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April 11, 2022

Minority Lender Claims Against Serta Simmons Avoid Deep Sleep: Breach of Contract and Lack of Good Faith Claims Survive


A recent decision in the Serta Simmons Bedding, LLC (Serta) saga provides valuable insights into the viability of non-pro rata uptier exchange transactions and may embolden minority lenders whose loans have become subordinated to those of the majority as a result of such transactions. In a win for non-participating lenders, US District Judge Katherine Failla of the Southern District of New York issued an opinion denying Serta’s motion to dismiss the action challenging its uptier exchange and allowing the minority lenders to continue to pursue claims against Serta for breaches of the credit agreement and the implied covenant of good faith and fair dealing.1 The court concluded, among other things, that Serta may have breached the credit agreement’s “open market purchase” provisions in consummating the uptier exchange and violated standards of good faith and fair dealing in depriving the non-participating lenders of their seniority status in the debt structure. The court also found that the minority lenders had standing to bring such claims despite a no-action clause in favor of the administrative agent under the credit agreement.

The Uptier Exchange

In June 2020, Serta entered into a transaction (Transaction) with a majority of its existing first lien and second lien lenders (Participating Lenders) that created two new tranches of debt (Priming Loans), both ranking ahead of Serta’s existing first lien loans: (i) a $200 million new-money tranche; and (ii) an exchange tranche comprising $875 million of loans created through an exchange of the Participating Lenders’ first and second lien loans. Serta and the Participating Lenders negotiated and executed a series of amendments to the loan documents including the First Lien Term Loan Agreement (Agreement), which allowed the Transaction to be consummated.2

Funds managed by LCM Asset Management (Plaintiffs) were not included in the negotiations resulting in the Transaction and their consent to the amendments was not sought by Serta or the agent.3

The Court Permits Claims for Breach of Contract and Lack of Good Faith and Fair Dealing

After the Transaction closed, Plaintiffs--holders of approximately $7.4 million of existing first lien loans--brought an action alleging, among other things, that Serta (i) breached the Agreement by structuring a debt exchange that did not qualify as an “open market purchase” and, accordingly, violated the lenders’ rights to receive pro rata payments under the Agreement, and (ii) breached the implied duty of good faith and fair dealing by depriving the Plaintiffs of their senior secured position in Serta’s debt stack.

Open Market Purchase Provision Does Not Expressly Allow Transaction. In deciding that the Plaintiffs’ claims were properly asserted against Serta, the court found that the term “open market purchase”4 was ambiguous and did not expressly allow the Transaction.5 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 closed to certain potential participants and, rather than utilizing a price set by the market, used a price that ultimately would induce lenders to enter into the amendments allowing the Transaction. In making such findings, the court rejected Serta’s definition that an “open market purchase” should be equated with fair market value and the price that a willing buyer and a willing seller can obtain in an arm’s-length negotiation.

The court’s determination that it is unclear whether the definite and precise meaning of the term “open market purchase” would permit an uptier exchange undertaken privately by a borrower and a select group of lenders is undeniably a win for asset managers and lenders that are being left out of uptier exchange transactions. While many credit agreements in the wake of Serta have added clear anti-layering protections for minority lenders requiring the consent of all lenders or all affected lenders to effectuate a priming transaction unless each lender is afforded the opportunity to participate ratably, it should be noted that some recent credit agreements have taken a completely opposite approach, instead clearly defining open market purchase to include privately negotiated transactions at or below par for cash, securities or any other consideration with one or more lenders that are not made available for participation to all lenders. This new language appearing in credit agreements specifically allowing for privately negotiated exchange transactions will provide a much stronger basis for borrowers and participating lenders going forward to argue that Serta-like exchange transactions are permissible.

Breach of 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, meaning 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.”6 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 technical sense, nonetheless deprived the other party of the benefit of the bargain. The court in Serta found that the Plaintiffs’ lack of good faith and fair dealing claim could proceed because (i) Plaintiffs expressly bargained for first lien, priority, pro rata rights; (ii) Serta engaged in furtive negotiations with a select few creditors and manipulated the Agreement to subordinate the Plaintiffs’ debt without their knowledge and struck a deal at their expense; (iii) the manner in which Serta exercised its contractual power to amend the Agreement constituted bad faith because the economic reality suggests an intent to harm a subset of first lien lenders; and (iv) the new loan was only offered to a subset of first lien lenders rather to all of them on a pro rata basis7. The court further recognized that even an explicitly discretionary contract right may not be exercised in bad faith so as to frustrate the other party’s right to benefit under an agreement.8 Accordingly, even if the Transaction were ultimately found to be a permissible “open market purchase” under the Agreement, Plaintiffs’ claim for breach of the implied covenant of good faith and fair dealing could survive.

The court’s reasoning is notable because it focused on the manner in which Serta exercised its contractual rights to arguably effectuate the Transaction rather than the mere existence of such contractual rights. The court expressly found that Serta’s actions in excluding the Plaintiffs from the amendment process and in “systematically comb[ing] through the Agreement” to transform a “previously impermissible transaction into a permissible one” could constitute grounds for a claim of bad faith when it deprives a lender of the benefit of their bargain (in Serta, senior secured priority status).9 This finding is significant and is reminiscent of Judge Ramos’ comments in the state court litigation involving Not Your Daughter’s Jeans (NYDJ) where he took issue with the borrower excluding minority lenders from a non-pro rata process that ultimately significantly prejudiced minority lender recoveries: “And I’m really disturbed at what the Plaintiffs are alleging happened ... what they’re alleging is that a group of lenders, without notifying another group of lenders, on their own said look, we can do something for ourselves at the expense of our co-lenders...This sounds like a conspiracy. I know that’s not a separate tort, but it offends me.”10 NYDJ and the excluded lenders settled with the borrowers shortly after the court made these comments.

