (other than dividends or distributions payable solely in equity interests of the Company or in options, warrants, or rights to purchase equity interests of the Company);
(b) the purchase, redemption, defeasance, or other acquisition or retirement for value of any equity interests of the Company or any direct or indirect parent of the Company;
(c) the making of any principal payment on, or the purchase, redemption, defeasance, or other acquisition or retirement for value of, any indebtedness that is subordinated in right of payment to the Notes, prior to any scheduled principal payment, sinking fund payment, or maturity; and
(d) the making of any "Restricted Investment" (as defined in the Indenture).
The restricted-payment covenant is one of the most important protections available to holders of high-yield unsecured notes. Its purpose is to prevent the issuer from depleting its assets through payments to equity holders or on account of junior obligations, thereby preserving the asset base that supports the noteholders' claims. In the context of a spin-off, the restricted-payment covenant is particularly relevant because the distribution of subsidiary stock to shareholders is economically equivalent to a dividend-in-kind — a transfer of value from the Company's balance sheet to its equity holders.
B. Application to the Distribution
The Distribution of Meridian common stock to all holders of Veldran common stock is, in substance and form, a dividend or distribution on Veldran common stock. Each Veldran shareholder would receive one share of Meridian common stock for each share of Veldran common stock held, pro rata and without consideration. This transaction falls squarely within clause (a) of the definition of "Restricted Payment" — it is a distribution on equity interests of the Company, payable in property (Meridian stock) rather than in cash.
We note that the definition of "Restricted Payment" typically excludes dividends or distributions payable solely in equity interests of the Company itself. This exclusion is designed to permit stock dividends and stock splits, which do not transfer value out of the Company. However, the Distribution of Meridian common stock is not a distribution of equity interests of Veldran — it is a distribution of equity interests of a different company (Meridian). Accordingly, this exclusion does not apply.
The value of the Distribution is material. Based on the preliminary Brackenridge & Co. analysis, the estimated fair market value of the Meridian equity to be distributed is in the range of $1.4 billion to $1.7 billion. For purposes of the restricted-payment covenant, the "amount" of this Restricted Payment would be measured by the fair market value of the property distributed — i.e., the fair market value of the Meridian common stock at the time of the Distribution.
The Indenture typically permits Restricted Payments only if all of the following conditions are satisfied:
(i) no default or event of default under the Indenture exists at the time of, or would result from, the Restricted Payment;
(ii) immediately after giving effect to the Restricted Payment, the Company could incur at least $1.00 of additional indebtedness under the fixed charge coverage ratio test set forth in the Indenture (typically a consolidated coverage ratio of 2.0:1.0 or higher); and
(iii) the aggregate amount of all Restricted Payments made since the issue date of the Notes (including the proposed Restricted Payment) does not exceed the cumulative amount available in the "Restricted Payments basket."
The Restricted Payments basket is typically calculated as a "builder basket" that starts at a specified inception amount and grows over time based on a percentage (usually 50%) of the Company's cumulative consolidated net income since the issue date, plus certain other add-back amounts (such as proceeds of equity issuances, returns on restricted investments, and dividends received from unrestricted subsidiaries). The basket decreases by 100% of cumulative consolidated net losses during periods of negative performance.
Given the estimated $1.4 billion to $1.7 billion value of the Meridian stock distribution, it is highly likely that the Restricted Payments basket, as calculated under the Indenture, would be insufficient to accommodate the Distribution without consent. Even assuming robust consolidated net income performance since the issue date, a builder basket calculated at 50% of cumulative net income would need to reflect cumulative net income of $2.8 billion to $3.4 billion to accommodate the Distribution — a level that is almost certainly beyond Veldran's actual cumulative earnings since issuance, given its historical revenue and EBITDA levels. The precise basket calculation will need to be confirmed upon receipt of the executed Indenture and the Company's historical financial data, but we consider it virtually certain that the basket would be exhausted.
