Serta’s Chapter 11: Upholding the Uptier

The first weeks of summer are upon us, and that means flocks of summer analysts have descended on midtown and flocks of analysts are trying desperately to escape on weekends to Montauk with their laptops tightly tethered to their side.

It’s been a pretty hectic few months, but let’s do a little blast from the past and talk about Serta. They’ve just had their Plan of Reorganization confirmed, and Apollo, et al. have found themselves on the wrong end of a decision that they’re now appealing to the Fifth Circuit.

There are a few reasons, beyond nostalgia and self-interest, that it’s worth talking about Serta...

First, because the resolution of Serta’s case matters for those who’ve done more “creative” transactions over the past few years that haven’t panned out – setting a precedence, or the perception of precedence, for how courts, or a singular court, will handle these cases regardless of the specific type of “creativity” employed by debtors.

Second, because the question of how Serta’s non-pro rata uptier would be ultimately resolved was the cause of much spilt ink over the past three years – primarily surrounding the open-market purchase language in Serta’s credit agreement and, more philosophically, if the uptier breached the implied covenant of good faith and fair dealing. These issues, along with the arguments on either side, are something that I wrote about and prognosticated on in the twenty-three-page Serta Guide a few years ago (needless to say, the guide was written when credit markets were quieter, and I had much more free time!).

Third, because it gives us a chance to talk about Judge Jones who is, objectively, a hilarious character. But the level of self-assuredness he demonstrates – paired with his literary stylings and his clear love of “financial titans” who are engaged in “winner-take-all” battles – has rubbed some the wrong way.

Personally, I think many have been unfair to Judge Jones; taking his arguments less seriously by dint of their delivery and failing to engage with the substance behind them. If this were a longer post it’d end up being more of a defense of how he’s handled the Serta case overall and expressio unius est exclusio alterius – but that’ll have to be saved for another day. 

Note: To say this is a far longer post - at well over 6,000 words - than I planned on would be a massive understatement. But I wanted to give a bit of background, context, etc. so here we are. The post bounces around a bit when it comes to the timeline. However, in the end you'll (hopefully!) have a good feel for things.

Note: Also, needless to say, the finer details here aren't things you'll need to know for interviews. However, as discussed in the Serta guide and Incora posts, it's a good idea to know generally what uptiers, drop-downs, etc. involve and it'd be fantastic to have a general idea of how Serta's shenanigans have unfolded. So hopefully you enjoy this post!

Evercore, Drop-Downs, and Uptiers

Serta Simmons is one of the largest bedding manufactures and distributors in North America, and in November of 2016 they secured a new $1.95b 1L Term Loan, $450mm 2L Term Loan, and $225mm ABL.

But the rise of DTC mattress options, increasing manufacturing costs, etc. began to weigh on Serta even before the onset of the pandemic. So, to try to retain leverage before the business deteriorated too much, they engaged Evercore in late-2019 to begin exploring alternatives that could enhance liquidity, extend out some maturities, and (hopefully) capture some discount on its increasingly cumbersome capital structure.

Note: If you’re interested in more background, you can read the declaration from Serta’s Linker after they filed that touches on why the business deteriorated, etc.

In the end, as discussed ad nauseum in the Serta Guide, they ended up completing an uptier transaction in June 2020 whereby certain holders (e.g., Eaton Vance, Invesco, etc.) provided $200mm of new money in a new super-priority first-out tranche; exchanged ~$1000mm of existing first-lien loans, at a 74% exchange rate, and ~$300mm of existing second-lien loans, at a 39% exchange rate, into a new $875mm super priority second-out tranche; and created a third-out tranche for future incurrence, although it remained unfilled.

The reason for the kerfuffle that ensued in the wake of the uptier was that it was non-pro rata: not open to everyone, including some more notable players (e.g., Apollo, Angelo Gordon, etc.). And those left behind – around $895mm of first-lien debt and $128mm of second-lien debt – effectively became third-lien and fourth-lien, respectively. (Assuming that the empty super-priority third-out tranche wasn’t filled!)  

