On June 6, 2023, the U.S. Bankruptcy Court for the Southern District of Texas confirmed the chapter 11 plan of bedding manufacturer Serta Simmons Bedding, LLC and its affiliates (collectively, "Serta"). In confirming Serta's plan, the court held that a 2020 "uptier," or "position enhancement," transaction (the "2020 Transaction") whereby Serta issued new debt secured by a priming lien on its assets and purchased its existing debt from participating lenders at a discount with a portion of the proceeds did not violate the terms of Serta's 2016 credit agreement.
The court also determined that: (i) the plan's nonconsensual exculpation provision was overly broad because it covered Serta's independent directors and managers, but was approved as amended to remedy this defect; (ii) the plan did not impermissibly indemnify lenders that participated in the 2020 Transaction; and (iii) distribution under the plan of $1.5 million to existing equity holders without paying in full the claims of nonparticipating lenders did not violate the "absolute priority rule" because equity provided "new value" in exchange. See In re Serta Simmons Bedding, LLC, 2023 WL 3855820 (Bankr. S.D. Tex. June 6, 2023), notice of appeal filed, No. 23-90020 (Bankr. S.D. Tex. June 6, 2023), stay pending appeal denied, No. 23-90020 (Bankr. S.D. Tex. June 21, 2023), stay pending appeal denied, No. 4:23-cv-2173 (S.D. Tex. June 29, 2023), direct appeals certified, No. 23-90026 (5th Cir. Sept. 18, 2023).
In November 2016, Serta entered into three credit facilities providing for $1.95 billion in first-lien term loans, $450 million in second-lien term loans, and a $225 million asset-based revolving loan. The credit agreement governing the loans (the "2016 Credit Agreement"), which the court characterized as a "loose" document because it gave Serta a great deal of flexibility to engage in liability management transactions, provided as follows with respect to assignment of the debt to "Affiliated Lenders" and Serta:
Notwithstanding anything to the contrary contained herein, any Lender may, at any time, assign all or a portion of its rights and obligations under this Agreement in respect of its Term Loans to any Affiliated Lender on a non-pro rata basis (A) through Dutch Auctions open to all Lenders holding the relevant Term Loans on a pro rata basis or (B) through open market purchases, in each case with respect to clauses (A) and (B), without the consent of the Administrative Agent[.]
Serta Simmons, 2023 WL 3855820, at *2 (quoting 2016 Credit Agreement § 9.05(g)) (emphasis added). Therefore, the 2016 Credit Agreement expressly allowed Serta to repurchase its debt on a non-pro rata basis by means of open-market purchases involving fewer than all of the lenders.
Section 2.18 of the Credit Agreement provided that pro rata sharing did not apply to "any payment obtained by any Lender as consideration for the assignment of or sale of a participation in any of its Loans to any permitted assignee or participant, including any payment made or deemed made in connection with Section 2.22, 2.23, 9.02(c) and/or Section 9.05." Id. (quoting 2016 Credit Agreement § 2.18).
Amendments to the 2016 Credit Agreement could be freely made with the consent of only a simple majority of the lenders, unless the amendment involved a "sacred right." Sacred rights, however, were subject to an exception for any purchase of debt under section 9.05(g):
[T]he consent of each Lender directly and adversely affected thereby (but not the consent of the Required Lenders) shall be required for any waiver, amendment or modification that: … waives, amends or modifies the provisions of Sections 2.18(b) or (c) of this Agreement in a manner that would by its terms alter the pro rata sharing of payments required thereby (except in connection with any transaction permitted under Sections 2.22, 2.23, 9.02(c) and/or 9.05(g) or as otherwise provided in this Section 9.02).
Id. (quoting 2016 Credit Agreement § 9.02(b)(A)(6)) (emphasis added).
After Serta began experiencing financial challenges (even prior to the pandemic), it began "to evaluate both liquidity enhancement alternatives and liability management alternatives designed to capture, discount, or otherwise manage [its] liabilities." Id. at *3. In connection with Serta's discussions with its lenders, two lender groups—the "PTL Lenders" and the "Objecting Lenders"—emerged with competing offers to address Serta's ongoing liquidity and financing problems. The Objecting Lenders, in fact, had acquired the majority of their debt holdings with the anticipation of entering into a position enhancement transaction with Serta that would exclude the PTL Lenders.
