On June 6, 2023, the US Bankruptcy Court for the Southern District of Texas (the “Court”) confirmed Serta Simmons Bedding, LLC’s (“Serta”) Chapter 11 plan and held that Serta’s 2020 uptiering transaction (the “Uptiering Transaction”) did not breach Serta’s 2016 first lien credit agreement (the “Credit Agreement”).
In the memorandum opinion (the “Opinion”)1, Judge David R. Jones held that Serta and the Participating Lenders (defined below) did not breach the implied covenant of good faith and fair dealing, and he further expounded on his prior bench ruling2 that the Uptiering Transaction constituted an “open market purchase” under the Credit Agreement. Judge Jones concluded that the Uptiering Transaction was not prohibited by the Credit Agreement and is “binding and enforceable in all respects”.
The ruling may have significant implications in a distressed market that has already seen an uptick in uptiering transactions and other liability management transactions, a number of which are currently being litigated.
The Uptiering Transaction
In June 2020, Serta entered into a transaction with a majority of its existing first-lien and second-lien lenders (the “Participating Lenders”) that created two new superpriority tranches of debt: (i) a $200 million new-money “first out” financing and (ii) a $875 million “second out” tranche created through a debt exchange of the Participating Lenders’ loans at a discount. The exchange was made in reliance on a provision in the Credit Agreement (and the second lien credit agreement) permitting the non-pro rata assignment of loans through “open market purchases”. As part of the Uptiering Transaction, Serta obtained the approval of the Participating Lenders to amend the underlying loan documents, including the Credit Agreement, to permit the priming loans. Serta did not seek participation by, or the prior consent of, minority lenders. Following the Uptiering Transaction, the Participating Lenders held over $1.075 billion of super-priority loans with rights senior to those of the (formerly first-lien and second-lien) minority lenders.
Litigation and Adversary Proceeding
Following the announcement—and then following the closing—of the Uptiering Transaction, certain minority lenders (the “Excluded Lenders”) challenged the Uptiering Transaction in New York state and federal courts, mainly arguing that: (i) the debt exchange did not qualify as an “open market purchase” under Section 9.05(g) of the Credit Agreement and therefore breached the Excluded Lenders’ “sacred right” under Section 9.02(b)(A) to receive a pro rata share of payments under the Credit Agreement; and (ii) Serta and the Participating Lenders breached the implied covenant of good faith and fair dealing by depriving the Excluded Lenders of their senior secured position in Serta’s capital structure. In the New York federal case, such arguments survived a motion to dismiss, with the District Court for the Southern District of New York finding, in particular, that the term “open market exchange” as used in the Credit Agreement was ambiguous.3
On January 23, 2023, Serta filed voluntary Chapter 11 cases in the Southern District of Texas, which stayed the ongoing litigation. Serta and certain Participating Lenders also commenced an adversary proceeding against the Excluded Lenders, seeking a declaratory judgment with respect to the Excluded Lenders’ main contentions. In a March bench ruling, the Court granted partial summary judgment, holding that the term “open market purchase” was clear and unambiguous and that the Uptiering Transaction qualified as an “open market purchase” under Section 9.05(g) of the Credit Agreement. The Court did not grant the requested relief with respect to the issue of whether there was a breach of the implied covenant of good faith and fair dealing.
Open Market Purchase
In the Opinion, Judge Jones expounded on his prior bench ruling that the Transaction qualified as an “open market purchase.” He pointed to the rule of contract interpretation expressio unius est exclusio alterius, which holds that the expression of a term means the intentional exclusion of others, and noted that Section 9.05(g) of the Credit Agreement sets forth two very different sets of guidelines for Dutch Auctions, with pages of implementation rules open to all lenders, and open market purchases between a buyer and a seller.
In addition, the Court looked to the “plain meaning” of “open market purchase.” Referencing the definitions of “open market” and “purchase” in Merriam-Webster, Judge Jones concluded that an open market purchase is “something obtained for value in competition among private parties.” The Credit Agreement, he noted, defines the scope of the market by limiting buyers to existing lenders.
He concluded that the Uptiering Transaction, which involved soliciting interest from existing lenders, negotiating multiple offers, and attempts by lenders to outmaneuver one another or undermine the winning deal, represented “the quintessential ‘Wall Street’ open market purchase.”
Good Faith and Fair Dealing
On the issue of a breach of the implied covenant of good faith and fair dealing, Judge Jones found no breach on the part of Serta or the Participating Lenders.
Judge Jones reiterated existing precedent that a court’s inquiry is an objective one, focused on the plaintiff’s reasonable expectations at the time of entry into the agreement, and is constrained by the entirety of the terms in the applicable agreement. Conduct that is expressly permitted under an agreement, and actions taken for a “legitimate business purpose,” even if self-interested, do not violate the implied covenant. Judge Jones determined that the parties were “keenly aware” that the Credit Agreement was a “loose document” and understood the implications of such looseness.