Serta Uptier Transaction Structure

Looking back, especially with how many drop-downs and uptiers have happened since, it’s difficult to remember fully how much of an impact the announcement of the transaction had.

It’s one of those relatively few times that a restructuring transaction causes a meaningful stir outside the industry. And it was certainly among the (very) few times that Apollo was on the receiving end of some sympathy, as the reflexive view among many, especially outside the industry, was that the transaction somehow went a step too far.

It was viewed as the opening of Pandora’s box, and many less active credit market participants began to worry that if even Apollo and Angelo Gordon could get outmaneuvered, then what chance do they have.

But let’s wind back the clock...

In 2020 the pandemic took hold and Serta’s already precarious prospects looked increasingly shaky. So, on April 7 2020, a somewhat ragtag group of holders – the PTL Lenders – banded together and reached out to the company to discuss potential options. Not hearing back, and thinking something was amiss, they reached back out on April 24 with a bit more meat on the bones: sending a proposal that outlined a solution to provide the company with additional liquidity that, importantly, would be open to all lenders.

The next week, after still not hearing back, it was discovered why: another group of holders – that we’ll call the Non-Participating Lenders, including Apollo, Angelo Gordon, etc. – presented the company with a drop-down (unrestricted sub transfer, think J. Crew) proposal back in March of 2020.

For this group, the impulse to do a drop-down was obvious: there was clear precedence for this style of transaction, the company had valuable assets that could be transferred to an unrestricted sub, and the company had ample basket capacity to effectuate the transaction.

So, the Non-Participating Lenders would simply lend new money against the unsub that now housed the valuable assets, and then exchange their existing debt into new debt at the unsub level. And, needless to say, this would all be non-pro rata (e.g., all existing holders wouldn’t be given the opportunity to participate). 

There was an ideal set-up here and the Non-Participating Lenders had been methodically building up their position within the 1L tranche to $575mm. They figured that any ragtag group of other holders that formed wouldn’t have the requisite size or sophistication to come up with a compelling proposal for the company, and this reality gave them the leverage, or so they thought, to exchange their debt at a higher rate (in other words, get a better deal).

The final deal put together by Apollo, et al. involved lending $200mm in new money and exchanging $630mm of existing 1L and 2L debt into approximately $470mm of new debt. This wasn’t too steep of an exchange discount given the increasingly precarious situation of Serta and would have actually raised Serta’s overall debt by $38mm along with its cash interest by $37mm.

But, like I mentioned above, it was the belief of Apollo, et al. that they were the only real game in town. So, if Serta wanted an infusion of new money to stay afloat longer, as they desperately did, they’d have to settle for the transaction terms being offered. Beggars can’t be choosers.

And, importantly, the Non-Participating Lenders were right to think this! The first few proposals from the PTL Lenders were uncompelling, and the reason why EVR didn’t engage with them was precisely because they pegged the chances of them ever offering something compelling, relative to the Non-Participating Lenders' offer, as minimal! (Hopefully I’m not sounding too defensive here...).

But on May 26 the PTL Lenders dropped a new proposal, taking advantage of their still larger and more diverse level of holdings of the 1L and 2L tranches. Within just nine days, the deal was wrapped up. There would be no drop-down, instead there would be a non-pro rata uptier.

In the wake of Serta’s decision to go with the PTL Lenders’ offer, the Non-Participating Lenders circulated an email that stated the obvious:

“Advent [Serta’s sponsor] has played our two groups [the Non-Participating Lenders and the PTL Lenders] off of each other and continues to do so… We concede that the Gibson/Centerview group [the PTL Lenders’ advisors] has outmaneuvered our group.”

This is an important piece of context because the litigation that followed had the Non-Participating Lenders feigning shock and indignation – pretending to be blindsided by the transaction and appalled at the company effectively allowing them to be primed by $1075mm of debt (with the capacity to incur further debt in a third-out tranche that was unfilled!).

But this was all performative to try to curry favor with the courts. In reality, the Non-Participating Lenders misjudged how much leverage they had until it was too late – when a new group, larger in size and incensed by the backroom dealings they were left out of, offered Serta something they couldn’t refuse.

