In a recent opinion issued in LCM XXII Ltd. v. Serta Simmons Bedding, LLC, No. 21-CV-3987, 2022 WL 953109 (S.D.N.Y. Mar. 29, 2022), US District Judge Katherine Failla of the Southern District of New York denied defendant Serta Simmons Bedding, LLC’s (“Serta”) motion to dismiss an action challenging its June 2020 non-pro rata uptier exchange transaction, thereby allowing the non-participating, minority lenders whose loans became subordinated to those of the participating, majority lenders to continue to pursue claims against Serta for breach of contract and breach of the implied covenant of good faith and fair dealing. Specifically, the court rejected Serta’s assertion that its uptier exchange transaction was expressly permitted under the underlying credit agreement because the court found the term “open market exchange” as used in the credit agreement to be susceptible to more than one reasonable interpretation and, thus, ambiguous. Accordingly, the court found no basis to dismiss the plaintiffs’ claims at the pleading stage.
The court’s reasoning in Serta is a partial victory for non-participating, minority lenders in a distressed debt market that has seen an uptick in uptier exchange transactions and subsequent litigation, commonly referred to by many in the industry as “lender-on-lender violence.” See, e.g., Audax Credit Opportunities Offshore Ltd., et al. v. TMK Hawk Parent, Corp., et al., 150 N.Y.S. 3d 894 (N.Y. Sup. Ct. 2021) (denying defendant’s motion to dismiss breach of contract claims relating to Trimark’s September 2020 uptier exchange); Compl., ICG Global Loan Fund I DAC v. Boardriders, Inc., No. 655175/20 (N.Y. Sup. Ct. filed Oct. 9, 2020) (challenging Boardriders’ September 2020 priming financing transaction by alleging that the transaction purportedly “unfairly favors” the controlling and allegedly conflicted equity sponsor and certain of the company’s first lien lenders to the detriment of the excluded, nonparticipating first lien lenders). Indeed, Judge Failla’s Serta ruling is likely to influence a potential challenge by the minority, non-participating lenders relating to Incora’s recent non-pro rata uptier exchange transaction. Press Release, Incora, Incora Completes Comprehensive Recapitalization (Mar. 29, 2022), https://www.globenewswire.com/en/news-release/2022/03/29.html
The Serta Uptier Exchange Transaction
In June 2020, Serta entered into a transaction (the “Transaction”) with a majority of its existing first lien and second lien lenders (the “Participating Lenders”)—not including plaintiff LCM funds who held approximately $7.4 million of Serta’s first lien loans—that created two new tranches of debt, both of which ranked ahead of Serta’s existing first-lien loans: (i) a $200 million new-money financing; and (ii) an exchange tranche comprised of $875 million of loans created through an exchange of the Participating Lenders’ first- and second-lien loans. As part of the Transaction, Serta obtained the approval of the Participating Lenders to amend the underlying loan documents, including the first lien term loan agreement (the “Loan Agreement”), toallow Serta to incur the priming loans. The plaintiff minority lenders were not privy to the negotiations and their consent to the amendments was not sought by Serta. Following the Transaction, the Participating Lenders held over $1.075 billion of super-priority loans with rights senior to those of the non-participating, formerly first-lien lenders, including plaintiffs.
Court Permits Claims for Breach of Contract and Lack of Good Faith and Fair Dealing
to Proceed to Discovery
Following the consummation of the Transaction, on May 4, 2021, the plaintiff minority lenders commenced an action alleging, among other things, that Serta breached the Loan Agreement in three primary ways when it engaged in the Transaction and ratified the amendments. First, plaintiffs alleged that the Transaction effectuated a debt exchange that did not qualify as an “open market purchase” authorized under section 9.05(g) of the Loan Agreement. Second, plaintiffs claimed that Serta violated their “sacred right” to receive pro rata payments under section 9.02(b)(A) by not seeking their consent prior to entering into the Transaction and amending the Loan Agreement, which allowed a select subset of first lien and second lien lenders to leapfrog plaintiffs’ priority rights. Third, plaintiffs alleged that Serta breached the implied duty of good faith and fair dealing by depriving the plaintiffs of their senior secured position in Serta’s debt stack.
Plaintiffs’ Breach of Contract Claim Allowed to Proceed Because the Agreement Did Not
Clearly Permit the Transaction.
