Six years after the underlying LME, Serta's lenders are staring at:
- A bill for $104.7m in damages and $56.9m in pre-judgment interest
- A fortnight to decide whether to appeal
- A set of payment mechanics that were never designed with a lender-on-lender judgment in mind
Our webinar on 21 July rounded up a tumultuous six-year saga for Serta Simmons. Our head of LMEs, Jane Komsky, was joined by the team at DLA Piper to discuss the mechanics of the judgment, its implications for CLOs and funds, and how documentation is already evolving.
DLA Piper speakers:
- Richard J. Reilly Jr, partner, co-head of structured finance
- Alex Cushman, partner
- Craig Martin, partner
- Alan Rockwell, partner
- David Parrish, partner, global head of private capital
Our top takeaways below answer key questions attendees were keen to get answers to.
And if you want to access the event recording, go here.
1. Where did the money come from?
The judgment landed on named entities, as “live CLOs, and CLOs that have been liquidated".
For live CLOs, payment mechanics are an indenture-by-indenture problem. Older vintage documents are tighter on what qualifies as an administrative expense, and even where the definition works, there is a cap, as Rich Reilly went on to explain.
"A couple of ways in which the CLOs could make a payment, is as an administrative expense at the top of the waterfall, assuming the definition is broad enough. But that's going to be subject to CAP, and the CAP is fairly low. So anything in excess of the CAP is paid at the bottom of the waterfall, just before the payment distributions and subnotes."
The other route is a contribution, either from the manager or, under more modern indentures, from any party. Older indentures restrict both who can contribute and what the contribution can be used for, and this too was discussed in the event.
Liquidated CLOs are the harder situation. Once the assets are gone, the indenture is discharged, the collateral management agreement terminates, and the vehicle itself winds up:
"These are probably 90% Cayman Islands CLO vehicles, they'll terminate; they won't exist anymore."
Chasing a judgment against an entity that no longer exists is, as Reilly put it dryly, "a more challenging situation", and that raises the obvious next question.
2. Can the plaintiffs go after the managers?
Reilly's take is that it's a hard argument to build, because a manager is subject to a standard of care and would have to be shown to be grossly negligent — a bar that is higher when the transaction was undertaken by several CLO managers acting in parallel.
Craig Martin added the point: "The judgment is against the named party, and so to get to a manager as a legal matter, there would have to be some theory asserted by which the manager could be vicariously liable for the named entity on the judgment.
“And as Rich said, the plaintiffs may be thinking about that, but that would require further enforcement process. It's not going to be automatic under this judgment as written."
David Parrish flagged one more source worth checking: "Is there an insurance recovery? Is there an insurance product out there that might be available from the named party to cover any of that risk?"
For payors outside the CLO stack, Alex Cushman went through the long-list of internal levers, including the balance sheet cash, available reserves, uncalled commitments, LP clawbacks, and fund-level financing facilities.
Beyond that, he floated three more creative options:
- Transferring the liability to a third party willing to price the risk of a lower future settlement
- Negotiating a structured payment that stretches the obligation over time
- For payors that need liquidity, tapping LPs for non-dilutive capital such as preferred equity
He noted the tools available to payees are just as important — including selling the claim on the secondary market, or borrowing against expected recovery through a receivables facility or litigation finance line.
3. What changes will emerge in future documentation?
The panel was united on the point that documentation is going to keep evolving — but split on how far.
CLO changes — placing LME types under a microscope
Reilly was measured on the CLO side; the changes, in his view, will be incremental rather than structural.
"Investors will take a closer look at the types of LMEs that their managers are entering into, or investing in. In terms of changes going forward, I don’t think it's going to give more flexibility; investors coming back with some additional steps, and maybe the rating agencies taking a view, but I don't think it's going to be dramatic."
The primary-market defence, Reilly argued, is at the investor-step level: investors will "reevaluate their LME step, to make sure that it's protective enough".
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The most obvious change he flagged was structural — avoiding participation in deals where excluded and participating lender classes are set up in the first place. "You wouldn't want to have an uptier priming transaction where you had excluded lenders and participating lenders."
David Parrish's reassuring headline for LPs is that fund docs on the sponsor side already do a lot of this heavy-lifting: "Most of the fund documents are actually built to manage the tail-end risk that this might provide, which turns out to not be tail-end."
However, he did flag where the drift is heading. "You're going to continue to see a drive for flexibility with more disclosure. And potentially pre-clearance of certain flexibility options on the solution side, to allow people to manage the liability risk exposure for doing these things."
Credit agreements — clarity vs flexibility
On the credit agreement side, Alan Rockwell noted the shift is already visible in the primary market. "A rough breakdown of credit agreements, even in the last 12 to 18 months upwards of 40% of new transactions now include a greater number of specifically enumerated exceptions."
Going forward, Rockwell expects contracts to spell out what a "payment" actually is — whether it captures a debt exchange, what qualifies as an open market purchase, and whether privately negotiated exceptions are permitted. But he was careful to flag that piling more items into the "sacred rights" bucket is not a costless move:
"It remains to be seen where the market will want to go, especially when you talk about embedding additional sacred rights into documentation. That could be a double-edged sword, and whilst it provides greater clarity, there are counter-arguments which suggest that sometimes having some degree of flexibility retained is not a bad thing."
4. Does this go back to the Fifth Circuit?
The judgment triggered a 14-day clock, and within that window, defendants have to decide whether to seek a stay and file an appeal.
A first-level appeal ordinarily goes to the supervising district court judge — but the original open market decision was certified straight to the Fifth Circuit, a mechanism available under the bankruptcy code for unsettled or first-impression issues. Whether that happens again is one of the open questions of the next fortnight.
The cost of staying the judgment is significant — a bond covering a stay-pending-appeal would need to cover the full judgment plus post-judgment interest at the federal rate. As Craig Martin puts it, "the bond would obviously be a significant portion in excess of $160 [million]".
Asked whether the underlying arithmetic might dissuade defendants from appealing at all, Martin was sceptical:
"It's hard to say with this many parties. This is a significant judgment that has great impact on broader than just the economics at stake, so there might be policy reasons to appeal it, and, if appropriate, to get a bond to stay the judgment. These are sophisticated, high-level institutions that don't have some of the same problems about posting a bond as, you know, smaller litigants might have."
Further reading
Check out our article on how much each CLO that participated in the LME will have to pay as part of the litigation award
Find out more about our coverage of Serta and other big names in distressed — get in touch for a free trial of the 9fin platform.
