Serta Simmons Bedding (SSB) was one of the first to litigate in federal court the propriety of an uptier transaction, which has made its Chapter 11 case better known for the rulings that the litigation produced than the fact that the mattress purveyor emerged from Chapter 11 with a USD 1.6bn overall debt load reduction.

The lenders that participated in the 2020 transaction at issue (represented by Gibson, Dunn & Crutcher) and the self-dubbed excluded lenders (represented by Quinn, Emanuel, Urquhart & Sullivan) have made their way through various courts in their disputes over the propriety of the transaction. On 7 July, Judge Christopher Lopez of the US Bankruptcy Court for the Southern District of Texas handed down the most recent ruling. He ruled that the participating lenders (which included, among others, Barings, Eaton Vance Management, Invesco Senior Secured Management, and UBS Asset Management) breached the credit agreement by participating in the 2020 transaction and that the credit agreement and New York law entitles excluded lenders (which included, among others, AG Centre Street, Silver Oak Capital, and Z Capital Credit Partners) to damages, including prejudgment interest.

Below, the Debtwire legal analyst team discusses key takeaways from Judge Lopez’s ruling, including why he rejected the participating lenders’ arguments that (i) no breach occurred, (ii) the participating lenders’ own conduct harmed their cause, and (iii) New York’s 9% prejudgment interest rate is too high under the circumstances. We also discuss why practitioners should be conscious of the wording not just in relevant provisions of credit agreements, but also the wording used in agreements governing exchange transactions, as both played a major role in the rulings.

In addition to reminding parties to carefully draft (and/or amend) their credit agreements or indentures and exchange agreements before engaging in LMEs, Judge Lopez’s decision also serves as a warning to creditors considering LME transactions in the future: courts may impose significant economic consequences – i.e., judgment in the hundreds of millions of dollars plus, as here, 9% annual interest on that amount that begins to accrue on the date the LME closes – if it is determined that the LME violates lenders’ sacred rights or otherwise breaches a credit agreement or indenture. More than a litigation risk, LMEs, when contested, can also carry significant monetary exposure for participants.

The 2020 uptier transaction

A high level discussion of the disputed uptier transaction is necessary to understand Judge Lopez’s ruling. In 2016, SSB issued USD 1.95bn in first-lien syndicated loans and USD 450m in second-lien syndicated loans, each governed by a separate credit agreement. SSB’s credit agreement governing the first lien loans prohibited SSB from paying its obligations to one lender while offering nothing to the rest. To further protect this sacred right of pro-rata sharing, the credit agreement generally required unanimous consent of any affected lender to waive, amend, or modify the ratable treatment provision in any way that would “alter the pro rata sharing of payments required thereby.”

While most provisions of the credit agreement could be modified with the approval of SSB and a simple majority of its lenders, the ratable sharing provision could not be modified without unanimous consent – subject to the following exception. The credit agreement permitted any lender to assign all or a portion of its rights and obligations under the credit agreement “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 . . . .” SSB qualified as an “Affiliated Lender,” and consequently was permitted to repay its loans without ratable sharing between lenders through either a Dutch auction open to all lenders or an open market purchase. The credit agreement contained a precise definition of the term “Dutch auction” but was silent as to what qualified as an open market purchase.

Under the transaction, the participating lenders provided SSB with USD 200m in new financing in exchange for USD 200m in first-out, super-priority debt. They also traded in USD 1.2bn of their first and second-lien loans for approximately USD 875m in second-out, super-priority debt. To facilitate the transaction, SSB and the participating lenders (which collectively held a bare majority of the outstanding first-lien debt) amended the first lien credit agreement and labeled the uptier transaction as an “open market” purchase.

SSB commenced its Chapter 11 case in January 2023 with USD 1.89bn in funded debt, USD 1.03bn of which was held by the majority consenting lenders who completed the 2020 debt exchange, and the remaining USD 862m of which was held by term loan lenders who did not participate in the uptier transaction.

