Background

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.

Potential Implications

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.

Reuters reports that the New Jersey bankruptcy judge overseeing the bankruptcy proceedings of Johnson & Johnson subsidiary LTL Management will allowing certain talc tort cases against Johnson & Johnson to proceed while LTL Management proceeds in bankruptcy. Specifically, Judge Michael Kaplan has stated that he may allow some of the 38,000 lawsuits against Johnson & Johnson to continue, despite LTL’s bankruptcy, which lawsuits allege that the company’s talc products caused cancer. Previous decisions in the LTL bankruptcy proceedings found that the automatic stay applicable in that case immediately paused all legal proceedings against both LTL itself and Johnson & Johnson, per Section 362 of the Bankruptcy Code.

On June 15th, the Wall Street Journal reported on the Federal Reserve’s decision to raise interest rates by 0.75 percentage points, the largest one-time increase since 1994. Such move raises the Federal Reserve’s benchmark federal funds rate to a range between 1.5% and 1.75%. Federal Reserve Chairman Jerome Powell stated that the bank’s ultimate goal is to reduce inflation to 2% based on which experts predict the Fed to further raise rates further to as high as 3% by later this year. Chairman Powell also warned that it is becoming increasingly unlikely that the economy will achieve a “soft landing” (i.e., avoiding a recession while the Fed nonetheless continues to raise interest rates). The Federal Reserve has indicated that it is seeking to reduce the amount of market volatility that could persist until inflation is curbed and to restore price stability.

Bloomberg reports on June 14th that EV-Truck startup Electric Last Mile has filed for Chapter 7 bankruptcy relief in the District of Delaware Bankruptcy Court. The filing marks the first bankruptcy by an electric-vehicle startup, that went public via a SPAC transaction.  The startup’s founders had planned to import electric delivery vans from China and assemble them in Indiana but had to resign in February amid accusations of improper stock purchases before the SPAC merger. The company listed $100 million assets and $100 million liabilities in its petition. Unlike a typical chapter 11 filing, the filing of a chapter 7 petition will provide a path towards liquidation, rather than reorganization, of the company.

On June 15th, Bloomberg Law reported that drug manufacturer Mallinckrodt Plc. is finally close to exiting Chapter 11 protection. The company filed its chapter 11 petition in October 2020, in the District of Delaware and had already spent $100 million by 2020 in fighting opioid-related lawsuits. Since entering bankruptcy, the Company was further accused of price gouging and proffering questionable third party releases in its plan of reorganization. Nonetheless, the Bankruptcy Court confirmed a plan which will allow the Debtor to slash a considerable amount of its debt amount.

The Wall Street Journal reports on the surprise Thursday announcement from the U.S. Commerce Department that the U.S. gross domestic product unexpectedly shrank at a 1.4% annualized rate during the first quarter of 2022.  The WSJ does not expect the GDP report to alter the Federal Reserve’s plan to raise interest rates this year, including at its upcoming meeting this week.  Meanwhile, some are concerned that that this could be the start of a period of stagflation—stagnant economic growth combined with high inflation that, together, significantly weakens purchasing power. [WSJ; April 28, 2022]

Reuters provides an update on the Sackler family’s latest efforts to finalize settlements and obtain releases of opioid-related claims in connection with the Purdue Pharma bankruptcy.  The Sacklers had originally promised to contribute $5 billion to Purdue Pharma to pay claims under Purdue’s confirmed chapter 11 plan, but the District Court, on an appeal of the Bankruptcy Court’s plan confirmation order, rejected the plan, holding that the non-consensual releases in favor of the Sackler family were unlawful.  Purdue appealed further to the Court of Appeals for the Second Circuit, which held oral argument this past Friday.  At the argument, the Sackler family representatives noted that their contribution had been increased to $6 billion while also arguing that settlements of this nature, including non-consensual releases of claims under a chapter 11 plan, are not prohibited under the U.S. Bankruptcy Code.  A decision from the Second Circuit could have widespread implications, not just for the Purdue bankruptcy case but as to the lawfulness of non-consensual plan releases more broadly. [Reuters; April 29, 2022]

Law360 discusses recent developments in the chapter 11 bankruptcy cases of three non-operating affiliates of Alex Jones’ InfoWars enterprise.   Bankruptcy Judge Lopez of the Southern District of Texas scheduled the U.S. Trustee’s and tort claimants’ motions to dismiss the three bankruptcy cases for May 27, and stated that those motions would be heard before the InfoWars debtors’ motion to appoint trustees for litigation trusts.  The U.S. Trustee argues that the cases should be dismissed for cause as bad-faith filings because the cases “serve no valid bankruptcy purpose and were filed to gain a tactical advantage in the Sandy Hook Lawsuits.” Meanwhile, under the debtors’ proposal, Alex Jones and another related entity would fund up to $10 million into the litigation trusts, over time, for the settlement of defamation claims brought against Jones and InfoWars. [Law360; April 29, 2022]