Furthermore, even if the basket were theoretically sufficient, the fixed charge coverage ratio test would need to be satisfied on a pro forma basis after giving effect to the Distribution. The departure of the Precision Flow Solutions Division (and its associated $133 million in annual EBITDA) from Veldran's consolidated results would reduce the Company's coverage ratio, potentially below the minimum threshold required for the incurrence of additional indebtedness. This secondary condition reinforces the conclusion that the Distribution cannot be consummated as a permitted Restricted Payment under the existing basket framework.
C. Potential Exceptions
We have reviewed the available draft of the Indenture for carve-outs within the restricted-payment covenant that might accommodate the Distribution. Common carve-outs in high-yield indentures include:
(a) Declared Dividends. A carve-out permitting the payment of dividends declared by the board of directors within a specified period (typically 60 days) prior to the payment date, provided that the dividend was permissible under the covenant at the time of declaration. This carve-out is designed for ordinary-course cash dividends and would not excuse compliance with the basket and ratio tests — it merely permits a brief timing gap between declaration and payment.
(b) Employee Equity Repurchases. A carve-out permitting repurchases of equity interests from current or former employees, officers, directors, and consultants, typically subject to an annual dollar cap (e.g., $15 million to $25 million per year). This carve-out has no relevance to the Distribution.
(c) Equity Proceeds-Funded Restricted Payments. A carve-out permitting Restricted Payments funded with the cash proceeds of equity issuances by the Company or contributions to the common equity of the Company. This carve-out is designed to allow the Company to use fresh equity capital for shareholder-friendly purposes, but it does not apply to the Distribution because the Distribution is not funded with equity proceeds — it is a distribution of property (Meridian stock).
(d) General Basket. Some indentures include a general basket permitting Restricted Payments up to a fixed dollar amount (e.g., $50 million to $150 million), without regard to the builder basket or the coverage ratio test. Even if such a general basket exists in the Indenture, it would be orders of magnitude below the estimated $1.4 billion to $1.7 billion value of the Distribution.
None of these standard carve-outs would appear to accommodate a spin-off distribution of subsidiary equity with a fair market value in the range of $1.4 billion to $1.7 billion. We have not identified any unusual or non-standard carve-out in the available draft of the Indenture that would cover the Distribution.
Conclusion. Unless the executed Indenture contains an unusual or broad carve-out not reflected in the draft we have reviewed, the Distribution would exceed available Restricted Payment capacity under the Indenture, both in terms of the builder basket and the fixed charge coverage ratio test. A consent or waiver from the requisite noteholders would be required.
D. Interplay Between Asset-Sale and Restricted-Payment Covenants
A critical interpretive question is whether the Distribution should be analyzed under the asset-sale covenant, the restricted-payment covenant, or both. Many high-yield indentures, including the Indenture, provide a definitional exclusion to prevent double-counting: a transaction that constitutes a "Restricted Payment" permitted under the restricted-payment covenant is excluded from the definition of "Asset Sale" (and, conversely, a transaction that constitutes an "Asset Sale" permitted under the asset-sale covenant is excluded from the definition of "Restricted Payment"). The effect of this exclusion is to channel each transaction into one covenant regime or the other, but not both simultaneously.
The question of which covenant controls depends on how the transaction is characterized and on the precise wording of the definitional interplay in the Indenture. If the Distribution is classified as a "Restricted Payment" — which, as discussed above, is the more natural characterization given that the Distribution is a dividend-in-kind to shareholders — then it should be excluded from the definition of "Asset Sale." In that case, the Distribution would be analyzed solely under the restricted-payment covenant, and the asset-sale covenant's conditions (fair market value consideration, proceeds waterfall, etc.) would not apply. Conversely, if the Distribution is classified as an "Asset Sale" — which is also plausible given that it involves the disposition of 100% of the equity interests of a subsidiary — then it would be analyzed solely under the asset-sale covenant.
