Summary
Majority lender groups and stressed borrowers notched another win in the uptier wars when Judge David Jones of the U.S. Bankruptcy Court for the Southern District of Texas (the “Court”) issued a June 6, 2023 opinion (the “Opinion”) approving confirmation of the chapter 11 plan (the “Plan”) of Serta Simmons Bedding, LLC and its affiliated debtors (“Serta” or the “Company”), and finding in favor of the majority participating term lenders (“PTLs”) in claims brought by certain non-participating minority lenders (“Non‑PTLs”) to Serta’s pre-petition uptier transactions.[1] The Court held that the debt exchange transaction with only the PTLs was an “open market purchase,” and that the PTLs and Serta did not violate the covenant of good faith and fair dealing by entering into the uptier transaction, as had been claimed by the Non-PTLs. Conversely—and although neither Serta nor the majority lender group had asserted it—Judge Jones added that the minority lenders’ actions evinced “an objective lack of good faith”[2] as the minority lenders had originally sought their own uptier transaction with Serta and were sophisticated and fully aware that the documents were flexible.
Further in favor of the PTLs and the debtors, the Court approved an indemnity in the Plan in favor of the PTLs from the reorganized debtors against any liability in connection with the uptier on the basis that it was just part of “a basket of consideration” received by the plan-supporting PTLs in exchange for their agreement to deleverage and provide exit financing.[3] Assuming this indemnification survives on appeal, the indemnity provides significant protection to the PTLs but also poses liability risk to the reorganized Serta.
If the Opinion survives intact in the appeal process, it suggests that, in the future, favored lenders and distressed borrowers can engage in exchange transactions that materially favor one set of lenders over another without concerns of violating the implied covenant of good faith and fair dealing or the “open market purchase” requirement in a credit agreement. Moreover, participating lenders may be able to shield themselves from liability from other lenders through indemnification provisions baked into a plan of reorganization. Market participants should note that with time it will become clearer whether this decision rests on the fact that the non-participating lenders competed with the participating lenders to execute an exclusive debt-for-debt exchange with the borrower.
Background
In May 2020, Serta and the PTLs agreed to an “uptier” transaction whereby the PTLs exchanged existing first and second lien loans for new superpriority loans in a facility that primed the existing secured debt.
Thereafter, certain excluded lenders sought a preliminary injunction in New York Supreme Court to stay the transaction, which was denied, and the uptier transaction closed in June 2020. In July 2020, one of the excluded lenders (the “Excluded Lender”) filed suit against Serta in the U.S. District Court for the Southern District of New York seeking damages for breach of the Non-PTL term loan agreement and the implied covenant of good faith and fair dealing, among other causes of action (the “Excluded Lender Action”). In March 2022, Judge Katherine Polk Failla denied a motion to dismiss the Excluded Lender Action for breach of contract and breach of the implied covenant of good faith and fair dealing (the “Failla Decision”).[4]
Serta filed for bankruptcy in January 2023. Commensurate with the filing, the debtors filed an adversary proceeding (the “Adversary Proceeding”) with PTLs as co-plaintiffs, seeking declaratory judgments from the Court that the uptier transaction did not violate the relevant loan documents and that the Company and the PTLs had not breached the implied covenant of good faith and fair dealing. In March 2023, the Court held in a summary judgment ruling that the uptier transaction complied with the undefined term “open market purchase” under the loan documents.[5] Judge Jones also ruled that the litigation with the Non-PTLs should be resolved via the Adversary Proceeding, rather than in the Excluded Lender Action, due to the fact that resolution of the litigation would impact findings the Court would make regarding the debtors’ Plan, and that the Court should not have its hands tied on confirmation-related determinations while waiting for the Excluded Lender Action to be resolved.[6]
The Confirmation Opinion
The Opinion found that the PTLs and Company did not violate the implied covenant of good faith and fair dealing and provided greater definition around the term “open market transaction.” On good faith and fair dealing, the Court found persuasive, that all parties “were keenly aware that the 2016 Credit Agreement was a ‘loose document’ and understood the implications of that looseness.”[7] In support of its finding, the Court noted that certain of the Non-PTLs made a proposal to the Company in 2020 that relied on the open market purchase provision in the credit agreement in the manner ultimately used by the PTLs, and had acquired the bulk of their loan holdings in the secondary market in anticipation of negotiating a deal that would be “exactly what they complain was done to them using the same provisions of the 2016 Credit Agreement.”[8] The Court also discussed the evolving offers and counteroffers received by Serta from different lenders and lender groups before ultimately settling on the transaction with the PTLs, and credited testimony that “negotiations between the parties were characterized ‘as being fairly typical for any competitive process, auction or competitive financing.’”[9] The Court also took aim at the actions of the Non-PTLs whom, after realizing they had been “outmaneuvered” by the PTLs, actively worked to disrupt the deal. These actions, according to the Court, are “reflective of the true motives of the Objecting Lenders in these proceedings, including an objective lack of good faith.”[10] Ultimately, the Court found that equity, to the extent relevant, is on the side of the PTLs: “On the scale of equity, it is the conduct of the Objecting Lenders that raises an eyebrow.”[11]