The Non-Participating Lenders soberly assessed the situation in the immediate wake of Serta’s decision and, recognizing the perilous position they were in, tried to come up with an alternative deal at the last minute (e.g., tried to saddle up to the PTL Lenders, do a deal together, and buy some of the PTL Lenders’ holdings at a premium to current market pricing).

Serta - Exchange Offer (Email)

But the leverage had shifted and the PTL Lenders weren’t interested in détente. It was only then that the Non-Participating Lenders pursued litigation because it was a bit of a call option. In other words, there’s asymmetric upside as the worst that’d happen is they lose some legal fees, that pale in comparison to how much their 1L and 2L holdings would erode under the PTL Lenders’ transaction, but the best that can happen is the transaction gets unwound and their holdings return to roughly where they were before.

Serta’s Credit Agreement: Where the Trouble Began

With the conciliatory advance of the Non-Participating Lenders being rebuffed by the PTL Lenders, the Non-Participating Lenders did what anyone would do after a novel transaction: sued for an injunction over the “unlawful transaction” to kill it in the crib (in other words, stop the transaction from moving forward).

Judge Andrea Masley of the New York State Supreme Court denied the request, believing the transaction did not appear to violate the Non-Participating Lenders’ sacred rights and thus didn’t require their consent (despite the Non-Participating Lenders’ protest to the contrary).

Many were surprised when Apollo, et al. appeared to drop their pursuit of unwinding the transaction after Judge Masley’s denial. It seemed a bit against type, and many chalked it up to the fact that Apollo, et al. would be happy to do non-pro rata uptiers in the future so there’s no sense fighting it. And, indeed, Apollo has been on the right side of a few uptiers over the past few years.

But, in reality, they were just biding their time to perhaps relaunch their litigation. Because, as anyone would have thought, upon Serta’s transaction occurring a few other similar transactions quickly followed (e.g., Boardriders and TriMark). This then allowed folks to see how the inevitable litigation from non-participating lenders in those cases panned out.

It’s not the time or place to go through all this litigation – or else this post will balloon even further – but in March of 2022 Judge Katherine Failla denied Serta’s motion to dismiss a challenge against their uptier transaction brought by other non-participating lenders, and in October of 2022 Judge Masley denied Boardrider’s motion to dismiss a challenge against their uptier transaction brought by non-participating lenders. 

Sensing the judicial mood had slightly shifted – along with concerns rising about Serta filing and their position in the capital structure potentially becoming crystalized – on November 3 2022 the Non-Participating Lenders (e.g., Apollo, Angelo Gordon, Contrarian Capital, etc.) took another kick at the can to try to unwind the transaction.

You can read the complaint here, and below you can see the heart of the argument (e.g., that the “Unlawful Exchange Transaction” was not an “open market purchase”) along with the reference to the other Serta case that spurred Non-Participating Lenders to try, try, try again...

Sacred Rights Argument - Credit Docs

Anyway, we may be getting a bit ahead of ourselves, but with Serta filing the question of whether or not this was really a prohibited transaction or not took center stage. For obvious reasons: if the transaction was upheld the Non-Participating Lenders would stand to get a pittance – just 1% of the post-reorg equity of the company given their lowly location in the capital structure.

Therefore, this was one of the last opportunities for the Non-Participating Lenders to give themselves the chance, however slim, to foist themselves back up the capital structure and get some meaningful recovery in the now seemingly inevitable filing.

So, let’s turn to the Credit Agreement and talk about the sections that Judge Jones – the presiding judge in Serta’s chapter 11 – refers to in his opinion that (spoiler alert!) upholds the transaction.

As mentioned earlier, in November 2016 Serta secured a new $1.95b 1L Term Loan, $450mm 2L Term Loan, and $225mm ABL. The Credit Agreement in question was relatively loose at the time it was written, a reflection both of the relative health of the company and of credit markets at the time.

But it’s important to keep in mind that this was a more innocent time in credit markets, well before drop-downs and non-pro rata uptiers firmly entered the lexicon and became seared into the minds of bleary-eyed lawyers when reviewing credit docs. 