As a practical matter, however, the economic consequences are similar under either covenant: the Distribution cannot comply with the substantive conditions of either covenant without consent. Under the asset-sale covenant, the Distribution fails because Veldran receives no fair market value consideration and there are no proceeds to apply through the waterfall. Under the restricted-payment covenant, the Distribution fails because the value exceeds available basket capacity and may cause a failure of the coverage ratio test. In either case, the Distribution appears to require consent or waiver from noteholders.
The preferred framing from Veldran's perspective may depend on which covenant path is more amenable to a consent solicitation. In general, consent solicitations involving the restricted-payment covenant are somewhat more common in the high-yield market, and noteholders may be more familiar and comfortable with the restricted-payment framework. Additionally, the restricted-payment covenant may present fewer mechanical complications than the asset-sale covenant (which involves the proceeds waterfall and mandatory offer mechanics). We recommend that the choice of framing be discussed with corporate counsel and with the investment bank advising on the consent solicitation process.
Regardless of the covenant under which the Distribution is analyzed, the fundamental conclusion remains the same: the Distribution cannot be consummated without the consent of the requisite noteholders or an amendment to the Indenture.
V. Successor-Company / Merger Covenant Analysis
A. Summary of the Successor-Company Provisions
The Indenture contains a successor-company covenant that restricts Veldran from consolidating with or merging into another entity, or selling, transferring, leasing, or otherwise disposing of all or substantially all of its assets, in each case in a single transaction or a series of related transactions, unless certain conditions are satisfied. These conditions typically include:
(i) the entity formed by or surviving such consolidation or merger, or to which such assets are transferred (the "Successor Entity"), is organized under the laws of the United States, any state thereof, or the District of Columbia;
(ii) the Successor Entity expressly assumes, by supplemental indenture, all of the obligations of Veldran under the Indenture and the Notes;
(iii) immediately after giving effect to the transaction, no default or event of default under the Indenture exists;
(iv) immediately after giving effect to the transaction on a pro forma basis, the Successor Entity (or the Company, as applicable) could incur at least $1.00 of additional indebtedness under the fixed charge coverage ratio test; and
(v) Veldran delivers to the Trustee an officers' certificate and an opinion of counsel, each stating that the consolidation, merger, or transfer and the supplemental indenture comply with the Indenture.
The successor-company covenant is designed to ensure that the entity obligated on the Notes maintains a sufficient asset base and that noteholders are not prejudiced by a transformative transaction that fundamentally alters the credit profile of the issuer.
B. Application to the Distribution
The Distribution does not involve a merger or consolidation of Veldran with or into another entity. Following the Distribution, Veldran would continue to exist as a separate legal entity, and the Notes would remain obligations of Veldran. Accordingly, the successor-company covenant is not triggered by the merger or consolidation prong.
The Distribution does, however, involve a transfer of all assets and liabilities of the Precision Flow Solutions Division to Meridian (in the Contribution step), followed by the distribution of 100% of the Meridian stock to Veldran's shareholders (in the Distribution step). The question is whether these transfers, taken together, constitute a transfer of "all or substantially all" of Veldran's assets, which would trigger the successor-company covenant's asset-transfer prong.
The phrase "all or substantially all" is not defined in the Indenture and is not defined in the Trust Indenture Act of 1939. Under Delaware law, which governs the Indenture and the corporate affairs of Veldran, the phrase has been interpreted in various contexts to mean approximately 75% or more of the corporation's total assets. The seminal Delaware case is Gimbel v. Northgate Technologies, Inc., 316 A.2d 599 (Del. Ch. 1974), which held that a transaction involving the sale of assets representing approximately 26% of the corporation's total assets, 41% of its net sales, and approximately 50% of its pre-tax earnings did not constitute a sale of "all or substantially all" of the corporation's assets. Subsequent cases have generally applied a multi-factor, quantitative and qualitative test, considering the percentage of total assets, revenue, and earnings transferred, as well as the nature of the remaining business.