He further noted that the Excluded Lenders presented their own liability management transaction (i.e., a drop-down transaction which would have excluded the Participating Lenders) to Serta using the same provisions of the Credit Agreement relied on by the Participating Lenders, acquired the majority of their loans in anticipation of entering into such liability management transaction, and once they were unsuccessful, complained about the Uptiering Transaction being undertaken to their detriment. Judge Jones found “an objective lack of good faith” on the part of the Excluded Lenders. Conversely, he found no evidence of bad faith on the part of Serta or the Participating Lenders, noting that Serta “always remained transparent in [its] goals” and the Participating Lenders “acted defensively and in good faith,” and that there was no evidence of an improper motive by Serta or the Participating Lenders.
Binding and Enforceable
The Court concluded that the Uptiering Transaction was not prohibited by the Credit Agreement, that it is binding and enforceable in all respects, and that there is no evidence of a breach of the Credit Agreement. The Uptiering Transaction was found to be “the result of good-faith, arm’s length negotiations by economic actors acting in accordance with the duties owed to their respective creditors, investors and owners.” In the Opinion, Judge Jones noted that each party received the bargain it struck, not the one it hoped to get, and that the parties could have easily avoided the whole situation with the addition of a sentence or two to the Credit Agreement.
Speaking broadly of liability management transactions, the Court espoused the view that liability management transactions “may or may not be a good thing. Lender exposure to these types of transactions can be easily minimized with careful drafting of lending documents. While the result may seem harsh, there is no equity to achieve in this case. Sophisticated financial titans engaged in a winner-take-all battle. There was a winner and a loser. Such an outcome was not only foreseeable, it is the only correct result. The risk of loss is a check on unrestrained behavior.”
The ruling may have significant implications in a distressed market that has already seen an uptick in uptiering transactions and other liability management transactions.
In particular, the Court’s decision signals to the debt markets that uptiering transactions, and other liability management transactions for that matter, may be upheld following judicial review if the terms of a credit facility’s loan documents do not expressly prohibit such transactions. Precise drafting is critically important since, as a general matter, courts evaluating the permissibility of uptiering transactions and other liability management transactions have focused closely on the express language of the applicable loan documents.
“Loose” loan documents that contain permissive provisions similar to those found in the Credit Agreement may embolden borrowers, sponsors and lender groups to pursue similar liability management transactions despite the possibility that such transactions may invite litigation from lenders that do not participate in such transactions. Indeed, in certain instances, sponsors have actually been pushing to include “privately negotiated transactions” within the open market purchase concept in their loan documents. Perhaps, going forward, lenders may press more firmly to ensure that certain protections (such as anti-Serta protections) are clearly laid out in the loan documents in light of the Opinion handed down by Judge Jones.
With respect to a borrower that has engaged in a liability management transaction being challenged by non-participating lenders and is contemplating bankruptcy, the Court’s ruling may incentivize such borrower to file in the Southern District of Texas.4
It will be interesting to see what, if any, effect the Court’s ruling will have on other uptiering transactions and other liability management transactions currently being litigated in other jurisdictions, such as the Boardriders case in New York state court, where similar arguments pertaining to the ambiguity of “open market purchase” and the breach of the covenant of good faith and fair dealing have survived a motion to dismiss5, but where the New York Supreme Court’s decision has been stayed pending appeal. Perhaps, on appeal, Judge Jones’ ruling will play a role in guiding the resolution of the Boardriders case and other similar litigation proceedings.
Please feel free to reach out to any of the authors above with any questions.
2 See Hearing Transcript, Serta Simmons Bedding LLC v. AG Centre Street P’Ship (In re Serta Simmons Bedding, LLC), Adv. Pro. No. 23- 9001 (Bankr. S.D. Tex. Mar. 28, 2023), ECF No. 133 (Transcript Access Restricted Through 6/29/2023).
3 See LCM XXII Ltd. v. Serta Simmons Bedding, LLC, No. 21-CV-3987, 2022 WL 953109 (S.D.N.Y. Mar. 29, 2022). For further discussion about the court’s decision, please refer to https://www.mayerbrown.com/en/perspectives-events/blogs/2022/06/southern-district-of-new-york-allows-challenge-to-serta-simmons-june-2020-uptier-exchange-transaction-to-proceed-to-discovery.
4 Even prior to this decision, other borrowers that had engaged in liability management transactions had also filed in the Southern District of Texas, including Incora on June 1, 2023. On the same day that Judge Jones issued the Opinion, he also delivered a ruling in the Incora bankruptcy and adversary proceeding imposing a two-month stay of a non-participating noteholder’s lawsuit in New York state court challenging Incora’s March 2022 uptiering transaction. A group of plaintiffs in another New York state lawsuit challenging the uptiering separately agreed to a temporary stay. See In re Wesco Aircraft Holdings, Inc., Adv. Pro. No. 23-03091 (Bankr. S.D. Tex.).