Serta ultimately elected to pursue the proposal offered by the PTL Lenders, which was consummated in the 2020 Transaction. The 2020 Transaction provided for the creation of a priority tranche of debt consisting of: (i) $200 million in new financing provided by the PTL Lenders; and (ii) $875 million in exchanged loans, with the first-lien loans exchanged at 74% and the second-lien loans exchanged at 39%. The Objecting Lenders were not invited to participate in the 2020 Transaction.
In June 2020, the Objecting Lenders, all of which were first-lien lenders, sued in New York state court to enjoin the 2020 Transaction. The state court denied the injunction based on the plaintiffs' failure to establish a likelihood of success on the merits. The Objecting Lenders filed a second suit in New York state court in 2022, seeking the same relief.
Armed with a restructuring support agreement supported by a majority of its lenders, Serta filed for chapter 11 protection on January 23, 2023, in the Southern District of Texas. Serta proposed a chapter 11 plan that, as later amended, provided for: (i) reduction of Serta's debt from $1.9 billion to $315 million by means of a debt-for-equity swap; (ii) new exit financing to be provided by the PTL Lenders in exchange for a "basket of consideration" that included indemnification by the reorganized Serta against any liability arising from the 2020 Transaction; (iii) payment of general unsecured claims in full; (iv) partial payment of certain other unsecured claims; and (iv) a $1.5 million payment to existing equity holders as consideration for the preservation of certain tax attributes. Serta's unsecured creditors' committee supported the amended plan as part of a global settlement with Serta.
The day after Serta filed for bankruptcy, the lead debtor and the PTL Lenders commenced an adversary proceeding against the Objecting Lenders seeking a determination that the 2020 Transaction was permitted by the 2016 Credit Agreement, and that the PTL Lenders did not violate the implied covenant of good faith and fair dealing under the 2016 Credit Agreement by entering into the 2020 Transaction. The Objecting Lenders asserted counterclaims and third-party claims seeking both a determination that the 2020 Transaction violated the 2016 Credit Agreement and money damages for the plaintiffs' alleged violations of the 2016 Credit Agreement's implied covenant of good faith and fair dealing. The parties filed competing motions for summary judgment.
In March 2023, the bankruptcy court awarded partial summary judgment to the PTL Lenders, holding that the term "open market purchase" in section 9.05(g) of the 2016 Credit Agreement was unambiguous, and that the 2020 Transaction constituted a permitted "open market purchase" under that section. The Fifth Circuit granted the Objecting Lenders' motion for a direct appeal of that order. See Excluded Lenders v. Serta Simmons Bedding, L.L.C., No. 23-90012 (5th Cir. Apr. 26, 2023). Briefing on the appeal had not been completed as of September 1, 2023.
While the appeal was pending, the bankruptcy court consolidated its consideration of confirmation of Serta's plan with the disposition of certain issues remaining in the adversary proceeding.
The Bankruptcy Court's Ruling
U.S. Bankruptcy Judge David R. Jones confirmed Serta's chapter 11 plan and overruled any objections that had not been resolved.
The Objecting Lenders opposed the plan and raised two objections. First, the Objecting Lenders argued that, by including an indemnity by the debtors in favor of the PTL Lenders for any liability related to the 2020 Transaction, the plan violated sections 502(e)(1)(B) and 509(c) of the Bankruptcy Code. Serta Simmons, 2023 WL 3855820, at *10. This argument was based on the Objecting Lenders' contention that the indemnity provision was a continuation of a substantially similar indemnity the debtors granted to the PTL lenders prepetition, rather than a new indemnity arising from a settlement in bankruptcy between the debtors and the PTL Lenders. Id. Second, the Objecting Lenders argued that the plan violated the absolute priority rule by providing for a $1.5 million payment to holders of equity interests while the Objecting Lenders' claims were not being paid in full. Id.