The parties dispute whether the Transaction was expressly permitted by section 9.05(g) of the Loan Agreement. Generally, section 9.05(g) allows first lien lenders to assign their rights under the Agreement to Serta or its affiliates on a non-pro rata basis through either a Dutch Auction or an “open-market purchase” for the purpose of retiring the first lien loans. Serta claims that the Transaction qualifies as an open-market purchase of the Participating Lenders’ loans under section 9.05(g) of the Agreement. The plaintiffs contend that no aspect of the Transaction occurred in the open market since Serta negotiated in private only with a select subset of lenders and arrived at a price not set by open-market forces.
In rejecting Serta’s view, at least for purposes of a motion to dismiss, the court found that the term “open market purchase” was ambiguous and thus did not expressly allow the Transaction. To the contrary, the court reasoned that the Transaction did not take place in what is conventionally understood as an “open market” because it was negotiated in private and closed to a number of possible participants—i.e., the minority, non-participating lenders. Accepting the factual assertions in the complaint as true, Serta and the Participating Lenders agreed on pricing that served to induce the lenders to enter into the amendments allowing the Transactions—and not by pricing driven by conventional market dynamics. The court disagreed with Serta’s argument that “open market purchase” could only be equated with fair market value, i.e., the price obtained in an arm’s-length negotiation between a willing buyer and seller. The Court also did not find it determinative that the exchange followed a competitive process among many lender groups—a fact proffered by Serta. Instead, the court also found plausible the plaintiffs’ definition that an open market could reasonably be defined to mean a market in which “any buyer or seller may trade and in which prices and product availability are determined by free competition.” Because the court found that the term “open market” was ambiguous, the court held that plaintiffs sufficiently alleged a breach of section 9.05(g) of the Agreement for that cause of action to survive a motion to dismiss and proceed to discovery.
Plaintiffs’ Claims for Breach of the Implied Covenant of Good Faith and Fair Dealing
Allowed to Proceed as an Alternative Theory of Recovery.
In the alternative to their express breach-of-contract claim, plaintiffs allege that Serta breached the implied covenant of good faith and fair dealing. Under New York law, a duty of good faith and fair dealing is implied in every contract, to the effect that neither party “shall do anything which has the effect of destroying or injuring the right of the other party to receive the fruits of the contract.” Thyroff v. Nationwide Mut. Ins. Co., 460 F.3d 400, 407 (2d Cir. 2006). Further, the implied covenant includes promises that a “reasonable person in the position of the promise would be justified in understanding were included” in the contact and, when the contact involves the exercise of discretion, a promise “not to act arbitrarily or irrationally in exercising that discretion.” Dalton v. Educ. Testing Serv., 87 N.Y.2d 384, 389 (1995). Thus, a claim for breach of the covenant of good faith and fair dealing may only be brought where one party’s conduct, without breaching the terms of the contract in a literal or technical sense, nonetheless deprived the other party of the benefit of the bargain. See CSI Inv. Partners II, L.P. v. Cendant Corp., 507 F. Supp. 2d 384, 425 (S.D.N.Y. 2007).
In allowing the plaintiffs’ lack of good faith and fair dealing claim to proceed, the court held that plaintiffs had sufficiently pled, among other things, that: (i) plaintiffs expressly bargained for “first-lien, priority, pro rata rights,” which rights were subverted by Serta’s creation of a new tranche of debt with priority rights senior to the plaintiffs; (ii) Serta engaged in furtive negotiations with a select few creditors, manipulated the Loan Agreement to subordinate the plaintiffs’ debt without their knowledge, and struck a deal at plaintiffs’ expense; (iii) the manner in which Serta exercised its contractual power to amend the Loan Agreement constituted bad faith because the economic reality of the Transaction indicated an intent to harm a subset of first lien lenders by subordinating their loans; and (iv) to the extent the Loan Agreement permitted Serta to effectuate the Transaction, Serta offered the new priming loans to only a subset of first lien lenders, rather to all of them on a pro rata basis. Accordingly, assuming arguendo that the court ultimately finds the Transaction to be a permissible “open market purchase” under the Agreement, the court concluded that plaintiffs’ claim for breach of the implied covenant of good faith and fair dealing could survive. Thus, the court allowed the claim for breach of the implied covenant of good faith and fair dealing to proceed.
The court’s reasoning in Serta is a victory – for now – for disgruntled lenders excluded from their borrower’s non-pro rata uptier exchange transaction, even where the underlying loan documents arguably permit such exchange. As discovery proceeds, the Serta case bears close watching as a bellwether for how claims relating to such transactions may withstand summary judgment or be resolved at trial.