Overview of the litigation

A brief summary of the litigation and rulings up to this point is also necessary. After SSB commenced its Chapter 11 case, SSB and the participating lenders sought declaratory relief against a number of lenders who held the first- and second-lien debt issued in 2016 but did not participate in the uptier transaction (i.e., the excluded lenders). More specifically, they sought a declaration that the uptier transaction (i) was permitted under the terms of the first lien credit agreement, and (ii) did not violate the implied covenant of good faith and fair dealing. The excluded lenders asserted various counterclaims in the action, including a claim for breach of contract. According to the excluded lenders, the uptier transaction (which they referred to as the “Unlawful Exchange”) and the agreements purporting to implement it violated the terms of the credit agreement and the implied covenant of good faith and fair dealing. The excluded lenders provided the following depiction of the uptier transaction in their answer to the participating lenders’ complaint.

Former Judge David R Jones of the US Bankruptcy Court for the Southern District of Texas granted partial summary judgment to SSB and the participating lender plaintiffs, ruling without much explanation that the term “open market purchase” was “clear and unambiguous,” and the uptier transaction was a valid “open market purchase” under the exception to the pro-rata sharing provision. In line with this ruling, former Judge Jones dismissed the excluded lenders’ counterclaims. Judge Jones certified his ruling for direct appeal to the US Court of Appeals for the Fifth Circuit (Appellate Court).

The Appellate Court ruled on 31 December 2024 that the uptier transaction was not permitted under the credit agreement. As the Debtwire legal analyst team discussed, the Appellate Court found that under New York State law, which governs the credit agreement, an open market transaction involving a syndicated loan must be one that is available to all participants in the secondary loan market.[1] In sum, the Appellate Court held that if SSB wished to make an open market purchase under section 9.05(g) of the credit agreement and thereby “circumvent the sacred right of ratable treatment, it should have purchased its loans on the secondary market. Having chosen to privately engage individual lenders outside of this market, SSB lost the protection of § 9.05(g).” 

Although the Appellate Court held that the uptier transaction was not permitted under the credit agreement, it did not rule that it constituted a breach of that agreement. Instead, it noted that if the 2020 transaction was not permitted under the open market purchase exception (and it held that it was not) the “Excluded Lenders have a strong case that SSB and the Prevailing Lender plaintiffs breached the 2016 Agreement.” The Appellate Court sent the matter back to the Bankruptcy Court to resolve the adversary proceeding in accordance with its ruling that the transaction was not permitted and reinstated the excluded lenders’ breach of contract claims.

Judge Lopez rules that the participating lenders breached the credit agreement

By the time the litigants returned to the Bankruptcy Court, SSB’s case was reassigned to Judge Lopez, as Judge Jones had resigned from the bench. Judge Lopez considered several issues in connection with the breach of contract and damages claims now before him, many of which depended in large part on section 2.18(c) of the credit agreement, which provides as follows:

Source: Bankruptcy Court Ruling

Guided by this language and appliable New York State law, Judge Lopez considered, among other things, whether:

• the USD 734m in first lien second out debt provided to the participating lenders in exchange for their USD 992m in first lien term loas was a “payment” in respect of such principal under section 2.18(c);
• such payment was “in respect of” principal on the first lien term loan; and
• participating lenders must pay damages plus prejudgment interest because they never purchased participations in the first lien term loans from the excluded lenders.

As further discussed below, Judge Lopez answered each of these questions in the affirmative. He then considered additional issues, including the proper calculation of damages and the impact, if any, of the excluded lenders’ actions on their rights to a recovery.

A debt exchange is a “payment” 

The participating lenders argued that the debt exchanged under the 2020 transaction was not a “payment” that triggered pro rata treatment under section 2.18(c). They pointed to section 2.18(a) of the credit agreement, which describes when and how a borrower must make payments, and how the administrative agent distributes payments to lenders. It requires such payments to be made “in Dollars.” According to the participating lenders, this means that the payment referenced in section 2.18(c) must be a cash payment (i.e., a payment in Dollars). Thus, they argued, that the debt exchange under the 2020 transaction is not a “payment” for purposes of section 2.18(c) because it was not a cash payment.