Applying this framework to the proposed Distribution:
• The Precision Flow Solutions Division represents approximately $820 million of Veldran's consolidated revenue of approximately $2.34 billion for fiscal year 2021, or approximately 35% of the total.
• The Precision Flow Solutions Division represents approximately $133 million of Veldran's consolidated EBITDA of approximately $418 million for fiscal year 2021, or approximately 32% of the total.
• Post-Distribution, Veldran would retain the Engineered Coatings Division, which generated approximately $1.52 billion in revenue and approximately $285 million in EBITDA for fiscal year 2021. The Engineered Coatings Division constitutes the substantial majority of Veldran's business by any relevant financial measure.
Based on these revenue and EBITDA percentages, the Precision Flow Solutions Division does not constitute "all or substantially all" of Veldran's assets. The transferred assets represent approximately one-third of the Company's consolidated operations, well below the approximately 75% threshold generally applied under Delaware case law. The Company would retain a large, profitable operating business — the Engineered Coatings Division — following the Distribution, and would continue to operate as a going concern.
Conclusion. The successor-company covenant is unlikely to be triggered by the Distribution because the Precision Flow Solutions Division does not constitute "all or substantially all" of Veldran's assets, based on the revenue and EBITDA data available. However, this analysis should be confirmed based on balance-sheet asset values, not just income-statement metrics. It is possible that the book value or fair market value of the Precision Flow Solutions Division's assets, including tangible and intangible assets, could represent a higher proportion of Veldran's total assets than the revenue and EBITDA percentages suggest. We have requested the relevant balance-sheet data from Rita Subramanian, CFO of Veldran, and Derek Okonkwo, VP Finance, Precision Flow Solutions Division, as noted in Section VIII below.
C. Internal Restructuring Steps
The Contribution step — the transfer of assets and liabilities of the Precision Flow Solutions Division to Meridian as a newly formed, wholly owned subsidiary — involves an internal restructuring of the Company's operations. Although the successor-company covenant is principally concerned with external transactions (mergers, consolidations, and sales to third parties), it may also apply to internal restructurings that involve the transfer of a material portion of the Company's assets to a subsidiary, depending on the precise language of the covenant.
Many high-yield indentures contain carve-outs within the successor-company provisions for intercompany transactions or transfers to wholly owned Restricted Subsidiaries. If such a carve-out exists in the Indenture, the Contribution step would fall within its scope and would not independently trigger the successor-company restrictions. However, the Contribution step should be analyzed separately from the Distribution step to confirm that the sequencing of the internal restructuring does not inadvertently create a covenant trigger — for example, if the Contribution were viewed as a transfer of "all or substantially all" of Veldran's assets to a subsidiary (which, for the reasons discussed above, we believe it would not be), the successor-company covenant could be implicated even before the Distribution occurs.
We recommend that this analysis be confirmed and coordinated with Whitfield & Gage LLP, which is drafting the Separation Agreement governing the terms of the Contribution, and with Thornapple McCord LLP, which is advising Veldran on corporate law matters in connection with the Spin-Off.
VI. Tax Opinion as a Condition to Consent or Waiver
If a consent solicitation or amendment is required to permit the Distribution under the Indenture, it is likely that noteholders or the Trustee will condition their consent on the receipt of a tax opinion confirming that the Distribution qualifies as a tax-free transaction under Sections 355 and 368(a)(1)(D) of the Code. This is a common requirement in consent solicitations involving spin-off transactions, because the tax treatment of the Distribution directly affects the economic position of the Company and, indirectly, the credit supporting the Notes.