SCOTUSBlog notes that the U.S. Supreme Court just agreed to hear a case that poses the question of whether Section 523(a)(2)(A) of the Bankruptcy Code may be used to exclude debts from an individual debtor’s discharge on the basis of “imputed fraud.” This provision of the Bankruptcy Code allows creditors to seek to exclude debts incurred via “false pretenses, a false representation, or actual fraud” from an individual debtor’s bankruptcy discharge, rendering such debts permanently nondischargeable.  By granting certiorari as to this case, the Supreme Court is positioned to resolve a circuit split as to whether fraud can be imputed to an individual who was entirely unaware of any wrongdoing, thereby rendering the innocent individual permanently liable for the fraud of another individual despite obtaining a discharge of other debts.  [SCOTUSBlog; May 2, 2022]

Bloomberg describes the latest example of a priming transaction that left minority lenders “fuming.” Recently, Incora, an aerospace supplier, announced a transaction with Silver Point Capital and Pacific Investment Management Co. in which it received new financing and will potentially save up to $90 million in interest expense. The transaction includes what Bloomberg characterized as “unusually aggressive moves” by its private-equity sponsor in which the sponsor’s existing unsecured debt was rolled up into secured debt.  [Bloomberg; April 5, 2022]

Russia missed bond payments due to foreign bondholders earlier this week. If the amount remains unpaid, Russia will default on its bonds in early May. According to the Wall Street Journal, new sanctions against Russia were largely to blame for the missed payment, as the U.S. government blocked Russia from using U.S. banks to channel payments on its foreign-currency bonds. Russia’s sovereign bonds are currently trading between 5 and 25 cents on the dollar. [WSJ; April 7, 2022]

The senior living industry (and healthcare more generally) continues to be under the watch for potential distress, as reported by McKnight Senior Living. The industry, which was operating at the margin prior to the pandemic, benefited from PPP and other stimulus funds, which are now rolling off. A BDO survey of 100 healthcare CFOs revealed that 50% of long-term / post-acute care and home health organizations defaulted on bond or loan covenants in the past 12 months (42% of healthcare organizations more generally defaulted on their covenants).  [McKnights; April 7, 2022]

The U.S. Senate has passed legislation that will raise the debt eligibility limit on small business filings back to $7.5 million, as reported by the American Bankruptcy Institute. The Small Business Reorganization Act (SBRA), which became effective in February 2020, provides small businesses with debts that fall within the eligibility cap a more streamlined path to restructure debts than typical Chapter 11 proceedings. The cap was increased in March 2020 to $7.5 million in response to the COVID pandemic, but that cap recently expired. The new legislation, if approved by the U.S. House of Representatives, will extend the $7.5 million limit for two years. [ABI; April 8, 2022]

Reuters reports that Mahwah Bergen Retail Group – the former owner of the Ann Taylor retail clothing brand – obtained bankruptcy court approval of its revised reorganization plan, from which certain non-debtor releases were removed.  The revised plan comes after the U.S. District Court for the Eastern District of Virginia held that the non-debtor releases contained in an earlier version of the plan were void and unenforceable. [Reuters; March 3, 2022]

Bloomberg reports on a new bankruptcy filing by Lear Capital Inc., a gold and silver coin dealer previously accused of deceiving customers.  The company was sued in recent years by both the City of Los Angeles and the State of New York for its deceptive business practices.  While those suits have since been settled, the company explains in its Chapter 11 petition that the bankruptcy process would help it simplify its process for resolving any potential future legal claims.  [Bloomberg; March 2, 2022]

Law360 discusses the United States Trustee’s recent filing in support of the dismissal of a Chapter 11 case filed by government contractor Team Systems International LLC.  The US trustee argues that Team Systems’ case appears to have been improperly filed merely to avoid a $6.25 million court judgment and should therefore be dismissed as having been filed in bad faith.  [Law 360; March 2, 2022]

According to a recent Fitch report, U.S. airlines generally avoided bankruptcies due to sizable liquidity balances, manageable debt and substantial government support while Latin American airlines were harder hit with three of Latin America’s largest carriers filing for Chapter 11.  [Fitch; March 1, 2022]

According to Reuters, businesses are contending with increased costs as supply chain issues continue to disrupt the economy. Companies have struggled to keep up with demand for consumer goods, which soared during the pandemic. Costs include rising prices for raw materials due to halted factory production and backlogs of ships waiting to unload cargo in American ports. Furthermore, employers must also factor in wage increases to attract and retain talent in an attempt to ensure that goods are produced and delivered as quickly as possible as labor shortages further compound the supply chain crisis. [Reuters; Feb. 25, 2022]