Judge Lopez disagreed, pointing out that the “Dollars” limitation is not included in section 2.18(c) which, he found, makes sense because this section is designed to protect ratable treatment between lenders in the same class of loans. He also found several other grounds supporting his ruling on this point. For one, he pointed out that section 2.18(c) distinguishes between borrower and lender payments by identifying non-cash exchanges as forms of “payment.”[2] Judge Lopez also stated that the parties included specific references to “Cash” in the credit agreement when they wanted to but did not do so in the relevant portion of section 2.18(c).

The participating lenders also argued that the industry understands that a “payment” only includes a transfer of cash. Judge Lopez rejected this argument, finding that New York State law “does not permit industry custom or practice to determine the meaning of a contract term when the meaning is found within the four corners of the contract.” Driving home his point, Judge Lopez stated that the participating lenders “structured the 2020 Transaction as an attempted open-market transaction falling within an express carve-out under § 2.18(c). It didn’t work, so § 2.18(c) applies. Under the plain language of § 2.18(c), the Participating Lender received a payment and no other carve-out applies.”

Payment received by the participating lenders was “in respect of principal”

Even if they received a payment for purposes of section 2.18(c), the participating lenders argued that they were not obligated to make payments to the excluded lenders because the payment they received (via the debt exchange) did not affect the principal due on first lien term loan and was not a principal or interest payment thereon. Again, Judge Lopez disagreed. This time, he based his ruling not only on the language of the credit agreement, but also on the wording of the exchange agreement.

He began by noting that “in respect of” is not defined in the credit agreement but is used several hundred times. As used in the agreement, he found that it broadly refers to matters concerning, regarding, or in connection with something. Next, he explained that the participating and excluded lenders were lenders in the same class of first lien term loans and, at the time of the 2020 transaction, all lenders were owed principal and interest on those loans. However, the participating lenders received a payment in the 2020 transaction that satisfied principal on the first lien term loan, and therefore it was “in respect of” their first lien debt because it was in connection with and concerning that loan.

Judge Lopez also cited the exchange agreement, which shows that each participating lender received a “Principal amount of Initial Exchanged Term Loans” that was equal to 74% of the “Principal amount of Purchased First Lien Loans” (i.e., the principal amount outstanding on each Participating Lender’s First Lien Term Loans). “As such, he found that “[t]he direct connection between the debt exchange effected during the 2020 Transaction and the satisfaction of the Participating Lender’s First Lien Term Loans could not be clearer.”

Moreover, Judge Lopez explained that, according to the exchange agreement, the participating lenders agreed to “sell, assign, and transfer” first lien term loans to Serta. And as “consideration” for the “sale, assign[ment] and transfer” of those loans to Serta, Serta gave the participating lenders first lien second out debt in an amount “equal to 74%” of the participating lenders’ first lien term loans. Thus, after Serta issued the new debt to participating lenders, it had to retire and cancel the first lien term loan debt it purchased, without any duty to pay it. Judge Lopez found that this “contemporaneous evidence leaves no doubt the new First Lien Second Out debt was a payment in respect of the First Lien Term Loans.”

Moreover, Judge Lopez explained that, according to the exchange agreement, the participating lenders agreed to “sell, assign, and transfer” first lien term loans to Serta. And as “consideration” for the “sale, assign[ment] and transfer” of those loans to Serta, Serta gave the participating lenders first lien second out debt in an amount “equal to 74.0%” of the participating lenders’ first lien term loans. Thus, after Serta issued the new debt to participating lenders, it had to retire and cancel the first lien term loan debt it purchased, without any duty to pay it. Judge Lopez found that this “contemporaneous evidence leaves no doubt the new First Lien Second Out debt was a payment in respect of the First Lien Term Loans.”

