Serta Simmons Bedding, LLC’s (“Serta”) chapter 11 reorganization plan has been confirmed by the U.S. Bankruptcy Court for the Southern District of Texas in its June 6, 2023 decision. The presiding judge, Judge David R. Jones, confirmed the Serta debtors’ chapter 11 plan and ruled that the 2020 uptier exchange transaction (detailed further below) (the “Priming Transaction”) was “not prohibited” by Serta’s 2016 credit agreement (the “Agreement”) and is “binding and enforceable in all respects.” Importantly, the court separately ruled that Serta and certain participating lenders to the Priming Transaction did not violate the implied covenant of good faith and fair dealing.
The ruling validates the Priming Transaction, which has been the subject of controversy, sending a message to the market that similar liability management transactions that favor a certain group of lenders over the others may clear judicial scrutiny if they are not prohibited by the terms of the lending documents.
The Priming Transaction involved the issuance of priming debt through amendments to the debt and liens sections of the Agreement approved by a group of majority lenders (the “Participating Lender Group”), coupled with a debt exchange. In essence, Serta (i) amended the Agreement to provide superpriority debt capacity and (ii) issued new superpriority debt pursuant to this capacity, in consideration for new “first out” term loans ($200 million) and for exchanging existing first lien and second lien term loans with the Participating Lender Group at a discounted value for new superpriority debt through the open market purchases provisions of the Agreement. The Participating Lender Group received better economics and debt that was better placed to recover in a bankruptcy scenario while the remaining lenders who were not invited to participate in the exchange (the “Non-Participating Lender Group”) were left with debt which was subordinated to the newly issued superpriority debt and, as a result, the market value of such debt was reduced considerably compared to its value before the exchange.
In the litigation that ensued, members of the Non-Participating Lender Group argued that the Priming Transaction breached the Agreement on the grounds that:
In January of this year, Serta filed for chapter 11 protection. In connection therewith, Serta entered into a restructuring support agreement with certain of its creditors and filed a prearranged chapter 11 plan as part of the proceedings. In addition, Serta concurrently filed an adversary proceeding in U.S. Bankruptcy Court against the Non-Participating Lender Group seeking declaratory judgment over the issues outlined above.
Serta won partial summary judgment on the first issue, with the U.S. Bankruptcy Court ruling on March 28, 2023 that the Priming Transaction “very clearly” constituted an open market purchase. Notably, the court did not define “open market purchase” or clarify what transactions would qualify as open market purchases. The court left for trial the issue of whether Serta and the Participating Lender Group breached the implied covenant of good faith and fair dealing.
Judge Jones ruled against the Non-Participating Lender Group, finding that the 2020 Transaction was “not prohibited” by the Agreement, the Priming Transaction was “binding and enforceable in all respects” and there was no breach of the implied covenant of good faith and fair dealing.
In evaluating a claim for breach of the implied covenant of good faith and fair dealing, Judge Jones noted that the court’s focus is on the reasonable expectations of the parties at the time that they entered the contract with a level of deference owed to agreements negotiated by sophisticated parties and constrained by the terms of the contract. Judge Jones noted further that conduct that is expressly permitted by the contract and self-interested actions taken for a “legitimate business purpose” will not violate the covenant.
In support of his decision, Judge Jones highlighted that the parties were sophisticated parties who were well aware that the Agreement was a “loose document” and understood the implications thereof. Judge Jones also noted that there was no evidence of an improper motive by Serta or the Participating Lender Group, who “remained transparent in their goals” and “acted defensively and in good faith.” Instead, Judge Jones suggested that if anything it was the Non-Participating Lender Group whose conduct “raises an eyebrow” given that they acquired the majority of their loan holdings after the issuance with a view to negotiating a drop-down transaction to the exclusion of the Participating Lender Group.
Judge Jones noted that while the result may seem harsh, the risk could have been easily minimized with careful drafting and that this was “the only correct result.” In other words, he concluded that the parties got what they bargained for.
While not central to his decision, Judge Jones took the opportunity to elaborate on his previous ruling on open market purchases. First, he noted that the differences between the regimes for Dutch auctions (which he noted has pages of implementation rules open to all lenders) and open market purchases (which he noted has comparatively few rules) cannot be ignored, citing the contract interpretation rule expressio unius est exclusio alterius which holds that if parties omit terms in one place of a contract and not in others it suggests that the omission was intentional. Second, by reference to Merriam Webster dictionary’s definition of the term “open market,” he defined an open market purchase “as something obtained for value in competition among private parties.” Finally, he opined that the process of soliciting interest from existing lenders, with multiple offers from various lenders attempting to outmanuever one another was the “quintessential ‘Wall Street’ open market purchase.”
The decision will have significant and immediate impacts on the high yield, leveraged loan and distressed debt markets.
While far from a definitive blueprint, and subject to appeals from the Non-Participating Lender Group, the ruling sends a message to the market that similar uptiering transactions may clear judicial scrutiny if they are not prohibited by the terms of the lending documents. Lender groups, borrowers and sponsors who are party to agreements with comparable flexibilities may be incentivized to implement similar liability management transactions, even at the risk of litigation, given the court’s blessing of the Serta Priming Transaction.
The decision further highlights that courts, as of yet, have been generally unwilling to look beyond a strict analysis of whether the debtor has complied with the “four corners” of the relevant debt agreement. As such, for lenders that want to avoid the risk of this type of liability management transaction, the most straightforward solution is to negotiate for explicit protections at the outset.