Judge Jones began his opinion by noting that the Objecting Lenders misconstrued Serta's plan in arguing that the plan violated sections 502(e)(1)(B) and 509(c) of the Bankruptcy Code by allowing Serta's prepetition indemnity of the PTL Lenders "to pass through the Plan unaffected." Id. He explained that the indemnification provision in the plan was new—it replaced a previous indemnification provision that expired upon Serta's bankruptcy filing. Moreover, Judge Jones emphasized, given the PTL Lenders' agreement to equitize nearly $1 billion in debt and provide exit financing, the new indemnity was a sound exercise of Serta's business judgment and represented a settlement that was fair, equitable and in the best interests of Serta's estate. He characterized as "irrelevant" the fact that Serta's decision "interfere[d] with the Objecting Lender's litigation strategy." Id.
Next, the bankruptcy court ruled that the $1.5 million to be paid under the plan to existing equity holders did not violate the absolute priority rule because Serta agreed to make the payment in exchange for "new value" in the form of a $54 million tax benefit held by equity. This decision too, Judge Jones noted, was a decision "in the range of reasonable business judgment." Id. at *11.
Addressing the adversary proceeding, the bankruptcy court stated that "based on the overwhelming evidence adduced at trial, the 2020 Transaction was 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 addition, Judge Jones determined, "the 2020 Transaction is binding and enforceable in all respects." Id. at *12.
According to Judge Jones, the evidence adduced at the trial undeniably demonstrated that: (i) the parties were "keenly" aware that the 2016 Agreement was a "loose document," and the Objecting Lenders understood what that entailed when they acquired the majority of their claims long after the debt was originally issued; (ii) there was no evidence of an improper motive on the part of Serta or the PTL Lenders, which, unlike the Objecting Lenders, acted "defensively and in good faith"; and (iii) neither Serta nor the PTL Lenders breached the 2016 Credit Agreement by entering into the 2020 Transaction. Id. at *13.
According to the bankruptcy court, the harsh result for the Objecting Lenders was entirely foreseeable and avoidable:
The parties could have easily avoided this entire situation with the addition of a sentence or two to the 2016 Credit Agreement. They did not. And this litigation ends with each party receiving the bargain they struck—not the one they hoped to get….
[Position enhancement 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.
Id. at **13-14.
Because the Objecting Lenders questioned the bankruptcy court's constitutional authority to enter either a final order on plan confirmation or a final judgment in the adversary proceeding, the court directed the parties to submit proposed findings of fact and conclusions of law that could be recommended to the district court in the event of an appeal.
Finally, Judge Jones found that "cause" existed to shorten the 14-day stay of the confirmation order specified in Fed. R. Bankr. P. 3020(e) to seven days, and stated that he was prepared to conduct an expedited hearing to consider any motion to stay the confirmation order pending an appeal and establish an appropriate bond.
Shortly after the bankruptcy court confirmed Serta's plan, the Objecting Lenders and creditor Citadel Equity Fund Ltd. ("Citadel") (collectively, the "Appellants") appealed the confirmation order to the district court and sought a stay of effectiveness of the plan. On June 21, 2023, the bankruptcy court denied the Appellants' motion for an emergency stay of the confirmation order pending appeal. On June 29, 2023, the U.S. District Court for the Southern District of Texas denied substantially similar motions for a stay pending appeal filed by the Objecting Lenders and Citadel. Immediately afterward, Serta announced that its chapter 11 plan had become effective, bolstering its argument that any appeal of the confirmation order will be equitably moot. As noted previously, the Fifth Circuit has already agreed to hear an appeal of the bankruptcy court's partial summary judgment ruling issued in the adversary proceeding. In addition, on September 18, 2023, the Fifth Circuit agreed to hear direct appeals of the confirmation order. As such, there are likely to be additional developments regarding this issue.
"Creditor on creditor violence" in the form of uptier transactions, whereby a borrower and certain of its existing lenders alter the repayment or lien priority of a portion of an existing loan to the detriment of other lenders, have featured prominently in recent headlines. Further developments regarding this contentious issue are likely, both from the appellate court(s) in Serta and from other courts, principally because the exponential growth of the $1.3 trillion leveraged U.S. loan market during the last decade has coincided with the loosening of loan covenants, including financial covenants and typical contract provisions obligating lenders to be repaid and otherwise treated on a pro-rata basis.
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