The Opinion also addresses the Plan indemnity in favor of the PTLs, stating that under the Plan, “the PTL Lenders agreed to equitize almost a billion dollars in secured claims plus provide the Reorganized Debtors with financing on a go-forward basis. In return, the PTL Lenders received a basket of consideration, including an indemnification, from the Reorganized Debtors for any liability related to the 2020 Transaction.”[12] Although a major change to the Plan, the Court subscribed to the idea that correcting a prior mistake or omission is something that “should never be discouraged.”[13]
The Opinion also considers various definitions of “open market purchases,” but ultimately turns to the dictionary and finds that an open market purchase is “something obtained for value in competition among private parties.”[14] Under this definition, the Court concluded that “[t]he process utilized by [Serta’s banker] to solicit interest [in a transaction] from [] existing lenders, the receipt and negotiation of multiple offers by the Debtors to achieve the greatest benefit for the Debtors, the attempts by various lenders to ‘outmaneuver’ one other with an ultimate winner announced, and the Objecting Lenders subsequent attempts to undermine the announced winning deal is the quintessential ‘Wall Street’ open market purchase.”[15] That is the Court takes an expansive view of the term “open market purchase” and does not require the exchange to be marketed to all lenders or be on “market” terms.
The Opinion closes with the suggestion that “[l]ender exposure to these types of transactions can be easily minimized with careful drafting of lending documents.”
Comparison with Prior Serta Decisions
As mentioned above, Judge Jones decided that the Court would not wait until Judge Failla adjudicated the Excluded Lender Action in district court and instead ruled on the key issues as part of confirming Serta’s Plan and resolving the Adversary Proceeding.[16] A comparison between the Opinion and Judge Failla’s Decision is noteworthy, especially as it relates to the definition of “open market purchases,” the role of negotiations among the parties, and the concepts of “good faith” and “fair dealing.”
With respect to open market purchases, Judge Failla canvassed open market purchase definitions proposed by each side before concluding, on a motion to dismiss posture, that the competing definitions rendered the term ambiguous and therefore the claim alleging failure to adhere to the open market provision survived the motion to dismiss.[17] Judge Jones considered substantially similar arguments from the parties, as well as multiple expert reports from each side, and concluded that the term “open market purchase” was not ambiguous based on the Merriam‑Webster Online dictionary definition of “open market” as “an economic market in which prices are based on competition among private businesses and not controlled by a government.”[18] As discussed, Judge Jones was satisfied that Serta conducted an open market transaction by soliciting competing offers and fostering a robust negotiation among the parties.[19]
The largest distance between the opinions may be their respective treatment of the good faith and fair dealing claim. Judge Jones focuses on the “loose” document terms and that the negotiations took place among “[s]ophisticated financial titans.”[20] On the other hand, Judge Failla found in the Excluded Lender Action that the Excluded Lender sufficiently alleged “that in negotiating, [the lender] expressly bargained for ‘first-lien, priority, pro rata rights,’” which rights “were subverted by [Serta’s] creation of a new tranche of debt with priority rights senior to those held by [the Lender].”[21] This subversion of lien priority was, in Judge Failla’s view, sufficient to conclude that the Lender had adequately alleged that Serta “deprived them of the benefit of their bargain in bad faith.”[22] Diverging from Judge Jones’ position of ”caveat lendor,” Judge Failla noted that “the Court is informed by caselaw establishing the principle that ‘even an explicitly discretionary contract right may not be exercised in bad faith so as to frustrate the other party’s right to the benefit under [an] agreement.’”[23]
Takeaways and Coming Attractions
Judge Jones’ decision to adjudicate the claims rather than defer to another court, based on timeliness concerns and relation to the confirmation process, should be recognizable to anyone who is familiar with the Brazos Electric Power Cooperative, Inc. bankruptcy, where Judge Jones adjudicated a number of issues arising out of February 2021 winter storm Uri over the objection of regulatory bodies who had argued that the litigation should proceed in Texas state courts.[24] By setting a precedent that the bankruptcy court will ultimately hear and determine the appropriateness of uptier transactions in connection with plan confirmation, the Court may ultimately incentivize such transactions and disincentivize the parties from negotiating a settlement.[25]
In addition to finding the uptier transaction complied with the credit agreement and applicable law, the Opinion also served to approve the Plan’s indemnity in favor of the PTLs. The indemnity creates additional cover to majority lenders in uptier situations, but it is an open question as to whether on appeal the appellate court will find that the indemnity was warranted and/or creates feasibility issues for reorganized debtors.
