Judge Lopez Hits Serta Participating Lenders With $261M Breach Judgment Plus 9% Prejudgment Interest; Rejects ‘Cash Payment’ Loophole, ‘Unclean Hands’ and Other Defenses

Relevant Document:
Memorandum Opinion

On remand from the U.S. Court of Appeals for Fifth Circuit, Bankruptcy Judge Christopher Lopez issued a detailed 48-page opinion last night, July 7, holding that the participating lenders in Serta Simmons Bedding’s 2020 non-pro rata uptier exchange breached the credit agreement’s ratable-sharing provision, awarding excluded lenders and the LCM lenders $261.13 million in damages plus 9% prejudgment interest running from the June 22, 2020 closing.

The opinion resolves six years of litigation stemming from the 2020 transaction in which Serta raised $200 million of new financing in the form of first-out superpriority debt and exchanged $1.2 billion of first and second lien term loans for about $875 million in second-out, superpriority debt. To do so, Serta amended its 2016 first lien term loan agreement to allow it to incur incremental debt and to authorize the administrative agent to enter into a separate intercreditor agreement for these new loans. Upon amending the 2016 agreement, Serta executed the superpriority term loan agreement with the participating lenders and an exchange agreement.

Judge Lopez held a trial in March on whether the participating lenders breached the 2016 credit agreement. The excluded lenders asserted the participating lenders breached the 2016 agreement’s pro rata sharing provision, claiming more than $400 million of damages.

The defendants’ liability is “several and not joint,” according to the opinion. Each remaining participating lender defendant owes its own proportionate share of the damages based on its first lien term loan (or FLTL) holdings as of the 2020 closing, with Apollo Global Management’s recovery separately capped at 50% under a prior stipulation which deemed half of the applicable debt purchases at issue to be null and void. In other words, a defendant’s share does not grow simply because other defendants settled.

Judge Lopez requires the plaintiffs to submit a proposed form of final judgment that names each remaining defendant, the face value of its FLTL holdings as of the 2020 closing, and its proportionate share of the adjusted damages total plus prejudgment interest.

Notably, the awarded prejudgment interest – calculated as 9% simple interest under New York law from the June 22, 2020, closing to the July 7 judgment date – is no small amount and estimated to be roughly about 54% of the unadjusted judgment amount, although recognizing each defendant’s individual judgment will vary based upon their share of FLTL holdings.

Breach of Contract Dispute

The central dispute addressed in Judge Lopez’s opinion was whether the debt-for-debt exchange constituted a “payment” under section 2.18(c) of the credit agreement, which requires a lender receiving disproportionate recovery to purchase participations in other lenders’ loans “for Cash at face value.”

The participating lenders argued that the sharing provision did not apply to debt exchanges, citing language in section 2.18(a) that all payments under the credit agreement “be made in Dollars.” Such language, they maintained, limited “payment” to cash transfers – meaning their exchange of $992 million in first lien term loans for $734 million in new first lien second out debt fell outside section 2.18(c) entirely.

The participating lenders also invoked Judge Michael Kaplan’s May Del Monte decision, arguing that it supports the argument that a cashless debt-for-debt exchange does not involve a payment that triggers pro-rata sharing obligations. In Del Monte, Judge Kaplan found that a $247.5 million DIP roll up was a cashless exchange that did not trigger a pro rata sharing provision. Judge Lopez does not discuss Del Monte in the opinion.

Instead, Judge Lopez finds section 2.18(c)’s open-ended “or otherwise” language and its express carve-outs for ratable treatment for non-cash transactions would be “surplusage” if debt exchanges were categorically excluded. “If debt exchanges don’t trigger [section] 2.18(c),” the judge writes, “there would be no need to carve-out these non-cash transactions.” He also invokes the canon that “a specific contractual provision controls over a general one,” holding that section 2.18(c)’s tailored carve-out structure overrides section 2.18(a)’s general provision requiring borrower payments to lenders in dollars.

The payment received by the participating lenders was “‘in respect of’ their First Lien debt because it was in connection with and concerning the First Lien Term Loan,” Judge Lopez continues. Pointing to the signature pages of the exchange agreement, which note that the participating lenders each received a principal amount of initial exchanged term loans equal to 74% of the principal amount outstanding on their first lien term loans, Judge Lopez concludes the “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.”

Judge Lopez also finds that the new first lien second out debt was a payment on the FLTL debt and that the participating lenders and excluded lenders were all in the same class of loans under the 2016 credit agreement. Contemporaneous evidence, including provisions of the exchange agreement and its signature pages, which show the amount of purchased first lien term loans each participating lender sold to Serta and the corresponding new second out debt each received, “leaves no doubt” of the structure of exchange, the court says.

Finally, Judge Lopez says the participating lenders received payment in respect of their first lien term loan without purchasing participations in the excluded lenders’ first lien term loans. The fact that the participating lenders exchanged at a discount is irrelevant because section 2.18(c) focuses on whether the participating lenders received a greater proportion of their loans than the proportions received by other lenders. “And they did,” Judge Lopez concludes.

The participating lenders separately argued that a majority-lender amendment had ratified the transaction as an “open market” purchase. Judge Lopez dismisses this position as a repackaged version of the argument the Fifth Circuit already rejected, noting the credit agreement required “unanimous” lender consent to alter pro rata sharing – the very protection that would become “illusory” if a lender majority could vote it away.

