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In 2010, we noted the behavioral change by senior lenders willing, by majority rule, to form a Newco, acquire collateral and drag-along the minority, whether as part of a "credit bid" or, more accurately, a non-cash bid that distributed new debt and equity instruments ratably to all debt holders. (Randall L. Klein and Danielle Juhle, "Majority Rules: Non-Cash Bids and the Reorganization Sale," 84 Am. Bankr. L. J. 297 (2010)). We argued then that the power of the majority was constrained by the duty of good faith; but, the doctrine of good faith, prevalent in the late 1800s and early 1900s, had been underutilized by courts and practitioners. We predicted, based on the increase in litigation among debt holders, that courts would revisit the doctrine of good faith as it pertains to actions not expressly contemplated by the underlying financial instruments.
Majority lenders who direct their agent to accept a non-cash bid (new equity or new debt, or both) are well-served to get a good faith finding as part of a bankruptcy order. DW Last Call Onshore, LLC v. Fun Eats and Drinks LLC, No. 17-cv-962, 2018 WL 1470591 (S.D.N.Y. Mar. 23, 2018). That said, credit bids and non-cash bids have become more the norm than the exception. Majority control has shifted beyond credit bids to "uptierings," "drop downs," or other euphemisms for amending credit agreements in ways that may not have been contemplated initially. These so-called "liability management" transactions (a term borrowed from bond deals for exchange offers and exit consents) have resulted in "majority rule" amendments followed by disgruntled minority lawsuits. The outer boundaries of what courts will condone is again being tested, much as had been done in the late 1800s in response to railroad restructurings.
Lawyers (and courts) understandably do not like uncertainty and fuzzy legal doctrines — the four corners of a contract, and all that. But overlaid on every contract is the implied covenant of good faith, just as lawyers have to deal with the nuances of constructive and actual fraudulent conveyance law or the undefined parameters of equitable subordination. Sometimes lawyers and their clients can go too far. Credit Agricole Corporate v. BDC Finance, LLC, No. 651989/10, 2017 WL 375324 (N.Y. Sup. Ct. Jan. 20, 2017). For example, at an industry panel to unveil the new ABA Model Intercreditor Agreement, I quipped that someday second lien lenders might acquire more than 50 percent of the first lien debt and then amend the intercreditor agreement to flip the priorities and turn the first lien debt into second lien debt. Some folks laughed. Some probably wondered if they really could get away with that. Others probably felt a need to hard-wire into their first lien documents an express prohibition against cross-over voting.
The point of this Alert is not to rehash the various strategies being employed among majority lenders (and their borrowers), but to focus on the risk to majority lenders (and their agents) who go too far. Goldberg Kohn represented one of the minority lenders in the NYDJ litigation who asserted, among other counts, claims for breach of the duty of good faith and for actual fraudulent conveyance. See Octagon Credit Inv., LLC v. NYDJ Apparel, LLC, No. 656677/17 (N.Y. Sup. Ct.). At oral argument, New York State Court Judge Ramos said he would have dismissed the complaint if the contract expressly permitted the transaction. But by not allowing the minority to participate in the transaction on the same terms, Judge Ramos refused to dismiss the complaint. He noted that the majority "maybe" had the right to do what it did because it was not expressly excluded, but "the right wasn't granted either. Again, we look at these contracts through a filter of commercial reasonableness and good faith." Id., p. 31. That is precisely the point. No contract is capable of being written in a way that includes all possible workout scenarios, so the doctrine of "good faith" is commonly referred to as a "gap filler." In other words, the duty is implied. After Judge Ramos' ruling from the bench, the majority lenders amended the credit agreement to allow the minority lenders the same opportunity to participate in the amendment, and the litigation was subsequently dismissed.