While each credit agreement, transaction and negotiation is different, the reasoning applied by Judge Failla likely will be utilized by disgruntled lenders that are excluded from discussions surrounding a non-pro rata transaction even where the credit documents arguably permit such transaction.

The Plaintiffs Maintained Standing to Bring the Lawsuit

Finally, Serta argued that the Plaintiffs were barred from bringing this lawsuit because the Agreement’s “no-action clause” provides that only the administrative agent has the right to bring such claims,11 and individual lenders cannot do so. This argument is a variation of the “collective action” jurisprudence that permits administrative agents under credit agreements to bring actions with majority lender consent even when individual lenders disagree with such actions.12

In Serta, as with the collective action case law, the court focused on the Agreement’s specific language which provided that “no Secured Party shall have any right individually to realize upon any of the Collateral or to enforce the Loan Guaranty…[which rights] may be exercised solely by the Administrative Agent on behalf of the Secured Parties.”13 Applying principles of strict construction, the court determined that the Plaintiffs’ claims did not fall within the Agreement’s proscription as they did not seek enforcement or payment of their loans or the conversion of noncash assets into cash assets.14Rather, the Plaintiffs’ claims sought an injunction and money damages for Serta breaching the Agreement. Accordingly, the court found that the Plaintiffs’ claims were not barred.

© Arnold & Porter Kaye Scholer LLP 2022 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.

  1. LCM XXII Ltd. v. Serta Simmons Bedding, LLC, 2022 U.S. Dist. LEXIS 57976 (S.D.N.Y. Mar. 29, 2022) (Serta).

  2. Among other things, the amendments modified the definition of “Incremental Equivalent Debt” permissible under the Agreement to include indebtedness issued under the credit agreement governing the two new senior tranches of debt. The amendments also authorized the administrative agent to enter into a separate intercreditor agreement establishing senior payment priority for the Priming Loans. Furthermore, the provision outlining the circumstances triggering mandatory prepayment of the first-lien loans were amended to affirm that the Priming Loans had rights of payment senior to that of the existing first lien lenders. The Amendments also eliminated the event of default triggered by the subordination of the existing first lien loans.

  3. See Serta, 2022 U.S. Dist. LEXIS 57976 at *2-13.

  4.  The undefined term appears in Section 9.05(g) of the Agreement, which states that “any Lender may, at any time, assign all … of its rights and obligations … in respect of its Term Loans to any Affiliated Lender on a non-pro rata basis … through open market purchases{.}”

  5. See Serta, 2022 U.S. Dist. LEXIS 57976 at *21-25.

  6. Thyroff v. Nationwide Mut. Ins. Co., 460 F.3d 400, 407 (2d Cir. 2006) (citation omitted).

  7. Serta, 2022 U.S. Dist. LEXIS 57976 at *48-49.

  8. Id. at *49 (internal citations omitted).

  9.  Id. at *14-16.

  10. Octagon Credit Investors, LLC v. NYDJ Apparel, LLC, No. 656677/2017 (N.Y. Sup. Ct. filed Nov. 1, 2018) (D.I. 91) Tr. 26:15-21; 27:20-21.

  11. Serta, 2022 U.S. Dist. LEXIS 57976 at *43-44.

  12. See, e.g., Beal Sav. Bank v. Sommer, 8 N.Y.3d 318, 321 (N.Y. 2007) (concluding that, in the absence of an express provisions regarding individual lender action, collective action was permissible pursuant to an analysis of the “specific, unambiguous language of several provisions, read in the context of the agreement as a whole”). New York collective action jurisprudence generally favors collective action in the absence of provisions expressly allowing individual holders to act. See, e.g., CNH Diversified Opportunities Master Account, L.P. v Cleveland Unlimited, Inc., 36 NY3d 1, 18 (N.Y. 2020) (“In stark contrast to the agreement at issue inBeal, the indenture in this case contained a specific provision . . . that affords each individual noteholder the absolute legal right to bring suit on its own behalf for payment of principal or interest, despite any “no-action clause” to the contrary . . . .”); A.I. Credit Corp. v. Gov't of Jamaica, 666 F. Supp. 629, 631 (S.D.N.Y. 1987) (finding individual lenders could sue to enforce borrower’s obligations where agreement expressly provided for such individual lender’s right). By contrast, “no-action clauses” are strictly construed—courts will not bar individual action that is not expressly barred by the terms of the no-action clause. See, e.g., Quadrant Structured Prods. Co. v. Vertin, 23 N.Y.3d 549, 560 (N.Y. 2014) (no-action clause which by its terms applies to rights and remedies under the provisions of the indenture agreement, but is silent on individual suits on the securities, does not preclude enforcement of a securityholder's independent common-law or statutory rights).

  13. Serta, 2022 U.S. Dist. LEXIS 57976 at *43.

  14. Id.