There’s been much ado about the looseness of the Credit Agreement, and the slightly sloppy wording of it. It’s true that the insertion of a line or two could have prevented the transaction from occurring, but it’s always easier to play offense than defense in these situations (e.g., take advantage of loose docs as opposed to anticipating how loose docs could be taken advantage of in the future). But even with that caveat, the Credit Agreement was “loose” in more traditional ways (e.g., it had no anti-subordination clause). 

Note: This is going to be a quick and dirty breakdown, so if you’re unclear on the linkages I’m making just pop open the links above and CTRL + F the sections noted below. Just be mindful that the way anyone discusses these sections is through the lens of their preferred outcome!

So, first, there’s the question of additional debt incurrence: namely, does the Credit Agreement actually allow for additional debt to be issued? This isn’t really a point of contention, as Section 6.01(z) expressly allows for $200m of additional incurrence – and those now litigating the transaction pitched Serta on a transaction that’d also result in $200m of additional incurrence.

Second, and more importantly, we get to the issue of if Serta can repurchase, at a discount, existing loans from lenders on a non-pro rata basis. Here’s what Section 9.05(g), in part, says...

Section 9.05 Credit Agreement - Serta

So, per Judge Jones, this means the Credit Agreement allowed for Serta to repurchase their debt from existing holders through a standard auction process that’s open to all holders, or through open-market purchases that could be non-pro rata (e.g., not open to everyone).

Expressio unis est exclusion alterius: if open market purchases must be similarly “open to all lenders” then it would have been, or should have been, specifically stated as it was for Dutch Auctions. The silence speaks volumes, at least per Judge Jones.

Third, we have the issue of amendments. In order to effectuate the transaction, certain amendments to the Credit Agreement needed to be made. And, per Section 9.02(b), amendments can be made so long as more than 50% consent with the exception of a small selection of “sacred rights” – among them the pro-rata sharing provision.

These sacred rights require the consent of each lender directly or adversely affected by the amendment – both of which would be true in any non-pro rata transaction where you’re on the outside looking in. However, Section 9.02(b)(A)(6) contains an explicit carve out for non-pro rata open market purchases. Here’s what that Section, in part, says along with some adversary complaint commentary that we’ll touch on more later...

Section 9.02 Credit Agreement - Serta

Finally, there’s Section 2.18(c) that, in part, states that pro-rata sharing does not apply to “...any payment obtained by any Lender as consideration for the assignment of or sale of a participation in any of its Loans to any permitted assignee or participant, including any payment made or deemed made in connection with Section 2.22, 2.23, 9.02(c) and/or Section 9.05.” 

Given these linkages, the transaction being prohibited or not boils down to what the meaning of the term “open-market purchase” really means and if this transaction really represents an open-market purchase. Thus, in a hearing that we’ll discuss shortly, attention was turned toward narrowly nit-picking this issue in every conceivable way given the term isn’t defined in the Credit Agreement.

But the suspicion of counsel to the Non-Participating Lenders was that Judge Jones already had a meaning in mind, and that this meaning would be consistent with the transaction being permitted. Either way, if you’re arguing before someone who you think is already pre-disposed against your argument, this isn’t an ideal way to start ingratiating yourself no matter how much backpedaling you then do...

Serta Oral Arguments - March Hearing

Serta's Filing and the Fallout

Evercore’s creative out-of-court rejiggering bought some time – but the mattress market is merciless, and the turnaround Serta was hoping for never quite materialized (if you’re curious, you can read the aforementioned Linker declaration for more details on why they filed). 

Serta ended up entering into a restructuring support agreement earlier this year that contemplated the business delevering from around $1900mm pre-reorg to $315mm post-reorg, and then filed on January 23 in the Southern District of Texas down in Houston (the hottest new venue in the world of restructuring literally and figuratively).

The next day, January 24, Serta, Invesco, et al. filed an adversary proceeding against the Non-Participating Lenders seeking a declaratory judgement that i) the uptier was actually permitted under the 2016 Credit Agreement and ii) they didn’t violate the implied covenant of good faith and fair dealing.

