Serta Uptier Excluded, Participating Lenders Disagree on Purpose of Credit Agreement Sharing Provision, ‘Unclean Hands,’ Mitigation of Damages in Closing Arguments

Today Judge Christopher Lopez heard closing arguments on the validity of Serta Simmons’ 2020 non-pro-rata uptier exchange, with counsel for the excluded lenders and participating lenders primarily disputing the meaning of “payment” under the credit agreement, the good faith of the excluded lenders and the excluded lenders’ efforts to mitigate their damages. Judge Lopez took the matter under advisement and suggested he will issue a ruling within 80 to 90 days.

The judge’s decision will resolve six years of litigation over the bellwether liability management exercise in state, federal and bankruptcy courts. Almost exactly three years have passed since former judge David R. Jones granted summary judgment in favor of the company and participating lenders in March 2023. The U.S. Court of Appeals for the Fifth Circuit reversed that decision in December 2024, sending the dispute back to the bankruptcy court. Judge Lopez heard evidence over five days earlier this month.

According to Susheel Kirpalani of Quinn Emanuel, counsel for the excluded lenders, his clients’ claims for breach of section 2.18(c) of the first lien credit agreement – which he characterized as a lender ratable treatment provision – turn primarily on whether the issuance of new first lien first-out debt was a “payment” satisfying the participating lenders’ preexisting first lien debt. Kirpalani argued that the plain meaning of the undefined term “payment” in section 2.18(c) includes not just cash, but new debt.

It would be “commercially unreasonable,” Kirpalani suggested, if a group of lenders could circumvent the principle of equal lender treatment – which he said the Fifth Circuit recognized as fundamental – simply by paying off the favored lenders with new, more valuable debt instead of cash.

The participating lenders’ use of the term “cash turnover provision” to describe section 2.18(c) is a misnomer, Kirpalani said: that term is not used anywhere in the credit agreement, and is typically used for provisions in intercreditor agreements requiring lenders who receive inadvertent payments to hold them in trust. Section 2.18(c) is not a “cash turnover provision” but a guarantee that all lenders will be paid equally, whether in cash or new debt.

Gregg Costa of Gibson Dunn, counsel for the participating lenders, responded that section 2.18(c) is linked to section 2.18(a), which requires Serta to make payments of principal and interest in “immediately available funds” – e.g., cash – and U.S. dollars. “Payment was already defined to be in dollars” in section 2.18(a), Costa explained, meaning it did not need to be defined as cash again in section 2.18(c).

Costa also pointed out that section 2.18(c) requires lenders that receive disproportionate payments to purchase participations from other lenders in cash, which he said does not make sense if the payments were made in new debt. “In the context of 2.18(c),” Costa said, “the contract tells us it has to be paid in dollars,” and references to the meaning of “payment” in other credit agreement provisions, other contexts or “the dictionary” do not apply.

Treating section 2.18(c) as a cash turnover provision that does not apply to a cashless exchange or rollover is consistent with New York law and industry practice, Costa added. According to Costa, there is no prior example of a provision like section 2.18 being applied to a debt-for-debt exchange because it is well-understood that the provision is intended to address situations where a “computer error” or other issue results in an inadvertent cash overpayment to certain lenders.

The parties “understood that this was a loose credit agreement,” Costa further noted, suggesting general policy notions of equality among lenders do not override the plain language of section 2.18 in this context.

Costa also emphasized that it was an excluded lender – Angelo Gordon – that started a liability management exercise “race to the bottom” by making an unsolicited intellectual property drop-down transaction proposal. The participating lenders merely acted in self-defense by proposing the uptier, according to Costa; they “were not going to allow the collateral we were relying on to get pulled out from under us.”

In support of this argument, Costa cited former judge Jones’ findings at confirmation of the debtors’ plan that the participating lenders acted in good faith because the excluded lenders’ drop-down threatened their collateral. Those findings were essential to Jones’ determination of the excluded lenders’ implied covenant claims, Costa explained, and remain binding because they were not reversed by the Fifth Circuit.