Equitable Defenses

Various equitable defenses raised by the participating lenders also fail, the opinion states.

The participating lenders asserted the “unclean hands” and “in pari delicto” defenses, citing the excluded lenders delivery of a proposed drop-down transaction to Serta and a $30 million offer to certain participating lenders to abandon their deal with Serta. Judge Lopez rejects the defense, however, because Serta never accepted the offer and the judge finds that the excluded lenders never acted in bad faith by making an offer and that there “was no injury to the Participating Lenders.” He further finds the unclean hands defense unavailable as a matter of law because the action sought only damages, not equitable relief.

In relation to the equitable defenses, Judge Lopez separately declines to treat as binding certain comments made by prior bankruptcy judge David R. Jones in 2023 about the excluded lenders’ objective lack of good faith when he granted partial summary judgment for Serta and the participating lenders on the open market purchase issue. Judge Lopez rules such comments were “non-binding dicta” that were “not necessary to any part” of the ruling.

A failure-to-mitigate defense fared no better. The participating lenders specifically argued the excluded lenders should have sold their FLTL loans on the secondary market after the 2020 transaction closed, rather than hold them as they declined in value. Judge Lopez finds the participating lenders “did not carry their burden” of proving the defense, stating “there was no meaningful market for Plaintiffs to sell their positions, and no real offers to buy their debt.”

Relying on rebuttal expert testimony from Marti Murray over the participating lenders’ expert Yvette Austin, Judge Lopez concludes the secondary market for the debt was too thin and illiquid – only $162 million traded against plaintiffs’ $700 million-plus position – to support a viable exit. The judge also notes that selling would have extinguished the lenders’ breach claims altogether, and rules the “mitigation doctrine does not require a plaintiff to abandon a claim it regards as existential to spare the breaching party a portion of the damages its breach caused.”

Damages Calculation

To determine how much the participating lenders owed for their breach, Judge Lopez adopts the “time of breach” methodology proposed by the excluded lenders’ expert Louis Dudney over the “time of emergence” approach, holding New York law measures contract damages as of the breach date rather than three years later at Serta’s emergence from bankruptcy.

The calculation relies on a “but-for world” versus “actual world” comparison to pinpoint the exact economic harm the excluded lenders suffered.

First, the court determines the total “benefit” the participating lenders received in the 2020 transaction when they traded their legacy debt for $734 million in face value of new, higher-priority senior debt.

Because the credit agreement requires that benefit to be shared proportionally across all $1.887 billion of the outstanding first-lien debt, every lender in the class was entitled to roughly $0.389 per dollar of principal they held. Since the excluded lenders held $895 million of that legacy debt, their proportional share of the $734 million benefit came out to a $348.17 million baseline. That sum is the cash payment that section 2.18(c) required the participating lenders to make to buy “participations” in the excluded lenders’ loans.

Second, to calculate final damages, the court weighs what the plaintiffs should have received against what they were left with, factoring in that Serta’s legacy debt was trading at a distressed market price of $0.25 on the dollar on the day of the breach.

Under the “but-for world” approach (if the contract was followed), the excluded lenders would have received the $348.17 million cash payment. Because that cash effectively purchased a portion of their legacy debt, their remaining legacy debt holdings would drop to $546.83 million. At the $0.25 market price, that remaining debt was worth $136.71 million. That brings their total hypothetical position to $484.88 million.

Under the “actual world” approach (what really happened), the excluded lenders received no cash and simply held onto their entire $895 million block of legacy debt. At the $0.25 market price, this left them with a stagnant position worth only $223.75 million.

By subtracting the actual world value ($223.75 million) from the but-for world value ($484.88 million), Judge Lopez arrived at the final net damages figure of $261.13 million. A chart in the opinion summarizing the calculation can be viewed HERE.

Judge Lopez rejects the defendants’ arguments that using the contractually defined face value was economically unrealistic. He rules that because sophisticated parties chose to take on a known litigation risk by bypassing the agreement’s sharing protections, the clear text of the contract must now be strictly enforced.

Other Findings

Judge Lopez also finds that Contrarian Capital “acquired the rights to seek recovery on the breach of contract claim” when it acquired a $39 million position after successfully removing itself from the DQ list.

Contrarian purchased notes between September 2021 and December 2022, and the court finds that each counterparty assigned all rights and obligations in its capacity as a first lien term loan lender, including all claims and causes of action arising under the 2016 credit agreement. Additionally, the standard terms and conditions for assignment and assumption warranted that the interests were free and clear of any encumbrance or adverse claim and the administrative agent accepted the assumption and assignment documents.

Taken together, the court concludes this evidence shows Contrarian’s assignments are valid and enforceable against the participating lenders.

The court also dismisses the defendants’ arguments that the LCM lenders abandoned their breach of contract claim based upon a Fifth Circuit statement that the LCM lenders had dropped their final judgment appeal during oral arguments. Judge Lopez rules the breach claim was alive and well, noting the Fifth Circuit explicitly clarified that the LCM lenders were not barred from recovering damages based on the open market issue, and that they properly filed amended counterclaims on remand tracking the specific breach and sharing requirements of Section 2.18(c).

Earlier this week, Judge Lopez entered a stipulation among the excluded, LCM and settling lenders dismissing third-party claims and counterclaims pursuant to a confidential settlement.