Yahoo Finance reports that the Federal Reserve has suggested raising interest rates in its semi-annual report to Congress, which was released on Friday. Citing a “strong” U.S. labor market, the Fed plans to raise rates at its March 15 meeting to counter high inflation. The Fed’s report also noted that lowering interest rates to nearly zero early in the pandemic contributed to elevated prices in riskier securities. [Yahoo Finance; Feb. 25, 2022]

Per Law360, Disney is once again battling a copyright infringement lawsuit from writer Jeffrey Scott, who claims the entertainment company stole his idea for a “Muppet Babies” spinoff in its 2018 reboot of the popular 1980s children show. Scott previously sued Disney in October 2020, alleging that Disney, which acquired Marvel Productions, failed to uphold his production deal with Marvel and Muppets’ creator Jim Henson by failing to pay him royalties and fees while employing his ideas for the reboot. The federal district judge in that case dismissed the complaint, ruling that Scott lacked standing because the claims were an asset of his bankruptcy estate. The Chapter 7 Trustee in Scott’s bankruptcy case revived the copyright infringement suit, filing a complaint on behalf of the bankruptcy estate in California federal court last Friday. [Law360; Feb. 22, 2022]

Fox Business reports that Boy Scouts of America’s insurer Chubb Ltd. has pledged to contribute $800 million to the Boy Scouts of America’s bankruptcy settlement deal. Boy Scouts of America, which filed for bankruptcy in February 2020, is currently on track to settle with approximately 82,500 tort claimants who claim they were sexually abused as children by troop leaders. The latest contribution by Chubb raises the total amount of available funds to resolve the claims to more than $2.7 billion. The fund is also backed by Boy Scouts of America’s primary insurer, the Hartford Financial Group, as well as the Church of Jesus Christ of Latter-day Saints. Ultimately, Boy Scouts of America’s emergence from Chapter 11 hinges on a settlement with tort claimants, and, while several victims have voiced support for the settlement deal, a separate committee of claimants voiced concerns that the deal compromises too much in exchange for a quick exit. The abuse claimants have until December 28th to vote on the reorganization. [Fox Business; Dec. 13, 2021]

Continue Reading What We’re Reading This Week [December 16, 2021]

Los Angeles Business Journal reports on the anticipated increase in bankruptcy filings by hotels in light of the uneven economic recovery and reduction of government support, as lender patience is expected to wear thin.

The Wall Street Journal writes that businesses are taking a wait-and-see approach to the new Omicron variant of Covid-19 that emerged last week.

The Economist assesses Jerome Powell’s agenda for his second term as chairman of the Federal Reserve.

LATAM Airlines announced on Friday that it has filed a chapter 11 plan of reorganization that the airline says has the support of its largest unsecured creditor group and various shareholders, and which will provide more than $8 billion of new equity, convertible notes, and debt to enable the company to emerge from chapter 11.

Hertz is making big news just months after emerging from its successful Chapter 11 bankruptcy. As reported by NBC News, Hertz has signed deals with Tesla (to add at least 100,000 Teslas to its fleet), Uber (to make up to half of those Teslas available to Uber drivers), and with Carvana (to sell its used vehicles to the used vehicle retailer for resale). Hertz had shed much of its rental car fleet during its bankruptcy and the pandemic-caused travel downtown, giving it the opportunity to rebuild its fleet with environmentally friendly alternatives.

A report on stablecoin from the President’s Working Group on Financial Markets was released on Monday, as covered by Reuters. The report recommends that Congress “urgently” pass a law to regulate stablecoin issuers. However, federal agencies such as the SEC and CFTC may be able to police certain aspects of stablecoin activity absent legislation. We’ve previously covered the risks that stablecoins posed to the financial system here.

The Wall Street Journal reports that Yango Group Co., a Chinese real estate developer, has proposed a bond exchange, pushing out maturities until September 2022, in hopes of preventing a default. The developer cited governmental policy, credit issues and consumer sentiment as reasons for it not having access to typical refinancing options.

As ESG continues to drive investment decisions, the Wall Street Journal considers an investor’s proposal that Shell—one of the best performing oil and gas companies on ESG metrics—divide into a “green” Shell and a “brown” Shell and sell off its oil operations.

Tether – the world’s largest issuer of “stablecoin” – has come under increased media and regulatory scrutiny in recent months as concerns over its liquidity have grown.  This, in turn, has led to increased concerns regarding the risk that Tether, and other stablecoin issuers, pose to the crypto economy specifically and to the global financial system more generally.

Continue Reading Is Stablecoin Stable? Media and Regulators Raise Concerns