Calderwood & Harkness LLP has been engaged to deliver a "should" level tax opinion in connection with the Spin-Off — that is, an opinion that the Contribution and Distribution, taken together, "should" qualify as a reorganization under Section 368(a)(1)(D) of the Code and that the Distribution "should" qualify as a tax-free distribution under Section 355 of the Code. A "should" level opinion represents the second-highest level of tax opinion comfort available, below a "will" opinion (which reflects the highest level of confidence) but above a "more likely than not" standard (which reflects a confidence level of greater than 50%). In the customary taxonomy of tax opinion levels, a "should" opinion is generally understood to reflect a confidence level of approximately 70% or higher.
The level of tax opinion required by noteholders in a consent solicitation is a commercial and negotiation point. Some consent solicitations require the delivery of a "will" level opinion as a condition to consent, on the theory that noteholders should not bear the risk that the spin-off fails to qualify for tax-free treatment. Others accept a "should" level or "more likely than not" standard, particularly where the tax issues are well-settled and the principal uncertainties relate to factual determinations (such as the adequacy of the business purpose) rather than legal uncertainties.
If the consent process requires a tax opinion, the timing of the opinion delivery and the resolution of outstanding opinion issues will be critical-path items for the transaction. As of the date of this memorandum, two significant tax opinion issues remain unresolved:
Business Purpose. The Section 355 regulations require that the Distribution be carried out for one or more valid corporate business purposes, as distinguished from shareholder purposes. Calderwood & Harkness's analysis of the business purpose requirement is set forth in a separate Business Purpose Memorandum dated July 18, 2022, which identifies several potential corporate business purposes (including operational focus, capital allocation flexibility, and management incentive alignment) but notes that certain of these purposes require further factual development and documentation by Veldran management.
Section 355(e) Plan Analysis. Section 355(e) of the Code imposes a tax on the distributing corporation (Veldran) if the Distribution is part of a "plan" (or series of related transactions) pursuant to which one or more persons acquire, directly or indirectly, a 50% or greater interest in the distributing or controlled corporation. Given Harrowgate's 62.4% ownership of Veldran and the potential for post-spin transactions involving Meridian, the Section 355(e) plan analysis requires careful examination. Calderwood & Harkness's preliminary analysis of this issue is set forth in a separate memorandum dated June 28, 2022, which remains subject to further development.
Until these issues are resolved, Calderwood & Harkness is not in a position to deliver the tax opinion. The timeline for resolution of these issues should be coordinated with the consent solicitation timeline to ensure that the tax opinion is available when needed.
VII. Comparison to First Lien Credit Agreement Analysis
A companion memorandum dated August 2, 2022, prepared by Garrett Simmons and reviewed by Leonard Cross, analyzes the covenant implications of the proposed Spin-Off under the Veldran First Lien Term Loan B credit agreement. The Term Loan B facility has an aggregate principal amount of $1.1 billion, with Ashfield National Bank, N.A. serving as administrative agent. The key findings of the credit agreement analysis are summarized below for cross-reference purposes.
The credit agreement analysis identified covenant triggers under the restricted payment, asset disposition, and change of control provisions of the credit agreement that are similar in substance to the Indenture triggers identified in this memorandum. The credit agreement analysis concluded that the lender group would require significant negotiation and that a refinancing of the Term Loan B facility may be necessary to accommodate the Spin-Off. Margaret Tsao of Ashfield National Bank, N.A. has indicated informally that lender consent will be required, and that the administrative agent and the lender syndicate will expect to participate in the structuring of the Spin-Off to the extent it affects the credit.
The Indenture analysis should be viewed in conjunction with the credit agreement analysis, as any consent solicitation process under the Indenture would likely run in parallel with lender consent negotiations under the credit agreement. The transaction team should be aware of the following key differences between the two consent processes:
Governing Law and Process. The Indenture consent process is governed by the Trust Indenture Act of 1939, as amended (the "TIA"), and involves a formal consent solicitation or supplemental indenture. The TIA imposes specific requirements on the form and manner of solicitation, including the preparation of a consent solicitation statement that is distributed to registered holders. The credit agreement consent process, by contrast, involves direct negotiation with the lender syndicate and the administrative agent and is not subject to the TIA.