Exactly a month later, the Non-Participating Lenders filed their answer, counterclaims, etc. seeking the uptier be unwound, money damages be paid for breach of contract, etc. This then set off a tit for tit, none of which we really need to get into, prior to Judge Jones conducting a hearing on the summary judgement motions on March 28 that was briefly mentioned in the prior section.

This is where things got interesting, as Judge Jones granted Serta’s motion for summary judgement on the open-market issue at the end of the hearing – and did it with a level of panache that made some smirk and some simmer. (He left the good faith and fair dealing issue for a trial we’ll discuss shortly). 

In his oral ruling Judge Jones said that the uptier was “very clearly” consistent with the open-market purchase language – in fact, he seemed bemused at the very idea someone could think otherwise saying the decision was “very easy” for him because he deals with credit agreement disputes “every single day” and “Sophisticated parties know what words they want to choose [in credit agreements] ...”.

I mean the Non-Participating Lenders built up the vast majority of their position in the run up to pitching the drop-down, so they didn’t choose any words and self-evidently didn’t foresee the transaction that ended up eventually occurring. But, as you’ll soon see, we need to pick our battles on what pontifications from Judge Jones we discuss, so we’ll let that slide.

Judge Jones clearly thinks that all the litigation – pre-filing and post-filing – about whether the uptier was permissible was just Apollo, et al. trying to extract empathy from some judicial rube who would fall for their faux outrage. And, like, he’s not completely wrong here.

But Judge Failla’s aforementioned prepetition ruling was that the phrase “open-market purchase” was too ambiguous to rule for Serta on, and there has been countless hours of commentary, on both sides, regarding the validity of Serta’s transaction.

When Judge Jones swats away any notion of this being a thorny question, it is a bit of a disservice to everyone – even those that agree with the outcome. It strikes me that Judge Jones is fastidiously focused on not appearing naïve – he wants to make it clear to everyone that he’s wise to the games that these “financial titans” (his words, not mine!) play with each other and he’s not going to be hoodwinked. 

But suggesting in his oral ruling that these financial titans “…do these transactions all the time”, when he’s referring to a relatively novel transaction is showing another kind of naïveté – just not one that Apollo, et al. in this instance can take advantage of.

Note: Rest assured, given the outcome here, when Apollo, Angelo Gordon, etc. are on the other side of the table down in the Lone Star State they will be sensationally sycophantic, saying basically: “The transaction at issue here is just a few financial titans battling for priority, as has been happening since time immemorial – and those on the other side are pulling out the old playbook of trying to relitigate their loss, hoping against hope that a judge will be moved by their insincere indignation.”

Anyway, the oral ruling from Judge Jones more or less set in stone the outcome here: the Non-Participating Lenders wouldn’t be given an inch, and Serta’s Plan would get confirmed. But it still needed to be wrapped up, so a joint trial was set on May 15 to consider confirmation of the Plan and to resolve the remaining adversary claims (e.g., the good faith and fair dealing question). 

The evidentiary trial took place the week of May 22 with closing arguments on May 25. The Seconded Amended Plan of Reorganization was filed on May 23 after Serta ironed out some issues with the Unsecured Creditors’ Committee and after Judge Jones requested that the death trap provision be removed from the Non-Participating Lenders’ class.

Note: To be honest, it was a bit of insult to injury to add the death trap provision to the Non-Participating Lenders’ class (Class 5). So, don’t say that Judge Jones is invariably debtor-friendly – sometimes he throws a bone to down-and-out creditors!

But the vast majority of the Plan stayed intact from the beginning: the FLFO (First-Lien First Out) Claims get their pro rata share of New Term Loans post-reorg; the FLSO (First-Lien Second Out) Claims get 100% of post-reorg equity subject to dilution and the remaining New Term Loans after distribution to FLFO holders (total New Term Loan size is $315mm); and the Non-PTL (Non-Participating Lenders) Claims get a pro rata share of 1% of post-reorg equity. (If you’re curious, you can read the full Plan here starting on page 64 of this PDF).

Many have suggested that the evidentiary hearing was tantamount to a (very expensive!) show trial, as Judge Jones was clearly going to confirm the Plan, regardless of what objections manifested, and decide the good faith question in favor of the debtor.