Years after NYDJ, the court in TriMark dismissed the claim for breach of the covenant of good faith and fair dealing. Audax Credit Opportunities Offshore Ltd. v. TMK Hawk Parent, Corp., 150 N.Y.S. 3d 894 (N.Y. Sup. Ct. 2021). Trimark involved a credit restructuring where the majority lenders exchanged their loans into a priming debt that subordinated the non-participating lenders. The TriMark court summarily dismissed the separate count for breach of good faith as duplicative of the breach of contract claim. Id. New York State Court Judge Cohen concluded, "if Defendants were within their contractual rights to amend the Original Credit Agreement without Plaintiffs' consent, that is the end of the story." The contract had to expressly prohibit the amendment or come close enough to a restriction in order to cloak the amendment with a good faith requirement. This, of course, stands in stark contrast to what Judge Ramos said about good faith in NYDJ.
Recently, New York District Court Judge Failla resuscitated the good faith doctrine. In Serta, she ruled that you could lose a breach of contract claim (i.e., no breach of the express terms of the agreement) while at the same time win a claim for breach of the good faith covenant. LCM XXII Ltd. v. Serta Simmons Bedding, LLC, No. 21-cv-3987, 2022 WL 953109 (S.D.N.Y. Mar. 29, 2022).The question is whether the lenders (and agent and borrower) must act in good faith when amending an existing contract, particularly when treating other lenders differently under the same collective agreement. In Serta, Judge Failla allowed the trial to proceed on the minority theory that "Defendant engaged in furtive negotiations with a select few creditors, manipulated the Agreement to subordinate Plaintiffs' debt without their knowledge, and struck a deal at Plaintiffs expense. Plaintiffs ascribe bad faith to the manner in which Defendant exercised its contractual power to amend the Agreement and engage in debt exchanges because the economic reality of the Transaction suggests an intent to harm a subset of first-lien lenders by subordinating their debt. Indeed, one could reasonably conclude from Plaintiffs' allegations that Defendant systematically combed through the Agreement tweaking every provision that seemingly prevented it from issuing a senior tranche of debt, thereby transforming a previously impermissible transaction into a permissible one." Id., at *15 (internal citations omitted).
Judge Failla could have relied upon venerable Second Circuit precedent, Hackettstown Nat'l Bank v. D.G. Yuengling Brewing Co., 74 F. 110 (2d Cir. 1896). Hackettstown was once a famous case, but has rarely been cited in the modern era.[1] The minority bondholders sued to set aside an amendment that extended the maturity date of the bonds (authorized per the terms of by the bond by a 75 percent vote). The district court held in favor of the majority based on the plan language of the bond and disregarded the facts that: (a) the majority position was accumulated by the brother-in-law of the owner, (b) the owner agreed with only the brother-in-law to guarantee his payment of interest when due and to personally repay the brother-in-law in full with interest at the new maturity, and (c) the owner and debt purchaser conspired to drive down the value of the bonds in the hands of the minority by operation of the amendment. The 2nd Circuit reversed, citing Supreme Court precedent, and remanded for a factual hearing on the good faith (or lack thereof) of the proposed amendment. "[C]ommunity of interest, whether in the case of partners or security holders, creates mutual obligations, and imposes upon all persons occupying that position the duty of acting in the utmost good faith toward the interests of their associates." Hackettstown Nat'l Bank v. D.G. Yuengling Brewing Co., 74 F. 110 (2nd Cir. 1896).
It is difficult if not impossible to reconcile Trimark with NYDJ and Serta. But the New York State Court in another case (ICG Global Loan Fund I DAC v. Boardriders, Inc., No. 655175/20) will be faced with that task, or to choose one approach over the other. Both sides in the Boardriders litigation have sent letters to the Court referring to the Serta decision (with the defendants arguing that it runs counter to Trimark). True, the decision in Serta is new; but the good faith doctrine and its endorsement by the Supreme Court and the Second Circuit is not.[2]
[1] 84 Am. Bankr. L. J. 297, at 305-308.
[2] See generally William W. Bratton and Adam J. Levitin, The New Bond Workouts, 166 U. Pa. L. Rev. 1597 (2018) (citing Hackettstown and suggesting that more courts should scrutinize bond modifications if made in bad faith).
©Randall Klein, principal and co-chair of the Bankruptcy & Creditors' Rights Group at Goldberg Kohn Ltd. Many thanks to paralegal Kristina Bunker for her assistance in preparing this alert.