Consent Thresholds. Under the Indenture, the consent of holders of a majority in principal amount of the Notes outstanding is typically required to amend or waive the asset-sale or restricted-payment covenants. Under the credit agreement, the consent threshold may differ and may require the consent of "Required Lenders" (typically defined as lenders holding more than 50% of the outstanding commitments or loans) or, in some cases, unanimous lender consent for certain fundamental amendments.
Consent Fees and Economics. Consent solicitations under high-yield indentures typically involve the payment of a consent fee to consenting noteholders, commonly in the range of 25 to 75 basis points of principal amount. Credit agreement consent processes may involve amendment fees, repayment premiums, or margin increases.
Both instruments will need to be addressed before the Distribution can proceed. We recommend that the transaction team develop a coordinated consent strategy that addresses the Indenture and the credit agreement simultaneously, in order to avoid a situation where consent is obtained under one instrument but not the other.
VIII. Open Items and Diligence Requests
The analysis in this memorandum is preliminary and is subject to confirmation upon receipt and review of the following materials:
1. Final Executed Indenture. We require a final executed copy of the Indenture, together with all supplements, amendments, and waivers thereto. This document was requested from Philip Crundell, General Counsel of Veldran, and from Priya Chandrasekar of Whitfield & Gage LLP, via the Initial Tax Diligence Information Request List dated April 25, 2022. The receipt status of this document should be confirmed on the diligence tracker maintained by the project team. Our analysis is based on a substantially final but unexecuted draft, and all conclusions are subject to revision upon review of the executed instrument.
2. Confirmation of Key Definitions. We require confirmation of the exact definitions of "Asset Sale," "Restricted Payment," "Restricted Subsidiary," "Unrestricted Subsidiary," and "all or substantially all" as used in the executed Indenture. The precise wording of these definitions will determine the outcome of several of the interpretive questions discussed in Sections III, IV, and V above, including the interplay between the asset-sale and restricted-payment covenants and the applicability of the successor-company covenant.
3. Balance-Sheet Asset Data. We require balance-sheet asset data for the Precision Flow Solutions Division, including the book value and estimated fair market value of the tangible and intangible assets to be transferred to Meridian in the Contribution. This data is necessary to confirm the "all or substantially all" analysis set forth in Section V.B above. This information has been requested from Rita Subramanian, CFO of Veldran, and Derek Okonkwo, VP Finance, Precision Flow Solutions Division.
4. Outstanding Waivers, Amendments, and Consent Solicitations. We require confirmation from Colton Trust Company (the Trustee) regarding any outstanding waivers, amendments, or consent solicitations under the Indenture that may be relevant to the analysis. It is possible that prior waivers or amendments have modified the applicable covenant definitions or basket calculations.
5. Correspondence with the Trustee. We require copies of any existing correspondence between Veldran and Colton Trust Company regarding the proposed Spin-Off or any other pending transaction, to the extent such correspondence bears on the Trustee's awareness of, or position regarding, the Distribution.
6. Historical Financial Data for Basket Calculations. We require Veldran's historical consolidated financial statements since the issue date of the Notes, for purposes of calculating the available Restricted Payments basket and the fixed charge coverage ratio. This data will be obtained from Veldran's financial reporting team in coordination with the corporate counsel workstream.
The foregoing diligence requests should be prioritized given their importance to the finalization of this memorandum and the overall transaction timeline.
IX. Conclusions and Recommendations
Based on the preliminary analysis set forth in this memorandum, and subject to confirmation upon receipt of the executed Indenture and resolution of the open diligence items identified in Section VIII, we reach the following conclusions and recommendations:
1. No Explicit Spin-Off blocker or Safe Harbor. The Indenture does not contain an explicit spin-off blocker provision that would categorically prohibit the Distribution. However, the Indenture also does not contain an explicit spin-off safe harbor that would affirmatively permit the Distribution without compliance with the substantive covenants. The absence of both a blocker and a safe harbor creates interpretive ambiguity that weighs in favor of seeking consent from the noteholders.