But this strikes me as a “head I win, tails you lose” kind of argument – although Judge Jones may have regretted having such a drawn out trial, as the Non-Participating Lenders stepped back up to the batting box talking about how unfair it was that they weren’t invited to participate in the uptier. Something Judge Jones was not amused with, since the open-market kerfuffle was supposed to be settled back in March...

Adversary Complaint Hearing Commentary

To his credit, he didn’t really provide any hints about how he’d come down at the end of closing arguments. In fact, he hinted at there being a glimmer of hope for the Non-Participating Lenders in his delivery of a kind of therapy-on-the-bench style monologue saying, “I have a lot of issues that have been raise that I haven't thought about. I have the responsibility to think about those issues. I'm doing everything I can do, I've cancelled my vacation, none of my staff is allowed in next week. There's some things I need to reread. There are some things I need to check on. Whether I grant confirmation, enter a declaratory judgment, deny confirmation, or do it in parts, the outcome is irrelevant to me. I just care about one thing, I just want to get it right.”

Anyway, a few weeks later we got the goods, and you can read his post-hearing opinion running through, and dismissing, the objections from the US Trustee, Non-Participating Lenders, etc.

<Note: In his written opinion he revisits his thinking regarding the meaning of "open market purchase" with a bit more depth - although some would say that's a low bar - by citing dictionary definitions, the context of the Credit Agreement, etc.

There was never much doubt about any classic confirmation considerations being roadblocks – the point of the prolonged trial was really to address the good faith and fair dealing question and, with that resolved, confirm the Plan.

So, here’s the crux of the good faith and fair dealing question...

Serta - Good Faith and Fair Dealing - Adversary Complaint

Per the thinking of Judge Jones, a court “...should provide a level of deference in reviewing agreements negotiated and executed by sophisticated parties” and “may not insert contractual terms where none exist”.

The natural implication of this is that since this situation could have been avoided with the addition of a line or two – or perhaps even a few well-chosen words – it’s not the job of Judge Jones, or anyone else, to come to the defense of holders who were on the wrong side of a transaction. You live and you learn.

Good Faith and Fair Dealing - Adversary Proceeding Findings

There is an underlying issue – never addressed by Judge Jones directly – that this is all well and good, but the nature of the transaction was not something envisioned (no pun intended re: Envision) at the time of drafting, or at the time that holders took their positions. 

The reality is that nearly all credit docs, relative to twenty years ago, are loose: but there’s a difference between existing creditors complaining about something like additional pari incurrence, something that’s explicitly allowed for or not in the docs, and more “creative” solutions where even those designing and implementing them aren’t entirely sure about their legality.

This is the blind spot of Judge Jones that I’ve alluded to before: his belief that this transaction is just another iteration, with perhaps a novel wrinkle at best, in a long string of transactions involving “financial titans” going tit-for-tat in “winner-take-all” battles.

And this explains his seeming animus towards the Non-Participating Lenders. Basically saying, “I can’t believe you had the audacity to keep coming back to me, and to appeal my prior decision, when you clearly just have sour grapes because you didn’t get your way in doing the drop-down.”

Judge Jones - Adversary Opinion

In his final salvo, Judge Jones unleashes the line that will live in infamy about “financial titans engaged in winner-take-all battles” and reiterates his findings as if there were any doubt: the uptier is consistent with the Credit Agreement, and no breach of the implied duty of good faith and fair dealing occurred.

Adversary Complaint Conclusion

Note: PET here refers to “position-enhancing transaction”, an acronym coined by Judge Jones to describe uptiers, drop-downs, etc. in a (potential) power play to make lawyers grovel by both repeating and extending it in increasingly cringe-inducing ways. I won’t attribute this quote to the lawyer who spoke it into existence in the closing arguments of the trial, but I’ll leave it here for you to contemplate: “My argument is that this transaction is more like an emotional support peacock than a dog or a cat, and it shouldn't be allowed.” God help us all.

Anyway, power-play acronyms aside, this strikes me as self-evidently the right outcome. The core thesis of Judge Jones is merely that it’s not the role of a court to depart from a strict reading because an outcome seems inequitable. In a case involving sophisticated parties, whether they’re financial titans or not, the onus is on them to ensure they know what they’re signing up for and to see around corners – especially those more shadowy corners involving undefined terms.

