After six years of litigation, the recent court decision awarding $261 million in damages to collateralized loan obligations (CLOs) and other lenders excluded from Serta Simmons Bedding's liability management exercise (LME) breaks little new ground. And that's good news for many lenders.
"The ruling is the first successful court challenge to a common form of [LME] built around 'open market purchase' provisions commonly found in syndicated credit facilities," according to a July 31 Mayer Brown report.
Those so-called up-tier transactions were prevalent several years ago and relied on the open-market purchase exception to skirt syndicated loans' pro rata sharing provisions that borrowers distribute value to lenders according to their percentage share.
If the defense had prevailed, it would have opened up a Pandora's box of LMEs.
Bankruptcy Judge Christopher Lopez's decision supporting the award largely stuck to the well-trod understanding of the pro rata provision, rather than agreeing with the defense's alternative.
"If the defense had prevailed, it would have opened up a Pandora's box of LMEs," said Kevin Eckhardt, deputy managing editor of legal, at Octus, a credit intelligence and data platform.
How we got here
Serta originated the $1.95 billion loan in 2016. In June 2020, it pioneered an aggressive up-tier LME that employed the open-market exception to skirt the loans pro-rata provision. That enabled a bare majority of lenders to transfer their senior positions to a new super-senior position, effectively subordinating lenders excluded from the transaction. Such aggressive transactions resulted in a rash of litigation.
The Fifth Circuit Court of Appeals decided in December 2024 that Serta's attempt to use the open market exception was invalid. The defense then presented a novel alternative argument that the pro rata provision only applies to cash payments, rather than the type of debt exchange that occurred in Serta's LME and occurs in most LMEs.
Had Judge Lopez decided in favor of the defense, "it would have created a hole in the pro rata sharing provision big enough to drive a nuclear submarine through," said Eckhardt, especially for aggressive LMEs that strongly favor participating lenders over excluded ones.
Critical Guidance
Mayer Brown said that Judge Lopez's decision provides important precedent for market participants, including a narrow interpretation of open market purchases that excludes privately negotiated exchanges, and that the transfer of value may include non-cash exchanges.
"The Serta litigation underscores that outcomes in up-tier transaction litigation are ultimately driven by the highly negotiated language of sophisticated parties' credit agreements, and that the financial consequences of varying from the language of the applicable agreements can be severe," Mayer Brown said.
In an August 7 note, BofA Securities said that many of the 134 CLOs listed as defendants in the litigation have either been liquidated and/or have equity net asset values (NAVs) that are negative or close to zero, significantly reducing recoverable damages.
It added that "the threat of litigation implies CLO managers likely view loan sales as a more effective way to deal with restructurings considering the legal costs involved in addition to the time, effort and infrastructure required to be involved in these cases."