It is “crystal clear” that the excluded lenders “threw the first punch,” and the participating lenders did “what anyone would do – we defended ourselves,” Costa asserted. Under these circumstances, Costa argued, the excluded lenders’ behavior “should not be rewarded.”

Kirpalani rejected Costa’s invocation of the unclean hands and in pari delicto defenses based on the excluded lenders’ alleged misconduct in proposing a drop-down. The equitable doctrine of unclean hands does not apply to legal breach of contract claims, Kirpalani argued, and the misconduct alleged by the participating lenders does not rise to the level required for the in pari delicto defense.

The excluded lenders’ purported wrongdoing – proposing a drop-down transaction, a “known technology” at the time – comes “nowhere near the level of misconduct required” by unclean hands or in pari delicto, Kirpalani said. According to Kirpalani, at most the excluded lenders had “unclean thoughts” about a drop-down that never happened.

Kirpalani also noted that Barings – one of the participating lenders – also proposed an IP drop-down transaction before joining the uptier.

Costa also highlighted issues with the excluded lenders’ damages calculations, calling their $400 million demand “pie-in-the-sky.” According to Costa, at most the excluded lenders suffered $30 million in damages from the transaction – as evidenced by their pre-transaction offer to pay the participating lenders $30 million to abandon the uptier proposal.

According to Costa, the excluded lenders really suffered zero damages because they had the opportunity to match the participating lenders’ proposed $0.74 exchange discount in negotiations with the company, but chose to stay at $0.78. Matching the participating lenders’ discount would have cost the excluded lenders approximately $31 million, Costa calculated – about the same amount as the $30 million offer. Accepting that offer would have been worse for Serta, Costa suggested.

The excluded lenders also failed to mitigate their damages by selling their loans in the market, Costa continued, pointing to testimony from the participating lenders’ damages expert, Yvette Austin. The evidence showed that “in the real world,” trades in the first lien debt – including purchases by Contrarian – were executed at prices very close to the indicative prices received by the excluded lenders, which were sometimes higher than the $0.74 discount the participating lenders agreed to, Costa said.

The reason only $186 million in first lien debt traded, according to Costa, was the co-op agreement executed by the excluded lenders in September 2021. That agreement “locked up” $634 million in first lien debt, Costa asserted, limiting the amount that could be traded.

Kirpalani countered that the excluded lenders were not required to mitigate by selling their loans rather than litigate over their contractual rights. The excluded lenders were “entitled to hold on to our loans until maturity and exercise our rights, and there is nothing wrong with that,” Kirpalani said. “This is America,” he added.

The excluded lenders nevertheless did take substantial steps to sell their loans, Kirpalani asserted. The members of the group monitored the market, engaged with brokers and retained Credit Suisse to conduct a “bespoke,” private-equity-style marketing process for their $700 million in loans, Kirpalani pointed out. “This is not a lender group that stuck its head in the sand,” Kirpalani remarked – the lenders were “struggling” with “how do we get out of this mess.”

Kirpalani also pointed to testimony from the excluded lenders’ damages expert, Marti Murray, that there was never sufficient demand in the market for the excluded lenders’ first lien loans. Kirpalani emphasized that the average trade in the first lien loans during the relevant damages period was $2.3 million, and “my clients held $700 million of this stuff.” Most damning, Kirpalani noted, was evidence that dealers were “stuck” with $44 million in first lien loans they could not unload.

At most, $186 million in first lien debt traded during the damages period, Kirpalani said, and there is no evidence the excluded lenders could have “displaced” all of those sellers, let alone sold more than $500 million in additional holdings without driving down prices.

Kirpalani denied that the co-op agreement prevented excluded lenders from selling their first lien debt and argued it was actually the post-uptier expanded disqualified lender list added to the first lien credit agreement by the participating lenders that limited liquidity. The expanded DQ list included “every natural buyer for deeply subordinated debt with litigation claims attached,” Kirpalani asserted.