Additionally, it’s telling that in the wake of Serta there was much fanfare about closing “loopholes” in existing credit agreements that’d allow for a Serta-style transaction. But now, three years on, there isn’t unanimity: many existing credit agreements, and newly drafted ones, still allow for this style of transaction to occur. It’s now, just like any other aspect of a credit agreement, a bargaining chip. If lenders want it omitted, they need to make concessions.

It would be one thing if, in the wake of Serta’s transaction, the “loophole” was closed for every existing credit agreement and every new one precluded a similar transaction from occurring. Perhaps then it’d signal that Non-Participating Lenders were the unlucky few – taken advantage of in a way that no one else will be moving forward and thereby signaling that what occurred to them was somehow beyond the fray in its inequity.

But this isn’t the case, and context surrounding how this transaction came to be matters to Judge Jones. The Non-Participating Lenders were initially in the driver’s seat (remember: the PTL Lenders couldn’t even get anyone to return their calls at first!) but then, suddenly, they weren’t. And, as the Non-Participating Lenders conceded in the wake of the uptier being announced, they were simply outmaneuvered by Serta, the PTL Lenders, and their advisors.

In my view – for however much value you want to ascribe to it – on the critical issues (e.g., the open-market purchase language and the good faith breach) the reasoning of Judge Jones is reasonable, albeit light on details, and the outcome is right. And if you were to pump sodium pentothal into those irked over the way he’s handled the case, they’d begrudgingly agree that he got it right where it mattered most.

The issue is that Judge Jones has a habit of appending commentary – where none is necessary, and no one is asking for it – that tends to betray the very kind of naïveté he’s trying to demonstrate that he doesn’t have. 

I’m not talking about more innocuous lines like the one about financial titans. That isn’t my cup of tea, but whatever. I’m talking here about the line that shortly follows: “The risk of loss is a check on unrestrained behavior.”

It’s one thing to lose a case, as Apollo, Angelo Gordon, etc. were anticipating they would here, but having a line like this thrown in does rub one the wrong way. I haven’t heard of anyone having an aneurysm after reading this line, but there were surely some bumping up their blood pressure medication.

To read this line charitably, it’s saying Apollo, et al. played a stupid game and won a stupid prize. The PTL Lenders initially wanted to do a deal open to everyone, were rebuffed, found out about the drop-down, and then used their larger holding size to offer something even better to Serta that the Non-Participating Lenders couldn’t match.

So, the thinking goes, presumably, that distressed funds will think twice before doing these kinds of transactions (“unrestrained behavior”) because someone else could find out their plan and put together a deal that undermines them. Ergo, the risk of loss being a check.

But Serta is relatively unique. It’s not the norm to see two groups – that, when taken together, represent the vast majority of holdings within a given tranche – pitching true non-pro rata solutions against each other. The point of these transaction is you can offer the company more new money, or more discount when exchanging your current holdings, by dint of being placed in a better position within the capital structure where few others reside – the “value” you’re getting circuitously comes partially through the destruction of value of your (former) compatriots in the capital structure.

Therefore, you want to find the minimally viable number necessary to get a deal done. It can’t be too small, as maybe another group will form leaving you on the outside, and you’ll need a majority for any amendments. But it can’t be too big or else the economics may start making less sense (e.g., taken to an extreme, exchanging at a discount and providing new money along with 95% of existing holders, leaving just 5% behind, isn’t going to be overly enticing).

If you’re a sophisticated holder, and you’re looking at credit docs that allow for a more creative transaction, when evaluating “the risk of loss” you’re naturally going to think about some other group preemptively doing something to you. So, ironically, you have an incentive to do “unrestrained behavior”, sometimes the most “unrestrained behavior”, and hope that litigation pans out in your favor or that you can craft follow-on transactions, at worse terms but that require participants consenting not to pursue litigation in order to participate, that makes litigation never materialize in a meaningful way (see: Envision’s very well executed strategy).