The next uptier case to watch in Judge Jones’ courtroom is Wesco Aircraft Holdings, Inc., et al. (“Incora”).[26] Although the uptier in Incora involved bonds rather than loans, making certain of the contractual arguments in the minority bondholders’ challenge different from Serta, Judge Jones’ position in Serta on indemnification, repeated invocation of the “looseness” of credit documents, and views of the application of good faith and fair dealing will be important considerations for the Court. The Incora debtors, who filed for chapter 11 on June 1, 2023, have already obtained an extension of the automatic stay to their non-debtor co‑defendants, and a pause of two pre-petition suits, analogous to the Serta debtors at the outset of these chapter 11 cases.[27]
Judge Jones’ open market purchase summary judgment decision is currently before the Fifth Circuit on direct appeal.[28] As of publication, at least one creditor has appealed the Opinion and is seeking to have its appeal consolidated with the open market purchase appeals and heard directly by the Fifth Circuit. Accordingly, it is likely that the Fifth Circuit will have the next word in this ongoing battle.
[1] See In re Serta Simmons Bedding, No. 23-90020 (DRJ) (Bankr. S.D. Tex. June 6, 2023) [ECF No. 1045] (the “Opinion”).
[2] See the Opinion at 7.
[3] See the Opinion at 8.
[4] See LCM XXII Ltd. v. Serta Simmons Bedding, LLC, 2022 WL 953109 (S.D.N.Y. Mar. 29, 2022).
[5] See In re Serta Simmons Bedding, No. 23-09001 (DRJ) (Bankr. S.D. Tex. Mar. 2023) (Hr’g. Tr. Mar. 28, 2023).
[6] See id.
[7] See the Opinion at 17.
[8] See id.
[9] See the Opinion at 5.
[10] See the Opinion at 7.
[11] See the Opinion at 17.
[12] See the Opinion at 13.
[13] See id.
[14] See the Opinion at 15.
[15] See id.
[16] See the Opinion at 17.
[17] See the Failla Decision.
[18] See the Opinion at 14.
[19] Although the Opinion and the Failla Decision reached different outcomes, there are certain elements of agreement based on the different procedural postures in which the decisions were rendered. For example, whereas Judge Jones describes the exchange of various transaction proposals from parties including certain lenders ultimately excluded from the uptier, a footnote from Judge Failla declines to accept these facts, asserted by Serta, at the pleading stage because the complaint did not include any allegations other than that Non-PTLs “were uninvolved and had no knowledge of Defendant’s plans to restructure its debts.” See the Failla Decision at 20. “To the extent Defendant engaged in robust negotiations with many lenders prior to agreeing on the terms of the [uptier] Transaction, that is a proper avenue for discovery,” the court continued. Id.
[20] See the Opinion at 17.
[21] See the Failla Decision at 39.
[22] See the Failla Decision at 40.
[23] See the Failla Decision at 40-41.
[24] See In re Brazos Electric Power Cooperative, No. 21-30725 (DRJ).
[25] In TriMark USA, another challenged 2020 uptier transaction, survival of contract breach claims at the motion to dismiss stage in New York state court led to a settlement less than five months later. See Audax Credit Opportunities Offshore Ltd. v. TMK Hawk Parent, Corp., 2021 WL 3671541 (Sup. Ct. N.Y. Cty. Aug. 16, 2021).
[26] See In re Wesco Aircraft Holdings, Inc., No. 23-90611 (DRJ).
[27] See In re Wesco Aircraft Holdings, Inc., No. 23-90611 (DRJ) (Bankr. S.D. Tex. June 2, 2023) [ECF No. 139].
[28] See In re Serta Simmons Bedding, No. 23-90020 (DRJ) (Bankr. S.D. Tex. June 7, 2023) [ECF No. 1050].
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