2. Asset-Sale and/or Restricted-Payment Covenant Trigger. The Distribution of Meridian common stock (estimated fair market value of $1.4 billion to $1.7 billion) would likely trigger either the asset-sale covenant or the restricted-payment covenant of the Indenture (or potentially both, depending on the precise definitional interplay between the two covenants). Under the asset-sale covenant, the Distribution fails because Veldran receives no fair market value consideration and there are no cash proceeds to apply through the mandatory offer waterfall. Under the restricted-payment covenant, the Distribution fails because the value of the Meridian stock far exceeds available basket capacity, and the pro forma fixed charge coverage ratio may not satisfy the required threshold. In either case, the available covenant capacity is almost certainly insufficient to accommodate the Distribution without consent from the requisite noteholders.
3. Successor-Company Covenant Unlikely to Be Triggered. The successor-company covenant is unlikely to be triggered by the Distribution because the Precision Flow Solutions Division does not constitute "all or substantially all" of Veldran's assets. The Precision Flow Solutions Division represents approximately 35% of Veldran's consolidated revenue and approximately 32% of consolidated EBITDA — well below the approximately 75% threshold generally applied under Delaware law. However, this conclusion should be confirmed based on balance-sheet asset data, which has been requested and is pending receipt.
4. Consent Solicitation Required. A consent solicitation from holders of a majority in principal amount of the Notes outstanding (i.e., holders of Notes representing more than $225 million in aggregate principal amount), or, if permitted, a supplemental indenture, will likely be required to permit the Distribution to proceed. The consent solicitation process will be governed by the Trust Indenture Act of 1939 and the terms of the Indenture, and will involve the preparation of a consent solicitation statement, the solicitation of consents from registered and beneficial holders, and the payment of a consent fee.
5. Tax Opinion Dependency. A tax opinion at the "should" level or higher may be required as a condition to any consent or waiver from the noteholders or the Trustee, creating a dependency between the tax opinion workstream and the Indenture consent workstream. The resolution of outstanding tax opinion issues — specifically, the business purpose articulation (see Business Purpose Memorandum dated July 18, 2022) and the Section 355(e) plan analysis (see memorandum dated June 28, 2022) — will be critical-path items for the consent solicitation timeline.
6. Coordination with Corporate Counsel. Coordination with Whitfield & Gage LLP (corporate counsel to Harrowgate Private Equity Fund IV, L.P.) and Thornapple McCord LLP (corporate counsel to Veldran Industries Holdings, Inc.) is essential to align the Indenture consent process with the broader transaction timeline, including the credit agreement consent negotiations, the preparation of the Separation Agreement and related transaction documents, and the regulatory filing process.
7. Update Required. This memorandum should be updated and finalized once the executed Indenture and all supplements thereto are confirmed in final form, the outstanding diligence items identified in Section VIII have been resolved, and the definitional questions regarding the interplay between the asset-sale and restricted-payment covenants have been confirmed based on the executed instrument.
Prepared by:
________________________________________
Leila Nazari Associate, Tax Department Calderwood & Harkness LLP
Date: August 3, 2022
Reviewed by:
________________________________________
Garrett Simmons Senior Associate, Tax Department Calderwood & Harkness LLP
Date: August 3, 2022
Distribution: Leonard Cross, Responsible Partner, Tax Department, Calderwood & Harkness LLP; Sylvia Hartwell, Calderwood & Harkness LLP; matter file HRW-SPIN-001. No further distribution without prior approval of Leonard Cross.
| TO: | Leonard Cross, Responsible Partner, Tax Department |
| FROM: | Leila Nazari, Associate, Tax Department |
| REVIEWED BY: | Garrett Simmons, Senior Associate, Tax Department |
| DATE: | August 3, 2022 |
| RE: | Indenture Covenant Analysis — Veldra |