Judge Lopez summed up his findings in favor of the excluded lenders on their claim that the participating lenders breached section 2.18(c) of the credit agreement as follows: “The Participating Lenders received a payment in respect of their First Lien Term Loan without purchasing participations in Plaintiffs’ First Lien Term Loans. The payment the Participating Lenders received was on account of and in satisfaction of their First Lien Term Loan debt. The fact that the Participating Lenders exchanged their First Lien Term Loan at a discount is irrelevant. Section 2.18(c) focuses on whether the Participating Lenders recovered a greater proportion of their Loans than the proportion received by other Lenders. And they did. The Participating Lenders received a payment on their First Lien Term Loan. Plaintiffs received nothing.”

The excluded lenders did nothing wrong 

The participating lenders raised several arguments based on conduct by the excluded lenders, including that they sent Serta a proposed drop-down transaction and offered USD 30m to certain participating lenders if they would abandon their deal with Serta. The participating lenders argued before Judge Jones, and now before Judge Lopez, that this conduct demonstrates bad faith on the part of the excluded lenders and as a result, the excluded lenders were permitted to defend themselves.

They relied on statements Judge Jones made in an earlier ruling in the case. Specifically, when considering confirmation of Serta’s Chapter 11 plan and other issues raised in the adversary proceeding, Judge Jones considered the fact that Angelo Gordon, Gamut, and Apollo sent a drop-down proposal to Serta, and the excluded lenders’ made efforts to stop the 2020 transaction. Judge Jones noted that such conduct reflected the excluded lenders’ “objective lack of good faith.” And later in his decision, in resolving the excluded lenders’ implied covenant of good faith and fair dealing claim, Judge Jones said the participating lenders acted defensively and in good faith and that, on the “scale of equity,” it was the excluded lenders’ conduct that “raises an eyebrow.” The participating lenders argued that Judge Lopez was bound by these findings. Judge Lopez disagreed, finding that Judge Jones’ statements were dicta that is not binding on Judge Lopez.[3]

The participating lenders separately asked Judge Lopez to apply the doctrines of in pari delicto and unclean hands to limit the excluded lenders’ damages.[4] Judge Lopez found that Serta started a process “to obtain multiple proposals for any transaction and enable a competitive process to obtain the best terms available for the company.” As such, he concluded that Serta was the one who ultimately pitted the excluded and participating lenders against each other in bidding on a transaction. He stated that “acts relating to submitting a proposal that was never accepted, which was followed by Serta creating a competitive bidding process, or offering millions to stop a deal, and other related prepetition behavior by the Excluded Lenders does not rise to in pari delicto or unclean hands.”

The participating lenders also argued that the excluded lenders failed to mitigate their damages. They contended that the excluded lenders should have sold their first lien term loans on the secondary market after the 2020 transaction rather than holding them through a sustained decline in value. Again, Judge Lopez disagreed. He pointed out that by selling their loans, excluded lenders would have forfeited the right to assert breach of contract claims against the participating lenders, and they could not be required to abandon their claims.

Complex damage calculations

After finding that the participating lenders breached the credit agreement and that the excluded lenders’ actions did not prevent them from recovering damages (or otherwise reduce their damages), Judge Lopez turned to calculating the amount of damages owing under the credit agreement.

He explained that damages should “return the parties to the point at which the breach arose” and “place the nonbreaching party in as good a position as it would have been had the contract been performed.” He considered expert testimony to determine the appropriate measure of damages which, he noted at the outset, must be calculated as of the time of breach – i.e., the closing of the 2020 transaction. He also noted that section 2.18(c) obligates the preferred lenders to “purchase (for Cash at face value) participations in the Loans of other Lenders of such Class to the extent necessary so that the benefit of all such payments shall be shared by the Lenders of such Class ratably.”[5]

Because of this language, damage calculations must focus on the benefit received by the participating lenders, which was USD 734m of first lien second out consideration. Judge Lopez noted that the class across which that benefit was required to be shared ratably was the total outstanding first-lien principal of USD 1.887bn.