Here's another way to put it: Random CLO LLC that holds 0.05% of some tranche isn’t going to get a seat at the table in any context. They’re per se engaging in no unrestrained behavior, and likely aren’t too familiar with the unrestrained behavior others could get up to. They’re just minding their business and clipping their coupons. But yet it’s exactly this kind of holder that’s at the greatest risk of loss in these transactions or, put another way, the only one who is definitely not going to win (at best they’ll be given scraps through a somewhat coercive follow-on transaction).

I don’t know. I’ve heard many interpretations of this line over the past few weeks, most shot through with expletives. It doesn’t matter, and it’s a throwaway line. Perhaps it’s a Zen Koan. A sentence for all of us to carefully contemplate, with its meaning never quite revealing itself but through which we’ll all find enlightenment.

Regardless, if you’re a lawyer on Incora, now before Judge Jones with its own adversary proceeding, you better be relentlessly repeating, “The risk of loss is a check on unrestrained behavior.” Don’t worry about what it means, for there’s only one person who needs to know what it means – and rest assured he most assuredly does.

Note: In the adversary complaint filed by Wesco (Incora) it took just six pages before we got a reference to Serta and how Judge Jones handled it – a prelude of what’s to come as they seek to have Judge Jones rubberstamp their uptier that we’ve discussed several times.

Note: The most charitable reading is perhaps that Judge Jones is referring to the unrestrained behavior of the company in creating the credit agreement to begin with. In other words, the risk of loss to lenders, if a company were to utilize the flexible language contained in the credit agreement, should be a check on allowing this loose language to be inserted. It’s a stretch.

Scandalized Over Serta

In the past few months we’ve seen a spat of companies that have pursued more “creative” out-of-court transactions bite the bullet – some, like Incora and Envision, suspiciously soon after completing their transactions and suspiciously soon after the various preliminary proclamations and pronouncements of Judge Jones on Serta that signaled his support of the transaction.

This has led to some cheekily calling this the new Texas two-step process: you do an uptier or drop-down, or in the case of Envision both, and then file soon after with the highest classes in your capital structure now being full of creditors more amenable to getting through court quickly.

The undertone of disapproval – that this is all, in some handwavy way, not right – is something I wrote about (read: ranted about) a bit in last month’s postscript, so won’t relitigate here. But it’s a bit hard for me to pinpoint what exactly everyone seems so scandalized over.

The reality is that Serta, facing an increasingly precarious situation, chose the transaction structure that bought them the most time and there’s no doubt that it did. That was, undoubtably, the primary aim of the transaction and they played two groups, both of whom held significant amounts, against each other perfectly to extract the best deal that’d maximize their runway moving forward.

But, insofar as the secondary aim of the transaction was to make any eventual filing, should one occur, more seamless through more easily signing up a restructuring support agreement, especially one that delvers the company more than they would’ve been able to with their pre-transaction capital structure, then that strikes me as entirely rational and reasonable.

When it comes to the PTL Lenders, the primary motive in the moment was, obviously, to provide a compelling enough offer that it’d be accepted – thereby ensuring the current value of their holdings didn’t get decimated by the Non-Participating Lenders doing a drop-down. The natural consequence of being higher up in the capital structure is then being able to get a higher recovery in-court and potentially extract some additional economics (e.g., through providing the exit financing, etc.).

But it’s not preordained – at the time of the transaction or now – that those recoveries will be better than just having clipped those FLFO and FLSO coupons. The PTL Lenders have self-evidently won the battle, but they haven’t yet won the war (read: earning a relatively healthy return over the duration of their holding period!). 

Anyway, the thrust of Judge Jones argument, even if the delivery could use some work, strikes me as right. Although the appeal to the Fifth Circuit makes it clear that they really didn’t appreciate how Judge Jones divined his views...

Fifth Circuit Appeal - Serta

Somehow I don’t imagine Judge Jones cares too much. He has Incora, GenesisCare, Instant Brands, and Diebold to deal with now – enough to delay many more of his vacations, and enough to make many more lawyers contemplate their life decisions, leave the world of restructuring behind, and retire to little hobby farms in Vermont in pursuit of quieter lives far removed from Houston.

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