Source: Bankruptcy Court Decision

Judge Lopez further explained that every lender in the first-lien class was entitled to USD 0.389 per dollar of their principal holdings as the ratable share of the USD 734m benefit. The participating lenders received USD 0.74 per dollar on their USD 992m of holdings, which is above the ratable rate, while the plaintiffs received nothing. Thus, he held that the participating lenders owed the plaintiffs the difference between USD 0.389 and USD 0, applied to their first lien term loan holdings and arrived at an amount of USD 348m.[6]

The participating lenders argued that this calculation made no economic sense because it requires them to pay USD 348m for a participation arguably worth USD 87m at the closing date, and that no rational party at the time of the breach would agree to that deal. Judge Lopez defended his calculation by issuing what could be considered as a warning for other lenders considering similar transactions: “Sophisticated parties accepted the litigation risk that came with [the 2020 transaction]. And it almost worked. They litigated that risk successfully in New York state court and bankruptcy court. But the Fifth Circuit ultimately held the transaction was not an open market purchase. The result of the decision is that, based on the record and applicable law, § 2.18(c) now applies. Damages viewed from that perspective is not absurd. It is what § 2.18(c) was designed to protect. Strict textual analysis was required to determine whether the 2020 Transaction complied with the Credit Agreement as an open market purchase without triggering any sacred rights. Now the text must be strictly applied when assessing damages.”

Last but not least, Jude Lopez also ruled against the participating lenders on the issue of prejudgment interest. Under New York law, prejudgment interest on a breach of contract claim is mandatory, and the rate is 9% per annum. The participating lenders argued that the excluded lenders sat on their rights because they unsuccessfully tried to enjoin the 2020 transaction from closing in New York state court, dismissed their lawsuits, and then didn’t commence another lawsuit until two years later. The participating lenders also noted that they initially won before the bankruptcy court, with that ruling having been reversed by the Appellate Court. For these reasons, the participating lenders argued that 9% interest on a multi-hundred million damages claim over six years was too much. Judge Lopez disagreed. He held that equitable considerations do not come into play in this breach of contract case because prejudgment interest is mandatory. He therefore awarded the plaintiffs prejudgment interest at 9% per annum from June 22, 2020 through July 7, 2026, and directed the parties to submit a proposed order laying out amounts owing to each of the excluded lenders that remained in the litigation, as no amounts were owing to plaintiffs who had settled their claims.

Biggest takeaways

Judge Lopez had little sympathy for the participating lenders, noting several times in his decision that they were sophisticated parties who took on the risk that they could subsequently be held liable for breaching the credit agreement when they entered into the 2020 transaction. Like most other judges, he relied not only on the governing state law, but also the particular wording of the credit agreement.

Decisions like this one often remind parties to take particular care in drafting credit agreements (or to go back and double check the provisions of their existing agreements). Judge Lopez refused to find that the debt exchange was not a payment on account of the existing loan because, as the participating lenders argued, a “payment” can only take the form of a cash payment. Although other provisions of the credit agreement referred to payments in US Dollars – the relevant section of section 2.18 did not do so. If the parties wished to limit the application of that portion of the credit agreement to cash payments (as opposed to set-offs or debt exchanges), they could (and should) have done so, as they did elsewhere in the agreement.

In addition to credit agreements, parties should also take care when drafting their exchange agreements. Judge Lopez relied heavily on the language in the exchange agreement in finding that the payment participating lenders received for participating in the 2020 transaction was “in respect of principal” on their first lien term loans.

Judge Lopez instructed the parties to submit a proposed order that, among other things, lists the amounts owing to each of the remaining plaintiffs.[7] Although we expect that that portion of the proposed order will be redacted, it does not yet appear on the docket. Regardless, given the dollar amounts at stake and the precedential value of Judge Lopez’s ruling, we would not be surprised if the participating lenders were to appeal the Bankruptcy Court’s ruling.

 

 

Prior to joining Debtwire, Sara was a law clerk to two judges in the United States Bankruptcy Court, S.D.N.Y. and practiced in the Financial Restructuring Group at Clifford Chance, where she represented financial institutions (as secured and unsecured creditors, defendants in adversary proceedings, and participants in DIP financings) in high-profile restructurings. She also represented foreign representatives in Chapter 15 cross-border cases.

Any opinion, analysis or information provided in this article is not intended, nor should be construed, as legal advice, including, but not limited to, investment advice as defined by the Investment Company Act of 1940. Debtwire does not provide any legal advice and subscribers should consult with their own legal counsel for matters requiring legal advice.

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[1] In brief, the Appellate Court ruled that the uptier transaction was not an open market purchase within the meaning of the credit agreement because an open market purchase is a purchase of corporate debt that occurs on the secondary market for syndicated loans, and SSB’s uptier transaction was not offered on the secondary market – it was only offered to certain of its existing lenders. The Court explained that an “open market purchase” takes place on a market that is relevant to the purchased product – here, the secondary market for syndicated loans.

[2] Section 2.18 provides that “If any Lender obtains payment (whether voluntary, involuntary, through the exercise of any right of set-off or otherwise) in respect of any principal . . . .” Judge Lopez noted that a set-off is a non-cash exchange and that the “or otherwise” catch-all is also open-ended and not limited to cash. He found that debt exchange in the 2020 transaction is covered by the “or otherwise” catch-all. He also noted that section 2.18(c) provides a carve-out to ratable treatment for payments made under §§ 2.22, 2.23, 9.02(c), and 9.05(g), which are all non-cash payments. He reasoned that, if debt exchanges don’t trigger section 2.18(c), there would be no need to carve out these non-cash transactions. In addition, Judge Lopez pointed out that, under New York law, a specific contractual provision controls over a general one.

[3] Judge Jones held that the parties were sophisticated and knew the credit agreement was “loose” and understood the implication of its “looseness.” He also found that the participating lenders’ actions were taken for a legitimate business purpose and did not violate the implied covenant of good faith and fair dealing. The law of the case doctrine, as Judge Jones explained, does not apply to dicta. The participating lenders also argued that the excluded lenders waived their right to argue that they acted in good faith because they did not expressly appeal that portion of Judge Jones’ decision. Judge Lopez disagreed and held that the same principle applies to waiver; if a court’s conclusion was dicta, then it wasn’t actually decided. Moreover, Judge Lopez explained that the excluded lenders’ notice of appeal to the Appellate Court identified the summary judgment order and confirmation order as the orders being challenged, and that the waiver doctrine does not require a party to appeal every sentence in an opinion to preserve its arguments. “It requires a party to appeal adverse rulings. And dicta is not a ruling.” The participating lenders also argued that the excluded lenders ratified the 2020 transaction. Judge Lopez similarly rejected this argument.

[4] In pari delicto is an equitable remedy that bars a party that has been injured – as a result of its own intentional wrongdoing – from recovering for those injuries from another party whose equal or lesser fault contributed to the loss. The doctrine of unclean hands is also an equitable remedy that applies when “the complaining party shows that the offending party is ‘guilty of immoral, unconscionable conduct . . . and the party seeking to invoke the doctrine was injured by such conduct.’”

[5] Emphasis added.

[6] “The arithmetic to ensure the $734 million benefit is fully distributed is: Participating Lenders retain $992M / $1,887M × $734M = $386 million as their own ratable share; and the Plaintiffs receive $895M / $1,887M × $734M = $348 million.”

[7]As Debtwire reported, several excluded lenders dropped out of the litigation after entering into confidential settlement agreements.